Inflation Investment Ideas

Inflation Investment Ideas

Inflation continues to shock the Global economy and has become a major concern when we discuss investment ideas. This week’s data showed the Consumer Price Index up 9.1% over last year, and the Producer Price Index is up over 11%. These are numbers not seen since 1981.

Today, I’m going to share some thoughts on inflation and get into how we want to respond to this situation. But first, here is an inside look at the government response to inflation.

Federal Reserve Hitting the Brakes

Last week, I attended a breakfast meeting for the Arkansas CFA Society at the Federal Reserve office in Little Rock. Our guest speaker was James Bullard, president of the St. Louis Federal Reserve Bank and voting member of the Open Market Committee which sets interest rates.

Bullard said that we were at a profound regime switching moment today, and that this is not just a blip in inflation but a “stunning amount of inflation”. He stated that the Fed would move aggressively to reduce inflation and that they were committed to their inflation target of 2%. He thinks the Fed will continue to raise rates until policy rates are greater than the inflation rate and may need to hold those high rates for years to come to bring inflation down.

Bullard felt that the current inflation levels are not simply a temporary supply shock from the Ukraine War. Output is actually up. In March 2020, the Fed responded very quickly to support an economy crashing from COVID-19 shutdowns. 60 days later, markets recovered and housing boomed. He wishes that they had reduced their asset purchases sooner. Instead, the Fed is only now ceasing to buy bonds and is allowing their holdings to run-off as they mature. The global stimulus response was correct, but has overheated.

He was less concerned about the possibility of a recession. Bullard said that recessions are difficult to predict and that the Fed is going to focus on getting inflation under control first. Inflation remains a global problem, but the US Federal Reserve will lead the way on fighting inflation, as the European Central Bank has other issues making them slower to respond.

Inflation, Rising Rates, Recession

It’s important to understand that even if inflation remains elevated for a couple of years, the impact of inflation may only be part of the story. Our investment ideas cannot simply assume high inflation as the only factor. We have to also consider the likelihood of rising interest rates and a recession. We’d love it if the Federal Reserve can orchestrate a soft landing as they apply brakes to this runaway economy. But they have not been very good at soft landings in the past.

The Fed policies are starting to work. Since the June inflation numbers, we’ve already seen the price of oil down by 20%. Mortgage applications are down and we should start to see housing inventories normalize and home prices stop their double digit increases. Interest rates have doubled compared to last year – 5.5% versus 2.75% for a 30-year mortgage – and this will impact how much home buyers can afford to pay. The Bloomberg Commodity Index was at 130 on June 16th and is now at 113, a drop of 13% in one month.

It is hard to imagine additional inflation shocks or surprises at this point. Despite the headlines, markets already know we have inflation. Inflation remains high, but may have peaked and should be starting to come down. The question is what is next? How will the markets respond to the Fed actions? Here are five thoughts about where to go from here.

Five Inflation Investment Ideas

  1. Rising Rates. Bond investors beware. The Fed is going to continue to raise interest rates for an extended period. Keep your duration short on bonds. Consider floating rate bonds, if you don’t have any. Stay high quality – rising rates may cause defaults in weaker credits.
  2. I-Bonds. These are inflation linked US savings bonds. They’ve been in the news this year, but I’ve been writing about them since 2016. Limited to $10,000 in purchases a year. These could do great for a couple of years.
  3. Recession and Stocks. We might already be in a recession today, but won’t know it until later economic data shows a negative GDP for two quarters. Please resist the temptation to try to time the stock market. Recessions are a lagging indicator; stocks are a leading indicator and stocks will bounce back sooner. If you try to get out of stocks, it will be very difficult to get back in successfully. Instead, focus on diversification, with Value and Quality stocks. Avoid the high-flying growth names, we are already seeing those stocks get pummelled.
  4. Roth Conversions. We are in a Bear Market, with the S&P 500 Index down 20%. This could be a good time to look at Roth Conversions, if you believe as I do that stocks will come back at some point in the future. An index fund that used to be $50,000 is now trading for $40,000. Do the Roth Conversion, pay taxes on the $40,000 and then it will grow tax-free from here. This works best if you anticipate being in a similar tax bracket in retirement as today.
  5. Cash is Trash. Inflation is reducing your purchasing power. Thankfully, rising interest rates means we can now earn some money on Bonds and CDs. We can build laddered bond portfolios from 1-5 years with yields of 3-5%. And we have CDs at 3% as short as 13 months. Those are a lot better than earning 0% on cash. If you don’t need 100% liquidity, short-term bonds, CDs, and T-Bills are back.

Perseverance and Planning

I believe in long-term investing. Times like these will challenge investors to have the perseverance to stay the course. Rising rates and a possible recession in the months ahead may pose additional losses to our investment portfolios. If I thought we could successfully avoid the losses and step away from the market, I’d do that in a heartbeat. But all the evidence I have seen on market timing suggest it is unlikely to add any value, and would probably make things worse. We will stay invested, continue to rebalance, tax loss harvest, and carefully consider our options and best course of action.

With higher inflation, the cost of living in retirement increases, and so we have to aim for equity-like returns to make plans work. For our clients who are in retirement or close to retirement, we typically have a bucket with 5-years of expenses set aside in short-term bonds. And that bucket is still there and we won’t need to touch their equities for five years. In many cases, we have bonds which will mature in 2023, 2024, etc. in place to fund your spending or RMD needs. So, I am happy we have the bucket strategy in place, it is working as we had planned.

We have shared some inflation investment ideas, but I think the risks to investors may be greater from the Fed. Rising rates and recession are likely in the cards as they look to slow the economy. In spite of the headlines, this will undoubtedly be different than 1981, so I’m not sure we have an exact road map of what will happen. But, I will be your guide to continue to monitor, evaluate, and recommend what steps we want to take with our investments.

Bear Market Has Arrived

Bear Market Has Arrived

Stocks continued their slide for an eighth week. Friday’s drop now brings the S&P 500 Index down 20% from its recent peak. We are officially in a Bear Market. Tech stocks, in the Nasdaq Index, are down over 30% and have already been in a Bear Market.

Investors have questions and want to know what to do next. I’m going to share five thoughts.

One. Predictions are a waste of time. I’ve spent too much time this past week, reading, listening, and watching “experts” suggest what will happen next. No one knows. Some say the bottom is in, others call for another 20% drop. Some say inflation is here to stay, some say we are already in a recession, other say stagflation. The challenge is Confirmation Bias. Are we really evaluating evidence with an open mind? Or are we only looking for evidence which confirms our point of view? Unfortunately, certainty is one thing which we do not get to have as investors. Luckily, we don’t need a crystal ball to be successful. We know what has worked over time: diversification, index strategies, and focusing on keeping costs and taxes low.

Two. Our Investment Themes for 2022 have been helpful. Year to Date: Value stocks are doing better than growth stocks. International stocks are doing better than US Stocks. Short-Term bonds and Floating Rate bonds have held up better than the Aggregate Bond Index. We are still down an uncomfortable amount, and that is to be expected. However, we are down less than our benchmarks across all our portfolio models. I am not ever happy about Bear Markets, but our asset allocation has been a positive factor.

Three. We are at a 52-week low in many stocks and indices. Look back over the last 10, 20, or 30 years of stock market history and find those 52-week low points. Going forward, were you better off selling those lows or buying those lows? Obviously, you would have done very well by buying historic 52-week lows and selling would have been a mistake eventually. Could the market go lower from here? Of course. We don’t know what will happen next, but market timing via selling 52-week lows has been a poor strategy historically.

Read more: Are We Headed For a Bear Market? (2015)

Four. We have made a few moves in our portfolio that I wanted to share. We sold some of our convertible bonds and replaced them with a Vanguard Commodities fund. This should help us reduce equity-like exposure and add an inflation hedge. We sold one emerging markets bond fund and replaced it with a newer fund (also from Vanguard) with a much lower expense ratio. We sold bond funds and replaced them with individual bonds, laddered from 1-5 years. Although interest rates may rise, we can hold bonds to maturity and receive back our par value. Overall, these trades do not drastically change our asset allocation. But we are always looking for ways to improve our holdings, even in modest, incremental ways. We are not ignoring the market, portfolios, or clients at this time.

Five. Patience. If you are a ways off from retirement, this is a great time to dollar cost average and be buying shares in your IRA, 401(k), or brokerage account. You make money in Bear Markets, you just don’t realize it until later. For those who are close to retirement, or in retirement, we are already diversified and have a withdrawal strategy that anticipates market volatility such as this. We are planning for the next 20-30 years. There will be multiple Bear Markets over your retirement. Although each Bear Market feels like a surprise, they are bound to happen. And like in 2020, we are using the current drop as an opportunity to rebalance portfolios and do tax loss harvesting.

Read more: Stock Crash Pattern (March 2020)

We’ve seen this before. We’ve been here before. Bear Markets are an unfortunate reality of being an investor. They stink and we would all prefer if markets only went up. When times are good, we need to invest with the knowledge that Bear Markets are inevitable. And then when Bear Markets do arrive, like Winter, we need to wait out the storms knowing that Spring will eventually return.

Ignore predictions. Our investment themes are on the right track. Don’t sell a 52-week low. Look for opportunities to make small improvements. Be patient and persevere. That is how we are responding to the Bear.

Why Index Funds Are Better

Why Index Funds Are Better

Twice a year, Standard and Poor’s provides an analysis of why index funds are better than actively managed mutual funds. Their report is known as SPIVA, S&P Index Versus Active. It is compelling evidence that investors would be better off using index funds. We’re going to look at the most recent data, discuss the perils of fund benchmarks, and then explain our approach of using Factor-based strategies.

Most Funds Lag Their Benchmark

Looking at 2021, 79.6% of US stock funds did worse than the overall market, as measured by the S&P 1500 Composite Index. It was a spectacularly bad year for active managers, even worse than most years. I focus on the long-term results, which are fairly consistent from year to year. For the 10 years ending 12/31/2021, 86% of US stock funds under-performed the market. Some of the funds which did out-perform did so by taking on much more risk. When we consider risk-adjusted returns, 93% of funds lagged.

The data is compelling and persistent. 80% or more of actively managed funds cannot keep up with their index over 10 or 20 years. And since that is the time frame that matters for long-term investors, the odds are in your favor if you use index strategies rather than active funds. It is extremely difficult for active managers to beat the index. There are many thoughts why this is the case:

  • Higher expenses. The cost of running a fund seems to wipe out any value they create through research and active management. Overall, market participants add up to the entire return of the stock market. That is the benchmark. But instead of being average (or actually Median) at 50%, the additional costs mean that 80% of funds trail the benchmark
  • Chasing performance. Active managers pay too much for hot stocks and ignore cheap stocks which are out of favor. Or they miss the handful of top performing stocks which are often the biggest drivers of market returns. Stocks, categories, and sectors go in and out of favor.
  • No information advantage. Today, analysts are smarter than ever and information is disseminated instantly online. The markets may have become so efficient that there are no “secret” stocks for active managers to uncover.
  • The 10-20% of managers who do outperform may have done so through luck, as they are typically unable to sustain out-performance from one period to another. Do we have data for that? Yes. It’s the S&P Persistence Scorecard.

Which Benchmark?

There are a lot of benchmarks and unfortunately, this can be confusing for investors. Sometimes, we might be comparing a fund to the wrong benchmark and not be making the most accurate comparison. Consider, for example, the Fidelity Contrafund. At $126 Billion in assets, it is one of the most successful active funds in history. And over the last 10 years, it has slightly beat the S&P 500 Index: FCNTX is up 282% through April 22, 2022, compared to 279% for the Vanguard 500 (VOO).

Unfortunately, that’s not the most accurate benchmark, because the Contrafund is a Growth Fund. As a better benchmark, you could have been invested in the Vanguard 500 Growth Index (VOOG). And VOOG was up 333% over the past 10 years. In this case, the active fund actually trailed the correct benchmark by 50% over 10 years. With Growth strategies dominating over the past 10 years, a lot of Growth funds look good compared to the S&P 500. But when we consider a Growth benchmark, you probably would have been better off in the index fund. (And for taxable accounts, the after-tax return of active funds are very often much lower than an ETF.)

Here’s another poor benchmark situation. This week, I was comparing two US Low Volatility ETFs with very similar strategies: the SPDR Large Cap Low Volatility (LGLV) and the Invesco S&P 500 Low Volatility (SPLV). Looking at a Morningstar report of 5-year performance, it showed that LGLV was in the 60th percentile while SPLV was better, at the 40th percentile. Unfortunately, the report was using two different benchmarks: large blend for LGLV and large value for SPLV. Their actual 5-year annualized returns were 14.01% for LGLV and 11.36% for SPLV. With different benchmarks, LGLV looked worse (60th percentile), even though it had actually out-performed SPLV by 2.65% a year! Which benchmark you use matters.

Using Factors To Look Forward

Although SPIVA shows why index funds are better, the harder part is deciding which index fund you want to invest in. You could just choose a World Index stock fund, like the Vanguard Total World Stock ETF (VT). And I am confident you would do better than most active managers over the next 10 or 20 years.

But, we don’t invest in an “all-in-one” fund.

Rather, my role as a portfolio manager is to determine the asset allocation for each model and level of risk. We decide which categories we want to own (large growth, small value, emerging markets, etc.) and what percentage to invest in each category. And rather than looking backwards at performance, we use today’s valuations to evaluate future performance. Once we have an asset allocation model, I can select an index fund to use to fulfill each category. It starts with the blueprint, not the funds themselves.

Rather than using generic index funds like a Total World Index fund, we buy 5-8 Index funds that invest using a “factor” strategy. This is a quantitative way of sorting stocks, using a characteristic such as Value, Size, Quality, or Low Volatility. They represent an Index or Benchmark, but have an additional screen to create a portfolio with specific qualities. There is evidence that Factors can outperform a benchmark over time, but clearly, they do not do so every year.

Today, we are concerned about some stocks’ high valuations. We have tilted our portfolios away from the large cap growth and technology names which have had such terrific performance that their values are so expensive today. Some of these stocks, such as Facebook (now called “Meta”) are down 45% year to date. That’s what can happen when a stock becomes too expensive and the market winds change direction.

Instead, we are looking ahead in anticipation of a reversion to the mean in categories such as Value, Small Cap Value, International and Emerging Markets. That’s no prediction that any of these will be up this year, it’s a long-term proposition. When I look at the S&P 500 Index today and see how expensive some of the names have become, I find it hard to stomach. And so, we are looking for ways to take advantage of passive, low cost, tax-efficiency of ETFs, but in a smarter manner than just throwing it all in a generic, market cap weighted index fund.

Once we understand why index funds are better, we are still left with two questions. Which benchmark to use and how do we want to invest? We are fortunate today to have easy access to many low cost index funds. Factor-based funds can help us establish potentially positive characteristics to our portfolios even compared to regular index funds.

We Bought An Airbnb

We Bought An Airbnb

In January, we bought a house in Hot Springs, Arkansas and have listed it on Airbnb. This is a new venture for us and I wanted to share my evolving thoughts about debt, inflation, cash, and real estate. Although the stock market has been down so far in 2022, don’t think that this means I am giving up on stocks as an investment. Not at all!

If you want to check out our property, here is the listing on Airbnb. My wife, Luiza, has done a great job of decorating and furnishing the house. And I owe a big thank you to my parents who spent three weeks helping us with renovations. It has been live for one week now, and we have eight bookings in April and May. Let me know what you think about the listing!

We Went Into Debt

Prior to this purchase, we were debt free and we purchased our new property with a mortgage. I could have sold investments and paid cash for the house, but I think that would have been a bad idea. Taking a mortgage is the better choice.

Leverage can be a tremendous tool, when used properly. Taking on debt to buy appreciating assets and cash flowing investments can have a multiplier effect. This is “good” debt. Bad debt would be spending on depreciating assets like cars, or using credit card debt to fund a lifestyle. I eventually realized that being debt-free would actually slow down our growth versus taking on some smart debt.

For Airbnb investors, a property evaluation is often based on the “Cash on Cash” return. What does that mean? Let’s consider a $200,000 house which produces a hypothetical $14,000 a year in profit. If you purchase the property with $200,000 cash, your Cash on Cash return is 7%. But if you put only 20% down ($40,000) and make $8,000 (net of the monthly mortgage), your cash on cash return is 20%. In other words, it can be a fairly attractive investment because of the leverage. Without the debt, the returns are not that compelling compared to stocks, for example. And if you use mortgages, you can buy $1 million of properties with $200,000 down. That could grow your wealth much faster than just buying one property for $200,000.

Debt, Inflation, and Government Spending

Beyond the numbers for this particular house, I think the world is now favoring debtors. Our government spending has been growing for years. And then when the pandemic hit, spending shot up dramatically and shows little sign of returning to its previous trajectory.

Our government, and many others, are running massive deficits and have no intention or ability to reduce spending. They will simply never pay off this debt. It will only grow. (See: the US Debt Clock.) We now have inflation of over 7%. I don’t think inflation will stay this high, but I also don’t think it will go back to 2%. Governments will have to inflate their way out of debt. There is an excellent video from billionaire hedge fund manager Ray Dalio: the Changing World Order. He documents historical civilizations who expanded debt and saw resultant inflation. It is a brilliant piece if you want to understand today’s economy.

Inflation favors debtors and penalizes holders of cash and bonds. 7 percent inflation over 5 years will reduce the purchasing power of $1000 to $600. The holder of a bond will see a 40% depreciation of the real value of their bond. And the debtor, such as the US government or a mortgage holder, will benefit on the other side.

I reached the conclusion that I should be a debtor like our government. Staying in cash and a lot of bonds, would be a poor choice long term. I didn’t sell any stocks to buy our investment property, but I did reduce cash and bonds. Today, we can borrow at 3-5% while inflation is at 7%. And if interest rates do come back down to 2%, I can always refinance the mortgage.

Read more: Inflation Investments

Thoughts on Real Estate Investing

  1. Real Estate is a business, not a passive investment. Managing an Airbnb is time consuming and can have headaches of dealing with people and problems. We have spent a huge amount of time (and about $14,000) improving our property and furnishing it for Airbnb. Buying an Index Fund does not carry as much risk or time commitment!
  2. It is the leverage which makes real estate attractive. Without the mortgage, not so much. (Imagine if we could buy $100,000 of an S&P 500 Index fund with only 20% down. That would be incredible over the long term.)
  3. Higher inflation can help real estate prices and rent prices, while our mortgage stays fixed. Besides the cash flow, we also benefit from: 1. Paying down the mortgage and building equity. 2. Increasing home value over time. 3. Some tax benefits such as depreciation.
  4. Your personal residence is still an expense, not an investment. More pre-retirees should be looking into House Hacking. This will enable many to retire years earlier.
  5. I like the returns on short-term rentals. With elevated prices today, many long term rentals have mediocre cash flow potential. Especially if we have some repair expenses and vacancy.

So far, we are happy to have bought an Airbnb. It fits well with our willingness to take risks, start a business, and do repairs ourselves. We are looking to buy another. But we know it’s not for everyone. If this is something which interests you, I am happy to discuss it with you and share what I know.

5 Ways to Buy The Dip

5 Ways to Buy The Dip

Right now, we are talking to investors about ways to buy the dip. From the highs of December, it is pretty remarkable how quickly markets have reversed. Stocks were already down in January as fears of inflation and rising interest rates took hold. The war in Ukraine has shocked the world and we are seeing tragic consequences of this inexcusable aggression. Inflation was reported at 7.9% for February and that was before we saw gas prices surge in March following the Russia sanctions.

This past Tuesday, we saw 52-week lows in international stock funds, such as the Vanguard Developed Markets Index (VEA) and the Vanguard Emerging Markets Index (VWO). Here at home, the tech-heavy NASDAQ is down 20%, the threshold used to describe a Bear Market. It’s ugly and there’s not a lot of good news to report.

Ah, but volatility is the fundamental reality of investing. Volatility is inevitable and profits are never guaranteed. In December, when the market was at or near all-time highs, everyone was piling into stocks. And now that many ETFs are near their 52-week lows, investors are wondering if they should sell.

Market timing doesn’t work

Unfortunately, our natural instinct is to do what is wrong and want sell the 52-week low rather than buy. Back in December, there were a lot of people hoping for a correction to make purchases. Now that a correction is here, it’s not so easy to pull the trigger on making purchases. The risks seem heightened today and nobody wants to try to catch a falling knife. Unfortunately, the market isn’t going to tell us when the bottom is in place and it is “safe” to invest.

Last week was the 13-year anniversary of the 2009 Lows. Most reporters say that the low was on March 9, 2009, because that was the lowest close. But I remember being at my desk when we saw the Intraday low of 666 on the S&P 500 Index on 3/06/09. Today, the S&P 500 is at 4,200 (down from a recent 4,800). Even with the 2022 drop, we have had a tremendous run for 13 years, up 530%.

A prospective client asked me this week what I had learned from being an Advisor back in 2008-2009. And I told her: First, you can’t time the market. Clients who decided to ride out the bear market did better than those who changed course. Second, individual companies can go out of business. You are better off in diversified funds or ETFs rather than trying to pick stocks.

Buying The Dip

While you shouldn’t try to time the market, we do know that “buying the dip” has worked well in the past. Since 1960, if you had bought the S&P 500 Index each time it had a 10% dip, you would have been up 12 months later 81% of the time. And you would have had an average gain of 12%. That’s a pretty good track record.

I feel especially confident about buying index funds on a dip. While some companies will inevitably become smaller or go out of business, an index like the S&P 500 holds hundreds of stocks. Over time, an index adds emerging leaders and drops companies on their way down. That turnover and diversification are an important part of managing an investment portfolio.

So with the caveat of buying funds, what are ways to buy the dip today? What if you don’t have a lot of cash on the sidelines? After all, if we don’t time the market, we are likely fully invested at all times already.

5 Purchase Strategies

  1. Continue to Dollar Cost Average. If you participate in a 401(k), keep making your contributions and buying shares of high quality, low cost funds. If you are a young investor, you should love these market drops. You can accumulate shares while they are on sale!
  2. Make your IRA contributions now. If you make annual contributions to an Traditional IRA, Roth IRA, 529 Plan, or other investment account, I would not hesitate to proceed. Make your contribution when the market is down.
  3. Rebalance your portfolio. Do you have a target allocation, such as 70% stocks and 30% bonds? With the recent volatility, you may have shifted away from your desired allocation. If your stocks are down from 70% to 65%, sell some bonds and bring your stock level back to 70%. Rebalancing is a process of buying low and selling high.
  4. Limit orders. If you do have cash, you could dollar cost average. Or, with your ETFs you can use limit orders to buy at specific prices.
  5. Sell Puts. Rather than just use limit orders, I prefer to sell Puts for my clients. This is an options strategy where you get paid for your willingness to buy an ETF at a lower price. We have been doing this for larger accounts with cash to deploy, but this not something most investors would want to try on their own.

Uncertainty, Risk, and Sticking to the Plan

There is always risk as an investor. Whenever you buy, there is a possibility that you will be down and have a loss in a week, a month, or a year from now. Luckily, history has shown us that the longer we wait, the better chance of a positive return in a market allocation. We have to learn to accept volatility and be okay with holding during drops.

We can go one step further and seek ways to buy the dip. To me, Risk means opportunity, not just danger. So, which is riskier, buying at a 52-week high or at a 52-week low? Well, neither is a guarantee of success, but given a choice, I would rather buy at a low. And that is where we are today.

I think back to March of 2020, when the market crashed from the COVID shut-downs. And I recall the horrible markets in March of 2009. In both cases, we stuck to the plan. We held our funds and didn’t sell. We rebalanced and made new purchases with available funds. That is what I have been doing with my own portfolio this month and it’s what I have been recommending to clients. We don’t have a crystal ball to predict the future. But we do know what behavior was beneficial in the past. And that is the playbook I think we should follow.

Amazingly, I have had only a couple of calls and emails from clients concerned about the market. None have bailed. We are in it for the long-haul. Market dips are inevitable. It is smarter to ignore them than to panic and sell. And if we can make additional purchases during market dips, even better.

Past performance is no guarantee of future results. Investing includes risk of loss of principal and Dollar Cost Averaging may not protect you from declining prices or risk of loss.

How to Reduce IRMAA

How to Reduce IRMAA

Many retirees want to find ways to avoid or reduce IRMAA. Why do retirees hate Irma? No, not a person, IRMAA is Income Related Monthly Adjustment Amount. That means that your Medicare Part B and D premiums are increased because of your income. We are going to show how IRMAA is calculated and then share ways you can reduce IRMAA.

Medicare Part A is generally free at age 65, and most people enroll immediately. Part A provides hospital insurance for inpatient care. Part B is medical insurance for outpatient care, doctor visits, check ups, lab work, etc. And Part D is for prescription drugs. When you enroll in Parts B and D, you are required to pay a monthly premium. How much? Well, it depends on IRMAA.

IRMAA Levels for 2022

IRMAA increases your Medicare Part B and D premiums based on your income. There is a two year lag, so your 2022 Medicare premiums are based on your 2020 income tax return. Here are the 2022 premiums, based on your Modified Adjusted Gross Income, or MAGI.

2020 Single MAGI

$91,000 or less

$91,001 to $114,000

$114,001 to $142,000

$142,001 to $170,000

$170,001 to $500,000

$500,001 and higher

2020 Married/Joint MAGI

$182,000 or less

$182,001 to $228,000

$228,001 to $284,000

$284,001 to $340,000

$340,001 to $750,000

$750,001 and higher

2022 Monthly Part B / Part D

$170.10 / Plan Premium (PP)

$238.10 / PP + $12.40

$340.20 / PP + $32.10

$442.30 / PP + $51.70

$544.30 / PP + $71.30

$578.30 / PP + $77.90

How to Calculate MAGI

I have written previously about how the IRS uses a figure called Modified Adjusted Gross Income or MAGI. MAGI is not the same as AGI and does not appear anywhere on your tax return. Even more maddening, there is no one definition of MAGI. Are you calculating MAGI for IRA Eligibility, the Premium Tax Credit, or for Medicare? All three use different calculations and can vary. It’s crazy, but our government seems to like making things complex. So, here is the MAGI calculation for Medicare:

MAGI starts with the Adjusted Gross Income on your tax return. For Medicare IRMAA, you then need to add back four items, which you may or may not have:

  • Tax-exempt interest from municipal bonds
  • Interest from US Savings Bonds used for higher education expenses
  • Income earned abroad which was excluded from AGI
  • Income from US territories (Puerto Rico, Guam, etc.) which was non-taxable

Add back those items to your AGI and the new number is your MAGI for Medicare.

Why Retirees Hate IRMAA

The IRMAA levels are a “Cliff” tax. Make one dollar over these levels and your premiums jump up. Many retirees plan on a comfortable retirement and find out that their Social Security benefits are much less than they expected because of Medicare Premiums. For a married couple, if your MAGI increases from $182,000 to $228,001, you will see your premiums double. And while young people think it must be so nice to get “free” health insurance for retirees, this couple is actually paying $8,164.80 just for their Part B Premiums every year! And then there are still deductibles, co-pays, prescriptions, etc.

Sure, $228,001 in income sounds a lot for a retiree, right? Well, that amount includes pensions, 85% of Social Security, Required Minimum Distributions, capital gains from houses or stocks, interest, etc. There are a lot of retirees who do get hit with IRMAA. And this is after having paid 2.9% of every single paycheck for Medicare over your entire working career. That’s why many want to understand how to reduce IRMAA.

10 Ways to Reduce MAGI for IRMAA

The key to reducing IRMAA is to understand the income thresholds and then carefully plan out your MAGI. Here is what you need to know.

  1. Watch your IRA/401(k) distributions. Avoid taking a large distribution in one year. It’s better to smooth out distributions or just take RMDs.
  2. Good news, Roth distributions are non-taxable. IRMAA is another reason that pre-retirees should be building up their Roth accounts. And there are no RMDs on Roth IRAs.
  3. Be careful of Roth Conversions. Conversions are included in MAGI and could trigger IRMAA.
  4. If you are still working, keep contributing to a Traditional IRA or 401(k) to reduce MAGI. If you are self-employed, consider a SEP or Individual 401(k). The age limit on Traditional IRAs has been eliminated.
  5. Itemized Deductions do NOT lower AGI. While State and Local Taxes, Mortgage Interest, Charitable Donations, and Medical Expenses could lower taxable income, they will not help with MAGI for IRMAA.
  6. However, if you are 70 1/2, Qualified Charitable Distributions (QCDs) do reduce MAGI. If you are younger than 70 1/2, donating appreciated securities can avoid capital gains.
  7. Avoid large capital gains from sales in any one year. Be sure to harvest losses annually in taxable accounts to reduce capital gains. Use ETFs rather than mutual funds in taxable accounts for better tax efficiency. Place income-generating investments such as bonds into tax-deferred accounts rather than taxable accounts. Consider non-qualified annuities to defer income.
  8. If you still have a high income at age 65, consider delaying Social Security benefits until age 70.
  9. Once you are 65, you cannot contribute to a Health Savings Account (HSA). However, you may be able to contribute to an FSA (Flexible Spending Account), if your employer offers one. The maximum contribution for 2022 is $2,850 and you may be able to rollover $570 in unused funds to the next year.
  10. Avoid Married filing separately. File jointly.

Life-Changing Event

Medicare does recognize that situations change and your income from two years ago may not represent your current financial situation. Under specific circumstances, you can request IRMAA be reduced or waived if you have a drop in income. This is filed using form SSA-44, as a “Life Changing Event”. Reasons for the request include:

  • Marriage, Divorce, or Death of a Spouse
  • You stopped working or reduced your hours
  • You lost income-producing property due to a disaster
  • An employer pension planned stopped or was reduced
  • You received an employer settlement due to bankruptcy or closure

Outside of the “Life-Changing Event” process, you can also appeal IRMAA within 60 days if there was an error in the calculation. For example, if you filed an amended tax return, and Social Security did not use the most recent return, that would be grounds for an appeal.

A few other tips: If you are subject to IRMAA and have Part D, Prescription Drug, coverage, consider Part C. Medicare Part C is Medicare Advantage. Many Part C plans include prescription drug coverage, so you will not need Part D. And there is no IRMAA for Part C. Lastly, while you can delay Part B if you work past 65, be sure to sign up immediately when you become eligible to avoid penalties.

IRMAA catches a lot of retirees, even though they don’t have any wages or traditional “income”. Between RMDs, capital gains, and other retirement income, it’s common for retirees to end up paying extra for their Medicare premiums. If you want to learn how to reduce IRMAA, talk with your financial advisor and analyze your individual situation. I’m here to help with these types of questions and planning for clients.

Bonds in 2022

Bonds in 2022

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

  1. We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
  2. Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
  3. We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
  4. Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
  5. I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Investment Themes for 2022

Investment Themes for 2022

Let’s look ahead to 2022 and consider what investment themes we believe should be incorporated into our portfolio models. This process is not meant to be a prediction of whether markets will be up or down. I don’t think anyone can time the market successfully. (Here is my letter to clients from March 21, 2020 for reference.) Rather, my goal is to add value to our investment process in three ways.

One, we want to tilt towards areas of relative value. That means when one category is cheap and another is expensive, we want to have more of the cheap stocks and less of the expensive stocks. This sounds obvious, but many investors chase performance without regard to valuation. Inadvertently, they load up on expensive stocks. Tilting towards cheaper categories is inherently contrarian as we are often buying what has recently lagged.

Two, we aim to identify Satellite categories which are attractive under the current market environment. Unlike our Core positions, Satellite positions are temporary and may be removed in future years. Satellite investments are stocks or bonds in a smaller, more focused niche than our core funds. For example, a Floating Rate Bond fund would be a satellite fund, whereas an Investment Grade Bond Index fund would be a core position. We select satellite funds with the goal of enhancing returns.

Three, to diversify our portfolios better, we include Alternative investments. We are looking for investments outside of the usual stock and bond categories which might offer an acceptable return, but with low correlation to the risks of stock markets or interest rates. This could include Real Estate, Hedge Fund Strategies, Preferred Stocks, Convertible Bonds, Commodities, Managed Futures, etc. Typically, these provide some ballast when stocks have a Bear Market, so their primary purpose is to reduce risk, rather than to increase return.

Stocks in 2022

Today, we are looking at our investment themes for stocks for 2022; next week we will cover bonds and alternative investments. Needless to say, there is a lot of uncertainty about the stock market going into 2022. As investors, we have to come to terms with the fact that markets do not always provide us with a clear and obvious direction. Uncertainty is the normal state.

No one knows what will happen with the virus or with the Federal Reserve trying to slow inflation without hurting the economy. Those are the two big questions facing stock investors at the end of 2021. However, those are known unknowns. Often, markets are surprised more by the unknown unknowns – the risks we aren’t even considering right now.

Over the past 50 years, the S&P 500 Index was down 12 years, up 37 years, and exactly at 0% in 2011. The 10-year return of the S&P 500 is 16% a year. Being negative on stocks has proven to be a losing bet over time. Yes, you can lose money on stocks and past performance is no guarantee of future results. With that disclaimer, I see no reason to attempt to try to time the market today and withdraw from stocks.

Tilts: Value, International, Small

Here is what I am doing for 2022: weighing relative valuations between stock categories. There are stocks which have gone way up and are probably overvalued. But there are also stocks which have lagged and are relatively cheap. We can break this down three ways: Growth versus Value stocks, US versus International Stocks, and Large versus Small companies.

Growth has lead the markets for more than a decade. As a result, the spread between value and growth categories has widened to historic levels. In fact, the difference today between Value and Growth is equal to what it was during the Tech bubble in 1999. For 2022, we are increasing our tilt towards Value. While we have little in pure Growth funds, we will be reducing our cap weighted index funds, which have become concentrated in Growth names.

US Stocks have led international for a long-time and there is now a wide gap in valuations. US stocks, especially Growth, are expensive. Most US investors have a significant home bias. For 2022, we will shift a small percentage from US to International. We are already overweight in Emerging Markets, and are not adding to our positions in EM.

Small versus Large has been very interesting in 2021. In the US, Small Value has had a great year and looks promising for 2022. US Small Growth, however, lagged Large Growth by more than 20%. In other developed markets, small cap lagged large cap by a small amount. In Emerging Markets, small cap outperformed large cap by more than 20% year to date. There is not a uniform trend here, except that Small Value has done better than Small Growth. In terms of diversifying and looking for cheap stocks, our small cap selection will lean towards value rather than core or growth.

Taxes Matter

We will be making trades to our portfolios for 2022. Even after these trades, a 60/40 portfolio is still going to have about 60% in stocks and 40% in bonds. But the weightings of the positions will change slightly and some of the funds used may change. Our goal is to reduce risk and stay broadly diversified, while using low-cost investments that are transparent and have a good track record.

Throughout the process, we aim for tax efficiency. Changes are easy to incorporate in IRAs and that is always our first choice. In taxable accounts, we harvested losses in March of 2020, which carried forward to 2021. That can also allow us to make some changes without creating additional taxes for the year. And while I could automate the trading process, I am looking at this one client at a time, to do what is best for you, not easiest for me.

Next week, we will discuss our investment themes for 2022 for bonds and alternatives. Then we will be placing trades at the end of December and into January for most clients. I should note that even without making any changes to the portfolio models, we would still be looking to rebalance here at the end of the year. We will do both steps at the same time – rebalancing and any changes to the model – to avoid any unnecessary trades.

I examine investments all year round, but try to limit changes to once a year to avoid short-term trading. Each year, in the fourth quarter, I go through a process of reviewing all our holdings and our allocations. Here is what I wrote last year, looking ahead to 2021: Investment Themes for 2021

Have concerns about your investment portfolio or specific investments? Will your portfolio be sufficient to achieve your goals? How will you transition your accumulation portfolio to spending it down? These are uniquely individual questions and where our conversations can be the most valuable.

Year End Tax Planning 2021

Year End Tax Planning 2021

Let’s discuss some of the key year end tax planning strategies for 2021. It has been a remarkable year with markets soaring, inflation picking up, and the economy booming as we recover from the Pandemic crash last year. A year and a half ago, there were losses everywhere. Now, investors in stocks, real estate, cryptocurrency, and other assets are facing significant gains. Taxes are a major concern.

Here are 10 tax steps to consider before December 31.

Capital Gains Considerations

1. Beware of active mutual funds distributing large capital gains in December. If you have active funds in a taxable account, then make sure you are NOT reinvesting dividends. Better to take that cash and invest in a more efficient ETF or to rebalance.

2. Harvest losses, if you have any for 2021. We harvested losses via tax swaps last year and carried forward tremendous tax benefits into 2021 for our clients. This will help us as we look to rebalance portfolios at year-end.

3. If you are in the 12% tax bracket, your long-term capital gains rate is zero. You can harvest long-term gains and pay no tax. Rather than harvesting losses, you should harvest gains! Then, you can immediately buy back your ETF or fund and reset your cost basis higher. This will help protect you against future taxes. Don’t hold on to gains until future years.

Who is in the 12% bracket? For 2021, this includes single filers with taxable income under $40,525 and married filers under $81,050. Taxable income is after you subtract your standard deduction. So, add back the standard deduction of $12,550 for single or $25,100 married, and you could have gross income of up to $53,075 (single) or $106,150 (married).

4. If you anticipate you will itemize for 2021, bunch deductions as possible before the end of the year.

IRAs and Retirement Contributions

5. If you are able, increase your automatic contributions for 2022. While IRA contributions remain at $6,000 for 2022 ($7,000 if 50+), 401(k) contributions are increased to $20,500 or $27,000 if 50+. Health Savings Accounts are bumped up to $3,600 or $7,200 for a family.

6. Washington wants to eliminate the Backdoor Roth IRA. If you are eligible for 2021, I would do it right away. It may be gone in 2022!

7. Alternatively, if you are in a low tax bracket, consider making Roth Conversions before the end of the year to convert within your low bracket. The key to making this work is making small conversions over many years. Not sure how much to convert? Then let’s talk.

Giving Strategies

8. Even if you do not itemize, you can take an above-the-line deduction for a cash charitable donation of up to $300. For couples, this is doubled to $600. This is only for 2021. In 2022, you will have to itemize to deduct any charitable donation. Above this amount, we suggest donating appreciated securities from a taxable account rather than cash.

9. Consider using your annual gift tax exclusion of $15,000 for personal gifts or for funding a 529 Plan for 2021.

10. If you are 72 or older, don’t forget to complete your Required Minimum Distributions for 2022! Congress waived RMDs for 2020 but they are back this year. If you are over 70 1/2, you can make Qualified Charitable Distributions from your IRA which will count towards your RMD. Be sure to complete any QCDs by December 31.

These are 10 of our top ideas for year end tax planning 2021. I am constantly searching for ways to improve client’s tax situation and add value to their financial planning. I have been getting many new clients this year who are facing large tax bills in the years ahead! Many people aren’t thinking about the eventual taxes as they are building a portfolio or growing a 401(k). And then one day, they realize they have need some help in managing their life in a more tax-wise manner. If that’s you, we can help!

House Hacking

House Hacking

If you are looking to buy a home and want to really grow your wealth, consider house hacking. Our ability to save, invest, and grow real wealth begins with a very simple premise. You have to spend less than you make. It couldn’t be more simple, but that doesn’t make it easy.

For most people, your three biggest expenses are housing, taxes, and cars. If we manage those three expenses well, you may be able to save a significant amount of your income. The more you save, the faster you grow, and the sooner you might reach your goals. Read more: Five Wealth Building Habits

The problem is that most Americans are doing the opposite and creating a lifestyle which consumes 100% of their income. And then there is nothing, zero, left to invest.

House Hacking gives you an incredible opportunity to reduce your biggest expense, in some cases, down to zero. Here’s how. Instead of buying a single family home, you buy a duplex, triplex, or four-plex. You live in one unit and rent out the rest. Your tenants will cover much or even all of your mortgage. You can live there with little or no monthly expenses.

With a house hack, you are freeing up your income so you can save and invest. You can pay off your credit cards. Maximize your 401(k) and Roth IRAs. Start saving for college in a 529. And it’s all because you were willing to live in a multi-family home rather than spending thousands every month on a single family home.

The Details

Sure, house hacking isn’t going to be for everyone. But maybe you want to ask how this might work, if you were to consider it. Although you are buying a multi-family building, you are going to use the house as your primary residence and live there. That means you can still use an FHA mortgage and not have to get a more expensive mortgage for a rental or investment property. With an FHA mortgage, you can put as little as 3.5% down with a FICO score of just 580.

Of course, if you have 20% to put down, you could also do a conventional mortgage as a primary residence. Or, if you’re a veteran, you might be eligible for a VA loan with zero down.

Once you have the property, you can split costs between the area where you live and the area which you rent. This means you can also enjoy some of the tax benefits of being a landlord. Let’s say for example, that your building is 3,000 square feet and you live in 1,200 feet and rent out the rest. You occupy 40% and have 60% as a rental.

Then you can look at your costs, such as insurance, utilities, repairs, taxes, etc. For your bills on the whole house, you can allocate 60% of those costs against your rental income on Schedule E. For the 40% where you live, you can also qualify for the Section 121 capital gains exclusion, when you sell.

Living with other people in the same building might not be your dream situation, but if you can make it work, there could be great benefits for you financially. When you manage your biggest expenses, it becomes easy to have money left over to save and invest. Put your savings on autopilot. Maximize your 401(k). Put $500 month into your Roth IRA to get to the $6,000 annual limit.

Who Can Do a House Hack

House hacking certainly makes sense for a first time home buyer, a single person, or a young couple. That’s probably the typical situation. But it could also work well for older investors who want to turbo charge their savings while they are still working. And if you could reduce your monthly housing cost from $2,000 to $200 or $0 a month, would that change when you will be able to retire? Probably. A house hack might enable you to retire at 55 versus 65. Under the 4% rule, reducing your expenses by $2,000 a month means you now need $600,000 less in your nest egg to retire.

Most of us will resist making a sacrifice to be able to save. Still, if you have an open mind, a house hack might be a brilliant way to save and invest. While your friends and colleagues are barely saving anything, you might be able to put away 50% of your income while your tenants are paying down your mortgage. If you can invest $2,000 a month for 10 years, at a 7% return, you could have $344,000. That might be worth a small sacrifice.

Housing is an expense. Your house should go up in value over time, but the expenses of interest, taxes, insurance, and upkeep are not building your wealth. What if you get someone else to pay for your house? When you reduce those expenses, you are giving yourself a tremendous opportunity to save and invest in appreciating assets. If that is important to you, look for creative ways to cut your biggest expenses!

Have you done a house hack? I’d love to hear from you about your experiences. Send me a note!