Behavioral Finance: Anchoring

(2008-07-21) by David John Marotta

Rational analysis is essential to making smart investment decisions. Unfortunately, our first reaction to a complicated situation, usually instinctive, often does not serve our best interests. The field of behavioral finance studies how and why we make economic decisions.

Researchers have identified dozens of mental shortcuts. One heuristic that the brain uses to solve complex evaluations is to make an initial guess and then adjust from that point as we receive additional information to find a better answer. This mental process is called "anchoring."

Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes. It's critical to admit this heuristic is hardwired in your brain or you will continue to succumb to it. To avoid making serious financial mistakes, you must become a vigilant contrarian.

In the mental process of anchoring, we begin with some tentative solution to our problem and then we seek a better or more accurate solution. For example, we walk onto a car lot and note the sticker price, and we use that number as our starting point for negotiations. We know we can buy the car for that amount, and we start the process of seeking to get a better price.

Studies have shown that the higher the first price we are given, the higher will be the final price we end up paying for the exact same item. Stores sometimes bump their prices 30% higher before a 30% off sale because they understand this principle. Sellers on eBay may set a "buy-it-now" price artificially high simply to induce higher competitive bids.

We use mental anchoring more when we are unfamiliar with what the right answer is supposed to be. Conversely, the antidote to anchoring is to have done your homework and be able to evaluate the anchors you are given. Doing your research online before setting foot on the car lot helps you step into the process with the ability to analyze the reasonableness of that sticker price.

To understand how paradoxically our minds can work, researchers have shown that even when we know the anchor is a completely random number, it still has a significant effect.

For example, ask a friend to use the last three digits of his Social Security number to form a date somewhere between A.D. 0 and 1000. Next, ask him if he thinks Attila the Hun died before or after that date. Finally, ask him what year he thinks Attila the Hun died. People with a higher last three digits of their Social Security number tend to guess a much higher date for Attila the Hun's death.

We are not rational creatures.

The antidote for this type of anchoring is doing the extra analysis to evaluate the answer more rationally. In other words, those who actually know the date of Attila the Hun's death do not succumb to the mental fallacy of anchoring on the last three digits of their Social Security number.

Anchoring is like finding ourselves sitting in a chair in a pitch-black room. When we stand up, we keep one hand on the chair and reach as far as we can in each direction to try to get a feel for our location. The anchor of the chair keeps us from straying too far from our original point. The answer, of course, is to turn on the lights.

Most investors feel like they are in the dark. Sometimes having too much information to evaluate equates with having no information at all. Consequently, we anchor on the latest market movements or the high-water mark of what something was worth.

Although nearly all of us seem to say we are long-term investors, our tendency is to be swayed emotionally by the most recent short-term movements in the markets. We want to invest more in sectors that have recently been doing well, and we want to avoid, eliminate or reduce sectors that have recently dropped in value.

One study found that because of moving in and out of mutual funds at exactly the wrong moments, investors in mutual funds experience returns that underperform the very funds they were invested in, by 2.2 percentage points annually.

Funds are more likely to take new deposits after performing well but less likely to perform that well going forward. Similarly, funds that have not performed as well take in much less in deposits or have net redemptions but usually do not continue to underperform quite as badly. Investors experience returns that underperform because they buy the fund high and sell it low.

This isn't to say you should stay in a poor mutual fund with high fees and expenses. But moving in and out of mutual funds to catch hot sectors of the economy produces returns that badly underperform a simple buy-and-rebalance strategy.

Even the investment news falls into the trap of describing past performance in the present tense. They say, "This stock is going up" or "This stock is plummeting" when what they really intend is simply to describe the most recent short-term past trend.

Given that 98% of daily stock market movements are noise, for long-term investors this is like saying, "We are bumping to the left" when driving on an old gravel road. Monthly stock movements are no better. They are 76% noise. Again, for a long-term investor, talking about monthly stock movements can be likened to saying, "We are curving right" when driving on a winding country road. Even annual returns have about 46% noise. Sometimes you need to drive south for an hour before you pick up the interstate. Only when you start looking over a 10-year time horizon can you safely describe your direction and say, "We are heading west."

Investors tend to fixate on relative past performance. If their portfolios have gone straight from 100,000 to 120,000 over the past year, they are happy. If their portfolios rose to 150,000 before dropping back to 120,000, however, they are upset and depressed. People anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high.

Avoiding the mistakes that stem from anchoring requires adopting an investment philosophy that does not depend on historical prices and past performance. Adopt an investment philosophy that dampens rather than amplifies trends. If your philosophy is to panic and sell at corrections and then wait to get back into the markets after they are appreciating again, your emotions amplify any losses.

Learn to be a contrarian and rebalance your portfolio regularly. Set buy and sell targets. Monitor an objective stock evaluation. Pretend you don't already own it and you have to buy it at the current price. Make half a mistake, sell some and take some profit off the table.

One of the first principles of investing is humility. Knowing that your first instinct is probably wrong, doing nothing is often better than doing something quickly. Hence minimizing trading, being patient and investing in the markets going up is an excellent way to tune out the noise of short-term movements.

Second, if your instincts are often wrong, and the markets are inherently volatile, plan on some of your investments losing money. Therefore avoid leverage or options that could amplify a mistake to a loss that might jeopardize your financial goals.

Finally, practice setting an asset allocation that provides diversification. Regular rebalancing to a target allocation gives you the best chance of meeting your goals and an objective standard to practice contrarian investing by selling what has gone up and buying what has gone down.

from http://www.emarotta.com/article.php?ID=293

Foreign Freedom Investing 2008 (2008-07-14)

by David John Marotta

You can both diversify for safety and boost your returns by adding international investments to your portfolio. In the past year, international stocks performed 2.5% better than U.S. stocks. And developed countries with the most economic freedom returned an additional 4.4% more than the international index.

None of these returns, however, were positive. During the one-year period ending June 30, 2008, the S&P 500 index lost 13.12%. The MSCI EAFE Index of international developed markets lost 10.6% (in U.S. dollars). Significantly, 10 of the most economically free countries only lost 6.2%.

These premiums for investing oversees in countries with the most freedom are even more impressive for longer time periods. Over the past five years, the S&P 500 has averaged 7.6% and the EAFE Index 16.7%. In striking contrast, the countries with the most economic freedom averaged 21.5%.

Put some money into the "emerging markets" category, and you can gain even greater diversification and returns. Emerging markets, as measured by the MSCI Emerging Markets Index, actually gained, appreciating 4.6% (in U.S. dollars) in the past year. They have averaged a whopping 29.8% over the past five years. Of course, there is a caveat. Emerging markets are inherently more volatile than the markets of more developed nations.

If you have a very small account, investing in one good international fund is sufficient. For slightly larger amounts, a savvy asset allocation might be to invest two thirds in the MSCI EAFE Index and one third in the MSCI Emerging Markets Index. Using this technique, you would have only lost 5.5% in the past year and averaged 21.0% over the past five years.

For larger accounts, use a more complex asset allocation for further diversification. Take advantage of the fact that economic growth often flourishes in countries with the greatest economic freedom. We use the Heritage Foundation's measurement to select those places that combine the greatest economic freedom with large investable markets.

Since 1994, the Heritage Foundation Index of Economic Freedom has used a systematic empirical measurement of economic freedom in countries worldwide. Their conclusions clearly show that economic freedom and higher rates of long-term economic growth go together. Investors can use the study to select countries for their foreign stock allocation.

According to the Heritage Foundation, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

The foundation bases a country's economic freedom score on 50 measurements. They fall under these 10 categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

Although all 10 boost economic growth, some, such as investment freedom, are more significant to outside investors. Others, such as monetary freedom, are more critical to that country's own citizens.

Only 17 countries out of 157 scored high in investment freedom, which measures the ability of capital to flow freely in and out of the country. Free countries impose few or no restrictions on foreign investment. Thus they represent the greatest opportunities for investment. More than a third of the world imposes serious restrictions on the ability to run businesses, purchase real estate or transfer capital. These countries are best avoided.

A number of the countries ranked high in economic freedom have exchange-traded funds (ETFs), such as Hong Kong, Singapore, Australia, Canada, Switzerland, United Kingdom, the Netherlands, Germany, Sweden and Austria. These funds track each country's market index and offer a convenient and inexpensive way to invest there. ETFs combine the liquidity of individual stocks with the diversification of an index fund. They also typically carry lower expense ratios than most mutual funds.

For larger accounts, we recommend you invest half of your assets using the simple technique just described. A third is invested in the MSCI EAFE Index fund and a sixth in the MSCI Emerging Markets Index fund. The other half is divided among the 10 countries with the most freedom whose markets also accommodate a country-specific ETF.

Canada had the best returns over the past year, mostly because of its emphasis on energy stocks, earning 13.9%. In the same time period, 8 of the 10 countries cited earlier beat the broad MSCI EAFE Index. Only two (the United Kingdom and Sweden) fell short.

Japan, with the world's second largest economy, has demonstrated more financial freedom in recent years. But government spending is greater than a third of its gross domestic product. And a large number of legal restrictions on capital make investing in Japan quite problematic. It is ranked below average in government size and financial freedom and lower than we would recommend in the important investment freedom category. These restrictions push the country down to the 17th most free economy. We can attribute Japan's malaise after its own stock market bubble to its lack of economic freedom and the government's overly aggressive interventions. Former prime minister Junichiro Koizumi's changes made the country a more attractive place to do business. It remains to be seen if these changes are significant enough.

Diversifying your foreign investments is just one critical element of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn't happen by accident or by working with someone whose interests are in conflict with yours. Visit the website of the National Association of Personal Financial Advisors at <a href="http://www.napfa.org" target=_blank>www.napfa.org</a> or call 1-800-366-2732 to find a fee-only advisor in your area.



from http://www.emarotta.com/article.php?ID=292

Rebalance Accounts Regularly (2008-07-07)

by David John Marotta

A year ago when the markets were all setting new highs, people were asking what they should do with their retirement portfolio. I answered, "Rebalance." Now that the market is setting new lows, I get the same question, and my response hasn't changed.

Rebalancing requires discipline. You set a target asset allocation for your investments and then periodically buy and sell different investments to stay focused on your objective. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst. Rebalancing avoids this needless anguish.

Investing in an S&P 500 index fund does the opposite of rebalancing. The S&P is a capitalization-weighted index. A stock's capitalization is the total outstanding shares multiplied by the stock's current price. Therefore, those stocks whose price has appreciated comprise a greater share of the index. The S&P automatically increases its holding in stocks that have gone up and decreases its holdings in stocks that have gone down. This is the opposite of what you want.

Having the right asset allocation in the first place is an essential part of rebalancing. Rebalancing back to an S&P 500 allocation misses the emphasis on value stocks that will help your portfolio returns.

Stocks that have decreased in price have a lower price-to-earnings (P/E) ratio. They are called "value stocks." These stocks on average do better than growth stocks. But capitalization-weighted indexes such as the S&P 500 miss this method of boosting returns.

Several new investment products tout what is called "fundamental indexing." They set target allocations based more on earnings than price and therefore gain a value tilt. This is a good strategy, but the funds using it are currently charging higher fees and expenses than necessary. As expenses on these funds drop, they may prove to be a better investing strategy. In the meantime, you can develop a less expense asset allocation with the same value tilt simply by putting part of your asset allocation into a value fund. Adding a large-cap value fund to your S&P 500 fund will emphasize those stocks with a low P/E ratio. A value fund will sell stocks whose price has appreciated enough that they are no longer considered value. And it will buy stocks whose price has dropped enough for them now to be considered value.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.

Even if you are creating a very aggressive portfolio, including some fixed-income investments actually increases returns. Stable investments provide some cash on the sidelines, and having cash to buy stocks after a market correction both boosts as well as evens out your investment returns. Thanks to the effect of compounding, smoother returns produce better returns.

Periodic rebalancing is the simplest and most common method. Waiting for an asset category to exceed some threshold and then bringing the allocation back within some tolerances seems to produce slightly better returns and lower volatility. Although different ways of rebalancing produce somewhat variable results, the method you use is not as important as committing to a regular rebalancing plan.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. They found that in secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage, but in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study of the same time period verified smaller advantages for even more frequent quarterly and monthly rebalancing. And a study of the Yale endowment attributed 1.6% of its portfolio returns to rebalancing.

Making an extra percentage point a year is significant. The Crestmont study concluded, "In choppy and volatile markets, a more frequent rebalancing approach can add significant additional return to an investor's portfolio. Based upon recent secular market history, the risk (cost) of more frequent rebalancing in secular bull markets is far less than the opportunity from more frequent rebalancing in secular bear markets."

Crestmont's observation is true because a secular bear market does not simply go down every year. Rather these markets often swing up and down wildly. The Crestmont study analyzed the secular bear markets from 1966 to 1981 and concluded that rebalancing more frequently made the difference between experiencing positive or negative returns.

Keep in mind what rebalancing in a secular bear market means: buying stocks after they have gone down and selling stocks after they have gone up. Probably the point at which more frequent rebalancing pulled ahead the most was 1973 and 1974 when the market dropped 17% and then 28%, and more frequent rebalancing meant putting more money back into the markets. Then in 1975 and 1976 when the market rebounded 38% and 18%, respectively, it provided better results.

Rebalancing is as daunting as putting more money into the markets now after our recent declines. But it is also as prudent as taking profits off the table a year ago when the market was setting new highs. Rebalancing, always a contrarian move, helps investors make those emotionally difficult but safer and more profitable decisions.

Portfolio design and rebalancing is both a science and an art. It may be helpful to understand the physics of why a spinning ball hooks and bends. But when you are playing golf or soccer, it is the execution and follow-through that produces the desired outcome. Knowing that rebalancing boosts returns is useless unless you as the investor have the time, discipline and nerve to follow through and actually strike the ball.

Untended portfolios can quickly become more volatile. Thus frequent watching of a portfolio is required even if frequent rebalancing is not the best methodology. Watching your portfolio every day and choosing strategic inaction allows you to seize the day when the portfolio is significantly far enough out of balance to warrant action.

How frequently you need to water your garden is totally contingent on current weather conditions. Similarly, when you should rebalance your portfolio depends more on what the markets are doing than the calendar.

Rebalancing need not trigger a taxable event. You can do it when you are adding to your portfolio or during retirement when you are making withdrawals. Another way of rebalancing without triggering capital gains is to make the changes in your traditional or Roth retirement accounts. You can also pay dividends and interest in cash rather than reinvesting them. Then use this cash to rebalance by purchasing more in the asset category, which has done the worst lately. But even if you have to trigger capital gains, the capital gains tax is at an all-time low and will probably be raised in the future. So go ahead and rebalance your portfolio and generate those capital gains.

If your portfolio had the right asset allocation to begin with, we would currently be advising you to add to U.S. stocks or withdraw from hard asset stocks or fixed income. However, most of the portfolios we see for the first time already have too much U.S. stock and little, if any, hard asset stocks. Again, getting the right asset allocation is always the first step to rebalancing.

Watching the asset allocation balance on a portfolio may not seem like a very active strategy. But because it can increase your returns by over a percentage point a year, it is worth the time and effort. At a minimum, you should have a target asset allocation and an easy way to rebalance it at least once a year.



from http://www.emarotta.com/article.php?ID=291

Inflation Part 3: Protecting Yourself Against Inflation (2008-06-30)

by David John Marotta

Officially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government has stolen productivity gains from Social Security recipients and pushed middle-class taxpayers into alternative minimum tax rates. But you can learn how to hedge your assets against underreported inflation and protect your retirement goals.

First, don't count on Social Security for your retirement, especially if you are young. It may be unthinkable, but Social Security payments will probably be eliminated for the middle class and above. And even if you qualify, the government's official cost-of-living adjustments will continue to be calculated significantly below actual inflation. If you don't keep pace with inflation, by the end of your retirement you will have lost your lifestyle, your independence and ultimately your dignity.

An irresponsible government may underreport inflation and jeopardize the retirement of truly needy seniors. But responsible citizens will strive to take care of themselves in retirement without government assistance. Public funds thus will be available for those who can't take care of themselves. In other words, financial planning is simply planning not to be the truly needy.

Second, ask yourself, "What are safe investments that should more than keep up with inflation?" This is a challenging question.

Because of inflation, cash, normally a safe store of value, has been the riskiest investment since 2002 when the U.S. dollar began losing much of its purchasing power. Since then, the U.S. Dollar Index has dropped over 39%, from 120 to 72.95. It has also dropped more than 44% against the euro and over 67% against gold.

During inflationary times, U.S. bonds are not a safe store of value either. They pay a fixed rate of return in diminishing dollars. In a rising interest rate environment, intermediate- and long-term bonds drop in value too. When interest rates are rising, keep your money in a money market account where the rates adjust immediately.

Inflation-indexed bonds only do slightly better. Because actual inflation is underreported, these bonds have not kept up with the real inflation rate. The adjustments on them are tied to the official consumer price index, so they also are depreciated for any productivity adjustments. These investments may do better but only to the extent that inflation is reported accurately.

Foreign bonds provide the best protection against a falling dollar but only if they are unhedged. Many foreign bond funds hedge their investments against a rising dollar, providing returns tied to U.S. dollars. If your goal is to guard against a falling dollar, a fund that hedges against the dollar defeats this purpose.

Unhedged foreign bonds yielded about a 10.5% return in 2007 and about a 6% return so far in 2008. Determining if a foreign bond fund is unhedged can require some research. Also, foreign bonds of developed countries perform differently than those of emerging market countries. They represent two distinct baskets of currency. Emerging market bonds at times have a higher return, but they also have a higher risk and volatility. We recommend putting a small portion of your foreign bond allocation into emerging market bonds.

The danger with any unhedged foreign bonds is that the U.S. dollar may strengthen against foreign currencies. Also, unhedged foreign bonds cannot protect you against global currency inflation. So you don't want all of your fixed-income investments in unhedged foreign bonds, although this investment does protect you to some degree against U.S. dollar inflation.

Cash, U.S. bonds and foreign bonds are all investments for stability rather than appreciation. Stable fixed-income investments generally make about 3% over inflation. It's not a wide enough margin to stay ahead of inflation during times when interest rates are low or rising.

A significant allocation to appreciating equity investments is necessary to accomplish the long-term growth that ensures a comfortable retirement. Equity investments, on average, make about 6.5% over inflation. Although they are more volatile in the short term, they give you a better chance of achieving the appreciation necessary in today's longer retirements.

The third way to protect your portfolio against inflation is to refrain from being too aggressive or too conservative. Keep most of your investments in appreciating equities, but plan the next five to seven years of spending in stable fixed-income investments.

If you don't have the next five years of spending in stable investments, you may be forced to withdraw from your portfolio while stocks are down. Your portfolio will be depleted and unable to rebound. However, if you are too conservative, you may sleep well tonight but eat poorly a decade from now because your fixed-income investments haven't exceeded inflation.

The balance between risk and return should not depend solely on your emotional risk tolerance. Rather you should focus on what risk-return allocation mix affords the best chance of meeting your investment goals. Your allocation to stability should be fixed and your allocation to appreciation should appreciate. The goal of stability eliminates risky, or junk, bonds. The goal of appreciation also eliminates speculation, which adds needless noise rather than real return.

The fourth principle is that investing for appreciation means selecting only investments that on average go up, are publicly traded, and have low expenses and fees. Savvy investors buy shares of long-term businesses that produce worthwhile goods and services.

Speculation, in contrast, can include trading options or commodities. It can encompass limited partnerships or hedge funds that are illiquid and often subject to high fees and expenses. Diversification does not mean buying every kind of investment regardless of its suitability to help you meet your financial goals.

The fifth protection against inflation is to guard over half of your portfolio against the risk of a falling dollar. The asset classes of foreign bonds, foreign stocks and hard asset stocks offer the best protection. As a class, hard asset stocks have also yielded one of the best returns since 2002.

Hard asset investments include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals, base metals, and other resources such as diamonds, coal, lumber and water.

Keep in mind that investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment in raw commodities or their volatility. Buying a gold mining company is a hard asset stock investment.

The Goldman Sachs Natural Resources Index tracks hard assets investments. It is comprised of 85% energy and 13% materials. At the end of May 2008, this index was up 12.12% year-to-date. Its three-year annualized return is 30.47%. Its five-year annualized return is 29.56%.

Foreign stocks also protect you against a falling dollar. They are priced in foreign currencies and benefit when the dollar drops in value.

The MSCI EAFE foreign index is only down 3.03% year-to-date compared with the S&P 500, which is down 3.80%. Over the past five years of a dropping U.S. dollar, the MSCI EAFE index has on average done much better than the S&P 500.

Adding international investments to your portfolio is an excellent way to diversify for safety while boosting returns. International stocks have appreciated more than U.S. stocks. What's more, companies located in countries with the most economic freedom have appreciated more than the broader international average.

Since 1994, the Heritage Foundation Index of Economic Freedom has used an empirical system to measure economic freedom in countries worldwide.

One of the 10 categories it measures is monetary freedom. The worldwide average inflation rate per country from 2004 to 2006 was 10.6%. Having a monetary authority to maintain a sound currency clearly is critical to economic freedom. As the Heritage Foundation report states, "Monetary freedom is to market economics what free speech is to democracy. Free people need a steady and reliable currency as a medium of exchange and store of value. Without monetary freedom, it is difficult to create long-term value."

When investing overseas, emphasizing countries with the most economic freedom can help prevent trying to avoid U.S. inflation only to be caught in some other country's inflation.

Finally, tax management is critical. Underreported inflation pushes middle-income Americans into higher tax brackets. Many techniques to tax-manage your investments are worth exploring. Putting fixed-income investments into pretax accounts and foreign stocks into taxable accounts can mean a tax benefit of about 1% a year.

Normally a Roth conversion does not have any benefit unless you are in a higher tax bracket during retirement. With inflation underreported, you are being pushed into a higher tax bracket every year. And with the political winds portending higher taxes regardless of inflation, you will almost definitely be paying more in the future. Paying the taxes now and funding or converting to a Roth account while you have a relatively low rate could result in significant tax savings.

So despite inflation rates that are higher than reported, you can still protect your investments, achieve your financial goals and enjoy a comfortable retirement.

 

from http://www.emarotta.com/article.php?ID=290

Inflation Part 2: The Results of Underreporting Inflation (2008-06-23)

by David John Marotta

Officially, inflation today is about 4%. Unofficially, it is over 7%. Inflation at this rate causes serious harm to our nation's economy and its citizens.

Since 1997 the Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation. This tactic has saved the government hundreds of billions of dollars. Entitlement program recipients find their benefits reduced every year. And middle-class taxpayers are pushed automatically into ever-higher tax brackets.

Instituted by the Clinton administration and willingly continued by the Bush administration, this hidden tax burden transcends the political ideology of conservative and liberal. It threatens the idea of limited government.

As economist Milton Friedman said, "Inflation is the one form of taxation that can be imposed without legislation." John Maynard Keynes agreed. He commented, "The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens." And none other than Vladimir Lenin wrote, "The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation."

Lenin may have intended to grind just the upper class. But in America, everyone ends up as grist for the mill. Average Social Security recipients, that is, retirees, are crushed the most. Technological advances are factored out of Social Security cost-of-living adjustments. Seniors are left to live Amish lives in a digital age.

Productivity and technological advances should result in dollars that are capable of buying more each year. If inflation was being reported accurately, simply putting dollars in the bank would result in a 3% boost in purchasing power. These technological advances are the fruits of capitalism and innovation as businesses develop better products and services. Why should the government deny people the advantages of business innovation by deficit spending and increasing the money supply?

In fact, the CPI is deceptively labeled. The name takes something that government has done to confiscate capital wealth and blames it on businesses: rising consumer prices. But businesses aren't at fault. If the CPI was accurately named, we would call it "Capital Piracy by Inflation."

Instead of seeing their money grow in value, people with dollars in the bank experience the equivalent of an extra 3% tax on their savings. People on fixed incomes such as Social Security experience the equivalent of a 3% reduction in their benefit payments. Like any compounded taxation, the cumulative effect over the past decade has taken its toll. The lifestyle of millions of the elderly has suffered as a consequence.

Middle-class workers aren't exempt either. The alternative minimum tax (AMT), established in 1970, is not even indexed to official inflation. So middle-class taxpayers are pushed higher and higher into a tax intended for the ultra rich. The AMT punishes taxpayers for having children or living in a state with high taxes. Thus being hit with the AMT turns many of the tried-and-true rules of thumb on taxes upside down. Ironically, many of the wealthiest taxpayers are now avoiding AMT penalties entirely. Those with large incomes pay enough tax to avoid the AMT while the middle class is penalized.

There's another concern too. Underreported inflation also masks the current recession. Official first-quarter real gross domestic product (GDP) growth was 0.9%. Current reports suggest that annual economic growth for 2008 will be 2.4%. But if official inflation is at 4% and actual inflation is over 7%, then real economic growth is 3% less than reported. That means growth for 2008 isn't 2.4% but rather -0.6%. If it feels like a recession, don't let official government statistics fool you.

During inflationary periods, finding capital is challenging. No one wants to loan expensive dollars today only to be reimbursed with dollars that are worth less in the future. This situation also makes it difficult for companies to capitalize their businesses. Why risk valuable dollars today to create and expand production when inflation devalues the rewards significantly? So of course businesses are not investing. First-quarter fixed investments were down 7.8%.

We risk a business environment similar to the 1970s. Inflation then caused declining price-to-earnings ratios and hindered small business capitalization. Small businesses are responsible for the majority of GDP and job growth. Inflation slows the economy and increases unemployment. Drastic steps by the Reagan administration were necessary to deal with the stagflation of the 1970s and put the economy back on a secure footing. Our current malaise may require some equally bitter measures.

Historically, people worldwide counted on the U.S. dollar holding its value. We sometimes forget that a stable currency is not a given in every country. In the past, people outside the United States were willing to trade their goods and services for nothing more than our currency's safe store of value. The result has been a trade deficit where our biggest export has been U.S. dollars. About 60% of all U.S. dollars today circulate outside the United States.

But global confidence in the dollar has been shaken recently. Now foreign markets are not committed to holding dollars. They would rather trade those dollars for some of our real goods and services. All those dollars coming home to roost may be good for our trade deficit. But it only exacerbates the problem of too many dollars in this country chasing too few goods and services.

When we have no reliable way to measure the purchasing power of the U.S. dollar, all statistics calculated in our currency become suspect. How can economists or accountants measure anything accurately when their ruler is made of rubber? And if statistics aren't measurable, then business forecasting is impossible.

All of these are serious public policy concerns. But they don't have to block your personal financial goals. Despite inflation rates that are higher than reported, you can still protect your investments from being ravaged. In the final part of this series, we will describe practical ways you can hedge against excessive and unreported inflation and secure and guard a comfortable retirement.

 

from http://www.emarotta.com/article.php?ID=289

Inflation Part 1: How the Government Lies About Inflation (2008-06-16)

by David John Marotta

Officially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation.

Recently I watched the 1997 movie "Conspiracy Theory" starring Mel Gibson and Julia Roberts. Before the opening credits have finished rolling, we understand that Gibson's character is a crackpot cab driver who sees conspiracies everywhere. But our perception changes by the end of the film when we realize for ourselves that some of his theories are true.

For years I've hesitated writing about the CPI, computed by the Bureau of Labor Statistics, for fear of being compared with a paranoid character like the one in "Conspiracy Theory." The message that the government lies to us about inflation and, as a result, quietly confiscates hundreds of billions of dollars from its citizens isn't the easiest message to swallow. It only goes down when accompanied by a healthy draught of political cynicism.

What's changed over the past year, however, is that we are closer to the end of the movie. It is clearer now not only that inflation is running rampant but also that the government's numbers are still ridiculously low. More Americans have come to mistrust official inflation statistics, and therefore they are ready to understand how and why the government skews these numbers and to learn how they can protect their family's savings.

Take 2007 as an example. Bread price rose 7.4%, gasoline 8.2%, health insurance 10.1%, whole milk 13.1%, eggs 29.2%, but according to the CPI, somehow inflation was only calculated as 4.1%. This year to date we have seen an even shaper rise, which still has barely affected the official numbers.

In 1975 programs such as government pensions, Medicare and Social Security were indexed to inflation. With rising inflation in the early 1990s, public officials realized that entitlement programs made government deficits impossible to control. Politically it was just too difficult to cut spending to this program. It was much easier simply to lower their cost-of-living adjustments.

So a commission of five economists in 1996 studied the CPI and issued a report stating that the index overstated inflation by at least 1.1%. Lower CPI adjustments would not only save money in entitlement programs but also raise tax rates mostly among the middle class. Tax brackets, personal exemptions and the standard deduction are all indexed for inflation. Lowering these adjustments has the effect of increasing the tax paid, with the greatest impact on middle-class taxpayers.

The argument that the CPI was overreported went something like this: In 1970 a mid-priced car cost about $3,500. Today, in 2008, the same size car costs about $25,000. After adjusting for inflation using official CPI data, today's car costs $4,515 in 1970 dollars.

It certainly looks like inflation has been significantly underreported, even though the government argues the exact opposite. In their 1996 study, they suggested that although it looks like today's cars are more expensive even in inflation-adjusted dollars and that CPI has been underreported, in fact it is the opposite. They claimed that today's cars are simply better built.

According to their logic, what we called a car in 1970 doesn't even qualify to be called a car today. It wasn't fuel efficient. It had no airbags, no power windows, no power door locks, no heated seats, no tilted steering wheel and no CD player.

The government has decided that the enjoyment you get from all of these extra features is why a car costs more today. Thus you are buying a better model than you did in 1970 and therefore it should cost more. The extra pleasure you get from the car should be measured as your choice, not as inflation.

You can see the problems with these government assumptions. You still need a car today. Apparently, you can't buy what we used to call a car in 1970. A combination of government mandates and changes in market preference have added features. Rather than being able to take advantage of these improvements simply because you are living in the 21st century, these improvements have diminished the value of your currency.

The official term for this type of adjustment is a "hedonic deprecator." If the computers available this year are twice as fast, then the government counts that as 50% deflation. You are getting twice the hedonism for the same dollar, so only half the price is reported in the price indexes. It evidently doesn't matter that you paid the same price. And it doesn't matter that a computer at the old speed won't run any of the new software.

Hedonic adjustments are a way to discount any improvements in productivity. Under the old method, when a reserved Federal Reserve kept inflation in check, productivity improvements resulted in every dollar of your paycheck buying more. Now, an unreserved Federal Reserve deflates the value of every dollar. By counting the bonuses from increased productivity, the government does not need to report the real inflation it is causing.

Not everything is more expensive. Clothes cost less, thanks to continued globalization. And communications costs less too, along with many other electronic gadgets. However even these items are used against consumers. In a concept called "creative substitution," the government CPI numbers did not count electronics when they were expensive but now counts the drop in their price as anti-inflationary.

The government's argument is that very few people owned a calculator when it cost $100. But now that the same calculator can be purchased for $5 and everyone owns one, it should be counted as deflationary. According to this mindset, the fact that your calculator and cell phone each costs $100 less should more than make up for the fact you can't afford to buy basic foodstuffs or drive your car.

With food, the government adjustments are a little more imaginative. They assume if the price of beef goes up, you will eat less beef and more chicken. If chicken goes up, you will choose pork. And if pork goes up, you will eat more tofu. They assume that when the price of something goes up, some people creatively substitute something less expensive.

Lacking any standard for a U.S. dollar, we can make two observations: your currency has been devalued, and this devaluing is not reported as inflation. Standard of living improvements due to technological advancements have been withheld from those who are on fixed incomes and those who keep their wealth in dollar-denominated investments.

It was none other than former Federal Reserve chairman Alan Greenspan who in 1966 wrote, "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."

Unreported runaway inflation has made dollars unappealing to hold. This is good for our trade deficit because those outside the United States now want to trade dollars of diminishing value for real goods and services, but it could have detrimental effects on our country and its citizens. Next week we will describe those effects and how to protect yourself against them.

 

from http://www.emarotta.com/article.php?ID=288

Last week's column described how certain critical assumptions can affect retirement planning. Here we discuss how to determine maximum safe withdrawal rates that will not compromise a long retirement.

Imagine you knew you were going to die peacefully in your sleep at the end of your 100th year. Becoming a centenarian is more common these days, and it's a much safer assumption than using average longevity. Half the people live longer than average, and a significant percentage live much longer. So our best case scenario is not just a fantasy.

As you turn 100, you could plan to spend 100% of your portfolio. At the end of the year when you run out of money, you also run out of life, literally dying broke. It makes sense to keep all of your assets in cash or a money market account. Investing in stocks risks a market correction that could leave you short on funds and make your last days miserable.

Now back up a year. You are 99 and could spend about half of your portfolio's value, reserving the other half for your final year. You will keep money for your 99th year in cash. Money reserved for your 100th year could be put in a CD or a bond for more interest. You should be making a real return on your investments that is greater than inflation.

Imagine you planned on reaching your 99th birthday and several years ago bought bonds to mature at the beginning of each of your last two years. The bond for your 99th year has just matured and is waiting in cash for you to spend. The bond for your 100th year has one more year to mature and is earning about 3% over inflation. So after factoring out inflation, you can spend 50.70% of your portfolio this year, knowing the 49.30% of your portfolio left in the bond will grow by inflation plus 3% to cover a cost-of-living increase for your final year.

Back up yet another year. You can spend a little over a third of your portfolio for your 98th year, just over a fourth for your 97th year and just over a fifth for your 96th year. Gradually as you work backward, the amount of interest over inflation you are earning becomes more significant. Once you establish a laddered bond portfolio of five to seven years, putting those assets with a longer time horizon into the stock market is a good idea.

Investing in fixed income gives you peace of mind, knowing your lifestyle for the next few years will be relatively stable and not depend on the whims of an inherently volatile market. Investing in stocks is appropriate only when your time horizon is at least five years or longer. Therefore, we recommend keeping the next five to seven years of spending in fixed-income investments during retirement. You can keep five years of spending in fixed income if you are aggressive and seven years if you are conservative. Five to seven years is an appropriate range. If you keep whatever you feel like based on an emotional risk tolerance, you may jeopardize your retirement lifestyle.

In our examples we assume you have set aside six years of spending for stable investments in fixed income and allocated the remainder of your portfolio in appreciating equity investments. This money is invested in quality fixed-income investments. There is no reason to invest in "high-yield" junk bonds for the stability side of your portfolio. Junk bonds act like stocks and are liable to fail when you need them most. With your fixed-income investments in quality bonds, you can safely afford to put more of your portfolio in appreciating stocks.

Knowing your retirement spending is relatively secure for the next six years, we suggest putting the remainder of your portfolio into more volatile stock investments to achieve a better long-term rate of return. With this technique, not only do you have a maximum safe withdrawal, you also have a maximum allocation to fixed income: to balance the need for six years of stable spending with the need for appreciation to cover the seventh year and beyond.

For your stable investments, we have assumed a rate of return consistent with fixed income, about 3% above inflation. Assumptions for the equity portion of your allocation are more problematic. In the long run, stocks average about 6.5% over inflation, but in that long a run both your retirement and your life are over. Stocks are inherently volatile. Do not count on any reliable rate of return during your retirement. Past performance is no indication of future results. Just because a 30-year loss in the U.S. markets hasn't happened yet doesn't mean it couldn't happen during your retirement.

You can handle uncertainty in two different ways: throw lots of dice and see what happens or make conservative assumptions. What we learn from the first can help us with the second.

In the financial planning world, throwing lots of dice is called Monte Carlo analysis. It involves running a retirement projection against many randomly generated investment returns to see if that portfolio growth outlasts many random lengths of life. Sometimes returns are selected from history; sometimes they are generated mathematically. Hundreds of assumptions are built into Monte Carlo simulations. As a result, the method illustrates risk better than it actually predicts or protects against it.

We learn from Monte Carlo that every plan has some small chance of failure, and you must accept the possibility that you will need to adjust your lifestyle. We also discover that a string of early bad returns with a high withdrawal rate makes for a difficult recovery. Monte Carlo analysis has so many associated problems, we advise taking the lessons learned and simply making some conservative assumptions.

Assume your stock investments will only average bond-like returns, about 3% over inflation. Normally the markets do much better, but sometimes they do much worse. Working backward from 100, at age 90 with 11 year of spending remaining, you should be able to spend 10.42% of your portfolio.

Continuing to work backward from age 100, we can compute exactly what percentage of your portfolio you can spend if you are retired at any age. Here are those maximum safe withdrawal rates by age, along with the maximum percentage you can safely allocate to fixed income and still leave enough in appreciating equities to keep up with inflation:

Age	Withdrawal Rate	Maximum Fixed Income
50:	3.64%	18.4%
55:	3.82%	20.4%
60:	4.06%	22.4%
65:	4.36%	25.0%
70:	4.77%	32.2%
75:	5.35%	36.4%
80:	6.22%	42.4%
85:	7.66%	51.6%
90:	10.42%	67.8%

The safe withdrawal rate never drops lower than 3%. If your portfolio appreciates 3% over inflation and you take 3% out, your portfolio will have grown exactly by the rate of inflation. You can retire the day you are born if you can live off 3% of your trust fund. A 3% withdrawal rate can continue indefinitely as long as your portfolio appreciates annually by at least 3% over inflation.

Every year your portfolio earns greater than 3% over inflation, your standard of living can go up. If your portfolio loses money one year, you may be able to keep your spending constant and wait for above-average portfolio returns to get you back on track.

In this way you can adjust your standard of living dynamically and avoid a "plan once and blindly follow," on the one hand, and "let my standard of living bounce between feast and famine" on the other. This middle ground keeps lifestyle spending appreciating when the market returns are typical and keeps spending constant in terms of dollars during down markets.

Withdrawal rates lower than these maximum safe rates provide an even safer retirement plan and also allow more of your portfolio to remain invested and appreciate. In addition, withdrawal rates lower than the maximum permit greater flexibility in your asset allocation. With conservative enough withdrawals, you can afford to put more assets either in fluctuating equities or in less appreciating bonds.

Staying under these maximum withdrawal rates in conjunction with a diversified asset allocation gives you an excellent chance of having enough money during your retirement. And if your portfolio experiences average market returns (as opposed to the average bond returns used for planning), you will also leave a nice legacy for your heirs.

from http://www.emarotta.com/article.php?ID=287

If you put the same assumptions into 10 different retirement calculators, you will most likely get 10 different results. The largest number may be more than twice as much as the smallest. Retirement doesn't give you a second chance. Measure twice and retire once.

The variations among retirement projections result mostly from differences in their assumptions. Six assumptions are significant in calculating safe withdrawal rates during retirement: inflation, average return, portfolio volatility, investment mix, longevity and lifestyle. Furthermore, these assumptions are interrelated and interdependent.

Many people wrongly suppose they can safely withdraw and spend from their portfolio whatever they earn on their investments. Nothing could be further from the truth.

Imagine you retired in 1973 with a portfolio producing a $10,000 annual return. In today's dollars, that amount of money is equivalent to $48,400. But spending all of your dividends and appreciation each year means your portfolio will not grow to keep up with inflation. Now, at the end of your retirement, your portfolio is still only generating $10,000 a year and your lifestyle is impoverished. Your withdrawal rate must be low enough to permit some funds to remain in your portfolio so future withdrawals can appreciate with inflation.

Inflation is a huge assumption, and most projections don't handle it well. Retirement plans tend to forecast the rate of portfolio returns and inflation separately. On average, stocks earn 10% to 12% and bonds earn 6% to 8%. Inflation runs about 3% to 5%. Those are huge ranges and can produce very different results. With so much wiggle room, the most favorable assumptions allow you to withdraw and spend about twice as much as the worst cases.

A better retirement planning method is to factor inflation out of your investment returns. Whatever inflation is currently running, stocks earn on average a 6.5% real return over inflation and bonds earn about 3% above inflation. Factoring inflation out of average investment returns removes some of the wobble factor in retirement projections.

You should also inflation-protect your portfolio through asset allocation. Some asset classes offer protection against loss of purchasing power, and at least half of your portfolio should be in these asset classes. Hard asset stocks provide an inflation hedge. So do foreign bonds and foreign stocks.

Stocks may earn, on average, 6.5% over inflation, but this estimate is too optimistic for planning purposes. To talk about "average stock returns" is like noticing that the average number on the roulette wheel is 18.5. Stocks may average 10% to 12%, but only four times in the last 70 years have stocks actually returned in that range. More commonly, they return +18% or -10%.

Reducing the volatility of your investments is one reason why asset allocation is so important. Dividing your investments among asset classes with low or negative correlation is the best strategy to reduce portfolio volatility and boost returns.

Most retirement projections assume your portfolio will have a fixed asset allocation that doesn't change during your 30-year retirement. But in fact, your asset allocation should start with a strong equity bias and gradually grow more conservative as you age. Static asset allocation assumptions may range anywhere from 40% to 25% of fixed income. Over the past five years, the average annual return for U.S. bonds was only 4.0%. The greater the allocation to fixed income, the less likely the portfolio will keep up with inflation and provide adequate growth for a long retirement. Maintaining an equity bias is critical during the early years of retirement.

Many plans assume the equity allocation will be primarily large-cap U.S. stocks such as those found in the S&P 500. But a more balanced allocation would include small cap, foreign stocks and emerging markets.

In the past five years, the S&P 500 has averaged 10.1%, S&P Mid-Cap 14.9% and the Russell 200 Small Cap 12.9%. The EAFE Foreign Index averaged 19.7% over the same period, and emerging markets averaged 31.5%. Obviously, with such disparate returns, asset allocation matters a great deal. We recommend investing significantly in equities for appreciation but diversifying both for safety and to boost returns.

Most retirement strategies make an assumption based on your age at retirement. The earlier you stop working, the lower the percentage of your assets you can withdraw and still have money until you reach 100 years old.

Many retirement plans are predicated on a 30-year retirement. At age 65, your average life expectancy is 86, or 21 years. But half of today's retirees will live longer, some well over 30 years. If a husband and wife both retire at age 65, the odds are 40% that one of them will live until age 95.

Average life expectancy makes a poor planning statistic. Compare it to making a doorway 5 feet 10 inches tall to accommodate the average person. Men will bump their heads on the average doorway, and women will run out of money in the average retirement projection. Doorways are 7 feet tall and ceilings are 8 feet tall for a reason.

Your specific demographics can skew your life expectancy significantly. Not only do women live longer, but so do those who have enough money to plan. Readers of this column probably live longer on average than those who don't, and we recommend planning to have enough resources for a comfortable lifestyle until age 100. My grandmother was mentally sharp and the best read member of the family. She missed becoming a centenarian by only six months, despite having smoked for much of her life. With medical advances, the likelihood of living for 100 years with an excellent quality of life continues to increase, and the possibility of reaching 110 is becoming much less remote. A 30-year retirement may be adequate, but we recommend planning to have money until you reach at least age 100.

Finally, lifestyle assumptions can skew retirement projections. Many assume your lifestyle in retirement will be only 70% of the lifestyle you enjoyed while you were working. Others assume you will be in a much lower tax bracket, and they fail to discount the assets of your traditional retirement accounts adequately. It is just as likely, and much safer, to assume that spending and taxes in retirement will continue to rise.

For our retirement assumptions, we try to play it safe but not to an extreme. We assume longevity to 100 years old and earnings of at least a bond portfolio, about 3% over inflation. These assumptions will not always be met, and even with these conservative assumptions, blindly following them will result in about a 7% failure rate.

Therefore, we urge you to update your retirement plan annually to make adjustments and course corrections. These adjustments include changes not only to your asset allocation but also to your lifestyle and thus the amount of your withdrawals.

Next week we look at what assumptions and withdrawal rates give you the best chance of keeping the lifestyle you want during retirement.

from http://www.emarotta.com/article.php?ID=286

Taking Early Retirement Withdrawals (2008-05-26)

by David John Marotta

Many academics are 403(b) rich. But they are poor in terms of their spendable assets, which limits estate planning and tax management options. It also makes retiring early difficult. Fortunately, an IRS 72(t) exception can help with early retirement.

Imagine that Professor Reddy Echols II is ready to retire from the mathematics department. Having proved the Riemann hypothesis, his life's work in math is complete. Now at the young age of 40, he is ready to give up the responsibilities of the classroom.

Life planning is less about financial success and more about personal significance. Having achieved a well-paying tenured position relatively quickly, it may be difficult for teachers to contemplate changing careers. But if you focus on reaching your goals, your finances need only match what your goals require. Professor Echols now wants to spend time on other pursuits. So he either needs to seek a new patron or find a way to provide for himself in early retirement.

Retirement, traditionally the brief period between a career that lasted longer than life expectancy and death, is being redefined. In fact, when the Social Security program began, benefits started at age 65 and life expectancy was only 61. My father took his first retirement when I was 16 years old, and retirement is the only endeavor that has ever stumped him. At 81, he has just finished teaching his course on global finance at Stanford University.

The new definition of retirement is financial freedom: having the means to do whatever you want to do regardless of the remuneration. Having achieved financial success, you are now free to seek personal significance.

Many people find it challenging to reach financial independence by age 65. It does require planning, but it certainly is not impossible. If you save 15% of your standard of living starting at age 20, you should be able to retire comfortably at age 65 even if the market performs poorly. But unfortunately, most people don't start saving at age 20, and few save at least 15% of their standard of living. Thus a majority of baby boomers are not on track to achieve financial independence at any reasonable retirement age.

Despite these statistics, however, retiring at age 40 is not a pipe dream. It simply requires more discipline. After adjusting for inflation and considering typical market rates of return on a balanced portfolio, for every dollar you save over 20 years you will be able to retire with a lifestyle equivalent to what you were saving. Start saving $1,000 a month, and in 20 years you can retire with the purchasing power of $1,000 a month today.

In his progression from brilliant PhD candidate to tenured professor in his 20s, young Echols never really left behind the frugal lifestyle of a graduate student. Continuing to live modestly, his salary increased without a parallel rise in his standard of living. Consequently, he started by saving $2,500 a month, or $30,000 every year. At a 10% rate of return, he now has $1.8 million at age 40 and rightly judges that his means should be sufficient for his wants.

You can retire at any age as long as you keep your wants modest compared with your total portfolio value. You must be able to support your standard of living until you reach 100, so the younger you are, the smaller the percentage of your portfolio you can withdraw each year. At age 40, you can safely withdraw about 3.38% of your portfolio's value and still support your lifestyle until you reach age 100. At a 3.00% withdrawal rate, you can support your lifestyle indefinitely because your portfolio should be able to earn at least 3% over inflation.

Having saved $1.8 million, Echols can safely withdraw $5,000 a month, or $60,000 a year. His $5,000 monthly stipend should provide the same purchasing power of the first $2,500 monthly contribution he made 20 years ago. Saving and investing through the university's 403(b) plan, Echols now has all $1.8 million in his retirement account waiting for him to turn 59.5 years old.

Taking money from your retirement account early normally results in a 10% penalty. Income tax always needs to be paid, but there are eight exceptions to the age 59.5 rule that allow for penalty-free withdrawals. You may be able to take money from a retirement account prematurely in any of these five situations: unreimbursed medical expenses, medical insurance if you are unemployed, disability, higher education expenses, and first-time home ownership. Additionally, if you have inherited a retirement account, you may be able to or even required to begin making withdrawals. And you may also withdraw money from a retirement account and roll it into another qualified plan.

The final way to make penalty-free early withdrawals is to make annuity distributions. Because all of these methods are available for traditional IRA accounts, the first step for Echols is to move his 403(b) into an IRA rollover account.

The annuity distribution method allows Echols to retire early by waiving the penalty on withdrawals at any age so long as they are substantially equal periodic payments that continue until age 59.5 or for at least five years, whichever comes later. Maximum payments must be calculated using one of the IRS-approved methods.

The first method is the life expectancy method. The IRS provides a table of divisors at every age for a single life expectancy or a joint life expectancy. The single life expectancy for a 40-year-old is 43.6 years. So Echols could withdraw $41,284 a year, or just 2.3% of his portfolio value--a very conservative number.

The life expectancy method is easy to calculate because it doesn't really factor in any significant account growth or appreciations. Each year your account balance at the end of the previous year is divided by a slightly smaller divisor. Amounts start small, and with any reasonable rate of return, the odds are that the account balance will grow enough to outpace withdrawals. This method works well for taking small contributions but not truly to retire and take the maximum safe withdrawals.

The second method is amortization: You are allowed to assume a reasonable interest rate of return for earnings on your portfolio. The IRS has even ruled that "reasonable" includes anything less than 120% of the "Mid-Term Applicable Federal Rate" for either of the previous two months. Using the month of April, the maximum reasonable rate of return is 3.45%, and Echols's annual withdrawal could be as high as $80,430.

Using the amortization method, Echols can justify any withdrawal less than $80,430 a year. Simply by lowering the reasonable rate of return from 3.45% to 1.81%, the withdrawal rate drops to $60,000 a year. Better yet, Echols can split his $1.8 million into two accounts. One account with $ 1,343,000 using 3.45% as a reasonable rate of return would justify withdrawals of $60,000 a year. The other account of $457,000 could simply continue to grow without withdrawals until he's 59.5 years old.

The advantage of having two accounts is that the second one can start withdrawals on a separate timing schedule and be calculated at a later date.

You would think the IRS rules would be clear and easy to follow, but they are not. Several IRS rulings suggest you can recalculate these numbers annually. Alternatively, you may be able to adjust for inflation annually.

The easiest method for getting more money in a future year would simply be to continue to create a new account and start an additional amortization flowing.

If your goal is retiring early, it is best to have significant taxable investments. As an alternative, the amortization method allows you to begin some withdrawal flows, as illustrated for young Echols. Fortunately, he is a former mathematics professor.

 

from http://www.emarotta.com/article.php?ID=285

That Rebate Check Could Ruin Your Retirement Part 2

(2008-05-19) by David John Marotta

Last week's article explained the wrong-headed decisions behind the current tax-stimulus package, its deleterious effects on an already fragile economy, and how consumers delude themselves in the ways they spend the money. This week I explain the effects of the rebate checks on the savings for retirement. Anyone who spends more than 4% of their rebate will actually lose ground saving toward their retirement.

Retirement is the ability to continue your current standard of living solely through the growth of your investment assets. Raising your standard of living is the fastest way to fall behind your retirement goals. Every time you increase your spending by $1, you need $23 more in your investments when you retire.

So if you spend even half of your $1,800 rebate check and put the other half in savings, you fall $19,800 further behind in your retirement. Spending the extra $900 means you are expecting to continue living a lifestyle $900 greater than the lifestyle you have been living. To support that lifestyle, you will need 23 times that amount, or $20,700 more, in the bank at your retirement. But because you are only putting $900 more in your retirement, you fall $19,800 behind.

The problem worsens with every dollar of rebate you spend. Spend the entire $1,800 and you fall $41,400 behind on your retirement savings. Get tricked by the windfall effect I discussed last week, and you will increase several smaller purchases and spend 2.5 times your rebate check. Spending $4,500 more means you have fallen $103,500 behind in saving for your retirement.

Even back at only spending half of your check, you've spent $900 and only saved enough to do that again next year. You've saved like there's only one tomorrow. To support a constant lifestyle increase and not simply a two-year binge, you can only spend about 4% of the $1,800, or $72.

At this point, I can hear your objections: "But I'd just be spending the $900 this year. I'm not really increasing my lifestyle."

Unfortunately, lifestyle is tricky to calculate. It is easy to ratchet up but nearly impossible to trim down. Just try cutting your spending by $900 this month and adding that amount to your investments if you think it's easy to economize. Whatever your standard of living, there are people living $900 below you who are considering using their rebate check to add the one thing they believe they are missing from your lifestyle.

You can't spend money apart from your lifestyle because that's the definition of lifestyle. If you add an additional $900 to your lifestyle, you will have to cut back by the same amount next year just to get back on track toward your retirement.

Most people spend money they will only receive once and are more cautious about spending additional salary. However, the exact opposite should be true. Money you are given once cannot support an increase in your lifestyle. You have to amortize the money over your entire lifetime and spend only about 4% in any one year. But additional salary can be counted on every year. Therefore you can spend between 70% and 80% of salary increases and still stay on track by always saving between 15% and 30% of your income each year.

A much better idea is to think of the rebate check is as a matching contribution. Imagine the government is making you the following deal: "We will give you a check only if you put it in savings and match it with your own money, cutting your lifestyle this year by that amount."

If you take the government's deal and cut your lifestyle by $1,800 and add that plus the rebate check to your retirement savings, then you really grow rich. First, you have added $3,600 more toward your retirement. But more importantly, by cutting your lifestyle by $1,800, you now need $41,400 less to make retirement a possibility! With one small matching funds incentive by the government, you are a total of $45,000 closer to financial independence.

Staying on course toward retirement is as much about moderating your lifestyle as it is about saving and investing. If you need 23 times your standard of living at age 65, you need about 10 times at age 50, 5 times at age 40, and 1.7 times at age 30. Investments can double quickly, but you must have something saved while you are young to get the process started. Delay saving for several years and you will cut in half your lifestyle in retirement.

Compare what you spend with what you have saved to see if you are on the money toward meeting your retirement goals. And consider that tax rebate gimmick for what it is: another cheap attempt at stopping you from achieving financial independence.

Here's a program I could support as president: Offer to pay people matching funds toward their retirement in accounts they would own and control. We wouldn't even have to call it "privatized Social Security."

from http://www.emarotta.com/article.php?ID=284

Tax Rebates Are a Losing Proposition Part 1 (2008-05-12)

by David John Marotta

Beginning this month until July, the government will issue over $100 billion in tax-stimulus checks, the equivalent of about 1% of annual consumer spending and some 70% of the country's $14 trillion gross domestic product (GDP). The assumption is that we can spend our way out of a recession by boosting third-quarter GDP growth over 4%.

More than 130 million households will receive $600 per adult plus $300 per child with a family of four receiving $1,800. But for taxpayers with an adjusted gross income of $75,000 ($150,000 filing jointly), who paid more than 60% of all taxes, these amounts are either reduced or eliminated. In contrast, many people who never file a tax return or pay any taxes will receive the full amount. The government has created special forms and public relations campaigns specifically to reach this group and encourage them to file and enjoy a rebate of taxes they never paid.

If I am elected president, I won't insult the public like this. Tax rebate stimulus checks are a cheap and inefficient gimmick that will increase the fragility of our economy and impoverish those who receive such checks.

You can't spend your way out of economic trouble as a country any more than you can lift yourself personally by pulling on your shoestrings. Increased spending is an indicator of economic health only when it is preceded by increased production and earnings. Rich people generally spend more, but it certainly is not what makes them rich.

It would be much better if we as a country tried to save and invest our way out of a recession. Imagine if everyone invested their rebate by creating new businesses or building factories. Then we as a nation would produce more. Increased annual production could be sold, which would increase our GDP.

Consuming more goods doesn't really help our economy when half the stuff we buy comes from China anyway. In fact, deferred consumption is the definition of capital and would allow us to use that capital to build more productive companies. It would lower unemployment and reduce inflation.

The tax rebate gimmick is extremely inefficient. The legislation itself added hundreds of pages to this year's tax code. The IRS launched a tax rebate information center offering check amount scenarios, along with information especially directed toward Social Security recipients and veterans. The agency was taking more than 50,000 calls per day over their normal tax-season load. Their automated-response phones handled 1.2 million calls specifically about the rebates, and the IRS reassigned 1,500+ employees just to deal with the inquiries.

To be eligible for the $300 rebate, parents had to apply for a Social Security number for their children. People not normally required to file a tax return had to do so to receive their rebate checks. The IRS Free File Alliance was created to provide free services to people who were filing solely to receive their economic stimulus payment.

None of these compliance costs are free. Someone has to be paying for them. Estimates suggest that compliance costs add an additional 50% to the expense of taxation. Because of the added burden of a unique program such as this, the costs are probably higher.

That means those $1,800 checks will probably cost taxpayers about $3,000 each.

The tax rebate gimmick impacts negatively on our economy. Economic systems change gradually and operate best in stable conditions. Only when goods and services are free to be used wherever they are deemed most valuable does economic growth have the best chance.

But rather than trust in the free markets, President Bush and Congress have tried to boost consumer spending artificially without any reduction of federal spending, thus increasing the money supply and fueling inflation. More dollars chasing static production is the definition of inflation. Many families earning $36,000 a year will receive a $1,800 rebate check representing an additional 5% bonus, only to find that prices on their purchases are 5% higher. Thinking they are better off, they will actually be poorer if receiving the check increases their spending habits by even a penny.

Every time the government bureaucracy engages in centralized spending plans, the economy is weakened. Free markets are the best method of self-rationing scarce resources to where they will do the most good. Every time the government tries to solve an economic problem via fiat, they can only do worse than the efficiencies of the market itself. By trying to strengthen or bail out one section of the economy, they slightly weaken and destabilize all the others.

Finally, the tax rebate gimmick will impoverish those who receive such checks. In polls, most Americans claim they will put the rebate in savings or use it to pay down debt, but behavioral finance research suggests otherwise.

Studies have shown that even the most rational of consumers who receive money spend more as a result. Surprisingly, when they receive relatively small amounts, they justify additional spending by more than 2.5 times the size of the original check. The psychology behind this thinking is so strong, it is safe to assume we are all influenced by it.

We see evidence that the effect is universal when we hear people say they will save the rebate or use it to pay down debt. The fact that they are thinking of the money from the rebate as though it were different from the rest of their budget means they are already engaging in the two-pocket fallacy of money, thinking of money differently simply because of the source.

Perhaps they will pay off some of their debt, but they did that the month before they got the check. Perhaps they will put money into their 401(k), but that happens automatically. Because these rebate checks will continue to be featured in the media for months as they dribble out, they will continue to be in the forefront of our minds. Someone will complain about a delayed check while other coworkers share what they've already purchased. And most Americans will use the idea they have some extra money to justify a purchase they would not otherwise have made, probably more than once.

In fact, studies suggest that average consumers will spend an additional $4,500 in relatively small purchases simply because they received a $1,800 check: an extra $45 eating out, a $90 electronic toy, and a $650 appliance. Children will be given their $300 as though it somehow belongs to them, and husbands and wives will use the money as an excuse to make that purchase their partner considers frivolous. Without even realizing it, past studies suggest consumers will spend 250% of their rebate check.

In polls, American claim they will spend only 18% to 40% of the rebate. But in reality, anyone who spends more than 4% will actually lose ground in saving toward their retirement. Next week's article will explain the realities of this scenario. Until then, don't spend a penny of those rebate checks.

 

from http://www.emarotta.com/article.php?ID=283

Subprime Lending

(2008-05-05) by David John Marotta

The subprime mortgage meltdown has cost the world 15% of its market capitalization, about $9 trillion. The primary culprit who caused all of this financial loss, pain and suffering is not the mortgage companies. Neither is it the overextended borrowers. It is our own federal regulations interfering with the free market.

For over half a century, only 45% of Americans owned their own home. Then home ownership rose in the postwar period, settling at about 64% in the early 1990s.

In 1994, President Clinton had the good intention of raising home ownership to 67.5% by 2000. He sponsored the revision of the Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. The banks complied and increased their lending to these families by 80%, more than twice any other group.

The sentiment was noble but ill advised. Community groups could now prevent banks from mergers, branch expansions or the creation of new branches simply by protesting to any of four different regulatory agencies. But these traditional activities of banks are necessary to stay responsive to the dynamics of the marketplace. To maintain this ability, banks paid millions to these community groups. In theory, they were supporting mortgage education efforts and fair lending practices. In reality, they were carrying a block of poor loans on their books simply as the price of doing business.

These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as a positive and encouraging trend. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had gotten $3.8 billion in loan commitments in the city of Boston alone.

Faced with excessive regulatory interference, banks risked additional loan defaults rather than face financial penalties and blocked business. But in a situation characterized by excessive regulation, we all pay the price.

The unintended consequences of good intentions can do more economic harm than all the mean-spirited greed within capitalism.

Part of the good intention was forcing banks to be good neighbors by making altruistic loans that discriminated in favor of underprivileged communities. Any attempts by banks to set higher rates, terms or conditions on people with questionable credit was labeled "predatory lending" and used to hold lenders hostage. This form of price controls held the price on questionable loans artificially low.

Normally, price encourages consumers to self-ration and to use less of a limited resource such as capital and put it where it is likely to do the greatest good. Price controls cause shortages because lenders protect their losses by extending fewer risky loans. But this time, regulations forced them to continue making the loans.

Price controls and lower interest rates caused a surge in the demand for mortgage loans. In response, banks raised the requirements to qualify for a traditional loan and wrote more adjustable-rate mortgages (ARMs). Even ignoring their poor credit rating, questionable borrowers could only qualify for an ARM, and they could barely afford the low teaser.

Clinton's goal was met in 2000 and then surpassed, boosting U.S. home ownership by 2005 to 68.9%. Ownership for minorities grew by 24.1% between 1993 and 2005, nearly three times the rate of for non-minorities.

Another good intention driving the legislation was that home ownership correlates to building wealth, stability and community support. If only we could get struggling people to own their own home, they too could share in the American dream. But we build wealth by deciding consciously to delay purchases such as a home, not to overextend ourselves financially to reach our goals.

The idea was that purchasing a home is an investment. But the home you own is not an investment. An investment pays you money. Rental property is an investment. The house you live in is a liability, which increases proportionately with its size. The fastest way to own a house is to rent as small as possible and save and invest the difference. Low-income households have limited resources, and home ownership drains too high a percentage of their income. In fact, studies show that low-income home owners save less than renters and have less of an emergency fund.

The belief was that home owners build equity in their homes by making regular payments that include both interest and principal. For most families, paying a mortgage is a forced form of savings. But this assumes home owners have the cash flow that allows them to build equity in their houses. Encourage those unaccustomed or unable to save to become home owners, and they are apt to refinance and take any growing equity out of their house to fund other expenses.

In fact, that is exactly what happened.

Another good intention was the assumption that mortgages are always good business for banks. Lenders who didn't cheerfully agree were accused of discrimination against minorities by using “old-fashioned” criteria, such as the size of the mortgage payment relative to applicants' income, their credit history or verifying their savings and income. Instead, applicants merely had to demonstrate their ability to manage debt by attending a credit-counseling program.

But these old-fashioned criteria were historically what made loans secure and limited defaults. Forcing banks to lend money to those least likely to repay is not a sound policy.

That the credit debacle took two presidential terms to unravel is simply how economics works. Dropping interest rates and rising house prices masked the default rates as those who would have defaulted simply refinanced a larger loan, milking their homes for 100% of their value like an ATM machine.

Economist professors Stan Liebowitz and Ted Day criticized the program in 1998 in their article "Mortgages, Minorities, and Discrimination" in Economic Inquiry. They wrote, "After the warm and fuzzy glow of 'flexible underwriting standards' has worn off, we may discover that they are nothing more than standards that lead to bad loans. . . . [T]hese policies will have done a disservice to their putative beneficiaries if . . . they are dispossessed from their homes." Unfortunately, no one ever listens to economists.

Everyone was busy praising lenders using relaxed underwriting standards as the paragon of virtue. Although widely understood that approving minority mortgage applications stretched the rules a bit, it was considered good social engineering. Now they are universally criticized by the same crowd that formerly praised them.

Today, the people who advocated lax lending standards are self-righteously critical of lenders for letting this debacle happen. Having forced millions of bad loans, they are now complaining the government is paying a small portion of the losses back to Bear Stearns. Having enacted regulations that ruined the U.S. financial markets, they now claim the credit problems stem from a lack of regulation. Only government uses its power to cause such havoc and then asserts it needs more power.

Bailing out borrowers makes the least sense of all. Although routinely cast as victims, we must remember they substituted attendance at a credit-counseling class for hard collateral in their promise to repay. They purchased homes beyond their means, lived in relative luxury and bilked banks of any building equity by refinancing cash-outs of their homes every time real estate markets appreciated.

Although it isn't their fault for padding their lifestyle by exploiting regulatory mistakes, borrowers don't deserve a penny more. Regulators especially don't deserve a second chance to impose rigid rules on a system that requires dynamic adjustments. Having been hurt so badly by the conspiracy of regulators and irresponsible borrowers, we should at least allow lenders the consolation of foreclosing on the house of cards.

If the subprime meltdown was the result of greedy capitalists, you would have to assume they were awfully dumb to have lost so much money. The markets are smarter than that. Only feel-good legislation could be so naive. How can more government regulation help when there is universal ignorance of how the government caused the problem in the first place?

from http://www.emarotta.com/article.php?ID=282

First Quarter Review 2008 (2008-04-28)

by David John Marotta

The first quarter of 2008 made the difference between well-designed portfolios and poorly designed portfolios obvious. Check your quarterly statement to see which category describes your portfolio.

You may hesitate to change your investment strategy even if you suspect performance is suboptimal. Perhaps you believe your current investment mix went down so much simply because of the markets and will go up when the markets rebound. But this assumption is faulty.

Systemic problems, not market volatility, explain why some portfolios performed extremely poorly in the first quarter. If your asset allocation was unbalanced, you took the brunt of the drop because you are invested primarily in U.S. large-cap stocks. An unbalanced portfolio will continue to be unbalanced and gyrate randomly rather than progressing steadily toward your goals.

Furthermore, if your underlying investments are laden with fees, they will continue to be even after the markets rebound. It may be difficult to see you are paying too much in hidden fees and expenses when the markets are going up. But when they go down, excess fees add insult to injury and exaggerate your losses.

We design portfolios using six asset classes, three for stability and three for appreciation. The three for stability are (1) short money (maturing in less than two years), (2) U.S. bonds and (3) foreign bonds.

1. Short money, such as cash, money market and CDs, continues to be the riskiest investment since 2002. Cash can be dangerous. When our currency decreases in value, we experience inflation and the purchasing power of our dollars is compromised. Having the same number of dollars doesn't do you any good if they won't buy as much as they used to.

The Federal Reserve lowered the rate of federal funds from 4.25% to 2.25% this quarter. It lowered the discount rate (the rate at which a limited number of institutions can borrow directly from the Fed) from 4.75% to 2.25%.

As a result, the dollar continued to slide in value, deteriorating several percentage points in the first quarter. The Euro rose about 3.4% against the dollar. The U.S. Dollar Index, measured against a broader basket of currencies, dropped about 5.3%. Even the Japanese yen rose over 8%. Finally, the price of gold went from $840 an ounce, past $1,000 and back down to $916, ending up over 9%.

This loss of the dollar's purchasing power means that losses in all other categories were compounded. Not only did the U.S. stock market lose value in dollars, but the remaining dollars were worth even less. Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes.

2. The second asset class in stability is U.S. bonds. The Lehman Aggregate Bond Index was up 2.17% in the first quarter. Annualized, that would produce an 8.68% return. Treasury inflation-protected bonds provide some protection against a dropping dollar and appreciated 5.18% in the first quarter.

Having the right balance of stability to appreciation (fixed income to equities, or bonds to stocks) is important for a portfolio's behavior.

Adding bonds to an all-stock portfolio can actually boost returns over the long term. When an all-stock portfolio performs poorly, you just have to wait for it to rebound. But when a portfolio is stable and the stock side bounces down, the natural process of rebalancing sells bonds at their high and adds to stocks at their low. This contrarian move helps the portfolio as a whole rebound more quickly by adding to the stock side when it is down.

Even in a very aggressive portfolio, bonds provide a stable store of value waiting for a market correction. This "dry powder," or cash on the sidelines, can be invested into the markets after a drop to help your portfolio rebound quicker.

3. Foreign bonds, the third asset class in stability, protect you better against the weakening of the dollar. They did very well in developed countries, appreciating nearly 10%. But emerging market bonds were flat. A mix of mostly developed countries and a third in emerging market bonds would have produced a return of around 7%.

The three additional asset classes for appreciation are (4) U.S. stocks, (5) foreign stocks and (6) hard asset stocks. U.S. stocks did the worst.

4. The Dow was down 7.55%, the S&P 500 was down 9.44%, the Russell 2000 lost 9.90% and the NASDAQ lost 14.07%. The average daily volatility in the first quarter was 1.21% compared with a historical average of 0.75%.

Value stocks lost less than growth with small value doing the best, only losing 5.28%. Oddly enough, small growth did the worst, losing 14.40%. Small- and mid-cap stocks have soundly outperformed large cap over the past five years, so your portfolio should tilt toward small and value.

Technology stocks did the worst this quarter. The sectors that lost the least were consumer services and consumer goods.

So U.S. stocks were definitely down. But if your U.S. stock losses were approaching 10%, one of three things is probably wrong with your portfolio: You have all U.S. large cap stocks, you are overly invested in volatile funds or your excessive fees are dragging down your investments. You can view the expense ratio on every fund you own at www.morningstar.com.

5. Many foreign markets fared even worse. Emerging markets were down 11%. Britain's FTSE was down 11%, France's CAC was down 16.3%, and Germany's DAX was down 19%. The EAFE foreign index, however, was only down 8.91%.

The 11 countries we recommend with the most economic freedom fared better than average, only losing 8.23% for the quarter. Overall, your foreign investments should have done slightly better than your U.S. investments. We believe foreign stocks provide better country diversification and also protect your investments against the devaluation of the dollar.

6. The third asset class for appreciation is hard asset stocks, which include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water.

These stocks exhibit a unique set of characteristics: They have a low correlation with other stocks and bonds and they appreciate with inflation.

Gold and oil both hit record highs in March. They then fell 12% and 11%, respectively, in just three days. Crude ended the quarter up 5.9%, gold was up 10.3% and natural gas was up 30.9%. These commodity prices affect the long-term price of hard asset stocks. With the gyration in prices, hard asset stocks have been much more volatile than normal and lost 4.89% this quarter.

Asset allocation means always having something to complain about, but it also means always having something to be glad about. The S&P 500 was down nearly 10%, but a well-balanced portfolio should be down much less. Don't assume that everything is down the same. Some portfolios just can't overcome having all their assets in large-cap U.S. growth stock funds with excessive expenses. And because they are poorly designed, these portfolios won't rebound as quickly with the markets.

Take the time to compute your first quarter's returns and determine if your investments are designed to meet your goals. It's an excellent opportunity to review your asset allocation and investment selection.

 

from http://www.emarotta.com/article.php?ID=281

Tax Freedom Day 2008

(2008-04-21) by David John Marotta

This year we celebrate Tax Freedom Day on Wednesday, April 23. That's the day we stop working for the government and start working for ourselves. For average workers, all of our earnings for the first 113 days of the year go to pay federal, state and local taxes. Starting April 24, we are free--at last--to take care of our own family's needs.

The nonpartisan Tax Foundation based in Washington, D.C., measures the tax burden on Americans every year. According to its 2008 report, published in March, this year's federal Tax Freedom Day comes seven days later than it did in 2003. Interestingly, the day falls three days earlier than it did last year. This decrease in taxes is the result of the slowing economy and a onetime fiscal stimulus tax cut.

Because of our progressive tax system, Uncle Sam usually collects more taxes as inflation rises, owing to "bracket creep." As your income growth keeps up with inflation, your purchasing power remains unchanged. But as inflation drives you into a higher tax bracket you pay higher taxes.

On average, taxes take nearly 31% of a worker's gross income: 20% for federal taxes and 11% for state and local taxes. For every eight-hour day, 2 hours and 28 minutes of our labor is spent paying taxes. Without taxes, you could leave your job at 2:32 p.m.

Only since 1992 have Americans paid more for government programs than we spend on food, clothing and medical care combined. For the amount of money we pay in taxes, the federal government could provide universal health coverage and feed and clothe us as well.

At the state level, Tax Freedom Day varies depending on location. California has moved up from the 7th to the 4th highest level of state taxes with its Tax Freedom Day now delayed until April 30. Virginia has risen from 17th to 12th in the race for the highest state tax rate, even though its liberation day arrives on April 25, only two days later than the national average.

The Virginia tax rate continues to climb higher each year, despite claims of no new personal taxes because of both bracket creep and the significant increase in state business taxes. This situation reflects a national trend. Business tax receipts have risen sharply over the past two years.

Most non-economists vastly underestimate the negative impact of taxes on the U.S. economy. Taxes encourage every American to do things themselves, outside of the taxable economy, even if specializing and working together would mean greater productivity. If you add the costs of complying with the complex web of regulations, the federal government costs us Americans collectively more than 50% of our wealth.

Imagine three contractors who could build three houses if they worked separately. If they collaborated and combined their expertise, however, they could build six houses instead. It may seem incredible that these builders would not take the opportunity to double their productivity, but with any tax rate higher than 50% they have no incentive to choose the more productive partnership. Putting their production into the taxable economy means they have to pay more than three houses in taxes. A 50% tax rate halves their productivity. Envision the economic boom if the other half of workers' labor were set free!

Imagine a skilled surgeon who has a marginal tax rate over 50%. Everything she pays someone else to do costs her twice as much because she pays with after-tax dollars. From a societal point of view, it is inefficient and wasteful for her to mow her own lawn, change her own oil or paint her own house, but specifically because she is in a high tax bracket, she can save more money than the average American by doing those chores herself. Another way to look at it is that without taxes, she could afford to pay twice as much to those who provide her these services.

Economist Arthur Laffer recognized that the law of diminishing returns applies to tax rates as well. According to Laffer, at a certain point, increased taxation actually yields the collection of fewer tax dollars. As we near a 100% tax rate, we approach driving commerce into the ground and collecting no taxes.

Many economists believe we are still beyond the point of diminishing returns. In other words, tax cuts would actually result in increased economic growth and more taxes being collected.

Presidents Kennedy and Reagan understood the Laffer curve well. In 1964 Kennedy reduced the top marginal tax rate from 91% to 70% and, to many people's surprise, tax revenues increased. Seventeen years later, the Reagan tax cuts reduced the top marginal rate from 70% to 50%. Again, revenues soared. Between 1980 and 1997, the share of federal income taxes paid by the top 1% rose from 19% to 33%. The share of taxes paid by the top 25% increased from 73% to 82%.

The top 1% now pays 34% of the taxes in the United States. Do you know how to join the top 1% of taxpayers? Just sell a house in California. The top half of taxpayers pays almost 96% of the income taxes, meaning the bottom half pay just 4%. These two statistics have increased despite all the complaints that tax cuts favor the rich.

Economists understand that the optimum rate of taxation is zero. The second-most ideal is as low as possible. In contrast, many Americans seem to believe that tax rates should be increasingly punitive. One notable exception is Alaska, where Tax Freedom Day arrived weeks ago on March 29.

Low taxes should not be a political issue that divides us. Every American should agree with the goal of keeping taxes as low as possible. In 2011 all of the federal tax cuts enacted since 2001 are scheduled to expire. If this happens, Tax Freedom Day will move an entire week later. In the words of John F. Kennedy, "An economy hampered by restrictive tax rates will never produce enough revenues to balance our budget--just as it will never produce enough jobs or profits."

from http://www.emarotta.com/article.php?ID=280

529 Plans Help with Estate Planning (2008-04-14)

by David John Marotta  and Matthew Illian

While many parents are struggling to fund their retirements adequately, the size of some grandparents' estates are prompting them to look for ways they can avoid paying excessive taxes. One effective estate-planning technique is using a 529 account both to fund their grandchildren's college and also help them avoid significant tax liabilities.

Families are finding it increasingly difficult to save for college. Four years costs about $55,000 at a public in-state school. With college inflation averaging 6.2% in the past decade, new parents in 2008 can expect the bill to swell to $160,000 by the time their children graduate from high school at age 18. Private schools are about twice as expensive.

Imagine Grandma and Grandpa Smith. Having come of age during the Depression and World War II, they built great wealth through an entrepreneurial can-do spirit. They are reluctant to subsidize their grown children, who already spend more frivolously than they should. But they love their grandchildren and support giving them as much of a debt-free higher education as they can achieve. And, of course, saving on taxes is a welcome benefit as well. So funding a 529 plan for each of their three grandchildren is an easy choice for them.

Investing in a college 529 plan offers several layers of tax savings. Virginia allows residents to deduct $2,000 of contributions from their 2008 state taxes. If Grandma Smith opens an account for each of the three grandchildren and Grandpa Smith opens his own accounts for each one, they can deduct $12,000 (six accounts times $2,000). Any contributions over this limit can be carried forward for deductions in following years. In 2009 the limit goes up to $4,000 a year per account. That year the Smiths can deduct $24,000, saving them $1,380 at Virginia's 5.75% rate. Saving $690 in 2008 and $1,380 per year for 17 years gives them $24,150 in Virginia state tax savings.

The Smiths can also use 529 plans to reduce their large estate. Anyone can gift $12,000 per person without being subject to the gift tax consequences. With a 529 plan, you are allowed to give five years ($60,000) all at once to get the account started by filing tax form 709.

Great benefit accrues to gifting the entire $60,000 in the first year rather than gifting $12,000 a year for five years. By putting the entire gift upfront, all of the growth is compounding completely in the child's estate. Gifting $12,000 each year leaves the remaining $48,000 compounding in the grandparents' account, exacerbating their estate-planning problem.

But gifting the entire $60,000 in the first year puts over $16,000 in extra compounded growth out of the Smiths' estate by the end of the fifth year. This extra contribution will continue to compound in each grandchild's college account for further savings. Because both the Smiths have an account for each of the three grandchildren, the extra estate exclusion by funding them upfront is $96,000. At a 45% estate tax rate, they will avoid $43,000 in estate taxes by the end of the five years.

And the tax-free compounded growth continues to provide estate tax savings. Over the 18 years before the Smiths' grandchildren go to college, the compounded growth is both tax free and out of the Smiths' estate. After 18 years of growth at 10%, their initial $360,000 investment will have removed over $2 million from their taxable estate, for a total estate tax savings of $900,706.

There is also a savings from tax-free compounding. Had the investments remained in the Smiths' accounts, the growth would at least have been subject to a 15% capital gains tax, if not higher. Avoiding this additional tax saved another quarter of a million dollars.

And after 18 years, as if to add the cherry on the top to all of these tax savings, each account will be worth $333,595. Stanford, my alma mater, currently costs more than $60,000 for four years. Growing at 6.2%, after 18 years it should cost about $180,000. With two accounts each, the Smiths' grandchildren should only be limited by their drive and academic achievement.

You might wonder why Grandma and Grandpa Smith are overfunding their 529 plans with more money than their grandchildren will likely spend on college. Any unused money can be allocated for the college expenses of future generations. Beneficiaries can be changed to the children, stepchildren, grandchildren, parents, grandparents, aunts, uncles and first cousins. After the grandchildren have finished college and gone through graduate school, the beneficiary of any existing money can be changed to their own children. The Smiths could be starting an educational dynasty with generations of tax-free growth.

The Smiths retain full control of these assets, even though they have been removed from their estate. Typical estate-planning instruments would require the Smiths to make irrevocable gifts. But with 529 plans, they can switch the beneficiary, change owners or even withdraw money for their own use if they are willing to pay the taxes and the 10% penalty on earnings. They could even make themselves the beneficiaries and enroll in classes themselves. If one of their grandchildren receives an athletic or academic scholarship, the Smiths can receive a tax-free refund up to the amount of the scholarship. And with a grandparent as the owner, a 529 plan is not considered as a resource for financial aid.

Unlike 529 savings plans, we do not recommend prepaid college tuition plans. At best, they match college inflation, and if used at an out-of-state institution, returns may not even keep pace with inflation. Virginia has several different flavors of 529 college savings plans. VEST, the Virginia Education Savings Trust, is marketed directly to the public. Another, CollegeAmerica, is offered through financial advisors. It has different share classes, some of which have loads that make them unattractive. No-load shares are available through fee-only financial advisors. The advantage of CollegeAmerica is that it allows an advisor to create his or her own asset allocation mix from a few dozen different funds.

The plethora of choices can often paralyze parents and grandparents from doing anything. To help, Matthew Illian CFP® will discuss how to evaluate college savings options at the next nonprofit NAPFA Consumer Education Foundation meeting on Saturday, April 19, 2008, from noon to 1:30 p.m. at the Northside Library Meeting Room in the Albemarle Square Shopping Center. To learn more about the NAPFA Foundation, visit <a href="http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm" target=_blank>http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm</a>.

 

from http://www.emarotta.com/article.php?ID=279