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.

Behavioral Tricks to Improve Your Finances

Posted On September 28, 2015 By Admin In Behavioral Finance /

I was saddened to hear of Yogi Berra’s passing last week. One of the great quotes attributed to him is “In theory, there is no difference between theory and practice. In practice, there is.” I’ve always thought this quote applied well to personal finance, where the academic expected behavior could differ significantly from the choices people make in real life.

The fact is that we all use our feelings, intuition, and past experience to make our decisions as much, or more, than we rely on logic, research, or an open-minded examination of evidence and data. Many academics take the view that any behavioral deviation from the theoretically optimal decision will lead to poor outcomes. And while that is definitely the case in many situations, my observation as a practitioner is that even the most successful individuals are not immune from this “irrational” behavior.

My point is that when theory and practice do deviate, there can still be good outcomes, in fact, sometimes even improved outcomes. Here are six ways you can use behavioral concepts to improve your financial situation. In theory, these won’t help. In practice, they will.

The 15-year mortgage. In theory, you can make more in stocks than the interest cost of a mortgage, so you should get an interest-only loan and never pay it off. Home values generally appreciate over the long-term, and there is no additional benefit to having equity in your home. Although this is theoretically correct, I suggest that home buyers get a 15-year mortgage instead of a 30-year or interest only note. The reason that the 15-year mortgage benefits buyers is that it will force you to buy a lower priced home to be able to afford the higher monthly payment. If you start your house hunt with a 15-year mortgage in mind, it might mean looking for a $300,000 home instead of a $350,000 home. The lower cost home will have lower property taxes, insurance, utilities, and other costs. More of your monthly payment will go towards principal with the shorter loan, so you will build equity faster, which is very valuable if you should need to move after five or ten years. Having a higher monthly mortgage payment will also force you to save more. By that I mean that if you had a payment that was $500 less, you probably would not save an additional $500 a month; you’d probably save only a small part of this, maybe $100 or $200 a month, and increase your spending by $300 or $400.
Set up your 401(k) contributions as a percentage. People are shockingly lazy with their 401(k) accounts. Many never change funds, and even more never change their contribution level. If you set up a $100 contribution per pay period, chances are good that five years later you are still contributing $100. If, on the other hand, you established a 10% contribution, your dollars contributed would have increased with your raises, promotions, and bonuses. If you can, increase your percentage contribution every year until you make the maximum allowable contribution, $18,000 for 2015.
Make it automatic. We are creatures of habit and momentum and will seldom change established our course. If you give someone $100,000 to invest, they will agonize over the fund choices and try to time their purchases. If the market goes down, they’ll bail out and blame the fund or the manager or something else. It’s better to set your investing on auto-pilot, invest every month into your 401(k), IRA, 529 college savings plan, or other investment vehicle. And then do what is natural for most of us: nothing. Keep investing when the market goes down. Stick with a basic, diversified allocation. That’s why people who have a created a $100,000 account by investing $1000 a month are more likely to stay on course than the investor who puts in a lump sum. Already have your investing on cruise control? Take the next step and make your rebalancing automatic, too!
Pay cash for cars. In theory, there’s nothing wrong with financing or leasing cars. However, if you get in the habit of paying cash for cars it will change your behavior for the better. It is incredibly painful to write a $35,000 check for a vehicle. If you pay cash for cars, it will force you to keep your current car for longer while you save for the next one. It will make you consider a used car or a lower cost vehicle. And it will be a strong incentive to keep your next vehicle for a very long time. Cars are often our second largest expense after housing. Most cars lose 50% of their value in five years, so would you prefer to lose half of $75,000 or half of $30,000? People don’t think this way when all they know is their monthly payment. When you pay cash for a car, you start to think like an owner and not a renter.
Do less research. One of the mental biases facing investors is overconfidence; the more research we do, the more we believe we can predict the outcome of our investing choices. This can lead to people being overweight in their company stock, getting in and out of the market, or making large sector bets. These choices often lead to increased risk taking and quite often to long-term under performance. We’re also likely to suffer from “confirmation bias”, where we cherry pick the data or articles which corroborate our existing point of view and ignore any contradictory evidence. Overconfidence and confirmation bias don’t just affect individual investors, they are significant challenges for professional fund managers. Since the majority of professional managers cannot beat the index, I don’t hold much optimism that an individual can do better. So, cancel your subscription to the Wall Street Journal, turn off CNBC, and buy an index fund.
Use “mental accounting” to your advantage. Money is fungible, meaning $1 is $1 regardless of where it is located. However, people like to divide their money into buckets for retirement, saving, spending, emergency funds, college, vacation, or whatever. In theory, this is meaningless, you’d be equally well off with just one account invested appropriately for your risk tolerance. Even though Academics would like to banish mental accounting, people are enamored with their buckets. While you should look at all your holdings as being slices of one pie, you can use mental accounting to your advantage. You are less likely to touch money when it is in a dedicated account. For example, if you put money in a savings account for emergencies, you may later be tempted to spend that money on a vacation or other splurge. If you instead put that money into a Roth IRA, you’d be much less likely to touch it. But if you did have an emergency, you could access the principal from your Roth, tax-free. The other benefit of buckets is that it may force you to do more saving when you have specific dollar goals for retirement, college, or other purposes. Then if you need to plan for a vacation, you know you will have to do additional saving and cannot touch the buckets allocated for other goals.

Use behavior to your advantage by making sure your choices are helping you get closer to achieving your goals. Investing can be simple; it’s people who choose to make it complicated. Stick to the basics and stay focused on saving and diversification. I’m not sure we can ever completely remove behavioral biases from our decision making process, but the more we are aware of those biases, the easier it is to step back and recognize what exactly is driving our choices.

Financial Planning for the Sandwich Generation

Posted On September 21, 2015 By Admin In Financial Planning, Retirement Planning / 1 Comment

Nearly every day, I talk with someone who is a member of the “sandwich” generation. No, this isn’t a group of people who like peanut butter and jelly. The sandwich generation refers to people, primarily Baby Boomers, who are caring and providing for both their own children and older family members, most often their aging parents.

This can create quite a strain, emotionally and financially, as adults have to prioritize their time and money to care for their own children as well as their aging relatives who may be dealing with health issues, financial problems, and sometimes declining mental faculties and decision making abilities. Needless to say, given these competing demands, their own retirement planning is often the casualty. Some become full-time caregivers and may be out of the workforce for years while they care for an ailing family member.

In recent months, I’ve heard many sad and difficult situations, including:

An 89-year old Grandmother who decided to have cataract surgery only when they said if she did not have surgery, they would take away her driver’s license. No one wants to lose their independence, but maybe her driving isn’t such a great idea, both for her own safety and for others on the road.
A relative’s 90-year old mother fell and could not get up. She was unable to reach a phone and spent more than four hours on the floor before someone found her. This was not her first fall incident, and still the children had to go to great lengths to convince their parents that they needed to move to a retirement home. The parents are nearly broke, so the bills will be paid by the son, who is also providing for two college-aged children.
A friend’s mother went into hospice and passed away shortly thereafter. He spent the whole summer sorting through her belongings and trying to ready her home for sale. Given her vast collection of items, there are still many months of work ahead.
A friend’s older sister was diagnosed with ALS this week. She lives alone, but recently suffered a nasty fall which resulted in a large gash to her head.
A statistic from the MIT AgeLab: for people over the age of 70, a broken hip has a 50% mortality rate within 18 months. This is not usually a direct result of the injury, but from a rapidly declining health situation if they become wheelchair-bound. It’s use it or lose it, when it comes to our mobility and health.

We are living longer today, which is a great blessing. However, it also means that many of us will live to an age where we may eventually need some assistance. This is a good problem to have. If everyone only lived into their 50’s, like we did in the 1800’s, we wouldn’t need to address these issues! We should be thankful that medical advances have so greatly extended our longevity over the past century.

While there are many difficult emotional aspects to these conversations, there are many financial considerations as well. If you are part of the sandwich generation, we can help you navigate the difficult decisions you face with your aging parents while making sure that you are also managing your own financial goals.

People who have these conversations with their financial planner in their 60’s may save a great deal of stress and burden on their children in 15 or 20 years. We can help you plan better to make sure that your future doesn’t depend on your children’s finances and generosity. Here are some thoughts about how you can remain healthy and happy as you age:

Create an income plan that budgets for rising health care costs. You do not want to run out of money in your 80’s and have to spend down your assets to qualify for Medicaid. That may be a safety net, but it is a lousy plan.
Work on your home to create a physical space which will allow you to “age in place”. A safe home can not only help prevent injury, but can allow you stay independent for longer.
While no one wants to be in a nursing home, if you live long enough, it is almost inevitable that you will eventually require some help with the Activities of Daily Living. Some are in denial about their abilities in this regard, and it is only a major event, like a broken hip, which eventually prompts a move.
A Long-Term Care insurance policy can pay for home health care. Rather than thinking of an LTC policy as a “nursing home” policy, think of it as the policy which can keep you out of a nursing home.
Today’s retirement communities offer a wide range of services, from truly independent living to round-the-clock skilled nursing. There are many benefits to being part of a community and spending time with friends who have similar interests and backgrounds. Health care professionals are beginning to recognize the significant impact that a social network has on healthy aging.
Create an estate plan which will not create an unnecessary burden on your heirs. Don’t leave a mess for your children to have to clean up.
Reduce taxes on your estate and your heirs. I saw two unfortunate tax situations this year which could have been avoided with better planning. In one situation, an elderly aunt made her nephew the joint owner of her home. The result: no step-up in cost basis on this out-of-state property! In another situation, a father made the beneficiary of his IRA a trust. The IRA was distributed to the trust and was not correctly established as a stretch IRA. As a result, the entire distribution is taxable in 2015. And since the beneficiary was a trust, the applicable tax rate will be 39.6%!

If you are already retired, we can make sure you have a retirement income plan, health care funding, and an estate plan to carry out your wishes. Don’t wait. Our cognitive abilities decline slightly each year, so it’s best to make these decisions in your 60’s or early 70’s and not wait until your 80’s or 90’s.

Men, especially, seem to be in denial about the importance of this planning. Typically, the husband does die first and most retirement homes I have visited are 60% to 90% women. So gentlemen, if you don’t want to plan for yourself, plan for your wife. If you fail to plan for her, sorry, that’s just plain irresponsible. And hopefully you agree she deserves better.

Whether you are in the sandwich generation or just want to make sure you aren’t going to make your children part of the sandwich generation in the future, financial planning can help.

Don’t Budget; Focus on Saving

Posted On September 14, 2015 By Admin In Financial Planning /

I used to feel a bit sheepish when clients asked about my personal household budget, because I don’t have one and never have. I always worried that I was being lazy and a poor role model for my clients. I’d see articles, books, or CFP materials touting the benefits of having a budget to be able to track your spending. Some said that without a budget, you would not be able to plan how to achieve your financial goals.

Eventually, I came to recognize that you don’t need to have a budget to accomplish financial goals and that creating a budget would be a waste of time. It’s true, I don’t know how much I spend on dog food, and I don’t have a set amount that I plan to spend on clothing, eating out at restaurants, or for car maintenance. Over the years, I’ve found that many successful investors skip making a budget and that it is not the prerequisite that many people would have you believe.

If you follow these three steps, you won’t need a budget, either:

Put your saving on autopilot. Figure out how much you need to save to accomplish your goals. Set up your contributions to your 401(k), IRAs, and other accounts. If you are saving your target amount (or more), don’t worry about spending the rest of your income. I think of this as reverse budgeting. Save first, and then whatever is leftover is yours to spend.
Don’t ever deplete your cash. While I don’t have a set monthly budget, I am aware of our spending and follow our credit card transactions weekly. We pay our credit cards every month and never carry a balance. In months when there are large expenses, we can always reduce discretionary spending or postpone other purchases. We keep an emergency fund, but after 17 years of marriage, we’ve never touched it. We won’t make a purchase if it requires dipping into the investment portfolio; we will have to build up cash in checking before making a large purchase, such as a vehicle.
Live frugally. Luckily, I don’t enjoy shopping, so I am not often tempted to buy new things. When I do want to make a purchase, it is never an impulse buy. I’ll do my homework, research online, and make sure we are getting a good deal. For me, the knowledge of how $50,000 could grow over the rest of my life is much more attractive than a $50,000 boat. So, I’m not sure I’ll ever be willing to sink huge amounts of money into depreciating assets.

I know that for some people, spending is like a gas that will expand to fill whatever space you allow it to have. For these folks, creating a budget is helpful so they actually know where their money is going. Many people have benefited from having a budget, and if it has benefited you, that’s wonderful. I am all about empowering people to take control of their finances and make informed changes for a better life. My point is not that no one should have a budget, just that not everyone needs to have a budget if you are meeting your savings goals without one.

Not sure how much you need to save to reach your financial goals? Check out the Savings Goal Calculator on Bankrate.com. Enter your current portfolio value as the “first deposit” and your ending goal under “How much do you want to save?”. Want a more sophisticated analysis to consider market fluctuations? Contact me for a consultation; we have terrific goal-based financial planning tools!

How to Make the 4% Rule Work for You

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

Retirement planning today has largely shifted from guaranteed income from pensions to withdrawal strategies from 401(k) accounts and IRAs. Most financial planners recommend retirees start with an initial withdrawal rate of 4%. This approach was developed because historically, a 4% withdrawal rate, adjusted for inflation each year, would allow a retirement portfolio to last for 30 years under almost all circumstances.

The market was up in each of the past six years, which can give retirees a false sense of security about increasing their spending. In recent years, investors could take out 5%, 6%, or more from their portfolio and still end the year with more money than they started with. Markets go up and down, and if you withdraw all of your gains when the market is up, you can run into trouble when the market drops by 20 or 30 percent.

I find the challenge many retirees face with the 4% rule is forgetting to budget for unexpected expenses. If they have $1,000,000, a 4% withdrawal would be only $40,000 a year (before taxes). They can get by on this amount, but when their car needs replacing, they want us to send another $25,000. Suddenly, their annual withdrawal is up to $65,000. The next year, they need $10,000 for a new roof, and the next year, it’s something else. The issue is rarely reckless spending, but failing to set aside money for these unanticipated expenses.

The danger is that if a retiree takes too much, too soon, there won’t be enough remaining principal in their account to last for 30 years. Diminishing your account early in retirement means that future dividends and capital gains will be smaller in dollar terms, and cannot adequately replenish the annual withdrawals. Then the retiree may have to make drastic changes in their spending and lifestyle to avoid depleting their account. If there is a multi-year correction (like 2000-2002), combined with several years of large withdrawals, it is possible a retiree could see their portfolio drop to one-half their starting value in just five years.

I write this because the first challenge with the 4% rule is that many retirees don’t follow it and take out much more when the market is up. The good news, however, is that for the great majority of history, a 4% withdrawal rate was actually extremely conservative.

In a recent article by Michael Kitces, he examined the 4% rule, looking at 115 rolling 30-year periods, invested in a 60/40 portfolio. He found that in more than 90% of the periods, after 30 years of inflation-adjusted 4% withdrawals, a retiree would have finished with more money than they had at the beginning of retirement. In fact, the median wealth after 30 years, was 2.8 times the initial principal. The 4% rule was not an average withdrawal rate, but based on surviving a steep and prolonged downturn like The Great Depression.

Looking at all 115 30-year periods, Kitces found that retirees could have withdrawn a range of 4-10% of their initial principal, with a median of 6.5%. The 4% rule is the lowest withdrawal rate that worked, and since we don’t know future returns, the safest assumption. While that’s no guarantee that the 4% rule will work in the future, investors should feel very confident with this approach.

Now for some even better news: looking at all 115 periods, Kitces found that whenever the portfolio had grown to 50% above the starting value, withdrawals could be increased by 10%. This “ratchet” approach could be done every three years, and is on top of annual increases for inflation.

For example, let’s consider a retiree who started with a $1 million portfolio and experienced 3% inflation for 5 years. The annual withdrawal amount would have started at $40,000 (4%) and grown to $46,371 with inflation. If the portfolio were now to exceed $1.5 million, we could ratchet up their spending by an additional 10%, to $51,008 and that would become the new annual withdrawal amount.

Here’s a summary of how to make the 4% rule work for you:

1) Make sure you stick to a 4% withdrawal and don’t forget to set money aside for unexpected expenses.
2) Remember that the 4% rule is based on the worst case scenario of terrible market performance.
3) You can plan to increase your withdrawals each year for inflation.
4) If your portfolio grows to 50% above your initial starting value, you can ratchet up your annual withdrawal by an additional 10%.
5) Finally, recall that the 4% rule worked for a portfolio comprised of 60% stocks, 40% bonds. Don’t think that you can apply the 4% rule to a portfolio that is 80% invested in cash or CDs. It’s stocks that fuel the growth which enables the withdrawals to be increased.

6 Ways to Reduce Stock Market Risk

Posted On August 31, 2015 By Admin In Portfolio Management /

We had a roller coaster ride this past week in the market. Last Monday, the Dow dropped nearly 1000 points as investors spooked from the previous Friday’s sell-off sold positions en masse. By Friday, however, the major indices recouped their losses and several even finished slightly ahead for the week. Anyone who sold during Monday’s mayhem locked in their losses and lost out on the subsequent rebound.

No one can predict what the stock market will do in the future, so I genuinely believe it is futile to respond to this week’s activity by making trades. The media has detailed the concerns which “caused” the market to drop this week, but there are always going to be reasons which drive the short-term gyrations of markets. This noise can distract investors from staying focused on their financial goals.

After an extended period of low volatility, a tough week often raises questions about how much risk is in your portfolio and how a downturn might impact your ability to fulfill your financial objectives like retirement. Before we invest, we have all our clients take the FinaMetrica risk assessment to better understand your personal beliefs and comfort with taking risk. Given the choice, we’d all prefer to have less risk in our portfolios. The reality, however, is that the reason stocks outperform other asset classes is that stocks provide a risk premium – that is a higher rate of return – in exchange for the volatility and unpredictable path of their results.

I am always interested in ways of reducing risk. While I think investors will have the highest long-term return by embracing risk intelligently with a diversified, index allocation, the most important factor is actually each investor’s behavior. If you aren’t willing to stay invested through the inevitable ups and downs of the market cycle, you are likely to greatly hurt your performance. The most important part of my job is educating investors and encouraging them to stick with the plan.

Investors want options and we are happy to suggest ways to reduce risk. Below are six ideas to reduce price volatility in your equity portfolio. Just bear in mind that “there is no such thing as a free lunch.” While each of these approaches can reduce risk, some may reduce your return as well. The first three strategies can be applied to a traditional portfolio; the second three options are slightly more unusual and may be unfamiliar to most investors.

Diversify. This is the most basic step, but forgetting this can be a big mistake. If you are investing in individual stocks, you are taking on specific risks that those positions could implode. This is an uncompensated risk which we can avoid entirely by investing broadly across the whole market. Over time, the majority of stock pickers fail to outperform the index. We prefer to invest in index exchange traded funds (ETFs). Diversification doesn’t always work quite as planned, but having non-correlated holdings improves the likelihood that when one category is down that other categories can offset or reduce those losses.
Increase your bond allocation. The biggest impact you can have on your overall portfolio risk is by changing your asset allocation. We run five model portfolios: Conservative (35% equities/65% fixed income), Balanced (50%/50%), Moderate (60%/40%), Growth (70%/30%), and Aggressive (85%/15%). If you want to shift to an allocation with less risk, the best time to change would be when the market is up. Be careful, because you are most likely to want to change at a market bottom, which is exactly the wrong time to become more conservative!
Consider Low Volatility ETFs. I’ve written about these previously. A Low Volatility ETF selects stocks from an index, but instead of weighting the positions by market capitalization, it weights the positions to emphasize the stocks with the lowest volatility. Historically, this process can produce a similar long-term return as a regular index, but with a somewhat less bumpy ride. How have they done recently? Over the past month, the iShares USA Minimum Volatility ETF (USMV) is down 2.72%, versus the iShares S&P 500 (IVV), which is down 4.80%. Year to date, USMV is up 0.83% versus IVV which is down 2.08%. In this time frame, the low volatility fund has been more defensive. However, you should expect a low vol strategy to under perform a traditional index fund in a bull market. For example, over the past three years, USMV’s annualized return of 13.59% has lagged IVV’s return of 14.50%. (Source: Morningstar.com as of August 28, 2015)
Bond + Options. Instead of buying an ETF that invests in the market, we can buy an option on the ETF or index. If you had $100,000 to invest in the S&P 500, we would purchase a zero coupon bond that would mature at $100,000 in several years. This bond would trade at a discount, say for $93,000. With the remaining $7,000, we would purchase an option on the S&P 500. At the end of the term, if the market was down, the option would expire worthless. However, you’d still get $100,000 back from the maturity of the bond and not lose any money. That’s a lot better than if you had put your $100,000 into an ETF, in which case, you could be down 30% or more. If the market was up, you’d receive the $100,000 from the bond and a gain from option on the index. While I love the simple elegance of this approach, there are three important considerations: i. With today’s low interest rates, the cost of bonds is quite high, leaving very little money to purchase an option. As a result, your option may not provide the same return as investing directly in the market. In other words, if the market was up 10%, your options may not return $10,000. ii. While this strategy eliminates stock market risk, it does introduce credit risk that the issuer of the bond defaults. iii. The option’s return will include price appreciation, but not dividends, so you will miss out on approximately 2% of yield that you would receive from investing in an ETF.
Equity-Linked CD. This is an FDIC insured CD, but instead of paying a fixed rate of return (like 2%), the return is based on the performance of an equity index, such as the S&P 500. If the market goes down, you are guaranteed to get your original principal back. Even if the bank goes bust, your CD is insured by the FDIC like a regular CD. Before you get too excited about this option, let me explain that you do not get the full start-to-finish return of the index. Rather they have a formula to calculate the CD return. For example, a common approach for a 5-year CD is to add up the 20 quarterly returns of the S&P 500, subject to a cap of 5% per quarter. This sounds good, but there are three caveats: i. If the market is up 20% in a quarter, you only get credit for 5%. But if the market is down 20%, that is a minus 20% counted towards the sum. ii. Since this approach adds quarterly returns instead of multiplying, you miss out on compounding. iii. Again, no dividends. An Equity-Linked CD is not redeemable during the term, so your return is not guaranteed if you do not hold to maturity.
Equity Indexed Annuity (EIA). Unlike the CD above where the return is unknown until the end of the term, most EIAs post a return annually using a “point to point” method. Typically this includes a cap on the annual return, and a floor of zero, so there are no negative years. These can be even more confusing than the CDs, however, because to access those returns and receive your money there may be withdrawal restrictions, surrender charges, and other complex rules. An annuity may work for someone who is close to retirement or in retirement and needing income with less market risk. For a younger investor, an annuity may not be the best fit.

The longer your time horizon, the less you should be concerned about short-term market volatility. We can implement any of these approaches for our investors and we’re happy to help you weigh your options to make the right choice for you. However, we don’t usually recommend numbers 4 through 6, because they’re likely to have a lower return. Let’s say that over 5 years, the market returns 8% a year, but one of these defensive strategies might only return 5%, because of no dividends (-2%) and because of caps or other weighting mechanisms (-1%). And over 5 years, that 3% difference in return on a $100,000 portfolio would make the difference between growing to $127,628 versus $146,923. What seems like just a small trade-off in performance becomes significant over time.

Risk may be a four-letter word, but you may be better served to think of risk as opportunity. This past week was a reminder that stock prices do go up and down, often randomly and sometimes quite painfully. This part of being an investor is challenging and frustrating, but also largely unimportant over time and out of our control. We are wiser to focus on the things we can control, including our saving, being diversified, and keeping costs and taxes to a minimum.

Can Being Frugal Make You Happy?

Posted On August 24, 2015 By Admin In Behavioral Finance, Financial Planning /

Gen Y is bringing frugality back in style. As a financial planner, I’m delighted to find frugality is cool now. I’ve read their blogs (where else would they write?) with fascination and appreciation for their candor. I’m calling this the New Frugality, and you’ve probably heard or read about some of these ideas, including the Tiny House, where people live in a home often smaller than 200 square feet. Others are embracing Minimalist Wardrobes, creating a personal, seasonal clothing uniform (think Steve Jobs with his jeans and black mock turtleneck). This past week, there was an article in Forbes about the Frugalwoods, an anonymous Boston couple who is saving 71% of their income so that they can retire at age 33 and move to a Vermont homestead with their rescue Greyhound.

In these blogs, the authors are never afraid to share their personal stories, from big-picture motivations and life philosophies, to the smallest minutiae of their daily decisions. Along the way, we invariably learn of their challenges, missteps, and triumphs. The blogs are part diary, part instruction manual, and part entertainment for their friends and fans. Even with different goals and approaches, there are common beliefs.

The New Frugality believes that less is more, and does not buy into the modern American idea that “buying more stuff” can make you happy. They have a maturity (which takes some people 70 years to develop) that recognizes that happiness comes from rewarding experiences, positive relationships, and a work/life balance that includes a higher purpose.
They want off the financial treadmill. Some had large student loans or crippling credit card debt before having an epiphany about becoming debt-free. Others found their corporate careers unsatisfying and were brave enough to recognize that spending the next 40 years in a job they hate isn’t worth it just to be able to afford a big house and a fancy car.
While others may view their frugality as a sacrifice, they often find that simplifying their lives and eliminating clutter brings a clarity to their sense of what is truly important to them.

The New Frugality is about seeking the quality of life you want today, rather than believing you should wait until some future date, i.e. retirement, before you can really do what you want. It’s an implicit rejection of the old notion of working 50 hours a week until age 65, then never working again.

[In case you are wondering, I contrast the New Frugality with previous beliefs about frugality which were created by those who lived through The Great Depression and who raised their children in a different, frugal manner. While both the old and new approaches want to stretch each dollar, the old frugality was characterized by self-reliance, never throwing away anything you might need in the future, risk avoidance, and mistrust of financial systems. Some of those traits were largely fear-based, which does not resonate with the abundance mentality I embrace and believe is required to be a patient and successful investor.]

Does frugality make you happy? I think the most literal answer is no. By that, I mean that if you are unhappy, spending less won’t make you happy. If you really enjoy going to Starbucks every morning, cutting out that $5/day habit isn’t automatically going to improve your satisfaction, even if it enables you to save $1,825 a year. Frugality works for these bloggers because they were willing to embrace changes to their habits even though society was telling them to spend more money instead. There’s no doubt that frugality is financially beneficial, but the sources of happiness include a lot more than just your financial situation.

Reading their blogs can help you appreciate your own spending more as well as to feel good, and not alone, when you do choose a frugal approach. We are continually bombarded with advertising that suggests we’d be happier, cooler, and more attractive if we had the right car, clothes, or beauty products. We’re told that our current life would be better if we had a bigger home, nicer furniture, or luxury vacations. Of course that’s not true. We know that spending to increase our satisfaction is at best a fleeting pleasure which can leave consumers addicted to living beyond their means. Unfortunately, there are so few voices pushing back on the advertisers’ message to consume.

Even if you don’t want to live in a tiny house, reduce your wardrobe to a few pieces, or bike to work, you can still take frugal steps to ensure you are working towards true financial independence, which we define as working because you want to and not because you have to. Here are six lessons to take away from the New Frugality:

Beware of lifestyle creep. Many of us were very happy in college, even though we may have had a rickety car, tiny apartment, and slept on a futon. It doesn’t take long after graduation to discover the urge to “keep up the Joneses”, as friends buy big houses and fancy cars. How can they afford it? Oftentimes, they can’t and they’re up to their eyeballs in debt. They’re more concerned about their image than their net worth, and that’s not something to emulate! If you increase your living expenses every time your income goes up, you aren’t ever going to become wealthy.
Save at least 15% of your income. Set financial goals, including a “finish line”. If you are highly motivated (or just impatient, like me), you will realize that the more you save, the sooner you will reach your finish line. Saving then is not a sacrifice, but the fastest, most direct way to achieve financial independence. When your goals are more important to you than a new (fill in the blank), your spending decisions become much easier.
Avoid impulse buys and emotional shopping, that is shopping to distract you from sadness, frustration, or boredom. Never buy on credit; if you don’t have cash to pay for something, it’s not worth going into debt. Be conscious and intentional about your spending behavior. Do your choices reflect your goals and beliefs?
Buy used. There is a growing market for used items, often selling at a small fraction of the cost of new items. This is the Craigslist economy, which is growing around the country. You can often buy what you need without paying full retail prices.
Savor success. There is a great deal of intrinsic satisfaction in becoming financially independent. Even taking the initial steps towards creating a positive cash flow are great confidence boosters because people feel empowered when they take control of their financial life. As every financial planner will tell you, the more you need to spend, the larger the nest egg required to be able to fund your future needs. Therefore, when you reduce your spending, you not only can save more, but you also reduce the size of the nest egg you will need to replace your income.
Reduce stress. While money is not the source of true happiness, there is no doubt that being broke, in debt, or just knowing you are not setting enough aside for the future, can be a significant source of personal anxiety and marital friction.

As a bonus, you will find great common sense financial planning tips on these blogs. What are the Frugalwoods doing with the 71% of their income the save? They maximize their 401(k) contributions and invest the rest in the market. They write: We’ve done well because we invest in boring index funds and we don’t sell when the market is down. That’s a great recipe for success!

Reading about the New Frugality is entertaining because many authors are willing to take their frugal habits to quite an extreme. Even if we don’t adopt their spartan lifestyle, they can remind us that we don’t have to spend money to be happy.

Five Financial Planning Steps When Getting Remarried

Posted On August 17, 2015 By Admin In Financial Planning /

For couples getting remarried, there are often additional financial complications and concerns compared to a first marriage. In a second marriage, there may be assets, income, and children which require special consideration. There are many ways to address these thorny issues so that you can focus on moving forward with your relationship and not let financial worries hold you back. Here are five financial planning steps to help:

1) Redo your financial plan. By working with a financial advisor who holds the Certified Financial Planner designation, you can create a comprehensive financial plan and know that your advisor is not just there to sell you investments or insurance. An advisor is a neutral, third-party expert who can help with your budget, savings, and spending goals as a couple. Your advisor can facilitate this conversation and create an objective plan that considers your joint assets, income, and expenses.

Specifically, your advisor should help you:

– Prepare a net worth statement detailing all your assets and liabilities.

– Determine when you might be able to retire and what income you should plan for in retirement.

– Evaluate your income and expenses. If you are working, we can determine how much you need to save to achieve your retirement goals. If you are retired, we can calculate how much you can safely withdraw from your portfolio each year. Use this information to develop your joint budget.

2) Discuss and recognize your differences. Often, couples do combine their finances, and there are some reasons and potential benefits from doing so. However, in many cases, adults who have managed their finances independently for many years will want to keep their finances separate. This can work well, especially once you decide on the logistics of how to split joint expenses like housing. While you could choose to continue to work with separate financial advisors, we can manage your portfolios separately based on your individual needs. This is increasingly common today, and does not pose any significant difficulty to manage two portfolios and sets of objectives. The benefit of working with one advisor is that you are making sure that your separate finances will be adequate to fulfill your individual and joint financial needs.

3) Update Beneficiaries. Redo your estate plans and be sure to update beneficiaries on 401(k) accounts, IRAs, and insurance policies. It is surprising how often this vital step gets overlooked or only partially completed.

4) QTIP Trust. When couples have grown children from a previous marriage, things can get complicated. There can be a tension between the kids and the new spouse about finances, as well as a concern for the parent that their kids could be excluded from an inheritance if their spouse should outlive them. There are risks when a couple sets up their estate plan to leave everything to their spouse. The surviving spouse might get remarried or choose to exclude the children. Sometimes, there is a concern that spendthrift children could manipulate the surviving spouse and get their hands on the a lifetime of savings.

One solution to this is a QTIP trust, which stands for Qualified Terminal Interest Property. A spouse leaves his or her individual assets to the trust. The surviving spouse, then, is a beneficiary of the trust and will receive annual income to pay for living expenses; they can access principal of the trust only under very limited circumstances, such as for medical needs, as proscribed in the trust instructions. When the second spouse passes away, the remainder goes to the heirs of the first spouse, under an irrevocable designation. This way, the first spouse can be assured they have provided for their spouse and that the remainder will absolutely go to their children. When you establish your estate plan and QTIP trust, by all means, tell your kids what you are doing and what they can expect. Even if they have never said anything, they may be wondering or concerned about your estate plan, and knowing that you have taken care of them will make it easier to accept your new spouse.

Besides establishing a QTIP trust, there are a couple of other ways to set money aside for children or grandchildren. If there are sufficient assets, a simple approach is to leave property and joint assets to the spouse and use beneficiary designations from life insurance or IRAs to leave money to children. For grandchildren, consider setting up 529 college savings plans and naming children as successor participants to manage the accounts after you pass.

5) Maintain Separate Property. In Community Property states (AZ, CA, ID, LA, NV, NM, TX, WA, WI), assets acquired during the marriage are generally considered to be jointly owned regardless of title. Only assets which pre-date the marriage are considered Separate Property, along with inheritances and gifts received. The challenge, however, is that assets are deemed to be community property unless you can prove that they are separate. If funds are commingled, contributions received, or dividends and interest reinvested, you may inadvertently cause the separate property to become community property. When a couple is getting remarried, it is important for both spouses to understand their separate property rights and take steps to ensure that these assets maintain their separate property character. For details on how to do this, please see my post, Community Property and Marriage.

Second marriages are increasingly common today, and each one has its own unique set of financial details. Smart financial planning can help provide solutions to these complex issues and ensure that both spouses are protected and able to accomplish their goals as a couple as well as individually.

The Secret Way to Contribute $35,000 to a Roth IRA

Posted On August 10, 2015 By Admin In Retirement Planning /

Roth IRAs are incredibly popular and for good reason: the ability to invest into an account for tax-free growth is a remarkable benefit. Unlike a Traditional IRA or Rollover IRA, there are no Required Minimum Distributions, and you can even leave a Roth IRA to your heirs without their owing any income tax. For retirement income planning, $100,000 in a Roth IRA is worth $100,000, whereas $100,000 in a Traditional IRA may only net $60,000 to $75,000 after you pay federal and state income taxes.

The only problem with the Roth IRA is that many investors make too much to be able to contribute and even those who can contribute are limited to only $5,500 this year. If you’re a regular reader of my blog, you may recall a number of posts about the “Back-Door Roth IRA”, which is funded by making a non-deductible Traditional IRA contribution and immediately making a Roth Conversion.

But there is another way to make much bigger Roth contributions that is brand new for 2015. Here it is: many 401(k) plans offer participants the ability to make after-tax contributions. Typically, you wouldn’t want to do this. You’d be better off making a tax-deductible contribution.

When you separate from service (retire, quit, or leave) and request a rollover, many 401(k) plans have the ability to send you two checks. One check will consist of your pre-tax contributions and all earnings, and the second check will consist of your after-tax contributions.

What can you do with these two checks? This was a gray area following a 2009 IRS rule. If the distributions were from an IRA, you would have to treat all distributions as pro-rata from all sources; i.e. each check would have the same percentage of pre-tax and after-tax money in it.

Remarkably, the IRS ruled in 2014 that when a 401(k) plan makes a full distribution, it can send two checks and each check will retain its unique character as a pre-tax or after-tax contribution. No pro-rata treatment is required. This will allow you to rollover the pre-tax money into a Traditional IRA and the after-tax money into a Roth IRA. This rule applies only when you make a full distribution with a trustee to trustee transfer.

Since this is a new rule for 2015, it is likely that your HR department, 401(k) provider, and CPA will have no idea what you are talking about, if you ask. Refer them to IRS Notice 2014-54. Or better yet, refer them to me and I can explain it in plain English!

Even though the salary deferral limit on a 401(k) is only $18,000, the total limit for 2015 is actually $53,000 or 100% of income. So you should first contribute $18,000 to your regular, pre-tax 401(k). Assuming there is no company match or catch-up, you could then contribute another $35,000 to the after-tax 401(k) to reach the $53,000 limit.

Let’s say you do this for five years and then retire or change jobs. At that point, you would have made $175,000 in after-tax contributions which could be converted into a Roth IRA, and since your cost basis was $175,000, there would be no tax due.

The earnings on the after-tax 401(k) contributions would be included with your other taxable sources of funds and rolled into a Traditional IRA. Only your original after-tax contributions will be rolled into the Roth account. Please note that this two-part rollover only works when you separate from service and request a FULL rollover. You may not elect this special treatment under a partial withdrawal or an in-service distribution.

Lastly, before attempting this strategy, make sure your 401(k) plan allows for after-tax contributions and will send separate checks for pre-tax and after-tax money. While this strategy is perfectly legal and now explicitly authorized by the IRS Notice, 401(k) plans are not required to allow after-tax contributions or to split distribution checks by sources. It’s up to each company and its plan administrator to determine what is allowed. The IRS Notice stipulates that this process is also acceptable for 403(b) and 457 plans, in addition to 401(k) plans.

Not sure if this works with your 401(k)? Call me and I will review your plan documents, enrollment and distribution forms, and call your plan administrators to verify. I think this would be a great approach for someone who is a handful of years away from retirement who wanted to stuff as much as possible into retirement accounts. Additionally, anyone who has the means to contribute more than $18,000 to their 401(k) each year might also want to consider if making these after-tax contributions would be a smart way to fund a significant Roth IRA.