Fiscal Cliff Negotiations: Our View Today

Important note:  This post is based on media reports from The Wall Street Journal and The New York Times, as of December 18, 2012. Fiscal cliff negotiations are very fluid, and until an actual deal is reached, and the fine print is released, a complete analysis is not possible.

The purpose of this post is to provide information and clarity, where possible, based on the information available as of this morning. It appears that concessions have been made by both sides, Democrats and Republicans, so basic concepts of a deal appear to be taking shape.

Tax rates: 

• The White House has proposed permanently extending the Bush-era tax rates (current rates) on household income below $400,000. Above $400,000, they are proposing an increase from the current 35% to 39.6%.
• While they are using a $400,000 figure, they probably mean "taxable income" of $400,000. So, after deductions, someone could actually earn well above $400,000, before the 39.6% marginal rate becomes effective.
• For those with household or taxable incomes (to be clarified) of less than $400,000, it appears that there will be no increase from current federal income tax rates.
• It is possible this $400,000 level will increase, as part of negotiations, but likely not to decrease.
• As part of the health care reform passed in 2010, an additional Medicare tax of 3.8% will apply to unearned income (investment income, such as interest and dividends; capital gains and rental income), for married couples with income above $250,000. This is already law, and is not part of the current negotiations.
• Also as part of the 2010 health care legislation,  income from self-employment and wages will be subject to an additional tax of 0.9%.  This applies to compensation of married couples in excess of $250,000 and single individuals in excess of $200,000 annually. 

Capital Gains and Dividend Tax Rates:

There has not been any published information on changes to the capital gains or dividend tax rates, or where these stand in the current negotiations. I would expect that the capital gains rate will increase from the current 15%, to 20% (plus the above 3.8% tax rate increase from the health care reform act). I cannot forecast what change, if any, there will be to the dividend tax rate, other than the known increase due to health care reform tax, discussed above.

Change in calculation of inflation:  There is a proposal to adopt a new method of calculating inflation, which is expected to result in showing less inflation. The impact would be to reduce the growth of certain benefits, such as inflation adjustments to Social Security. There are other impacts of this inflation calculation change, such as slowing the rate that tax brackets rise each year, so taxpayers would pay more Federal income tax each year, than if this change had not been made.  I have not seen any details on how the new inflation factor would be calculated, or whether this would affect the inflation factor that is used in the investment return for TIPS (Treasury Inflation Protected Securities). This change is subtle, but a very important provision.

AMT (Alternative Minimum Tax):  The White House is proposing to permanently extend the AMT inflation adjustment provisions, which Congress has done every year or two, for many years, as the original law did not include any inflation adjustments. This would provide needed clarity and correct a measure that Congress usually fixes anyway.

Payroll Tax Cut: The Wall Street Journal, but not the Times, reported that the White House did not request an extension of the Social Security payroll tax cut. This would represent a tax increase as of January 1, from 4.2% to 6.2% of the social security tax that all workers pay. This is a change in position for the Democrats, as it would directly affect workers of all income levels.

Deductions:

There were no reports of any changes to itemized deductions. It is possible there will be some type of cap or limitation on total itemized deductions, such as 28% or 35% of one's adjusted gross income. It is possible that this change, if enacted, would only affect very high income levels.

Other items:

• The White House is requesting upfront infrastructure spending, as well as a temporary extension of expiring unemployment benefits. Other tax breaks may be extended permanently, such as research and development credits for businesses. 
• It is also expected that a permanent adjustment will be made to physicians' Medicare reimbursements. This is to correct a 1997 law, that has been corrected on an annual basis, to prevent massive reimbursement reductions.
• It is unclear whether there will be an increase in the age for Medicare eligibility, which is currently 65.  Republicans are proposing to increase this age to 67, to slow the growth of Medicare spending.
• There are no details on specific spending cuts, or when the actual tax reform changes will be drafted. We would expect some tax changes to be approved in the near term, with further revisions in 2013.

Estate taxes:  There has been no public information about how estate taxes will change going forward, based on these negotiations.

If you would like to discuss any of these matters further, please contact our office.

Sources:  The Wall Street Journal, http://online.wsj.com/article/SB10001424127887324407504578185362961624862.html?mod=WSJ_hpp_LEFTTopStories

The New York Times, http://www.nytimes.com/2012/12/18/us/politics/president-delivers-a-new-offer-on-the-fiscal-crisis-to-boehner.html?hp&_r=0&pagewanted=print

   

Election and Investment Planning

The election of 2012 is finally here. How will this affect your financial future? How will this affect your investment decisions?

For many, the election and the impending "fiscal cliff" have been influencing their financial decision making. For some, these issues have led to a lack of decision making, as they are waiting for these issues to be resolved, before moving forward with financial decisions. Some are even waiting to allocate funds to stock investments until they can "see" more clarity.

For our clients, we have been discussing these issues, but have certainly not allowed these issues to control our decision making or our actions. We adhere to the following motto: focus on what you can control and focus on things that matter, and especially when these two intercede.

How does this apply to the financial advice we have been giving to clients throughout 2012?

We have adhered to the financial plans that we have developed for our clients. For clients with stock allocations, that has been very beneficial during 2012. With many US and International broad stock averages up by approximately 10-15% for 2012, this is far superior to just holding cash, while waiting for these issues to be resolved.

We have actively pursued various strategies for our clients, to take advantage of the market volatility which has existed in 2012.

• For clients that purchased stock funds in early 2012, we did tax loss selling in the 2nd quarter of 2012, when the market declined. If we had not done this at that time, and waited until now, there may not be tax losses to harvest. Thus, these clients will have tax benefits, and still have unrealized gains. Our clients benefit from our monitoring of tax loss selling throughout the year, not just at year end.

We have met with clients during the year, and assisted them with their estate planning matters and charitable gifting (working closely with their attorneys). The future of estate tax rates is not known. However, with uncertainty comes opportunities that must be addressed and analyzed.

Once the outcome of the election is determined, one aspect of uncertainty will be removed. However, many issues will remain unresolved. Uncertainty will always exist, it is just the issues that change. As advisors, we guide our clients to handle these unknowns.

No one has an accurate crystal ball to know what the financial and tax impacts will be regarding the “fiscal cliff” issues, and how they will be resolved. Many “Wall Street experts” will make post-election predictions and recommendations, but do they really know? Will they be accurate?

Our investment strategy is not based on guesswork. By developing a globally diversified portfolio, we provide a solid and effective investment strategy. We know that structuring an investment portfolio that minimizes taxes and can reduce dividend distributions (if desired) will always be advantageous, and this is one of the strengths of our firm.

We know that decisions must be made. By assisting our clients with these decisions, we enable them to have the comfort and financial security they desire.

In these times of change, volatility and uncertainty, we can assist you with your important financial and wealth management decisions.

A Valuable Conversation Worth Having

Extended families gather for many occasions. Celebrations. Holidays. Life cycle events. Family vacations. The discussions at these events and gatherings are generally the same: updates on kids and relatives, grandchildren, health, politics, sports, food, etc.

Between the generations of most families, however, the topic of money is rarely discussed. These types of discussions should be happening. Sometime. Anytime. And sooner rather than later.

We all have unique and different family backgrounds and situations. I did not get my education in money, investing and estate planning from my parents. We grew up as a lower-middle income family. I know that my mom struggled financially and worked very hard to support me and my three sisters. Investing was not a relevant topic. How I would pay for my college education, how much I had to work and save money for college education was a very relevant topic.

Fast forward 30+ years… and now I advise people professionally about their money. We have many discussions about their finances, their goals and how to deal with the volatility of the world and financial markets. These discussions are critical, and the educational aspect of these conversations makes our clients better and more successful investors.

I now want my firm to emphasize an additional type of conversation. This is a conversation between generations. These can be difficult discussions, which is why they are generally avoided. But if these discussions take place, tremendous value and important long term benefits can result. Clients can have these conversations (or “family meetings”), or we can assist in facilitating them.

Many couples deal with estate planning. Most view it like going to the dentist; painful, put it off, but they eventually get it done. Once an estate plan is completed, it usually becomes a set of documents that remain locked in a cabinet. One aspect of the discussion that I’m addressing is to make the estate plan real. Make it a living and breathing document and set of plans. Talk about your intents and wishes. Now, while you are healthy and able to have the discussion.

I’m suggesting that parents and grandparents sit down with their next generation, or generations, and talk about their “family” finances. For example, my extended family is going on vacation later in June. My siblings and my parents will be together for a week. We should set aside some time to have a discussion of what will happen when each of them passes away. What is their intent? How will we handle things?

We have actually had this discussion, but it was many years ago. It should happen again. But most families have never had a multi-generational discussion. The topics can vary, depending on the financial assets (small, large or very wealthy), and the ages of the different generations.

At family events, the telling of family stories is how family histories are remembered. The discussion of money, both positive and negative, can be important as well. Parents and grandparents can share their financial and investment lessons, both good and bad, with their next generations. This would be very valuable.



Note: I would like to thank Nathan Dungan, for the valuable session he led on this topic at a seminar I attended in May, as well as Susan Weiner (@susanweiner), who wrote an excellent blog post encouraging financial advisors to write in a more personal manner, which inspired this post. Thanks to both of you.

Investing: Can an Advisor Add Value?

Do you want this person/fund to manage your money?  Is this the right fund for you?

Resume:

• Beat the S & P 500 every calendar year from 1991-2005
• Named "Portfolio Manager of the Decade" in 1999 by Morningstar
• Barron's included him on its "All-Century Team" in 1999
• Fortune Magazine desribed him as "one of the greatest investors of our time" in 2006 profile
• And then there is this fact:  For the five year period ending December 31, 2010, this fund was LAST among 1,187 US large cap stock funds, as tracked by Morningstar.

The fund and fund manager described above is Bill Miller, manager of the Legg Mason Capital Management Value Trust for 30 years, who recently announced his retirement, effective in April 2012. The facts of this stock mutual fund performance clearly shows why it is nearly impossible to consistently predict the "best" fund managers over a long period of time.

After his great track record and much publicity, his fund was in the 98th or 99th percentile in 4 out of the last 5 calendar years, through 2010.  Through October, 2011, his fund is in the 82nd percentile. (per Morningstar data).

How can someone who is so "good," then become so unsuccessful?

This is a key question, which every investor must consider, in determining their advisor and investment philosophy. Was Miller lucky?  Did he lose his touch?  How do you know if your advisor or mutual fund manager will do the same?

Understanding what occurred with this fund, and how common this inconsistency in mutual fund performance is, is the basis for one of the fundamental investment philosophies that we adhere to. We recommend this strategy for your investment success, over a long period of time.



To describe the different philosphies, Bill Miller picked stocks for his fund that he thought were "value" stocks. He believes in active investing; that he could identify the best stocks to own that were undervalued. We believe that no one has the ability to consistently identify fund or money managers that can outperform a respective benchmark, over a very long period of time. Thus, we adhere to a "passive" strategy, which means that we recommend a very globally diversified set of stock mutual funds that hold a set of stocks in each "asset class," without making predictions or claiming to have a crystal ball.

It would have been very reasonable in 2000 or 2005 to put money into Bill Miller's fund, based on his past track record. Let's see how his fund did, and compare it to one of the funds that we use, in a similar asset class. Bill's fund is a large company value fund, so we will compare it to Dimensional Fund Advisor's (DFA)US Large Cap Value III fund (DFUVX).

For the 10 years ended 11/29/11, $10,000 invested would have grown as follows (per Morningstar.com):

• Legg Mason Fund:           $8,363 (a loss of $1,637)
• DFA US Large Value      $15,388 (a gain of $5,388)
• Vanguard S&P 500         $12,627  (a gain of $2,627)

By using the appropriate long term strategy, as your investment advisor, we can add significant value. We can provide you and your family with a solid investment strategy, that will result in greater comfort and sense of security.

Other Conclusions:

The Lost Decade:  There has been much written about how the past 10 years ended in 2010 were considered the "lost decade," where investors made no money. This was true for many investors. While the  figures above are for the 10 years ended in November 2011, the DFA US Large Value fund was very profitable over this period. This shows the importance of diversification and owning more than just the S&P 500 as the basis of your portfolio.

Costs and expenses: 

We believe to be most successful, you should focus on the things that you can control. Thus, evaluating mutual fund expense fees should be an important part of your investment approach.

Bill Miller's fund charged various up-front fees, depending on which "class" of the fund that an investor used. None of the funds that we recommend charge such fees.

The annual expense ratio of Miller's fund is 1.75%. This means that each year, the fund subtracts 1.75% in fees, from whatever the actual performance is. The comparable DFA fund that we utilize, DFUVX charges .14%, one of the lowest expense ratios in the industry, for this fund category.

There are many other lessons to be gained from reviewing the experience of this fund and this fund manager, as well as carefully evaluating most mutual funds, or your own investment portfolio.  
  
Important notes:  The above examples are illustrative only. No one fund should constitute an investment portfolio. The above figures do not include an investment advisory fee, which our firm charges, separate from mutual fund fees. Legg Mason's fund would have charged a load, which is not included in this information.

Sources:  Morningstar website, 11/30/11; article by Weston Wellington, Dimensional Fund Advisors, dated 11/29/11