Living on the Financial Edge

 Living on the Financial Edge

At Paragon Financial Advisors, we recommend our clients have a 3-6 month cash “ready reserve” to meet unexpected expenditures. For most Americans, accumulating that amount appears to be much easier said than done. In the May, 2016 The Atlantic magazine, Neal Gabler wrote an article entitled “The Secret Shame of Middle Class Americans.” Some of the items he mentioned (and the sources he quoted) are shown below.

Unexpected Expenses

A Federal Reserve Board survey designed “to monitor the financial and economic status of American consumers” found that 47% would not be able to cover a $400 unexpected expense unless they borrowed, sold something, or could not cover it at all. David Johnson (University of Michigan) surmised that Americans usually smooth consumption over their lifetime: borrowing in bad years and saving in good years. People are now spending any unexpected income (bonuses, tax refunds, etc.) instead of saving it.

A 2014 Bankrate survey found that only 38% of Americans had enough in savings to cover a $1000 emergency room visit or a $500 car repair. Nearly one-half of college graduates could not cover the expense through savings. In 2015, A Pew Charitable Trust study found that 55% of households didn’t have enough liquid savings to cover one month’s living expenses.

Another study by Annamaria Lusardi, Peter Tufano, and Daniel Schneider asked whether a household could raise $2000 within 30 days for an unexpected event. More than 25% could not; another 19% would have to pawn something or use a payday loan to raise the money. Nearly a quarter of households with an income of $100-$150,000 per year could not raise the $2000 in one month.

Liquidity or Net Worth

Is this situation only a liquidity problem or is net worth (the net sum of all assets including retirement accounts and home equity) also at risk? Edward Wolff, an economist at New York University, reported that net worth has declined significantly in the last generation. Net worth declined 85.3% from 1983 to 2013 for the bottom income quintile, decreased 63.5% for the second lowest quintile, and decreased 25.8% for the middle quintile. He looked at the number of months a household could fund its current consumption by liquidating assets if the household lost all current income. In 2013, the bottom two quintiles had no net worth; hence, they couldn’t spend anything. The middle quintile (with an average income of approximately $50,000 per year) could continue spending for 6 days. A family in the second highest quintile could maintain current spending for a little over 5 months.

Research funded by the Russell Sage Foundation found that the inflation adjusted net worth of the median point of the wealth distribution was $87,992 in 2003. In 2013, it had declined to $54,500—a decline of 38%.

Debt

Value Penguin did an analysis of Federal Reserve and Transmission data pertaining to credit card debt. In 2015, credit card debt per household was $5700. Thirty eight percent of households carried some debt; the average debt of those households was greater than $15,000. Apparently the rise of easy credit availability has supplanted the need for personal savings. The personal savings rate peaked around 13% in 1971, fell to 2.6% in 2005, and has risen only to 5.1% now. These debt levels reflect only personal debt; no serious attention is being paid to our $19 trillion government debt.

What’s Going On?

Financial products are becoming more sophisticated, both in quantity and complexity. Such additional products should provide a better way to manage personal financial “hiccups.” Lusardi and her associates (in a 2011 study) found that the more complex a country’s financial and credit market became, the worse the problem of financial insecurity becomes for its citizens. That study measured the knowledge of basic financial principles (compound interest, risk diversification, the effects of inflation, etc.) among Americans ages 25 to 65. Sixty five percent were basically financially illiterate.

Why are we at a financial advisory firm writing about this situation? The United States finds itself in the midst of a most unusual political situation. Some candidates for President of the United States are espousing theories or programs outside the normal capitalistic structure. Are conditions such as the ones described above partially to blame?

A crucial part of managing investment portfolios is attempting to monitor the economic, political, and social conditions that might affect the investing environment in the future. What will that environment look like and how will it affect the selection of assets going forward? We at Paragon Financial Advisors don’t have a crystal ball for the future, but we do try to help our clients invest for the long term. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas.  We offer financial planning and investment management services to our clients. 

The Retirement Plan-Success of Failure

When one reads about retirement planning, the writer usually focuses on planning for retirement. An equally important part of that plan needs to focus on what to do after retirement. A spending plan normally covers the adequacy of income over expenses during retirement and whether or not that income is sufficient over a long period of time. A well-developed spending plan is much more than that. Increasing life spans (and the corresponding lengthening of retirement years) has some interesting consequences.

A symposium at the recent Financial Advisors “Inside Retirement” conference (May 5-6, 2016 in Dallas, Texas) included a discussion on why people “fail” at retirement. Failure is not defined as “bankruptcy,” or inability to retire; , only a failure to live retirement as originally planned. Some of the items discussed for such failure include the following:

1. Health Care—Health care costs are increasing, even if one has health insurance. A retired couple could easily face medical costs in the hundreds of thousands of dollars over their life spans. A USA Today article (March 14, 2015, “How much will health care cost in retirement?”) quoted a study indicating that a man will spend $116,000 on health care in retirement; a woman will spend $131,000. Fidelity Investments has projected that a 65 year old couple retiring in 2015 will spend $245,000 on health care during their retirement.
2. Divorce—Surprisingly, an increase in divorces in the 50 plus age group has appeared. The reduction in assets from such a separation means a potentially lower standard of living for both parties. Multiple marriages (through divorce or death) may also bring the necessity of planning for a subsequent re-marriage. Pre-nuptial agreements, especially where a disparity of assets exists between the couple, can prevent many future problems and are a definite item to consider.
3. Overspending—Prior to retirement, a couple may spend more (especially on week-ends when they are not working) than they do in the normal course of living with a five day a week job. At retirement, every day is Saturday! Spending patterns may need to be adjusted significantly (i.e. reduced).
4. Children-Parenting never stops. Many children return home after college to save money until they “get established.” Helping a child with bills, a substance abuse problem, or even a special needs child can add significantly to retirement outflows.
5. Second Home-A second home purchased prior to retirement might be easily maintained financially while working. In retirement, property maintenance, insurance, property taxes, etc. may become more of a financial burden.
6. Business-Starting a business in retirement may sound appealing, especially if another family member (see “Children” above) is involved. Some basic rules apply: a) It will cost more than you think, and b) revenues will come in more slowly than you plan. Always have a good business plan and, if other parties are involved, have a written agreement spelling out what is to be done. Allocate a set dollar amount (the maximum which you can afford to lose in entirety) to prevent “throwing good money after bad.”
7. Identity-Many individual’s identity and self-worth are associated with their professional, work life. Retirement can change that significantly. Prepare for that transition. Retire to something, not from something.

Most individuals work long and hard during their active career; they look forward to a retirement period that matches their expectations. We at Paragon Financial Advisors assist our clients in developing plans for and during retirement. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas.  We offer financial planning and investment management services to our clients.

“It’s the Life Insurance Guy Again”

How much should I own?

How do I know how much death benefit is appropriate for my family? This is where working with a Financial Planner can help you accurately assess how much exactly your family would need today if you were to pass. How much of your current debts, future college costs and retirement would you like covered if your family were to have to cover these costs without your income? Many times life insurance agents will try to sell more insurance coverage than is needed to earn more commission on a higher annual premium. We always recommend consulting with Paragon Financial Advisors before buying a policy.

What type of life insurance should I own?

Term Insurance- this is the most affordable way to purchase a death benefit; you can lock in your premium for a set amount of years or “Term”. Many term policies allow you to convert the policy from term or temporary coverage to a permanent policy at the same risk class you were approved on for your term policy years prior. But why would you want to do that? Let’s say that Bob was approved at Select Preferred for a 20 year term policy and a $500,000 death benefit. At year 10 of the policy being in effect, Bob gets a rare disease that could potentially cause him to die prematurely in the next 10-20 years. With the conversion option, Bob has the ability within the life of the 20 year term policy to convert it to a permanent life policy at his select preferred rating without going through medical underwriting again. Otherwise, it’s very likely he would be uninsurable and denied life insurance coverage.

Universal Life Insurance- this is a form of permanent life insurance that allows for flexibility on the premium payment each year. Universal life is generally a less expensive means to a permanent life insurance policy offering the same death benefit compared to other forms of permanent insurance. Additionally, VUL (Variable Universal Life) or IUL (Indexed Universal Life) contracts offer higher potential returns than some other fixed insurance contracts. With a VUL or IUL contract the insurance and administrative expenses are not fixed and could increase as the insured nears mortality age. As interest rates continue to fall since 2008, many Universal Life policy holders from pre 2008 have received notice that their premiums are going up. The flexibility that these life insurance companies offer comes with flexibility on their end as well. Another disadvantage to Universal Life policies are surrender charges to cash values, which can vary from company to company, but many times are 10 years or more. This limits your ability to access the full portion of the cash values until the surrender schedule has been met. Let’s quickly explain some of the different types of Universal Life contracts.

• Guaranteed Universal Life: a “GUL” contract accrues little cash value, maintains a level death benefit and a level premium guaranteed to a certain age (Most are to age 100 or for life). This looks and acts very similar to term insurance, except it is for the insured’s lifetime.
• Variable Universal Life: a “VUL” contract does accrue cash values and has a potentially increasing death benefit with a minimum guaranteed face value that stays in force as long as the premiums are paid. The accrual of cash values and the death benefit is tied to the performance of “separate accounts” which for all intents and purposes are mutual funds. These contracts offer the policy owner market participation via these separate accounts. If the policy underperforms than it could require the policy owner to dump more money into the contract to keep it in force.
• Indexed Universal Life: “IUL” contracts are the most popular universal life policies currently sold. Unlike a VUL contract, they are actually a fixed interest rate product that offers a crediting rate tied to an index, mostly the S&P 500. Insurance companies generally offer several crediting methods: monthly sum, monthly average, a trigger method, or the most popular point to point. These policies many times offer a “floor” or minimum crediting rate to the policy of say +.5% even though the S&P 500 Index return for the year was negative. However, they also “cap” the upside potential of the return of the index and it’s important to note that the insurance companies do have the ability to lower the cap rate and the participation rate on inforce policies. Many IUL policies offer 100% participation up to 12.5%. One final note, the crediting rate applied based on the return of the S&P 500 does not include dividends, a sizeable portion of the total return over 10, 20 and 30 year time periods.

Whole Life Insurance- this is a permanent form of life insurance that accrues cash value and has a guaranteed “face” value or death benefit. Most whole life policies have a contractual guarantee on the return of cash values, many of the large mutual insurers offer 4% currently. It is important to note that this is not a 4% return on your total premium paid but a guarantee return on the net amount applied to cash value after all expenses have been taken out of your premium for the cost of insurance and operational expense. In addition, whole life policies may pay “dividends” into the policy, though these are not guaranteed. This term is not to be confused with the dividend that you receive from some of your stocks in your investment portfolio. Dividends from a mutual company are a return of surplus profits from their investment earnings, mortality experience (death benefits paid) and expenses over that time period and returned to their policy holders, hence the name participating life insurance. When contemplating a whole life policy, generally a well-designed one should reveal positive net cash values at the end of year 5 or 6 under the Current Assumptions Illustration.

What is the purpose of life insurance?

Risk Management: depending on how long your debts and future expenses extend, will help you determine the appropriate length of time you need coverage and what amount of coverage is needed. Many times term insurance will suffice for this need.

Estate Tax: the goal of this policy is to get the highest return of your premium on the death benefit. Many times a husband and wife will get a joint, last survivor policy that pays on the death of the second insured’s passing. This usually allows the insureds to get more death benefit for the same amount of premium. Also, when dealing with estate tax issues, it’s important to note that life insurance does offer an income tax free death benefit, but this amount is included in the value of the estate. In order to exclude the death benefit from the inclusion into the estate value for estate tax purposes, an Irrevocable Life Insurance Trust or “ILIT” is often used.

Creditor Protection & Cash Accumulation: life insurance is a creditor protected asset in the state of Texas and allows the policy holder to enjoy creditor protection on their life insurance values. Once you have maximized your retirement vehicles, life insurance if designed appropriately, may be a good place to put some excess cash.

Tax deferral & Tax Free Distributions: life insurance cash values do enjoy tax deferred growth as the policy values accumulate. In addition, after all premiums have been withdrawn, policy holders can take out cash via loans as a tax free distribution assuming the policy is not a Modified Endowment Contract

What is a Modified Endowment Contract?

A ‘MEC’ is essentially a policy that’s cash value has been “overfunded” based on the limits under the Internal Revenue Code. When a policy is classified as a MEC, any distributions from cash values of the policy are received on a taxable basis first or Last In First Out “LIFO” accounting method. The interest received on premiums is taxed at ordinary income rates and then the premium portion is returned tax free. A ‘MEC’ still benefits from a tax free death benefit, tax deferred growth and creditor protection. To determine if a contract is a MEC, a premium limit is set. This limit (referred to as a seven-pay limit or MEC limit) is based on the annual premium that would pay up the policy after the payment of seven level annual premiums. This limit is based upon rules established by the Internal Revenue Code, and it sets the maximum amount of premium that can be paid into the contract during the first seven years from the date of issue in order to avoid MEC status. Under what is known as the MEC test, the cumulative amount paid at any time in the first seven years cannot exceed the cumulative MEC limit applicable in that policy year.

What company should I use?

First, it’s important to make sure the life insurance company you’re considering is a stable and functioning company able to pay claims to its policy holders with enough reserves set aside to meet these obligations. You never want to purchase a policy from a company that is more sick than you are when you need them! Finding one with a Comdex score above 90 or a minimum Moody’s Investors Service rating of AA or higher is strongly recommended.

Secondly, we recommend using a broker to shop your life insurance need out to many different carriers. Career Agents or those working for a specific life insurance company, have strong incentives tied to their personal benefits to sell their company’s policies even though it may not be the very best one for your situation.

Please contact the Paragon Financial Advisors to review your life insurance policy(s) or help you review the available options to meet your life insurance needs. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas.  We offer financial planning and investment management services to our clients.

 

 

Longevity of Retirement Income

In early May, we attended an “Inside Retirement” conference sponsored by Financial Advisors magazine; the topics were centered on “income and longevity.” Various nationally known speakers discussed pertinent items related to those themes. We found some presentations worthy of discussion here. Some presentations were individual speakers; some presentations, panel discussions. Various concepts were presented for discussion; we don’t necessarily agree with all ideas presented but did find most of them thought provoking.

 

The World Today

 

Interest rates today are at historic lows. The 10-year US Treasury note yields approximately 1.8%, and some overseas developed countries have negative interest rates for their sovereign bonds. Low interest rates mean lower earnings available from an investor’s bond portfolio to supplement retirement income. Also, since bond prices relate inversely to currently low interest rates (as interest rates increase, bond prices decrease), bond prices are currently high.  The Federal Reserve Governors have continuing discussion about when (not if) to raise interest rates.

 

The stock market also poses some interesting challenges. Volatility in the market is significant, and some market analysts feel that stocks may be overvalued. Low interest rates have made some investors move into dividend yielding stocks in search of return—taking increased risk in the stock market in exchange for a higher current yield. Note that this higher current yield could be offset by loss in value if the stock prices decrease.

 

Other sources of retirement income have come into question. Social Security, a major source of retirement income for many Americans, faces funding shortages in the not too distant future. Changes are needed; however, the nature of those changes is still to be decided.

 

Finally, retirement life spans appear to be increasing. As life expectancies increase (and people are not working significantly longer), the length of time spent in retirement increases. Couple that increased longevity with potentially higher health care costs, and we face increasing pressure for financial longevity.

 

What to Do?

 

Much has been written and discussed about retirement planning (or the lack thereof) of Americans. We believe that retirement should also have a defined plan. Such planning should include planning for contingencies, structuring an investment portfolio, and a distribution strategy from any qualified plans. Since our major discussion above was related to investments, that’s what we will discuss here.

 

Market volatility is a fact of life. Stock market downturns will occur: the questions are when and how much. A retiree needs a stock component in a retirement portfolio. Stocks provide the long term growth necessary to preserve buying power over the long term—especially given the longevity previously discussed. Consequently, an investment portfolio should be structured to provide several characteristics.

 

1. Liquidity--enough liquidity to cover necessary expenses over years when the stock market is down. This structure implies cash equivalents and bonds to cover 4-5 years of needed income without having to sell stock in a down market. Liquidity also means the ability to readily convert a portfolio holding into cash. In the 2008 downturn, some securities (auction rates) could not be readily sold at a fair market price.
2. Total Return—low interest rates practically guarantee that an investor cannot meet all income needs from interest income only. Therefore, consider an investment plan that encompasses interest/dividend income with harvesting some of the investment gain in the portfolio. That’s “total return” investing where the income needs from the portfolio are met from a combination of dividends, interest, and gain from appreciated securities.
3. Diversification—much has been made of the need to diversify assets. That diversification should include asset classes that may not have been utilized in the past. Use of alternative investing strategies (hedging techniques, conservative option strategies, etc.) and asset classes (commodities, etc.) may be warranted in selected portfolios. Note that alternative investing may be used to reduce risk, not just as a yield enhancement.

 

Investing for long term income in the current environment poses special challenges. Not all items mentioned here are necessarily advisable for all investors. We at Paragon Financial Advisors assist our clients in building portfolios that match that particular client’s goals and objectives. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

 

 

Retirement-The Big Picture

In early May, we attended an “Inside Retirement” conference sponsored by Financial Advisors magazine; the topics were centered on “income and longevity.” Various nationally known speakers discussed pertinent items related to those themes. We found some of the presentations worthy of discussing here.

 Alicia H Munnell (Peter F. Drucker Professor of Management Sciences at Boston College, and director of the Center for Retirement Research at Boston College) gave a presentation with the title of this blog: The Big Picture. She has written extensively on income in retirement. Some of her major points include the following:

• More than one-half of today’s workers will not be able to maintain their current lifestyle in retirement. Why not?
• People will live longer.
• In spite of this increasing life span, people will work only a “little” longer before retiring—thus increasing their retirement life span.
• Health care costs are increasing. The increasing cost of care will be coupled with increased cost of health insurance—both private insurance through the Affordable Health Care Act and through Medicare Part B increases. In 1980, Part B Medicare premium was 6.8% of the Social Security benefit; in 2030 it is estimated to be 19.4%.
• Interest rates are at historic lows; lower rates reduce the amount of income generated from personal savings.\
• Retirement income has historically come from a combination of a) Social Security benefits, b) pension plans (either defined benefit or defined contribution), and c) individual savings. Let’s examine each separately.
• In 1985, Social Security benefits represented 42% of pre-retirement earnings. After Part B Medicare costs, the proportion decreased to 40%. Benefits were not taxable at that time so there was no further erosion due to income taxes. By 2030, those proportions are estimated to be 36% replacement before Medicare and income taxes; 32% after Part B Medicare expense, and 30% after Medicare and income taxes. Note that these percentages represent current replacement rates and do not include any potential changes to remedy the Medicare shortages currently under discussion.
• We live in a DC (defined contribution) or 401(k) world. The older DB (defined benefit) or pension plan is fast disappearing.  401(k)s limit the employer obligation only to offer contribution of funds to a retirement plan. The acceptance—and performance—of the plan is shifted to the employee from the employer. Here’s where we stand:
• Employees who don’t join the plan—21%
• Employees who contribute less than 6% of their pay—53%
• Plans with high asset fees—54%
• Plans losing assets through “leakage” (i.e. cash outs, hardship withdrawals, post 59 ½ penalty free withdrawals, loans, etc.)—25%Note: This leakage impact over the life of the plan can reduce the ending amount at retirement by as much as 25%.
• Retirees who don’t have a systematic plan for withdrawing assets in retirement—99%  How much (and when) should withdrawals be made from a retirement plan? Too much too soon and the retiree can run out of money; too little too late and IRS required minimum distributions can have significant income tax and Medicare Part B premium impact.
• Individual savings (or the lack thereof) are a topic for a separate writing; they warrant a much greater discussion which we will examine later.
• So what should a pre-retiree do?
• Work longer. A longer working career has the dual advantage of allowing retirement savings to grow and reducing the time during which retirement assets are needed.
• Save more. Savings should be increased preferably through a systematic plan (such as a 401(k)) or a periodic contribution to a savings account.
• Consider non-traditional sources of retirement income. There are two primary assets for most employees today: their 401(k), and their home. Tapping the home asset is a complex topic—another one that will be addressed in a separate writing. Home assets should be used only after careful analysis and with a full understanding of all their ramifications.

We at Paragon Financial Advisors strive to assist our clients in formulating a “big picture” for retirement. Please call us and we can discuss your individual circumstances.   Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

"Robo" Retirement??

There is much discussion today about “robo” or “robot” advisors (i.e. advice given by computer based on your input). Just answer a few questions, press a button, and you have the asset allocation you need for investments or you will know if you can retire.  The Saturday/Sunday February 20-21, 2016, Wall Street Journal (p. B11) also published online HERE reported an academic study of retirement calculators that warrant consideration.


Researchers at Texas Tech University and Utah Valley University evaluated 36 of the most prominent retirement planning calculators (both free and low cost). A hypothetical couple earning $50,000 each and in their early to mid-60s were used and their retirement was planned using the calculators. More than two thirds of the retirement calculators said the couple could retire with a significant degree of confidence. That significant degree of confidence was 70% or greater probability that the couple had enough money for retirement. Eleven of the 36 calculators correctly identified that the couple was in a precarious retirement position—those 11 calculators were not specifically identified. The calculators used did include ones from companies such as Fidelity Investments, Vanguard, T. Rowe Price, AARP, the Financial Industry Regulatory Authority (FINRA), and MarketWatch. MoneyGuidePro software was used by the researchers to make their own analysis.


A tradeoff exists between simplicity of input and quality of output. The more questions asked in the input phase (and the quality of those questions), the more rigorous the retirement plan output. For example, what is a reasonable life expectancy for the individual given family history? Will there be any inheritances from parents/relatives? Are there expected Social Security benefits? Will the individual have pension plan income; if so, is there a survivor benefit? A question frequently omitted is the smoking background of the individual (a factor that has significant impact on life expectancy).


In addition, there are numerous assumptions underlying each planning model. Does the model consider inflation? What rate of return is assumed on investment assets? How are those returns predicted (every year on average or by some other methodology)? These are only a few of the many planning assumptions in most retirement models.


Anyone using such a retirement calculator should look for a model that asks pertinent questions for input. Also, the model assumptions should be available for validation. Ideally, multiple calculators should be compared. Retirement is generally not difficult in the first few years; but those later years, when an individual is no longer able to work, can cause the problem.


We, at Paragon Financial Advisors, assist our clients in their retirement planning. That planning should be done well in advance and, as a process, should not be taken lightly. (By the way, we use MoneyGuidePro to assist in our retirement planning.)  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Medicare in 2016

All Social Security recipients are aware there was no cost of living increase in Social Security benefits for 2016. However, some recipients are facing a reduction in their Social Security check. The reason: the Medicare Income Related Monthly Adjustment Amount (IRMAA). The amount individuals pay for their Medicare coverage is a function of their modified adjusted gross income (MAGI) as reported on their tax return to the IRS. Higher income levels mean increased cost for Medicare for the same level of Medicare benefit. If the MAGI plus any tax exempt interest income exceeds $85,000 for an individual or $170,000 for a couple, the cost of Medicare Parts B and D increase. There is an increasing increment paid based on 5 levels of income.

Parts B (Doctors) and D (Drug)

For example, at the highest level, an individual making more than $214,000 ($428,000 for a couple) will pay $389.80 per month instead of the standard $121.80 for Part B benefits. That additional amount is paid by both spouses in the case of a couple receiving Social Security benefits. Those individuals in the highest income bracket would pay an additional $72.90 for their Part D drug benefits. The bottom line: each spouse in a couple receiving Social Security benefits (who are in the maximum tax bracket) will pay an additional $340.90 per month with no increase in benefit.

What to Do?

We will not get into the debate of higher income individuals should have to pay more, even though they have been taxed once on wages subject to the Social Security tax. Our point is that prudent financial management dictates managing one’s affairs to minimize tax payments. To that end, there are some basic things that could be done. By managing MAGI, one can possibly eliminate stepping into a higher Medicare bracket. Type of account (taxable or tax qualified) holding various investments, tax loss harvesting on securities held, and required minimum distributions made directly to a church/qualifying charity from an IRA are some examples of actions available.

We at Paragon Financial Advisors will help our clients evaluate possible courses of action the help reduce Medicare (as well as other tax) costs; however, these actions should be verified with your personal tax preparer or CPA to ensure they are appropriate for your circumstances. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Death and Taxes

Two things are inevitable: death and taxes. The occurrence is certain; only the timing is unknown. The tax portion has some implications that may affect future planning. Mr. Obama, in his 2017 budget proposal, included items that would effectively increase the taxes Americans will pay. While these items have not been implemented (yet), it does provide information for guidance in the future. The proposals include the following:

Excess Accumulations

Under Mr. Obama’s proposal, an individual would not be allowed to make tax deferred contributions to an IRA or defined contribution (i.e. 401(k), etc.) plan if the amount in the plan could produce an annual benefit in excess of $210,000. A Treasury Department document explaining the tax proposals in the budget stated “Such accumulations can be…in excess of amounts needed to fund reasonable levels of consumption in retirement…” and thus do not justify tax deferred treatment.

Inherited IRAs

Under current rules, an heir of an IRA can elect to receive distributions from the IRA over the lifetime of that heir, effectively “stretching” the distributions from the IRA over many years. This stretching allows the IRA to continue earning tax deferred for (potentially) many years and limiting tax payments to only taxes required on the amount withdrawn. The White House proposal would require an IRA inherited by anyone other than the surviving spouse to withdraw all proceeds from the IRA over a maximum of 5 years (and pay taxes on the withdrawals, of course).

Mandatory Roth IRA Distributions

Roth IRA contributions are made with after tax dollars; earnings accumulate tax free and there is no required minimum distribution under current rules. Two changes are proposed here: 1) minimum distributions beginning at age 70 ½ would be required (just as with regular IRAs), and 2) no additional contributions would be allowed after age 70 ½.

“Back Door” Roth IRA Contributions

Currently, Roth IRA contributions are not allowed for individuals making more than $132,000 annually for singles ($194,000 for couples) in 2016. However, individuals can open a regular IRA with non-deductible contributions and immediately roll the funds into a Roth IRA. That process effectively allows high income individuals to contribute to a Roth IRA regardless of the income level. The budget proposal effectively prohibits this practice in the future.

Net Unrealized Appreciation on Employer Stock

Retiring employees currently have the option of taking employer stock from a company plan at retirement. Their tax liability (as ordinary income) is based on the original cost of the stock to the employer plan. If the stock is held for a year or longer, the excess of the sale price above the plan cost (the net unrealized appreciation) is taxed at the more favorable long term capital gains rate. The budget proposal eliminates that option for employees under age 50 as of 12-31-16.

Other Items

While not included in the budget plan, there have been other tax measures discussed which affect investors. One is a “transfer fee” on securities transactions i.e. a tax on each security purchase and sale. I imagine the rhetoric will be couched in terms of affecting the only the wealthy and “hedge fund managers,” however; such a tax would also affect mutual funds. Those funds are the investment vehicle of most middle class investors and are the bulk of investments for 401(k), 403(b), etc. plans. It thus appears that such a tax would have a much wider impact on more Americans.

Income taxes have long been a favorite vehicle for raising revenue. Another item has been discussed—a wealth tax. Such a tax would be applied to the assets the investor owns. The amount and the frequency of collection (annually??) have yet to be determined. It will be interesting to see if such a proposal again appears.

In this political climate of “fair share” and “income inequality,” one can anticipate some tax changes will be forthcoming. We, at Paragon Financial Advisors, assist our clients in managing their financial assets in a changing tax world.  Specific actions should be discussed with your CPA to ensure appropriateness in your individual circumstances, but let’s try to delay both death and taxes. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Happy New Year-2016(II)

On January 4, 2016, we wrote a blog about the volatility and performance of the financial markets in 2015. To say the financial markets have been “interesting” since then exemplifies an understatement. As we write this on Feb 11, 2016, the S&P 500 has declined approximately 10% since the end of 2015 and has fallen approximately 13% from its high in May of 2015. No way can one look at an investment portfolio in these market conditions and “be happy!” However, we should try to look at these conditions in light of 1) how to protect (to some extent) against such market moves, and 2) what to do now.

 

What’s the Perspective?

 

Fresh in most investor’s memory is the October, 2007- March, 2009 decline. The S&P 500 declined from about 1565 in October, 2007 to 676 in March, 2009 (a decline of about 57%!!). The S&P regained its October, 2007 high in March, 2013 (or 4 years later) on its way to 2131 in May of 2015. Obviously only one incident may not be representative of future market movements; however, the stock market historically moves up, even with the intermediate ups and downs.

 

How Should You Prepare?

 

So what does an investor do? With perfect hindsight, one would have moved into cash to avoid the downturn. Such market timing always brings the question of “when” to reinvest. Numerous empirical studies show investors suffer anemic returns because they wait too long to re-enter the market. For example, Putnam Investments published research showing that an investor who missed the best 10 days in the market during the time period 12/31/2000 -12/31/2015 would have an annualized return of 1.18% vs. the 5.80% earned by the investor who held the portfolio throughout the time period. That return differential represents $11,365 more on an initial investment of $10,000 ($23,295 vs. $11,930).

 

Numerous factors go into portfolio management; we will discuss only one here—asset allocation. Asset allocation involves having a portfolio positioned in such a manner that “not all eggs are in the same basket.” Some ramifications of that are as follows:

1. Money needed in the near term is invested in cash or conservative bonds such that those needed moneys are not subject to the volatility of the stock market.
2. Different investments in the portfolio can move in different directions relative to each other and the market in general (their correlation). We mentioned the S&P is down about 10% year to date; the aggregate bond index is up approximately 2% in the same time period.
3. A subset of the correlation argument is use of alternative assets where the investment itself or the investment manager’s style is designed to give some portfolio protection in a declining stock market. Mutual funds utilizing a “long/short” or “market neutral” strategy are available to provide some loss protection and still maintain liquidity. Obviously the quality of that investment is highly dependent on the fund manager and fund strategy; care should be taken when integrating such assets into a portfolio.

What Do You Do Now?


Preparation is great, but it’s an historical thing. If it’s not done before now, you may be too late. So what does an investor do now? Consider the following:

1. Review the cash needs from the portfolio for the next several years. Do you have sufficient cash or investments with gains to cover those needs? If so, you can “wait it out.” You have no need to go into panic portfolio liquidation.
2. Almost every diversified portfolio will have some assets with a gain—especially if they have been in the portfolio for a while. Do some “tax harvesting” where assets are sold and the gains of the “winners” are offset by losses of the “losers.” This action results in avoiding taxation on the gain and allows resetting cost basis on investments in the future.
3. What did you do the day after Thanksgiving? Millions of Americans went shopping because things were “on sale.” Apply the same mindset to the stock market. Stocks are currently going “on sale.” Investors may have hard time thinking about adding to positions in such markets, but for the right stocks and in the right portfolios, these times may be buying opportunities.

Let’s Review

We are not saying “do nothing.” We are saying that an investor should review his/her current portfolio in view of the investor’s needs/long term goals and should consider the composition of the portfolio. Wholesale selling in a down market usually works to the investor’s disadvantage. In addition, tax consequences of selling at a loss can be tricky and should be done with tax consultation. Also, buying declining securities of companies should be considered carefully—is the decline of stock price related to the general market sell-off or is there a systemic problem with the company?

We, at Paragon Financial Advisors, will be happy to discuss your portfolio and circumstances with you in these “interesting” times. Please feel free to contact us.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

NOTE: All investing involves some degree of risk and possible loss of principle. Stock offer greater long term growth potential but may have wider and greater price fluctuation while yielding lower current income. Bonds may involve credit/default risk resulting in loss of principle; they historically have provided consistent income. Alternative investing and techniques are specialized situations and should be used only when one understands the risks and restrictions involved. Nothing in this discussion should be construed as a general investment recommendation; appropriateness is dependent on the investor and his/her particular circumstances.

Social Security Changes

The Bipartisan Budget Act of 2015 passed by the 114^th Congress in December made some changes in benefits that were available for claiming Social Security benefits. How, and when, individuals and couples claim their Social Security benefits can have significant impact on the amounts received over the claimant’s lifetime(s). Usually, the minimum age for claiming benefits is 62; however, benefits will be reduced by 6 2/3 % for each year younger than the “full retirement age” (FRA) at which benefits could be received with no reduction. That FRA is dependent on the claimant’s date of birth. Benefits increase by 8% per year for each year beyond FRA that a person waits to start drawing his/her Social Security. The increase in benefit applied only until age 70; no further increase is available after that age. Two major changes were impacted by the Budget Tax Act; it eliminated “file and suspend” and “spousal benefit” provisions. The old rules are in place until April 30, 2016; after that, new rules are in place.


File and Suspend


The file and suspend provision allowed on individual who had reached his/her FRA to file for Social Security benefits but defer the collection of those benefits until sometime in the future. That delay allowed the recipient’s benefits to increase by 8% per year until benefit payments actually started. If, during that suspension time, the claimant decided to receive the original payment from FRA, that option was available. And, a lump sum for the amount that would have been received was available. In addition, auxiliary benefits might be available to a spouse or minor dependent. The real benefit was the spousal benefit (see below).


Restricted Claim for Spousal Benefits


The spousal benefits provision allowed a spouse (who had reached FRA) to file for 50% of their spouse’s Social Security benefit (who also reached FRA) while letting their own benefit grow. For example: Spouse A could receive $2000 per month at FRA; that spouse “files and suspends.” Spouse B (at FRA) could receive 50% ($1000 per month) while both spouses let their own benefits increase by 8% per year until age 70. Spouse B could then take the larger of the 50% or his/her own benefit.


The Rules Change


After April 30, 2016, an individual may still file and suspend at FRA; however, no one else may collect any benefits on the individual’s record while the suspension is in place (subject to the exception below). In addition, the option to request a lump sum payment for deferred benefits no longer exists.


Anyone who is age 62 or older at the end of 2015 retains the right to claim only spousal benefits when they reach age 66 and receive their (hopefully larger) retirement benefit at age 70. Anyone younger than 62 at the end of 2015 will no longer have the option of which benefit to claim; they will be paid the higher of their own benefit or as a spouse.


Divorcees who were 62 or older at the end of 2015 fall under the four year phase in rule also. They must have been married at least 10 years, divorced two years, and are currently single. They can file for spousal benefits at age 66 and change to their own higher benefit at age 70.


We at Paragon Financial Advisors work with our clients to help them achieve their financial goals. That includes evaluating Social Security options; we do request that each individual discuss his/her personal circumstances with the Social Security personnel to confirm their personal history. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Happy(??) New Year! - 2016

The Markets-2015

 

Well, 2015 is in the rear view mirror; and what a year it was from an investing perspective. Let’s look back at the financial markets over the year. The S&P 500 was down .73% for 2015; the Dow Jones Industrial Average was down 2.23%; the Barclay’s Aggregate Bond Index was down 1.84%; and interest rates on the 10 year US Treasury rose from 2.09% in January to 2.27% in December (with a corresponding decrease in bond values). This means that a blended portfolio of 50% stock in an S&P index fund and 50% bonds in an aggregate bond index fund would have returned negative 1.29% for the year.

 

But that’s not the whole story. When we look at the components of the S&P (the sectors that comprise the index), we find an entirely different story. There was significant difference in the sector performance—as follows:

 

Sector                                                   2015 Return                        Weight in Index

Consumer Discretionary                           +8.4%                                    12.8%

Healthcare                                                 +5.2%                                    15.2

Information Technology                           +4.3%                                    20.5

Consumer Staples                                     +3.8%                                    10.2

Telecommunications                                 -1.7%                                     2.5

Financials                                                  -3.5%                                     16.5

Industrials                                                  -4.7%                                     10.0

Utilities                                                     -8.4%                                      3.1

Materials                                                   -10.4%                                    2.7

Energy                                                       -23.6%                                   6.4

 

In addition, there was significant volatility in stock prices in 2015. The S&P 500 index crossed over its flat line beginning value 26 times (positive to negative and vice versa) during the year. Looking at the consumer discretionary sector (up 8.4% for the year), had volatility of monthly changes during the year ranging from +9.0% to -6.6%.

 

What does this tell us? First, while there is empirical evidence giving credence to passive index investing, such a strategy would not have worked well in 2015. Second, the variation in sector returns implies the opportunity for positive returns exists through active investment management. But what form does that active investment take?

 

Looking Ahead

 

One can read all the tea leaves from the past and discuss what has happened historically in similar circumstances e.g. market performance in election years, market performance post interest rate increases, etc. But, if one is pursuing an active management strategy, looking at the current state of affairs should assist in the active management tactics to take going forward. Some macro-economic items to be considered (by no means a comprehensive list) are listed below:

1. Interest Rates—The Federal Reserve has begun its policy of “normalization” with its first rate increase in December, 2015 (up 0.25%). The Fed’s policy statement from December, and Chairwoman Yellen’s press conference, has been focused on inflation as the primary driver of future rate increases. The Fed’s 2% target inflation has not been forthcoming and has driven speculation of another 1% rise in rates in 2016. However, economic indices offer different (and sometimes conflicting) information that may affect this rise in rates.
2. Oil Prices—As we begin 2016, oil is currently in the sub $40/bbl. range. This is a boom to some parts of the economy (the general consumer) but a bust to others (oil related industries). There is significant turmoil in the Middle East but the need for oil revenues should continue as many countries are so dependent on oil revenues that reduced production does not appear to be a factor.
3. Strong US Dollar—The US $ has been strengthen over the last two years, making US exports more expensive to foreign markets and multi-national overseas corporate earnings worth less if repatriated to the US. While this strengthening may slow down, it is doubtful that there will be a significant decline.
4. US Gross Domestic Product (GDP)—Current projections for economic growth in the US are in the 2-2.5% range; by no means robust but significantly better than the global outlook. The tax cut-spending package passed by Congress in December will add a stimulus to GDP but with a corresponding deficit that will likely increase in 2016 by 1% of GDP. The debt-to-GDP ratio (already at troubling levels) will begin to rise again. (Note: This excessive debt is a subject worthy of its own discussion and more than we can include here!)
5. Global growth is slowing; especially China which appears to be transitioning from manufacturing and construction into services.

 

So what does the astute investor do? Economic indicators are giving conflicting advice.

• Rising interest rates imply decreases in bond values.
• Unemployment rates are coming down (don’t ignore the calculation methodologies of this number), but the percent of the labor force employed remains at historic lows.
• The Institute for Supply Management (ISM) December, 2015 manufacturing data showed a contraction for the second month. Overall manufacturing is slowing, but new orders and production increased over November. The ISM manufacturing index for December was 48.2; anything above 50 indicates economic expansion and anything below 50 indicates contraction.
• Credit spreads (the difference between “high yield” or “junk” bond yields and high quality bond yields) are increasing; this implies a greater risk in the junk bond market.
• There is a widening gap between corporate earnings and sales results. In the third quarter of 2015, 60% of reporting companies exceeded their earnings per share (EPS) estimate; however, 59% of the reporting companies missed their sales estimates. How did this happen (expense reduction??)? In addition, there is a widening gap between the normal accounting EPS and the “adjusted” EPS being reported by some companies. Adjusted EPS eliminates some “extraordinary” or “non-recurring” expenses which results in a higher EPS. The gap between normal and adjusted EPS has been approximately 30% (normally about 10%) with adjusted being the higher.

What to Do?

Given the above, what’s an astute investor supposed to do?

First of all, consider your goals and objectives. Position your portfolio according to those goals and your risk tolerance. Attaining your goals with a risk level that makes you sleep well at night is more important than “chasing return.” For example, some investors have been increasingly pursuing risker assets in their search for maximum return. But if your goals are funded by a more moderate approach to returns, why take the extra risk. This shift basically involves an “asset-liability” matching strategy (matching your needs from the portfolio against your asset allocation) vs. a “maximum return” strategy.

Second, use these periods of market volatility (a normal part of market activity) to reposition diversified portfolios to your target levels.

Third, continue to maintain a diversified portfolio consistent with your goals and objectives. It is important to note here that diversification may be taking on a new meaning. The traditional “stocks, bonds, cash, commodities” portfolio allocation may require a different perspective; a perspective that provides more flexibility and a wider opportunity set of choices. There other markets available which may provide suitable investments (infrastructure, re-insurance, emerging markets, frontier markets, etc.). Alternative investments and hedge fund techniques (real estate, long-short investing, merger/acquisition, distressed security investing) may be beneficial in a portfolio. However, these investments/techniques have peculiar characteristics (possible lack of liquidity, extremely long time horizons, etc.) which require due diligence before investing.

We, at Paragon Financial Advisors, assist our clients in reaching their desired financial goals with an appropriate risk level. Please feel free to contact us.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

 

 

NOTE: All investing involves some degree of risk and possible loss of principle. Stock offer greater long term growth potential but may have wider and more price fluctuation while yielding lower current income. Bonds may involve credit/default risk resulting in loss of principle; they historically have provided consistent income. Alternative investing and techniques are specialized situations and should be used only when one understands the risks and restrictions involved. Nothing in this discussion should be construed as a general investment recommendation; appropriateness is dependent on the investor and his/her particular circumstances.