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May 6, 2014

Dear Clients and Friends:

It has been a particularly long and bitter winter for those of us residing in the Northeast. Knowing that spring and warmer temperatures would inevitably arrive gives us hope for better days. Although most changes bring anxiety, the predictability of the season’s change brings some comfort.

There are patterns in the economy and the markets, but they are far less predictable. Patterns and cycles repeat, but their lengths and magnitudes are a mystery. Economies go from recession to growth and back again. Markets go from depressed levels to bubbles, driving human behavior from levels of fear to greed and the many points in between.

This is the challenging environment that financial advisors face when providing guidance to clients who need to balance existing and expected resources with current and expected needs.

Why is Risk Important?

In the world of investing, "return" is the buzzword of the industry. You cannot read an article on mutual funds or the front cover of a financial magazine without seeing the word mentioned, usually followed by table of numbers and possibly graphical illustrations. We invariably hear from prospects or friends, "What are your returns?" The rarity is when we hear, "How risky is your portfolio?" or "How much risk are you taking?" This stems from the general inability to get our heads around the term "risk" and how it impacts investing. We will attempt to bridge this gap through a couple of examples:

1. You have a choice of loaning money to Warren Buffett, or a friend who has difficulty holding a steady job and has little savings. Warren is willing to personally guarantee you 5% interest on a five-year loan. Your friend, however, is willing to guarantee you 7% annually over five years. Which one would you choose (financially speaking)? How did risk impact your decision?

2. You know in advance that company A’s price will increase exactly 5% per year for ten years, growing by 63%. You also know that company B will drop in price the first year and will also drop in price another four out of the following ten years, but recover in price so that by year ten it is 63% higher than today. You can buy either company only today and sell either company at any time during the ten-year period. Would it make sense to view investing in company A the same as company B? After all, the ten-year prospective return is exactly the same.

3. You are allowed to make only one investment this year with your entire portfolio. Unbeknownst to you, its performance will be based on the equivalent of a coin flip, with a 100% return on "heads" and a 100% loss on "tails". You are lucky. Heads it is and you earn 100% on your investment. The following year, your friends ask you how your investment performed. You smile and say that your "return" was 100%. How meaningful is that statement without disclosing that it was based on the equivalent of a coin flip?

Remember, the assessment of risk is only relevant at the beginning of the investment period, not at the end, when realized return becomes the only reality. It is like asking a lottery winner to evaluate the risk of loss of their $1 lottery ticket after she has won the $10 million jackpot.

Bottom line: All return is not created equal; it must be considered in light of perceived risk. Risk is forward-looking; it does not carry the benefit of hindsight. One win of a coin toss is an isolated event.

Convenient Rose-Colored Glasses

A large commercial bank / securities firm presents hypothetical portfolios with unrealistic return assumptions to woo prospective clients into signing up with them for portfolio management. We have seen these time and time again. The returns presented often rely on internally generated capital market assumptions, which supposedly represent the prospecting firm’s most accurate projection of risk and returns for the next 10-15 year period. The returns are almost always unrealistically high and self-serving.

We recently reviewed some marketing material presented to a client. Because the hypothetical returns were extremely high, we asked for the underlying return assumptions for the various asset classes (you know what they say about assumptions). Their return assumptions are on the attachment titled "Strategic Asset Allocation". For comparative purposes, we included the prospective return assumptions of an impartial firm that advises institutional investors and is not in the business of asset gathering. The asset gathering commercial bank / securities firm projects that cash equivalents (e.g. savings accounts and money markets) will return 3.5% and large U.S. stocks will return 9.25%. The institutional advisory firm projects a return for cash equivalents of 1.04% and a return for large U.S. stocks of 5.42%. What a world of difference! Which one do you think will attract more clients?

Bottom line: There is no shortage of biased information and deceptive marketing practices. We hear about our friends’ winning investments, but rarely the losing ones. We see mutual fund companies tout the performance of their best funds, while merging their worst into other funds to erase their history. We see financial firms choose convenient beginning and ending periods for which to report returns. Much too often attractive historical returns are used to lure prospective investors, while burying "past performance is no guarantee of future results" in fine print and at the bottom of marketing material.

Interest Rates

The Federal Reserve Bank (the Fed) can influence the direction of interest rates in a number of ways. One way is to lower the discount rate charged to banks for borrowing money. This rate is now 0.75%. It also influences the rate that banks charge each other for overnight loans. This rate is 0.25%. In addition, the Fed has been buying back Treasury debt and mortgage debt. This buying program lessens the need for issuers to offer higher yields to entice buyers. Sensing some improvement and stabilization in the economy, the Fed has lowered its monthly bond buying program. This has caused many commentators to anticipate higher interest rates. The new Federal Reserve Bank chairwoman, Janet Yellen, while continuing the policy to reduce bond buybacks, is still committed to retaining a low interest rate environment. In a speech in late March she said: "While there has been steady progress, there is also no doubt that the economy and the job markets are not back to normal health. The recovery still feels like a recession to many Americans, and it also looks that way in some economic statistics."(Source: The Wall Street Journal)

What does this mean for investors? It means we should expect the yields on fixed income investments to remain low and asset prices in areas like real estate and the stock market to continue to be artificially supported by low interest rates. The hope is that keeping interest rates low will lead to investments that boost the economy and jobs. However, much will depend upon consumer demand. Without demand, there is less incentive for employers to take advantage of lower interest rates.

 

Is the Stock Market Rigged?

The CBS News program 60 Minutes recently aired a story about high-frequency trading. It was based upon the book Flash Boysby Michael Lewis. Mr. Lewis summarized his book by stating that he believed that the stock market was rigged. This is a sensational statement that caught the attention of regulators and helped sell his book. Unfortunately, it may encourage savers to park their assets under their mattresses, or only slightly better, in a savings account earning 0.25%.

Most trading in stocks is no longer done on the floor of the New York Stock Exchange. Today the fast majority of trades are made using a network of computers at lightening fast speeds. Technology has made it possible for some trading firms to see buy orders and, in milliseconds, get in front of that order by buying shares at one price and selling them to the investor placing the original order at a slightly higher price. This is called "front running". Is this fair? No. The SEC is aware of this and is investigating the practice.

Technology is and always has been a double-edged sword. It can be used to enhance efficiency and productivity but it can also quickly destroy and disrupt. Even with its inherent dangers, most would agree that technology has been a net positive for society. The same can be said for the use of technology in the financial markets today.

There are many examples of unfairness within our financial systems. Does that mean we should elect not to play? No. Why? Because the markets may not be fair but they still offer the opportunity for our savings to work hard and earn more than the "safe" return alternatives, such as a two-year Treasury note paying 0.43%.

 

Taxation of Irrevocable Trusts

Tax law changes effective on January 1, 2013 impact the effective federal tax rate paid on capital gains recognized by irrevocable trusts. Unlike a revocable or living trust, this trust has its own tax identification number and files its own tax return. As long as the irrevocable trust pays out net ordinary income (e.g. interest and dividends) to beneficiaries, the taxation of this income is the responsibility of beneficiaries and no additional tax is paid at the trust level. If the irrevocable trust has long-term capital gains in excess of deductible trust expenses, the net capital gains are taxed at the trust level and not at the beneficiary level.

Irrevocable trusts with net retained capital gain income greater than $12,150 in 2014 pay a tax rate of 20% plus the 3.8% Net Investment Income Tax. We will be reviewing 2013 trust tax returns and identifying trusts where financial planning can be applied to reduce the impact of this tax law change. These recommendations may include changing the mix of investments held by the trust, exploring the distribution of some or all trust principal to beneficiaries, and/or making sure an appropriate amount of investment advisory fees are paid by the trust to reduce taxable income.


Federal Estate Tax Exemptions and the Portability Feature

Each spouse has a federal estate tax exemption of $5.34 million in 2014. The 2010 Tax Relief Act created the "deceased spousal unused exclusion amount" and the concept of portability, effective for the estates of decedents dying in 2011. This provision was made permanent in 2013. In the past it was necessary to isolate assets in the name of each spouse, or each spouse’s revocable trust, to maximize their respective individual exemptions. Now executors can elect to carry forward the amount of unused exemption of the decedent to the surviving spouse’s estate. This makes it possible for married couples to exclude up to $10.68 million is assets from federal estate taxes.

The increased exemption amount and the portability feature mean that there may be a financial planning advantage to amend existing trusts. If your trust directs the executor to fill up the credit shelter (residuary) trust up to the amount of the available estate exemption, the following could result:

  • The assets in the residuary trust will have creditor protection – a favorable result.

  • The assets in the residuary trust will not be subject to estate tax in the surviving spouse’s estate, a favorable result, but may be unnecessary if combined estates are under $10.68 million.

  • Unlike assets owned by the surviving spouse, assets in a residuary trust will not benefit from a step-up in tax basis when the initial surviving spouse dies – an unfavorable result.

  • The residuary trust will be subject to higher income tax rates (see Taxation of Irrevocable Trusts above) – an unfavorable result.

We will perform a review of trusts and estate sizes to determine which clients should contact their estate planning attorneys to amend the language in existing revocable trusts.

If you prefer to contact your estate attorney now, before we complete a firm-wide review, please feel free to do so. We would appreciate letting us know if you take this step as we would like to be part of the discussion.


How to Get the Most out of Our Services

The extent we can help align your financial resources with your objectives and values depends upon many factors. The first of which is the assembly and review of information representing the current status of your financial affairs. The more we know about you, the more we can help. Be thorough in your disclosures and keep us up to date with changes in your lives.

If you are contemplating a decision that will, or could, have a significant impact on your life or the lives of your family, we believe it to be in your best interest to discuss it with us before finalizing any commitment. Better information, not necessarily more information, should lead to better decisions. We will do our best to help you determine whether a course of action is comfortably within your financial resources.

We understand this takes effort on your part. We also understand that we are asking you to give away financial privacy in return for the benefits of high-level financial planning. After thirty years in business, we can say that it is worth it. Clients who keep us in the loop, provide requested information on a timely basis, and follow through with mutually agreed to recommendations move through their working and retirement years with confidence, not with high levels of anxiety.

If you are concerned about any issue that impacts you financially, do not hesitate to call and discuss it with us. Chances are we have helped other clients in a similar situation find a solution.

 

The Wall Street Journal

A regular feature in The Wall Street Journalspotlights a prominent financial advisor with an interview, during which the advisor presents and discusses an example of a currently recommended investment portfolio. As the director of investments at Schiavi + Dattani, Ravi was featured in The Wall Street Journalarticle titled "Think ‘Global’ When Picking Stock Funds" on May 5, 2014.

 

We continue to work daily to earn your trust and confidence.

Best Regards,

Vincent A. Schiavi, CFP®, CPA/ PFS      Ravi P. Dattani, CFP®, CPA
President                                               Vice-President

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