Asset Allocation in a Flat World (think globally, not locally)

Global Diversification
One of the three big questions investors must consider today is: How and how much should one allocate to stocks in and outside of the U.S.? In his book, "When Markets Collide," author Mohamed El-Erian describes a multilateral economic future in which domestic demand in emerging markets is a counterbalance to U.S. growth. His recommendation is that U.S. investors be exposed to a globally diversified set of stocks, with only a third to one-half in the U.S.


If you agree, and we do, then what does "globally diversified" actually mean and how do you determine how much and where?


The difficult issue is determining a valid reference point. The obvious approach would be to start with an established benchmark as a frame of reference. A good neutral frame of reference would be the total world stock market value, except for the risk that constantly annoys capitalization weighted markets - you potentially overweight overvalued markets! A better alternative might be economic size as measured by GDP in that the weightings are not affected by short-term market momentum or overvaluations.



The total world stock market value and GDP for 2008 is as follows:
mkt. value GDP
U.S. 36% 23%
Europe 26% 36%
Asia Pacific 28% 26%
Mid East/Africa 3% 6%
Americas 4% 7%
Canada 3% 2%


Implementation


The most common approach is to achieve targeted international equity country weightings using a combination of developed international and global emerging markets strategies. Alignment with the MSCI EAFE (Europe, Australasia and the Far East) and the MSCI EM (Emerging Markets) Index will accomplish this.


These markets vary from relatively to significantly inefficient, therefore our suggestion would be to engage active portfolio managers who have the ability to create alpha (excess risk-adjusted return) consistently (keep the index funds for your short duration fixed income funds and large cap U.S. funds).


It is possible that the next ten years will bring lower correlations of international markets with the U.S., as regions like Asia decouple as they mature and become less dependent on the U.S. and continue to demonstrate growth in their domestic economies.



Christopher Blakely Sept. 2009

sources: International Monetary Fund, MSCI

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