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A Monthly Newsletter Source of Financial Sources • Data Shows It’s Better to Err On the Side of Safety in Investing. • Recent REIT Volatility Makes Other Private Placement Real Estate’s Greater Yield and Lower Volatility More Attractive for Patient Investors. • Trading Gone Wild: The impact on investors of mutual fund diversification requirements and the redemption process. • 401(k) Rebalancing: Unguided Missiles • 16 Strategies for Saving Estate Taxes #5 – Intentionally Defective Trusts. • Modest Family Foundations Work When Donors Want Hands On Involvement in Changing a Small Part of The World LIFE PLANNING/PERSONAL FINANCE • Pay Attention to the Non-Financial Issues on Planning Retirement. • Confronting Performance Issues Helps Cement Client Relationships. Data Shows It’s Better to Err On the Side of Safety in Investing. Missing returns during an up market will not kill you -- but being invested in a buy and hold portfolio when the market collapses could and does permanently alter retirement plans. A certain group of pre- and post-retirees have been hit by a double whammy, twice in the last eight years as they have watched their portfolios pile up losses. And now they either need to retire on less capital, or they were retired and have been spending down their capital to live. The recent market drop has had a negative impact on portfolios if Boomers entrusted all of their assets to a firm that sought to meet or exceed the S&P 500 index through diversification. Many of these investors also experienced the last worst-case scenario in 2000. They must now withdraw from their accounts for living expenses and draw down on their twice-depleted capital significantly. Many financial advisors depend on diversification to solve the problem of protecting assets during a market downturn, but that approach has drawbacks. If the focus is primarily on returns, i.e. a portfolio with a heavy emphasis on equities, there can still be significant downside risk. If the emphasis is placed on safety, i.e. a larger allocation to fixed income, there is a loss of returns (and still some downside risk). Returns might be acceptable relative to a particular index benchmark like the S&P 500, but relative returns do not pay the light bill. The investment industry has focused on relative returns but most individual investors are focused on absolute returns. In fact, the media made much recently of the fact that portfolios that had lost value in 2000 had finally broken even seven years later. Now those same investors are forced into the same waiting game as they wait for their portfolios to get back to go. Recent retirees however don’t have time to wait. Those retirees who understood that it is all about winning by not losing are in good shape by any comparison. PMFM, Inc, a money manager based in Watkinsville, Georgia proved the wisdom of this winning by not losing philosophy when they were able to post a positive return in each year of the 2000-02 bear market. As a result, their 10 year performance has exceeded the return of the S&P 500, while their beta is closer that of a portfolio with 40% in fixed income. That same philosophy has been of great benefit to their clients more recently also. The PMFM Managed Portfolio Trust (ETFFX), following a tactical asset allocation strategy, went to all cash in November and has protected its client’s assets against much of the recent downturn. (See chart below).
The goal of the fund is to win by not losing. Usually, when the market goes down it’s just a short-lived correction and recovery doesn’t take too long. But sometimes the correction turns into a full-fledged bear market and the losses can become severe. Every correction doesn’t turn into a bear market, but every bear market starts as a simple correction. That is why PMFM treats each correction seriously by becoming more defensive and shifting the portfolio to cash. If it turns out to be nothing more than a correction they will reinvest when it is a clear the upward trend has resumed. Using this strategy, PMFM has saved clients from some pretty nasty drops in the market, and while in cash, their portfolios were inching higher in money market investments. In the first two instances of market drops shown on the attached chart, the market went back up quite quickly. PMFM clients were protected in case either of those two market drops turned into bear markets. “Using 20/20 hindsight we know that oftentimes when we move to a more defensive position it turns out to be unnecessary” says Tim Chapman. “That’s okay. It’s o.k. to be wrong; the key to success is that we won’t stay wrong. And it’s especially okay to be wrong if we’re erring on the conservative side. We treat every correction as if it were the beginning of a bear market. The key to success is don’t stay wrong,” he says. In both instances shown on the chart, PMFM assets were reinvested and portfolios made gains. There is a psychology for most investors where they allow themselves to stay in the market and ride it all the way to the bottom. “We don’t want our clients to get trapped in bear markets,” says Chapman. Tim Chapman is the co-founder of PMFM/401kToolbox, Watkinsville, Georgia, The firm has more than $1 billion in assets under management.and provides tactical asset allocation money management and managed account services for client and 401(k) plan participants PMFM has a lengthy history of good risk-adjusted performance.
Tim can be reached at 800-222-7636 or tim.chapman@pmfm.com Recent REIT Volatility Makes Other Private Placement Real Estate’s Greater Yield and Lower Volatility More Attractive for Patient Investors. Currently, private, direct real estate investment typically generates higher current yields than REITs. As of the end of January, NAREIT reported that equity REITs were yielding slightly under 5% while direct private investments in real estate were available at 6, 7, or 8%. For any two investments with the same internal rate of return (IRR), the one where more of the return comes from yield will inevitably be less volatile. This does not explain the sudden increase in REIT volatility though. Since the value of the underlying real estate has fluctuated but has not been fluctuating wildly, the likeliest cause for the recent REIT volatility was the new investors in the sector. In the last few years REITs had increased in price quite violently, generating total returns of 38% 9% 25%, and 31% before taking a 26% hit this last 12 months. Those very rapid increases seem to have attracted many new investors in very large volumes who were seeking IRRs that real estate simply cannot sustain. More yield-driven private placement investors who were willing to sacrifice liquidity for their higher dividends did not expect unreasonable IRRs and were not as likely to be terrified when the impossible did not occur. Even today, after the recent REIT debacle, those more patient investors are achieving current yields substantially in excess of what they can get from REITs, though at the price of much less liquidity. Commercial and residential real estate have been a fairly slow-moving target for analysts. The demand side, driven primarily by population growth, employment, and consumer purchasing has varied at the margin, but the long-term trend based on population growth has been steadily upwards. On the supply side there have been periods of overbuilding, notably in the late 1980s. But it takes a long time to buy land, get zoning and permits, finance and build a new property. In the last twenty years the commercial and multifamily rental financing spigots were turned off well before too much damage was done, with the clear exception of single family homes whose demand and finance drivers are quite different. This explains why from the 1970s through about 2004, REITs typically offered investors as much as 40% less volatility than the S&P. Lately that has gone haywire, and at times in the last few weeks REITs have generated 3 and 4 times as much volatility as the S&P and other mjaor indices. At the same time private market values for commercial and residential real estate have fluctuated much less. Millennium Credit Markets, LLC, headquartered in Rockefeller Center, New York is an affiliate of United Group of Companies. Contact: Michael Dowd, Senior Vice President, 781-264-2678, dowdboston@aol.com, www.ugoc.com Trading Gone Wild: The impact on investors of mutual fund diversification requirements and the redemption process. Too much stock trading within mutual fund portfolios not only wounds, but pours in salt afterwards. There are two poorly designed pieces of machinery under the hood of every mutual fund: diversification requirements and the redemption process. Both of these force money managers to sell stocks that they would rather hold, causing funds to choke and splutter. In order to perform well, portfolios need both solid net performance and minimal taxes. By forcing stocks within the fund to be traded, diversification requirements and the redemption process strip mutual funds of both. Legal restrictions force mutual fund managers to sell the best performing stocks in their portfolios. By law, most stock positions can represent no more than 5% of the entire portfolio; therefore, when a stock starts to soar, the manager must begin selling it off. These diversification requirements were put in place over 60 years ago; they have not been updated since. Now, consider that the average modern mutual fund holds 130 stocks in its portfolio. Here, the old regulation becomes counterproductive. It flattens the potential for gains from stocks that outperform the market, since the companies hitting the long balls must be sold off right away. The large collection of underperforming stocks dilutes the strong performance of companies with aggressive growth. By adhering to the unreasonably small percentage limit of 5% per company, mutual funds twist the value of diversification into the vice of dilution. The 5% rule will only affect the best stocks in the portfolio. Since the stocks that have appreciated most are the ones that must be sold, trading to met diversification requirements means larger capital gains taxes, too. These taxes are spread out indiscriminately to all investors in the fund, whether they have been invested for years or days. When an investor wants to bail out of a mutual fund, he cashes out of his shares and redeems them, at their net asset value, for cash. The cash comes from cash on hand and from the sell off of stocks in the portfolio. Each of these activities drives down the performance of funds and the sell off increases the investor’s tax bill. The cost to the investor is that of lost opportunity. Cash that you assumed was at work in the market is actually sleeping on the sidelines, stashed away for future redemption requests. When there is a run on redemptions, managers liquidate stocks in order to obtain the extra capital needed to redeem shares for investors who bail out. Since investors are most inclined to want out in a down market, money managers have no choice but to sell stocks at low prices. Your money manager is powerless in the face of mounting redemption requests. The managers must sit and watch buying opportunities pass them by. Just when they want to hold what they have and buy other stocks at good prices, the manages are often prohibited from purchasing any additional stocks while they sell off what are often massive amounts of their portfolios. Selling when you would rather buy is a losi9ng proposition. But the beating that the fund’s net performance takes by forced selling is compounded by the capital gains tax suffered by everyone who remains in the fund. Of the many shares the manager has to sell, some will have appreciated in value. In each of these cases, every investor who stays will pay capital gains tax, even if the fund as a whole has lost value. Tim Decker, President, ISI Financial Group, Lancaster, PA, is a fee-only financial advisor providing comprehensive financial advice and retirement planning. He is the author of the soon to be released book “The Sleep At Night Investor”. He can be reached at 800-342-5474. His radio show “Financial Freedom” can be heard every Saturday at 2:00 pm on WHP 580 AM providing financial guidance and answering questions from callers. Media review copies of “The Sleep Well At Night Investor” now available by e-mailing beth_chapman@inkair.com with Sleep in the subject line. Provide a mailing address. 401(k) Rebalancing: Unguided Missiles nvestors in their 50s who start to look at their retirement asset numbers may find that they have made one huge completely avoidable error in their efforts to save. They never rebalanced their 401(k) account. They started out with four different funds allocated at 25% each, and those funds changed dramatically over time. Many 401(k) plan participants choose a risk tolerance strategy a group and then choose investments available within that strategy when they sign up for their 401(k) account. Money is added regularly to their account --automatically deducted from their pay and automatically contributed by their employer. The markets go up and markets go down and the employee rarely looks at his or her statement. If the funds had been looked at quarterly, they could have been trimmed back and rebalanced. If one fund had grown to 32% of the portfolio, that means another is down 7%. The goal for participants is to maintain their original allocation that met their risk tolerance. Rebalancing inside a 401(K) causes no tax consequences so selling shares of one fund and buying shares of another is efficient. The employee must decide what is a reasonable variance from their original plan. If something is 5% up in value, there is an opportunity to sell. The mistake is in assuming that the percentages of your investments that are invested in certain market sectors stay the same. They rarely do. Take an example of John Ketchum. He signed up for his 401(k) plan 7 years ago (just after the tech wreck) when he joined the company. He chose a 60/40 Equity/Bond portfolio that did very well until the last year. Now, with all the talk about the market’s recent drop on the news every night, he finally looked at his statement for January 30 and was shocked that his portfolio originally at 60/40, had grown to a 65/30 and after market corrected, growth on the equity portion had changed his 60/40 to 55/35 equity/bond and his losses in the recent market turmoil have been substantial. In effect, John’s account was an unguided missile and he had no control over where it would land. It’s counterintuitive that fixed income should be sold and equities purchased in a market down turn to bring his balance back to 60/40, but that will allow him to take advantage of the next market upswing. Had John chosen to take his portfolio information to an investment professional, they would have pointed out that his equity growth was putting him in harm’s way should there be a sudden market drop. The professional would have suggested he make a change of fund in his portfolio. He would have looked at the underlying funds in his portfolio to see if there was duplication in the stocks that were driving the increase in value of the portfolio. Such duplication can double the impact of a market downturn. The advisor can also talk to John about his time until retirement and his expectations for monthly income at retirement, as well as what his wife Judy’s 401(k) account is invested in and other taxable investments the couple might have. An overall look at John and Judy’s total investments and rebalancing on at least an annual basis might have saved them the discomfort and investment losses they just experienced. Stonegate Wealth Management’s highly experienced professionals, including partners Thomas J. Geraghty, Jr., CPA, CFP, Steve Craffen, MBA, CFA, and Craig Marson, JD, CPA, solve complex financial challenges and provide counsel for the pressing financial issues confronting their high net worth clients. They have deep knowledge and experience in taxes, estate planning, investment management and divorce settlement counseling. The firm manages $175 million in assets under management. Tom Geraghty, tomg@stonegatewealth.com, office, 201-791-0085, cell 908-347-3032 16 Strategies for Saving Estate Taxes #5 -- Intentionally Defective Trusts Emily and Abner Brown have spent many years running their popular seaside resort and have a large taxable estate. Their grown children have worked with them in the business and they want them to have it. The resort is appreciating in value and the Browns want to get it out of their taxable estate with the fewest tax consequences possible. The Browns have been responsible about taking advantage of appropriate one-time exemption gifting and continue annual gifting to their children and grandchildren as they look at their estate planning. Now they have maxed out their gift tax exemption opportunities, but still have a $5 million dollar property to give to their children. They know that the transfer of a family business from parents to children is a difficult issue because of taxes. If they give the business to their children outright, the kids will owe the IRS over 40% of the value of the property or $2 million. Emily and Abner are working hard to avoid that scenario. With the help of their advisor, they set up an intentionally defective trust. This strategy allows them to save gift taxes and allows the value of their business to grow tax free in the future. The Brown’s chose to sell their business to their children at fair market value inside the trust drawing up a legal mortgage note. The children will use the revenue from the growing business that they now own inside the trust to make the monthly mortgage payments of principal and interest to their parents. By purposely making the trust defective, all the taxes incurred by the business are taxable to the parents, not the children, and will be paid using the parents’ other taxable assets helping them draw down their taxable assets over time further reducing transfer taxes. The greatest benefit to the parents is, of course, that the $5 million dollar business is no longer in their estate. The mortgage note gets smaller every year and the parents pay all the taxes, which in effect, are additional gifts to the children without gift taxes. Another benefit accrues to the children if the business earns 10% going forward and all that revenue goes to trust. The children can pay 5% or $250,000 in mortgage payments and still have an additional 5% or $250,000 revenue to share without any gift tax. If they leave the $250,000 a year in revenue from the business in the trust, growing at 6 or 7 percent annually, the business could be worth $10 million in ten years. The Browns have the potential of saving more than $3.75 million in estate taxes by getting the resort to the next generation with no gift or estate tax using an entirely aboveboard strategy. Pearson Financial Services, Dennis, MA, is the author of "The Two Million Dollar Gift: Dynasty Trusts. Why Leave Your Assets Any Other Way", written for his clients, his clients' families, and his own family. He offers a fully integrated wealth management process, incorporating investment, retirement, financial and estate planning specialists under one roof, serving clients as their family's office, designing and implementing strategies to protect and distribute their wealth and highly appreciated property. Seth Pearson, CFP, 800-385-7925, seth.pearson@verizon.net. Modest Family Foundations Work When Donors Want Hands On Involvement in Changing a Small Part of The World The 77 % increase in the number of newly formed private foundations over the past ten years (Foundation Giving Trends 2007 edition) supports the trend of Boomers and their younger siblings engaging in philanthropy with high levels of personal involvement. The “new” philanthropists want to change the world for themselves, their children and grandchildren and they are choosing family and private foundations to create this change. Sixty-seven percent of private foundations (48,123) have assets under $1 million and showcase the fact that an individual or family does not need to have huge amounts of assets to create a foundation that can effect change. Foundations have been an engine of social change for more than a century, and while the well known, very large foundations get most of the media attention, it is certainly true that modest foundations with very specific goals have made headway on those issues. A great reference is the paperback “Casebook for The Foundation: A Great American Secret by Fleishman, Kohler and Schindler.” This book covers both large and small foundations and their impact on science, education, and public policy. For Americans looking to make a difference, the family or private foundation offers distinct advantages over donor-advised funds. The major difference is control. Family foundations maintain control over every aspect of distribution and evaluation of the value of their gifts. Certainly assets given to donor-advised funds will be directed to the causes of choice, but the relationship to the dollars is very long distance. In addition, the IRS requires family foundations to distribute at least 5% of the assets every year. Donor-advised funds, on the other hands can simply accrue and do not always require a distribution; it is fair to say that the IRS is looking at this practice of donor-advised funds with an eye to change. The combination of activist Boomers and young high tech millionaires brings dollars to the foundation world that can be expected to be aimed at finding solutions to some of our current society’s most visible and knottiest problems. It is important for donors to determine the best structure for their foundation dollars, particularly as many gifts are purpose driven by today’s hands on activists. Tom Gillespie is a Certified Financial Planner (CFP) ® with Matrix USA, LLC, a New York City-based brokerage firm. Tom provides comprehensive financial planning and money management, finding and monitoring the right investment managers for every client’s goals and objectives. He can be reached at 212-220-5117, or tgillespie@matrixusallc.com.
LIFE PLANNING/PERSONAL FINANCE Pay Attention to the Non-Financial Issues on Planning Retirement.After you have secured your finances your focus will change to family, friends, fun, and fitness Three questions posed to financial planning clients by advisor George Kinder, Boston and Hawaii, have become well known for helping pre-retirees who have arrived at financial security to focus on how to plan the non-financial aspects of their third stage or Power Years in life. He poses three questions in his book “The Seven Stages of Money Maturity.” They are:
Suddenly, your client’s focus changes from accumulating retirement assets to living a successful retired life. With your help, there are three areas where you client needs guidance;
Family: Many people want to spend more time with their family. For some that may mean reconnecting with their spouse. For others, it may mean getting to know their children as adults, and/or enjoying their grandchildren. Clear communication between spouses is essential when moving forward into retirement. Goals in retirement need to be articulated between the couple and a location for retirement needs to be agreed upon. A strong trend among Boomer retirees is to rent or own a small apartment near their grandchildren or to move to their area. It is all about communication within all members of the family. Friends/Fun: Many retirees now have time for reacquainting themselves with friends and even traveling with them for fun-filled adventures. Others find that their community offers many opportunities for making new friends, purposeful volunteering, and classes to enrich their continuing interest in learning. Studies show that friends, more than family, were more important in predicting good mental health. Fitness: Retirees must make every effort to stay healthy. Starting an exercise program, changing the way you eat, and making small adjustments can help you begin your journey to greater health. When you are ready and wish to start a formal exercise program, get your doctor’s approval, find a credibility buddy to exercise with, and locate a facility or program that suits your budget or location. Remember that walking, biking, gardening, or following exercise tapes from the library are all affordable alternatives to the gym. The best financial planners know that the management of a client’s money is the easiest part of the relationship. Remaining a pro-active leader in your clients’ life helps them stay focused on what truly matters in their life. When your conversations are centered on helping clients identify and remain focused on their personal goals and dreams, you truly become their life-long advisor and someone committed to placing their interests first. Confronting Performance Issues Helps Cement Client Relationships. When news is good, we like to tell as many people as possible. When news is bad, the natural inclination is to ignore it and hope it goes unnoticed. When dealing with clients and their investments, financial advisors ignore bad news at their peril. If accounts have dropped in value, as is very likely given the current economic circumstances, an advisor has several options. They can try to ignore the short term performance or try to dress up the poor performance as best as possible or focus on what went wrong and whether any aspect of the investment portfolio needs to be changed. The first option may work for some clients, but others will wonder if you are paying attention yourself. Also, dancing around the poor performance may strike some clients as mere political spin. There is nothing wrong with pointing out that the client didn't lose as much as the S&P 500, but you still need to face up the fact that down is down. The best option is to address the losses with the client before the client calls you. It gives you the ability to have your facts in order. What parts of the portfolio did poorly? What parts held up? Did you make changes before or after the fact to mitigate losses or to take advantage of the down market? Are there any tax loss option that can help the client without damaging the investment portfolio. By confronting the performance issue with the client, you demonstrate that you care about their investments and that you care about the client. You also get to frame the discussion. It's not: why have you lost me so much money. It becomes: here is the damage and here is what we have been and what we will be doing about it. The conversation shows that you are a trustworthy advisor working for the client in good times and in bad and that you are in charge of the situation. It will reenforce to the client that they need you to manage their assets in these difficult times. Donald L. McCoy, J.D., CMFC -- Planners Financial Services, Inc., 952-835-9000. Minneapolis, Minnesota. Registered investment adviser and subsidiary company Montgomery Investment Management, specialize in the management of no-load mutual fund portfolios for individuals and retirement plans designed to protect capital by reducing risk. 952-835-9000 - pfshim@usinternet.com. |
