Appreciating Assets Part 2: Other Investments

(2010-04-26) by David John Marotta

Your top-level asset allocation determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you, appreciating more than inflation to become an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

Stocks average 6.5% over inflation. Bonds average 3% over inflation. Thus after 25 years, $100,000 invested in stocks will have a buying power of $483,000. And $100,000 invested in bonds will have a buying power of $209,000.

Many other assets fare worse than these two categories. Understanding the average appreciation of these assets can help you model retirement projections and decide to invest or not.

Commercial real estate barely appreciates at the rate of inflation. Actually, it depreciates against inflation by about 1% a year. Fortunately, it should produce enough income to overcome this depreciation and produce a real return of about 4.9% over inflation. We invest in Real Estate Investment Trusts (REITs) that are publicly priced and traded as equities on the stock exchanges.

Handling a private commercial real estate requires more work. If private commercial real estate isn't generating a lot more income than it costs to maintain it--including depreciation--it isn't pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.

Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.

A few years ago real estate was the darling that appreciated at over 1% a month. Now in parts of Michigan, Florida and California, those same homes are going for 20 cents on the dollar in foreclosure sales.

Remember that the house you are living in is an expense, not an investment. An investment pays you money. Although the principal portion of your mortgage payment is forced savings that will nearly keep up with inflation, it doesn't grow and work for you. Because you are occupying the house, you forgo the rental income that would provide the real return above inflation.

Gold is even worse than real estate. There is never any possible income from gold, so it just holds its value. And gold can be extremely volatile, losing 69% of its value in a 21-year decline from $850 an ounce in 1980 to $260 an ounce in 2001.

At least gold holds its value. Cash loses its buying power by the rate of inflation. After 25 years, although you might still have $100,000 in cash, it will only have the buying power of about $32,000. An inflation rate of 4.5% is devastating over the long term.

Fixed annuities act like cash. They lose their buying power quickly over time. Even if you could get an immediate annuity paying 7% at age 65, it would still be a bad deal. Seven percent sounds good only because you fail to take into account the immediate loss of 100% of your principal. If you die any time during the first 14 years, your return would be zero. You would only have received your own money back.

Assuming you live an average lifespan, your return would be 3.06%, not even keeping up with inflation. And even if you and your spouse both lived to be 100, your annual return would only reach 6.35% or a 1.85% real return, which is worse than an all-bond portfolio.

Immediate annuities initially seem like sufficient spending money, but that's only because they are front-loaded with buying power. If you want to maintain a certain standard of living, you should save some of the initial payout to supplement purchasing power at the end.

Even if you could purchase a $100,000 fixed annuity paying 7%, or $7,000 a year, you should only spend half of that amount. You would need to save the other half to supplement your spending later when you need more money to keep the same lifestyle.

Social Security is a little like a fixed annuity. Because it is indexed to the government's official inflation numbers, it doesn't keep up with real inflation. As a result, Social Security has a real return of about -2%

At this rate, over 25 years your Social Security payments will drop to about 60% of their initial purchasing power. Consequently, at the full retirement age of 66, we recommend only spending 84% of your Social Security income on your standard of living. Save the other 16% and invest it in equities to supplement your lifestyle later when the buying power of your Social Security payment dwindles because of inflation.

No one should count on Social Security. Had the money we've paid into Social Security been saved and invested in almost anything, every senior would be retiring as a multimillionaire. Until our Social Security system is privatized--like the one in Chile--it is not an investment you own. It is completely subject to the political risk of the next stroke of the pen. Inevitably Social Security benefits will be means tested so that people with more than a certain amount of assets, say a half million dollars, will no longer receive benefits.

We pencil Social Security payments into retirement equations tentatively and then see where we are without considering them. The younger the client, the less chance of collecting even the smallest fraction of what was contributed.

Many other expensive items should not be considered an investment. Just because it costs a lot doesn't mean it is an investment. For example, art is not an investment. Neither is furniture or a new roof. Neither is installing solar or geothermal. It may save you money, but that doesn't make it an investment. If it saves you money, you should be able to reduce your standard of living accordingly and put more money into your real investments. If that is the case, I would call putting more money into your real investments the "savings" and not consider the energy efficiency an investment.

If you can't put more money into your savings, then your purchase simply allowed you to increase your spending someplace else and was neither an investment nor did it save you any money. This principle should be applied toward anything that salespeople are apt to call an "investment," such as energy-efficient cars or time-share rental property.

Just calling something an investment doesn't make it so. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on non-investments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.

from http://www.emarotta.com/article.php?ID=387

The Fragility of Freedom at 60%

(2010-04-19) by David John Marotta

In 1977 economist Milton Friedman wrote an article "The Line We Dare Not Cross: The Fragility of Freedom at '60%.'"

He predicted that as the percentage of society that owes a portion of their livelihood to government spending increases, the ability to limit the growth of government will decrease. At some tipping point, attempts to reduce the size and scope of government become too difficult. Welfare statism sets in as a permanent malaise and drags on the growth of the economy.

Friedman said, "We still have some ruin in us, but pretty soon we are going to be forced to face up to the issue." We did a good job of keeping government spending relatively constant as a percentage of gross domestic product (GDP) for the next 30 years. Total government spending was at 33% in 1977 and had risen to only 35% by 2007. But since 2007 we've expanded the scope of government from 35% of GDP to 45%.

This overspending is certainly severe, but the cumulative deficit spending is even more critical. When Friedman warned us about the fragility of freedom, the gross public debt was at 47% of GDP. After three decades of deficits it had risen to 81%. Today it is at 120%. In just three short years we've added more to the deficit as a percentage of GDP than in the three decades before.

We don't have much ruin left. We have to face up to the issue. We are in danger of crossing a line we dare not cross.

Every time government spends money to provide security to a few, it destabilizes the rest of society. Shore up one sector and you risk impoverishing other sectors. Soon catastrophes in those sectors that are left free of government support are perceived as further evidence of the failure of the free market. Each crisis becomes an opportunity to expand the scope and power of government.

Most government spending consists of benefits given to the few while the costs are borne by the many. Thus a small minority has a large vested interest in seeing the legislation passed, and for the large majority it isn't worth the time and effort to try and defeat it.

Imagine there are 100 people in society and each earns $100 a day. Now imagine for just $5 a day from each person you could support five people so their income was secure and they could do public good. For the five people involved, it is a great deal. Everyone else is too busy to organize and fight against funding them. After all, it is only worth $5 to fight against it, but it is worth $100 each for those five to organize and agitate for it.

Perhaps there are another 10 people who benefit most from the good being done. It will only cost them $5 a day, and they might get $20 a day worth of benefit. Under the free market they could have purchased the benefit directly, but it would have cost them more. Never mind that they are middle class and could have afforded it. Why should they be obliged to pay when they can vote for the government to provide it for "free"?

The other 85 people only get $1 worth of benefit and it costs them $5 in taxes, but it isn't worth fighting, so they end up paying it. The cost to society is $500, and the benefit to society is only $285. The rest is lost opportunity costs. Most people, had they kept their $5, would have spent it on exactly what they valued at $5, and there would have been no waste. But because society pooled its money, few got what they really wanted.

And now that everyone only has $95 left to spend, everyone's businesses will collect 5% less in revenue. Society as a whole will be poorer as a result. In our example the level of missed opportunity costs was only 40% of what was collected plus an additional 5% less in GDP. In reality, the level of waste is much higher. Compliance and collection are costly. Federal monopolies are rife with enormous inefficiencies.

Ultimately the five individuals who are on public support have secure jobs, better pay, superior benefits and guaranteed pensions. In fact, we are there already. A Bureau of Labor Statistics study this month showed that federal jobs paid better than the exact same job in the private sector 83% of the time.

The difference is striking. The average salary in the private sector is $60,046, whereas the average federal worker earns $67,691. That's 12.7% more pay for the public servant. And the difference was even more pronounced in benefits. Health, pension and other benefits total $40,785 per federal worker but only $9,882 per private worker. So the total compensation package for the federal worker is $108,476--a full 55% higher than the worker in private industry whose total compensation amounts to only $69,928.

There is also the inevitable building of government fiefdoms and use it or lose it budgeting. Government bureaucrats each serve their own private interests. Many are seeking to further their careers or salaries. Others are seeking to extend their power and prestige. The legislation and regulations they put in place uses force to implement their interests.

An example from Friedman describes the problem succinctly. In a political decision, if 51% vote for red neckties and 49% vote for green, 100% of the people get red neckties. Each individual vote counts for very little in the political process. Contrast that with the free market where every vote counts and people get exactly the color they want.

The strategy for building a politically powerful coalition is to find a dozen such minorities who are willing to support you if you vote for their pet project regardless of what else you may do. This aggregate spending may be burdensome to society as a whole, but each item by itself will have a strong advocate. Although there may be popular support for cutting government spending in general, people will be reluctant to cut any specific programs because of the vehement support by an emotionally vested minority.

Friedman asked this very important question: Is there anybody in the vast American electorate who would take his or her vote away from a representative because that person voted to keep some small special-interest project? We need people like that. We need people who are against society specifying tie color even if they want red ties.

We need government employees who are willing to vote for limited government. We need middle-class families who are willing to let entitlement programs stop after funding the truly needy. And we need liberals who are willing to join with libertarians to say "Enough."

Holding the line on the growth of government is challenging, but there is a line we dare not cross. Just because something is good for most people doesn't mean it is good for everyone. Society is interconnected. We must cooperate in nearly every component of the economy.

We can either allow that cooperation to be voluntary or coerce behaviors through force. The first spreads a multitude of small benefits over many people. The second gives larger benefits to a privileged minority. One leads to freedom and prosperity. The other leads to tyranny and misery.

from http://www.emarotta.com/article.php?ID=386

Social Security Loopholes (2010-04-12)

Social Security Loopholes

(2010-04-12) by David John Marotta and Matthew Illian

Had you simply saved and invested, you would probably be retiring as a multimillionaire. But because you were required to pay into Social Security, now you have to figure out how best to get back some of your money. Being aware of some Social Security loopholes will help you choose between options that differ by as much as a quarter of a million dollars.

Like all government law, Social Security is not a simple piece of legislation. Since the Social Security Act became law in 1935, hundreds of amendments have been added. A worker's Social Security contributions can total up to $440,000. So you want to make sure you have done your homework when beginning to pull this money out. And to make the best decision, you must consider health, income before retirement, income during retirement and taxes. By learning about three Social Security loopholes, you may be able to recoup thousands of dollars.

Three strategies for maximizing your Social Security dollars are available to married couples. You won't find them by reading the government's printed literature or general web pages. And in a time when many families are stretching to make every dollar count, the extra income can go a long way.

The first loophole comes in the form of an interest-free loan provided by Uncle Sam. Many retirees are not aware that they are eligible to repay their Social Security benefits at any time and for any reason in order to claim a higher deferred benefit and at no interest. This ability to undo your selection will raise your monthly payment by 33% at full retirement age and by 76% at age 70. As you can imagine, this payment can be quite hefty if you've waited years before repaying and refiling your benefits. Some savvy retirees have found a benefit by claiming Social Security early and stashing this money in a CD or other fixed-income account. That way they can earn eight years of interest on the money.

Those unsure of Social Security's viability and solvency can use this method to play both options. If benefits are reduced, you will be happy to have filed early. If not, just repay and refile.

This money may be free, but it's not easy. This "File, Repay and Refile" strategy requires you to amend each year of tax filings to recoup the extra taxes and lost interest applied to those earnings. Interested retirees will need to fill out a Withdrawal of Application to begin the repayment process.

The Senior Citizens' Freedom to Work Act of 2000 provides a second loophole that can boost total benefits payments for retirees by as much as 15%. This option is called "File and Suspend." It works well for couples who have a large disparity in their earnings history.

Consider the dilemma of James and Susan who are fast approaching their retirement. James is coming to the end of a long career as an executive in a carpet factory. Susan's earnings history was cut short when she decided to stay home to raise their children leaving a limited personal Social Security benefit.

A loving husband, James would like to maximize the survivor benefit that he leaves Susan. He can accomplish this by delaying his Social Security filing. But neither are sure they will make ends meet during the ensuing years on Susan's limited monthly payment.

Thanks to loophole number 2, there is a way to increase their current income without compromising longevity insurance. When James, the higher earner, reaches full retirement age (FRA) at 66, he files for Social Security but suspends receiving any benefits. Filing only to immediately suspend may sound like silly gymnastics. But this strategy allows Susan to begin collecting a spousal benefit based on James's higher earnings record. And because James delays to accrue a higher personal payout, Susan is guaranteed to inherit the highest possible payments as a survivor.

With this "File and Suspend" method, stay-at-home moms who would typically have to wait for their spouses to file before realizing any benefits can now access their spousal benefits before their husbands retire. It is particularly beneficial when the primary bread winner is expected to have a limited life expectancy. The surviving spouse will inherit the larger benefit that much sooner.

If, instead, we assume that both James and Susan have strong Social Security earnings records and are in good health, they should consider the final loophole.

This third and potentially most profitable loophole is called "Deemed Filing." In this scenario, James and Susan are both 66. James is due a benefit of $2200 per month. Susan is due a benefit of $2100 per month. Typically, Social Security only gives you the higher of your personal benefit or spousal benefit. But those who file after FRA can deem to only collect spousal benefits. If Susan has already filed for her benefit and James is FRA, he can file for spousal benefits. That would entitle him to half of Susan's $2100 benefit. Then at age 70, when his personal benefit has fully appreciated, he can file for his own larger benefit. When appropriate, this "Deemed Filing" approach can add up to $50,000 to joint lifetime income.

These three loopholes all require careful analysis, but their payoff can be well worth the effort and planning for the right individuals. The further big government stretches into all areas of civic and economic life, the more savvy U.S. citizens will become in order to "game the system." Complexity creates a breeding ground for inefficiencies and loopholes. Big government will require even bigger calculators.

To help you understand your options before locking in the wrong choice, attend the nonprofit NAPFA Consumer Education Foundation seminar, "How to Determine the Best Age to Claim Social Security," on April 17, 2010. This free presentation will take place at the Northside Library meeting room in the Albemarle Square Shopping Center from 10 to 11:30 am. Financial advisor Matthew Illian is leading the seminar. For more information, e-mail .

from http://www.emarotta.com/article.php?ID=385

Appreciating Assets Part 1: Stocks and Bonds (2010-04-05)

Appreciating Assets Part 1: Stocks and Bonds

(2010-04-05) by David John Marotta

All assets are not equal. Some investments appreciate better on average than others. If you have $100,000 saved toward your retirement, how you invest it can make a difference in the likelihood and standard of living of your retirement.

Let's look at various investments over a 25-year time horizon. That span of time could be before retirement, say from age 40 to 65. Or it could be your retirement years from age 65 to 90.

We begin with equities, shares of stock in companies that earn a profit and grow their business. Equities could be individual stocks, stock mutual funds or exchange-traded funds (ETFs). On average, equity investments appreciate at a rate of 6.5% over inflation.

In the United States, inflation has been higher since 1970. It has also been officially underreported since 1996 when the government changed the way it calculates the Consumer Price Index (CPI). This lowered the official inflation figures by about 2% a year. But for the purposes of this article, I assume inflation is a constant 4.5%.

The stock market averages between 10% and 12% a year. But the annual return almost never falls in that range. Just look at the returns of the prior five years: 4.9%, 15.8%, 5.5%, -37.0%, and 26.5%. None of these fell even close to the 10% to 12% average.

This return comes partly from a 4.5% annual inflation and partly from a 6.5% real return over inflation. Add those two components together, and you get an average 11% return. When inflation runs higher than 4.5%, you may get a higher return, but you won't get increased purchasing power. In fact, all you will get is taxed on the larger capital gains caused by inflation.

The appreciation of equities produces an engine of growth. Over our 25-year period at 11% growth, our $100,000 initial investment grows to over $1.3 million. At this rate of return, our investment doubles every six years.

Two important reminders: First, equity markets don't provide a smooth return. Pick any 10 years over a century, and 6% of the time you will find returns that are zero or have losses in the S&P 500. Diversification helps, but the equity markets are inherently volatile, especially in the short term.

Second, the $1.3 million you end up with only has the buying power of about $483,000. Inflation eats the other $875,000. You also have to pay capital gains on the entire $1.2 million growth. With Congress raising the capital gains tax from 15% to 20% or even 25% because health care reform has passed, it hardly seems worth all the risk. But as we will see, the alternatives are worse. Economically, the capital gains tax should be zero. It would certainly produce more jobs than taxing business to pay for extending subsidies of people not working and calling it a jobs bill.

When planning with clients, I've found it much better to factor out inflation and not use inflated numbers. It is difficult to hear $1.3 million and mentally translate into the equivalent in today's dollars. So let's use a 6.5% real return and compare against our $100,000 growing into $483,000 over 25 years.

Some equities, although more volatile, can boost returns even higher. Mid-cap and small-cap stocks average higher returns. So do value stocks and emerging market stocks. If small-cap value stocks averaged 8.5% over inflation, your initial $100,000 would grow to a buying power of $769,000. And history suggests the small-cap value growth rate is even higher.

Equities are the engine of your retirement savings. Most of your savings should be invested to take advantage of this appreciation. Even in retirement, you need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

The second largest portion of a good investment plan should be in stable assets such as fixed income. Fixed-income investments are most commonly bonds: individual bonds, bond mutual funds or bond ETFs. A stock means you own a piece of the company. A bond means you have loaned the company money, and it has promised to pay you back with interest. If the company goes bankrupt, you may not get your money back. And if the company does incredibly well, you will not have a share in that good fortune. The most you will get is what you put in plus the agreed-on interest.

Fixed-income investments are much more stable than equity investments. On average, however, they only earn about 3% over inflation. With inflation at 4.5%, fixed-income investments should be paying about 7.5% on average. With the Federal Reserve holding interest rates low, fixed-income investments currently are earning below their historical averages.

Your $100,000 investment earning a 3% real return would grow to a buying power of just $209,000 over 25 years. Again, although you might have $609,000, you would only have the buying power of $209,000. And you would have had to pay ordinary income taxes on the $400,000 of interest that just kept up with inflation.

But you should not tie a large portion of your assets up in fixed-income investments over 25 years. We recommend only having the next five to seven years of safe spending rates in fixed income were you to retire today.

At age 65, this strategy would allocate about 25% to stable fixed income and the remaining 75% of investable assets to appreciating equity investments. This is a higher equity allocation than many agents would suggest. They will earn their fee just as well off a bond fund as an equity fund. And they have found that investors don't notice the high fees as much if they have a lot in stability.

They might allocate 40% or 50% to fixed income instead of just 25%. But this reduces your return. Stocks average 6.5% over inflation. Bonds average 3% over inflation. Any mix between the two provides a blended return. So a 50-50 allocation has a 4.75% average return. And a 75-25 portfolio averages a 5.625% return.

Your average real return is this percentage minus the expense ratio charged by your investments. With low expense ratio investments from Vanguard or iShares, your expense ratio should be around 0.4%. Typical mutual fund selections have average expense ratios of 1% or more. The average 401(k) plan has even higher expense ratios.

So a 50-50 allocation from an agent selling funds with an average expense ratio of 1.2% produces an expected real return of only 3.55%. But a 75-25 allocation with an average expense ratio of 0.4% produces an expected real return of 5.62%. In our 25-year case study, your $100,000 portfolio only grows to have the buying power of $239,000 in the conservative portfolio with higher fees. And in the other case, it grows to $392,000. Those who combine playing it safe but suffering higher expense ratios retire on average with a lifestyle of only 61% as much.

The top-level asset allocation decision determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you. They should appreciate more than inflation in order to be an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

from http://www.emarotta.com/article.php?ID=383