In light of the recent headlines around bank failures, which may have brought back some very bad memories for those investors who lived through the 2008 financial crisis, it is helpful to examine what the rules are in order to sleep better at night.
When it comes to a bank or a credit union, your deposits are insured up to $250,000 per depositor with the Federal Depository Insurance Corporation (FDIC) or the National Credit Union Administration(NCUA). That ratio is per institution, not per account number. As a result, opening two separate joint accounts with your spouse in the exact same title will not increase your coverage. Additionally, adding a beneficiary such as a child or sibling onto an account will add an additional $250,000 per beneficiary. This is called a Payable on Death (POD). However, the FDIC limits this to a maximum of six beneficiaries.
We strongly encourage individuals to stay within the FDIC/NCUA limits allowable. Recently, the FDIC has extended unlimited deposit insurance to institutions such as Signature Bank and Silicon Valley Bank. However, there is no guarantee this will be the case with all banks. The manner in which these banks saw increased FDIC limits is already in question. Under the 2010 Dodd-Frank bill, the Federal regulators have the authority to raise the deposit cap to cover all accounts should a “liquidity event” take place. However, this is only after an expedited vote by the U.S. Congress, which hasn’t yet happened.
The selection of certain banks to have unlimited deposits as opposed to other banks creates a number of rather obvious potential problems. However, permanent unlimited deposit insurance creates a whole host of other longer-term issues. Imagine if all deposits were unlimited. Savers would likely overwhelmingly chase the highest rates, which would place more money in the institutions that take the highest risk, thereby encouraging more risk in the financial system.
As a saver and investor, it is important to know how and where you are protected. When you are a depositor at a bank, your deposit is your asset. To the bank it is a liability. The deposits in your name are subject to the creditors of that bank in the event of a default over whatever the allowable insurance limits are over that time. This is because banks lend out their monetary base as much as a 10-1 ratio under the Fractional Reserve Lending System. The mechanics of that system are quite complicated and beyond the scope of this article. What is important to know is that your deposits above the limit can very much be at risk.
Let’s then compare this to how a broker-dealer works in terms of their custody of your assets. A brokerage firm is required to legally segregate client assets from firm assets. This means when you examine the balance sheet and profitability of a brokerage firm, they can’t list your stocks and bonds as an asset on their balance sheet. As a result, in the event of a liquidation of the firm, your accounts simply receive a new custodian. During the 2008 financial crisis, we witnessed Lehman Brothers, a 158-year old investment firm that catered to some of the wealthiest investors in the world go out of business in a couple of weeks. As scary as this was at the time, it’s important to note that 100% of client assets were returned to them as multiple divisions of Lehman were split up across many companies. This does not mean that the value of your securities are inherently safe. If you own 10 shares of stock in Amazon, and the stock declines, it is still worth less to you. It only means that your 10 shares of Amazon will be returned to you simply because they are not subject to the creditors of the brokerage firm. This is true with your employer 401k and other retirement plans as well.
Does this mean that brokerage firms don’t need insurance? Absolutely not. Brokerage firms maintain insurance via the Securities Investor Protection Corporation (SIPC). SIPC covers you up to $500,000 per investor. However, the way in which SIPC works is it insures you in the event of something like fraud. If a firm is liquidated and the client assets are being returned to them, but somehow you uncover that shares are not there, then the SIPC would begin coverage. A famous example would be the Bernie Madoff case, in which he provided clients with fictitious statements of their balances. The SIPC coverage reimbursed them up to the $500,000 limit. Additionally, most major brokerage firms offer additional private coverage that can sometimes be unlimited protection from such examples of fraud or missing securities. In the case of Madoff, he did not maintain any additional insurance above the SIPC limits, most likely because they would have uncovered the fraud much sooner.
As a result of the way insurance on deposits actually work, it could be argued that a cash position above the FDIC limits in a brokerage firm sitting in a money market is actually quite a bit safer than a bank. Money markets are essentially mutual funds that invest in cash like short-term debt instruments that are maturing usually between 30-90 days. As a result, they are highly liquid. The risk with a money market has more to do with the underlying debt and the risk of default. It is extremely rare for a money market to default. However, an investor concerned with such a risk could choose a money market that invests only in government backed securities, or more specifically just US treasury T-Bills. This eliminates the default risk, with the exception of the US Government declaring a default. If such a thing were to happen, it really wouldn’t matter very much where you put your cash anyway, as it would be worthless paper and nothing more than kindling for the fireplace.
While more bank failures may be possible, we would highly encourage investors to stay within the legislated FDIC limits. However, understand that the way in which a brokerage firm segregates your assets is very different from that of a bank.
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Investing can be a very emotional rollercoaster ride for many individuals. These emotions are inherently counterintuitive. The desire to sell during difficult periods can be quite strong. Additionally, the desire to put money to work when markets are doing well can be equally as strong. These emotions often lead investors to sell low and buy high, which is precisely the opposite of what they should be doing.
Ultimately, the ability to time the correct entrance and exit into financial markets has proven to be an ongoing exercise in futility. The data around market timing consistently demonstrates this to be the case. There are many examples of this. The annual Dalbar studies demonstrate year after year how the average investor underperforms the overall market due to these types of poor decisions around timing. Additionally, the Standard & Poor’s Index Versus Active Management report (SPIVA) consistently shows that professional money managers demonstrate a very poor track record of outperforming markets as well, with roughly 90% of mutual fund managers failing to outperform their benchmark.
Additionally, a landmark study “Determinants of Portfolio Performance” done in 1986 by Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower revealed that approximately 90% of your investment return comes from the overall allocation of assets, and has less to do with individual security selection. The importance of this paper helped reinforce the earlier work of economist Harry Markowitz and his research in 1952 on Modern Portfolio Theory, for which he was later awarded the Nobel Prize in Economics.
Today, we see data that suggests little has changed. The ability to time markets is as difficult as ever, and the importance of staying invested as opposed to timing the market is no different than in decades past.
Looking at some recent data on asset allocation in the above chart, we can see the 1-year, 3-year, 5-year, 10-year and 20-year rolling returns for various asset allocation models. What we can see from the data is that the longer you are invested, the better you’ll do. While that should be no surprise to anyone, what we can also see is the probability of posting a negative period is much lower as you reduce exposure to stocks and increase exposure to fixed income.
Looking at the data we can see that a portfolio that is approximately 55% stocks has seen few negative 3-year rolling periods. In no circumstances were the 5-year or more rolling periods negative.
When looking at an investment portfolio that has a 73% exposure to stocks, we see a very nominal potential decline in any 5-year rolling period, with the overwhelming number of periods producing positive results.
When we expand the time frame to 10-year rolling periods, none of the asset allocation models have demonstrated any negative rolling periods, with the exception of being 100% invested in stocks via the S&P 500. It’s also important to note that even in the few examples in which the S&P 500 posts a negative 10-year period, this is an example that illustrates only price return, and does not factor in the dividend income from investing in the S&P 500. When we correct for the dividend cash flow generated, the worst negative 10-year periods actually go from negative to positive.
This chart demonstrates several important points.
The likelihood of success by staying invested improves dramatically over time.
The more of a balanced portfolio you have, the less likely you are to experience a negative result, even during a relatively short period of time.
There is a point of diminishing returns in which the degree of increased short-term risk and volatility does not produce an equivalent increase in long-term return.
It is often said by the novice investor that “the stock market is like going to a casino”. In fact, the opposite is actually true. When you enter a casino, you may get lucky and win in the short-term, but if you stay long enough, the probability is you will lose as the odds are very much in the casino’s favor. Investing is precisely the opposite. You may very well see a negative return within the first year or two. However, the probability that you are still losing money within a 3-5 year window of time is very low. As investors, if you are disciplined enough to stay invested, you are essentially the casino owner as opposed to the gambling patron.
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In recent months there has been increased interest in US Treasury savings bonds, particularly I-Bonds, because of the higher interest rates resulting from the recent spike in inflation. Investors who are pursuing these bond should ask the question, “what is the plan when they mature, or if you want to redeem them?” If Inflation ends up reverting to a more normalized historical rate, then the yields on these bonds will go down, and could even go to zero as they have in some years during the 2010’s. Given this potential issue, it’s important to have a game plan.
Clients that have accumulated a relatively significant amount in Series EE Savings bonds may have concerns about the tax implications if they cash them in, as they are taxable when redeemed. When they have fully matured, and they stop paying interest, investors may be interested in getting their money working again. One possibility is college funding. Imagine if you were a grandparent looking to help with the education of your grandchildren. Given the potential tax concerns in such a situation, we might suggest cashing in a little bit at a time each year, and subsequently opening a 529 for each grandchild with the proceeds. This can allow you to deduct the realized interest income from the bonds that are cashed in annually. There are nuances with this approach as it is important to ensure income is below certain limits to take advantage of this tax strategy. Additionally, creating too much taxable income from the interest generated can impact Medicare premiums as well. It’s also important to be aware of how the new account will be titled, as well as the gifting rules. Although there are many things to address, if done properly, this could be a good strategy to accomplish a number of financial goals for some investors.
Technically, the income exclusion rule allows for certain savings bonds to be redeemed and the proceeds to be used for qualifying higher education expenses. Expenses that qualify are tuition and fees, not room and board or books. Qualified expenses also include 529 college savings plans, Coverdell Savings accounts for oneself, a spouse or dependent. In order to take advantage of these rules the bonds must be Series EE bonds, or Series I-bond. The Series EE bonds must have been purchased after 1989. All Series I-Bonds will qualify. The owner of the bonds must have been at least 24 years old when the bond was purchased. They must be in the bond holder’s name or their spouse’s name.
There is an income phaseout, whereby being above this level precludes one from taking advantage of the income exclusion. The level is typically adjusted for inflation annually. For 2023, the phaseout begins with a Modified Adjusted Gross Income (MAGI) of $91,850 and completely phases out at $106,850. In the case of married couples filing jointly, the phaseout starts at $137,800 and ceases at $167,800. The exclusion is not eligible if you are married and still filing single. It’s important to note that when redeeming these bonds, it will create a taxable event. As a result, you should ensure that you don’t go over these levels, after the redemption of these bonds has been factored in. If you are under these income levels, you will also stay within the first tier of Medicare premiums increases which also can be increased as your income grows.
The next thing to be aware of is how the new account should be titled. The new account can be a Coverdell Education Savings account or a 529 College Savings Plan. The 529 Plan does have some advantages over the Coverdell. However, based on the client’s needs, each plan needs to be evaluated.
The new account must have the grandparent as the beneficiary. The owner doesn’t necessarily need to be the grandparent, but will make it easier to make changes to the plan in the future. Then the beneficiary can be changed over to the child at a future date, perhaps in the following year. It’s also important to be aware of the specific rules with regard to changing beneficiaries on your plan. Also note that when changing a beneficiary, gifting rules will apply. For 2023, a person is allowed to gift up to $17,000 per year without triggering a gift tax filing. Remember, if you go over the annual amount, you will be required to file IRS form 709 with your taxes. However, no actual gift tax is due. The amount simply reduces your lifetime exclusion. It’s advisable to consult with your tax advisor when planning on a larger gift in order to remain in compliance with the latest rules.
Funding of the account should be done within 60 days of redeeming the bonds. IRS form 8815 is the form that is filed in order to claim the income exclusion on the bonds that are redeemed.
Several factors must align in order to take advantage of this strategy. However, if your situation checks all the boxes, it could be another way to save on income taxes, reduce your estate and help your kids or grandkids with college expenses.
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