2016 Contribution Limits and Medicare Information

Posted On December 7, 2015 By Admin In Retirement Planning /

Inflation was almost non-existent in 2015 due to falling commodity prices. This means that for 2016, most of the IRS contribution limits to retirement accounts are unchanged. Zero inflation creates some unique problems for Social Security and Medicare beneficiaries, which we will explain.

If you are automatically contributing the maximum to your retirement plan, good for you! You need not make any changes for 2016. If your contributions are less than the amounts below, consider increasing your deposits in the new year.

2016 Contribution Limits
Roth and/or Traditional IRA: $5,500 ($6,500 if age 50 or over)
401(k), 403(b), 457: $18,000 ($24,000 if age 50 or over)
SIMPLE IRA: $12,500 ($15,500 if age 50 or over)
SEP IRA: 25% of eligible compensation, up to $53,000
Gift tax annual exclusion: $14,000 per person

Tax brackets and income phaseouts increase slightly for 2016, but there are no material changes. People are still getting used to the new Medicare surtaxes, which include a 3.8% tax on net investment income (unearned income), and a 0.9% tax on wages (earned income). The surtax is applied on income above $200,000 (single), or $250,000 (married filing jointly).

Capital gains tax remains at 15%, with two exceptions. Taxpayers in the 10% and 15% tax brackets pay 0% capital gains, and taxpayers in the 39.6% bracket pay a higher capital gains rate of 20%. For 2016, you will be in the 0% capital gains rate if your taxable income is below $37,650 (single) or $75,330 (married).

For Social Security recipients, the Cost of Living Adjustment (COLA) for 2016 is 0%. We previously had a 0% COLA in 2010 and 2011, and it creates an interesting situation for Medicare participants. Medicare Part A is offered free to beneficiaries over age 65. Medicare Part B requires a monthly premium.

Part B premiums should be going up in 2016, but about 75% of Part B participants will see no change, thanks to Social Security’s “Hold Harmless” provisions. The “Hold Harmless” rule stipulates that if Medicare Part B costs increase faster than Social Security COLAs, beneficiaries will not have their SS benefits decline from the previous year. And since there is no COLA for 2016, any Medicare Part B premium increase would cause SS benefits to negative.

For the past three years, Part B premiums have remained at $104.90 per month. You are eligible for no increase under the “Hold Harmless” rule, if you are having your Part B payments deducted from your Social Security benefit AND you are not subject to increased Medicare premiums under the Income Related Monthly Adjustment Amount (IRMAA).

For most Part B recipients, Medicare premiums are fixed. For higher income participants, IRMAA increases your premium, as follows for 2016:

MAGI $85,000 (single), $170,000 (married): $170.50
MAGI $107,000 (single), $214,000 (married): $243.60
MAGI $160,000 (single), $320,000 (married): $316.70
MAGI $214,000 (single), $428,000 (married): $389.80

If you fall into one of these income categories, above $85,000 (single) or $170,000 (married), you are ineligible for the “Hold Harmless” rule and will have to pay the premiums above, even if this causes your Social Security benefit to decline from 2015.

If you are delaying your Social Security benefits and pay your Part B premiums directly, you are also ineligible for the “Hold Harmless” rule. Finally, if you did not participate in Social Security, for example, teachers in Texas, you would also not be eligible for the “Hold Harmless” rule.

The Benefits of an Older Car

Posted On November 30, 2015 By Admin In Behavioral Finance /

The average car on the road today is 11.5 years old today, according to USA Today. Today’s cars are more dependable and long-lasting than ever and yet for many consumers, transportation remains their second largest expense after their home.

Last November, I purchased a used car, and not the typical 2-3 year old gently used vehicle, but a 2002 Toyota 4Runner with 179,097 miles. I wanted a larger vehicle to transport my three big dogs and wanted something I wouldn’t worry about getting muddy or scratched.

Admittedly, I have been leery of older cars. What if they break down? The last thing anyone wants is to have unexpected large expenses trying to keep a dying vehicle on the road. And I especially do not want to have an unreliable or unsafe vehicle when it is 102 degrees in July or 20 degrees in January.

Well, I’ve lived with my old car for a year now and will give you a full report, including a breakdown of all my costs. I drove the car almost every day and put just over 11,000 miles on this year (the photo is my current odometer reading: 190,182 miles). During that time, it has been 100% reliable (knock on wood…). The car has always started and worked perfectly. I have had zero breakdowns and no unplanned maintenance.

As a student of behavioral finance, I think people’s car buying choices are interesting to study. Most of us buy what we want, but then create a rationalization that sounds good for why we “need” a new car. Oftentimes, it’s really about projecting an image of success or trying to fit in with others in the office, neighborhood, or group of friends.

Many people prefer a new car, under warranty, to avoid the unpleasantness of having to pay for car repairs. This is known as “loss aversion”, which means that the pain of a $500 loss is much more intense and memorable than the satisfaction of a $500 gain.

Getting a new car every three years may cost $400 or $500 a month regardless of whether you lease, finance, or pay cash. With an older car, your depreciation can be very small, and instead your main expense is typically maintenance. You may end up spending $800 twice a year in repairs and upkeep. That sounds terrible, but which costs more: $400 a month, or $800 twice a year?

Having a used car may leave you on the hook for unplanned repairs, but the chances are good that those repairs will be a small fraction of the ongoing cost of getting a new car every three years. It’s loss aversion that makes $1,600 a year in unplanned repairs feel much worse than the fact that you might save $400 a month ($4,800 a year) by not having a car payment.

I paid $4,500 for my Toyota, and had to pay $316.75 in sales tax and registration fees. My biggest expense for the year was for a set of four new tires, $744.84. I did all the work on the car myself, including three oil changes, replacing the rusty radiator, hoses, and thermostat. I changed the fluids, including brake, transmission, power steering, and differential oil. I installed a new air filter, PCV Valve, and wipers, and cleaned the intake twice. In total, I spent $521.23 on maintenance, which was quite low since I did the work myself.

According to Kelly Blue Book, the current value of my vehicle is $4,044, so my estimated depreciation for the year was $456. Including depreciation, my cost for the year was $2038, which works out to 18.4 cents per mile (not including fuel). My insurance cost was much lower with this car; I kept the same high level of liability coverage as my other vehicles, but dropped collision. The annual insurance premium was $510.40, less than half the cost of our other vehicles.

What are the takeaways from this experience? A couple of thoughts:

A well-maintained vehicle can certainly last 150,000 miles or more. Your best choice is always to keep your current vehicle for as long as possible and remember that even if you spend a couple of thousand on repairs per year, that is a small amount compared to the costs of depreciation associated with the first 5 years of a new cars’ life.
Buying a used car is always going to be a bit of a gamble. Do your homework and choose a vehicle known for its dependability and ease of repair. Keep up with routine maintenance, using the manufacturer’s recommended schedule. Get to know a trustworthy independent mechanic.
I know that keeping a car for 10 years is a great idea, but for me, I just get bored with a vehicle after a couple of years and want something different. Knowing this preference, I can buy a used car every couple of years and not have the staggering depreciation costs of new vehicles.
It’s okay to spend money on cars, but if you think that retirement, paying down debt, saving for college, or growing your net worth are more important, than you need to make sure to prioritize those goals ahead of new cars. Every financial planner has met lots of people who have a new Mercedes but who “can’t afford” to contribute $5,000 a year into an IRA. Make sure your spending reflects your values and goals, and is not based on what you want others to think.

Why You Should Harvest Losses Annually

Posted On November 23, 2015 By Admin In Portfolio Management /

This time each year, I review every client’s taxable accounts in search of losses to harvest for tax purposes. While no one likes to have a loss, the reality is that investments fluctuate and have down periods, even if the long-term trend is up. I’ll be contacting each client in the next two weeks and will let you know if I suggest any trades.

Even though we may make some sales, we still want to maintain our overall target asset allocation. Under US tax rules, we cannot buy a “substantially identical security” within 30 days in order to claim a tax loss. This precludes us from taking a loss and immediately buying back the same ETF or mutual fund. It does not however, prevent us from selling one large cap ETF and buying a different ETF that tracks another large cap index or strategy. This means that we can harvest the loss without being out of the market for 30 days and missing any potential gains during that time.

When we harvest losses, we can use those losses to offset any gains we have received and reduce our taxes in the current year. The criticism against tax loss harvesting is that it just serves to postpone taxes rather than actually saving taxes.

For example, let’s say that we purchased 10,000 shares of an ETF for $10 per share and today those shares are only worth $9.00. Our cost basis is $100,000 and if we sold today for $90,000 we could harvest a loss of $10,000. We replace that position with a different ETF and invest our $90,000. Fast forward a couple of years and the position is now worth $120,000. If we sell for $120,000, we would have a $30,000 gain, whereas if we had not done the earlier trades, our gain would be only $20,000. Apply a long-term capital gains rate of 15% and the savings of $1,500 in taxes this year is offset by $1,500 in additional taxes down the road.

So, why bother? There is an additional benefit to tax loss harvesting besides deferring taxes for later: you may be able to use those losses to offset short-term capital gains or ordinary income, which can be at a much higher tax rate than the 15% long-term capital gains rate.

The rules for capital gains are that you first net short-term gains and short-term losses against each other. Separately, you will net long-term gains and long-term losses. If you have net losses in either category, those losses may be subtracted from gains in the other category. So if you had $10,000 in net long-term losses, you could apply those losses against $10,000 of short-term capital gains. For someone in the 35% tax bracket, that $10,000 long-term loss could be worth $3,500, if you can apply that loss towards short-term gains, instead of the $1,500 we would normally associate with a long-term loss.

If you have more capital losses than gains in a year, you can apply $3,000 of those losses against ordinary income, and carry forward the remaining losses into future years indefinitely, until they are used up. If we can use our $3,000 loss against ordinary income, a taxpayer in the 35% bracket will save $1,050 in taxes, which is a lot better than the $450 we would save in long-term capital gains if we did not harvest the $3,000 loss.

After deferring gains for many years, taxpayers may be able to avoid realizing gains altogether two ways. First, if you have charitable goals, you can give appreciated securities to a charity instead of cash. If you give $1,000 worth of funds to a charity, the charity receives the full $1,000; you get a full tax deduction AND you avoid paying capital gains on those shares.

The second way to avoid capital gains is if you allow your heirs to inherit your shares. They will receive a step-up in cost basis and no one will owe capital gains tax. That’s a rather extreme way to avoid paying 15% in capital gains taxes, and most people are going to need their investments for retirement. However, the fact is that delaying taxes can be beneficial and that the tax is not always inevitable.

The reason I share this is that the argument that tax loss harvesting only serves to delay taxes ignores quite a few benefits that you can realize. You may be able to use those capital losses not just to offset capital gains at 15%, but potentially to offset short-term gains at a much higher rate, or to offset $3,000 a year of ordinary income.

Since we primarily use ETFs, we already have a great deal more tax efficiency than mutual funds, and we should have little capital gains distributions for 2015. If you’re not with GLWM and have mutual funds in a taxable account, be aware that many mutual funds have announced capital gains distributions for the end of this year.

There are quite a few ways we aim to add value for our clients and we take special interest in portfolio tax optimization. If there’s a way to help you save money in taxes, that’s going to help you meet your financial goals faster.

Tax Comparison of 15 and 30 Year Mortgages

Posted On November 16, 2015 By Admin In Financial Planning / 1 Comment

I received a tremendous response from readers about last week’s article comparing 15 and 30 year mortgages (read it here). A number of readers astutely asked how the mortgage interest tax deduction would impact the decision of choosing between the 15 and 30 year note. Here is your answer!

For our example, we are looking at buying a $250,000 home, putting 20% down and assuming a mortgage of $200,000. At today’s interest rates, we’d be choosing between a 15 year mortgage at 3.00% or a 30-year at 3.75%. Here are the monthly payments, not including insurance or property taxes.

15 Year Mortgage @ 3.00%	30 Year Mortgage @ 3.75%
payment $1381.16	payment $926.23
	difference = $454.93

Over the full term of the mortgages, you will pay the following amounts of principal and interest:

15 Year Mortgage @ 3.00%	30 Year Mortgage @ 3.75%
principal $200,000.00	principal $200,000.00
interest $48,609.39	interest $133,443.23
total payments $248,609.39	total payments $333,443.23

You will pay a significantly higher amount of interest over the life of a 30 year mortgage. The interest payment of $133,443.23 increases your total payments by 67% over the amount you have borrowed. And that’s at today’s rock bottom mortgage rates! I should point out that above 5.325%, the interest portion on a 30 year mortgage exceeds the original principal. In other words, the interest would double your cost from $200,000 to $400,000.

You can deduct the mortgage interest expense from your taxes, but the amount of the benefit you will receive depends on your marginal federal income tax rate. Here is the value of the tax benefit for six tax brackets.

15 Year Mortgage @ 3.00%	30 Year Mortgage @ 3.75%
interest $48,609.39	interest $133,443.23
15%: $7,291.41	15%: $20,016.48
25%: $12,152.35	25%: $33,360.81
28%: $13,610.63	28%: $37,364.10
33%: $16,041.10	33%: $44,036.27
35%: $17,013.29	35%: $46,705.13
39.6% $19.249.32	39.6%: $52,843.52

Obviously, the 30 year mortgage provides much higher tax deductions, although they are spread over twice as long as the 15 year mortgage. If we subtract the tax savings from the total payments of the mortgage, we end up with the following costs per tax bracket.

Total Cost, after the tax savings

15 Year Mortgage @ 3.00%	30 Year Mortgage @ 3.75%
15%: $241,317.98	15%: $313,426.75
25%: $236,457.04	25%: $300,082.42
28%: $234,998.76	28%: $296,079.13
33%: $232,568.29	33%: $289,406.96
35%: $231,596.10	35%: $286,738.10
39.6%: $229,360.07	39.6%: $280,599.71

It should not be a surprise that even though the 30-year mortgage provides higher tax deductions, that it is still more expensive than a 15-year mortgage, even when we consider it on an after-tax basis.

For most Americans, the actual tax benefit they will receive is much, much less than described above. That’s because in order to deduct mortgage interest, taxpayers have to itemize their tax return and forgo the standard deduction. As a reminder, itemized deductions also include state and local taxes, casualty, theft, and gambling losses, health expenses over 10% of AGI, and charitable contributions.

For 2015, the standard deduction is $6,300 for single taxpayers and $12,600 for married couples filing jointly. So, if you are a married couple and your itemized deductions total $13,000, you’re actually only receiving $400 more in deductions than if you had no mortgage at all and claimed the standard deduction. And of course, if your itemized deductions fall below $12,600, you would take the standard deduction and you would not be getting any tax savings from the mortgage whatsoever.

While the mortgage interest deduction is very popular with the public, economists dislike the policy because it is a regressive tax benefit. It largely helps those with a big mortgage and a high income. For many middle class taxpayers, the tax benefits of mortgage interest is a red herring. With our example of 3.75% on a $200,000 mortgage, even in the first year, the interest is only $7,437. That’s well under the standard deduction of $12,600 for a married couple, and the interest expense will drop in each subsequent year.

Compare that to someone who takes out a $1 million mortgage: their first year interest deduction would be $37,186 on a 30 year note. Simply looking at the amount of the mortgage interest will not determine how much tax savings you will actually reap, without looking at your other deductions, and comparing these amounts to the standard deduction.

Even if you are one of those high earners with a substantial mortgage, you have another problem: your itemized deductions can be reduced under the so-called “Pease limitations”. These limitations were reintroduced in 2013. For 2015, itemized deductions are phased out for tax payers making over $258,250 (single) or $309,900 (married).

Bottom line: If your mortgage is modest, your interest deduction may not be more than your standard deduction. And if you are a high earner, you are likely to have your deductions reduced. All of which means that the tax benefit of real estate is being highly overvalued by most calculations. There is a substantial floor and ceiling on the mortgage interest deduction and it provides no benefit for taxpayers who are below or above those thresholds.

Ceiling: Pease limits on tax payers making over $258,250 (single) or $309,900 (married).
Middle: receive a tax benefit between these two levels.
Floor: no benefit on deductions below the standard deduction of $6,300 (single) or $12,600 (married).

The 15 Year Mortgage: Myth and Reality

Posted On November 9, 2015 By Admin In Financial Planning /

Everyone seems to be talking about Real Estate again. This month, I sat with three friends, and remarkably, all three were looking at moving and buying a new house. Real Estate is hot right now in Dallas, and almost everywhere else, too. The losses from 2009 have been erased and prices are making new highs. Even if you aren’t looking to move, chances are good that your property tax assessment has moved up significantly in the past two years.

Major corporate offices are being built in North Dallas, bringing tens of thousands of jobs to the area. And those relatively well-paid corporate employees are going to want to live in close commuting distance to work. Home owners have equity in their property, and interest rates, which have remained low, are expected to start creeping up. Many feel like right now is the perfect time to move up to their dream house. It has been a seller’s market, with many houses being sold quickly and often meeting or exceeding asking prices.

Anyone who has read this blog or my book, knows that I recommend home buyers consider a 15 year rather than a 30 year mortgage. Let’s go through those numbers in detail and consider the myths and reality of your mortgage decision.

For our example, let’s assume you are buying a $250,000 house and putting 20%, or $50,000, down. You will finance $200,000 through a mortgage.

At an average current rate of 3%, your monthly payment on a 15 year mortgage (not including taxes or insurance) is $1381.16. The 30 year mortgage will cost you approximately 3.75%, but your monthly payment will be only $926.23.

15 Year Mortgage @ 3.00%	30 Year Mortgage @ 3.75%
payment $1381.16	payment $926.23
	difference = $454.93

A lot of people will look at the 30 year mortgage and will say that it “saves” them $454.93 a month. Let’s break that down. On the 15 year mortgage, your first payment consists of $500 interest and $881.16 in principal. On the 30 year note, the first payment includes $625 in interest while only $301.23 is applied towards interest. Most of your payment on the 15 year note is going towards principal, building your equity, where as most of the 30 year payment goes towards interest. So, even though the 15 year note costs $454.93 more, in the first month, it applies $579.93 more towards your principal.

15 Year Mortgage	30 Year Mortgage
payment $1381.16	payment $926.23
principal $881.16	principal $301.23
difference = $579.93

After making 10 years of payments, your remaining balance on the 15 year note would be $76,864.99 and you will have paid $42,604.59 in total interest. On the 30 year, $200,000 mortgage, your balance after 10 years is still $156,223.55, and you will have paid $67,371.29 in total interest. At this point, the person who chose the 15 year note has paid off most of their loan and has the end in sight.

15 Year Mortgage @ 10 years	30 Year Mortgage @ 10 years
Balance $76,864.99	Balance $156,223.55
Interest Paid $42,604.59	Interest Paid $67,371.29

Assuming your home value increases a modest 1% a year, here’s a look at how your home equity would compare after 10 years under both mortgages.

15 Year Mortgage @ 10 years	30 Year Mortgage @ 10 years
Home Value $276,156	Home Value $276,156
Balance $76,865	Balance $156,224
Equity $199,291	Equity $119,932
Difference = $79,359

The nearly $80,000 difference in equity after 10 years shows how the 15 year mortgage is a really another way of “forced savings”. You would have equity to buy another house if you should want or need to move. Or if you’d like to retire, a 15 year mortgage may enable you to have no house payment when you reach retirement age.

So far this is pretty simple. But you may be wondering, what if I were to choose the 30 year mortgage and invest the difference of $454.93 per month? If you did this for 10 years, and earned 7%, you would have an investment account with $78,740. That’s almost the same as the difference in equity in the chart above.

Let’s take this further and assume that you invest the $454.93 for the full 30 years. How would this compare to paying the 15 year mortgage and then investing $1381.16 for the following 15 years?

15 Year Mortgage

30 Year Mortgage

Pay mortgage for 15 years, then invest $1381.16

for the next 15 years, at 7%

Invest the difference of $454.93 for 30 years, at 7%

Investment Value $437,760

Investment Value $554,959

This shows that choosing the 30 year mortgage and investing the difference versus a 15 year mortgage could generate a better outcome over 30 years. So then why would I suggest that home buyers choose the 15 year product instead? Here are two reasons:

1) If you go to a bank, mortgage broker, or realtor and say that you can afford a $1381 per month payment, they are not likely to help you decide between a 15 or 30 year mortgage. Rather, they will assume you will choose the 30 year note and then tell you how much house you can “afford”.

Instead of looking at the $250,000 house in our example, you could afford a $370,000 house with a 30 year note. And you will not be investing the $454 per month difference as in the theoretical example. With the more expensive house comes more expensive costs, including taxes, insurance, utilities, and maintenance.

People who become wealthy look at their housing as a cost, not as an investment. While you can afford a more expensive house under a 30 year mortgage, that doesn’t mean that it is in your best interest to do so, if you have other financial goals such as retirement.

It is vitally important to remember that there is a conflict of interest throughout most the real estate industry. People who are paid commissions have an incentive to put you in the most expensive house and mortgage that the bank will allow them to sell. They do not get paid to help you retire, save in your 401(k), or send your kids to college. It’s remarkable to me that six years after the sub-prime crisis that there has been so little change to the fundamental conflicts of interest in the real estate industry.

2) I don’t know very many people who actually have the discipline to invest the $454.93 a month they would “save” with a 30 year mortgage. More likely, they will increase their other discretionary spending (cars, vacations, furnishings, etc.) that accompany “keeping up with the Joneses” in a nice neighborhood.

The only way someone would be able to make it work would be automate the process and establish a recurring monthly deposit of $454 into a mutual fund or IRA. By the way, the 30 year example above only showed a good outcome because I assumed the investment was made into stocks and earn 7% for 30 years. If you put that money in cash and only earn 3%, the 15 year mortgage produces the superior outcome. The 30 year mortgage only produces a better outcome if you can greatly exceed the cost of borrowing (3.75% in our example). Here’s what it looks like if returns are only 3% over 30 years:

15 Year Mortgage

30 Year Mortgage

Pay mortgage for 15 years, then invest $1381.16

for the next 15 years, at 3%

Invest the difference of $454.93 for 30 years, at 3%

Investment Value $313,486

Investment Value $265,105

My fear of the 30 year mortgage is that it is not used by consumers or real estate professionals to maximize saving and growth investing. If it was, it would be a good tool for increasing your net worth. Rather it is used to maximize the amount of home you can purchase today.

For professions where career income is expected to rise only at the rate of inflation (such as teachers and musicians), your income is not going to increase fast enough to enable future saving when you take on a jumbo-sized mortgage. The result is that all your disposable income will go towards the house, with very little towards retirement, saving, or investment.

If today’s real estate market has you excited, be careful. It’s great that your home value has shot up 20% or more in the past couple of years. That makes it a great time to downsize, but actually an expensive time to buy a bigger house. We are lucky in Dallas that Real Estate prices have remained affordable; in many cities on the coasts, home buyers have no choice but to use the 30 year mortgage because prices are so high. If you start with the 15 year mortgage in mind when you are considering how much house you can afford, it can help you increase your net worth faster.

What Should You Expect from Social Security?

Posted On November 2, 2015 By Admin In Retirement Planning /

The big surprise this week was that the new budget approved by Congress and signed by President Obama on Monday abolishes two popular Social Security strategies for married couples. The two strategies that are going away are:

1) File and Suspend. A spouse could file his or her application but immediately suspend receiving any benefits. This would enable the other spouse to be eligible for a spousal benefit, while the first spouse could continue to delay benefits to receive deferred retirement credits until age 70.

2) Restricted Application. Also called the “claim now, claim more later” strategy, this would allow a spouse to restrict their application to just their spousal benefit at age 66, while continuing to defer and grow their own benefit until age 70.

Both of these strategies were ways for married couples to access a smaller spousal benefit, while still deferring their primary benefits until age 70 for maximum growth. And now, these strategies will be gone in 6 months from today. It was estimated that these strategies could provide as much as $50,000 in additional benefits for married couples. Needless to say, people close to retirement who were planning on implementing these strategies feel disappointed and upset.

Some Baby Boomers have done a lousy job of saving for retirement and are going to be heavily reliant on Social Security. According to Fidelity Investments, the average 401(k) balance as of June 30 was $91,100 and their average IRA balance is $96,300. If an investor had both an average IRA and 401(k), they’d still have only $187,400. But those figures don’t tell the true depth of the problem facing our nation, because those “average balances” don’t count the 34% of all employees who have zero saved for retirement. For many retirees, savings or investments are not going to be a significant source of retirement income.

Looking at current beneficiaries, the Social Security Administration notes that 53% of married couples and 74% of single individuals receive at least 50% of their income from Social Security. For 47% of single beneficiaries, Social Security is at least 90% of their retirement income! As of June 2015, the average monthly benefit is only $1,335, so that should give you some idea of how little income many retirees have today.

Our country simply cannot afford to let Social Security fail, and yet the current approach is unsustainable. People think that Social Security is a pension or savings program, but it is not. It is an entitlement program where current taxes go to current beneficiaries. Back in the years when the ratio of contributors to retirees was 5 to 1, there was a surplus of taxes which was saved in the Social Security Trust Fund. Currently, there are only 2.8 workers per beneficiary and since 2010 Social Security benefits paid out have exceeded annual revenue into the program. By 2035, there will be only 2.1 workers per beneficiary, and this demographic change is the primary reason the system cannot work in its current form.

Today’s estimate is that the Trust Fund will be depleted by 2034. The Disability Trust Fund will be depleted next year, in 2016, at which time funds will have to shifted within Social Security to pay for Disability benefits not covered by payroll taxes.

The 2015 Trustees Report calculates that to fix Social Security for the next 75 years, the actuarial deficit is 2.68% of taxable payroll. This represents an unfunded obligation with a present value of $10.7 Trillion. Every year, the Trustee’s Report tells Congress the size of the shortfall, so Congress can take steps to either reduce benefits or raise taxes to correct the problem.

Unfortunately, changing Social Security has become a “hot potato” which no politician wants to touch. For those who have been brave enough to propose a solution, they are attacked with one-liner sound bites, accusing them of “trying to take away your Social Security benefits.” It is so disappointing that our elected officials cannot come together on a solution to ensure the solvency of our primary source of national retirement income.

It was surprising that the two Social Security claiming strategies were abolished so quickly and with such little opposition or discussion. This will save Social Security a small amount, but it’s doubtful this will make any material improvement in the program’s long-term viability.

For workers close to retirement, it seems unlikely that there will be any significant changes to the Social Security system as we know it today. The best thing you can do is to delay benefits from age 62 to age 70, which will result in a 76% increase in benefits. If you live a long time (to your late 80’s or longer), you will end up receiving greater lifetime benefits for having waited, and the guaranteed income from Social Security will decrease the “longevity risk” that you will deplete your portfolio over time.

For younger workers, I think it is highly probable that we will see the Full Retirement Age increase or a change in how the Cost of Living Adjustments are calculated. For high earners, I believe that you will see the current income cap of $118,500 increase significantly or be removed altogether. Another proposal is to apply a Social Security tax to unearned income, such as dividends and capital gains, to prevent business owners from shifting income away from wages in order to avoid taxes.

I think the strongest approach for investors will be to save aggressively so that your nest egg can be the primary source of your retirement income. Then you can consider any Social Security benefits as a bonus.

How a Benchmark Can Reduce Home Bias

Posted On October 26, 2015 By Admin In Portfolio Management / 2 Comments

Home Bias is the tendency for investors to prefer, and greatly overweight, the stocks of their local, domestic companies to the detriment of their portfolio’s performance. If you lived in Sweden, where local equities comprise only 1% or so of the world’s equity markets, and still had most of your money in “domestic” stocks, you’d obviously be missing out on a great deal of opportunities and diversification.

From our vantage point here in the United States, the local Swedish investor is likely losing out by only investing locally. As obvious as that example appears to us, many US investors do the same thing. Today, US stocks comprise only half of the value of equities worldwide and represent only 25% of the total number of stocks. Both figures are likely to drop significantly in the decades ahead as foreign populations, economies, and stock markets grow at a pace much faster than here in America.

50 years ago, or even 25 years ago, it was difficult to invest in international equities, so investors stuck with local stocks out of necessity. Today it is as easy to invest in foreign stocks or bonds as it is to invest in domestic securities, and yet many investors still have little or no weighting in foreign holdings in their portfolios.

By allowing their Home Bias to persist, investors miss out on the benefits of diversification. Fidelity published a study this August, looking at US versus Foreign stock performance from 1950 through 2014. Over this period, US stocks had an annualized return of 11.3%, slightly ahead of the foreign stock return of 10.9%. Since foreign stocks lagged US stocks, you might think that adding them to a portfolio would make your return worse. Remarkably, that isn’t the case: a portfolio of 70% US / 30% Foreign equities produced a return of 11.4% over this period.

Adding foreign stocks improved returns because of diversification and rebalancing – when US stocks are down, foreign stocks may be up, or vice versa. In addition to increasing returns, the 70/30 mix also reduced volatility (standard deviation) from 14.4% to 13.1%. The Fidelity study is a great example of how diversification can help investors improve returns and lower risk at the same time. People who think that foreign stocks are riskier than US stocks aren’t looking at the bigger picture of what happens when you combine both types of stocks into one portfolio.

In recent years, US Stocks have performed well and as a result, carry a higher valuation today than Developed Market or Emerging Market stocks. If you are concerned about shifting some of your US funds to an international fund that has a worse 5-year track record, you may be placing too much weight on past performance – looking backward – rather than looking forward. The lower valuations found today in foreign stocks are a positive sign that there are opportunities for growth there. That’s no guarantee of what those stocks will do in the short-term, but generally, I think this is a smart time to be shifting from US to foreign stocks if you are underweight on the foreign side.

One of the ways we try to remove the behavioral “safety blanket” of familiar domestic equities, is through our benchmark. We run five portfolio models here at Good Life Wealth Management. Our benchmark for equities is the MSCI All-Country World Index (ACWI), and for a global portfolio that is a more appropriate benchmark than a US-only index like the S&P 500, Dow Jones Industrial Average, or the NASDAQ composite. The ACWI is currently 52% US Stocks and 48% Foreign stocks. I’m not saying that everyone needs to be invested in exactly that percentage (52/48), but by using the ACWI as a benchmark, we have the best measure of the performance of global equities. Then we can look at our own performance and see if the segment weightings we have selected were able to add value or not.

The internet has revolutionized business and today we truly have a world economy. It’s time that investors lose their Home Bias so they don’t miss out on the benefits of diversification. Using the All-Country World Index as our benchmark is a good way to start thinking globally in terms of our opportunities and how we create a portfolio.

Reversion to the Mean

Posted On October 19, 2015 By Admin In Behavioral Finance /

One of the more counter-intuitive financial concepts to embrace is reversion to the mean. Markets tend to behave in fairly consistent ways over the long-term. Wharton Finance Professor Jeremy Siegel examined 200 years of stock market returns and found that the average after-inflation rate of return of stocks, in all periods, was between 6.5% and 7.0%. This phenomenon has been named “Siegel’s constant” by economists. Even though the market can be down for 1 year or even 10 years, when we look at longer periods of 20 or more years, real returns have been remarkably uniform.

Investors are rewarded for their patience because returns do revert to the mean. This is an easy concept to understand, but the resulting decisions are often difficult to embrace, because they often require doing the opposite of what is currently working. When the tech sector was booming in the 1990’s, Blue Chip dividend stocks lagged, but that is precisely what you should have been buying in 1999 to avoid the subsequent meltdown in the over-valued tech stocks. This is obvious in hindsight, but at the time, it was very difficult to choose a lagging value fund, when you could have put your money into a hot sector fund that had returned 50% or more in the previous year.

One of the easiest ways to use mean reversion to your benefit is through rebalancing. When our positions deviate by more than 10% from our targets, we trim what has out performed and we purchase what has under performed. Besides helping us maintain our target allocation and risk profile, rebalancing can be beneficial by buying what is out of favor when it is on sale. The same benefit occurs when you dollar cost average in a volatile or declining market, or when you reinvest dividends over time.

A number of years ago, an analyst from Research Affiliates was visiting Dallas and dropped by my office to share a recent white paper they had produced on factors effecting index performance. They ranked stocks by factors such as momentum, and then tracked the performance of the stocks with either high or low momentum. Strangely, both the high and low momentum segments had a better long-term number the overall Index. At first, I thought this must have been a mistake, thinking both halves should equal the average of the whole index. But what was actually occurring was that the ranking process was in effect an annual rebalancing, dropping stocks from that segment when they peaked (in the high momentum category), and then adding them when they were out of favor (to the low momentum category). This annual rebalancing was actually a significant driver of investment returns.

The counter-intuitive part of rebalancing is that instead of buying what is working, you must buy what is lagging. This works for broad asset classes, but you should not apply this approach to individual stocks, lest you buy more of the next Enron. Stocks can go to zero, but categories do not.

And that brings us to today’s market. With volatility spiking in the third quarter, we have leading and lagging segments for 2015. Here are three categories of special interest today, in terms of reversion to the mean.

1. Growth continues to outperform value in 2015. Through October 16, the iShares S&P 500 Growth (IVW) is up 3.53% while the S&P 500 Value (IVE) is down 3.27%. The Growth ETF outperformed the Value ETF in 2014, 2013, and 2011. Over the past five years, the annualized return on the Growth ETF is 14.88% versus 12.52% for the Value ETF. Historically, Value outperforms Growth, and that is the case over the past 15 years for these two ETFs. Currently, Growth is in favor, but I think the smart approach for investors is to believe that the returns will be mean-reverting, and we will eventually, if not soon, see Value return to favor. Currently, Growth is benefiting from high returns from tech and health care sectors, which appear to be getting frothy. Value is being held back by energy stocks, which have been very weak this year. Our approach: we own a broad market index (iShares Russell 1000) which has both Growth and Value segments, plus we own a Value fund with a terrific long-term record of good risk-adjusted returns.

2. Emerging Markets have lagged Developed Markets. Through October 16, the Vanguard Emerging Markets ETF (VWO) is down 6.82%, compared to the iShares Russell 1000 (IWB) which is up 0.20%. The Emerging Markets ETF was also down in 2014, 2013, and 2011. Why would we want to hold such a perennial loser? Mean reversion, of course. While EM is currently out of favor, those stocks are becoming cheaper and cheaper while developed stocks are becoming increasingly expensive. Let’s look at a couple of metrics: for VWO, the Price to Earnings ratio is 11.75 and the Price to Book ratio is only 1.46. US Stocks (IWB) are much more expensive, with a PE ratio of 17.16 and a PB ratio of 2.26. The more concerned you are about US Stocks, the more you should want to own EM stocks. So despite a very difficult Q3 for Emerging Markets, we will continue to own the segment and will rebalance as needed in portfolios.

3. High Yield Bonds are down. The SPDR Short-Term High Yield (SJNK) is down 1.88% through October 16, while the Barclays Aggregate Bond Index is up 1.56% to the same date. As the price of high yield bonds declined this year, yields increased and the spread over Treasury bonds has widened, offering a better risk/return profile than previously. The yield on the 10-year Treasury remains around 2.1% today, while the SEC yield on SJNK has increased to 6.81%. But this is more like a series of popular online friv games than what is described above. That’s not to suggest that high yield bonds are risk-free, but the mean reverting approach suggests that the sell-off in high yield presents an opportunity relative to Treasuries.

Understanding the reversion to the mean is crucial for investors to offset the behavioral influence of recency bias. Recency bias is the natural tendency to mentally overweight the importance of recent events and to disregard a more rational decision making process. For example, if a coin turns up “heads” four times in a row, people are more likely to assume that the streak continues, even though the chance of the next coin toss remains 50% heads and 50% tails. The more coin tosses you make, the closer you will get to 50/50 over time. That’s mean reversion. If you understand this concept, you are less likely to make the mistake of assuming that last year’s hot sector, fund, or stock is the best place for your money today. Instead, you’ll realize that rebalancing is a smarter process than chasing past returns.

Data from Morningstar, as of October 18, 2015.

Vulnerability Analysis

Posted On October 12, 2015 By Admin In Financial Planning /

You’ve worked hard, saved for decades, and have saved a nice nest egg for yourself and your family. One day, you are involved in a serious auto accident and the other party sues you. A sympathetic jury finds you liable for $10 million from the accident. How much of your assets could be seized by creditors?

You probably have never thought about this question, and hopefully, you will never be in such a scenario. However, we live in a litigious society, and if you have wealth, you can be sure that there are thousands of attorneys who would jump at the chance to bring a lawsuit against someone with deep pockets.

What we offer our clients is a Vulnerability Analysis, where we look at all of your assets and calculate what percentage of your assets could be seized by creditors. The goal of our Vulnerability Analysis is to determine the creditor status of each asset and help you substantially shift your wealth into assets which are exempt from creditors.

We will determine how much of a buffer your insurance will offer and show you which of your assets could be attached by creditors. We will make recommendations for moving funds to accounts, assets, and trusts which will offer creditor protection. It’s important to take these steps today, because you cannot “hide” assets from creditors after an event has occurred. By undergoing our Vulnerability Analysis process, you will know you have protected a large portion of your wealth from creditors, if you should ever find yourself in the unfortunate situation of being sued.

Each year, we can update your Vulnerability Analysis and make sure that you are protecting your family. While this analysis is particularly valuable for doctors who potentially face malpractice claims, it is also beneficial for anyone who owns a business or property. And while some professionals are keenly aware of the possibility of being sued, the reality is that almost anyone could be sued, even for the actions of their teenage children.

You may have done everything right for the last 25 years, but if all your assets are in non-exempt accounts, then your vulnerability is 100% today. That’s why the value of financial planning includes much more than just which mutual funds you pick. Our Vulnerability Analysis process is included for our Wealth Management clients; call or email me to find out how you can become a client.

I was the driver of the car in this photo. On June 15 of this year, another driver ran a red light and hit us, totalling the car. The other driver admitted he was at fault, was distracted and didn’t see the red light. Luckily, we all survived. You always think these things only happen to other people, but accidents can happen to anyone. Hope for the best and prepare for the worst.

Why You Need to Drop Your Mutual Funds for ETFs

Posted On October 5, 2015 By Admin In Portfolio Management /

We just finished the third quarter this week and it was a tough one. The market struggled to make new highs all year before it finally ran out of steam during the week ending August 21. The S&P 500 Index traded above 2100 in July, but dropped roughly 10% to 1920 to close the quarter on September 30. Year to date, the index is down 6.75%.

While it was a disappointing quarter, we should remember that we’ve had an exceptionally long run without a correction of any size. Still, no one likes to open their quarterly statements and see that their accounts are down.

One of the myths of active fund management is that managers are able to add value during corrections through their defensive strategies. At least, that’s what we’re told when they lag during a bull market. So how did actively managed funds fare during the third quarter?

According to a report this week by JPMorgan, 67% of active funds performed worse than their benchmark in Q3. Half of those funds (34%) lagged their benchmark by at least 2.50%.

The long-term picture is even worse for active management. The Standard & Poors Index Versus Active (SPIVA) Scorecard was recently updated with data through June 30, 2015. They found that over the past 10 years, 79.59% of all Large Cap funds were outperformed by the S&P 500 Index. Over this period, the index produced an annualized return of 7.89%, versus 7.03% for the average large cap fund.

If you are still using actively managed mutual funds, chances are good that 1) your Q3 returns are even uglier than the overall market, and 2) your long-term performance has suffered significantly. That’s why we use Index Exchange Traded Funds (ETFs) as the core positions in our model portfolios. Investing in an index doesn’t mean “settling” for average returns, it has actually been the most likely and consistent way to ensure your performance is better than the average active fund.

If that isn’t enough to get you to trade in your mutual funds for an ETF portfolio, then read this article from Morningstar on mutual fund capital gains. Morningstar notes that after a 6-year rally, many mutual funds have used up their tax losses and are increasingly likely to distribute capital gains to fund shareholders at the end of this year. If this quarter’s drop causes a large outflow of capital, active fund managers will be forced to liquidate positions, creating a tax bill for the shareholders who remain in December.

It’s entirely possible for an actively managed mutual fund to be down for the year and still create capital gains for shareholders, due to trading within the portfolio. We haven’t seen this scenario in a number of years, but it looks like a distinct possibility for 2015. Index ETFs on the other hand, are extremely tax-efficient; it is quite rare for an equity index ETF to distribute capital gains, thanks to their unique structure.

If you’re a client, thank you for sticking with the plan when the market is down. We know it is frustrating. Corrections are a natural and inevitable part of the market cycle. You can take solace knowing that our Index ETF approach is demonstrating its merit both in its relative performance in Q3 and in its long-term outperformance over actively managed funds.

If you’re not currently a client, please give me a call and we can discuss how our disciplined portfolio management process can help you accomplish your financial goals. While we can’t control what the market is going to do, we can benefit greatly by focusing on what we can control, including tax efficiency, minimizing expenses, diversification, and using a time-tested index methodology.

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