New Year, New Cost Basis Reporting Rules

By Lori Eason, CFP(R)

2010 has been filled with a lot of uncertainty and chaos surrounding taxes (one year disappearance of the estate tax, expiration of the Bush tax cuts, temporary Social Security tax cut, etc.), but one thing is for sure, 2011 brings big changes with regard to cost basis reporting. I'm sure you all remember the Emergency Economic Stabilization Act of 2008, a.k.a. the "Bailout" bill. This law authorized the US Secretary of the Treasury to spend up to $700 billion to purchase distressed assets and make capital injections into banks. It also introduced various tax provisions, one of which comes into effect January 1^st, 2011, the new cost basis regulations. These rules will drastically change the way cost basis is reported to the IRS and affects brokers, financial advisors and investors in a major way.

The new provisions will be gradually phased in over the next three years, with stocks leading the way in 2011. Brokers will be required to keep track of cost basis for stocks acquired after January 1, 2011 and form 1099-B will be expanded to include this data as well as classify whether a gain or loss was short term or long term. As you know, 1099s are sent to both the taxpayer and the IRS, so the purchase price of securities sold reported on your tax return will now have to match what was sent to the IRS. This is the same as how currently the total securities sales amount on your tax return has to match the proceeds from sales figure on your 1099. Until now, the IRS has never had a broadly reliable way to confirm cost basis and could only detect misreported cost basis info through an audit. These changes are expected to generate more than $6 billion in additional tax revenue over the next 10 years. Cost basis reporting on mutual funds, ETFs and Dividend Reinvestment Plan shares is set to be phased in on January 1, 2012 and reporting on all other securities, including options and fixed income investments, will be phased in on January 1, 2013.

It is important to distinguish between covered and uncovered securities. Covered securities in 2011 are stocks purchased on or after January 1, 2011. Brokers are only required to report cost basis info on covered securities on the 1099s sent to the IRS. However, many brokers, including Charles Schwab, have decided to provide all cost basis info they have available (for covered and uncovered securities) on 1099s sent to clients to avoid confusion as to why some securities show cost basis and others don't. Taxpayers must realize that it is still their responsibility to report cost basis info for all uncovered securities to the IRS because brokers will not be doing so.

Just because the burden of reporting cost basis is shifted from the taxpayer to the broker does not mean everyone else is off the hook. At the time of sale, the person placing the trade must select which tax lot is being sold. The selection must be made between the trade date and settlement date, generally 3 days, and once made, it cannot be changed. In the event that no tax lot is specified, the IRS requires a default tax method be used - First In First Out (FIFO) or Average Cost, if eligible. One of the most cumbersome requirements is that brokers must immediately file corrected tax forms with the IRS when they receive corrected information. As many of you are aware, corrected 1099s can greatly delay tax filings and cause multiple amended returns.

The concept of keeping track of cost basis info and choosing tax lots at the time of trade is not new to us. We have always traded in a tax efficient manner and therefore chosen the most prudent lots to sell. Our portfolio management software keeps track of cost basis information and whenever we receive assets transferred into a taxable account, we have always made an effort to get the most accurate cost basis information available from the client. For those of you who have accounts managed by us, you shouldn't notice any significant changes from your end except the 1099 you receive for 2011 in early 2012 will include cost basis info. These figures should match the information contain in the Realized Gain and Loss report we send in January. For those of you with accounts not managed by use, it would be wise for you to educate yourselves further on these changes and understand how your brokerage firm's trading policies will be affected.

While brokers have had 3 years to prepare for the changes about to take place, it would be very optimistic for us to assume this transition will happen smoothly. As mentioned above, the legislation will take place in 3 phases with stocks, the simplest type of investment, being Phase 1. Things get much more complicated down the road when fixed income securities such as asset backed bonds become subject to the new rules in 2013. As always, the devil is in the details.

To Convert or Not to Convert, That is the Question (November, 2010)

By Lori Eason, CFP(R)

Since the dawn of 2010, there has been a lot of talk about the expiration of the Bush era tax cuts. Among the cuts is the disappearance of the $100,000 Roth conversion income limit for this year only. This means that you can opt to pay taxes on your traditional IRA balance over the next two years in exchange for tax free withdrawals during retirement. For months I have read article after article portraying this opportunity as an easy decision and sure way to save money on taxes, but in reality there are many changing variables that greatly affect the benefits to conversion.

The logic behind the conversion for investors is to pay taxes now at a sure rate before taxes increase. But today’s tax rates are not low and adding the additional income created from the conversion to a taxpayers ordinary income can easily push them into a much higher tax bracket. So why would someone volunteer to pay taxes now when they could be deferred to a later date?

There is no argument that it only makes sense to convert if you have funds available to pay the taxes outside of your IRA. Otherwise you would reduce the potential tax free growth on that amount, defeating the purpose of the conversion. But even if you have enough cash flow or taxable savings to pay the tax bill, you have to consider the opportunity cost of using that money to pay taxes when it could be invested and earning a return.

The decision to convert depends heavily on what your goals are with your IRA. If your primary goal is to leave as much money as possible to your heirs and you don’t need any IRA funds for your retirement, a Roth conversion is probably a good idea for you. You would escape the Required Minimum Distribution rules which require traditional IRA owners to take a minimum calculated amount from their IRA annually beginning at age 70 ½ and therefore pay taxes on those withdrawals. In addition, the benefit of tax free withdrawals is passed on to Roth IRA beneficiaries who then take the non-taxable withdrawals over their life expectancy.

For the rest of you who plan on using your IRA to at least partially fund your retirement, the decision requires a lot more thought. One big unknown factor that can greatly sway the results is life longevity. It can take many years to make up for the amount of taxes you have to pay now and the lost potential earnings on those dollars. This is where the opportunity cost arises. As an example, if you convert a $200,000 IRA, it can generate a combined federal and state tax bill as high as $80,000. Not only has your savings been reduced by $80,000, you also lose all the future earnings that that $80,000 could have ever made. In order for the conversion to be a good idea, the sum of the taxes not paid on Roth withdrawals would have to add up to more than the opportunity cost. The way the math works out, the longer your time horizon, the longer the Roth has to catch up. For this reason, if you are already retired or within a few years of retirement, it is unlikely that you’ll benefit from converting. If you live long enough to see it, the Roth IRA will eventually pull ahead of the traditional IRA, but this is assuming Roth withdrawals are never taxed.

This brings me to the last, and in my opinion, most important point I am going to make: what guarantee do we have that congress is not going to change the rules on tax free withdrawals from Roth IRAs down the road? Imagine this: 20 years down the road, the deficit is still huge, republicans and democrats are still fighting, and tax receipts from traditional IRAs are declining because the government in effect collected those back in 2010 through conversions. It is not inconceivable that they would look toward all these privileged retirees who have diligently saved and already paid taxes on their traditional IRAs and are withdrawing hundreds of thousands of dollars each year…tax free. That sounds like an easy place for the government to pocket some much needed revenue. Maybe it would be a good idea to means test the tax free benefit, only allowing those who withdraw under a certain amount each year to avoid taxes. We have certainly seen these sort of games played in the past (Social Security) and I wouldn’t put it past our government.

I don’t find it a coincidence that during these times of unprecedented deficit and uncontrollable federal spending, these conversions are so highly promoted, after all how rosy does an extra $662 billion in tax revenues look to the government? While I can see why it makes sense to covert to a Roth IRA in very specific situations, in most cases the cost and political risks just don’t seem to outweigh the benefits.

What's This Foreclosure Mess? (October, 2010)

By Alan Gaylor

It is impossible to watch the news these days without hearing stories about our country’s continuing real estate bust and the resulting wave of foreclosures. The number of foreclosures in the US hit 1.65 million in the first half of this year. That is an increase of 8% from the same period a year ago, and a 5% decrease from the previous six months. As one would expect, with this many people losing their homes, there has been a lot of talk about finding a way to keep these people in these homes by restructuring their loans and instituting a foreclosure moratorium. In addition, there has also been a lot of controversy surrounding the foreclosure process. A big part of this controversy pertains to who owns the loan and thus who should be initiating the foreclosures. On the surface, this would seem to be an odd problem to be faced with. To understand how this came about, you have to first understand the modern mortgage process.

Many years ago, homebuyers would borrow money directly from their bank to finance their home. The bank would make the loan and the homeowner would directly make mortgage payments to the bank. The bank would hold the home as collateral and keep the loan in their portfolio for the full term of the note. Nowadays, bank and mortgage brokers originate loans but do not keep them. They package these loans and sell them to investors in a process called securitization. This is where the government entities Fannie Mae and Freddie Mac and Wall Street come into play. They group hundreds of similar loans together to create a mortgage backed bond. These bonds are then sold to investors in the private market. Typical investors are mutual funds, insurance companies, pension plans, individual investors (our clients included), etc. It takes so much money to finance all the homes in this country that mortgage backed bonds is now the largest segment of the bond market, currently 9 trillion dollars.

Most people think that the financial institution they make their payment to is the same company that holds their mortgage. In most cases, this is just the loan servicer and instead the homeowner’s debt is part of a mortgage pool and is owed to the bondholders. This confusion lends itself very well to politicians with an agenda and the media who likes to portray this as a “Main Street” verses “Wall Street” issue.

There is no dispute that in almost all cases, foreclosures have been initiated on homeowners who have defaulted on their loans making this a “failure to pay crisis” rather than a foreclosure crisis. In fact, a lot of the mortgages have been past due for more than a year, or in some cases, two years before foreclosure proceedings occur. The controversy surrounding the foreclosure process involves how the paperwork was filed when the loans were securitized and procedural errors during foreclosure. In either case, these are mere technicalities slowing down the inevitable and preventing the property from being owned by individuals who can afford it.

As painful as the process appears, we need the foreclosures to continue before we can move forward as a country. These losses are felt throughout the economy and not just by the banks. Property values in general will not begin to recover until this large inventory of distressed properties are back in the hands of responsible owners. The longer it takes to turn over the property, the bigger the losses. There are real expenses associated with holding property such as insurance, maintenance and taxes.

Another fallacy is that the banks and Wall Street are the ones bearing the brunt of these losses. In reality, these losses are being felt by almost all the citizens of the country directly as taxpayers and indirectly as investors and pensioners. So far the taxpayers are on the hook for $213 billion to bailout Fannie and Freddie. These two government-backed mortgage finance companies own or guarantee over half of the $12 trillion U. S. mortgage market.

There are many structural changes that will take place in the mortgage market as a result of this crisis. Underwriters will have an incentive to have higher underwriting standards, there will be fewer types of loans available, borrowers will be subject to higher credit standards and home ownership will be less viewed as a right, all changes that will be very helpful and need to take place. What is not helpful is for Washington to continue to demonize the very mortgage market participants, bankers and investors that make housing affordable in this country.

What's a Fiduciary and Why Should I Care? (September, 2010)

You may have heard the term “fiduciary” thrown around during the current financial crisis. Over the past few years, the financial services industry has been plagued with scandals surrounding so called “financial advisors.” People such as Bernie Madoff have certainly tainted the term “financial advisor” by taking advantage of trusting investors and putting their own greed and corruptive practices ahead of the wellbeing of their clients. Recently there has been a lot of talk about the Dodd-Frank law, more commonly known as FinReg, which President Obama signed in July. Designed to protect consumers, this bill is widely considered the most sweeping regulatory overhaul since the Great Depression. But similar to the health care bill, the details in the 848 pages are clear as mud. Buried in the bill is a new requirement that charges the SEC with the task of determining if brokers should be held to a higher “fiduciary duty” standard.

So what does “fiduciary standard” mean? This standard requires investment advisors to act and serve a client’s best interests with the intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment advisory to render advice which was not in the best interest of his or her clients. Currently, brokers are held to a lower standard and must only ensure that the investment they are recommending is “suitable” for the client, but are not required to choose the “best” option. As you can imagine, defining the words “suitable” and “best” is no easy task and there is definitely a lot of grey area. The SEC was given 6 months to conduct a study to determine what new regulations will come into effect.

Contrary to brokers, Registered Investment Advisors are already required to adhere to the fiduciary standard which was laid out in the Investment Advisor Act of 1940. Registered Investment Advisors are individuals or firms that are in the business of giving advice about securities and are registered with the SEC or a state’s securities agency, depending on size of the practice or firm. Our firm is a Registered Investment Advisor currently registered with the SEC.

So now that we have distinguished brokers and unregistered financial advisors from Registered Investment Advisors based on the requirement to adhere to the fiduciary standard, we can further differentiate those RIAs that fall into the “Fee Only” category and the list becomes much smaller. Fee Only advisors are compensated solely by the client and do not receive any compensation that is contingent on the purchase or sale of a financial product (i.e. no commissions). Going with a Fee Only advisor is the best way to eliminate conflicts of interests and should not be confused with fee-based which is commonly used by brokers and denotes they are paid both ways, by fees and commissions. Alder Financial Group has been a Fee Only Registered Investment Advisor since our creation in 1996.

Last month, we joined the National Association of Personal Financial Advisors (NAPFA). We have written in the past about our affiliation with the Certified Financial Planner and Charter Financial Analyst organizations and want to share a little about this organization and our reason for joining.

Created in 1983, the National Association of Personal Financial Advisors is the nation’s leading organization of Fee Only comprehensive financial planning professionals. Many of you are probably familiar with consumer advocate Clark Howard. For those of you not familiar with him, he can be seen on CNN and has a syndicated radio program that provides helpful insight, advice and warnings to consumers on a wide array of issues. Clark consistently recommends seeking a Fee Only financial advisor and has recognized NAPFA as a good resource for choosing an advisor. He has a link to NAPFA.org in the resource section of his website.

You may be wondering what a firm must do in order to join NAPFA. While there are different levels of membership, the top level of membership is a NAPFA Registered Financial Advisor, which is the level we chose to pursue. To become NAPFA registered, a financial advisor must meet certain educational and professional requirements.

First and foremost, a NAPFA Registered Financial Advisor must adhere to the fiduciary standard and must be compensated by Fee Only. From an education standpoint, the advisor must have at a minimum a Bachelor’s degree and have a broad-based education in financial planning. As of January 1, 2010, NAPFA requires the Certified Financial Planner (CFP) credential which both Alan Gaylor and I currently hold. While the CFP Board requires at least 30 hours of continuing education and NAFPA tacks on 30 hours more, requiring a total of 60 hours. The advisor must also have at least 3 years of comprehensive financial planning experience.

Candidates to become a NAPFA Registered Financial Advisor must submit a comprehensive financial plan for peer review. The financial plan must address a number of financial planning issues including income taxes, cash flow, retirement planning, estate planning, investments and risk management.

When Alder Financial Group was created in 1996, we primarily defined ourselves as investment managers. Over several years of experience, we have realized that our clients have come to rely on us for comprehensive advice in many different areas of their financial lives from mortgage refinancing to wills, not just investment management. In fact, their investments serve as the means to achieving their long term personal and financial goals. A comprehensive financial plan serves as a road map for investing and without it the investment process can become directionless and unfocused.

Joining the National Association of Personal Financial Advisors is just another way for us to continue to better serve and demonstrate our commitment to our clients. I hope it gives our clients peace of mind knowing that we will always be their advocate in a world crowded with conflicts of interest and lack of objectivity. Working in our fiduciary capacity, we will continue to hold ourselves to higher standards every chance we get.

ETF's and Mutual Funds (August, 2010)

Here at the Alder Financial Group, we use a wide array of financial instruments in client portfolios. Two of the most common are mutual funds and exchange traded funds, or ETFs. While they share many similarities, there are also a few very important distinctions between them. We think it’s important to make sure our clients understand the securities that we are buying for them and some of the reasoning behind them.

Mutual funds and ETFs are both “pooled investments”. These pools contain several different stocks, bonds or other securities depending on the goal of the fund. By owning a mutual fund or ETF, investors have the ability to create diversified portfolios essentially made up of hundreds of securities without the hassle, risk or expense of owning the securities individually.

Mutual Funds

The very first mutual fund was founded in 1926. They really began to take their modern form in 1940, with the passage of the Investment Company Act of 1940. In the 1960s, the idea of these funds blossomed. By the end of that decade there were about 270 mutual funds in existence with $48 billion in assets. The first modern index mutual fund was created in 1976 and is now known as the Vanguard 500 Index Fund. Today, it has over $100 billion in assets all by itself. As of October 2007, there were over 8,000 mutual funds in the United States with combined asses over $12 trillion.

Most mutual funds don’t charge commission for buying and selling, so investors have used them as a place to put small amounts of money, and money they plan on moving somewhere else soon. Their lack of commissions also makes them good for the technique known as “dollar cost averaging” since there is no penalty for purchasing often.

Some mutual funds have minimum investment amounts as high as $50,000. This can be a big obstacle for small investors who don’t have that sort of money to spend. The mutual funds we use here at Alder, in most cases, have a minimum investment of $1 so everyone is eligible for them. It is also possible to own a fraction of a share of a mutual fund, so they are ideal for “filling in the holes” in an account. For example, you may need $100 of small cap stocks. The small cap ETF may cost $75 per share and the small cap mutual fund may cost $15 per share. We will buy one share of the ETF and $25 worth of a small cap mutual fund to finish filling the allocation. In this case we will buy 1.667 shares of the mutual fund.

Most mutual funds are “managed”. This means that they have a team of analysts and fund managers whose goal is to outperform a certain benchmark. This mandate is very difficult to do, and most mutual funds underperform their benchmark. Actively managed mutual funds also carry higher expense ratios, which directly impact the performance the funds. Paying the fund managers, analysts and marketing the fund are all included in these expense ratios. Most of the mutual funds we use here fall into the “index” category. Their purpose is to mimic a benchmark like the Dow Jones Industrial Average, or the S&P 500 Index. These funds are managed by computers, so their expenses are very low and they usually perform exactly the same (within a percentage or so) as their target benchmark.

Mutual funds are structured differently from ETFs. When investors buy a mutual fund, the managing company takes that money and buys shares of the stocks that will make up the underlying assets in the fund. Alternatively, when an investor sells a mutual fund, the fund company has to sell shares of the underlying stocks to raise cash to give to them. This causes two problems for mutual funds. Eventually, as a mutual fund becomes more successful and popular, they will run out of good investment choices. As the good investment choices run out, the fund managers are forced to make worse and worse decisions and the performance of the entire fund suffers. This is one of the factors that contribute to the poor performance of some mutual funds. The same is true when fund owners sell their shares. The managers of the fund must select which securities they are going to sell, which affect the performance of the rest of the fund.

The structure of mutual funds also has an important tax impact. Since the fund managers must sell stocks in the fund when investors sell back their mutual fund shares, the fund incurs taxable capital gains on the securities that they have sold for a profit. These capital gains are passed on to the rest of the owners of the mutual fund. It is possible to still have a big tax bill on a mutual fund, even in a year that the fund itself has gone down in value.

Mutual funds came be very helpful if they are used properly. Investors are best served by using index mutual funds as a portion of their allocation in certain asset classes. By using the strengths of mutual funds (their lack of commissions, and flexible position size), investors can get the most out of their portfolios.

Exhange Traded Funds

The first exchange traded fund was established in 1989. It was only sold for a short period of time before a lawsuit halted its trading in the U.S. The first major, successful ETF in the US was the Standard and Poors Depository Receipts (ticker SPY). It was released in January of 1993. SPY became very popular and in 1995, its sibling MidCap SPDRs was released (ticker MDY). ETFs have continued to become very popular. As of May 2008, there were over 680 ETFs with combined assets of over $610 billion.

Exchange traded funds function similarly to normal stocks. They can be bought or sold at anytime during the day when the stock market is open. They share several other attractive advantages with stocks. Just as with common stock, an investor is allowed to short an ETF, betting on its price going down. Most ETFs are also eligible for options trading. This allows investors to use the myriad of options strategies available to stocks on the diverse sectors and indexes that ETFs follow.

ETFs are structured in a special way. Fund companies buy huge “pools” of the stocks they wish to hold in an ETF. Then, they issue shares of the pool, the ETF itself. These shares in the pool are bought and sold in stock exchanges like normal stocks. Investors buying and selling ETFs have no impact on the pool of underlying assets. For every sale of a share of an ETF, there is a corresponding buyer. Since this transaction is separate and distinct from the underlying assets of the ETF, investors don’t have to worry about getting a tax bill for capital gains passed on to them from the fund company (in most cases).

Unlike some mutual funds, there is no minimum investment in ETFs; it is possible to purchase one single share if you want. However, you are limited to purchasing whole shares of ETFs (unlike mutual funds, where partial shares are allowed). This can lead to positions that are either slightly smaller or slightly larger than you would like due to the price of the shares. Also, while it is possible to purchase a very small number of shares of an ETF, the commission you will be charged for them may make this approach disadvantageous. This may soon be irrelevant because brokerage houses are starting to offer tiny or even free commissions for trading the most popular ETFs.

Another consideration with ETFs is that they distribute their dividends in cash. This creates the need for a good investment plan, so you know where to invest the cash that you accumulate in your accounts over time.

ETFs and mutual funds both have important roles in your portfolio. ETFs are extremely valuable for their liquidity, tax efficiency and versatility. Mutual funds are also very useful because they are free to buy and sell in small amounts. If you are one of our clients, the next time you are looking at your statement or quarterly report from us, you can easily pick out the mutual funds because most of the ones we currently own have 5 letter symbols that end in “x”. The ETFs have 3 letter security symbols. If you would like to learn more about these securities feel free to contact me any time.

Social Insecurity 2 (July, 2010)

To recap last month's article, we took a look back at Social Security's creation and how it has evolved into an overly burdensome and fully inefficient program. The taxable wage base has skyrocketed from $3,000 to $106,800 and the Old Age and Survivor's tax rate has more than tripled, but still the "Trust Fund" is scheduled to be depleted in 2037. This supposed Trust Fund has been used as a mechanism to fund all sorts of government expenditures through purchasing federal bonds that will someday need to be redeemed. Where the cash will come from at the point benefits owed exceeds tax revenue (2016) is a mystery to us all!

So how long will we keep pouring money into a program that cannot survive in its current state? Social Security reform has been heavily debated with all political parties agreeing that something must be done, but the agreement stops there. Of all the proposals out there, only one really seems to make sense and that is privatization. I am going to take a look at the meaning of privatization, the main concerns and objections as well as the alternatives.

Privatizing Social Security would mean allowing each individual to invest and manage their own account, rather than allowing the federal government to do so in a collective pool for everyone. Based on the annual salary limits and tax rate, young to middle-aged workers are faced with the prospect of receiving retirement benefits that represent between 0-1.5% return on their lifetime contributions. I am positive the private market could easily beat that level of return and we wouldn't have to worry about the government's mismanagement! To add a little clarity to the privatization debate, I'd like to address some of the main concerns that have been put forth thus far.

Private accounts are too risky. Let's be clear about one thing; accounts are not risky. It's the investments in the accounts that are risky. To that end, beating the current 1% you're getting from Social Security doesn't require taking on any risk. This myth is spawned from the belief that Social Security is currently investing in Treasury Bonds that are yielding bond market based returns. Accepting this at face value, which in and of itself is hard to do, then why are we only offered retirement payments that equate to an average annual return of 1%? Those supposed long-term bonds should be yielding around 6%. Does this imply that the government is charging a 5% management fee on their bond fund or are they investing in some sort of special 1% Treasury bond that is sold only to the Social Security Administration? If every bit of Social Security tax you and your employer paid went into a private account and was invested in Treasury bonds (the very same bonds the "trust fund" claims to own), you would retire with 3-times the amount of income currently offered. Although we don't think they should be excluded, the argument that private accounts are too risky is easily defused by removing equity securities as an option for private account investment.

Privatization is too expensive. If the Feds were to get out of the retirement planning business, the cost would be enormous. The process would require weaning the government off the Social Security tax revenue over many years. This is precisely why most reform proposals only involve redirecting a small portion of the tax dollars into private accounts - they have to start small. Be assured that the long-term goal of the reform movement is to eventually have all withholdings directed into private accounts. To help fund this transition younger Americans would have to be willing to forego any benefits that they have accrued so far. This is why the superior long-term prospects of stock-based returns are being discussed so much. It is hoped that the chances of higher returns will be enough to entice young Americans to opt-out of the current system. This is where the real success in transitioning will occur. It is the future liabilities of these young people that add the highest costs.

Another point to keep in mind about some of the cost figures being tossed around is that none of this is going to occur overnight. The alarmists will loosely throw around trillion dollar figures without providing the framework by which that will come about. These costs that the government will have to expend will take generations to be fully realized. Keep in mind that the cost of Social Security on its current path will be far greater than the costs of transitioning to privatization. The really frightening figures become evident when you look at waiting to fix the system when it is near collapse. If people are truly afraid of the costs of reform, they should be pushing for a faster overhaul of the system rather than none at all.

Social Security is the only income for many seniors. Under no circumstances is anyone even remotely contemplating changing anything about the system that would affect current retirees. To imply otherwise is nothing less than dishonest. Paying for the current retiree obligations are the least expensive liabilities that the program faces. It is the youngest participants (individuals in their 20's and 30's) that pose the greatest risk to solvency. One point of irony here is that a system designed as a safety net for seniors has become so burdensome that it will most certainly be the major cause of poverty among retirees in the future due to its mismanagement.

This will only enrich the financial services industry. This argument appeals to the conspiracy theorist. Although it might seem a little self-serving because our firm falls into this category, this argument is just plain silly. It's a little like saying we shouldn't have electricity because the power company may make money on it. While it is true that privatization would be a huge boost to the financial services industry, that doesn't mean that anyone would be forced to use their services. As we've discussed earlier, simply buying Treasury bonds (a totally free transaction available at www.savingsbonds.gov) would provide you with higher returns than you're currently getting from your Social Security contributions.

People can't be trusted to make wise investment decisions. This comes from the big government camp. These are the people who think that every problem, real or imaginary, can be fixed with a government program. This is mostly a philosophical argument. We would respond by saying that this government program has had 70 years to get it right, and has yet to do so. Let's try something different.

All kidding aside, it is true that there are a great many poor decision makers out there. By definition, that's why we need some form of forced savings program. The objections to the current system arise from the mismanagement of those funds and not by its existence. Any program that would involve private accounts would be tightly controlled and would have limited investment choices for those funds.

Now that we have taken a deeper look into privatization, let's consider the alternatives. While there are many proposals that keep an entirely government run system, they all fall into two categories: they either raise taxes or cut benefits.

Three common proposals for increasing tax revenue include raising the Social Security taxable wage base which is currently set at $106,800, increasing the payroll tax rate and raising taxes on Social Security benefits. I think I made how I feel about raising Social Security taxes clear in last month's article so I won't harp on it again here!

There are a variety of ways to cut Social Security benefits. One way would be to increase the retirement age. Supporters suggest that as life expectancy increases, workers will be able to work longer. While this may be true for some workers, we all know that the older we get, the greater the chances for disability and other health issues. Another proposed way to reduce costs would be to reduce the Cost of Living Adjustment. The COLA is the percentage by which benefits increase year to year. Without the COLA, retirees would continuously lose purchasing power. Supporters of the current system have also proposed indexing benefits to prices rather than wages since prices increase more slowly than wages. While all these proposals would help with the Social Security shortfall, they are all at our expense and offer us nothing but a lower standard of living in retirement.

I hope that I've been able to hit the high points in this debate and that you have found this informative. This issue obviously hits close to home for us and we think it is far too important to have this decision based on which special interest group or political party can spin it the best.

Our belief is that if a financial account is truly yours, at a minimum, it should:

Be in an account with only your name on it.

Regularly provide a statement that values the account in today's dollars.

Contain investments that can be sold close to the price quoted on the statement.

Here is one last thought on private accounts; under the current system, we are all subject to a stealth estate tax, regardless of wealth. It is currently impossible for your Social Security contributions to be passed on to your heirs because there is no value associated with your benefits. With private accounts, you would have this ability because there would be an identifiable account with your name on it. This would particularly help the least wealthy in our society. And most notably, the government would not be allowed to confiscate what is rightfully yours upon your death.

Social Insecurity (June, 2010)

This month I decided to write on a topic that affects everyone and is a cause for great concern: Social Security. While I could write a 12 month series on the subject, I am going to narrow it down to just two! A fix to this unsustainable program is long overdue.

The other day, I received my most recent Social Security statement along with a flyer entitled “What young workers should know about Social Security and saving.” The words I read were infuriating. In big, bold print, the flyer presents the question: “Will Social Security still be around when I retire?” Of course their answer is “Yes.” but it is followed by the fact that the Social Security Board of Trustees now estimates that based on current law, in 2037, the Trust Funds will be depleted. Just last year, the year of depletion was 2041. As a 26 year old, I’ll be 53 when the Social Security program estimates that it cannot pay all scheduled benefits, still several years away from my full retirement age which is to-be-determined. I know that I am definitely on the younger end of the spectrum of workers paying into the Social Security system, but that is irrelevant. No matter what age or political affiliation, every American should be concerned with the logic behind this program and the direction it is headed.

First, let’s take a moment to define what this “Trust Fund” actually is. Most people think of a trust fund as an account with money in it. Social Security uses this term to describe the balance of taxes taken in verses benefits paid out. Over the years, Social Security has taken in about 1.2 trillion dollars more than it has paid out. This money has been used to purchase bonds of the federal government. The interest earned on these bonds has been paid back to the Trust Fund in the form of yet more bonds. As of the end of 2009, the Trust Fund now holds 2.5 trillion dollars worth of these bonds.

This whole process of course is absurd. You can’t lend or borrow money from yourself. The reality is that this excess cash that the government has been receiving over the years has simply been spent. Therefore, the source of the money used to pay the monthly Social Security benefits currently comes from that month’s payroll taxes. It is estimated that in 2017 we will reach the point where Social Security outflows are greater than payroll tax inflows. This is really when Social Security becomes insolvent. The 2037 date mentioned earlier is when the scheduled benefit payments will even consume what is in this supposed Trust Fund.

Reading on in the flyer I received, I am reassured that just because the trust fund will depleted does not mean that my benefit payments would disappear. There should still be enough funds to pay about $760 for every $1,000 in benefits scheduled. If I’m going to receive less benefits, that means I should pay less into the system, right? No way. As you will see in a moment, there has been a severe upward trend in taxes paid since origination of the Social Security system. But tax increases alone would not be anywhere close to enough to make Social Security sustainable. There has also been a lot of talk about changing the indexing of benefits to include all years instead of just the highest 35 years and raising the retirement age, both of which decrease the benefits we receive without lowering our tax burden, clearly a lose-lose situation for every taxpayer. Not to mention the government thinks it is acceptable to tax up to 85% of the Social Security benefits some retirees receive after they have already paid taxes on that income.

Let’s take a quick look back at Social Security in the beginning. It was signed into law by Franklin D. Roosevelt in 1935 as part of the New Deal. Its main components are Old Age, Survivors and Disability Insurance, with Disability only accounting for a fraction of the tax revenue and expenditures as one has to be pretty much desolate to qualify. It is important to understand that the system today has little resemblance to the system 60 years ago. One of the biggest, and worst, changes in the management of this program occurred when the LBJ administration and Congress merged the Social Security tax receipts into the general fund of the Federal government in 1968. This was done to mask the size of the increased spending and budget deficits of the Federal government.

Another major change over the years has been in the level of wages that are subject to Social Security taxes. The original limit when the system was started was $3,000. This means that the employee and employer only paid SS taxes on the first $3,000 the employee earned per year. In addition, the tax rate was only 3% (1.5% each). This limit was not put in place to give the wealthy a break. Instead, it was created to establish a sensible link between the amount paid in and the benefits paid out for an individual. Although the income cap and tax percentage rate were periodically raised, there was still a reasonable relationship between the amount one received from disability, survivor or retirement benefits and the lifetime taxes paid. In 1970 this limit was $7,800 and the tax rate was 7.3%. It is interesting to note that between wage limit increases and tax rate increases, the total annual taxes paid increased 2.5 times during the 1960’s – the first sign of trouble.

Year	Wage Limit	Old Age and Survivor’s Tax Rate
1950	$3,000	3%
1960	$4,800	5.5%
1970	$7,800	7.3%
1980	$25,900	9.04%
1990	$51,300	11.2%
2000	$76,200	10.6%
2010	$106,800	10.6%

After Social Security was merged into the general fund the program became nothing more than a tax collection tool for every other expense in the federal budget. There is no better evidence of this than the fact that the cap today is $106,800 with an applicable tax rate of 10.6%. President Obama has proposed raising the income cap and has said “the nation's "most regressive tax" needs to be revamped to increase revenues to the retirement fund and spread the burden of paying for the program more evenly.”

When I flip over the page of the flyer, I am lectured on the need to save and invest as Social Security is only meant to replace about 40% of annual preretirement earnings. As a financial planner, I fully appreciate the benefits of saving and encourage everyone to do so. That being said, I have to make the following point. Study after study has shown that if a person saves 10% of all income over their working years, he or she will be able to retire comfortably. Between my employer’s contribution to Social Security on my behalf (which could be paid to me in salary if not owed to the government) and my contribution, I am “saving” 10.6% per year, but I’m only supposed to receive 76% of 40% of my preretirement income. The math just does not work out in my favor! And by the way, I am saving this money into the general funds of the federal government which is then used to fund all sorts of government expenditures.

I’ve grown up being told not to count on Social Security being around when I retire, but NOTHING has been done to correct or even mitigate the forthcoming disaster. So what is the solution? One word: privatization. And no, that does not mean trusting your retirement to the whims of the stock market! Why would anyone think it is a good idea for the government to manage money when they currently have a 1.3 trillion dollar deficit and can’t seem to stop spending? Stay tuned as next month I will discuss privatization and its criticisms as well as other proposed alternatives.

When Emotions Take Charge (May, 2010)

There’s no debate that the past year and a half has been a challenging period not just for Americans, but for people around the world. We have seen volatility in the stock market that rattled the confidence of even the most risk tolerant investors. September of 2008 began a two month range of extreme volatility during which the Dow experienced its largest one day point loss, one day point gain and largest intra-day range, closing at a six year low of 7,552 in November of 2008. While we have come a very long way since then, the so called “Flash Crash” on May 6^th , where the Dow closed with a 348 point drop after falling as low as 999 points intra-day, reminded us of the looming unpredictability in the markets. While there have been numerous economic and political reasons for such volatility, we can’t ignore the role emotions, such as fear, play in large market swings.

An increasingly popular field in the finance arena is behavioral finance, a combination of psychology and finance to explain why people make seemingly irrational decisions regarding money. Just take a look at the lottery. Millions of people purchase lottery tickets hoping to hit the big jackpot. Logically, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder (about 1 in 150 million). Most economic and financial theories assume that individuals act rationally and consider all available information when making decisions, but many researchers believe that this is not the case and the incorporation of psychology can help explain many stock market anomalies, bubbles and crashes. Let’s take a look at a few examples that reveal patterns of irrationality in the way people arrive at decisions when faced with uncertainty.

First let’s consider the Prospect Theory which proposes that investors fear losses much more than they value gains. Studies have shown that if an investor is offered the choice of a sure $50 or, after the flip of a coin, the possibility of winning $100 or winning nothing, he or she will most often choose the sure $50. However, if that same person is offered the choice between a sure loss of $50 or, after the flip of a coin, the possibility of losing $100 or nothing, he or she will likely choose the coin toss. Applying this to the stock market, investors willingly remain in a risky stock position hoping that the price will bounce back because they do not want to realize the loss. People are willing to take more risks to avoid losses than to realize gains.

Continuing with the example of a coin toss, another theory, know as the Gambler’s Fallacy, suggests that individuals often erroneously believe that the onset of a certain random event is less likely to happen following an event or series of events. For example, if you flip a coin 20 times and it lands on heads every time, it is common to think that the next one will likely land on tails. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. The same goes for choosing numbers on a lottery ticket or pulling the handle of a slot machine.

Human beings tend to fear being left behind in the event of a market upturn. According to the Herd Effect, people tend to mimic the actions (rational or irrational) of a larger group. An infamous example is the bursting of the dot.com bubble in 2000. Herd behavior leads to greed in bubbles and fear in crashes. Fear during crashes such as Black Tuesday of 1929, Black Monday of 1987 and on a smaller scale the 2010 Flash Crash led to massive sell offs.

Although there are many more theories pertaining to behavioral finance, I’d just like to mention two more. The concept of Confirmation Bias proposes that investors tend to look for info that supports their previously established opinion and decision. This leads to overvaluing the stocks of currently popular companies. Along those same lines, the Neglected Firm Effect suggests investors tend to undervalue stock of overlooked companies. This also relates to the Herd Effect: if no one else sees value in this company, why should I?

You’ve all been told the key to making money in the stock market is buying low and selling high, but investors repeatedly do the opposite: they watch a stock go higher and higher until they can’t take it anymore and they buy. As the stock falls, they watch it go lower and lower until they can take no more and sell. I feel strongly that there is enough evidence to prove that investors are not always rational and emotions do come into play in making financial decisions, especially when losses are involved. In 1969, a psychiatrist came up with a 5-Stage process people go through in dealing with grief. Recently this process has been applied to investors coping with the current global financial crisis. The five stages of grief are denial, anger, bargaining, depression and acceptance and I will briefly show how I would assign recent economic events to this process.

During the denial stage, people tell themselves “this isn’t happening to me.” The denial stage of the global financial crisis probably began in late 2007. After the housing market peaked in 2006, home prices had began to decline and people debated whether or not we were in a housing bubble. Subprime lending had skyrocketed over the past 2 years and some people began questioning whether or not there was a mortgage problem brewing. While there were some defaults and foreclosures, many companies still had high earnings expectations and for the most part investors were convinced that any downturn would be temporary.

The denial stage is followed by the anger stage when we ask ourselves “why me?” People often begin to play the blame game. From late 2007 through late 2008, the market faced a deep and steady decline. The blame shifted to many different groups including mortgage brokers (too lenient of lending policies), mortgage holders (took out more than they could afford), regulators (loose regulation), the Fed (lax monetary policy), and Wall Street speculators among others.

The third stage is the bargaining stage during which we have realized that there is a problem and are trying to fix it before things get out of control. I think we entered this stage in late 2008. In September of 2008, the government stepped in to rescue GSE’s Fannie Mae and Freddie Mac to address a capital deficiency and to try to calm the markets. This was followed by a series of bailouts including AIG, the auto industry, Citigroup, and BOA. The Federal Reserve continued lowering the federal funds rate. Unfortunately the economic downturn continued.

The next stage is depression which is characterized by feelings of hopelessness, self pity and mourning. We most likely entered this stage around Spring of 2009 after the Dow closed in March at its lowest level since Spring of 1997. Unemployment had sharply increased and companies engaged in unnecessary mass layoffs as they feared the direction the economy was heading. Those who were laid off feared how they would pay their bills, perhaps most importantly their mortgage, and those who had jobs feared they could lose theirs at any moment.

Acceptance is the final stage of the grief process and is when people begin to deal with reality. I believe that we are currently in this stage and have been since fall of 2009. The market has begun to rebound significantly and unemployment along with other aspects of the economy has stopped getting worse.

In summary, after examining these five stages of grief and how they can be applied to the global financial crisis of 2007-2010, it seems obvious that human emotions do affect the way we perceive the economy and what we do with our money.

So if it is human nature to let emotions play a role in financial decisions, what can you do to lessen the negative effects this can have on your portfolio? Here is one simple answer: have an investment plan and stick to it through thick and thin. In many cases this also means hiring an investment manager. An investment manager can be an unemotional third party that will help prevent you from acting on your impulses. On the contrary, sales people such as brokers benefit financially by catering to investors’ emotions. This is due to the way that they are compensated.

The dust seems to be settling from the major market downturn we have been facing. If you do not have an investment plan or question the one you have, there has never been a better time than now to address those concerns. If you know someone who could benefit from a second opinion, ask them to call us for our free portfolio consultation. More information is available on our website at http://www.alderfinancial.com/PortfolioReview.htm.

Inflation 3 (April, 2010)

Welcome to the final installment in my series about inflation. As I've mentioned before, inflation is the "silent killer" of portfolio value, and is very important for investors to understand. Inflation is a phenomenon that has existed since the advent of money, thousands of years ago. It will continue to be a force into the future, probably as long as we still measure value in currency. This month, I will be bringing the series to a close with some thoughts about the practical impact inflation has on a portfolio and a few strategies that investors use to combat inflation's effect.

As I've mentioned several times, inflation eats away at the value of your money in silence. If you keep $100,000 under your mattress, in 10 years with 2% inflation (the approximate, long term average) it would have the same value as about $82,000 today. You would lose $18,000 in purchasing power without losing a dime of your money! This fact is what leads financial advisers to caution strongly against leaving your money "under the mattress" or in low yielding savings and checking accounts for long periods of time.

Fortunately, there is good news for investors. There are several strategies and securities that can be used to minimize the effects of inflation for everyday investors.

Younger investors who own mostly equity (stock) type instruments don't need to worry about inflation. Over time, the earnings of the companies they own will increase with inflation, and this will be reflected in their stock prices. As we have seen over the last several years, stocks may not increase for years at a time but in general earnings should increase with inflation.

Another common "hedge" against the effects of inflation is commodities. Commodities are raw materials such as oil and gold that can be bought in the financial markets. They can also be bought in the form of diversified funds that track the price of multiple commodities at once. The value of commodities is measured in dollars. As dollars have less and less value, the number of dollars needed to value a certain amount of commodities goes up. Buying commodities negates the effects of inflation by exchanging your money for an asset that isn't affected by the change in value of currency. Later, you can sell the commodities for an increased price since dollars have been depreciating due to inflation.

Other strategies have to do with investing in foreign currencies. The theory is that since inflation doesn't have the same impact everywhere in the world, investing in the right foreign currency will lessen the impact inflation has on your portfolio. This is difficult to do because it involves projecting interest rates and inflation rates in the U.S. as well as the country in which you plan to invest.

Finally, the most common way investors can mitigate inflation is through U.S. Treasury Inflation Protected Securities, or TIPS. TIPS work like normal bonds; they have a purchase price and pay interest. The principal is adjusted to account for CPI periodically and this indexes it to inflation (approximately). One problem with TIPS is the way they are taxed. The gains on principal are taxed even before they are realized (the so called "phantom tax"). Even so, TIPS can be an excellent way to minimize inflation effects on part of your portfolio.

Inflation is a very important topic for investors to understand. It must be accounted for and kept in check because it has the ability to diminish the value of a portfolio over long periods of time. There are several techniques for diminishing the effects inflation will have on a portfolio, but there is no real "silver bullet". Using a variety to techniques will yield the most effective inflation strategy.

I hope you've enjoyed this series. Inflation is a very complex topic and there are entire fields of study devoted to it. Although this has been more of an overview than an in depth study, I hope you have learned a little bit more about inflation, its causes and what investors can do to mitigate its effects. If you are interested in learning more, there is a wealth of information and statistics on the internet, or feel free to contact me at any time.