January 31, 2013
Dear Clients and Friends:
The American Tax Relief Act of 2012, signed into law on January 2, averted the fiscal cliff and preserved many existing tax provisions. As a result of the new law and negotiations, these are some important takeaways:
- The 2% reduction in the employee’s portion of Social Security taxes was allowed to expire at the end of the year. As a result, employees and employers will revert back to being equally responsible for contributions in 2013.
- Tax rates for earned income, dividends and long term capital gains will stay the same for all single filers with taxable incomes of $400,000 or less, and all joint filers with taxable incomes of $450,000 or less. For individuals above those limits, long-term capital gains and dividends will be taxed at 20% (up from 15%) and ordinary income will be subject to a rate of 39.6% (up from 35%).
- Beginning in 2013, the phase-out of itemized deductions and personal exemptions has been re-instated for single filers with Adjusted Gross Income (AGI) over $250,000 and for joint filers with an AGI over $300,000.
- The Alternative Minimum Tax (AMT) is still with us, but at least the annual exemption amount will be automatically increased with inflation. We are no longer subject to last minute patches by Congress to avoid even more taxpayers from being subject to this separate tax system.
- The federal estate tax exclusion of $5 million was retained and indexed for inflation. The exclusion is $5,250,000 this year. The exemption is portable, meaning that any unused exemption of a decedent can be elected to be carried forward for the benefit of a surviving spouse.
- Taxpayers subject to required minimum distributions from retirement accounts and plans can designate up to $100,000 of the distribution to qualified charities for 2012 and 2013. This is valuable for clients who would not normally receive a tax deduction for making charitable contributions or wish to lower their AIG to lessen exposure to Social Security taxation, high Medicare premium adjustments, or personal exemptions.
In addition to the above, the Patient Protection and Affordable Care Act (also known as Obamacare) includes the following tax changes for 2013:
- There is a 3.8% surcharge on a taxpayer’s net investment income if the taxpayer’s modified Adjusted Gross Income exceeds $250,000 for joint filers and $200,000 for single filers. Common investment income categories included are: interest, dividends, annuities, royalties, passive activities, and net gains from the disposition of property not used in a trade or business.
- The employee portion of the hospital insurance tax part of FICA (Federal Insurance Contributions Act), normally 1.45% of covered wages, is increased by 0.9% on wages that exceed $250,000 for joint filers and $200,000 for single filers.
- The itemized deduction of unreimbursed medical expenses has increased from 7.5% of adjusted gross income to 10% of adjusted gross income for taxpayers younger than 65.
The two major areas of financial uncertainty have been taxation and deficits. With taxation guidelines having been set by the above two Acts, focus has now shifted to spending guidelines. The battle remains over how and when to address deficit spending and growing debt. The inability of addressing these issues in any meaningful way is akin to passing the problem and the required sacrifices on to children, grandchildren and future generations. This is an unattractive legacy and one we hope today’s leaders will not ultimately accept.
A Smoother Ride
Our goal from an investment standpoint is clear. We aim to reduce the bumps in the investment road by amply diversifying and selecting strategies that have inherently lower volatility. Of course, the strategies vary depending on current and future client cash needs. This approach has a clear benefit. Reducing volatility should enable clients to stay the course and not fall victim to a sequence of bad returns, nor abandon course as a result of sharp market downturns. We will explain why a focus on risk, while often ignored by investors, is a key element to investor success.
Risk, the Stealth Financial Killer
Investors vastly underappreciate the concept of risk and how our brains process it. As advisors, risk is ingrained in our head as a result of being inundated with: financial information and solicitations, exposure to client’s emotions through market up and downs, and proactive reading of books that address the topic (Black Swan, Why Smart People Make Big Money Mistakes, Your Money Your Brain, and most recently, Thinking Fast and Slow). For most investors, performance and even more so, recent performance, is their single metric of focus. It is not coincidental that investment product marketing preys on this focus. Ask yourself how many times you have viewed a financial advertisement that emphasizes risk, rather than return. By the way, if you find such an advertisement, please forward it to us.
Consider the following example, which compares the returns of two funds over the last few years:
Which fund would you rather own?
We would imagine that most investors, given this limited amount of information, would choose Fund A with little hesitation. How many of us reach a conclusion or make a decision based on limited information? The reality is, most of us do. We just do not make the effort to consider information we are lacking, which would lead to a better understanding of the options and better decisions.
By the way, Fund B is the Vanguard S&P 500 (Ticker: VFINX) and Fund A is an ETF (Ticker: RSU) designed to deliver approximately two times the returns of the S&P 500 using derivative exposure. This essentially means that Fund A and B are correlated almost 100%, with Fund A moving twice as much as Fund B in the same direction. Incidentally, in 2008, the year of the Lehman bankruptcy, Fund B returned -37.02% and Fund A, as one would expect given the additional information above, returned -67.67%. Bottom line is that Fund A carries twice the risk as Fund B, but that isn’t apparent by looking at the string of returns listed.
Risk is especially important to an investor who needs periodic cash flow from their portfolio. If initial cash needs coincide with portfolio downturns, it leaves less money to appreciate when the portfolio rebounds. If the recovery of the portfolio is prolonged, the results can be financially catastrophic. The sequence of returns, especially any large market declines, matters when it comes to financial survival.
The following article from Thornburg Investment Management illustrates this point:
Sequence of Returns
To illustrate the importance of the sequence of returns to retirees and just how misleading using a historical average return can be, let’s look at a 20-year period (1989-2008) of returns for the S&P 500. We used this period to illustrate the impact that the sequence of returns might have had for a retiree who began retirement right before the beginning of the 2008 financial maelstrom. You can see from figure one that the average return for this twenty-year period was 8.43%. Reverse the sequence, 2008–1989, and once again, the average annual return is 8.43%! This average annual return is only relevant to an investor who did not invest or withdraw additional funds during this entire 20-year period. For retirees taking systematic withdrawals, the order in which they realize their returns is crucial to the long-term sustainability of the retirement portfolio.
To more fully understand the impact of the sequence of the returns, review the 1989–2008 returns and note how nine of the first ten years had positive returns which would have allowed the portfolio to grow nicely. Conversely, for the 2008–1989 sequence, the first year experienced a substantial decline of negative 37% and four of the first ten years were negative as well. This poor sequence would have created pressure on a portfolio that was already undergoing the stress of systematic withdrawals.
Impact in Retirement
To illustrate the combined effects of systematic withdrawals and sequence of returns, let’s use the 1989–2008 and 2008–1989 sequences on a retiree who has a hypothetical $1 million in retirement savings, wishes to spend $50,000 (5% initial withdrawal rate) in the first year, and is indexed to inflation (3.0% average).
The portfolio is invested 100% in equities represented by the S&P 500 Index. As you can see from the chart in Figure two, after 20 years in retirement, the 1989–2008 sequence has supported the retirement spending and allowed the account value to grow to over $3.1 million. However, the results for the 2008–1989 sequence are quite different. The negative 37% performance in year one followed by significant negative returns in years seven, eight, and nine dramatically deteriorated the account value to approximately $235,000.
Figure 2. Sequence of Returns Impact on a Hypothetical $1 Million Investment Undergoing Systematic Withdrawals
Sponsored by Thornburg Investment Management, 2300 North Ridgetop Road, Santa Fe, New Mexico 87506
While the above piece clearly illustrates how market downturns can impact a portfolio, it is even worse when we consider investor psychology. Behavioral finance has proven that investors feel the pain of loss much more than the pleasure of a similar gain. The consequence is that a large downturn in the market, as happened in 2008, can very likely cause an investor to abandon equities at exactly the wrong time. We can echo this finding by our own personal experience in late 2008, during which some clients called us with a desire to become more conservative by shifting out of stocks, or abandoning stocks altogether. Morningstar validates this as well by measuring investor returns versus actual returns of all mutual funds. The measure calculates the returns that are actually achieved by an investor, based on points of entry and exit versus the return of the fund, if it was bought and held through the entire period. Rather than providing the full Morningstar article, their ultimate conclusion was irrefutable. Investors capture better returns in funds that exhibit lower volatility (less risk). The rationale is that investors are most likely to chase funds after a significant upside move only to get whipsawed and sell out after funds decline. Here is the data on the CGM Focus fund to illustrate (returns ending 7/31/2009):
CGM Focus' trailing 10-year return suggests that a $10,000 investment a decade ago would now be worth $51,633. The fund's trailing 10-year Investor Return over that span, however, suggests that the same $10,000 shriveled to $1,585! The difference, all $50,048 worth, is attributable to investors' repeatedly mistiming their purchases and sales in chasing performance.
Investment Allocation Implications
We will increase our low correlated stock market exposure in a conservative manner using the Ironclad Managed Risk fund (IRONX). The fund has clearly demonstrated its ability to earn superior, risk-adjusted returns. Also, we will continue to hedge out a substantial portion of our fixed income interest rate risk using the ProFunds Rising Rate Opportunity Fund (RRPIX). Please note this fund is being used for the specific purpose of hedging out interest rate risk against the other bond fund positions in client portfolios. It is not an explicit bet that rates are on the rise. The position should be viewed in concert with the other fixed income funds as a whole, and not independently. From an equity standpoint, we will continue to overweight large-cap U.S. stocks outside our core global fund positions. U.S. multinationals trade at better valuations than small cap equities, and suffer less during market declines. We will be splitting our hard asset exposure between two funds with the addition of the RS Global Natural Resources Fund. Real assets provide protection against devaluing currencies.
Part of the increase in IRONX will be through the divestiture of the Hussman Strategic Growth Fund (HSGFX). We continue to believe that Jon Hussman’s research on the market is extremely valuable and that he makes a valid case on how much market exposure to accept based on fundamental factors. However, we are concerned with the cost of his hedging techniques that continue to eat away at investor principal as the market continues its bull run. IRONX has a similar conclusion on the market, but adopts a more constructive stance on the positioning of his fund, which ultimately is less costly for investors as market dynamics play out.
Annual Net Worth Statements
We are in the process of preparing personal Net Worth Statements as of December 31, 2012. Taking a picture of assets and liabilities on an annual basis provides us with the ability to improve our services to you. Some examples include:
- Should any existing financial accounts be consolidated in the interest of simplification?
- Should there be any changes in asset ownership that will minimize income taxes?
- Should there be any changes in asset ownership that will minimize estate taxes or probate expenses?
- What is the nature of any current debt? Should any debt be paid off or refinanced? Was personal spending supplemented by an increase in debt, which could impact retirement feasibility or retirement security?
- Have there been any additions to personal property requiring insurance coordination?
- Were there any purchases, sales, or gifts of real estate interests?
- Were there any changes in asset ownership not communicated to us? Ownership changes impact insurance, taxes and estate planning.
We consider the preparation of these Net Worth statements an important part of our coordinated financial planning service. Please respond promptly to our request for December 31, 2012 values.
Information for Tax Return Preparation
In recent years the IRS has placed increased emphasis on the accurate reporting of tax cost basis information when securities are sold. In 2005, the IRS estimated that the federal government lost $11 billion in revenue as a result of inaccurate reporting. As a result, new requirements for custodians, such as brokerage firms, were signed into law in 2008. Custodians are required to report to investors and the IRS on Form 1099-B:
1. Stock transactions posted on or after January 1, 2011.
2. Mutual fund and dividend reinvestment plans on or after January 1, 2012.
3. Financial instruments such as debt securities and options on or after January 1, 2014.
The above are considered "covered" transactions requiring reporting. Transactions before these dates are "uncovered", meaning the custodian is not required to submit accurate basis information for those transactions.
We will review a sample of 1099-B forms as they are posted to client accounts at Fidelity and reconcile them to our portfolio accounting records. We recommend that clients forward both custodian-produced 1099-B’s and the Schiavi + Dattani Realized Gains and Losses Reports to their tax preparers. If you would like us to forward our Gains and Losses Report directly to your preparer on your behalf, let us know.
Please note that if you were not a client of Schiavi + Dattani for the entire 2012 year, gains and losses that occurred prior to our management will have to come from your own records.
We will also forward to clients, and their preparers if requested, a summary of financial planning and investment advisory fees paid in 2012.
Annual Delivery of Privacy Statement
We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.
Information Filing - Securities and Exchange Commission (SEC)
The Securities and Exchange Commission requires all registered investment advisors to update the information on file with the agency on Form ADV within 90 days of year end, or March 30. We intend to revise that form and have a copy posted on our website by that date. If anyone does not have access to our website and desires a copy of that form, please contact us.
2013 Annual Tax Planning Limits
A summary of key tax planning limits for the current year has been attached for your reference.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA
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