This is my quarterly missive intended primarily for my fellow financial professionals wherein I share items I have run across or thought about this quarter which I think might be beneficial to you.


Between now and the end of the year I have seminars for CPAs (through Surgent) in Little Rock, Dalton (GA), Mobile, Charlotte, Duluth (GA), Memphis, Chattanooga, Macon, and Raleigh. I would love to see you at one of those sessions.

Also, if you are looking for a speaker at your professional conference or event, please feel free to contact me for more information. I shared this last time, but thought I would just once more, I spoke at the FPA of North Alabama a while back and they made a short video clip.


First, here is a good article from HBR on non-linear thinking. Most of it I already “got” but the part about client satisfaction was interesting and a new thought for me.  Improving the satisfaction of clients who already love you is more important than worrying about improving your relationship with those with whom you have a mediocre relationship. I.e. fire more clients who aren’t a good fit.

One of the areas where I think investment folks mistakenly think linearly is with portfolio turnover rates.  It is much better to reduce turnover from 10% to 5% than it is to reduce it from 100% to 50%.  100% turnover implies a one-year average holding period.  Reducing that to 50% means it is now two years.  Meh.  10% portfolio turnover implies a 10-year average holding period.  Reducing that to 5% means it is now 20 years!  Holding a total stock index and never trading is a big deal. Using my spreadsheet calculator assume a 6% growth rate plus a 2% qualified dividend yield on a stock fund, and a 28% ordinary income rate, 23.8% LTCG rate plus 6% state and itemization (so the net rate is 23.8% + 6% - (28% * 6%) = 28.12%).  Here are the average annual net returns for a 20-year holding period:

100% turnover 5.75%.
50% turnover 5.83%.
10% turnover 6.14%.
5% turnover 6.26%.
0% turnover (until selling in the 20th year) 6.42%.

Second, here is a great flowchart (created by another advisor) for whether a client can do an IRA or Roth (click for larger version).

Third, although this is from 1987, it explains so very much: The Basic Laws of Human Stupidity.

Fourth, this is an off-topic grammar lesson, but it made me literally laugh out loud. Back in May, former FBI director James Comey said “It makes me mildly nauseous to think we might have had some impact on the election.” Many (most?) people confuse the terms nauseous and nauseated. But of course, I am a grammar nazi so I know better.  As vocabulary.com explains: “If you’re nauseated you’re about to throw up, if you’re nauseous, you’re a toxic funk and you're going to make someone else puke.”  So Comey (unintentionally) said he is so disgusting he makes other people nauseated!  Now that’s funny!

Fifth, in this article, the head of retirement research at Morningstar (presumably not an idiot at all) falls prey to the common behavioral finance mistake of anchoring.  Specifically, where he said, “The benefit has to be meaningful to make a move, since you can’t get back in the plan once you’re out.”

To see why that is bad advice, suppose we flip it around and an investor was in an IRA but had the opportunity to roll it to a 401(k) but only if they “act now!”  In other words, the investor will not be able to roll into the 401(k) in the future – they will have to stay with the IRA if they don’t act.  I doubt Mr. Blanchett would recommend they roll in even if it is a close – but losing – call simply because the opportunity is limited.  Of course, the two situations are identical, I have merely framed it differently (so perhaps this is the framing error and not anchoring).

We all have to be vigilant and guard against human tendencies toward mental mistakes – even smart people at Morningstar.

Sixth, I recently had a discussion with some fellow CFAs about the optimal retirement plan for self-employed clients with no employees. Generally, an individual/uni/solo 401(k) is preferable to a SEP. Below are the factors roughly in order of importance (though the specific ranking would obviously depend on the client).

  1. Adjusted profit < $270k & want to contribute more than 20% – advantage 401(k) because of the larger maximum contribution.
  2. Age > age 49 and want to contribute more – advantage 401(k) because of the availability of the “catch-up.” (In scare quotes because it isn’t really a catch-up but rather a higher limit for people over 49, a true catch up lets an individual contribute more to compensate for undersaving in early years (and thus catch-up to where he or she should be) but here the provision is available regardless of balances or previous contributions.)
  3. Backdoor Roth strategy in use – advantage 401(k) because of the pro-rata rule on Roth conversions.
  4. 12/31 balance > $250k – advantage SEP because a 5500 is required to be filed for the 401(k).
  5. Implementing > 12/31 for prior year – advantage SEP because a 401(k) cannot be established after year end, but a SEP can.
  6. Plan loans – advantage 401(k) but they frequently aren’t available on the individual 401(k) plans either.
  7. Roth contribution option – advantage 401(k) but they frequently aren’t available on the individual 401(k) plans either and they can be created manually with conversions.
  8. Want a non-spouse beneficiary without the spouse’s knowledge or consent – advantage SEP because the beneficiary of an IRA can be anyone you like without anyone else consenting. Qualified plans must benefit the spouse unless they sign off (generally notarized) on it being someone else.

Items 1-3 are the big ones.  For example, suppose a client is 55 years old, has adjusted net business profit (net profit less ½ of FICA) of $180,000 and AGI of $200,000.  Here’s the comparison:

Item

401(k)

SEP

Difference

Employer Contribution:

$36,000

$36,000

$0

Employee Regular Contribution:

$18,000

$0

$18,000

Employee Catch-up Contribution:

$6,000

$0

$6,000

Roth Contribution:

$6,500

$0

$6,500

Total Tax-Advantaged Contributions:

$66,500

$36,000

$30,500

The fourth item isn’t a huge deal.  The fifth one would only be necessary the first year (then you would switch to the 401(k) plan).  The sixth and seventh, while advantages to 401(k) plans in general, are frequently not available options in most solo versions. The last one is unimportant in the vast majority of cases, but it did occur to me as a difference.

Seventh, two years ago (July 2015) I started keeping a formal list of tax changes that to me seem likely to happen in the future.  Here is the list with the ones that have already happened crossed off:

  • Pretty likely at some point:
    • Minimum GRAT term of 10 years
    • SS claiming strategies (file and suspend) eliminated
    • Curtailment of minority interest discounts
    • Limit the GSTT exemption to a finite period
    • Require consistency in valuations for transfer and income tax purposes
    • Payroll taxes on S-corp owner distributions
    • LIFO repeal (or at least require the same treatment for both tax and reporting to shareholders)
    • Carried interest taxed as ordinary income
    • Require 5-year payout maximum of IRA, etc. balances for non-spouse beneficiaries
    • Restrict conservation easements
  • Much less likely but possible at some point:
    • Reduction in qualified plan maximum contributions
    • Muni bond interest becomes taxable (unlikely to be retroactive)
    • Life insurance death benefits become taxable (unlikely to be retroactive)
    • Surcharge on large Roth balances
    • Cap on IRA/qualified plan contributions based on balance
    • Elimination of 1031 exchanges
    • Carry-over basis on inherited property

We haven’t had comprehensive tax reform yet and 40% of my “pretty likely” list have already happened.  Anyway, strategies around the one I highlighted above (and how it might be implemented) are discussed here (subscription to Trusts & Estates required unfortunately).  Highly recommended to read the article so you are ready to go when (as seems very likely) this passes.

Eighth, an author contacted me about using one of my graphs in his book.  Specifically this one (I updated to 2016 for him):

In that time period, the premium for stocks over bonds was 6.5%.  Risk aversion models are unable to explain why it should be so high.  (This is frequently called the Equity Premium Puzzle.) In the 1996 paper The Equity Premium: It’s Still a Puzzle the authors posit 3.5% as the maximum – over t-bills not the 5-year treasuries in the graph above!

If I lower the historical stock returns by 3% to correct for the anomaly the graph looks like this:

Notice I changed the x-axis too.  Over the time-period I originally used it stays around 60%.  So going forward, if the ERP really is 3% lower than it has been historically, then ceteris paribus, there is only around a 60% chance stocks beat bonds over even multi-decade horizons.  You need about 50 years to be 90% certain!

This is why we have more bonds in portfolios than many advisors would – even in this low-interest-rate world.  We have no clients more aggressive than 80/20 and average 60/40.

Ninth, a fellow advisor asked me about NUA.  Thought it might be valuable to you all as well.  Here is my explanation to him (the portion about the factors involved):

It comes down to the interplay of three factors usually:

  1. Taxes:
    1. The gap between the current ordinary income tax rates and future ordinary income tax rates for the client.  In other words, on the “basis” piece while they are still working they might be in the 35% bracket, but later in retirement their ordinary income rate might just be 25%.  That will make it less favorable obviously.
    2. The gap between capital gains rates in the future and ordinary income in the future.  In other words, if someone is in the 35% ordinary/20% capital (15% gap) that is better than 25% ordinary/15% capital (10% gap).  (I’m ignoring state, Medicare surcharges, etc. just to keep it simple.)
  2. Time Horizon – it will be less favorable for someone who won’t draw any retirement funds for decades vs. someone who will start spending the funds immediately.
  3. Percent Gain – the larger the percentage gain the more favorable.

Two examples:

First the bad case. The employee/client:

  1. Is in the 35% OI bracket now, and expects to be in the 25% bracket (15% LTCG) in retirement.
  2. Has a taxable portfolio of $2,000,000 which will be spent first and probably last the first 20 years of retirement.
  3. Has stock worth $1,000,000 in a 401(k) with a total value of $2,000,000.  Original cost of the stock was $900,000.

With those facts, the client will pay 35% taxes now rather than 25% in 20+ years on $900,000 ($90,000 extra cost, 20 years earlier, and taxes on turnover and income along the way) to be able to pay 15% rather than 25% on $100,000 ($10,000 savings) in 20 years.  Clearly a terrible decision.

Second the good case. The employee/client:

  1. Is in the 25% OI bracket now, and expects to be in the 25% bracket (15% LTCG) in retirement too.
  2. Has no taxable portfolio so will start spending down the IRA immediately at a rate of $100,000 a year or so.
  3. Has stock worth $100,000 in a 401(k) with a total value of $5,000,000.  Original cost of the stock was $10,000.

With those facts, the client will pay 25% taxes now on $10,000 ($2,500) to reduce the taxes on the $90,000 from 25% to 15% immediately ($9,000 savings).  Clearly a great decision.

Tenth, I have never really liked the terms active and passive as related to investing – mostly because “passive” sounds so, well, passive!

Inspired by this WSJ article, the following is a better way to think about the choices of how to invest:

  1. High-cost or low-cost?
    1. Expense ratio
    2. Transaction costs (these include market impact, bid/ask spread, trading commissions at both the fund and retail levels, and taxes – all of these rise with turnover so the turnover ratio is a reasonable, though not perfect, proxy for these costs)
  2. Rules-based vs. forecast-based?

Passive funds tend to be both low-cost and rules-based.  Active funds tend to be higher cost and forecast-based.  The key isn’t active/passive it is really the two decisions above.

Eleventh, I would suggest you realize that the market doesn’t care about:

  • Your cost basis on an investment.
  • The returns you need to hit your financial goals.
  • Your feelings.
  • Your experience.
  • Your success (including other endeavors, your past investing overall, and your last trade).
  • Your degree of difficulty (how complex your strategy is).
  • Your effort (how much time you spend on it).
  • What legendary investors, market prognosticators, or TV talking heads say.
  • What happened historically.
  • Whether you’re right or wrong.

(Adapted from this excellent post by Jonathan Clements, with tweaks by me.)

Twelfth, it’s always important that we solve the right problem. This article from the HBR is a very good general management article on exactly that topic. I wonder when clients complain about their relative performance (portfolio up less than the S&P 500 or something like that) if we don’t have the “elevator problem”.  I don’t have any brilliant insights, but I think it would be an interesting brainstorming exercise to see if there is a solution equivalent to putting up a mirror.

Thirteenth, A reporter for Money Magazine was working on an article about using the 0% gains rate.  My email to her:

In this blog post I have section on gain harvesting.

Obviously, a zero percent rate makes the analysis compelling.  Two caveats, most people in this situation are either very young and may be subject to the “kiddie tax” or older where it may impact the taxability of SS benefits.  In other words, the zero percent rate may not actually be zero percent.  That said, there are cases where it arises and is compelling.  We have a few clients where we gain harvest every year.  Particularly with retired married couples where they are expected to “perpetually” be in the 15% marginal bracket (hence zero percent on gains) at some point one of the couple may pass away leaving a surviving spouse who, on the single tax tables, is no longer in that low bracket.  So gain harvesting is a way of reducing that future tax risk for the surviving spouse.  There would be a half-step up in common law states so while the strategy is still worthwhile, half of the gains would be eliminated anyway.  In a community property state there is a full step-up so if the couple really will be in that bracket ongoing there is no need to harvest the gains.  But on the other hand, why not if it’s free?  Attention should be paid to other costs though.  In addition to the SS mentioned earlier, there may be state income taxes and/or transaction costs.

Finally, my recurring reminders:

J.P. Morgan’s updated Guide to the Markets for this quarter is out and filled with great data as usual.

Jonathan Clements, Morgan Housel, and Larry Swedroe, all continue to publish great stuff. Just a reminder to go to those links and read whatever catches your fancy since last quarter.

That’s it for this quarter. I hope some of the above was beneficial.

Addendum:

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Regards,

David E. Hultstrom
770-517-8160

Disclaimer: The information set forth herein has been obtained or derived from sources believed by author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.