Wealth Clarity Blog

Contrary to the common approach of taking Social Security early, I’ve found that after running hundreds of financial plans, it’s often best to wait. 

The primary reasons people start early is the assumption they can earn better returns than the government or believe they might as well take what they can before entitlement reform kicks in.   While this is reasonable, the decision to take benefits early comes with steep lifetime benefit cuts that increases their risk of outliving their money.   This is further complicated by increasing life expectancies due to medical advancements.  By transferring more of the longevity risk to the government, retirees may find they can go into their later years with more confidence.

Most pundits believe social security reforms will focus on younger workers and won’t impact people who are near or in retirement.  Anything is possible but this makes sense due to the political difficulties of reducing benefits on this influential voting bloc.  One reason high net worth individuals might take benefits early is the risk they could be “means tested” in the future.  However, the potential benefit of starting early if this happened may not provide enough reward to offset the permanently reduced benefits that come with this decision.

With all this in mind, I’ll touch on three potential mistakes I see retirees make:

1)      Taking Benefits Too Early.  70% of retirees take benefits earlier than their normal retirement age.  Age 62 is the earliest you can start and the lifetime benefit reduction is 25%.  One rationale for taking early is you can earn returns on the money you receive; pushing the break-even age (compared with waiting) to the early 80’s if you do well.  What happens if you live past 80?  The life expectancy of a 62 year old female is 86.

2)      Not Considering Joint Life Expectancy.  Upon death, the surviving spouse’s benefit (if lower) jumps to the deceased spouses benefit.  If the husband has a higher benefit, there is a real planning opportunity due to lower male life expectancy.  The husband can wait until 70 to take benefits and receive 32% more compared to starting at 66, while his bride can start her benefits at 62.  If the husband dies first, she can step up to his higher benefit for the rest of her life.  This is especially powerful if the husband is older than his wife. 

3)      Triggering the “Earnings Penalty.”  You temporarily lose $1 of benefit for every $2 of “earned income” over $14,160 if you take benefits before full retirement age, which can be a bad cash flow surprise.  You eventually get this back but it isn’t worth the rigmarole and tax headache.  If you are working part time after you retire from your full time job, it’s best to wait until full retirement age to start Social Security.

From a planning perspective, it’s good to look at scenarios assuming full and reduced benefits to see the implications.  The best age to start is unique to each retiree’s situation and depends on health and a host of other factors.  If you have recently signed up and want to reconsider, the good news is you can change your mind within the first twelve months. 

Due to the fact this is a very complex area, please don’t hesitate to contact me if you have additional questions.

Our recent investment snapshot posed this question: “Is the current economic crisis a ‘soft patch’ or the beginning of a double-dip recession?”  I’m starting to wonder if we aren’t instead in a mud puddle.  I recently heard this term used to describe the space between soft patch and recession, and it resonated with me.

In short, our economic outlook is messy – muddy, in fact.  Yesterday’s stock market response showed some of the pent-up concern and frustration with our political circus, our persistently stuck unemployment, and the slow (or absent) economic growth that is lingering like a fog over any sense of confidence.

Is this “Groundhog Day” as it relates to the recessionary period starting in 2008?  Are we heading back towards a repeat of that time frame?  I really don’t think so, primarily because the backdrop is different this time around.  The consumer has taken steps to deleverage and in fact is saving more; businesses have gotten leaner and are generating decent levels of cash flow; and economic indicators including auto sales, home starts, and unemployment are already hovering near their lows.  It doesn’t mean they won’t move lower, but our economic dashboard is already anemic and that isn’t news.  (One important caveat: the European debt crisis could continue to have material global effects.)

Objectively, equity valuations are below historical averages on a price to earnings basis, and the earnings yield (inverse of the P/E ratio) is trending well above 10-year Treasury rates.  This is something even Warren Buffett likes to see!  When compared to other investment alternatives, including negative real rates of return on money market funds, growth assets should not be arbitrarily put in the dog house.

I have found that one healthy way to look at your portfolio is to use the following exercise:  assume that your portfolio is sitting in cash today instead of the current positions you may hold.  Then, look at all of your possible investment alternatives from a risk and return standpoint and ask yourself how you would you allocate the money if you had to right now.  Many times investors can get anchored to their existing holdings too strongly, especially when viewed through the lens of trading costs, unrealized gains/losses, and taxes.  If you try to position your portfolio using the approach above, you can minimize the emotional challenges of making investment decisions.

So, here are a few investment keys for working through this financial mud puddle while keeping you moving towards your goals:

1.  Focus on fundamentals more than you focus on the news—now is the time to hone in on the facts and not get blown around by the ever increasing list of “experts” espousing fear (in most cases.)

2.  Stay agnostic about the investment choices you have—remember that interest rates are at historically low levels, and cash is paying virtually nothing.  This isn’t the case in equities, nor in a few other spaces.  I’m not suggesting increasing your risk posture without great consideration – instead, focus on objectively seeking value where it exists.

3.  Don’t change your investment philosophy or strategy now—my experience has shown that successful investors hold tighter to their investment approach during times of uncertainty.  Better to have an approach and philosophy that you believe in (even if it’s not perfect) than to not have one at all, because the damage caused can be material.

4.  Be nimble—the world changes quickly, and the pace of change continues to increase. Make sure that your investment approach has the ability to make tactical shifts as new information emerges.

5.  Favor quality and cash flow in this potentially low growth environment—going forward, as noted in previous posts about the “New Normal,” adjusting your return expectations downward and looking at cash flow as an important part of return will be critical.  Don’t get seduced into reaching for yield or outsized returns.

How can you work through these types of world stress points?  Be resilient.  Be a survivor, and not a hero. Feel free to contact me if there is a specific question you would like me to address.

If you missed our webinar earlier this month, you’re in luck!  Click this link for playback of the Preserving, Protecting, and Enhancing Wealth in the New Normal webinar. Slides, audio, and tips.

Sorry you missed the ‘live’ webinar, we’ll let you know when our next one will be.  In the meantime, do you have any questions or feedback for us?

Below is another very helpful tax missive from our friends at Kovarik and Kim CPAs detailing many of the anticipated tax changes coming our way at the end of this year.  You might remember that the Bush-era tax cuts will be expiring on 12/31 if Congress doesn’t act before then.  In addition, the new Healthcare Reform legislation signed into law by President Obama will also usher in another slew of tax changes (read “increases”).  The real impact will be on the higher income and wealthier individuals. 

The high points in summary are as follows:

1. When fully phased in, the top long-term capital gains rate could climb from 15% to 23.8% including applicable surtaxes, and ordinary dividends will no longer have preferential treatment.
2. Regular marginal tax rates will increase from 35% to 39.6%.
3. Shifting income into 2010 could be an interesting tax planning strategy to review in light of the changing future environment. Continue Reading »

It’s the third Friday, which means it’s our third and last guest sports blog!

Guest post by Daniel McGilvray, vice president of investments, Highland Capital Management

During the U.S. Open at Pebble Beach a month or so ago, Dustin Johnson lost a three shot lead going into the final round on Sunday and actually ended up outside of the top 10. Justin Rose followed the week after at the Travelers Championship by blowing a three shot lead over the rest of the field and did not end up even coming in the top five. Both of them seemed to lose the strategy that got them to the top of the leader board in the first place. They went from making great shots to getting cautious to making horrible shots to try to make up for the cautious shots and losing the lead. Contrast that with what happened this past weekend with a virtual no name in golf: Louis Oosthuizen. He went into the final day of the British Open at St. Andrews leading by four strokes and actually EXTENDED his lead by a few strokes on the final day. While he adjusted his strategy to be slightly less risky, he stuck with his overall game and did not get too cautious.

It can be the same way at times in investing…we stray from our originally intended strategy because things get “too bad” or there’s a new “normal” or new “paradigm”.  At Highland, while we make tactical over weights or under weights at certain times, we work hard to come up with the right strategic targets for clients as the anchor to ensure that the underlying investments do not stray too far from target (high or low) and get too far away from the originally intended strategy. Without those “anchors” to make sure you don’t stray too far from the original strategy, you could easily end up losing all the gains you’ve made and possibly even going below what you originally had if there is no process to assure some money is taken off the table and gains are harvested (or that funds are added to those areas that underperform over an extended period of time).

In this manner, an investor can ensure that they do not lose the lead (or are unable to ever get back losses). An obvious example of this is the advisor/investor who gets conservative near the bottom of the markets or aggressive near the top of the markets. Bad timing in either account can cause losses to persist. So remember, stay anchored to your long-term strategy.

It’s Friday, which means we’re bringing you part two of our three part guest blogging sports series!

Guest post by Daniel McGilvray, vice president of investments, Highland Capital Management

While watching the U.S. soccer team in the World Cup, it was interesting to note that essentially every single game (with the exception of Algeria which should have had an early goal, but their shot hit the cross bar), the U.S. got behind within the first 10-15 minutes and were playing from behind the rest of the game. I’m 100 percent sure the U.S. did not come out with a plan to get behind right away, but it did seem to me that for some reason they played MUCH better when they were behind. I’m not sure if it was just a greater sense of urgency, or what, but either way, the coach obviously did not do what he needed to do to get the team to come out ready to play from the moment the game started.

I think that it’s the same way at times in investing. Until people lose a certain amount of money in their portfolio or are really “forced” to have to do something with their money, at times, they would prefer not to think about it and just “let it ride”.  It’s important to take into account all of your investment psychology, history, thoughts, goals, dreams, needs, wants, etc. before setting up your long-term strategic asset allocation targets and work with you to determine the right set of parameters. While we also remain “in the game” after strategic targets have been determined by making tactical moves in/out of certain investments or over/underweighting certain asset classes, the overriding principle of the portfolio is the strategic asset allocation.

Do you know what your long-term strategy should be? Are you comfortable with being “in the game”? If not, maybe you don’t have the right plan, or need to collaborate more with your investment advisor to come up with the right one.

A few people have recently expressed concerns to us about market volatility and where the economy is heading. Other people have asked us what options are available to help drive portfolio returns in the midst of such low yields on bonds (the two year Treasury yield recently hit its lowest point ever at 0.6 percent and the 10 year yield is now below three percent). Alternative assets, which we have built into client portfolios over the past few years, are a natural solution for reducing portfolio volatility and boosting returns. As a firm, Highland now has approximately 20 percent invested in alternative assets and even our most conservative clients generally have 10 percent or more of their portfolio exposure in alternative asset classes. Over the past quarter in fact, most of the alternative asset classes were down ½ or less than the equity markets and some (specifically gold and certain hedge funds) were actually up.

We wrote a white paper as a primer on alternative assets, which generally help mute portfolio volatility due to their low correlations with traditional asset classes. As mentioned, they can also help bolster returns. Alternative assets do have some drawbacks: namely, they tend to have longer investment horizons, involve higher risk at times, and have less liquidity than traditional asset classes. In the past the cost of participating in alternative investments was prohibitively high, however, there are now more options that allow investors to participate at lower dollar amounts. If you’re curious about alternative asset classes and what role they play in your portfolio, the white paper is a good introduction for how these asset classes behave and a description of the mechanics for making investments.

If interested in the white paper, shoot me an email (info@highlandcm.com) and I’ll send it to you for free.

It’s Friday, which means we’re bringing you part one of our three part guest blogging sports series!

Guest post by Daniel McGilvray, vice president of investments, Highland Capital Management

Many of you may have seen a portion of, or at least heard about the longest match in tennis history, which was played a few weeks ago at Wimbledon. Unless you are a tennis player however, you may not realize exactly how in the world this happened.

Basically, each of the players had a great serve and not a very good return of serve so neither could ever beat the other one on their serve. In fact, there were 215 aces in the match with each player serving over 100 aces! With a typical game being the first one to get four points and a typical set being the first one to get 6 games that means both John Isner (who finally broke serve in the 138^th game of the 5^th set to win it) and Nicolas Mahut each won over four sets on aces alone! In fact, this match could have gone on forever if it weren’t for exhaustion because without a tie breaker in the 5^th set if someone doesn’t break the other persons serve the match would literally go on forever and no one would ever lose (or win).

There is a term and strategy in investing which is very similar to holding serve in tennis; it’s called passive investing. With it, you will never underperform the benchmark (assuming the investment vehicle you use tracks the benchmark closely), but you also will sacrifice any opportunity for outperformance. This is precisely why we, and many other investment firms, have a “core” holding in passive indexes for one, or many, asset classes to provide the “beta” in the portfolio. The strategy allows you to at least meet the benchmark on a portion of your portfolio at virtually no cost.

To win a tennis match, however, one has to break serve. Similarly, to beat the benchmark, a portfolio has to take some deviation from the benchmark. This is commonly known as active investing or providing “alpha” to the portfolio. At Highland we do this by trying to pick the best active funds over both a long period of time and recently and those that have a fairly consistent history of beating the benchmarks in their respective categories. We also watch our funds closely for any changes in management, changes in strategy, weakening returns, etc. to make changes if/when necessary. So, while everyone hopes to win the match (beat the benchmarks), there is some comfort, as Isner had in this match, of holding serve.

First, there is a huge sell-off in stocks starting in 2008; then, the big rally back higher this past year.  It really didn’t matter what stock you owned in either case as most moved in tandem. 

Now what?  In general, I would argue that stocks aren’t overly cheap; and, stocks aren’t extremely overpriced.  So, what do you do in this confusing time?

In a recent article in The New York Times titled When Stocks Stop Moving Like a Herd, Paul Lim gets it right in several respects:

It is easier to invest when all you have to do is jump in when everything is moving up, like the past year, and critical thinking about specific investments is less relevant.  Just get the direction right and you win…but that dynamic is changing fast.

The equity markets appear to be moving towards an environment that will reward those who can find value.  You can still purchase growth stocks, but it would behoove you not to overpay for them.

Active management can be a key contributor to performance during this type of uncertainty because of the opportunity to tilt your portfolio towards undervalued investments and adjust to new information.

The quality of your advisor will play a big part in the results you see over the next few years.  A well-defined investment process and experienced team is as important as ever.

Keeping Paul’s ideas in mind, I wanted to give you a few tips that could really help your portfolio results during the next few years.

1. Review how much of your portfolio is indexed versus actively managed — I would argue that a higher allocation to actively managed assets is appropriate in this uncertain economic environment.  Increasing volatility expands the chances of finding interesting opportunities.
2. Make sure your investment selection process includes a valuation screen and doesn’t just focus on growth.  If history repeats itself, we could see value stocks outperform growth stocks in the years ahead. (Note:  We believe our internal stock strategy of growth at a reasonable price is particularly timely in this type of economic environment.)
3. Evaluate your advisor’s investment philosophy and strategy — can they communicate it to you so you understand it?  Does it make sense to you?  Did they stick to it or did they abandon it during the recent financial meltdown?  What did they learn during the past few years and what adjustments are they making?  A high quality advisor is more important now, than ever.

Do you have any investment tips to add that you’ve been successful with?

David Swensen, the brain behind the well-chronicled success of the Yale Endowment investment portfolio, pioneered an approach that pushed the boundaries of traditional portfolio management.  By adding large concentrations of illiquid assets (real estate, private equity, hedge funds) to the traditional liquid portfolio, he produced excellent results, especially during the tech bubble of 2000.

As you might have guessed, just about the time individuals and large institutions started copying Yale (and Swensen), the strategy had a tough year last year and produced large losses.

Why the Yale Model of Investing Doesn’t Work for Everybody – Justin Fox – Harvard Business Review

I recently read this insightful blog post by Justin Fox at Harvard Business Review and took away five key points that I thought wealth creators could benefit from and I’m sharing them with you.

1. Don’t chase yesterday’s stars — By the time the strategy is well documented and discovered and lots of money has poured in, the excess return provided by the approach is usually gone.
2. Keep learning— Swensen and team don’t keep static portfolio allocations.  Theirs isn’t a buy-and-hold-type approach.  The strategy stays the same, but they adjust their portfolio allocations to match what they believe will happen in the future based on research, judgment, and experience.
3. Stick with it— One of the reasons that Swensen (or Buffett for that matter), is successful is that he has developed a strategy for investing and he has the patience and gumption to stick with his approach and believe in it over the long term.  One bad year doesn’t cause the strategy to change.
4. Trust is required — Find a good, smart person (or team) to run a strategy, especially a person who is in it for the long haul, and then don’t dwell excessively on quarter to quarter results.
5. Design the strategy for your needs — Yale’s model works partly because it is good for Yale.  It was designed and executed for their needs and requirements not someone else.

How does your portfolio strategy stack-up to this?