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.

The Fed’s Surprising Profitability

In 2008, the Federal Reserve famously purchased a lot of subprime bank loans that have been described, in the banking industry, as “toxic waste”–in an effort to clean up the balance sheets of large lending institutions. Since then, the Fed has been an active buyer of Treasury securities and, in its latest (and ongoing) QE3 program, become the single largest buyer of mortgage securities issued by Fannie Mae and Freddie Mac, working hard to drive down their coupon rates.

These dramatic gestures are supposed to help revive the American economy, but what are they costing our nation’s reserve bank? The Reuters news service looked at last year’s audited results and reports a surprise: the Fed’s increasingly complex balance sheet generated $88.9 billion in profits last year. That’s far more than the most profitable U.S. companies, like number one Exxon Mobil ($41 billion); number two Chevron ($27 billion), #3 Apple ($26 billion) or Microsoft ($23 billion).

Under Chairman Ben Bernanke, the Fed has gotten in the habit of earning a profit on its operations. In 2011, 2010 and 2009, it took in $77.4 billion, $81.74 billion and $53.42 billion in profits, respectively.

Where does this money go? Does the Fed pay out this largesse to its executives in the form of bonuses, like Goldman Sachs? Fortunately not. The Fed sent $88.4 billion to the U.S. Treasury last year, and gave taxpayers back a comparable percentage of its profits in previous years. The interesting truth is that the most profitable entity in the American economy is run like a nonprofit on behalf of our government.

Sources:

http://www.huffingtonpost.com/2012/03/21/federal-reserve-profit-2011_n_1369354.html

http://www.huffingtonpost.com/2013/03/15/federal-reserve-record-profit_n_2884366.html?utm_hp_ref=business

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.

Tax Planning: Better Plan for 2013 Now

Currently millions of taxpayers are trying to get their tax returns prepared. But if you are wise, I would take a look at what’s coming in 2013 and take action now to address it.

If the tax code remains as it currently stands, we will face the largest tax increase in history. The majority of this would come from the expiration of the Bush Era tax cuts. Current tax brackets would go from 10%, 15%, 25%, 28%, 33%, 35% to 15%, 28%, 31%, 36% and 39.6%. Capital gains rates would increase from 20% for those who are currently subject to the 15% rate and those eligible for the current 0% rate would be subject to the 10% rate. The most egregious taxes would be for qualified dividends. Rates would revert back and be taxed at ordinary rates. Those currently paying 0% in the 10% and 15% tax bracket would pay 15% and 28% next year. Those currently paying 15% could be pay either 31%, 36% or 39.6%. Dividend paying stocks have been in vogue these days, but this could quickly come to a halt. In addition, the phase-out of itemized deductions and exemptions would return affecting higher income households while the marriage penalty would return.

Outside of the expiration of the Bush Era tax code, there are a few other taxes coming into play for 2013. The payroll tax cut is set to expire at year. Also the 3.8% healthcare reform act surtax on investment income will start. For those who will be in the 39.6% tax bracket next year, their qualified dividend income will go from 15% to a whopping 43.4% which doesn’t take state income taxes into account.

Now there is periodic talk about extending or modifying these tax issues. But I’m not holding my breath. Election years tend to create standstill before the election. After the election, lame duck politicians are hard to rely on – especially if the power is split up between political parties within Congress and the Presidency. Rather than relying on politics and other things that we can’t control, I am advocating a more proactive approach. These are the things you may want to consider:

Tax Location: This strategy involves allocating your individual investments into accounts in a manner which optimizes the after tax efficiency of your overall portfolio. I like to call this tax account diversification as Roth IRA/401(k)’s are designed to be tax free, Traditional IRA/401(k)’s are tax deferred and then investors can also have regularly taxable accounts. You would want to be more cognizant of placing more of your tax efficient investments within taxable accounts. Low turnover stock funds and index funds and municipal bond funds (if they don’t have a great deal of private activity interest which is subject to the alternative minimum tax (AMT)) are very tax efficient in a taxable account. Roth IRA’s/401(k)’s are a great place to place the high growth portion of your portfolio. The greater the growth potential, the more potential dollars you should have for your needs over the long haul; all of this would be tax free. Mutual funds that invest in higher risk stock and commodities tend to be a good location for a Roth. Tax deferred vehicles such as Traditional IRA’s/regular 401(k)’s tend to be a great place for your slower growing diversifiers within the portfolio. Leaning slower growers in the tax deferred accounts means that less of your dollars will be subject to ordinary tax rates when withdrawn. Taxable bond funds and other high turnover/non-tax efficient strategies tend to fit well within the tax deferred account. If you have a mix of different accounts, you will find this strategy more powerful in the years to come.

Tax Gain Harvesting: Most of the time financial planners talk about tax loss harvesting. But given the higher future capital gain rates, one may want to consider taking capital gains now at the current lower rate rather than incurring a higher tax rate later in the future, especially if you were planning to incur a capital gain with an asset sale in the near future. If you find yourself in the tax bracket where you would be subject to the 0% capital gain rate, it may even make sense to incur a capital gain only to buy the holding back to create the higher cost basis for a later sale date. It may defy common logic, but sometimes the best financial strategies are counterintuitive in nature.

Roth Conversions: If you have a large portion of your portfolio in a Traditional IRA and enough funds outside of retirement accounts available to pay the tax (and if your taxable income will get hit the hardest by the tax increase), you may want to consider converting some or all of your Traditional IRA to a Roth IRA. In the future, I will discuss Roth conversions in greater detail.

Higher Funding of Tax Advantage Accounts: Higher future taxes increase the attractiveness of funding tax advantaged accounts whether they are IRA’s, employer provided retirement plans, health savings accounts, college funding vehicles and tax deferred annuities. You just want to make sure that you have accessible funds available for an emergency fund and future spending needs that aren’t subject to a tax penalty for early withdrawal. But it may make sense to keep your taxable accounts as small as possible.

Don’t Let the Tax Tail Wag the Dog: Be careful to make sure that the funding vehicle fits your goals and future needs. Often times I see people mistake tax efficiency for tax avoidance and they end up investing in areas that are a poor fit for their needs. For example I often times life insurance will be sold as an investment vehicle where a need for the actual insurance need should take precedent over the investment characteristics.

With some careful planning, there is a lot to benefit from if you think about your future tax circumstances right now. Before taking action, I would highly recommend working closely with your financial planner and tax accountant (and coordinate it so they are communication to each other as well) to see what actions make the most sense for you. With our current and projected federal budget deficits, it would suggest we will be more likely to face a higher tax environment in the future. Small tax efficient measures now could potentially make a big difference over the long term.

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.

The Curse of Cash

Recently the Wall Street Journal highlighted how the Federal Reserve’s policy of keeping interest rates low to spur economic growth has hurt retiree’s who rely on interest rates to maintain their lifestyle. In the article Fed’s Low Interest Rates Crack Retiree’s Nest Eggs, they highlight residents within the Port Charlotte area of Florida and how many of them are coping with little help coming from their CD’s and Money Market accounts.

Unfortunately, this highlights that an all cash portfolio may not last a lifetime. You will never lose principal and you don’t face the same risks as you do with the stock market. But an all cash portfolio can provide as much risk of running out of money during your lifetime as stocks or other investments. Here are my thoughts on cash and the retirement portfolio:

1.) Obsolete Core Holding for Many: Cash in the past used to be a great and logical core holding for retirees. However the forces of longevity and inflation make it very hard for people to continue to maintain their purchasing power over the long term (especially after taxes are considered). In my experience, the few who could afford an all cash portfolio usually had rich pensions (which are diminishing as well) and Social Security coupled with disciplined frugality.

2.) Don’t Touch the Principal is Outdated: It is very difficult to have a sustainable retirement cash flow strategy without having to touch the principal. The great draw for risk adverse people towards cash is the interest is consistently spun off without principal. But this limits your alternatives. When you have a diversified portfolio of other asset classes with varying traits, you may be able to touch the principal and still have a better chance of not outliving your money. With a diversified portfolio you can harvest cash flow from investments which are doing well and ripe for the picking while leaving your under-performers in the garden to mature. Dividends, interest, capital gains, principal redemption, it is all money.

3.) Where Are The Bonds? The most interesting thing that I see is most investors have a “barbell” portfolio approach where the decision is either stocks or cash. Where are the bonds? Bonds over the past decade have done quite well as interest rates bottomed out. I suspect that if some of the people highlighted in the WSJ article had part of their nest egg in bond funds over the past decade, they may not be facing the same predicament they are in now.

4.) Cash Has Its Place: Cash is great for expenses needed within the short term, usually within the next 3-5 years. Bad market cycles for stocks usually take three years to recover. By having cash on hand, you avoid the sequence risk of having to sell stocks at lows and instead you can use cash to allow these investments the time to recover their losses.

5.) Excessive Risk Taking May Set In: Chasing yield or going outside the norm usually suggests a tipping point with the retiree who relies on cash and is frustrated with low yields. The real estate bubble was spurred on by mortgage backed securities that were leveraged to provide that higher yield than other interest deriving vehicles. Reverse mortgages or insurance products with implicit “guarantees” start looking attractive. A 70 year old person in the article had 80% of his portfolio in stocks. Why so high? He was quoted as saying, “That’s why most of us are in the stock market, because there is no place to go.”

6.) Problem Appears When It Is Too Late: In retirement planning, usually the problem of having too much cash appears later in life. Even if the person is presented with this projection with time to fix it, many people don’t take action or make change. Why? Human nature tends to discount delayed gratification and provide a premium for today. But for a lot of these people, small changes made a decade ago would have gone a long way. Now the choices are few without taking on excessive risk.

7.) Where’s the Planning? This is where a little financial planning would have gone a long way. A financial planner could have helped these people determine if they had a sustainable lifestyle, addressed the risk of having all cash, and could have helped developed a strategy to balance the needs of today with those of tomorrow. In the article, it discusses one person who turned primarily to cash after the stock market crash of 1987. Unfortunately I suspect a lot of damage may have been done with that one move.

Unfortunately relying on interest rates is something that is out of your control. In the end, I am a firm believer that financial education is a 21st century survival skill and that people need to work with things they can actually influence. The above illustrates that there is a large need for this as I suspect we will see more of these stories as the Baby Boomers enter their retirement years.

(Tentative) Tax Deal Highlights:

Although the tax deal isn’t a done deal yet, I expect an accord to be reached prior to year end. The below is a brief synopsis of the tentative tax deal in place. Just keep in mind that this may be tweaked a bit depending on the political wrangling between now and when it is signed into law:

Tax Rates: Tax rates instituted during the Bush era will be extended for two years (through 2012). The big question over the past several weeks was whether these rates would be extended to all taxpayers or just the lower tax brackets.

Long term capital gain and dividend rates: Current long term capital gain and qualified dividend rates will be extended for two years (through 2012).

Alternative Minimum Tax Patch: The exemption within the AMT calculation will remain at similar levels in 2010 and 2011. This patch has been pushed through for several years now and has prevented millions of taxpayers from being subject to this tax. Over the past few years it has been the end of the year tax drama to see if the patch will be continued. So it’s nice to see that we won’t have to worry about this next year at this time.

Payroll Taxes: Amounts paid toward Social Security from employees will lower from 6.2% to 4.2% in 2011.

Estate and Gift Taxes: The top rate will be 35% (it was set to go to 55%) and an exemption of $5 Million per individual (where it would have reverted to $1 Million). This is the primary bone of contention within the political parties and may have a higher likelihood of change than other aspects of the legislation.

Extenders: These continue to allow for contributions directly out of an IRA for charity for those over age 70 ½, the state and local sales tax deduction as an itemized expense, the extra real estate tax deduction for those who do not itemize and the deduction for teacher’s expenses for 2010 and 2011.

Credits: The child credit of $1,000 is maintained for two years as well as higher education credits and expands the earned income tax credit.

Unemployment Benefits: These are extended at their current level for 13 additional months.

With all of this, I’m sure there will be additional minutia on this once the details come out. Over the course of the next few weeks I will be posting on my blog the planning implications of and how this will affect our economy over the short and long term as finality and details come in.

Political Change, Economy and Markets

With the elections now behind us, I’ve been asked several times what to expect in the markets now that the U.S. House of Representatives has changed political power and what to expect in the economy moving forward.

Historically, a divided Congress has not coincided with stellar stock market returns. According to a recent report by Morningstar, since 1926 there have been 10 years where this has happened and the average annual returns for the S&P 500 have been 1%. Meanwhile, when Congress and the Presidency have been controlled by one party, the average return has been 14.8%; when the Congress was controlled by one party and the Presidency by another, the average return has been 11.1%. So divided power has historically not bode well for the markets.

However, I wouldn’t give all hope up yet. The third year of a four year presidential election cycle has coincided with powerful market returns in the past. Since 1926, the annualized total return for the S&P 500 in a presidential pre-election year has been 17.6%. Meanwhile the post election year has returned 6%, the mid-term year 6.1% and the election year, 9.5%. Some speculate that administrations in power turn up the economic throttle in the third year so they can get re-elected. The S&P 500 has been positive during the last 17 presidential cycle third years with the last negative year being 1939.

The problem of trying to predict the markets and politics in a vacuum is that it takes no consideration of the economic climate or valuations. The economic condition that we currently are in isn’t something that occurs quite often. Valuations tend to historically suggest lower than average results looking forward. I would also suggest this data sample here is so small, that the market/political results can just be a statistical coincidence. Human nature loves to try to find patterns where they may just be meaningless random probability and we should be aware of that.

Meanwhile I continue to see gridlock in Washington. As long as our representatives continue to act more concerned about keeping their jobs and maintaining political power, the longer it’s going to take to find compromise and forward moving solutions to our economy. I suspect that Ben Bernanke has overcompensated on his side and pulled out all the stops with quantitative monetary easing is because he has little faith that our elected officials will do anything positive on the fiscal side. If Congress were to really put their money where their mouth is, they’d be paying attention to what Great Britain is doing. They are taking their financial austerity punches now rather than punting this to future generations. And I suspect that they hard choices they are making NOW will get them on the road to normalcy and growth a lot quicker.