Important New IRA Rules

Starting January 1, 2010 the qualifying income limits that have prevented many individuals from converting a traditional IRA or employer-sponsored retirement plan to a Roth will be eliminated. The change is one of the most important on the IRA landscape in years. The question most frequently asked is, “should I convert my traditional IRA to a Roth IRA?”

There is no simple answer but there are several important considerations.
First there is the fact that there is little to no advantage to doing a Roth IRA conversion if you have to withdraw money to pay the resulting income tax from other retirement plan assets.

Moreover, conversion to a Roth IRA should be account balance neutral (see the table below for a sample illustration).

And yet there may be several reasons to consider conversion. At RKM we have the capacity to run the numbers to assist you in making the right choice.

+ When rates are going down the conversion likely makes no sense.
+ When interest rates are going up the conversion is more likely to make sense.
+ Conversions are likely better for the person who doesn’t need to live off the funds. There are no required distributions associated with a Roth IRA. With traditional IRAs, you must begin tapping your account after reaching age 70½. In doing so, you increase your taxable income starting in your 70’s.
+ Conversions are generally better for a person that has other funds to pay the taxes. Paying taxes with IRA assets defeats the purpose.
+ Conversions for a couple may make sense.
+ Conversions for a person with an estate tax issues will make more sense than for a person without. Your estate ends up with a higher percentage in tax-favorable retirement plans.
+ Conversions to leave a Roth IRA to grandchildren often have merit. Because Roth IRA owners are not subject to required minimum distribution rules the assets in the account continue to grow tax-free. And over a period of years this growth can be exponential. Although Roth beneficiaries are required to take distributions each year the withdrawals are tax-free. Making the Roth a great retirement asset for which to transfer the greatest amount of wealth.
+ Conversions for a person with net operating losses or other loss carry-forwards can make sense. In order to realize this favorable tax attribute there is the option of using a Roth IRA conversion to “offset” the loss or carry-forward.
+ Triggering large capital gains to pay the income tax on the Roth IRA conversion, one essentially loses tax deferral that might otherwise normally occur in a portfolio – this may make a conversion to costly.
+ A person who will need the money in retirement will need to withdraw less from a Roth IRA, because they won't need to cover the tax liability. This leaves more money in the account and leaving more in the account can be a great comfort during retirement and adding a tax-free account gives you the most flexibility to keep taxes low in retirement.

Who Qualifies?

Individuals whose modified adjusted gross income for 2009 is $120,000 or more can’t contribute. For couples who file joint tax returns, the cutoff is $176,000.You can’t convert traditional IRA assets to a Roth if your household’s modified adjusted gross income exceeds $100,000. A married person who files a separate tax return is prohibited from converting—no matter how what their income level. While the income limits for funding a Roth will remain, the rules for conversions are about to change.

As part of the Tax Increase Prevention and Reconciliation Act, the federal government is eliminating permanently, the $100,000 income limit for Roth conversions, as well as the restriction on spouses who file separate tax returns. The changes also should allow more retirees—who rolled over their holdings from 401(k)’s and other workplace savings plans into IRAs—to convert to Roth IRA’s.

When you convert assets from a traditional IRA or workplace plan to a Roth, you have to pay income tax on all pretax contributions and earnings included in the amount you convert. However, you may either report the amount you convert in 2010 on your tax return for that year or spread the amount converted equally across your 2011 and 2012 tax returns, paying any resulting tax in those years. The two-year option is a one-time offer for 2010 conversions.

If you are age 70½ or older and taking required minimum distributions from a traditional IRA or workplace plan, you can convert remaining traditional IRA assets to a Roth.

If you hold traditional IRAs made up largely of pretax contributions, such as a 401(k) rollover, your tax bill could be steep. One way to mitigate the tax-bill pain is to get your tax advisor to help you figure out how much you could convert within your current tax bracket each year without bumping yourself into a higher one. Interestingly, the new rules come at a time when many IRAs have significantly declined in value, meaning the taxes on such conversions will likely be lower, as well. And with taxes expected to rise in coming years, the idea of an account that’s safe from tax increases may appeal to you.

If you expect your income to be lower in retirement—and tax rates to stay about where they are—then a Roth conversion might not make sense. Whether you convert or not basically depends on what you expect to happen with your income in retirement, compared with your income while working, and whether you’re more comfortable paying taxes sooner at current rates or betting on lower taxes later.

First Things First

First look at past tax returns you have in file boxes. You’re supposed to keep a running record of nondeductible IRA contributions on IRS Form 8606 and file it with your tax return. If you haven’t done so, you can either buy back your old tax returns from the IRS, using Form 4506, or you can order a free transcript of everything that’s reported about you to the IRS, using Form 4506-T. Included in your transcript is information from IRS Form 5498, which reports contributions you made to an IRA. Other resources are year-end statements from your IRA custodian.

Some owners of IRAs that hold variable annuities with depressed account values are planning to convert those investments to Roth IRAs as well. The current value of the underlying investments in their variable annuities has fallen below their income benefit or death benefit. In that situation, if you convert to a Roth, you’d pay tax on the lower account value—and potentially get a higher benefit in the future, tax-free.

Still, if you have a variable annuity and you’re considering a Roth conversion, make sure you value the account according to the latest IRS rules. The IRS ruled that you have to get the actual fair-market value of your account from the insurance company and use that number.

The Next Steps

Organize paperwork for any nondeductible IRA contributions you’ve made in the past. By taking that step, you should be able to come up with an estimate of how much of your potential conversion would be taxable. If you expect your 2010 income to be similar to 2009 you can look up the tax brackets at http://www.irs.gov/ to get an idea of the taxes to be paid.
It may help to consult a financial planner or tax advisor who has experience working with retirees relying on IRAs. The tax rules governing IRAs are convoluted and obtuse. A mistake may leave you with significant unintended consequences.

Chris Blakely, CTFA 08-09


Sources: The Wall Street Journal, IRS.gov, rothconversion.com

Out of the Frying Pan into the Other Frying Pan?

Recession Ending?

The pace of U.S. job losses slowed more than forecast last month and the unemployment rate dropped for the first time since April 2008, the clearest signs yet that the worst recession since the Great Depression is easing.
Payrolls fell by 247,000, after a 443,000 loss in June, the Labor Department said today in Washington. The jobless rate dropped to 9.4 percent from 9.5 percent.
The report stoked optimism for a recovery in the second half of 2009. While the Obama administration’s fiscal stimulus efforts are projected to have a significant impact on the economy, any rebound in hiring may be delayed as this recovery like the last may be labeled a jobless recovery. Unemployment is a lagging indicator.
We – as consumers - are by no means out of the woods, but we are moving in the right direction, many economists have revised forecasts to reflect moderate growth in the second half of 2009 and more of a pickup in 2010.
Even so, economists predict consumer spending, which accounts for 70 percent of the economy, will be slow to gain speed. Wages and salaries fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department data issued this week.

Tax Increases?

The current administration recently raised its estimate for this year’s federal deficit by 5 percent to a record $1.84 trillion as the recession reduces tax receipts and increases the costs of propping up the economy. U.S. consumer prices may rise from 2 to 4 percent in 2010, according to economists in a Bloomberg News survey, and may head higher from there.
On August 2, 2009, on ABC's This Week, Treasury Secretary Timothy Geithner refused to rule out middle class tax hikes in an interview with George Stephanopoulos. Following is some of the exchange from the show:
George: "I know you believe that passing health care is central for getting the deficit under control. But independent analysts say even with that you are going to need to find new government revenues. The former deputy Treasury Secretary Roger Altman said it is no longer a matter of whether tax revenues should increase but how. Is he right?"
Tim Geithner: "George, it is absolutely right and very important for everyone to understand we will not get this economy back on track, recovery will not be strong enough to sustain unless we can convince the American people that we're going to have the will to bring these deficits down once recovery is firmly established."
The U.S. Treasury expects the U.S. national debt to bump up against the debt ceiling of $12.1 trillion (yes that’s trillion with 15 zeros) in the final quarter of 2009. One way to bring down deficits is to raise taxes.

Monetary Policy as the Economy Recovers

From the Board of Governors of the Federal Reserve System Monetary Report to Congress (July 21, 2009):
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve's legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve's dual objectives of maximum employment and price stability.

While the Fed has done a yeoman’s job averting depression it looks as if they have given short shrift to recovery plans. Specifically on dealing with the expected inflation that heavy economic stimulus brings.
We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation. Therefore, inflation-hedge securities should be in most investor’s portfolios when the economy begins to gain some traction. (Refer back to the beginning of this piece.)
A well diversified portfolio includes asset sub-classes such as agribusiness, managed timber, Treasury Inflation-Protected Securities, known as TIPS, commodities, energy and others. These mostly real assets have historically done well in inflationary environments.

CPB, August 2009

Sources: Bloomberg LP, the Board of Governors of the Federal Reserve

The New Normal

The New Normal

In a recent speech Bill Gross of PIMCO outlined what his firm has termed the "New Normal." In a world of more regulation, private-sector deleveraging and less consumption, "it's hard for PIMCO to imagine" the Dow Jones Industrial Average/quotes/comstock/10w!i:dji/delayed climbing back to 14,000 or home prices returning to 2006 levels, growth will be stunted," he said. "It will be a different type of world and we have to get used to that."

“The U.S. economy will grow at between 1 and 2 percent a year rather than 2 to 3 percent a year for the next three to five years at least, that will make a significant difference for corporate profit growth," he said. Moreover, unemployment will hover around 7 to 8 percent rather than the recently typical 4 to 5 percent, he added, and the higher rate would be around "for a long time to come." Gross added that inflation would also start to accelerate in the near future.

This “New Normal” economic climate prompts investment advisors to question many previously held assumptions -- especially about whether stocks will outperform bonds, and what this means for their portfolios. Data shows that over certain time cycles, bonds have outperformed stocks.
Many experts have been pointing out how great U.S. government bonds have done the past 30 years – which they have - but in our view at RKM it's nearly mathematically impossible for bonds to do that again, based on current yields. The future can't be like the past; in fact it might be a mirror image – that is a reversed image.

We are convinced that equities now are priced more attractively. Government bond yields coupled with the looming threat of inflation - the curse of fixed-income investors - as the government prints money to combat the financial crisis provides more ammunition for this case.

What about the Banks? Financial engineering had supplanted real engineering in cities like London and New York and whole economies (Iceland) became dominated by the fast growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10 percent in the early 1980’s to 40 percent in 2007! The stock market value of financial services firms increased from 6 percent in the early 1980’s to 23 percent in 2007! Why didn’t they see this crisis coming?

Relying on financial innovation has proved disastrous - think 80’s S&L crisis, 90’s international banking and LTCM crisis and the debacle we are still living. In “A Short History of Financial Euphoria,” economist John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." At this point we recommend avoiding bank stocks and bank sector mutual funds until the smoke clears.

What to do
Maintaining your wealth in the future will require strategies that reflect this changed vision of global economic growth. Bond investors should confine purchases to shorter maturities where price protection is more probable and as inflation increases, cash from maturing notes can be reinvested at higher rates. Investors may experience lower rates of return than what they grew accustomed to until 2008. Returns are the result of an economic environment.
In light of this “new normal” reality, investors should look for stable income from a portion of their investments, rather than reaching for returns. Short-term bond ladders and income paying stocks are two good examples.

Also, there is a chance that the dollar will lose its reserve status. The U.S. simply has too much debt. To be ready for that day, investors should invest outside the U.S., in faster growth economies. In particular, the BRIC countries - Brazil, Russia, India and China, for instance, consumption in China is 35 percent of GDP compared to nearly 70 percent in the U.S.- that shows huge growth potential.

PIMCO’s co-CIO’s Gross and El-Erian sum things up succinctly with the following half dozen sentences. “For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 [U.S., Japan and Europe] and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector.”

“The banking system will be a shadow of its former self. With regulation more expansive in form and reach, the sector will be de-risked, de-levered, and subject to greater burden sharing. The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions as well as the investment management industry.”

“In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth.”

If the above holds true and you are paying your advisor 2 or 3 percent in total fees your portfolio may suffer needlessly, therefore think about lowering your costs. As John Bogle was recently quoted saying, “A financial system that takes too much out of investor returns doesn't create additional value. We want to beat the market but will inevitably fail because of [transaction] costs, so I question our values and what is really enough.”


Chris Blakely, June 2009

Sources: PIMCO, Bloomberg LP, JK Galbraith, John Bogle, Morningstar, Marketwatch.com, NBER

Portfolio Management: Focus on the Future

Failures in Conventional Thinking

As we near the end of the first decade of the new millennium there are several new terms we use that rarely appeared in common conversation just 10 years ago, terms such as GPS, MP3, Blog, Plasma TV, Subprime and Stem Cells to name a few. All around our society, information describing our world expands at daunting rates and this explosion requires advancing analytics to make sense of it all. For most of the investment advisory business, portfolio building techniques and analyses sit in a conventional state lacking in thinking adapted to the world we know today.

Synonyms for diversification are words such as assortment, divergence, variety, and potpourri. In the in vestment business though, diversification has a very specific meaning: “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

The notion of this specific diversification definition shows up on a wide variety of advisory websites under common concepts such as ”reduce the fluctuations”, “moving in the opposite direction”,” least amount of fluctuation”, “reduce the overall variability”, and smooth out the ups and downs.”

Truly, combining one asset class in the top quartile of the correlation continuum and one in the bottom quartile will smooth returns. However execution of this concept fails theory. Over time, asset classes have become highly correlated mathematically, defined as the top quartile in the correlation continuum – or correlation values of 0.5 to perfect correlation of 1.0.

Consider these facts:
* There are over 300 benchmarks correlated to the S&P 500 and average correlations have increased from 0.38 in 1996 to 0.63 in 2008 – an average solidly in the top quartile where little diversification exists.
* Bonds which used to be uncorrelated to U.S. stocks have moved from a negative correlation (-0.77) during the period from 1997-2002 to a positive correlation (0.68) during the time period 2002-2007.
* Corporate bonds which were clearly not correlated to all stocks10 years ago moved from -0.686 to a positive correlation over the last five years of 0.203.

Many investors have noticed the increased correlations of the capital markets. In a recent study of wealthy investors by PNC, the following quote appeared:
“The ultra wealthy likely are looking longer term, knowing that historically the stock market has advanced when interest rates are falling.”

Actually, investment theory says that a market that is good for bonds (falling interest rates due to recessionary pressure) is bad for stocks. In recent years though, it’s clear that the stock market benefits with interest rate declines and suffers with interest rate increases - to cool down an overheating economy. We also can see in the newspapers that global markets are highly integrated with our markets, reflected in a correlation of the MSCI EAFE (Europe, Australasia, and the Far East) index to the S&P 500 of 0.9 – remember 1.0 is perfectly correlated!

What we end up with is a portfolio built with the presumption of return diversification – smoothing returns over time – but in reality, a portfolio that delivers little real benefit.
Many advisors are quick to show reduced return and volatility factors using a mixture of asset classes. This is a bit of investment sleight of hand. Correlations reflect patterns of returns, the ups and downs of the market as shown in the chart below. High correlations between investments do not mean the actual returns are the same, just the pattern of returns. That does not mean investment diversification has been achieved. Think of it this way, varying the ingredients will make cakes look and taste different, but, in the end, you still have cake!

The world is flat and correlated
A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways, to this point, would anyone dispute that a single industry (banks) can alter an economy? A portfolio defined today must play out in the uncertainty that is the future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Chris Blakely - May 2009

Sources: Dictionary.com, Investopedia.com, Bloomberg L.P., Investment News (12/14/2007)

What Goes Down Must Go Up

Confidence or Prozac
In his most recent article, Jeremy Grantham describes seemingly reasonable people, armed with terrifyingly accurate data, foretelling of the end of the world. Investors with lots of cash become inert objects, mired in cement, and too terrified to invest. Those investors who are fully invested move from fear to denial and finally to panic, at the end becoming catatonic.
Grantham encourages all investors, before rigor mortis sets in, to evaluate where they currently are, where they want to be, and how they can get there. A clear “battle plan”, developed by taking motivation from both your head and your stomach, he says, should clear the way for investors to overcome “investment paralysis”.
Elaine Garzarelli, formerly a Prudential analyst, called the market correctly in 1987, when shortly before the market crashed in October she put her clients into cash, where they stayed until the mid 1990’s, ultimately missing out on much of the rally in the stock market during the Clinton administration. She was only half right. In other words, you have to be right twice about something that no one knows with any certainty.
For those who are waiting for the tide to turn before they purchase stocks, remember that human nature is hard to overcome. For instance, you decide to invest when the market moves up 10 percent. That day comes, but you may decide, “is this rally groundless?” Therefore, you wait until the market moves up another 10 percent – just to be certain. At that point, you decide to wait for the market to pull back a bit and then buy because you’ve already missed 20 percent. As you wait for a better day the market advances another 20 percent and now with current investor psychology very bullish (a condition usually evidenced somewhere near the top of the market) you decide to jump back in having missed 40 percent of the market’s appreciation. Unfortunately, at every signpost, the future is no more predictable than it was at the last one.
What goes down must go up
“Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.” This quote by Warren Buffett from his letter to Berkshire Shareholders sums it up quite well. It is worth noting that since market records have been kept, stocks have outperformed every other investment category – including the period of the Great Depression, when they lost nearly 90 percent of their value!
If you have substantial cash you will need to (re)invest at some point. There is motivation to start now (confidence), as long as you are willing to risk the possibility of short-term declines in return for long-term profits. Remember, the future is not foreseeable and the fundamental goal of equity investing is to buy lower and sell higher. RKM has long advocated a strategy of buying into market declines, given that the biggest risk for many investors is to over-allocate to cash, missing upward movements in the market, which normally happens rapidly and abruptly.
Year of the Ox (aka Bull!) –coincidence?
We don’t know when the market will bottom. But whether it’s this month or December of this year, we are confident it will. It the meantime there is a strategy for the large cap equity portion of a portfolio that offers high current income with the potential for long-term appreciation. We suggest adding high quality equity/income funds or “dividend aristocrat stocks” to the portfolio, as this likely increases current income with appreciation potential. The S&P 500 dividend “aristocrats” are the 52 companies in the S&P 500 index that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. The current yield on several equity/income funds averages about 5 percent. That’s comparable to starting a 100 yard dash on the 50 yard mark, given that large cap stocks returned on average about 10 percent annually over the last 70 years. Investment income, whether from dividends or interest provides a cushion in down markets and many top-quality stocks have higher yields than the 30-year Treasury and better appreciation potential.
Grantham calculates the “fair value” of the S&P500 at 900, approximately 30% above where the index sits now. Although he believes that the index has a 50/50% chance of dropping below 600, many stocks and funds will have posted a double digit return per year above inflation for the next seven years. This might not be the absolute bottom of the market, but it is so close to a bottom, prudent investors are now investing.


Christopher Blakely 03/2009

Sources: The Wall Street Journal; Bloomberg LP, GMO North America

Equity Investment Thoughts February 2009

Graham’s premise (which he did not abandon even during the great depression) was that sooner or later the markets will reflect underlying corporate valuations. Therefore, long-term investors had a “basic advantage” over other investors, because they could ride out the tough markets rather than be panicked into buying or selling.
While stock markets periodically make dramatic swings up and down the earning power of the U.S. economy endures (with fluctuations). As Roger Lowenstein phrased it recently in the New York Times Magazine, “The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.”
Therefore, it is with a heightened sense of perspective that we review the recent past and share our investment view for the future.
Great Depression II? We think not. The U.S. economy is experiencing what appears to be its deepest secular recession since the mid 1970’s and it may take a few more quarters for the economy and consumers to deleverage and turn the supertanker that is our economy around. In spite of this there are some bright spots for the upcoming year:

> The corporate sector is in relatively good shape with low debt and inventories
> Energy prices are down significantly with gasoline prices cut in half, now that the speculators are out of the market (good for consumer confidence and boosts disposable income)
> When aggregate demand for goods is insufficient, the solution is for the government to provide demand when the private sector will not – JM Keynes and Paul Samuelson (Recently signed into law by the new administration.)


Although stocks may weaken a bit further, for the long-term investor, many stocks are priced to deliver attractive returns. The ValueLine Survey estimates the appreciation potential of the broad market to be over 25 percent annually on average for the next five years. The current S&P 500 price to earnings ratio, commonly referred to as the P/E ratio, is currently just over 11X, while the P/E ratio of the S&P 500 over the last 25 years has been about 18X earnings. Therefore, if appropriate with your investment objectives take advantage of the relatively inexpensive stock market. We suggest adding high quality, dividend paying stocks or low cost, no load funds with that objective. The current yield on these funds averages about 5 percent, it’s like starting a 100 yard dash on the 50 yard mark, given that large cap stocks returned on average about 10 percent annually over the last 70 years. Investment income, whether from dividends or interest provides a cushion in down markets and many top-quality stocks have higher yields than the 30-year Treasury and appreciation potential.

Christopher Blakely

http://twitter.com/cblakely

Sources: Goldman Sachs, Standard & Poor’s, The New York Times, Bloomberg LP, ValueLine