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

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

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

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

Decide to Be Rich (2008-04-07)

by David John Marotta

It used to be that becoming a millionaire was regarded as a huge achievement. In today's dollars, however, it is fairly trivial. According to the Department of Labor's inflation calculator, $1 million today was worth only $183,285 in 1970. But $1 million in 1970 had the same buying power as $5,456,005 today.

That's the new rich: over $5 million.

Depending on your lifestyle, if you have amassed $1 million at age 65, you may not even have enough to retire. At age 65, you can withdraw only 4.36% of your assets each year to ensure you don't deplete your savings before you die. So if you are just a millionaire, you must be able to live on an annual income of $43,600. And if your lifestyle demands twice that amount, you don't have enough money to retire yet.

Many of our parents and grandparents were fortunate enough to have pension plans that continued to pay their salary in retirement. Even though they never had a large investment account, those guaranteed benefit plans were extremely valuable. A pension paying $43,600 a year starting at age 65 is worth $1 million in the bank. Our parents and grandparents were truly millionaires, although they didn't know it!

But the days of defined benefit plans are over. Most employers today provide defined contribution plans. They define the amount they contribute to your retirement, usually in the form of matching dollars, and you are responsible for saving a sufficient amount and investing it wisely. Thus employees must amass $1 million for every $43,600 they'll need when they retire.

Want a higher lifestyle? Save $1.5 million and you can spend $65,400 each year. Save $2 million and you can spend $87,200. At $2.5 million you can spend $109,000. So don't think people with a big income don't have to worry about money. Those accustomed to a high lifestyle can find it very difficult to save enough to retire.

All this information leads us to the most important lesson about wealth. You can live rich or you can be rich. Many people live as though saving and investing wealth is wrong. Yet consider the alternative: Is spending every dime you earn virtuous? Isn't it better to produce more than you consume? Isn't it preferable to consume less and therefore have more wealth that you can invest and put to work creating jobs and producing goods? After all, the economic definition of capital is deferred consumption. Can you put off spending or decline to consume long enough to create investment capital that creates factories, businesses and jobs so others can benefit?

Consider two families with identical incomes. Family A lives rich, buying high-definition TVs, indulging in luxurious vacations, dining out frequently, and so on. Family B chooses to save and invest instead. Which family is wasteful and addicted to wealth, the family that is living rich or the one that is growing rich?

Family B may live simply and modestly below their means during their entire working careers. Amazingly, for every $100 a month they save and invest at 10%, they will have $1 million more when they retire. The two families may have the same income, but Family A spends $250 each month on a richer lifestyle and Family B retires with $2.5 million in assets. Interestingly, one of them we encourage, help and support and one we envy, tax and ridicule.

The members of Family A who have lived rich will have no assets at retirement and will further strain the Social Security and Medicare systems. We perceive them as the truly needy when in fact they have lived life as the truly greedy. They could have taken care of themselves, but instead they burdened society simply by ignoring their retirement.

To add insult to real societal injury, these same people often claim they just don't care about money. They are above amassing wealth and instead just live to enjoy themselves. If they truly were indifferent about money, however, they would be able to live on 15% less than their take-home pay and save and invest the difference.

A couple we know just retired with $2.5 million after working and earning quite modest salaries. They lived simply and practiced frugality. Nothing was wasted. They waited a few years before purchasing the latest technological gadgets and then bid for them on eBay. They made do or did without. They grew rich by shopping at sales and avoiding impulse buying on credit.

Now that they have managed to save $2.5 million, however, some of the presidential candidates have suggested increasing the tax on investment gains to 28%, rather than taxing the consumption of those living rich. That will mean if your investment assets earn an 8% return, you will be unable to make any progress toward your goals. Five percent of your return will just keep up with inflation, and you will owe 2.24% for a 28% capital gains tax. You would only be left with a 0.76% real return after taxes and inflation.

We won't be able to help the truly needy until a majority of Americans realize they are part of the problem. People's failure to save for their retirement stresses our governmental programs with those who ought to be multimillionaires. Saving just a few hundred dollars a month over your working career makes the difference.

No matter what your income, a similar family is living off half of your salary and still saving more than 15% of their take-home pay. Another family is earning twice what you earn and struggling to make ends meet. Nearly every family we work with wishes they had an extra $10,000 a year to make life easier.

Because of inflation, the gap between the rich and the poor is growing. If $5 million today is less than $1 million in 1970, the absolute dollar difference between the rich and the poor has to be at least five times greater. The poor always have zero.

Greg Mankiw, a professor of economics at Harvard, offers an interesting analysis (gregmankiw.blogspot.com): "If we compare the incomes of the top and bottom fifths, we see a ratio of 15 to 1. If we turn to consumption, the gap declines to around 4 to 1. Let's take the adjustments one step further. Richer households are larger--an average of 3.1 people in the top fifth, compared with 2.5 people in the middle fifth and 1.7 in the bottom fifth. If we look at consumption per person, the difference between the richest and poorest households falls to just 2.1 to 1."

That's the difference. The richest 20% in America live 2.1 times more extravagantly per person than the poorest 20%.

Another study by Steven Landsburg shows that leisure used to be evenly divided among the classes, but it isn't any longer. Although Americans as a whole have an extra four to eight hours of leisure per week (or about seven extra weeks of leisure per year), this extra leisure has not been gained evenly. About 10% have no more leisure than they did in 1965. These hard workers, it turns out, are highly educated and have had the largest gains in income. At the other extreme, about 10% have gained 14 hours a week or more (over 18 extra weeks of leisure per year). These excessive gains in leisure have gone, oddly enough, to those who are the least skilled, least educated and have the most stagnant incomes.

It used to be the leisure rich or the idle rich. Now it is the working rich and the idle poor.

Many believe it is OK to redistribute income but would consider it absurd to redistribute leisure. It turns out there really is little difference.

Decide to be rich. Your retirement, and the country's welfare, depends on it.

from http://www.emarotta.com/article.php?ID=278

Ignore Daily Financial Noise (2008-03-31)

by David John Marotta

Investors are fickle. Investing should not be.

Even with a brilliant investment plan, it takes diligence to overcome emotional biases and avoid making investing mistakes. Naturally you love it when your portfolio values go up. But when they go down, even slightly, you may be tempted to make poor choices. Here are some reminders to help you resist succumbing to the fallacies of behavioral economics.

Psychologists suggest we feel a loss about 2.5 times as much as an equivalent gain. This "loss aversion" phenomenon means that even we see an equal number of ups and downs, we still feel miserable. Daily market movements are nearly always noise. Only 52% of daily movements are positive. Because the negatives feel worse, your average day could feel 68% negative. Quarterly odds of satisfaction are 62% but still feel 13% negative. But if you discipline yourself to look at annual numbers, you get 77% odds of happiness, and when you analyze 3-year, 5-year, or since-inception returns on your reports, it will make you even happier.

You may believe you have a high risk tolerance when the markets were going up, only to regret being in when they go down. You also remember your uneasy feelings just before the markets dropped and forget you had the same ones just before the markets went up. All this leads to a false confidence in your own ability to predict what will actually happen and possibly a weakening confidence in your financial advisor's skills to see the obvious.

Research repeatedly shows that jumping in and out of the markets reduces returns. But some people persist in believing that if they just had enough information, they could predict what, in reality, only seems obvious after the fact.

Remember to ignore daily financial information. Most so-called news is just noise; we call it financial pornography, which includes everything from CNBC to the nightly news.

The markets are inherently volatile, but until recently they have been well behaved. Between 2004 and 2006, the S&P 500 moved up or down by more than 2% on only two days. Since mid-2007, we have had 27 days over 2% and market volatility has returned to historical averages. Between 2004 and 2006, the S&P 500 moved a daily average of only 0.51% compared with a historical average of 0.75%. Since mid-2007, volatility has been slightly above average at 0.99%. You must remember that such volatility is normal.

Every January 1, sometime during the year we will have a foot of snow in a week, 6 inches of rain in another week, and a 5% to 10% market drop in one month. It is almost beyond commonplace. But the snow always melts, the rain dries up, and the equity market resumes its great long-term uptrend.

The markets are inherently volatile but also inherently profitable. It is prudent to diversify for safety and stay invested for long-term growth. So although we don't know the markets won't go lower (no one does), don't let your short-term emotions trump an effective long-term strategy. Remember that strong long-term investment returns do help, but the best way to achieve your financial goals is to moderate spending and stay on track with savings.

You can resist the temptation to overgeneralize or to succumb to the random noise with these two simple rules. First, a diversified asset allocation with a fiduciary financial advisor sitting on your side of the table ensures the best chance of meeting your goals. And second, don't forget to relax and enjoy life at least 364 days out of each year.

from http://www.emarotta.com/article.php?ID=277

Gold Mining Companies Glitter More Than Bullion

Last week gold broke $1,000 an ounce. Gold advertisers and gold investment newsletters are touting their wares as though gold only goes up in value. Nothing could be further from the truth. Gold may glitter, but it is still better to own the mine.

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 directly in raw commodities or their volatility, whereas buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power, and the goods and services we buy cost more. Commodities as an asset class generally maintain their buying power in terms of dollars. Stocks as an asset class, in contrast, generally appreciate over inflation after factoring in dividends. And recently, hard asset stocks such as precious metal mining companies have been appreciating nicely.

Jeremy Siegel, author of the book "Stocks for the Long Run," analyzes investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be worth $1.07 today. Because of inflation, a dollar today would only have had the buying power of about 7 cents back then! However, the stock market, on average, has been appreciating about 6.5% over the long-term rate of inflation. Hard asset stocks give you the best of both worlds: the stability of a real asset plus higher market returns.

The beauty of hard asset stocks is that they are not highly correlated to U.S. large-cap stocks as a whole. The correlation between the Goldman Sachs Natural Resources Index and the S&P 500 Index is only 0.49. Importantly, the correlation between the Goldman Sachs Natural Resources Index and the Lehman Aggregate Bond Index is even lower at –0.26. A negative correlation means that bonds and natural resources, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk that inflation poses to a bond portfolio.

Natural resource companies sell valuable tangible commodities. Thus their earnings are tied to inflation because their resources are worth more as the dollar declines in value. This situation can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

Consider a gold mining company in 2001 whose expenses and overhead allowed it to pull gold out of the ground for $290 per ounce and sell it for $300 per ounce, making the company a $10 per ounce profit. As the price of an ounce of gold rose 3.3% from $300 to $310, the company's profit doubled from $10 an ounce to $20 an ounce--a 100% jump--which caused the company's earnings and stock price to soar. Now that gold is more than $1,000 per ounce, the current price level of gold stocks is much higher than it was in 2001.

Therefore, we segment hard asset stocks into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks generally correlates less with the movement of other asset classes such as bonds. Second, hard assets react in a unique (and positive) way to inflationary pressures. And third, in certain periods in the longer term economic cycle, including hard assets helps boost returns.

Direct investments in gold react a little differently, however. The correlation between the price of gold and the S&P 500 is nearly zero, lower than hard asset stocks at –0.02 instead of 0.49. But the correlation between the price of gold and the Lehman Aggregate Bond Index is also nearly zero at 0.09 instead of –0.26. In truth, the price of gold does not fluctuate with investments because it is simply holding its value.

But although it is true that gold generally holds its purchasing value, it still fluctuates wildly based on other factors of supply and demand. While it does so, the part of these movements that is not just random noise is simply an inverse reaction to the value of the dollar.

In January 1980, gold reached its high of $850 an ounce. The following year my wife and I became engaged and chose modest wedding rings that were still very expensive. Note that $850 in 1980 had the same buying power as $2,184 in today's dollars. Gold trading at $850 an ounce then was like gold trading at more than twice its current price. Those people who purchased gold in 1980 have lost over half their buying power during a 28-year investment.

In August 1998, gold reached its low of $356 an ounce. So those who had invested 18 years earlier at $850 an ounce had lost 79% of their purchasing power. By 1998, an ounce of gold should have been worth $1,682 just to keep up with inflation, but instead it had dropped dramatically.

A small percentage of your portfolio should be in precious metal mining companies. It provides a balance to your portfolio that you cannot gain by investing directly in gold.

Here are three mutual funds we have used for investing in precious metal mining companies. We look for a low expense ratio, a turnover ratio of under 50% and returns that capture the lion's share of the sector's returns.

Vanguard Precious Metals and Mining (VGPMX) earned 36.13% during 2007 and has had an annualized return of 35.28% for the past five years. It is up 12.74% for the first two months of 2008. It has an expense ratio of 0.35% and a turnover ratio of 24%. Although closed to new investors, VGPMX is probably one of the best funds.

U.S. Global Investors World Precious Minerals (UNWPX) earned 23.02% during 2007 and has had an annualized return of 36.66% for the past five years. It is up 15.05% for the first two months of 2008, with an expense ratio of 1.01% and a turnover ratio of 54%.

American Century Global Gold (BGEIX) earned 15.12% during 2007 and has had an annualized return of 20.53% for the past five years. Although it underperformed relative to other funds last year, it is up 16.52% for the first two months of 2008. It has an expense ratio of 0.67% and a turnover ratio of only 3%.

Because of the negative correlations, our firm uses these investments and others in this sector for a small percentage of a balanced portfolio. Diversified and negatively correlated investments can help your portfolio maintain its equilibrium when the U.S. markets are losing money.

from http://www.emarotta.com/article.php?ID=276

Life Insurance: Determining Your Need

You may have heard that "Life insurance is a gift of love." But if you bought a $100,000 whole-life policy because you wanted to build some cash value when you should have bought a million dollars of low-cost term insurance to meet the survival needs of your family, your well-intentioned effort was not an act of love.

Objective life insurance advice is hard to find. Prior to joining the National Association of Personal Financial Advisors (NAPFA), Bob Arms, CLU, ChFC, AIF®, coauthor of this week's column, sold life insurance for 26 years. He is currently licensed as a life insurance consultant, a fiduciary whose legal obligation is to represent the client first.

The first step toward representing your best interests entails an in-depth discussion of how much life insurance you might or might not need. The formula is Future Financial Needs minus Current Assets equals Your Current Risk. How much you want to provide for your loved ones should you predecease them (A) minus how much you have that could be used to provide for the survivors (B) equals your surplus or shortage (C).

To the extent that a gap exists between your financial needs and your current assets, life insurance is the most efficient product available to provide tax-free dollars exactly when you need them. As you go through the life changes of marriage, children, and career, you should recalculate your need and revisit the life insurance you own.

When members of a young family are making a decision about life insurance, six line items are significant.

1. Debts: The baggage of debt makes the journey toward financial success difficult. Avoid debt if possible, but if you have any, don't burden your family with it after you are gone. Being able to liquidate all credit card debt and car, home equity, and personal loans will give your surviving family the best chance at success in life.

2. Mortgage: Carrying a long-term fixed-rate mortgage keeps more money invested in the markets and qualifies you to enjoy a tax deduction on the interest. Leverage is a popular financial strategy of the rich. But if you would sleep better at night without a mortgage, sleep is more important. Either way, you need enough insurance or investments to pay off the mortgage.

3. Educational and child-care expenses: Depending on the age of your children, multiple expenses must be considered. If your children are preschoolers, the cost of child care may make it impractical for the surviving spouse to return to work. Consider the math. When the children are school age, will you want them to attend private school? Call the schools in your area and work the numbers. What percentage do you want to help with college? In-state tuition, room, board, books and transportation for college presently averages $6,185 annually. Private schools cost about $23,712 per year. Which do you want to fund?

4. Final expenses: Include a small amount for your funeral, approximately $10,000. The average funeral today costs $5,000 to $7,000, but expenses can exceed $10,000.

5. Family income: Estimating a young family's income needs is very challenging. To ease the mental strain, use seven times your adjusted gross income as a rule of thumb. A more accurate prediction requires either a financial calculator or a computer program.

6. Emergency fund: No one can forecast the exact amount a surviving family will actually need, but this category does absorb a potential miscalculation. Most gaps are filled by using 10% of the total of the other five line items: debts, mortgage, education, final expenses and family income.

Now that you have an estimate of how much your family needs, compare the total with your current assets. Include only the assets the surviving spouse can use for expenses. So do not include your house because your spouse needs someplace to live; your car because transportation is essential; or your retirement assets, which the surviving spouse will need during retirement. Nor should you count any inheritance. The old adage is true: Don't count your chickens before they hatch. This category is the total of your current life insurance and all investment assets.

The easiest math remains: Your Total Future Financial Needs minus Your Current Assets equals The Current Risk you may want to insure against. To determine how much life insurance the other spouse should carry, trade places as the first to die and rerun the numbers. Clearly, if the bottom line is positive, you've done something right and either you have enough life insurance or you are self-insured. Congratulations. If the bottom line is negative, thankfully you still have time to take action.

Financial planning is a lifelong process that covers multiple areas, including investments, insurance and taxation. Reviewing all of your financial affairs periodically with a trustworthy advisor who sits on your side of the table will ensure that you achieve your financial goals.

For more information about life insurance--how to shop for it, what to buy, what to do with what you have or other questions--you are invited to attend the NAPFA Consumer Education Foundation meeting. Bob Arms, CLU, ChFC, AIF®, will present a talk, "Straight Talk about Life Insurance," on Saturday, March 22, noon to 1:30 p.m., at the Northside Library in the Albemarle Square shopping center.

For more information, call (434) 244-0000 or e-mail charlottesville@napfafoundation.org. To learn more about the NAPFA Foundation, visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm. All presentations are free and open to the public. You are encouraged to attend and to bring your financial questions.

from http://www.emarotta.com/article.php?ID=275

Remember to Fund Your Roth IRA (2008-03-10)

by David John Marotta

If you are eligible, make sure you fund your Roth IRA or your Roth 401(k) this year with the maximum contribution possible. It may be your last chance to pay a reasonable tax rate before the prevailing winds of class envy swamp your retirement sailboat.

Although a traditional IRA and a Roth IRA share some features, they differ significantly in the way they are taxed.

Money put in a traditional IRA comes out of your paycheck before paying taxes, so your contribution reduces your taxable income this year. Traditional IRA investments grow tax free. But you must pay ordinary income tax rates when you take the money out in retirement, on both what you contributed and on the growth in the account.

In contrast, the money you put in a Roth IRA comes out of your take-home pay after you have paid taxes. So your contribution does not reduce your taxable income this year. Like a traditional IRA, your Roth IRA investment grows tax free. But because you have already paid tax on the money, in retirement you won't be obligated to pay any additional taxes.

So you can pay now on what you contribute to a Roth IRA, or you can pay later on the value that has accrued in your traditional IRA.

The standard wisdom favored funding the traditional IRA. Assuming your tax bracket would be lower in retirement, it thus would be advantageous to avoid the higher tax rate now and pay at the lower rate later. But for many retirees, this advice has proven misguided.

Employees typically contribute to a traditional IRA or 401(k) from the day they start working. Of course their starting salary is relatively low compared with what they earn later in their career. Thus an increasing number of employees find themselves in a higher tax bracket during their retirement than they were when they were contributing to a traditional IRA or 401(k). This phenomenon has produced some strange economic results.

Some workers have lost money, but the government has gained. As people have contributed to their traditional IRAs and 401(k)s, the government has given up a little revenue. But workers have invested that small amount and grown their money, thanks to the magic of compounded returns. Now the government is anticipating a windfall of taxable income as the baby boomers withdraw these investments during retirement.

The good news for the government is that budget projections do not include any of these retirement withdrawals. Thus taxes on traditional IRA distributions should cover about a third of the existing federal deficit.

But it's not your job to help the government get out of debt. Tax rates today are at an all-time low, but the political climate makes tax hikes much more likely in the next administration. Kennedy lowered the top marginal rate from 90% to 70% in 1964. Then Reagan lowered it from 70% to 50% in 1981. And in 2003, Bush lowered the top rate from 39% to 35%. Historically, income taxes have not been this low since 1931. So pay as much tax now as you can and fund a Roth IRA rather than deferring your taxes until later when the rates are higher.

As long as you (or your spouse) receive a paycheck, you are eligible to open a Roth IRA. Account owners may contribute $4,000 per year in 2007. Contribution limits rise to $5,000 in 2008. All account owners age 50 and older are permitted an additional catchup contribution of $1,000 annually.

Unlike a traditional IRA, you are not obligated to begin required minimum distributions at age 70½. As a result, a Roth IRA can help fund the end of your retirement.

And if the tax benefits of a Roth IRA aren't enticing enough, the estate-planning benefits are amazing. Leaving a Roth to your heirs can be likened to setting up a lifetime tax-free stream of income. Because Uncle Sam has already taken his cut of the principal when you put the money in, withdrawals can be made tax free, either by you or by your beneficiaries.

With a traditional IRA, you must begin distributions at age 70½, whether you need the cash or not. But when you do this each year, you put the brakes on the snowball effect of compounding interest. Plus your required withdrawals deplete the account, making it difficult to control what you actually leave to your beneficiaries.

A Roth can help you keep more of your money by sheltering your investments from capital gains and from minimum distribution requirements during your lifetime. Spouses who inherit a Roth can also forgo taking distributions, preserving the account's ability to grow unchecked year after year.

Only when members of the next generation inherit a Roth IRA must they begin taking distributions, and then they are withdrawn based on the beneficiary's age. By taking the smallest required distribution each year, the beneficiary achieves the maximum tax-free growth of tax-free income.

No traditional IRA can offer that kind of benefit to your heirs. If they were to inherit a traditional IRA of equal value to a Roth, the former would run dry long before the latter. The required minimum distributions for a traditional IRA are based on the original owner's age, not the beneficiary's, so required withdrawals are larger in the next generation. Also, because taxes are due on withdrawals from a traditional IRA, larger amounts must be taken out to match the tax-free sums taken from the Roth. Those hefty withdrawals from the traditional IRA eventually drive it to zero. Meanwhile the Roth account would still be growing and withdrawals could continue to be made.

If you already own a regular IRA, you may have the option to convert it to a Roth. You pay taxes now so your beneficiaries won't pay later. Even if you inherited a traditional IRA from your spouse, it is still not too late to convert to a Roth.

Converting may be a smart move, especially if you plan on leaving more than $2 million to your heirs. Paying taxes for the conversion will mean you reduce the size of your estate and thus its tax liability. Your heirs will pay less estate tax, and they will inherit a tax-free income stream.

The option to convert to a Roth currently is limited to those with an AGI less than $100,000. If your income exceeds that number, current law does not allow Roth conversions to all Americans until 2010. By then, significant tax hikes may have been implemented.

A Roth in itself cannot provide a complete answer to your estate-planning needs. Seek the advice of a financial planning professional who can provide you with a comprehensive financial plan. To find a fee-only financial planner in your area, visit <a href="http://www.napfa.org" target=blank>www.napfa.org</a>.

from http://www.emarotta.com/article.php?ID=274

Loss Aversion (2008-03-03)

by David John Marotta

Even with a brilliant investment plan, it takes diligence to overcome our emotional biases and avoid making investing mistakes. Here is the wisdom that both advisors and investors need to bear in mind to avoid succumbing to the fallacies of behavioral economics.

It doesn't take extensive research to determine that we are much happier when our portfolio values go up. When they go down even slightly, however, we are tempted to make poor choices. To avoid these unfortunate choices, we need reassurance and a sense of how our instincts can deceive us.

The tendency to experience significantly more discomfort with slight losses than to experience happiness with large gains is called "loss aversion."

Psychologists suggest we feel a loss about 2.5 times as much as an equivalent gain. That means if you see an equal number of ups and downs, you feel miserable. You feel some pleasure when the markets move up and a great deal of pain when the markets move down. But most of the daily and weekly fluctuations in the markets are just random noise.

Therefore, the more frequently you look at the markets, such as daily or weekly, the more discouraged you get. And even if you have a well-crafted investment strategy, you may be tempted to make changes in order to alleviate your suffering. Every study shows that loss aversion actually causes greater than average losses.

Consider that over the past decade, the daily movement in the markets was positive only 52% of the time. That means if you watched the markets every day, you were content on 190 days and despondent on 175 days. Because you grieve the down days 2.5 times as much as you celebrate the positive ones, on the average day you're glum, and instead of remembering the reality that the markets dip 48% of the time, you feel as if they go down 70% of the time.

If you only look each week your odds of happiness rise slightly to 54%, but your misery remains low, still feeling like they go down 68% of the time. The monthly odds of happiness are 62%, but you still like they go down 64% of the time. Quarterly returns go up 68% of the time, but your average emotions tell you they only go up 55% of the time.

Even though the vast majority of calendar quarters in the market are positive, it is the shortest time period in which, on average, we won't be disappointed. Only if you can refrain from looking at the markets for an entire year, will you be more likely to feel satisfied. Annually you get happy news 77% of the time, although you only perceive it as 62%.

These are the best case scenarios, assuming you have an outstanding investment plan. You may feel much worse whether you have a poorly designed portfolio or a well-designed one. Here’s why.

A poorly designed portfolio is typically laden with fees and commissions, putting a drag on your returns. It may also be inadequately diversified and oscillating with an even higher noise-to-performance ratio than necessary. In this case, your odds of happiness are slim indeed.

But even if you have a well-designed portfolio, your may feel unsettled. Being diversified means always having something to complain about. You must recognize the difference between a poorly designed portfolio and a well designed portfolio. You must know when to heed the warning signs and when to ignore the noise.

If you own a handful of mutual funds that are commission-based A, B or C shares, you probably have a reason to be discouraged. If that is the case, first set a diversified asset allocation that has the best chance of meeting your goals with a fiduciary financial advisor who sits on your side of the table. And second, relax and enjoy life 364 days out of each year.

from http://www.emarotta.com/article.php?ID=273

by David John Marotta

I've decided to run a mock campaign for president again as a forum to talk about public policy. Every four years I look for a candidate who understands economics, only to find politicians instead. My political bias, like many economists, leans toward freedom. The unintended consequences of much of our legislation result in great harm to the economy and to people's livelihood. If elected, I promise to do less harm.

Lots of polls are out there supposedly to help us choose a candidate. I hate them all. They inevitably ask a battery of two dozen questions dealing with issues I don't care about and only vague questions about the ones I do. As a result, these polls are as useful as recommending I vote for a candidate because we like the same flavor of ice cream.

From helping people from all walks of life with their family finances, I've discovered that the most successful people recognize that their financial future mostly depends on actions under their own control. The best way for people to achieve their financial goals is to moderate spending and stay on track with a savings plan.

The issues I consider of primary importance are those that interfere with everyday families becoming self-sufficient. Unfortunately, these are not the issues that voters seem most passionate about. But they should be. Issues such as the capital gains rate determine if we will be able to save toward retirement or not.

Saving and investing just a dollar a day over your working career produces $400,000 at retirement. Saving $2.50 a day produces $1 million at 11% after 45 years. Obviously, most families don't save at all. They are struggling because of the choices they make. Financial planners encounter this problem so often, it's been dubbed "the latte effect." People spend $2.50 a day on lattes rather than becoming millionaires.

Being a good citizen means first and most importantly to produce more than you consume. This will ensure you can take care of yourself. It will also mean you can be charitable and give to the truly needy. You, however, are not the truly needy. Odds are there are people getting by just fine earning half of what you bring home. Don't succumb to envying those who make more than you. At the same time, embrace the virtue of compassion for those who make less.

The previous few generations did not accrue much in savings, but they did have defined pension plans for their retirement. A pension paying $75,000 a year is equivalent to having a $1.7 million portfolio for your retirement. As we all know, however, the days of defined benefit plans are largely over. We need to grow our savings to more than $1 million simply to fund a modest retirement. The government can help us reach that goal by eliminating the capital gains tax.

Every economist worth his PhD agrees that the correct rate for the capital gains tax is zero, zip, nada. Some have even suggested the optimum tax rate for capital gains is negative! Unfortunately, all the 2008 presidential hopefuls (except for me) who would reduce or eliminate the capital gains tax have dropped out of the race.

Certain proposals regarding the capital gains tax are totally unrealistic. Some would like to impose ordinary income tax rates on capital gains; others want to raise the rate to 28%. Many people divide the nation between those who have an adjusted gross income over $75,000 and those who do not. All of the suggestions just described will dissuade Americans from saving and investing, the very activity we should be encouraging.

Under these rules, if your investment assets earn an 8% return, you will be unable to make any progress toward your goals. Five percent of your return will just keep up with inflation, and you will owe 2.24% for a 28% capital gains tax. You would only be left with a 0.76% real return after taxes and inflation. And at ordinary income tax rates, your return would be even more dismal. At these rates, everyone with taxable investments in the market would do better to pull their money out and buy municipal bonds and Treasuries.

Hopefully there isn't a chance these policies would be implemented, but I use a candidate's views on economic matters to judge his or her competence. I find this year's choices particularly discouraging.

We need an incentive to save and invest in order to create an economic environment that encourages the hard work and risk taking that pays everyone's salary. Investment is simply capital, and capital is simply deferred consumption. Why defer consumption if you are penalized for it?

Investment is what builds the factories, businesses and entrepreneurial endeavors that actually make money. Investment stimulates the economy, and as the economy grows, jobs are created and real wealth is produced.

The prospects for our Social Security system look bleak. There won't be enough money to support the number of retirees. Chances are only the worst off will receive anything significant from current funding. Now the political winds are blowing to make saving and investing for your own retirement much more difficult. It seems as though "fair" is being redefined as everyone being impoverished and reliant on the government.

Without incentives, we may as well all go have another latte.

from http://www.emarotta.com/article.php?ID=272