One of the confusing aspects of reading a monthly statement or your positions page on the website from your brokerage firm is the gain and loss column. While this is something that sounds like it should be fairly straightforward, it isn’t. Many investors often confuse what reflects as a current gain or loss for their performance data. There are several reasons why that is not the case.
Realized vs Unrealized
When reading the positions on your statement, you are reading exclusively unrealized gains or losses. This can make the performance information look better or worse.
Imagine that your advisor bought a position of 100 shares of Apple stock at $180 per share for a total of $18,000.
Six months later the advisor sells 80 of those shares for $230 per share for a total of $18,400, leaving you with the remaining 20 shares on your statement. Then another 6 months later Apple declines to $175 per share.
According to your statement you now own 20 shares of Apple at $175 per share, or $3,500 in total. Since those shares were originally purchased at $180 per share, that will reflect as a loss of $5 per share, or -$100.
However, the statement of positions doesn’t reflect that prior sale of 80 shares for $18,400 which was $400 more than your original investment. Once that sale was completed, you would have locked in a profit on the original transaction, and whatever happens with the remaining 20 shares is all gain. While these transactions will show in your account history from six months earlier, they do not reflect in your current balance. In such a scenario, you made money, but your current statement for accounting purposes reflects a loss.
The opposite can also be true.
Imagine a scenario where your advisor buys $10,000 worth of an S&P 500 index fund. The market subsequently declines substantially, and the fund is now worth $8,000. If this is in an non-retirement account, the advisor may do the prudent thing and sell the fund for the $2,000 tax loss, only to immediately buy something very similar, such as the Russell 1000 stock index. This is a strategy known as “tax-loss harvesting” whereas you maintain market participation but realize the loss for tax deductibility.
Now imagine that the new position in the Russell 1000 index fund appreciates from $8,000 to $9,000 dollars. The monthly statement you receive will show a position that reflects a gain of $1,000. However, while this is correct for accounting purposes, it is really a loss from the original $10,000 investment.
Accounting for Dividends & Interest
This is another area that can be confusing, particularly when it comes to bond funds. Since bonds in most years don’t fluctuate that much in price, the majority of the return that comes from a bond or bond fund is the interest payments that are collected, which typically reflects monthly in a bond fund.
If you purchased a bond fund for $10,000 and it paid a 5% interest payment annually that would mean a $41.66 payment monthly, or $500 annually. It’s fairly common for investors to own a fund for many years. If you opted not to reinvest the dividends, at the end of five years, you would have earned $2,500 in interest payments.
However, what if the value of that funds share price had declined from $10,000 to $9,500? On your monthly statement, you now reflect a loss of $500. In reality, you have a $2,000 gain when you add back the interest you’ve earned. Nevertheless, for accounting purposes your statement will correctly show a loss of $500, when in fact you actually made money.
The reinvestment of a dividend can cause a similar issue as each time you are buying more shares of an investment by acquiring these shares at what may be a higher, or lower price than your original purchase price. Each time you reinvest a dividend, you are altering your cost basis for accounting purposes.
Imagine the same example of a $10,000 bond fund purchase. You have now taken that same $2,500 in dividends payments, which are all 100% gains and added them in at new purchase prices each month.
The sum total of all the shares you acquired from reinvesting those dividends could be valued at $2,300, which is $200 less than the $2,500. This will reflect as a loss of $200 on your statement, yet in fact it is a gain of $2,300 since all of the purchases were the source of an already realized gain.
While to some this may seem complicated and confusing, it is little more than an accounting record. A monthly statement is just an accounting record of your unrealized gains and losses and does not reflect what has already been realized or closed out. The true measure of performance is the change in total market value over time once you’ve corrected for withdrawals and deposits.
Cost basis should only be used to calculate capital gains and losses for tax filing purposes, not to measure performance.
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Among the most consistent questions my colleagues and I have received as financial planners from investors relates to the timing of when they should take their Social Security (SS) benefits. Social Security is a relatively complex system with many rules that pertain to various circumstances. Let me first emphasize that there are no absolute answers, and each individual’s situation should be assessed on its own merits. Unless of course you can tell me precisely when you will die, in which case I can provide you with a far more precise answer.
I would venture to guess that the majority of articles and publications on this topic will suggest that you wait as long as possible to collect. I will attempt to defy what may be the conventional wisdom, because in my experience the conventional wisdom is often wrong. Let me first say, none of this is based on the known actuarial problems facing the SS trust fund, which begins to run a shortfall projected around the year 2033. The SS trust fund is made up of intragovernmental debt (US Treasuries). The funding sources for SS have been merged with the general taxes collected for many decades. Since the United States operates as a fiat currency, “running out of money” is essentially impossible. I say this not to minimize the challenges that such entitlement programs face, as they can have many other substantial economic consequences on the nation beyond the scope of this article. However, the fear of the government “running out of money” should play no role in determining when you should collect your benefit.
SS benefits allow under normal circumstances that you can collect your benefits prior to your full retirement age (FRA) as early as age 62, or past your full retirement age as late as age 70. Full retirement can be differing ages as defined by SS depending on when you were born. Each year you delay the benefit, it increases by 8% using a simple interest calculation rather than a compounding calculation.
The first thing to understand is that SS is actuarially designed so that when you reach your statistical average life expectancy you will have received the same exact total amount of dollars regardless of whether you began at age 62, age 70, or anytime in between. Each day you live past your average life expectancy, the total amount of dollars received is greater for someone who delayed collecting their benefits versus someone who collected earlier. Additionally, the term “average” life expectancy is quite misleading. In financial planning we also study “longevity” planning, which is different than the average. The average can be misleading because averages are impacted by unfortunate events such as infant mortality or a teenager killed in a car accident. When we look at longevity, a couple that actually reaches age 65 has better than 75% chance that at least one of them will reach age 92 years old. So, if you live long enough to qualify it would seem statistically highly probable that you will surpass the average, and therefore you are better off delaying your benefit. While it may seem that way, here is why it may not.
The majority of examples that illustrate when an individual should opt for their SS benefits will look in isolation at the SS benefit, and often not enough at the details surrounding an individual or couples overall financial picture. This approach will most often encourage you to wait as long as possible. Let’s first look at the most common example, which is a married couple. Many people are unaware that unlike a traditional retirement plan, SS does not offer a traditional survivor benefit. This means that if Spouse A is earning $2,600 at full retirement, and Spouse B is earning $1,800 at full retirement, upon the death of either of the spouses, the survivor will receive the higher of the two benefits and lose the lower benefit permanently.
Let’s imagine a common example. Client A is born in 1955 and their full retirement benefit at age 66 and 2 months. The annual benefits offered are as follows:
Reduced benefits at age 62: $25,181
Full retirement benefits at age 66: $33, 933
Delayed benefits at age 70: $44,792
For the sake of these illustrations we are going to discount the annual inflation increases on the SS payments because they would be applied at the same rate linked to the consumer price index regardless of what age you opted to begin collecting your benefit.
Client A’s benefit of $25,181 between the age of 62 until 70 is an aggregate income of $201,448 over the 8 year period. If client A does not receive this annual benefit because they waited until age 70, then we might presume that they needed to spend down the $201,448 from another source such as a 401k, IRA, savings or another investment account in order to meet their income needs. So how much is the time value of money on the $201,448 spent down to replace the SS benefit that was not collected because Client A waited until age 70 for the enhanced benefit?
Let’s be conservative.
If the same $201,448 remained invested earning an average return of 5% (which is well below historical long term market averages), that would compound into $297,630. It is widely accepted based on countless financial planning studies that a properly balanced investment portfolio can sustain a 4% withdrawal strategy for 30 years increasing with inflation without depleting assets to zero. If you were to wait until age 70 to begin withdrawals, a 4% withdraw should be more than sustainable and quite reasonable. Even a 5% withdrawal at age 70 is highly plausible. In the interest of remaining conservative in the assumptions used, we will use the 4% withdrawal approach.
The pool of investment dollars has compounded to an additional $297,630 because Client A did not need to draw on these assets due to the early SS benefit supplementing their income, how much is this worth as an income? Using a 4% withdrawal strategy annually from $297,630 beginning at age 70, you have an annual income in year one of $11,905. This figure is still smaller than the difference between your age 70 benefit and the age 62 benefit ($44,792-$25,181=$19,611). That is a difference of $7,706 annually. So why would it be better to realize the lower income?
Let’s remember that you don’t receive more in total benefits by waiting until you reach your average life expectancy, (currently approximately 81 for women and 76 for men). What happens if Client Adid not live to their statistical average and were to pass away at age 70? Remember that the survivor benefit to the spouse is the higher of the two benefits, but they lose the smaller benefit. In such a case the surviving spouse would lose not only the smaller income (which is at least 50% of the larger income), but the benefit of inheriting the $297,630 that was never realized because the assets were spent down rather than saved and grown via an investment portfolio during the 8 year period while waiting to collect the higher benefits. The result of the combined loss in many cases can be dramatically impactful, if not financially catastrophic on many surviving spouses.
It is sometimes argued and entirely possible to insure this risk by buying a term life insurance policy on the amount of the lost savings. However, term insurance typically ends at age 80. In the event the insured died at age 81, the surviving spouse never receives the death benefit, nor do they have the accumulated additional dollars saved by collecting earlier. Additionally, they lost the cost of the life insurance premiums they paid for 18 years, which negates some of the benefit of having just barely passed the breakeven point at their average life expectancy. This strategy also presumes the individual is in fact insurable, which is not always the case depending on their past medical history.
What if Client A waits to collect at age 70 and both spouses live to the ripe old age of 95?
With the average life expectancy for a man being approximately age 76, that is an extra 19 years with an additional $7,706 per year past the breakeven point. That is a total of an additional $146,414 ins SS income.
So while Client A may have collected a total of an additional $146,414 in total benefits by delaying benefits, we cannot ignore the investment capital that was spent down between ages 62-70, which we established earlier was equal to $297,630 with a 5% return for 8 years. While this capital using the 4% withdrawal strategy is presumed to be generating less income, it does not necessarily mean it will be spent to zero.
In fact, according to research done by Michael Kitces, if you spend at a rate of 4% per year over a 30 year period in a balanced portfolio (defined as 60% stocks & 40% bonds), statistically 2/3rds of the time you’ll have more than 2 times the amount of assets at the end of a 30 year period.
More than ½ the time the value will nearly double.
More than 1/3rd of the time the retiree ends up with 5 times the amount of principal they started with at the end of 30 years.
90% of the time retirees finish with more than their starting principal at the end of 30 years.
That is equal to between $595,260 –$892,890 at the end of retirement. So while Client A may have collected an additional $146,414 from their delayed SS benefit, they likely lost somewhere between $595,260 -$892,890 due to 38 years of missed compounding.
From a legacy perspective, Client A’s estate is greatly enhanced by collecting early. While an estate is more of a benefit to Client A’s heirs, either way the bills were paid to support their lifestyle during retirement, and their total net worth is higher at the end of their life.
Many of the above assumption are very conservative growth estimates. However, it is still worth noting that in order for this to work, Client A must stick to an investment plan in a disciplined manner. While many retirees certainly do just that, others have a tendency to panic during periods of market volatility which then undermines the above assumptions.
There are other variables worth considering such as taxes. If the funding source for the theoretical investment capital is a retirement account subject to income taxes on withdrawals, this must be compared with SS income which has some additional tax benefits. SS income is exempt from State income tax, and at least 15% of the benefit is exempt from Federal income taxes. While that is a slightly greater benefit for SS, it is not enough to offset the benefit of collecting early in many circumstances.
What if you had no need for your Social Security Income at all?
If you and your spouse have no need for the SS income or the assets you have saved to generate a cash flow because perhaps you have a large pension benefit that more than pays for your lifestyle, then that SS income possibly becomes discretionary investment capital.
Assuming you live to age 95 and the income was invested annually compounded at 5%.
Collecting $25,181 at age 62 would compound at age 95 to $2,116,895
Collecting $44,792 at age 70 would compound at age 95 to $2,244,685
In this example, if you never needed the funds and invested them at the same rate of return, and lived to age 95, it paid to wait. However, you would need to live until at least age 82 to have benefited from waiting. Once again, if either you or your spouse pass away prior to that, the lack of a survivor benefit on the lower income is a substantial difference.
As we referenced earlier, there are no absolutes, and circumstances do exist in which it certainly does not pay to collect early. In the event that you are still working, you want to delay benefits until at least your full retirement age in order to avoid penalties that would negate a substantial portion of the income, if not all of it.
If you and your spouse are in a position where you have not saved an adequate amount of money to support your lifestyle and you are likely to run out of money no matter what you do, it likely pays to delay the benefit as long as possible since you will not have investment capital to produce any compounded growth. If you are essentially running out of liquid assets anyway, you are likely spending all of the SS benefit every month, and no wealth is accumulated no matter what happens. Therefore, the larger lifetime payment makes sense. If you died well before your average life expectancy, you never reached your breakeven point. But either way there is no legacy of assets left to heirs.
Each situation must be examined independently in order to make an educated decision. However, it is wise to be cautious of software programs, or any form of advice that measures only the metrics of the SS benefits formula without accounting for all the other moving parts that make up your personal financial profile.
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In 2003, in order to address a shortfall in Medicare, Congress passed the Medical Modernization Act of 2003. In it, they created a progressive monthly surcharge to Medicare Part B coverage (which covers outpatient services) called the Income Related Monthly Adjustment Amount or IRMAA. The surcharge began affecting those on Medicare in 2007. In 2010, with the passing of the Affordable Care Act, they instituted a progressive surcharge on Medicare Part D premiums (which covers prescription drugs). The premiums are based upon your annual income from two years prior to the current year, which is derived automatically by reviewing your tax return from two years earlier.
As it relates to IRMAA, income is defined as adjusted gross income plus tax exempt interest, also known as modified adjusted gross income (MAGI).
In the year 2023, if your income dating back to 2021 as a single filer was $97,000 or less, or if you’re married filing joint income was $194,000 or less, then your monthly premium is $164.90. This increases to $230.80 after $97,000 or $194,000 filing jointly. It tops out at $560.50 if your income as a single filer is above $500,000 or if your joint income is above $750,000. This is also per person, so a married couple each pays this additional charge.
Medicare Part D surcharges begin for single filers with income over $97,000, and $194,000 for married filing jointly. The first bracket surcharge is $12.20 per month and increases to $76.40 per individual if income is over $500,000 as a single filer, or $750,000 if married filing jointly. A married couple could end up paying $1,273.80 per month in Medicare Part B and Part D premiums if in the highest tier!
As you can see, premiums can get quite expensive for retirees and if not properly planned for, can potentially derail a client’s retirement plans.
Retirees often express their frustration when they realize that despite contributing to a system throughout their lives, diligently saving and making wise financial plans, they are still required to pay additional premiums for Medicare at age 65. This added cost is imposed solely because they have been fortunate or have responsibly saved for their future, even though they receive the same benefits as others. Often the question arises, what can be done to plan for this potential outcome.
The first thing to know is what income is used to determine your Modified Adjusted Gross Income. Examples of income are wages, business income, dividends, interest both taxable and tax exempt, pensions, social security, rental income, and taxable distributions from retirement accounts such as IRA’s or 401k’s. Distributions from Roth IRA’s, Health Savings Accounts and Life Insurance are not includable.
So, planning to reduce your income to avoid the surcharge is a potential way to plan around the assessment. Remember, IRMAA looks at the income from two years prior. Consider the timing of your income if you can.
As an example, if you have a gain that you’re anticipating, perhaps recognize the income earlier in life or being smart about recognizing it in a year where you have losses to offset the income. Other considerations are Roth conversions to reduce future income from retirement accounts, actively using tax loss harvesting to reduce your current income or future capital gain income, gifting assets to reduce income recognition, charitable giving, either itemizing to reduce your current year income or using a Qualified Charitable Distribution to avoid the income from an IRA. Using one or more of these strategies can potentially save a significant amount of money.
In some cases, you may have nominal control over the timing of income. However, in the case of items such as stock options, stock grants, non-qualified deferred compensation plans, and other investments, there is a greater degree of control as to the timing of when you realize income, and how you may be able to spread out that tax liability. Some advanced planning several years prior to age 65 can be impactful.
Remember that the income used to determine your income is from two years ago. This means that in 2023, the premium is based on looking at your final 2021 income, not an average income since 2021. As you can imagine, that can pose many issues as most people retire, then apply for Medicare. They might have had their highest earning years in those years before retirement due to level of career success achieved later in life, additional hours worked, vacation payouts, option exercises, deferred compensation payouts or any other number of compensation arrangements.
As you retire, your income could be fixed and significantly reduced, and you’re possibly faced with higher monthly premiums than you anticipated. In order to apply for relief, you can file with the Social Security Administration using form SSA-44. This is used to notify Social Security of your income change due to a life changing event. The life changing events that qualify are death of a spouse, getting married, divorce, reduction in work, complete stopping of work, loss or reduction in pension or loss of income from property due to things out of your control such as a natural disaster.
In the event your income naturally declines due to a life event such as retirement, your Medicare premium increase will adjust when your taxable income declines. However, because of the two-year look back on income, someone retiring at age 65 may have as much as two years of substantially higher premiums. Once your new income is updated, there is NO REFUND for the higher premiums paid over that two-year period. Instead, only your future premiums will decline. As a result, filing the IRMAA appeal can be highly beneficial.
As with all planning, it’s important to know the rules that you need to navigate. If you’re unsure, consider working with a Certified Financial Planner® who is familiar with the rules and has experience in working with clients in retirement.
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If you are expecting to inherit a sum of money, there are many key considerations to be aware of in order to make the most of your inheritance regardless of the amount. As you can imagine, the decisions can be tough but as with anything, going in with a plan is the best course of action.
Communicate with the Executor or Trustee
If someone has passed and you’re expecting an inheritance, you will be notified by the person in charge of the estate. In the case of an estate that is being probated, the Executor will administer the estate. When an estate is settled via a trust, it would be the trustee. They are going to provide you with the information that you need, where to open accounts, what type of accounts, and any money or assets that you’re due, if they know. Sometimes, they might not know the exact amount due to market fluctuations, possible sales of assets at unknown amounts or even taxes and fees that may be due from the estate.
Determine your Responsibility
Where are assets?
Depending on the type of asset, the type of account you need to open may be different. If the estate has a bank account, it could be very simple in that the estate might just provide a check to you. If the estate owns stocks or bonds, and they decide they are going to bequeath those positions to you, you will need a brokerage account to accept those positions. If you are inheriting an IRA, then you may need to set up an Inherited IRA to accept those assets. From there you can decide what to do with the IRA assets, whether you want to receive a distribution or if you want to stretch those distributions out according to allowable IRS guidelines. There are some relatively complex rules governing the IRA along with potential tax implications. Suppose you inherit a car, or a home. You will have to update the title to those assets. Make sure you register the car, properly insure any assets that need insurance, and update your estate plan!
Distribution requirement
As mentioned earlier, if you inherit an IRA or become an Income Beneficiary to a trust, receiving a distribution will be required. It’s very important to know your responsibilities if you inherit an IRA. Your distribution requirement is determined by your status of being an Eligible Designated Beneficiary or a Non-Eligible Designated Beneficiary assuming the person passed in 2020 or later. An Eligible Designated Beneficiary is a spouse or minor child of deceased, disabled or chronically ill individual or an individual that is not more than 10 years younger than the IRA owner or plan participant. It’s important to note, a minor child is required to take the distribution over ten years once they turn age of majority. The Eligible Designated Beneficiary can take the distribution over their life expectancy, or the ten-year rule, whichever is longer. You can always take more out if you need it, it just becomes taxable so try to time your distributions appropriately. If you are going to receive distributions from a trust, they could be taxable income. You would receive the proper tax forms but it’s important to know that up front for planning purposes.
A Non-Eligible Designated Beneficiary must take their distributions over the ten-year rule, which essentially means that all the funds must be distributed at the end of ten years. You may need to take annual distributions during that 10-year period. If the IRA was a pre-taxed account as opposed to a Roth IRA, then the distributions will be treated as ordinary income.
Set Up New Accounts
If you are required to set up a new account, you will need to provide your information along with identification. Reach out to the firm to ensure you have the necessary documentation and any additional information such as your bank or beneficiary information.
Titling of Assets
When you inherit assets, you must determine how the assets will be titled. You may be able to own certain assets individually, joint or through a trust.
If you do decide to title an asset in individual ownership, you should be aware it may pass through probate. In order to prevent probate, make sure you add a beneficiary if you can, or have a trust own the asset. The benefit to having one owner is that you can determine who the asset will go to and may be prevented from having been declared a spousal asset in the event of a divorce or passing.
If you choose to own an asset in joint titling, there is more than one way to title an asset jointly.
You can use Joint Tenants with Rights of Survivorship (JTWROS). This means that upon your passing, the other joint tenant inherits 100% of the asset.
There is also the option of Joint Tenants in Common, in which your share passes to your estate, while the joint tenants inherits their share.
When using JTWROS, which is the most common, remember you’re giving up a portion of the asset to the other party, and that can pose a risk. It’s important to think through how the title could affect those assets. Although titling assets in joint name can help as both can access and use the asset, it would be inherited completely by the other party if something happens to you. The new owner can determine the new beneficiary. That could pose a problem in a second marriage if kids that are not yours inherit these assets.
Another method would be to title the assets via the use of a trust. Perhaps the assets are required to move to a trust. With proper planning, you can determine if a trust is a better way to title the assets such as in a second marriage situation, creditor and spendthrift protection. As always, it’s important to have a discussion with professional guidance in order to ensure the titles align with your goals.
Taxes
The federal government does not assess an inheritance tax and only six states have an inheritance tax as of this writing. However, as referenced earlier, if income is received from the assets, then that income will accrue to you, and you will have to account for that income for tax purposes. It’s important to be aware of the income and the tax nature of that income. Make sure you have proper withholdings in place. As with IRA’s, plan out when you can receive that income in the best year to the extent possible.
Set Goals
As with all planning, receiving any money is impactful to improving financial plans. As with any financial plan, it’s important to set goals, determine where the money will go, whether it’s used to pay off debt, build an emergency fund, pay for or save for college, retirement, vacations, renovations, charitable causes or other purchases. It may be that your goals are some or all of the above. The appropriate type of account would be determined based on the stated goals.
Make Prudent Decisions
Work with professionals.
As with any asset, you should use this opportunity to improve your overall financial plan. In order to make sure you have a second set of eyes and help with making sure you don’t make any mistakes, we would encourage you work with the proper professionals such as your Estate Attorney, Accountant and your Financial Planner. It can be a blessing to receive a windfall, and the proper planning can avoid irreversible mistakes.
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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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After nearly a decade of near zero interest rates, 2022 was a year in which the Federal Reserve aggressively reversed course and increased interest rates multiple times. The aggressive moves by the Fed had a major impact across the financial markets. One of the few positives for 2022 was the increase in return that good savers good generate.
A savings account is never a great long-term investment option. However, it’s imperative that all investors maintain some degree of short-term liquidity for emergencies. In general, it’s a good idea to have at least six months to one year of an emergency fund so you don’t have to liquidate a longer-term investment option at an inopportune time. With the recent increases in savings rates, investors are closing in on rates of return that have not been seen since before the 2008 financial crisis.
Money Markets & Savings Account
Historically money markets offer savings rates that have higher yields than a typical savings account at a national bank. Money market accounts are essentially a mutual fund that invests in short-term debt instruments with maturities that can be as short as 30 to 90-day maturities. As a result, money market rates tend to adjust very quickly to rate increases or decreases. The goal of a money market is to always maintain a constant $1 dollar share price with a changing rate of interest. There have been some extremely rare circumstances in which a money market has “broken the buck” and returned less than the $1 per share price. This happens when the underlying debt they invest in such as short-term corporate commercial paper defaults. However, that is extremely rare. In the current interest rate environment, even a government reserves money market in which all of the debt is government backed and there is no default risk can pay nearly 4%.
Another option is the traditional FDIC insured savings account. Today competitive savings rates are upwards of 3% as well. One option that offers some better rates can be found in the online banking space. The lack of “brick and mortar” costs associated with online banks will often lead to interest rates that are more competitive than a larger national bank found on every corner in the nation. It’s important to shop these rates from bank to bank, as there can be vast differences in the rates offered. A savings account is an asset to you, but a liability to the bank. As such, many of the larger banks that have excess reserves have no incentive to offer better rates to increase deposits. Many of the smaller regional banks are often more competitive.
Traditional savings and money market accounts are useful when it comes to fulfilling the need for an account that will require day to day liquidity.
Certificates of Deposit
CD’s are still a viable option as a short-term savings vehicle. While the rates may not always seem that much more attractive than a typical savings/money market, they may still make sense. If you likely have no need to spend down cash other than an unforeseen emergency, then a CD may still make sense if it’s short-term. Perhaps one year to possibly 18 months. Even if you need to lock in a CD for 3-5 years, typically the only penalty you would incur should you need to break it would be the loss of the interest that you would have earned. There is generally no risk to your principal as long as you stay within FDIC limits. Today a one-year CD is paying in the vicinity of 3.5%-4% as a current rate of return.
Short Term Bond Funds
An ultra-short term bond fund comprised of very-high credit quality is not a savings account. They typically come with very nominal downside risk for the investor who doesn’t have any known short-term needs. However, with the aggressive rates hikes of 2022, it was a terrible year for bonds, and even the ultra-short-term bond funds saw negative returns. In some of the better cases, they still lost around -1% for the year.
It’s important to pay close attention to credit quality, as a short-term bond fund in an extreme market downturn can see noticeable short-term losses if they experience sizeable defaults. While these declines are unlikely to look anything like the declines seen in equity markets, they can still be impactful.
At the height of the market panic in late March of 2020 it was not uncommon to see a 5%-10% decline in short-term funds that took greater credit risk. One clear indicator is the yield of a fund. If the yield is noticeably greater than the rest of the market, then more than likely it’s worth looking closer at the credit rating of the issuers the fund is buying. In contrast, most short-term funds of very high-quality debt actually appreciated as the markets plummeted in March of 2020, yet still saw declines in 2022 in the face of significantly higher rates. Today, many of these short-term bond funds have yields in excess of 4%.
Annuities
Many of us have had the local bank teller notice a large cash position and encouraged us to speak to the local investment professional at the bank. One such option they will propose is what is known as a Single Premium Deferred Annuity (SPDA). The SPDA is an insurance contract that functions much like a CD with no fluctuations to your initial investment principal. They are not insured by the FDIC, but rather backed by the insurance company, and sometimes further backed by the state insurance commissioner’s office up to certain limits.
The advantage of the SPDA is that they sometimes offer rates that are a little better than a CD, and the interest is tax deferred. Once they mature, the contracts usually have a floor interest rate that you can continue to collect without exchanging into a new annuity. At times those interest floors have been attractive compared to current market rates.
The disadvantages are they don’t typically permit you to break the contract penalty free. What you can often do is withdraw a percentage of the contract, sometimes 10% per year without penalty. There is also a penalty on withdrawals made before age 59 ½, so it’s not a suitable option for those younger in age.
Credit Risk Caution
One area to be very cautious is in the floating rate space. Floating rate notes are extremely short-term corporate debt that is only available to institutional buyers. However, a number of mutual fund companies offer floating rate funds that buy such paper and offer more attractive yields. A quick look at a chart of most floating rate funds will show price changes that are typically between 2%-3% principal fluctuation during positive or negative market changes.
During the 2008 financial crisis when the credit markets came to a near total freeze, these floating rate funds saw average declines of -27%. This is an area that is often mistakenly looked at as a short-term cash position. We would caution against such an approach. Floating rate securities can be an attractive investment at times, but any vehicle that offers substantive credit risk is not an ideal savings alternative.
In the current interest rate environment higher quality floating rate funds pay in excess of 4%, but not much more than a higher quality short-term bond fund. Some of the lower quality funds with much more credit risk can offer as much as an 8% yield, but much more potential for volatility.
When it comes to an emergency fund, it’s important to remember that the goal is stability at the best interest rate available with a reasonable amount of liquidity, and not to become too frustrated with the low returns. Emergencies often happen during periods of great market volatility. What you don’t want is to find yourself in a position of having to sell a quality asset at a depressed price, therefore eliminating your ability to benefit from an eventual price rebound.
Maintaining a proper emergency fund should actually provide you with more comfort in your ability to take greater risk with your other investment accounts with the knowledge that the short-term risk has already been addressed.
2022 was a year in which inflation reared its ugly head in a way not seen in forty years. In reality savers were better off with rates at 0.50% and inflation at 2%, which was a net real loss of -1.5% annually on the purchasing power of cash. Today with savings accounts at 3-4% and inflation at 7%, that is a real net loss of between -3% to -4% annually on the purchasing power of cash. However, as inflation moderates downward over time, savers will fare much better unless the Fed begins to aggressively cut rates again. Until that time, it’s even more important that investors maximize the rate of return on their emergency funds in this high inflationary period in order to close the gap between what they earn and what it costs them to live.
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