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Tales from the Tax Prep Front Lines

Tax preparation gives interesting insight about personal financial situations.  Here are some examples.

Last year an elderly lady brought her tax documents to the AARP Volunteer Tax Service for preparation.  Her 1099s, etc. were not well organized, but appeared to be adequate.  She, herself, was a little disorganized, and not entirely comfortable with what she needed.  For example, she didn’t have her prior year return, one item that we specifically request.

One item was a 1099 for an IRA distribution of about $150,000, from which there was federal withholding of 10%, no NY withholding.  I immediately thought that she would be grossly underwithheld unless there were huge deductions or unless some of it had been rolled over to another IRA.  I asked about it and she told me she took it all out and bought gold.  Alarm bells automatically went off in my head.  I asked who her advisor was, or what firm had done this transaction for her:  her response was that she did it herself and bought the gold from the guy on the late-night talk radio program, Coast-to-Coast.  I finished the tax return and explained that she would owe over $20,000 to the IRS and over $6,000 to New York State.

She told me she would sell the gold to get the cash to pay IRS.  When asked how that would work, she told me that she had not yet received the gold, and that she had bought it back in the fall of the previous year.  I fear that she will never see the gold, or proof that she owns it.  With any luck, she has the gold or certificate of ownership, but she did just about everything wrong to get it.  This transaction may work out for her but is full of questions that should have been addressed by an advisor with fiduciary responsibility prior to the initial IRA distribution.

Another return this year points out just how important it is to plan for your retirement.  A few years ago I met with a couple who planned to retire early at age 62.  They had company 401k plans and would begin to collect Social Security at age 62.  Presently they were covered by a subsidized company health plan at a total monthly cost to them of $400.  Fast forward to a return I just did for a single individual age 60 who paid $1,300 monthly for health insurance, and another $2,000 for co-pays and deductibles in 2010.

Imagine the shock for this couple when they factor this kind of expense into their retirement cash flow budget.  Their monthly medical costs will have gone from$400 to $2,800. They would need another $100,000 in assets just to pay for health care costs to get them to age 65, at which time they would be eligible for Medicare coverage at a lower cost (assuming it still exists at today’s premiums and coverages).  They had budgeted and saved for years for this early retirement goal, but the single most critical factor in their decision to retire early is this important, necessary expense.  Of course, they could self-insure and take the risk of not needing health insurance for three years, but I don’t recommend it for anyone with today’s costs of health care.

A realistic plan for retirement is important, as well as a regular periodic review of your financial status once retired.  Lots of things change, some of which we as retirees can’t control.  Your investment advisor can help develop and monitor a retirement plan for you.

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Investing for Retirement Income – Part 2

One of today’s biggest challenges facing investors in retirement or in semi-retirement is obtaining enough income and growth from their portfolio to match annual expenses.  Is it possible to create a mix of steady income, upside potential and longevity protection by a blend of 80 percent bonds and 20 percent stocks?

My definition of income investing is to construct a portfolio with a heavier emphasis on income producing assets.  Ideally, the investor does not need to access principal to meet daily living expenses.  In a low rate environment, this becomes difficult without relying on high yield bonds for a significant part of the portfolio mix.  Another common approach with investors is to hold high paying dividend stocks.

An alternative investment approach is to maintain a more balanced portfolio allocation, understanding that principal will need to be accessed to meet annual expenses.  This allows for a higher equity allocation with the possibility for overall portfolio gains with stock appreciation.

The income dilemma highlights how investing is about tradeoffs between different risks.  Perhaps more analysis of risk factors and which risks to mitigate would result in portfolio allocation decisions that investors can be more comfortable with.

Some risk factors can be easily addressed—e.g. diversification and keeping fees low.  But few investors see these as important if they believe they are missing the next new investment opportunity.  I have a neighbor that claims to have recently made a lot of money investing in oil futures.  I suggested that while his gamble paid off, that this was not investing.  But he cannot see the risks inherent in this strategy, in part, because the gamble paid off. But is this any worse investment behavior then the investor who is so concerned about the next financial catastrophe that he can only purchase insured CDs?

So to meet cash needs, perhaps the investor needs to first address the risks associated with different investment strategies and understand their tolerance for various risks.

For some investors, a comfortable risk tradeoff may well be an 80/20 split between bonds and stocks.

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Combating Investor Overconfidence

In my discussions with clients and prospects, one of the recurring themes is how, as their investment advisor, I can best provide advice contrary to their bias, intuition, or reaction to current business/economic  events.

An example is the current investor bias toward equities since the stock market has performed so well recently and bonds are feared because of the threat of increased inflation.

It is probably natural to hear that the asset allocation decision made just a short time ago is being questioned based on market psychology and the resulting impact on investment decision-making.

My role, as an investment advisor and fiduciary, is to challenge these tendencies and serve as a source of independent insight.

One client is a couple in their early 50s who have put two of three children through college.  They have a substantial joint income, no debt, but few investment assets.  We have established that they will require $2 million in investable assets to afford a comfortable retirement and they have less than one-third of that amount presently.  We have used an Aggressive Model for their investments with 70 percent invested in equities.   Investment panic has set in with the realization that full retirement in their early 60s is unlikely.  Their reaction is to move 100 percent into equities and is buoyed in that opinion by the recent stock market results.

As their investment advisor, I want to avoid simply confirming my clients’ bias in order to accommodate them.  They are overconfident in the stock market by extrapolating recent gains into overly rosy forecasts.  I find this behavior pattern is especially prevalent with people who have been successful in the business world.  It is similar to the thought that “I can beat the market” since I have made other correct decisions in my professional career.

Research has shown that individuals who report that they are “100% sure” of a particular fact are wrong 20% of the time.  I experience the phenomena with my barber, who never met a fact he could not mangle.  Overconfidence is the best known bias in making investment decisions.

Clients working with Rockbridge have two advantages.  First, we provide investment models that are not subject to current whims of the investment media.  Second, we provide independent advice and we see our role as providing an unbiased viewpoint.

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Investing for Retirement Income – Part 1

A sense of security comes from seeing a regular monthly income from your investment portfolio.  Especially when one is retired or is dependent on investment income to meet everyday expenses.

In the investment community, bonds are considered second class citizens.  Investors are told that holding bond funds is done primarily to reduce the overall portfolio risk of owning stock funds. (You never hear it put the other way—stocks are owned to add some spice to your bond portfolio).   At parties, who ever talks about the bond market?

The following are questions I will opine about in future articles:

Is focusing on income different than investing based on asset allocation?

Does an increase in the equity portion of your investment portfolio equate to income from the fixed income portion?

What is the best way to think of stock dividends?

Other than age, when should you be 80 percent or more invested in fixed income securities?

With everyone predicting inflation around the corner, how can you be comfortable with a sizable proportion of your investment portfolio in bonds?

Why don’t more people invest more in bond funds?

What is an appropriate bond fund strategy?

When does investing in a high yield bond fund make sense?  And does this answer change if you substitute the term “junk bond fund”?

Investor inquiry—“I don’t really care about asset allocation; I just want my one million dollar portfolio to produce $4,000 of income every month.”

 

Well, why not construct a portfolio that mimics an annuity, without the costs and fees.  And returns the principal to the investor.  And earns a 5 percent return in today’s interest rate environment.  Can this be done within an acceptable risk profile?

My model portfolio could look like this:

  1. $700,000 in a high yield fund at 6.1% produces $3500 per month.
  2. $200,000 in a total bond market fund at 2.7% produces $450 per month.
  3. $100,000 in a total stock market fund with a 1.3% dividend yield produces $100 per month.

This results in a 90/10 bond/equity mix.  The bond funds each have duration of 5.0.  Most importantly, the investor can depend on a predictable monthly income stream.

Are the risks unacceptable?  Inflation would seem to be the most significant risk with a one percent increase in rates reducing the portfolio by $45,000.  Default risk is always an issue with high yield funds.

But for some investors the tradeoffs might seem acceptable.  I would argue that this is a preferable approach than to purchase an annuity producing this amount of monthly income.  This is primarily because an annuity carries such heavy fees.  I just recently talked with a neighbor who paid a 5 percent upfront fee to purchase an annuity from a well known insurance company.  Seems like a high price to pay.

By Dan Edinger

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