PWJohnson Wealth Management Blog

In today’s blog we explore the world of leveraged ETFs.  For those of you who are not familiar with ETFs (Exchange-Traded Funds), they are mutual funds that are bought and sold like stocks.  Most ETFs are passively managed and based on some index, allowing the investor to purchase a single fund that represents an entire asset class.  Not only are there ETFs that address the larger asset classes, such as the S&P 500 or the BarCap Aggregate Bond, there are also ETFs that focus on much narrower asset classes such as small cap US stocks, emerging markets bonds, etc.

A few years ago ProShares Advisors and Direxion Funds introduced what are commonly called leveraged ETFs.  These are ETFs that double or triple the daily returns (or losses) of an un-leveraged ETF.  Why would anyone want to buy such a product?   Well, if you really believed that some asset class was extremely undervalued, it would be like doubling down on your investment without having to shell out any additional money.  But such a gambling analogy is unfortunately very appropriate.  Even ignoring the increased risk of loss when the asset class moves in the wrong direction, the real problem is that over time the returns you get will be very unexpected.

Take emerging markets, for example.  Below is a chart from Morningstar showing the cumulative return from 12/31/07 for three ETFs: the Vanguard Emerging Markets Stock ETF (VWO) in red, which tracks an emerging markets stock index; the Short MSCI Emerging Markets ProShares ETF (EUM) in yellow, which shorts the same index (that is, returns the opposite of the index); and the UltraShort MSCI Emerging Markets ProShares ETF (EEV), which double shorts the same index.  For example, if the index is up by 2% on a given day, VWO would be up by 2%, EUM would be down by 2%, and EEV would be down by 4%.

Take a look at the chart.  After one year, VWO was down a bit over 50% (consistent with the index).  But EUM was not up by 50% as you’d expect; instead it was up by only half that.  And EEV, which you’d expect to be up by double the index, actually lost money.

How can this be?  It’s because of the mathematics of compounding returns over time.  These funds work as expected if index returns are always increasing or always decreasing.  But when they go up and down over time, as most investments do, the cumulative results can be very surprising.  The worst case is when an asset class rises, and then falls back to its starting point over some period, such as some commodities did in 2008.  In such a case, if you were to calculate the daily returns for the leveraged and un-leveraged ETFs tracking the index and apply them cumulatively, you’d find that the cumulative return for the un-leveraged ETFs would end up close to zero, while the returns for the leveraged ETFs, whether long (up) or short (down), would all be double-digit negative.

And it’s not like the fund companies don’t warn you.  Direxion, for example, includes “daily” in the name of its leveraged ETFs. And a fact sheet lists the products as suitable only for sophisticated investors who understand “the consequences of seeking daily leveraged investment results.”  Nonetheless, investors typically hold these ETFs for much longer that a single day, and that’s where the problems occur.  “Leveraged ETFs kill portfolios,” said Paul Justice, associate director of ETF research at Morningstar. “They are probably too complex for most individual investors.”

There are over 700 non-leveraged ETFs available in the market today with total assets exceeding $850 billion.  That’s more than enough to craft a portfolio covering any number of asset classes if that’s the approach an investor wants to take.  We don’t see any need to utilize leveraged ETFs in prudent, risk-managed portfolios.  But if it’s gambling you want, we’ve heard of a great place in Vegas…

When we talk to our clients and others in the community about their retirement goals and plans, they often ask, “How much money will I need to accumulate before I retire in order to be able to live the lifestyle I’d like?”  While this is an important question, more specifically what they’d really like to know is how much they can spend each year, and whether or not that will be enough.

We won’t address the latter question today, since it depends on each individual’s goals.  But we can provide you an indication of how much you can expect to withdraw safely over a 30-year retirement (age 65 through 95) without running out of money.

Bill Bengen did the first research on this topic in 1994.  He looked at data going back to the 1930s and determined that for any 30-year period since that time you could have retired and withdrawn 4% of your first year’s portfolio balance each year, adjusted for inflation, without running out of money.  For example, if you retired in 1932 with $500,000, you could have withdrawn $20,000 in 1932, $20,000 (adjusted for inflation) in 1933, $20,000 (adjusted for inflation) in 1934, etc. for the next 30 years.  Bengen found this to be true during periods of high inflation – such as during the 1980s – as well as during periods of severe market contractions such as during the 1930s.  It’s important to note that Bengen’s safe withdrawal rate is pre-tax and is not adjusted for fees and expenses.  That means that taxes and fees would have to be paid out of the amount withdrawn each year, reducing the amount of money available for other retirement goals.  The rate is also dependent on the mix of stocks and bonds in the portfolio.

Jon Guyton and Bill Klinger came up with the concept of guardrails in a series of studies beginning in 2006.  They determined that a retiree could start with a safe withdrawal rate as high as 5.5% as long as he or she would be willing to make adjustments to future withdrawals based on portfolio performance (hence the term guardrail).

Recent research by Michael Kitces extended Bergen’s analysis as far back as 1871 and confirmed that the 4% safe withdrawal rate still held.  Even more interesting, he determined that the timing of one’s retirement plays a big part in what the initial withdrawal rate could be.  If one retires during a period when the 10-year trailing P/E ratio of S&P 500 stocks is high (that is, when stocks had been priced relatively high on average over the previous ten years), the safe withdrawal rate will be close to 4%.  But if one were fortunate enough to retire at a time when stocks had been priced low over the previous 10 years, a safe withdrawal rate would be as high as 5.7% (even without considering guardrails).

Although not definitive, the 4% withdrawal rate is a number you should be able to utilize if you are doing your own retirement planning and want to get a sense of how big your retirement portfolio needs to be when you retire.  And if you are especially worried about stock market volatility, there are other financial products you can utilize to mitigate some of the risk.  But that’s a topic for another discussion…

With all the recent  market volatility, and with the threat of a Greek default in the news, investors may be wondering if the latter has anything to do with the former. And where things might be heading. We thought we’d step in and provide a bit of perspective.

In brief:  we’re not terribly surprised that markets have paused or even declined after their recent ascent.  We’ve seen valuations recover fully, even to slightly optimistic levels, since the depths of the credit and economic crisis of 2008/2009.  Nor are we terribly concerned, based on what we know about the world economy.  Economic recovery is proceeding apace, and with the notable exception of Greece’s debt problems, there has been little in the way of developing negatives to portend a significant, sustained decline from today’s market levels in the short run. The longer run may be a different story, but that’s a subject for another time.

Let’s take a deeper look into some of the factors behind our outlook for stock market prices.

First, let’s look at stock market valuation.  Based on price/earnings ratios, the U.S. stock market is not trading at dangerously high levels.  Various sources that look at market measures of valuation have pegged the U.S. stock market as anywhere from 5% to 35% overvalued.  While asset class valuations can remain high (or low) for extended periods of time, markets do tend to revert towards their means, or averages, over time.  In other words, regardless of whatever is happening in Greece, the US stock market has been ripe for some kind of a correction.  It’s certainly unnerving when markets drop quickly, like they did yesterday, but the decline itself does not come as a big surprise.  And aside from market valuations, almost all other significant factors that influence stock market prices are pointing to continued market strength.  These include an accommodating Federal Reserve policy, the lack of divergence of stock prices within market sub-groups, and a substantial global economic rebound.

Now Greece.  It’s been reported that Greece has been one of the most profligate of the European Union (EU) countries, with overly generous pay for government workers, endemic corruption, tax evasion at a level that some have estimated at $30 billion a year, and either poor or corrupt government record keeping that has masked many of these problems.  To put it succinctly, it’s a country that has been living beyond its means.

If Greece still used the drachma instead of the euro, the government would have most likely followed the path that most countries facing this dilemma have followed: a major devaluation of their local currency, together with higher inflation.  That would have negatively affected everyone who earned wages in drachmas (public and private sector alike) and every domestic or foreign investor or creditor earning drachma-denominated interest or investment returns.

Instead, having joined the EU and having given up control of their currency, Greece’s choices are much more limited.  At this point they either need someone — their banking creditors, the European Central Bank (ECB), the International Monetary Fund (IMF), or someone else — to lend them money to enable then to roll over their current loans, or Greece will default on them.

Paul McCulley of PIMCO sees four possible scenarios playing out:

• Germany and other members of the EU step up and commit to standing behind Greece and any other members in the future that need support.
• The ECB gets engaged and acts as a fiscal authority for EU members.
• Greece defaults and remains within the EU.
• The grand experiment of EU monetary union comes to an end.  McCulley believes “That would make what happened with Lehman seem like a walk in the park.”

While the first scenario is the most likely, all it does is solve the immediate problem.  Unless Greece can manage to reduce its debt (which is heading towards 130% of GDP by 2012), reduce government spending, and at the same time grow its economy, the problem is likely to recur sometime in the future.  Not only would this be an extremely difficult balancing act, but it’s also not clear whether or not Greece has the cultural or political will to make it happen.

Other countries that have been reported to be at similar risk, like Portugal, Spain and Ireland, aren’t all in the same boat as Greece, according to David Herro from Oakmark International.  He notes that Spain has high consumer savings.  And he sees Ireland as demonstrating the willingness to take the painful steps to reduce its debt problem.  So while there is the risk of a “domino effect” were Greece to default, the likelihood of it occurring is perhaps not as great as it would appear at first glance.

What would happen to U.S. stocks if Greece were to default on its debt?  Many investors may not remember the Latin American crisis that in 1982 caused Argentina, Mexico, and Venezuela all to default, followed by Brazil and Chile in 1983.  A host of smaller countries such as Costa Rica, the Dominican Republic, Ecuador, Panama, Peru, and Uruguay, followed.  And in 1983, the eight largest U.S. banks had 260% of their capital lent to Latin American countries.  Despite this, in 1982-83 the total return on the S&P 500, including both share appreciation and dividends, was 49%.  So U.S. equities can still do very well even when foreign economies are in turmoil.  And today no U.S. financial institution has any kind of significant exposure to Greece or any other European country, according to Brian Westbury of First Trust Advisors.

However, Herro also notes that Greece is a warning shot for the U.S., where debt to GDP ratios are approaching 100%.  He says a debt crisis here can be avoided if the political will is there to implement the necessary economic policies.  We agree.  It has been our belief since early 2009 that the speed and endurance of the economic and financial recovery will be largely based on whether or not the government takes the right actions at the right times.  So far, we have been encouraged, but uncertainty still remains for the longer term.

What should an investor do?  As always, continue to follow the investment strategy that was developed as part of your financial plan.  Short-term market movements, while anxiety-producing, should not affect your longer-term goals.

The Patient Protection and Affordable Care Act was signed into law by President Barack Obama on March 23, 2010.  This law, together with the Health Care and Education Reconciliation Act of 2010 (signed into law on March 30, 2010), provides for the largest change to the nation’s health care system since Medicare was introduced.  Many of the provisions will go into effect over time.  Thanks to the Financial Planning Association, here is a summary of the benefits and tax effects of these new laws, particularly those provisions that will take effect in 2010.  In future blogs we will address the provisions scheduled to take effect in future years.

Highlights

• No lifetime benefit limits and only limited annual benefit limits
• Coverage for dependent children up to age 26, as long as they do not have access to other employer-sponsored health coverage (the reconciliation bill also assures that this coverage can be provided on a tax-free basis)
• No preexisting conditions for children under age 19
• No cancellation of health coverage, except in cases of fraud (primarily an individual insurance policy issue)
• New limitations on Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs)
• Higher taxes on wages and investment income for taxpayers with earnings over $200,000 and 250,000 (joint)
• Requires employers with 50 or more employees to offer coverage to their employees or pay a fine

Provisions effective in 2010

Immediate access to insurance for uninsured individuals with a pre-existing condition. Provides eligible individuals access to coverage that does not impose any coverage exclusions for pre-existing health conditions. This provision ends when Exchanges are operational. Exchanges will be created to help people purchase health insurance from a variety of plans on the open market. This provision is effective 90 days after enactment, and coverage under this program will continue until new Exchanges are operational in 2014.

Tax credits for small businesses. Tax credits of up to 35 percent of premiums will be immediately available to firms that choose to offer coverage; later, when Exchanges are operational, tax credits will be up to 50 percent of premiums. The full credit will be available to firms with 10 or fewer employees with average annual wages of $25,000, while firms with up to 25 or fewer employees and average annual wages of up to $50,000 will also be eligible for the credit. There is also up to a 25 percent credit for small nonprofit organizations.

Elimination of pre-existing condition exclusions for children. Bars health insurance companies from imposing pre-existing condition exclusions on children’s coverage, effective six months after enactment and applying to all new plans in the individual market. (This provision will apply to all people in 2014).

Prohibition of rescissions. Prohibits abusive practices whereby health insurance companies rescind existing health insurance policies when a person gets sick as a way of avoiding covering the costs of enrollees’ health care needs (except in cases of fraud or intentional misrepresentation of material fact). This takes effect for plan years beginning on or after the date that is six months after enactment.

Patient protections. Protects patients’ choice of doctors by allowing plan members to pick any participating primary care provider, prohibiting insurers from requiring prior authorization before a woman sees an ob-gyn, and ensuring access to emergency care. This provision takes effect six months after enactment and applies to all new plans.

Elimination of lifetime limits and restriction on annual limits. Prohibits lifetime limits on benefits in all group health plans and in the individual market and restricts the use of annual limits. This takes effect for plan years beginning on or after the date that is six months after enactment. When the Exchanges are operational in 2014, the use of annual limits will be banned for new plans in the individual market and all employer plans.

Extension of dependent coverage. Requires any group health plan or plan in the individual market that provides dependent coverage for children to continue to make that coverage available until the child turns 26 years of age. This takes effect for plan years beginning on or after the date that is six months after enactment.

Prohibition of discrimination based on salary. Will prohibit group health plans from establishing any eligibility rules for health care coverage that have the effect of discriminating in favor of higher wage employees. This provision takes effect six months after enactment and applies to group health plans.

Reduction in the cost of covering early retirees. Creates a new temporary reinsurance program to help companies that provide early retiree health benefits for those ages 55-64 offset the expensive cost of that coverage. Effective 90 days after enactment.

Reduction of the Medicare (Part D) “Donut Hole” or coverage gap. Provides a $250 rebate check for all Part D enrollees who enter the “donut hole.‟ Currently, the coverage gap falls between $2,830 and $6,440 in total drug spending. Effective calendar year 2010. (Beginning in 2011, institutes a 50 percent discount on brand-name drugs and begins generic coverage in the donut hole; fills the donut hole by 2020.)

Additional Medicaid flexibility for states. A new option allowing States to cover parents and childless adults up to 133 percent of the Federal Poverty Level (FPL) and receive current law Federal Medical Assistance Percentage (FMAP) will take effect as of April 1, 2010

Expansion of the Adoption Credit and Adoption Assistance Program. Increases the adoption tax credit and adoption assistance exclusion by $1,000, makes the credit refundable, and extends the credit through 2011. The enhancements are effective for tax years beginning after December 31, 2009.

Tax relief for health professionals with state loan repayment. Excludes from gross income payments made under any State loan repayment or loan forgiveness program that is intended to provide for the increased availability of health care services in underserved or health professional shortage areas. This provision is effective for amounts received by an individual in taxable years beginning after December 31, 2008.

OK, we suppose that any year would be a bad year to die.  But 2010 is shaping up to be unusually problematic.  Not for you, but for your heirs.  We’re talking about the massive confusion brought about by Congress’ inability to address the elimination of the estate tax this year.

First, a bit of history.  In 2001 the Bush administration signed into law the Economic Growth Tax Relief Reconciliation Act, more simply known as EGTRRA.  In addition to income tax reductions, this law slowly reduced estate taxes from 2001 through 2009, eliminating them completely in 2010. In order to garner the needed votes to pass this comprehensive tax reduction bill, the administration agreed to put in a sunset clause terminating the provisions after ten years.  In other words, without any subsequent government action, the estate tax would be reinstated in 2011 with the same high tax rates and low exclusions as existed in 2000.

Now fast forward to 2009.  The government had been expected to address the termination of the estate tax in 2010 by either coming up with a better approach or by extending the rules for 2009 into 2010 to give themselves more time.  But a funny thing happened.  The government did not act, and as of January 1 of this year, there is no longer a federal estate tax.

The first question you may be asking is, “Why didn’t they act?”  And, perhaps more importantly, “Does it matter?”

There were several factors at play in Washington in 2009.  The first was that Congress was distracted somewhat by the worst financial crisis in the past 80 years.  A more directly contributing factor was the extreme political polarization in Congress between the Democrats and Republicans, the worst it’s been in at least a generation.  The result was complete gridlock when it came to passing any kind of estate tax legislation.

So how does this impact the average taxpayer?  Well, the estate tax is really not an evil death tax (as its opponents have labeled it).  It was originally created to try to get back some of the taxes that had been successfully sheltered by the wealthiest families.  As such, even as recently as 2005, it affected less than 1% of taxpayers.  But there’s a much bigger problem with the elimination of the estate tax that will affect a lot more taxpayers, and that’s the consequent elimination of the step up in basis.

Estate tax law requires the decedent’s estate to pay taxes on a certain amount of the wealth that is transferred to the heirs  But the heirs don’t have to pay any taxes on what they receive.  So far so good for the heirs.  The problem arises when an heir wants to sell what he or she inherited.

Suppose you inherit a $1 million house from your rich Uncle John.  But it’s located in Virginia, and you live in Florida.  You don’t need the house, don’t much like living in Virginia, and, by a happy conicidence, you’ve been trying to figure out how to finance that restaurant you’ve always wanted to start up.  So you sell the house and use the proceeds to start your restaurant, pay off all your credit cards, and hire a financial planner to help you invest the rest.  Congratulations on your prudent approach to financial management!

But what about the taxes on the house sale?  You have to pay capital gains taxes on the difference between what you paid for it (called it’s cost basis) and what you sold it for.  But you didn’t buy it, you inherited it.  So what’s its cost basis?  Under normal estate planning rules (that is, NOT in 2010), the cost basis of an inherited house is “stepped up” to its value at the time the owner dies.  Therefore, if you sell an inherited house right after you inherit it, the sales price would be the same as the cost basis, so you wouldn’t owe any capital gains taxes at all.  Sweet!

But if this scenario occurs in 2010, the results would be quite different.  Uncle John’s estate would not have had to pay any estate taxes, but at the same time you (the heir) would not have received a step up in basis for the inherited house.  When you sell it, you would have to find out how much Uncle John paid for it, and then pay taxes on the difference between his cost and the price you received.  If he purchased it in 1957 for $20,000, you’d end up paying the IRS 15% of $1,000,000 – $20,000, or $147,000.  Ouch!

This same step up in basis rule applies to stocks, bonds, and other investments you inherit.  Not only will Uncle John’s heirs have to pay a lot more in taxes when they sell their inherited property than if he had died in 2009, but imagine the nightmare of their having to track down how much Uncle John paid for all of this stuff forty or fifty years ago before they’re able to complete their 2010 tax returns.

The point again is that the loss of the step up in basis is likely to impact a lot more taxpayers than the estate tax ever did.  Recognizing this problem, the government did include a clause for 2010 that allows heirs to take a step up in basis for up to $1.3 million of inherited property.  So in our example above, you would still be able to avoid paying capital gains taxes on that million dollar house.  But those of you with rich uncles living in the Bay Area are highly likely to inherit property that exceeds this figure.

So the next time you talk to your rich old uncle, ask him to do you a favor – try to stay alive this year!