Friday, August 29, 2008

A Genesis Tale

"First God made heaven and earth.
The earth was without form and void,
and darkness was upon the face of the deep;
and the Spirit of God was moving over the face of the waters."
- Genesis, Chapter 1, verses 1 and 2

Day 1
God saw that money was without form, and darkness was upon it.
And God said, “Let there be financial engineering, that money may have form and be multiplied.”
And it was so, and God saw that it was good.

Day 2
God saw that there was no one to promote money in all its forms.
And God said, “Let there be Wall Street, that money in all its forms may be spread to the far reaches of the earth.”
And it was so, and God saw that it was good.

Day 3
God saw that Wall Street had no one to send out upon the earth to sell money.
And God said, “Let there be Salesmen, that the products of Wall Street may have promoters.”
And it was so, and God saw that it was good.

Day 4
God saw that the Salesmen had no one to call on.
And God said, “Let there be Prospects, that the Salesmen have someone to call upon.”
And it was so, and God saw that it was good.

Day 5
God heard the anguished cries of the Salesmen that they could not make enough money on salary alone.
And God said, “Let there be commissions, that the Salesmen shall earn bounteous incomes from the Prospects.”
And it was so, and God saw that it was good.

Day 6
And God saw that there was wickedness and avarice in Wall Street and the Salesmen, and the Prospects were crying out in anguish.
And God said, “Let there be independent advisors, that the Prospects may receive unbiased advice from fiduciaries.”
And it was so, and God saw that it was good.

Day 7
And God rested. Finally.

(I am an independent advisor and I accept the fiduciary role for my clients).


Thursday, August 28, 2008

401k Freedom of Choice

“Oh freedom (freedom), freedom (freedom), freedom, yeah freedom
Freedom (freedom), freedom (freedom), freedom, ooh freedom”
- Think - performed by Aretha Franklin

Many (if not most) 401k plans offer a limited menu of investment choices. One would expect that larger employers would offer more choices, but there doesn’t seem to be any correlation between the size of the employer and the investment options offered in a 401k plan. Unfortunately, many employers do not offer what financial planners would call a sufficient range of investment options. A typical 401k plan offers a limited number of mutual funds, often funds from the same mutual fund family e.g., T. Rowe Price, Fidelity and others (not to pick on either of these firms). A newer trend in 401k plans is offering mutual funds from several different fund families and, while better than “single family” options, the choices are still often narrowly limited.

Enter, the Brokerage Window.

Recognizing the desire for more investment diversity and control, more employers are adding the ability to establish a brokerage account within their 401k plans. With a brokerage option in a 401k plan, employees have an almost unlimited choice of investment options. One can finally build a 401k account tailored to their individual risk tolerance without compromising based on a limited menu of investment choices.

If your employer is offering a brokerage account option for your 401k plan, sign up.

Now, just because you can buy (almost) anything doesn’t mean that you should. This is your retirement money, not your Vegas money (you've seen those ads - "What happens in Vegas, stays in Vegas"? they don't mention that mostly what "stays in Vegas" is your money...). Build an asset allocation plan tailored to your personal risk tolerance and stick to it (e-mail me - see below - for a self-scoring Risk Tolerance Questionnaire). Professional financial planners (such as yours truly) design asset allocation plans all the time. Seek out competent advice – paying a professional fee for an hour or two of work will be money well spent.

The brokerage account option should allow you to invest in Exchange-Traded Funds (ETFs). ETFs are in many ways superior to mutual funds – cost being one of the most desirable. The cost of ownership in the average mutual fund is ~1.35% vs. ~.41% for the average ETF (per CNN). Why is this important? Because returns always vary, but expenses go on and on. Given the exact same investment performance between the average mutual fund and the average ETF, the ETF will have a return that is nearly 1% higher because of the lower cost.

1. Sign up for your plan’s brokerage account option.

2. Design an asset allocation plan – with professional help if needed.

3. Implement the allocation plan using ETFs.

4. Relax. Enjoy life.


Thursday, August 21, 2008

Think the Housing Crisis is Over?

" It ain't over 'til it's over "
- Yogi Berra

We’ve been hearing every week for some time that the credit crunch is over, that the banks have come clean on all their bad assets, the economy is averting a recession, housing prices have stabilized and everything is rosy again.

Time to buy a house! (There are a few banks that would love to sell you a house).

Trouble is, we’ve been hearing the same thing every week for a year and in spite of the increasing repetition, it is no more true now than it was then.

If you are thinking of buying a house, wait. They will be cheaper next year. There’s no feeling like watching the equity shrink in a house you just purchased. If you have to sell the house you own now first, be prepared to wait for a buyer and be prepared to slash your price.

Here is a chart I borrowed that is based on federal government statistics. It portends a total drop in home values of 34% to get back to the historical price trend line.


There are lots of other scary charts out there illuminating different facets of the same point: housing prices are not sustainable and have to come down (further). This is true in other countries too – easy credit made the leap across the oceans. Mortgage foreclosures are on the rise all over the world. Banks aren’t in the business of owning real estate – what will they do to get rid of the homes they’ve repossessed? Slash prices until they find buyers. What will this kind of price pressure do to the prices of other homes on the market? Yes – prices are going down.

It ain’t over yet. Just ask Yogi.


To Roth or Not to Roth

If you have a choice between a tax-deductible retirement plan and a non tax-deductible retirement plan, which one should you pick?

The answer has a lot to do with a current unknown – future income tax rates.

Let’s leave aside the issue of increased future tax rates since we don’t know what they will be and can’t do anything about them if we did.

If you contribute to an IRA or 401k and deduct the contribution against your current income you are probably better off if you assume your marginal tax rate (the rate you pay on the last dollar of income each year) will be the same as it is now. This is due to the difference between your marginal tax rate and your effective (average) tax rate.

Here is the 2007 Tax Rate Schedule for married couples filing a joint return:

The income ranges shown in the “Over/But not over” columns are called brackets. Each bracket has its associated tax rate of 10% to 35%. If your taxable income lands you in the 28% bracket, then you pay 28% on each dollar of taxable income in excess of $128,500. By making a tax-deductible contribution to a retirement account, you reduce your taxable income and thus your income tax due by the same percentage.

Overall though, your income – including taxable retirement plan distributions - is taxed at your effective or average tax rate. Calculate this by dividing your tax for the year (Form 1040 line 63) by your taxable income for the year (Form 1040 line 43). The resulting percentage will be less than your marginal rate.

As long as your effective tax rate at the time of retirement account distributions is lower than the marginal rate at which the contributions were deducted, you are probably better off using a deductible retirement account if eligible. Since we don’t know now if this will be true, hedging one’s bets is advised.

You can hedge your future tax exposure by having a mix of “deduct now/pay later” (Traditional IRAs and 401ks) and “pay now/pay nothing later” (Roth IRAs and Roth 401ks) retirement accounts.

The income eligibility limitations for opening a Roth IRA are higher than they are for making tax-deductible contributions to a Traditional IRA. So it is possible that if you can’t deduct a Traditional IRA contribution you could be eligible to open a Roth IRA. If you don't qualify to make a tax -deductible IRA contribution, but are eligible to make a Roth IRA contribution do the Roth, as a Roth IRA is superior to a non-deductible IRA. (A non-deductible IRA contribution is not taxed upon withdrawal, but the earnings are taxed as ordinary income). There are no income limitations for participating in 401k plans although contributions may be limited for high income earners due to the non-discrimination rules if the plan doesn’t pass the required testing.

Remember that the rules can change: "Congress giveth, and Congress taketh away".


Wednesday, August 20, 2008

Carrots and Sticks

" If the people don't want to come out to the ballpark, nobody's going to stop them "
- Yogi Berra

You may be contemplating how best to allocate your retirement savings contributions among the many choices available. You have probably heard about the Roth IRA and its cousin, the Roth 401k. Let’s see if we can shed some light on the issues involved in making the choice of a Traditional IRA or a Roth IRA. Along the way we’ll do the same for the Traditional 401k and the Roth 401k.

Let’s assume that you want to save for retirement and that you can afford to do so.

So where do you put your money? We must distinguish here between the conduit by which you save and the actual investment of the funds. These are two different things. Today we are talking about the conduit by which you save and have little interest in the actual investment of the funds.

The conduit by which you save is the account into which you make your deposit – “contribution” in retirement account parlance. For example, an IRA (Individual Retirement Account) is not an investment in and of itself, but a conduit through which one can invest. I’ve had many conversations over the years in which people have told me they have an IRA but when I query them about what it’s invested in, they revert to insisting they have an IRA, believing the IRA itself is an investment. So, an IRA (or other retirement savings conduit) is not an investment but is a means by which one can invest. An analogy may be helpful: think of an IRA (or other account type) as a garage and the investment as your car that you park in the garage.

So which type of retirement conduit should you have? Like a lot of answers in the financial world, “it depends”, so let’s do a little compare and contrast.

#1 Caveat: All information here is based on U.S. tax laws as they exist in 2008.

#1 Carrot: ALL retirement accounts offer tax deferral on account earnings. No income taxes are due during what is called the "accumulation phase" - the period during which you are making contributions.

#1 Stick: You will pay income taxes on some or all of your retirement account balance at some point in time (either when the funds go in or when the funds come out).

Traditional IRA (tax deductible)
Carrot: Contributions made to a Traditional IRA may be tax deductible. This means for those who qualify, the amount contributed is deducted (line 32 of the IRS Form 1040) from “total income”. The annual contribution limit for those under age 50 is $5,000 ($6,000 if you are 50 or older). So if you contribute the full $5,000 and qualify to deduct the entire amount, then your income is reduced by the $5,000 ($6,000) contributed to the IRA. You have reduced your income tax by the amount of the IRA contribution times your marginal tax bracket. Assume your marginal tax bracket is 28%. This means that the last dollar of income you receive each year is taxed at 28% (not accounting for special treatment for capital gains, dividends, etc). This works in reverse when making a tax deductible IRA contribution. $5,000 times 28% = $1,400 off your tax bill for the year. Magic? No, just math. The bottom line is that putting away $5,000 only cost you $5,000. Without the deduction, you would have to earn $6,944, pay 28% in income taxes to bring home the $5,000 to put in the account.

Stick: All distributions from a Traditional IRA (with all contributions deducted) are taxed as ordinary income (no capital gains or other special treatment). An additional 10% penalty tax is added if the account owner is <59 – look for Publication 590.

Roth IRA (non-deductible)
Stick: Contributions made to a Roth IRA are not tax deductible. To put $5,000 in a Roth IRA account, you have to earn $6,944 then pay 28% income taxes to bring home the $5,000 to put in the account.

Carrot: All qualifying distributions from a Roth IRA are not taxed. This means no income taxes are due on the money earned by your contributions. A “qualifying distribution” is one that occurs after the account owner is 59 ½ AND the account has been open for five years. HINT: If you are eligible, open a Roth IRA now to get the five year clock started – especially if you are >50.

Income limitations apply - check the eligibility rules for opening a Roth IRA at – look for Publication 590.

Traditional 401k (tax deductible)
Carrot: Contributions made to a Traditional 401k are tax deductible. The annual contribution limit is $15,500 ($20,500 if 50 or older). Your employer may match a portion of your contribution. The employer contribution is not taxed to you at the time it is made. The same tax accounting applies as for a Traditional IRA: since the contribution is tax deductible, it only costs you $15,500 to make a $15,500 contribution.

Stick: All distributions from a Traditional 401k (including employer contributions and related earnings) are taxed as ordinary income.

Roth 401k (non deductible)
Stick: Contributions made to a Roth 401k are not tax deductible. Contribution limits are the same as for the deductible 401k and the rules are written such that total 401k deferrals are limited to $15,500 (or $20,500) so you can contribute to both types of 401ks at the same time, but the total contribution allowed doesn’t increase. To put $15,500 in a Roth 401k account, you have to earn $21,527 then pay 28% income taxes to bring home the $15,500 to put in the account.

Carrot: Qualifying distributions of your contributions plus earnings from a Roth 401k are not taxed. Employer contributions are not taxed to you when they are made.

ALERT: Employer contributions to a Roth 401k (plus related earnings) are accounted for separately and are taxed as ordinary income upon distribution. This is so for the simple reason that the employer’s contribution is a tax-deductible expense to the employer – since the employer contribution is deducted on the way in, it must be taxed on the way out.

So now that we’ve covered the basic differences between the retirement accounts available to most people, the question occurring to you is probably something like this: If I have a choice, what should I choose? We’ll cover that topic in our next post.


Monday, August 11, 2008

Word o' the Day: Insurance (ABC’s of Financial Planning)

Insurance is a risk transfer device.

For a fee, someone else will indemnify you, your possessions or property against loss for a certain time period.

The concept of insurance is based on the law of large numbers which states that the larger the number of observations of an activity, the more likely the observed outcomes of the activities will be equal to the expected outcomes. In essence, the more participants buying a particular type of insurance, the more likely the actual claims experience will match the expected claims experience. This allows insurance companies to price the risks they assume, knowing that a certain percentage of the insured population will submit a claim, but that a certain percentage will not. This is why insurance works – in some cases – or doesn’t work – in other cases.

I define “works” in this context as meaning the desired type of insurance is reasonably priced and readily available to those seeking the protection offered. Examples are auto insurance, life insurance and home insurance.

A good example of insurance that “doesn’t work” is health insurance in the U.S. It is – generally speaking – not reasonably priced and not readily available to those seeking protection. There are a number of reasons for this, but the basic reason is that health insurance in the U.S. is in violation of the law of large numbers. There are too many people who are not insured. If the U.S. were to somehow insure everyone living in the country, the cost of health insurance - on a per capita basis - would go down.


Thursday, August 7, 2008

Your House as ATM

“Cause I love to live so pleasantly,
Live this life of luxury,
Lazing on a sunny afternoon,
In the summertime.”
- Sunny Afternoon – The Kinks

There haven’t been too many sunny afternoons here this year, but that hasn’t stopped many homeowners from wanting to live pleasantly. Rising home prices over the last several years created large increases in home equity, prompting many - insert your town name here - homeowners to treat their home like a cash machine via home equity loans (HELOCs) or re-financed mortgages.

In the financial world, borrowed money is called leverage. In a leveraged transaction, the borrower invests borrowed money, and if successful, repays the loan, keeps the profit, minus the cost of borrowing. If unsuccessful, the borrower still has to repay the loan plus interest, but since the investment was a loser, she doesn’t have all of the borrowed funds to repay the loan and must cover the loss from other funds. This can be very painful financially.

The problem for - insert your town name here - homeowners leveraging the equity in their homes is that a good portion of the money borrowed is not invested in appreciating assets. Many - insert your town name here - homeowners spent the money in one of three ways: home improvements, experiences (vacations and trips) and depreciating assets (cars, boats, home furnishings, etc). Spending borrowed money on home improvements can work out successfully – if the home is increasing in value at a rate higher than the cost of borrowing. To be fair, there can be intangible rewards too, e.g., increased satisfaction with one’s living space. But, spending borrowed money on lifestyle choices (experiences or depreciating assets) is a poor use of leverage because neither experiences nor depreciating assets can be used to repay the loan. Long after the experience is over or the car is sold, the borrower is still making payments on the home loan. When the value of homes stops increasing or even declines, equity-leveraged homeowners can find themselves with little or no equity but – you guessed it - they still have loan payments. Home values in my local area have been fairly stable after the large run up in 2004 - 2006 unlike many other regions in the U.S., lulling local homeowners into perhaps a false sense of complacency. I can only imagine what people in parts of the country where housing values are diving are doing: working second and third jobs, cutting out all the extras and in the end, walking away (“jingle mail” - that's where you put your keys in an envelope and mail them to the bank).

Rainy Day Advice: if you haven’t tapped the equity in your home, don’t start now. If you have, review your decision and develop a strategy to repay the loan. If home values keep falling, today’s home equity party can easily become tomorrow’s home equity hangover.



“It is not the strongest of the species that survives, nor the most intelligent that survives.
It is the one that is the most adaptable to change.”
- Charles Darwin

Here in the United (Consumer) States, the shock of exponentially higher oil prices is rippling through the economy. The cost of simply getting around has nearly doubled in the past year. This not only affects your direct cost of putting gas in the tank, but virtually all of your indirect costs when you consider the cost of transporting the products you buy every day. Not to mention the almost innumerable products that are made from oil – e.g., plastic drink containers.

I was recently in Europe where consumers have been adapting to high energy prices for many years. Their houses are smaller (lower heating and cooling costs), their cars are smaller (lower operating costs), they ride bicycles (it’s a little shocking at first to see a guy in a business suit riding a bike), they have well-developed public transportation networks and they use them, they ride motor scooters, hot water is provided by on-demand gas heaters (no money wasted on heating a tank of water that may only be used 1 hour a day), dishwashers are uncommon and their clothes washers are low volume front loaders. If the laundry hanging from balconies and windows everywhere is any indication, clothes drying is commonly provided by Mother Nature.

Here’s a picture of gas prices in Milan, Italy (June 30, 2008):

That’s €1.55 (Euros) per Liter.

The exchange rate for U.S. dollars into Euros (at the time this picture was taken) was about US$1.58.

There are 3.8 Liters in one US gallon.

The price of one US gallon of gas in Milan: US$9.30.

How would you adapt to paying US$9.30 per gallon?

Walk more. Use public transportation. Drive less. Downsize your car. Ride a bike. Downsize your home. Replace your appliances. Europeans have been doing all of these for years. Here is a typical euro-sized car:

This is not to say that you have to adopt any of these changes, the US is still the land of the free and the home of the brave, and there aren’t any laws – except the economic laws of the marketplace – that compel energy consumption behavior changes (yet). It seems that $4 per gallon gasoline is the pain threshold that is causing at least temporary habit changes.

Reducing one’s energy consumption is an incremental process that should be reviewed in the context of one’s overall living cost. As an example, it may not pencil out to trade in a large SUV for a smaller car even though the smaller car travels two or three times as far on a gallon. Look at the total cost of such a trade – prices for used SUVs are falling faster than a Randy Johnson splitter - while the price of efficient smaller cars (particularly hybrids like the Toyota Prius) is rising as demand increases. Calculate your break-even on such a swap before proceeding. You will probably be surprised at how long the pay off takes. Another example is compact fluorescent light bulbs. Yes, they last longer and use less electricity than incandescent bulbs, but they also cost three times as much (not considering sales and sponsored giveaways which are currently popular). They also make every room look like a morgue. Incandescent bulbs will likely be legislated out of existence – remember what happened to full flush toilets. The last thing you want to do is throw out a working incandescent bulb. At least wait until it burns out before upgrading. LED lights - which are superior in every way - will replace fluorescent bulbs anyway, it’s just going to take a while before innovation brings the price down.

So if we don’t change our ways are we going to die? No. Newsflash: we’re going to die anyway…