Dear Clients and Friends:
The Big Picture
The economy continues its slow rate of improvement, but we are far from out of the woods. The troubles in Europe have not been adequately addressed and the fear that these troubles will spread, currently referred to as "contagion," will not easily fade away.
America has not made sufficient progress in areas of employment and housing. Low unemployment and a sound housing environment have been key ingredients in America’s recipe for financial success. Our concern is the possibility that both employment and housing have entered new paradigms with difficult futures.
It is becoming more and more apparent that if nothing significant is done, America will become a land of significant over-achievers and significant under-achievers. America needs jobs. The gap between the education and skills learned by our children and the requirements of available jobs has to close significantly. The pace of technology’s impact will not slow. Education and training that does not keep pace will contribute to a widening achievement and income chasm.
Iran, Syria, and North Korea are hotspots that could easily boil over. In our view, the most dangerous from an economic view is Iran, with its ability to disrupt oil tanker traffic in the Straights of Hormuz. Twenty percent of the world’s oil trade flows through its four mile channel. Clients should expect short-term disruptions to financial markets, if trouble erupts in any of these areas.
Savers continue to carry the load for debtors as interest rates stay historically low. After inflation and taxes, money markets and CDs are producing negative returns. The Securities and Exchange Commission (SEC) and Congress are debating changes in the money market fund industry. There is a movement to let the share price, or Net Asset Value (NAV), float to reflect the underlying market value of the financial investments in the fund, instead of a constant $1 price quote. Any changes could significantly impact the way emergency cash is held. We will keep you posted on any developments.
Attention is being drawn to the $1 trillion in outstanding student debt and the impact it is having on young people attempting to establish households. The interest rate on government subsidized loans is scheduled to double without legislative relief. Any attention to this area is welcome. For parents in a position to help their children, the cost of college becomes a retirement problem. For students, excess loan balances feel like a heavy backpack on a long hike, it makes progress slower and more difficult.
A rule of thumb proposed by some is to limit undergraduate student debt to the student’s expected first year salary.
As many of you know, umbrella insurance provides excess liability protection for claims related to home and auto incidents, as well as protection for claims that are not traditionally covered by home and auto insurance polices. Deciding how much umbrella coverage to purchase is a challenge. We have come across recent professional recommendations suggesting that liability protection should approximate one’s net worth. Take a moment to compare your most recently prepared net worth statement to your total liability insurance protection. We realize that every client’s risk exposure is different and that many may not require additional coverage. However, if you are concerned and want to discuss adjusting your coverage, please give us a call.
The Health Insurance Portability and Accountability Act (HIPAA) was passed by Congress in 1996. The Privacy Rule became effective on April 14, 2003. As a result, medical providers are more careful about releasing medical information to even close family members of patients.
We encourage you to review your health care directives to see if they specifically waive your HIPAA privacy rights, allowing your appointed health care agent access to important medical information. In the absence of that language, you may need a specific HIPAA release form. We will coordinate your findings and questions with your estate planning attorney.
Retirement Account Tax Treatment
There is serious talk in Congress of limiting contributions to qualified retirement savings plans, like 401ks, and accelerating the taxation of inherited IRAs. Congress is desperate to increase revenues and reduce the deficit. Even though money contributed to retirement plans is eventually taxed, immediate deferrals are looked upon as tax saving expenditures that can be reduced.
As employers continue to erode pension benefits, our legislators should be promoting thrift and self-reliance.
Successful investing, especially in the withdrawal stage of life, involves minimizing downside risk even if that means forgoing some upside return. Remember, an important goal of prudent financial management is to spread out the economic benefits of our "working years" over our entire lifetimes. Unfortunately, the variableness of our lifespan makes this an inexact science. Two investors could have the exact same long-term return and same spending patterns, but have very different outcomes. The reason: success depends on the pattern of returns.
To illustrate, let’s assume that we have two investors, Bob and Beth. Both retired with $1,000,000 and wish to withdraw 4% from their initial portfolio balance, adjusted for 3% average inflation. They both have an average 6% annual return over a five-year period.
Bob’s pattern of returns to achieve 6% per annum is smooth and uneventful. Beth’s pattern of returns is: -15%, 15%, 3%, -2%, 35.63%. Bob ends year five with a portfolio value of $1,099,624, and Beth ends with $1,058,157, a difference of $41,467, even though both investors achieved the exact same 6% return over the five-year span.
In short, it is not just total return that matters, the pattern of returns impacts results. Most investors focus on returns and not the variability of the returns. When we mention risk, volatility, or minimizing downside risk, this is our focus as advisors.
The primary macro factor influencing our current defensive stance is corporate profits. The current level of these profits, we believe, distorts the current stock price to earnings per share ratio (P/E), which is widely viewed as the best way to assess how "cheap" or "expensive" the stock market is. One of the methods that removes a point and time snapshot of earnings is the cyclically adjusted price to earnings ratio (CAPE). We have discussed this at length in the past. CAPE normalizes earnings by averaging ten years worth of profit data. This prevents outliers from distorting the P/E metric.
The P/E of the S&P 500, based on current earnings,is close to 13, where normalized earningsCAPE stands at 22. At a P/E of 13, stocks are cheap from a historical perspective, but at 22, they are expensive.
A different, yet similarly compelling way to arrive at the same conclusion is by comparing current corporate profit marginsto their long-term averages. Today, margins are at an all time high of 10.3% of Gross Domestic Product (GDP). The fifty-year average profit margin for stocks is 6.2%. If we take the current P/E of 13, and adjust it for average profit margins, we arrive at an adjusted P/E ratio closer to 20.
We cannot predict if P/Es will stay at these levels for a month, a year, or even longer. However, we do believe they will revert back to their mean, or average. History has always shown this to be the case, and there is little evidence to suggest otherwise. Long periods of tame inflation have been the only environment where stocks remain priced at elevated levels. Above average inflation or deflation changes everything. We are not willing to assume that inflation will remain tame indefinitely. As a result, we do not believe it would be prudent to reverse our defensively shaded investment allocations.
Health Savings Accounts
An increasing number of our clients are gaining access to Health Savings Accounts (HSAs). As a result, we thought it would be useful to provide a brief summary of HSA features.
HSAs were created in 2003 to help individuals save for future medical expenses on a tax-free basis. Employee contributions to HSAs are deductible even if the employee does not itemize, investment earnings are not taxed, and withdrawals to pay medical expenses are not taxable. In order to be able to contribute to an HSA, an individual must have a qualified "high deductible health plan" in place, have no other first-dollar coverage, not be enrolled in Medicare, and cannot be claimed as a dependent on someone else’s tax return. Both employees and employers can contribute to an HSA. Contributions are limited to $3,100 for individuals ($4,100 if over age 55) and $6,250 for families ($7,250).
You can use the funds placed into an HSA for the out-of-pocket costs of your high deductible plan as they are incurred, or you can build up your account over the years and reimburse yourself later.
If you are considering using an HSA and want to discuss in greater detail, please let us know. We encourage all currently employed clients to use us as a resource when considering employer-sponsored benefits during your enrollment period.
An Important Request from Retired Clients
We would like to ask our retired clients for some pertinent information. Transitioning into retirement is a significant challenge. Many of our clients have successfully made this transition and are happy with their decisions. Their positive outlook and grace in dealing with the speed bumps of life is inspiring.
We would greatly appreciate your recommendations regarding retirement. We will use your responses to better our planning skills for clients. Please take a moment and reflect on your own personal journey. What has worked and what would you do differently? Feel free to direct your feedback to Vincent’s attention.
Form ADV Part II Annual Update
The SEC requires all federally registered investment advisory firms to file an annual amendment. This amendment is attached for your review.
2011 Tax Returns
Please provide us with a copy of your completed 2011 federal and state income tax returns, including Form W-2, along with a copy of any planned 2012 estimated tax payments. This information is critical to more effectively perform tax planning. To date, we have received a number of returns from tax preparers authorized to do so. Before contacting your preparer and asking them to forward this information to us, you can check with us to see if they have already sent us a copy.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA