As Detroit Goes…

You’ve probably read that the city of Detroit has filed for bankruptcy protection. If you’re like most Americans, you assumed that this is because the city has been declining, economically for decades. And indeed it’s true that America’s 18th largest city, once the 4th largest, has seen its population fall by 1.3 million people, leading to a 40% aggregate drop in tax revenue despite property taxes that are now twice the national average. Detroit’s unemployment rate is more than double the U.S. average–a situation which is unlikely to slow the exodus.

But Detroit’s fiscal problems actually have little to do with its woeful economy. The problem lies in the assumptions that the city made about future returns in its investment portfolio–the portfolio that funds all city pensions and retirement benefits. With the benefit of hindsight, it is clear that these assumptions were disastrously off-kilter. Recent estimates say that the discrepancy between what the city has promised to its current and retired employees, and the money the city has to pay for those promises, could be anywhere between $3.5 billion and $9 billion dollars.

Here’s the punchline: the calculations that Detroit’s municipal authorities relied on to say that they were perfectly solvent follow generally accepted actuarial principles. Many other cities and states appear to be making the same mistake, and it’s perfectly legal.

Without getting too deeply into the complicated math, the bottom line is that the city has been assuming that its portfolios would generate a steady return of between 7% and 7.5% at least since the turn of the century. In 2011, as the city’s financial picture worsened, its pension fund managers increased their projections of future investment returns to 8%, which made the pension system seem potentially better-funded in future years.

Why is this a problem? If you’ve ever happened to glance at your own portfolio statements, you may have noticed that no conservatively-managed investment portfolio has earned anything close to 7% a year since 2000. But Detroit’s actuarial team accounted for that by “smoothing” the projections–a fancy way of saying that they assumed higher returns in the future would offset the lower returns they’d experienced.

These assumptions had two highly-desirable results: they allowed the city to make much smaller contributions to the pension fund than would have been necessary with more realistic investment projections, and they allowed the city to promise future retirement (income and healthcare) benefits that were much more expensive than the city could actually afford.

The problem is that Detroit is not alone.

It doesn’t take a rocket scientist to notice, as a writer did recently at The Economist magazine, that the New York City public school system account statements show a yearly return on teacher annuities that is six percentage points higher than the highest going rate on bank savings accounts. New Jersey recently cut its investment projections to 7.9 percent, a mere ten basis points less than Detroit. Over the past ten years, the giant California pension, Calpers, has been using various smoothing techniques to give its municipalities the illusion of greater solvency. Some states and cities, when they post job listings for staff actuaries, require that the potential hires hew to the generally-accepted principles. No sober doses of reality will be sought or tolerated.

Why hasn’t anybody blown the whistle on this long-term overstatement of returns and understatement of liabilities? Who benefits from putting that whistle to their lips? The city employees, whose monthly statements show returns and benefits that are orders of magnitude higher than they could get in the open market? The city officials, who would then have to deal with the scandal of underfunding and have to make huge tax dollar commitments to catch up, often with money they don’t have? The municipal bondholders, who are clipping coupons and whistling in the dark, hoping they’ll be paid off before somebody tells them, as Detroit bondholders are now being told, that their investment is worth pennies on the dollar?

Taxpayers, who could be on the hook for billions of dollars worth of promises that the state constitution and city charter declare must be kept?

In fact, the New York Times recently reported that the Society of Actuaries itself is revisiting its generally accepted principles, fearing a black eye for the profession. The debate could lead to a policy that favors more realistic investment assumptions, while officials running for office may have uncovered the next scandal that could shoo them into office.

Either way, you can expect to hear more about bankrupt cities and municipalities, and the next headline probably won’t be about a city whose population has been declining since the Eisenhower Administration. How far and how deep this readjustment will go, how much has been overstated across millions of workers and hundreds of thousands of retired municipal workers, is a potentially alarming mystery.

Sources:

http://www.realclearmarkets.com/articles/2013/07/24/the_real_message_behind_detroits_decline_100499.html

http://www.irishtimes.com/business/economy/detroit-bankruptcy-filing-comes-after-long-financial-decline-1.1469526

http://www.economist.com/blogs/democracyinamerica/2013/07/detroit-s-bankruptcy

http://dealbook.nytimes.com/2013/07/19/detroit-gap-reveals-industry-dispute-on-pension-math/?ref=marywilliamswalsh

This article was written by Bob Veres and re-printed with his permission.

Congress’s Answer to Consumer Protection: Make Everybody a Wall Street Broker

On April 25, 2012, Rep. Spencer Bachus of AL and Rep. Carolyn McCarthy of NY introduced a bill which, according to the accompanying press release, would enhance consumer protection in light of the 2008 market meltdown that took the U.S. economy to the brink of collapse, and the Bernie Madoff scandal.

The solution: expand the regulatory authority of the organization that currently regulates Wall Street brokers. Make all who give investment advice answer to the organization that allowed Wall Street to sell trillions of dollars of toxic mortgage pools and derivatives, and which once had Bernie Madoff sit on its board of governors.

In other words, create a world where all advisors become brokers, and eliminate consumer access to independent, objective advice.

The Bachus-McCarthy bill, also known as the Investment Oversight Act of 2012, talks about enhancing the protection of financial consumers by allowing the Securities and Exchange Commission to delegate its oversight of many thousands of independent registered investment advisors to a self-regulatory organization. As many press reports have pointed out (see links below), the self-regulatory organization would be the Financial Industry Regulatory Authority (FINRA), the regulator that oversees Wall Street, and which has Wall Street executives sitting on its board of directors.

FINRA is the same organization that was in charge of policing Wall Street when the 2008 scandals broke. Bernie Madoff was under FINRA jurisdiction for his entire career (including its predecessor organization, the National Association of Securities Dealers or NASD), served as a member of the board of governors of the NASD in 1984, and on numerous committees. His brother and business partner, Peter Madoff, was elected vice chairman of the NASD in November 1992. FINRA’s lack of oversight continues. Joel Blumenschein, a member of FINRA’s Board of Governors, resigned. Last week, Blumenschein, president of Freedom Investors, Inc., was fined $30,000 and suspended by FINRA for allegedly failing to supervise one of his company’s brokers, Gary Gossett. The complaint claimed that Gossett made “a series of unsuitable penny stock trades in the retirement account of a customer of limited means,” without the customer’s permission. FINRA described Freedom Investors, Inc.’s oversight system as “so inadequate that Blumenschein was unable to provide a consistent or coherent description of it.” FINRA also claimed in the settlement that “his testimony, under oath, was at times both evasive and contradictory, thus highlighting the system’s inadequacies.”

We do not support handing over expanded regulatory authority to an organization that failed to prevent the flood of toxic mortgage pools, the sale of derivatives and sat by unconcerned while the Madoff Ponzi scheme continued for decades.

The real agenda of the bill is very clear: to give Wall Street (through its regulatory arm) control over its most persistent competition: independent advisors who, in contrast to the Wall Street sales culture, put the interests of their clients first when giving financial advice. At a time when Wall Street’s credibility is at its lowest ebb, when consumers are walking away from the opportunity to send their retirement dollars into the bloated brokerage industry bonus pools, the preferred solution is not more transparency, not changing the culture to put the consumer’s interests first, but to create a new regulatory overlay on the competition and bury it in paperwork.

In fact, when the Boston Consulting Group evaluated the expected cost of FINRA regulation on registered investment advisors, it concluded that the cost would be $51,700 a year in additional expenses for the average independent advisor. This is more than twice as much as it would cost to develop enhanced oversight by the Securities and Exchange Commission. (See the link below for more detail on the numbers.)

There are other ways to estimate the cost differential. FINRA (as mentioned earlier) is not exactly transparent about its salary structure, but public records show that current SEC chairperson Mary Schapiro’s base salary as FINRA CEO came to $3.2 million a year–plus a $9 million bonus payment she received when she left to join the SEC. (We only know this because a number of news outlets filed Freedom of Information Act requests that were vigorously resisted before the data was finally handed over.)

Schapiro’s current salary at the SEC: $163,000 a year. If we simply compare that with her base salary at FINRA, without including the bonus, it would appear that FINRA regulation would be a remarkable 19 times more expensive than the SEC as a regulator of RIA activities.

There is reason to think this is a low estimate. In 2009, FINRA collected over $700 million in regulatory fees, user fees, dispute resolution fees, transparency services fees, and contract services fees. In the same year, FINRA’s leadership used the dues collected from its members to pay its top ten executives $11.6 million, to spend over $1 million lobbying Congress and the SEC (do regulatory organizations engage in lobbying activities?), and to spend undisclosed amounts on advertisements in The Washington Post and on CNN touting its record as a regulatory body. In 2008, eight FINRA executives received more than $1 million in compensation and benefits, and the top 12 most-compensated employees received more than $24.8 million. One might fairly question the organization’s rigorous stewardship of dollars allocated to regulatory efforts.

In addition, consumers and members of the press might be astonished at how little transparency FINRA operates under.

To take a recent example, just last year, Amerivet Securities president Elton Johnson (a former Green Beret) managed to get seven proxy votes onto the agenda at FINRA’s 2010 annual meeting. These initiatives would, among other things, have required FINRA to do things that any guardian of the public interest would normally do as a matter of course: tell us the compensation paid to its ten most highly-paid employees, disclose FINRA’s investment transactions to members and the public, and open up its board meetings or at least provide transcripts of the discussions among Wall Street executives and others who currently (this, to me, is amazing) make the organization’s decisions in secret.

All seven of these initiatives passed overwhelmingly, garnering more than two-thirds of the membership vote, some more than 80%. The FINRA board of directors debated these measures in a closed meeting, and decided to reject them.

There may be significant conflicts of interest in the way this legislation was crafted and produced. It has long been clear that Rep. Bachus speaks as a proxy for FINRA on the subject of “enhanced” regulation, and I don’t think anybody close to the profession can see this as anything but a way to let FINRA take over regulation of the fiduciary RIA profession. The press release accompanying the legislative proposal goes so far as to praise the diligent regulation of broker-dealers and the lax regulation of RIAs. I think this one line offers particular insight into where this legislation is coming from:

“Customers may not understand the different titles that investment professionals use but they do believe that ‘someone’ is looking out for them and their investments. For broker-dealers that is true, but for investment advisers, it is all too often not true and that must change,” concluded Chairman Bachus.

In other words, the RIAs, who are required by law to live up to a fiduciary standard (and put their clients’ interests first in all advice-giving) are the bad guys in the marketplace, who must be watched much more vigilantly, while the brokerage firms (which have resisted registering their brokers as RIAs and thus evading this tougher standard behavior) are the good guys who protect consumers.

This, of course, is taken straight from the mouths of FINRA and SIFMA (the brokerage industry’s lobbying group), and it is not hard to find out why this particular legislator has been so persistent on this subject. When you look up where the lobbying money has gone, you find that Rep. Bachus’s top ten contributors include commercial banks (a total of $213,650 in 2011-12), insurance companies ($191,010), securities and investment firms ($184,277), finance/credit companies ($90,438) and “miscellaneous finance” ($89,250). In the 2011-2012 election cycle, he was the number one fundraiser from commercial banks, from finance/credit companies and from mortgage bankers and brokers. (All of that can be found here: http://www.opensecrets.org/politicians/industries.php?cycle=2012&cid=n00008091&type=I&newmem=N)

Beyond that, Rep. Bachus has been accused of a peculiarly Wall Street crime: insider trading (see link below).

When you connect the dots on this piece of legislation, it becomes frighteningly clear that the actual agenda is something very different from consumer protection. Yet unless the public learns about this power grab by Wall Street just a few years after it brought the economy to its knees, consumers may find themselves living in a world where everybody who gives investment advice is a broker, and regulated like one.

The SRO would be FINRA: http://www.financial-planning.com/blogs/veres-sro-sec-finra-2678577-1.html

http://www.investmentnews.com/article/20120425/FREE/120429948#

The excessive cost of FINRA regulation: http://www.fa-mag.com/fa-news/9412-rias-back-sec-as-regulatory-body.html

http://www.financial-planning.com/news/finra-sro-napfa-2678574-1.html

FINRA’s regulatory effectiveness (or lack thereof): http://registeredrep.com/advisorland/opinion_finra_is_an_ineffective_regulator_1006/

FINRA’s lack of transparency at the board level: http://www.dailymarkets.com/stock/2010/06/22/finra-owes-america-answers-on-these-proposals/

http://newsandinsight.thomsonreuters.com/Legal/news/2011/02_-_february/court_refuses_to_dismiss_lawsuit_demanding_finra_transparency/

Rep. Bachus insider trading scandal: http://www.washingtonpost.com/politics/rep-bachus-faces-insider-trading-investigation/2012/02/09/gIQA21Ui2Q_story.html

Do brokerage industry representatives actually sit on FINRA’s board of governors? Here’s a list of the current board of governors: http://www.finra.org/AboutFINRA/Leadership/P009756 Among others, you find representatives of Morgan Stanley Smith Barney, LPL Financial, Deutsche Bank and Edward Jones.

But look more closely at some of the “public” members of the board of governors. John Schmidlin, who is listed as a member of the consuming public, is the former chief technology officer and managing director at JP Morgan Chase (http://www.harlemacademy.org/about/board-trustees). Richard S. Pechter, another member of the consuming public, is actually former CEO of Donaldson, Lufkin & Jenrette, and chairman of the board of Credit Suisse USA. (http://investing.businessweek.com/research/stocks/private/person.asp?personId=12665753&privcapId=165284&previousCapId=23021&previousTitle=SONY%20CORP-SPONSORED%20ADR) Kurt Stocker was chief Corporate Relations Officer of Continental Bank Corp. (http://investing.businessweek.com/research/stocks/people/person.asp?personId=11713969&ticker=NYX:US&previousCapId=3777896&previousTitle=Rensselaer%20Polytechnic%20Institute ) “Public” governor William Heyman is the former Chairman of Citigroup Investments, and Executive Vice President of the Travelers Companies.

This was taken from a recent press release received.

Butchers, Brokers, Dieticians and Fiduciaries

In the world of healthcare, representatives of pharmaceutical and medical device firms do not administer advice directly to patients. This avoids the inherent conflicts of interest as representatives have a natural incentive to sell as much of their product and this could influence the advice in a manner that it is not in the best interest of the patient. Unfortunately I wish I could say the same for the financial care field.

The financial service industry doesn’t always require the same level of care – it can differ from firm to firm. Some financial service firms recommend products that they create or holdings they have on inventory that they don’t deem worth holding onto anymore. Some are required to act in your best interest first while others only have to determine if a product is suitable. A recent New York Times Editorial by former Goldman Sach executive Greg Smith and the Fox News report “Citigroups Embarrassing E-mails” sheds some appalling light on how the financial customer could be adversely affected in some cases.

What can you do? The first thing that you can do is understand the difference between a fiduciary arrangement and a brokerage engagement in a financial service engagement. A great whiteboard video showing the difference was produced by Hightower Securities which compares brokers to butchers and fiduciaries to dieticians. In simple terms, you don’t want to ask a butcher if a certain cut of meat is healthy for you.

If you then believe that your financial service advice you receive should be held to a fiduciary standard, I recommend going to The Committee for The Fiduciary Standard website a pull up their Fiduciary Oath. I would print this and provide this to your current or prospective financial adviser to sign. If they sign this, it doesn’t eliminate all potential conflicts of interest, but it requires disclosure of material items and that the adviser acts in your best interest. If they refuse to sign it, at least you know the type of engagement you have and you can make the decision to continue the engagement or move on.

Finally there is a debate going on in Washington concerning the subject as some parties don’t feel a fiduciary obligation is necessary or is too onerous and would prefer things to remain “as is” or to create a watered down definition. Unfortunately many of our elected officials haven’t expressed an interest and/or expertise on the subject. If you feel this is important, I recommend that you forward the above whiteboard demonstration to your representatives.

Thoughts on the Downgrade of the U.S.

On Friday, Standard & Poor’s lowered the credit ranking of the United States from its most creditworthy status of AAA to AA+. This is the first time in history the United States has been lowered. As a result, the stock market tumbled with the S&P 500 down roughly 6.7% for the day. Here are my thoughts on the situation:

• The announcement of the downgrade by Standard & Poor’s simply reflects what is already known. The creditworthiness of the United States is still strong, but we have structural issues with our fiscal policy that need to be addressed. The only new news was the announcement. This created no surprise to me.

• The ramifications of a downgrade would suggest that interest rates would increase as buyers of United States bonds would require a higher interest rate as compensation for more risk. Ultimately the market would decide this, but given the weak economic conditions around the world, I doubt that rates will rise quickly in the near future. Japan was downgraded earlier this year and no one flinched.

• The other concern would be the loss of the dollar as the reserve currency of the world. But it begs to ask, what would replace the dollar? The only remaining “real” AAA rated countries are too small to handle the volume or do not want to assume this implied leadership. The Chinese want our dollar strong so they can continue to sell stuff to us at affordable prices. The Euro is worse off and there is not enough gold in the world. The United States economy is weak, but it is still the largest and strongest economy in the world and our largest companies are still quite profitable. Ironically Treasuries rose yesterday because they are still the safe haven of the world.

• The real risk is uncertainty. The announcement of the downgrade was nothing within itself. However, the consequences of the announcement and combination of reactions could potentially create a tipping point or Black Swan event, creating capitulation similar to the fall of 2008. We won’t know if this will create a tipping point or if this is a tipping point until we are looking back at this in the future. The risk of these events is always present in both good and bad times.

• Keep in mind that a country with a sovereign debt issue that can control its currency can never fall into actual default. When you control your currency, all you need to do is start printing currency and devalue the debt away. Unfortunately the cost of this is high inflation.

• A political silver lining? I think our elected officials thought they were going to get off easy last week. They thought they could do some political posturing, defend their ideology and make a last minute deal to avoid chaos and save face. Ironically it backfired because as their inability to address our debt problem in the long term created a ripple in an already fragile global economy. It’s time to address the situation rather than kick the can down the road – remember – we are the ones that vote them into office.

• The ratings agencies don’t have a great track record. A few years ago, Standard & Poor’s gave solid credit ratings to Lehman Brothers, AIG and plenty of those toxic mortgage backed securities. None of these exist anymore. Billionaire Warren Buffett, the world’s most successful investor, said S&P erred and the U.S. should be rated “quadruple-A.” I don’t know about you, but I’d trust Buffett more than Standard & Poor’s. Moody’s today also rebuked S&P’s downgrade.

• Unless there is some unforeseen tipping point as discussed above, I believe the reaction of the markets were more emotion and animal spirits than based on fundamentals. And the financial press does not help quell that fear because sound investing principals don’t generate great ratings. As discussed the other day, if the market continues to give you trouble, one of the best things that you can do is periodically rebalance your portfolio. This is nothing sexy, but rebalancing forces you to buy low and sell high.

Finally, no matter how scary it might seem, this is atypical market behavior. If you allow yourself to be swept away by Mr. Market every time a blip occurs, you will not be very successful over time. If you allow yourself to work with the things that you can control and be opportunistic of what the market brings you, a contrarian investment strategy can be very rewarding.

What If We Don’t Raise the Debt Ceiling?

This is the question that clients, friends and colleagues having been asking me over the past several weeks. Here is my take on the subject:

Will They Reach a Deal? At this point, I feel that the likelihood of a technical default is low and that some sort of reconciliation will be made prior to August 2nd. The one thing that I can count on is politicians wanting to stay employed. I suspect the only reason the politicians have been posturing so long is because the financial markets haven’t over-reacted to this point. There is a sense of caution out there, but it is definitely not panic. If Washington felt votes were on the line, this would be a done deal.

Will There Be Panic if Congress Fails to Make a Deal? There have been some catastrophic predictions of what would happen if we failed to raise the debt ceiling. Most notably, Bill Gross of the PIMCO funds in a recent letter stated: “default would still be a huge negative for the U.S. and global financial markets, introducing fear and unnecessary volatility into the economy and global trade. The market situation might resemble what happened after Lehman Brothers collapsed in 2008.” A post Lehman situation is always a possibility, but I would think it would take a combination of negative events like more trouble from the Euro zone or sudden weakness in China’s economy along with a technical default to set off a contagion like event. Just keep in mind that the probability of a “Black Swan” event is always a possibility and usually comes out of the blue from some combination of catalysts that nobody can foresee. Given there has been quite a bit of doomsday talk about what would happen here, I’m skeptical that contagion would be created solely from technical default; there would have to be more out there.

The Long Run: My main concern focuses on the long run implications of what will happen if we don’t get our financial house in order. The U.S. federal debt to GDP ratio is closing in on the 100% level. Once we go beyond this mark, it begins to have a detrimental effect on economic growth. If the confidence of buyers of U.S. debt wanes, this would erode our status as the reserve currency of the world. With more perceived risk in us meeting our obligations, this would result in higher interest rates, inflationary pressure and would undermine our ability to grow economically. Although it wouldn’t be pleasant, I would even accept some short term anxiety if action was taken to fix the problem in the long term. The days of kicking the can down the road should end.

The Reality of It All: Our problem is far from being unfixable. However it won’t be fixed overnight either so I think it’s absolutely silly for our politicians to be dangling the debt ceiling and deadlines as a bargaining chip. In the big picture the reality is that the plan will take years of gradual implementation to eventually right the ship, while not blowing up the economy in the process. Both sides are going to have to compromise. If a politician discusses deficit reductions without talking about entitlement reform, they will never fix the problem. The same thing goes for those that think that permanent changes in our tax system are not a necessity. Everyone will have to experience some pain in the form of paying more or getting less. It should not be “us versus them” in this debate. In reality it’s just us. I would rather be able to address the problem while it is still manageable, rather than creating a crisis that probably my kids would need to fix. Greece is now stuck and has no easy choices anymore. We don’t want Greece’s problem to be our problem as well.

“See You At the Next Financial Crisis”

I think it’s ironic that the best investigative reporting on the financial meltdown and its aftermath isn’t coming from any financial newspaper or magazine. It’s coming from Rolling Stone.

In the August 6th issue of Rolling Stone, Matt Taibbi does it again. In the article, Wall Street’s Big Win, he digs into the political maneuverings of the Finance Reform Bill that was passed earlier this year and how both political parties gutted the legislation to the point where no true reform was made to prevent another financial meltdown.

The article focused on two aspects of the legislation. The first one involved invoking the Volker Rule, which would have restricted commercial banks from proprietary trading, or in other words allowing them to invest in the markets for their own profit. Banks were going to once again become a bank and if they wanted to speculate for their own profit, the taxpayer wasn’t going to rescue them this time.

As described by Taibbi, this part of the legislation wasn’t even considered by the Democrats until Republican Scott Brown won Ted Kennedy’s long time Senate seat and the article suggests that the 180 was done by the Democrats only as a near jerk reaction to try to quell populist anger. Then began the roadblocks engineered by both parties. When the amendment was brought forth by Democratic Senators Carl Levin and Jeff Merkley, the Republicans invoked the unanimous consent rule where the amendment could only be added if all 100 members of the Senate agreed to do so. Failing in its first attempt, then Levin and Merkley tried to piggyback it on another amendment. It looked like it was only going to pass until the Republican sponsor of the amendment Sam Brownback withdrew the amendment only to add it later on without the Volker Rule with Democratic cooperation. Meeting an end in the Senate, then Levin and Merkley tried to get it added within negotiations between the House and Senate. That’s when Treasury Secretary Geithner got into the act, vying for various exemptions to allow for some proprietary trading and the legislation wasn’t going to occur unless this was part of it. The exemptions were limited in nature, so it looked like some reasonable limits were set. Then at the last moment a congressional delegation from New York led by Democrat Senator Chuck Schumer changed the legislation which agreed to the percentage limit on proprietary trading, but that now based on the banks Tier 1 Capital rather than its tangible equity. This would allow a bank to put up 40% more in proprietary trading. Viola, the limit on proprietary trading now has no teeth.

Then Taibbi went on to the second part of the legislation involving Democrat Blanche Lincoln’s proposal to have the banks spin off their derivatives desks. If you traded derivatives, then again the taxpayers weren’t going to bail you out like they did with AIG. This legislation made it pretty far. The most interesting thing is that fellow Democratic Senators were so worried about Chris Dodd showing up in the middle of the night to throw big loopholes on the Senate floor without opposition, that fellow party members kept vigil on the Senate floor to prevent him from doing this. With hope of passing, this was then was met from strong opposition from all angles. In the end, Lincoln gutted her own rule. As soon as she defeated Bill Halter in an election run-off, she offered an exemption for community banks and then the flood gates opened. In the end after everyone got their share, 90% of the derivatives market was exempted.

There it is, the under-pinnings of the huge financial reform bill in all its glory. Taibbi did convey that some good things were made out of the legislation such as lending standards for mortgages and some derivatives to be traded and cleared on open exchanges, but Taibbi says that it does nothing to prevent the systematic risk taking that caused the financial meltdown and another meltdown is only a matter of time; an opportunity wasted. In closing, Taibbi states “See you at the next financial crisis.”

Healthcare Reform: Financial Planning Tips

Love it or hate it, what our government calls healthcare reform is now law. These are the financial planning implications you should consider in light of the changes:

Higher taxes: If you are single and making over $200K or married and making over $250K, watch out. Starting in 2013 people with these income levels are going to see their Medicare payroll tax increase from 1.45% to 2.35%. In addition, any investment income such as interest, dividends, capital gains and rental income will be subject to a 3.8% Medicare Tax. This tax is egregious as if you fall just one dollar above the stated income limits, ALL of this unearned income is subject to this Medicare tax, not the dollar amount over the limit.

Also be aware, the tax environment was already scheduled to get worse before the healthcare reform legislation was enacted. Next year the current tax bills “sunset” where qualified dividends will be taxed as ordinary income (from its current 15%) and long term capital gain rates will go to 20% (from its current 15%). So it may not seem like the new Medicare taxes are that costly, but the combination of this and the expired tax breaks may become very costly to some people. Think about it, some people will pay a 43.4% tax for dividends where they are paying 15% now.

If you are on the fringe of these income levels, you better plan now. For example, if you have investment property that you are considering selling that has a large capital gain, you may want to accelerate the sale into this year or at least by 2012 rather than waiting. You may want to begin repositioning any taxable investment accounts into more tax efficient holdings such as index funds, municipal bond funds or save more towards tax efficient IRA’s or employer sponsored retirement plans. If your situation dictates, you may want to consider converting a Traditional IRA to a Roth IRA if you have a taxable account that generates a lot of income now and is sufficient enough to cover the tax cost of the conversion. Not only could this lower the amount of unearned income that could be exposed to the new Medicare tax in the near term, converting it to a tax free Roth can reduce the chance you may be subject to the tax later in life. Finally, people who own C corps with high accumulated earnings may want to take a large dividend this year before the higher rates are imposed.

Now if you have a high deductible health insurance plan or are considering one, things will change here as well as the deductible will be limited to $2,000 for an individual and $4,000 per family. The lower deductible is most likely going to result in an increase in premiums. Current high deductible plans are grandfathered as long as they meet certain minimums so you may want to consider enrolling in a high deductible plan while you still can. It also would be advised to contribute as much as you can now to a health savings account.

Finally, if you decide not to carry health insurance, starting in 2016 you will pay a fine of $695 or 2.5% of income, whichever is greater. In 2018, if you pay premiums in excess of $8,500 for an individual and $23,000 for a family, then there is a 40% tax on the excess amounts.

The above just addresses planning aspects from an individual perspective. If you are a small business owner, there are a lot more planning implications that should be considered. But start planning now because all of the financial implications are right at our doorstep.

No Fiduciary Standard – No Financial Reform

Yesterday, a Senate sub-committee chastised Goldman Sachs executives for creating and selling mortgage backed securities to investors while betting against them in their own account. If only the Senate would eat their own cooking.

The new regulatory reform legislation originally had language that would address this issue. It would have required everyone who gives investment advice to the public to act as a fiduciary. Or in other words, the advice would have to put aside the interests of the individual and the firm that the person works for and give recommendations that are in the best interest of the client. If Goldman Sachs was a fiduciary, I would think they would be in a lot of trouble now. But Goldman Sachs does not have any fiduciary responsibility. Registered investment advisors have this obligation but Goldman and other brokerage firms do not.

This leads to the irony of the story. The language in the new reform bill requiring a fiduciary obligation was removed by Senator Tim Johnson of South Dakota earlier this year. Instead Senator Johnson wants the Senate to “study” the issue instead. I don’t have too much confidence in conducting a “study.” A few years ago the Rand Corporation was commission to do a study on the issue and came to the conclusion that consumers were confused and that’s about all that came out of that.

In the end, Goldman Sachs will probably prevail against the SEC suit. They aren’t a fiduciary; ethically questionable actions were made, but they are allowed to do this. So we may see them pay some fine without admitting any wrongdoing and both parties will go about doing what they do. In the end, these mortgage backed securities were not the reason for the financial crisis, but they played a hand in exacerbating the severity of the problem. And a fiduciary obligation probably would have played a strong hand of stemming this severity.

The sad part of this is that the Senate subcommittee totally danced around the fiduciary issue yesterday, but I truly feel they don’t get it. Earlier this year former Presidents George W Bush and Bill Clinton spoke together at a conference geared towards the financial planning community. When asked about fiduciary standards, they both looked at each other and didn’t know what to say. Senator Susan Collins yesterday seemed to be one person yesterday who knew the difference between who does and doesn’t hold a fiduciary obligation. In the end, when the subcommittee was chastising Goldman, too bad that Senator Johnson wasn’t asked to explain why he thinks a fiduciary standard isn’t that important. And it isn’t too late to ask your Congressperson why its not important either.

A great article was written in the Wall Street Journal at this link:

http://online.wsj.com/article/SB10001424052748703940704575089413832399630.html

Goldman Sachs Defensive Letter

Last week, Goldman Sachs defended its controversial policies in a letter to its shareholders last Wednesday. Within the letter, CEO Lloyd Blankenship and President Gary Cohn justified its relationship with AIG, the bonus structure for its employees and defended its short selling of the mortgage market while selling these investments to its clients.

But as reported last week from the Wall Street Journal, there was one line that was quoted from the letter bothered me the most:

“Our first priority is and always has been to serve our clients’ interests,”

Really? It’s kind of interesting because there has been a lot of debate within the financial reform agenda concerning the obligations that financial advisors have when serving their clients. Registered investment advisors have a fiduciary obligation to act in the best interest of the clients first and disclose conflicts of interest. On the other side is the brokerage world, which including Goldman Sachs only has to adhere to suitability standards. Since the financial crisis, there has been a lot of talk about imposing this fiduciary duty across the board. In the meantime, Brokerage firms have been lobbying hard against this or creating a watered down definition of what it means to have a fiduciary duty.

What say you Goldman? Aren’t you a member of the brokerage world and part of the system that is against the fiduciary obligation? If you are, then actually do what your letter says, put your money where your mouth is and join the fiduciary club. Maybe then and only then will you find that acting on the best interests of the client isn’t such an onerous task. But until then, your letter is a lot of empty rhetoric.