2016 Market Update

While the Brexit turmoil in June roiled markets, stocks, bonds, and our portfolio models finished in positive territory for the half-year through June 30. I am happy to provide periodic updates on market performance, but I would be remiss if I did not include my customary remarks that we really should not dwell on short-term performance, let alone mistakenly believe that this type of data should form the basis of our portfolio management or trading decisions.

Looking globally at equities, the iShares All-Country World ETF, ticker ACWI, was up 2.06% through June 30. Our US Large Cap ETF (IWB) tracks the Russell 1000 Index and was up 3.68%. Not surprisingly, international developed stocks were down slightly, with our ETF, VEA, down 1.93%. Strong performances were contributed by Emerging Markets (EEMV), which was up 7.36%, and top honors go to Real Estate Investment Trusts (VNQ) at 13.48%. All considered, not bad, and even the categories which were down – and received a great deal of news coverage – were in fact only down a couple of percent.

We may be starting to see a shift which I have been anticipating for several quarters. Value lagged growth for years, but that seems to be reversing in 2016. Same for Emerging Markets Equities: after years of trailing US stocks, their valuations have become too cheap to ignore and EM outperformed over the past six months. Our process is based on contrarian investing. We overweight the segments which are the cheapest and often, have performed the worst in recent years. “Buy low and sell high” means buying segments that are temporarily out of favor.

While stocks were up in the first half of the year, bonds were actually up more, thanks to interest rates’ steady decline. As fear picked up in the second quarter, investors fled to the safety of bonds, pushing prices up and yields down. As of last Friday, the 10-year US Treasury bond had a yield of 1.37% and the 30-year bond of 2.11%. It is absolutely unbelievable to see US bonds at these levels, except that the yields are even lower in Germany, Japan, and a handful of other developed countries. Through June 30, the US Aggregate Bond ETF (AGG) was up 5.30% and we saw even greater gains in our high yield and emerging markets debt funds.

Looking ahead to the second half of the year, I have modest expectations for stocks. The S&P 500 Index is currently over 2100, and it seems to stall each time we reach this level. I think the market needs to see significantly better than expected earnings to finally catapult the index over 2200. We should be prepared for increased volatility, like we saw in June. I would not hesitate to put money to work on any drops in equities.

If bonds were overvalued six months ago, they have only become more so today. However, that doesn’t guarantee that yields are poised to rip higher this year. There seems to be an increasing belief that these shockingly low yields are not a temporary phenomenon, but a new reality caused by the high debt, slow growth, zero inflation backdrop that seems to be spreading throughout the world. We will continue to emphasize short duration in our fixed income holdings. The quest for yield has become very expensive, and some investors may not realize the potentially high risks that accompany many 3, 4, and 5% yields.

We will not be making any changes to our model portfolios for the second half of 2016. We focus on low-cost index strategies that are diversified, tax efficient, liquid, and transparent. It’s a recipe for success for the patient investor. I am pleased that we are up this year, even if it just in the low single digits.

How America Saves

Defined Contribution (DC) Plans are the backbone of retirement planning in America. Vanguard manages DC plans for 4 million Americans, with over $800 Billion in assets. So, I am always interested to read their annual report, How America Saves, which offers a window into the state of retirement preparation in America.

Link: How America Saves, 2016 Report

Looking through this year’s report, I see both reasons for optimism as well as concern. On the positive side, 78% of eligible employees participated in their company plan. And the average account balance was $96,288. It’s great that a majority of employees are participating.

However, it is surprising to discover the difference between the average and the median. (As a quick refresher, the median is the data point that is exactly in the middle – with half being higher and half being lower than this point.) The difference between the average and the median scores in Vanguard’s report belies a growing chasm between participants who save the minimum and those who save as much as they can.

While the “average” account balance was $96,288 in Vanguard Retirement Plans, the median participant had only $26,405. That means that half of all accounts have under $26,405, and that the average is skewed higher by very large accounts of $300,000, $400,000 and more.

The problem is that many participants are simply not contributing enough. The average deferral rate is 6.8%, but the median again is lower: 5.9%. Disappointingly, the average deferral rate is down from 7.3% in 2007, which means that most people are saving even less than they were 10 years ago.

People really do need to save 10% or more for their retirement. Instead, many invest only 3% or whatever is the default minimum. That’s because many participants only contribute up to the company match. In fact, when I ran a plan for a small company with a dozen employees, all but two only contributed up to the match. When you contribute the minimum over the course of a career, you are not thinking in term of the outcome. Will I have saved enough to fund a comfortable retirement? Am I on the path to financial independence?

However, there are good savers out there. 20% of the participants in a Vanguard plan are saving more than 10% of their salary into their retirement plan. These are the accounts which are bringing up the median of $26,405 to the average of $96,288. And this is what you want to do -you want to be a savings overachiever!

Over time, compounding makes a huge gap between people who contribute the minimum versus those who save more. To examine this, let’s consider two employees: Minimum Mike and Saver Sally. They both have the same salary of $45,000 and earn 3% raises over the next 35 years. Mike contributes 3% to his 401(k) and gets the company match of 3%. Sally contributes 10% and also receives the 3% match. Both earn a return of 7% compounded annually.

Here are their account balances after 35 years:
Minimum Mike: $567,615
Saver Sally: $1,230,417

Saving 10% really does make a big difference over the length of a career. Although the news media would like for you to believe that your financial future hangs by a thread on the outcome of the Brexit, or the Presidential Election, or whatever new crisis is on that day, the reality is that the biggest determinant of your long-term wealth is likely to be the percentage you contribute.

Being average is still a lot better than being median. If you want to be above average, start by increasing your deferral rate.

There is still time to increase your 401(k) or 403(b) contribution for 2016. The maximum contribution is $18,000 for 2016, with an additional catch-up of $6,000 if you are over age 50.

Can You Retire In Your Fifties?

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I recently wrote that most people should plan to work to age 70 before retiring. As a society, embracing 70 as the new full retirement age, would greatly alleviate the forthcoming retirement crisis and reduce the level of poverty in senior citizens. While there are many advantages to waiting until 70, I also see how attractive it would be to retire in your fifties while you are young and healthy.

With enough planning, saving, and advanced preparation you can retire in your fifties. But, retiring at 55 is not the same as retiring at 65. Social Security won’t kick in until 62, and if you read my previous article, you know I suggest waiting until 70. You won’t have Medicare until age 65, so you will need to have your own health insurance coverage, a significant expense which keeps many would-be retirees in the workforce until 65.

I’m going to go through the math of how you might be able to retire in your fifties, and then I’m going to tell you how most fifty-year old retirees actually did it. (Which may disappoint you…)

The “4% rule” suggests that the safe withdrawal rate from a 60/40 portfolio is to start at 4% and subsequently increase your withdrawals for inflation to maintain your standard of living. This research, assumes a 30 year retirement period, such as 65 to 95. If you retire at 50 or 55, it is likely that you or your spouse could live for another 40 or 50 years, especially with continued advances in medical care.

Unfortunately, the 4% rule has a higher failure rate when applied to periods longer than 30 years. That’s because market volatility, especially in the early years of a plan, increases the possibility that an account will be depleted. So, if someone wants to retire in their fifties today, they may need to use an even more conservative withdrawal rate, such as 3%. That way their account will still grow, net of withdrawals, to cope with the inflation that will occur over the next 40 plus years.

Currently, we have record low yields in the bond market, and relatively high valuations (Price/Earnings or P/E ratio) in the stock market. Looking forward, our expected returns should be lower than historical returns. This is another reason why a 4% withdrawal strategy may be too aggressive today for someone who wants to retire in their fifties.

Link: BlackRock CEO says retirement savers should expect returns of as little as 4%.

An alternative to the 4% Rule is the Actuarial Method, which is what the IRS uses for Required Minimum Distributions: you take your current life expectancy and use that as a divisor to determine your withdrawal rate. If you think your life expectancy is 33 years, use 1/33 or approximately 3%.

Then to retire in your 50’s here’s the rule of thumb: at a 3% withdrawal rate, you need your investment assets to equal 33 times your annual withdrawal. For example, if you plan to spend $100,000, you should have at least $3.3 million in your investment portfolio.

This is a pretty high hurdle for most investors. Few people in their 50’s will have accomplished this level of assets, especially if they are still paying mortgages or for their children’s college educations.

The majority of people I know who have actually retired in their fifties have something I have not mentioned: an employer pension. They may have worked for the military, a municipality, school district, or increasingly rarely, a large corporation, and stayed for 25 or 30 years, starting in their twenties. Now in their mid fifties, if they are debt free, it may be possible for them to retire with a pension that pays maybe to 50 to 80 percent of their previous salary. Their taxes will be much lower, so they will actually keep a higher percentage of their pension and there will not be any OASDI or Medicare taxes withheld.

If their pension covers their basic necessities, they can avoid dipping into their portfolio, which can be used for discretionary spending. When the market is up for several years, they can spend a little more on trips or buy a new car. If their portfolio is down, they can hold off on purchases until the market rebounds. And while they may be scrimping by for now, they may get a raise later when they or their spouse become eligible for Social Security. But the key ingredient remains the guaranteed monthly income from their pension.

Most of us will not have a pension, in which case, we will need to be very aggressive savers if we are to end up with a portfolio 33 times the size of our annual withdrawal requirements. If you want to retire in your fifties, I can help you do it. It will take years of planning, so the best time to get started is right away.

Keep Calm and Carry On

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I’m posting today in response to the vote in Britain to leave the European Union, which surprisingly passed 51-49 yesterday. This action has roiled global markets today and I wanted to reach out with some thoughts.

Looking at foreign equities, the Vanguard Developed Markets ETF (ticker: VEA) is down 7% this morning. It is undoubtedly a significant and painful drop. The ETF is recently trading at $34.35 a share. To put this in context, the same shares traded as low as $34.02 on June 16. So all we have done today is give up the past eight days of gains. It is not the devastating loss that news channels would like to have you believe.

I do however anticipate further volatility next week, especially on Monday morning, after more panic sets in over the weekend. As an investor, we accept the reality that corrections of 10% or more are a common occurrence, and in fact, swings of 10% or more occur in a majority of years. In the long run, events like the Brexit are nothing more than noise which unfortunately distracts investors from staying focused their long-term goals.

If you have cash on the sidelines, I’d suggest placing orders to add to a diversified asset allocation in line with your goals and overall risk tolerance. That’s what I’ve been doing this morning: placing limit orders to add to our existing ETF positions for clients who have cash in their portfolios. We have not sold any positions and discourage investors from selling based on today’s news. While the Brexit vote increases uncertainty in Europe, the actual implications for the drivers of investment growth – corporate earnings and balance sheets, economic fundamentals, and credit conditions – remain largely unchanged.

Our investment philosophy is based on the significant evidence of the importance of asset allocation and diversification. While we are strategic in our model portfolios, we can and do adjust the weightings of asset classes in a contrarian manner. We want to buy (or “overweight”) those assets which are the cheapest and typically, have performed the worst recently. If European stocks weakens further, we will actually consider increasing our allocation.

Even without changing our Portfolio Model targets, our discipline is to rebalance portfolios if the categories move more than 10% away from our target weightings. To actually profit from volatility, you have to view events like today as an opportunity. That is easy to do in hindsight, but difficult to do in the present, unless you have a rigorous and systematic approach.

I am happy to report that my phone is not ringing off the hook this morning. Hopefully, the consistent message of the reasons and benefits of sticking with your plan are being heard. If you want to talk about your portfolio, have a question, or just want to catch up, please don’t hesitate to give me a call or send me a note. Otherwise, keep calm and carry on!

P.S. If you aren’t currently a client of Good Life Wealth Management, I’d like to share with you the benefits of having your own financial plan. Investing should be tailored to your needs, which only happens after you have an individual plan! Call me at 214-478-3398 or reply to this email.

Link: The Good Life Financial Planning Process

Do You Know Your Spouse’s Beneficiary Designations?

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Beneficiary designations are important. The people you list on your IRAs, retirement plans, and life insurance policies will receive those monies regardless of the instructions in your will. What happens when you don’t indicate a beneficiary or if the beneficiary has predeceased you? In that case, the estate is named as the beneficiary of the account.

It is usually much better if you have a person indicated as the beneficiary rather than the estate, for the following reasons:

  1. If a person is the beneficiary, they can receive the assets very quickly by completing a distribution form and providing a copy of the death certificate. When the estate is the beneficiary, you may tie up the assets in probate court for months, or even years.
  2. A person can roll an inherited IRA into a Stretch IRA and keep the account tax-deferred. The beneficiary is required to continue taking Required Minimum Distributions, but even doing so, the IRA can last for many years. When a spouse is the beneficiary of an IRA, he or she can roll the assets into their own IRA and treat it as their own. By spreading distributions over many years, taxes may be lower than if you took a large distribution all in one year and are pushed into a higher tax bracket.
  3. When the estate is the beneficiary, they do not have the option for a Stretch IRA. They can either distribute the IRA immediately or over 5 years. Either way, the estate will be paying taxes sooner than if the beneficiary was a person.
  4. The tax rate on estates can be much higher than for individuals. An estate or trust will pay the maximum rate of 39.6% on income over $12,400 whereas a married couple would hit this tax rate only on taxable income that exceeds $466,950 (2016 rates).

For many individuals, a substantial portion of their estate may be in IRAs, retirement plans, life insurance and annuities, where the beneficiary designation is vitally important. In the last two months, the IRS has issued two Private Letter Rulings (PLR) specifically on beneficiary designations and the rights of surviving spouses. A PLR is official guidance from the IRS on how they interpret and enforce tax law, based on specific cases which are brought to the IRS.

In PLR 201618011, a spouse did not indicate any beneficiaries on her IRA. When she passed away, the absence of a beneficiary designation meant that the estate would be the beneficiary of the IRA. The husband was the sole beneficiary and executor of the estate under her will. The IRS ruled that in this scenario, the surviving spouse has the right to rollover the inherited IRA and treat it as his own, even though the decedent failed to designate a beneficiary. This exception is granted only for surviving spouses and does not apply to other beneficiaries, such as children.

On June 3, the IRS issued PLR 201623001, which is of particular interest to Texas residents as it deals with community property issues for married couples. (Texas is one of nine states with Community Property laws.) A man listed his son as the sole beneficiary of his three IRAs. He passed away and his wife claimed that she should be entitled to one-half of the IRA assets because they were community property of the marriage. The IRS ruled that Federal Law takes precedence over state law and rejected her claim.

Both of these rulings show how important it is to know your spouse’s beneficiary designations on all of their accounts. Even if you have a will that is up to date and perfectly legal, it won’t help you if you don’t indicate a beneficiary, or indicate the wrong person. Review your beneficiary designations every couple of years and especially if you have gotten married, divorced, or had births or deaths in your family.

Beneficiary designations are not exciting or complicated. However, a big part of financial planning is getting organized and taking care of these small details. If your beneficiary designations are wrong, it could have a major impact on your heirs and cost thousands in additional, unnecessary taxes.

Should You Get a New Car to Save Gas?

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I applaud frugality and will be the first to tell you that it doesn’t matter how much you make, but how much you spend. Wealth is created by the surplus between those two numbers. So, it would definitely make sense to get a more fuel efficient car, and save money at the gas pump, right? Let’s find out.

Cars are much more fuel efficient today. Electric cars and hybrids are at the forefront of this improvement, but so are diesel engines and small turbo engines. Many car makers now offer a 2.0 liter turbocharged four cylinder engine as their base engine. And this isn’t just for economy cars – the base engine for the BMW 5 series, Mercedes E Class, Jaguar XF, and other midsize luxury cars are all 2.0L turbos.

Coincidence? Not a chance! The world’s largest auto market – six years running – is China, at 23 million vehicles a year. To try to slow the growth of greenhouse gases, China imposes an excise tax on the sale of all cars, based on the size of the engine. At 2.0L, the tax is 5%, but if the car had a 2.1L engine, the tax would be 9%. For an engine over 4 liters, like many V-8s, the tax is 40%. This is a significant incentive for car makers to create small engines that offer more power and improve fuel efficiency.

Given the nice gains in fuel economy for today’s cars, does it make sense to trade in your current vehicle for a less thirsty model? Let’s run the numbers for a couple of different scenarios.

1) According to the US Department of Transportation, the average American driver logs 13,476 miles per year. Let’s consider a significant improvement in fuel economy, from 20 to 30 mpg.

At $2.25 a gallon for gas, the 20 mpg vehicle would consume $1,516.05 in gas per year. The 30 mpg vehicle would require $1,010.70 in fuel, a savings of $505.35. That sounds pretty good! Who wouldn’t like to save over $500 a year?

The problem is how much did it cost to save that $505? If you spent $25,000, it would take you 50 years to make back your “investment” in the new car. The gas savings is a 2% return on your money. In terms of opportunity cost, it seems like a very poor return to spend that money rather than keeping it invested. If you could make just 6% on your $25,000, you’d receive $1,500 in annual gains. With compounding at 6%, your $25,000 would become $50,000 in 12 years, $100,000 in 24 years, and $200,000 in 36 years.

So while it is alluring to “save” $500 a year on gas, you are likely to be better off by keeping your current vehicle and keeping your cash invested. Most people don’t think this way, because they don’t pay cash for their cars. If you start to pay cash for your cars, as I do, it will definitely change your perspective. However, don’t think that just because you take a loan or lease a vehicle that this math doesn’t apply to you. Instead of having an opportunity cost on your cash, you are paying interest on a loan or a lease. Either way, there is a decrease in the future value of your wealth, and whether we look at opportunity cost or interest expense, the decrease in wealth is going to be larger than just the $25,000 price tag on the car.

People are not logical about their car purchases. Cars may be a necessity for most of us, but they are a poor use of money. Most vehicles lose 50% of their value in the first five years. People decide they want a new car and then create a rationalization as to why they “need” it. It’s okay to buy nice stuff you want, especially if you have met your savings and investing goals. But let’s not fool ourselves into thinking that spending $25,000 on a new car is a way to “save money”.

Let’s consider a more extreme example of high mpg, using actual car models:
2) What if you drive a lot of miles, say 20,000 highway miles per year. And let’s say you are thinking about trading in your 2011 Toyota Camry for a hybrid, a 2016 Toyota Prius.

The Prius is estimated to get 50 mpg on the highway, versus 33 for the 2011 Camry. At $2.25 for gas, the cost savings is only $463.64 a year. Surprised it isn’t more? Our intuition fools us here – even though the difference in fuel economy is 17 mpg and we are driving more miles than in example #1, the actual cost saving is less. The difference in fuel consumption in this example is 206 gallons: 606 gallons for the Camry versus 400 gallons for the new Prius.

For a base 2011 Camry in clean condition and 100,000 miles (20,000 per year for 5 years), your trade in value would be only $5,744 according to Edmunds.com. For the 2016 base Prius, the MSRP is $25,095. Is it worth spending $19,351 (plus tax) to save $463 a year? No, it is not!

My recommendation: if you are genuinely interested in maximizing the utility of your hard earned dollars, drive your current car into the ground. If you have a 2011 Toyota with 100,000 miles, you’ve already experienced most of the car’s depreciation. Try to keep it for another 100,000 miles. Keeping one car for 200,000 miles will save you a ton of money versus having two cars for 100,000 miles, or worse, four cars for their first 50,000 miles.

The fuel economy question is a distraction. Looking at the total cost of a new vehicle, depreciation is your largest expense. Don’t get a new car to try to save money at the pump. Get a new car – or better yet a used car – when your current car is all used up. When it is time to get your next vehicle, by all means, consider fuel economy along with the other costs of ownership. Until you have to get another vehicle, it is likely going to be more cost effective to stick with your current car, even if it means spending more money at the pump.

Is This Amazing Technology A Danger To Your Career?

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Last October, electric car maker Tesla introduced self-driving features into its cars overnight, with a software update installed via wifi. In January, General Motors invested $500 million into car-service Lyft with plans to begin testing driver-less car services for actual customers in one year. Google, Apple, Ford, Toyota and others are racing to produce self-driving cars and we are very, very close to seeing this incredible technology become a reality. Could your next car be an Apple iCar?

Technological change is nothing new, but we may be on the verge of seeing the rate of change increase dramatically, with significant implications for individuals and the economy as a whole. Some of these changes are fairly easy to predict, but there will be secondary and tertiary impacts which will be much more difficult to imagine. And while the changes will be net positive for society, cost savings often come about when jobs which are no long necessary become eliminated.

Self-driving cars will be much safer, virtually eliminating accidents from distracted driving, driver error, fatigue, or drunk driving. Driver-less trucks and taxis will gradually replace drivers, reducing transportation costs. Families will no longer need two, three, or four cars, and many will forgo car ownership altogether, being able to summon a vehicle for the relatively few minutes a day they require transportation. Your newborn child or grandchild may never even have a driver’s license!

Speeding tickets and traffic infractions will decline, creating budget gaps for cities who previously enjoyed significant revenue. Warren Buffett called self-driving cars a “real threat to insurers” like GEICO, which derive substantial revenue from car insurance. As insurance premiums fall for safer driver-less cars, you can expect that premiums for the remaining human drivers will skyrocket as they will quickly become the high risk vehicles on the road.

There are so many positives about driver-less cars that will make our lives better. However, if you are a truck driver, own an auto body shop, work for an insurance company or emergency room, you should expect less demand for your services, reduced revenue, and loss of jobs across your industry. For those individuals, the driver-less car will have the same effect as Henry Ford’s Model T had on carriage makers and buggy whip manufacturers a hundred years ago.

Innovation is great for society and the economy, but can come at a high cost for those individuals who get left behind. Last month, I wrote about the benefits of working until age 70. The greatest challenge for many people will not be their ability or willingness to work until 70, but just keeping their job for that long.

Last year, I met an individual who lost his job of 30 years at age 57 when his employer closed. He wanted to keep working and was not prepared, financially or emotionally, for retirement. However, his skill set was decades out of date. He wanted to hold out for his old salary and was unwilling to relocate or consider jobs that were not near. He looked for a job for three years before officially declaring himself retired at age 60. Now, he has no choice but to start Social Security at age 62 and lock-in a greatly reduced benefit. His retirement will be quite tight, which wouldn’t have been the case had he been able to work and save for another 8-10 years as he had originally planned.

To work to age 70, most folks will have several different careers and will need to continually educate themselves and possibly even retrain entirely if their profession is going to be impacted by innovations such as the driver-less car. Education will become life-long, instead of something which is completed and left behind in your early twenties. There is no doubt that it is a challenge to be a job seeker in your 50’s or 60’s, which is why the best thing for those at risk of job loss is to keep your skills and certifications fresh and to change jobs before you find yourself unemployed.

The two most valuable companies in the world today are Apple and Google, each with a valuation of roughly $500 Billion. That shows the remarkable economic opportunity behind innovation. And Google created that value in less than 18 years! As investors, it’s easy to recognize the growth achieved from new technology. For the sake of your individual financial plan, however, you first need to make sure that you will have an income to save and invest! Consider what are the risks to your career before those risks become a reality.

The Saver’s Tax Credit

Since most employers today no longer provide defined benefit pension plans for their employees, the burden of retirement saving has shifted to the employee. Not surprisingly, saving for retirement is a pretty low priority for the many Americans who are focused on how they are going to pay this month’s bills.

Taxes and Retirement

New retirees are often surprised that even though they may have stopped working, they are still paying quite a bit in income taxes each year. For those who are getting close to retirement, it’s important to know how your various sources of income will be taxed once you are retired.

Avoiding Capital Gains in Real Estate

I’ve gotten a number of questions about Capital Gains and Real Estate recently, so I thought it was time for a post. While many home sellers do not have to pay any tax on the sale of their home, for others, capital gains taxes can be significant, even hundreds of thousands of dollars. Here are five ways to reduce capital gains when you sell real estate.