Dion Money Management Blog   Money Management for Retirees and Their Families

Last weekend I had the chance to attend an annual charity event that I enjoy. In addition to the charitable giving opportunity, the event provides a rare opportunity to speak with one of the world’s legendary investors, Warren Buffett.

The event began Friday night with a reception where I had the opportunity to ask Buffett what his prediction was for the economy. Buffett was very optimistic in his outlook. He believes that we will survive the current recession and reminded me that Americans have seen a seven-fold advance in the standard of living over the past century—and that there had never been anything like that in the history of the world.

Buffett also addressed the assembled crowd on Saturday and noted that in the last 100 years, we have survived the Great Depression, two World Wars, the Cold War, and the Atomic Bomb; the country has moved forward, and it will move forward again. Moreover, no one has ever “bet against the U.S.” and won. He also noted that still “people were trying to get in, not leave” the United States. We have always been a country of renewal, one in which ingenuity thrives and economic progress prevails.

There was a mild correction in the past week, but the S&P 500 Index has fought its way back to even territory. The benchmark index has spent the better part of this month above its 200-day moving average, a feat last achieved in 2007.

Economic data out this week was mostly positive. Instead of a 5.7 percent decline in GDP, the Bureau of Economic Analysis reported that first quarter GDP fell at a 5.5 percent annualized rate. The smaller decline was the result of adjustments to imports and inventories. Accompanying the GDP release was data on initial claims for unemployment, which were up slightly from last week but still well below the highs set earlier this year.

Earlier in the week, durable goods orders increased 1.8 percent, well ahead of expectations of a decline. A very positive sub-figure was the 4.8 percent increase in non-defense capital goods excluding aircraft. Capital investments are the driving force of higher wages and economic growth.

Home sales were a mixed bag, with existing-home sales increasing and new-home sales declining. New homes are less attractive than foreclosures and the difference in price leads to the discrepancy. Eventually, existing sales will decline and new home sales will increase to close the gap, but it’s unclear where these numbers will settle.

Overall economic data show that the economy’s contraction is slowing. Growth has yet to arrive in force, but the natural process of recovery is underway. Optimism has emboldened investors and politicians alike, and the appetite for further government action is dwindling. Two major issues, climate change and health care, could be defeated due to concerns over current economic growth and the burgeoning deficit. If these worthwhile efforts failed, I believe it would be bullish for most stocks, because both are clouds of uncertainty hanging over the economy.

Disclaimer

Signs of market stabilization and recovery are prompting some investors to once again look to the future and reconsider the range of retirement investment vehicles available to them. Many individuals, burned by their recent experiences in the stock market, are seeking alternative investments in areas claimed to be “safer” or “non-correlated” to the market as a whole. There has been a resurgence of self-directed IRA “experts” across the Internet who are ready to help investors build their IRAs with alternative investment options. While legitimate experts certainly exist on the Internet and elsewhere, many analysts and regulators agree that investors, particularly those reaching retirement age, should carefully research the advantages and disadvantages of SD-IRAs before establishing such a plan.

An SD-IRA involves a high level of involvement on the part of the owner, who must make investment decisions and choose investments for the plan. These types of IRAs, which have existed since 1974, can often be allocated to a broader range of investment choices. IRS regulations require that either a custodian or a qualified trustee hold assets on behalf of the owner, helping to maintain assets and transaction reports. The trustee/custodian will also file required IRS documents, issue client statements, and help the owner understand the rules and regulations pertaining to his or her account.

Alternative Assets
While some SD-IRA custodians limit the type of assets that participants can select, “true SD-IRA” custodians will permit investors to select just about any investment area permitted by IRS code. While investors will still have the option to place assets in stocks, bonds and mutual funds, other investment areas such as commodities, private placements, foreign real estate, limited liability companies and other not so publicly traded investment options draw many SD-IRA participants who have been burned by traditional market investments.

In a 2005 Fortune magazine article touting the advantages of SD-IRAs, Raymond Yu, chief administrative officer of Entrust Administration (theentrustgroup.com) of Oakland, California, which handles $1.7 billion in self-directed IRAs, spoke of his investors having success with such varied investments as cemeteries and heads of cattle. The most popular sector that SD-IRA investors have flocked to in recent years is real estate.

Tax Considerations
During the real estate boom, some investors used the unique tax benefits of SD-IRAs to take advantage of real estate opportunities. For example, an investor familiar with real estate development might use IRA assets to purchase a commercial real estate lot. If the investor is able to flip this investment, capital gains on the sale will not be due until the investor begins taking distributions. However, unlike investing in stocks, mutual funds and bonds, losses incurred in the above real estate transaction cannot be written off.

Prohibited Transactions
While the range of acceptable SD-IRA investments is broad, prohibited transactions stop individuals from “self-dealing” with their tax-deferred funds. “Self-dealing” refers to the benefit that investors could receive today from investments made with IRA-deferred income. For example, if you buy a vacation home through your SD-IRA, you can rent it for profit. However, if your family decides to use that same house for your own vacation time, it would be a violation of the IRA’s self-dealing rule. Another violation would be to make repairs to the house yourself, rather than hiring out someone else to do so.

Using IRA funds to start a business can be similarly complicated. While you can legally use SD-IRA money to fund a start-up, you can’t be a majority owner of the business or pay yourself a salary unless the business is structured in such a way that the amount you get paid is not within your control.

While most investors utilize SD-IRAs for their intended purpose—a way to help invest retirement capital in alternative investments—others believe that they can use the structure of an SD-IRA as a loophole to buy a vacation home that they can use today and pay the taxes on later. Investors should avoid this temptation, as one misstep in your SD-IRA portfolio could result in the entire balance being taxed or subjected to penalties. Any self-dealing, even just fixing a leak in the roof of an SD-IRA financed house with a personal check instead of paying out of the SD-IRA, will prompt IRS investigation.

Due Diligence
Among the most important considerations when setting up an SD-IRA are the relevant regulatory agencies and the track records of custodians. Different custodians are overseen by different regulatory agencies, so before selecting someone to manage an IRA, investors should find out whether the custodian in consideration is regulated by a state securities administrator, a state attorney general’s office, the Securities and Exchange Commission or FINRA (Financial Industry Regulatory Authority), as is the case with broker-dealers and stockbrokers. Understanding who the regulators are means knowing who to go to if things go wrong.

While some of the companies promoting SD-IRA management have an established track record, it is important to choose a firm that is knowledgeable about the type of investments that you are interested in. In a recent interview, John Gannon of FINRA noted, “[You] want to know how long the firm has been in business, how long the firm has been a custodian of self-directed IRAs [and] how much experience they have with the specific type of asset to be held in the self-directed IRA.”

Assessing the Alternative
Reflecting in 2009, however, on the many SD-IRA participants who directed their funds toward real estate—from storage facilities to strip malls—it is evident that these alternative investments do not always pan out over the long haul. While managers who promote the advantages of SD-IRAs today may place a heavier emphasis on the latest hot investments—such as commodities or emerging market real estate—it is important for investors to remember the many bubbles in alternative asset markets that have occurred in the past.

Following a period of equity market disappointment there is often a resurgence of firms promoting alternative investment strategies to weary investors. While many investors will successfully use SD-IRAs to diversify their larger investment picture, it is important to remember that any concentrated investment could prove disastrous. In 2008 and 2009, investors were forced to face difficult losses in the real estate markets—a pain felt more acutely by those who had staked their retirement on the sector. It is tempting to shy away from an uncertain equity market to try to capture the next big alternative investment, but it is essential to evaluate the pros and cons of SD-IRA investing and view any concentrated positions as just part of a larger investment framework.

Disclaimer

Economic data was mixed last week with improvements in housing, retail sales and jobless claims, while the unemployment rate continued to tick higher and interest rates threatened to stall any housing recovery. Foreclosure activity declined 6 percent in May; retail sales increased 0.5 percent on higher gas prices and bargain hunting in the auto market. Initial claims for jobless benefits fell to the lowest level in six months, although unemployment continues to grow as a percentage of the labor force. 10-year Treasury yields hit 4 percent and 30-year mortgage rates passed 5.5 percent.
This week consumers were happy to see that inflation fell 1.3 percent in May versus the year earlier period, even though energy prices have run up recently. Housing starts and building permits came in higher than expected, but industrial production numbers were slightly lower than anticipated. The U.S. current account deficit, which measures trade and services, is at the lowest point since 2001. With stimulus spending set to flow through to economic data later this year, the balance should tilt in favor of the bulls.
In addition to this week’s economic news, the financial overhaul proposed by the Obama administration was the most significant event. As with most things the government does, it is a mix of good ideas, with some overreach in places and a bit of rear-view mirror driving. Nevertheless, from an investment standpoint, the reforms make it clear that the financial sector will not return to business-as-usual. As a result, the industry will find it hard to boost its earnings to prior levels. Just as a retailer or manufacturer increases their earnings through increased sales, banks increase their profit through increased sales, or more loans. Regulations will make it tougher to loan money, both by restricting bank capital and limiting the ways consumers can be offered credit. But just as we experienced following the technology bust earlier this decade, other sectors, such as energy now, can lead the market higher.
In technical terms, the S&P 500 is sitting right at a major point of support, the 200-day moving average. The index is 72 days into a rally, but the moving average continues to drop because the 200-day currently stretches back to the beginning of September. That means the market can fall and still retain a bullish technical bias. In July and August, however, the crash months will fall out of the calculation and the 200-day average may bottom. If the market were to tread around current levels, the average would be around the 860-870 level for the S&P 500 Index. For the summer, the trend in the moving average favors the bulls, and gains from here would push the index well above the moving average. Although many are fearful of a market reversal here, a correction may be the worst of it.

Disclaimer

The small weekly gain from the S&P 500 Index through yesterday came as 10-year Treasury yields rose to 4 percent, continuing their steady march higher since the end of May. Mortgage rates followed Treasuries higher, such that interest rates for borrowers have risen from just over 4.5 percent to more than 5.5 percent. If 10-year yields increase at the same pace they rallied over the past three weeks and reach 4.25 percent, 30-year mortgages are likely to hit 6 percent, achieving pre-crash levels last seen in the summer of 2008.
Higher interest rates, along with higher oil prices, represent a potential drag on the economy as it tries to recover from the mountain of debt hanging over consumers. Retail sales increased 0.5 percent in May, but most of the increase was due to higher gasoline prices. Excluding gasoline, sales were up just 0.2 percent—within the margin of error.
The S&P 500 Index has been flat since rates started to rise in earnest at the end of May. Further signs of economic stabilization can fuel higher prices, but the risk of higher rates will limit the market on the upside until government finds a way to cut the deficit—without raising taxes—the way millions of common sense American consumers have lowered their debt, by cutting their costs and increasing their savings.
In other economic news, jobless claims dipped, foreclosures declined, and inventories continue to draw down. Although the S&P 500 Index has not gained much ground since the end of May, this rally has appeared to stall many times before continuing.
This week Bank of America (BAC) was the target of a Congressional inquiry into its purchase of Merrill Lynch last year, but collateral damage could spread much further than anticipated. In April, as part of an investigation into the bonuses paid at Merrill Lynch, New York Attorney General Andrew Cuomo discovered that Bank of America CEO Ken Lewis was pressured by Treasury Secretary Paulson and Federal Reserve Chairman Bernanke to go through with the Merrill Lynch takeover, even though Lewis believed it was in the best interest of shareholders to invoke the material adverse change clause.
Lewis’ testimony is an appetizer to the main course brewing in Congress, as Republican Rep. Ron Paul’s effort to have the GAO audit the Federal Reserve is nearing fruition. After stalling with mostly Republican support, Democrat Rep. Alan Grayson, a critic of the Federal Reserve’s transparency, made a push to garner support from his side of the aisle.
The risk here is what happens once Congress opens up the Federal Reserve to serious political scrutiny. Independence is vital to central banks, and it’s unclear what happens once this train gets moving. At the very least, I expect there are a few politically unpopular transactions on the books waiting to be uncovered in the process. Consider the outrage over bonuses that amounted to less than 1 percent of total bailout money, and then consider that the Federal Reserve has loaned out several times more than the Treasury. The risk that the Federal Reserve is unable to act with the same freedom it currently enjoys is real. Whether you believe that is good or bad, it will affect the way monetary and fiscal policies are shaped in the future.

Major life events—marriage, the birth of a child or grandchild, the death of a spouse—are almost always busy and highly emotional occasions. Investments, insurance and retirement planning all recede into the background during the joy that attends the birth of a newborn or the grieving process that accompanies the death of a loved one. Moreover, it’s just human nature to put off thinking about retirement and estate planning, particularly when the daily routines of work, home and family present so many challenges. But letting your financial plan fall too far behind the changes in your life can put your financial future at risk. Below, we outline some of the major life events that should prompt you to readjust your financial plan.

Disclaimer

Marriage

Start planning for retirement. It may seem unromantic, but starting early is the key to greater wealth in retirement. The reason is simple: you want your assets to have as much time as possible to grow in tax-deferred accounts like deductible and Roth IRAs, and 401(k) and 403(b) plans. If both you and your spouse are employed by companies that sponsor retirement plans, your goal should be to fund both plans at least up to the level of your employers’ matching contributions. If that’s not in the budget, then fund the plan with the best features, i.e., employer match, investment options, vesting schedule and loan program. If you are able to make the maximum contributions to your employer-sponsored plans, think about sheltering more income in a traditional or Roth IRA.

Make a will. If you’ve put it off, now is the time for you and your spouse to get a will drawn up. Include a living will and a health care power of attorney so that your spouse will know your wishes and have the authority to make health care decisions on your behalf in the event you are unable to do so.

Think about insurance. If one spouse is the sole breadwinner, then a life insurance policy probably makes sense. Consolidating auto insurance under one carrier can often save on monthly premium costs.

Birth of a Child or Grandchild

Begin saving for college. The cost of a college education has been outpacing inflation for years. According to the College Board, the organization that administers the SAT, the average cost of attending a four-year private college during the 2008-2009 academic year was $25,143 (9 percent of private institutions cost $33,000 or higher). Congress changed the Internal Revenue Code in 2001 to make tax-advantaged 529 plans a particularly attractive option for college saving. While these plans are typically funded with after-tax dollars, assets grow tax-free, and distributions are also tax free if spent on qualified educational expenses. Certain states, which sponsor the plans, allow in-state residents to take a state tax deduction for their 529 contributions.

Take advantage of the gift-tax exemption. You can give up to $13,000 per recipient per year without triggering the gift tax. Married couples can give up to $26,000 per recipient. Taking advantage of this provision of the tax code can be a useful way to deplete an estate that would otherwise trigger the estate tax while helping to fund a child’s 529 plan or trust.

Update estate and insurance documents. Be sure to update life insurance policies to reflect the fact that your family now includes a child. Married couples with enough assets to trigger the estate tax ($3.5 million in 2009) should consider advanced estate planning strategies such as credit-shelter trusts, charitable giving, and sheltering assets in a Roth IRA.

Divorce

Avoid the retirement account tax trap. Note that in almost every state, courts consider amounts contributed to retirement accounts during the marriage to be marital property. It’s absolutely critical that retirement accounts—including employer-sponsored plans as well as IRAs—be divided pursuant to a qualified domestic relations order (QDRO) issued by the court or by your divorce property settlement. If not, then any distributions from these accounts will be treated as taxable events, and you will be on the hook for taxes and penalties.

Take charge of your finances. If your ex-spouse was the one who paid the bills and managed the investments, you may want to meet with a financial adviser to discuss retirement and tax planning.

Update important documents. Update bank accounts, estate documents such as wills and trusts, life insurance policies, and beneficiary designations on retirement accounts. If you fail to do so, your ex-spouse could inherit from your payable-on-death accounts like joint bank accounts and retirement accounts.

Death of a Spouse

Collecting spousal benefits. If you are over 60 at the time of your spouse’s death and your spouse paid into the Social Security system for at least 10 years, then you will be eligible for survivor’s benefits. In addition, most insurance policies will pay out directly to the named beneficiary upon proof of the policy-holder’s death. You will likely have to choose whether to take a single lump sum or a series of periodic payments. It’s important to consider the tax consequences of this decision. A large lump sum payment may seem appealing as a way to pay off debts immediately, but it could bump you up into a higher income-tax bracket. If your spouse was employed at the time of death, his or her benefits coordinator will be able to answer questions about spousal pension benefits or other employer-sponsored retirement plans your spouse may have participated in.

Jointly-owned assets. As a general rule, any assets that were jointly held by you and your spouse will pass directly to you outside of the probate process. This includes joint bank accounts and real property held jointly with right of survivorship. For other assets that were titled solely in your spouse’s name but that have passed to you through a will (or through your state’s laws of intestacy), you will have to have them re-titled in your name. Your state’s Department of Motor Vehicles will be able to advise you on the proper procedure for re-titling an automobile. Consult an attorney for assistance with changing the name on title documents to real property.

Update retirement plans. The death of a spouse may change the way you think about your retirement. You may decide to sell the principal residence and move. The death of the main breadwinner may require a new investment strategy, with a focus on income generating assets. A consultation with a financial adviser can help.

GM’s bankruptcy generated the most news this week, much of it lamenting the fall of a once great American corporation. In the markets, investors and traders greeted the demise with a relief rally that sent the S&P 500 Index up 2.58 percent on Monday. General Motors was a company in decline for decades, and the political panic was far out of proportion to the economic reality. GM problems were known for years, but they intensified in the past decade. It may be the financial crisis that finished the company off, but even without the recession, bankruptcy was always a possibility.
The U.S. government’s bailout of the automakers, a policy repeated by other governments around the world, will turn the automobile industry into the airline industry. Companies will move in and out of bankruptcy because only liquidation can end the overcapacity that makes the industry a destroyer of capital. The current solution will allow Chrysler and GM to emerge more competitive than their rivals, who may in turn enter bankruptcy in future years and then emerge stronger, and the cycle could repeat.
By Wednesday, GM was long forgotten as markets turned to economic data. Employment numbers remained weak in the ADP report, and the Labor Department announced that unemployment had reached 9.4 percent after another 345,000 jobs were lost. Also, the Challenger, Gray & Christmas report on job cuts showed that governments have started to trim labor, even though corporate cuts declined. CEO John Challenger said, “The second quarter is typically the lowest quarter of the year when it comes to job cuts. Corporate downsizing may continue to remain slow during the summer months, but if the past is any indication, we could see the pace accelerate again in the latter half of the third quarter through the end of the year.”
How investors view the employment situation will be important for the short-term direction of the market. No one can know the thinking of the hundreds of millions of people that make up the markets, but judging from the news, it seems the herd swung from six months of “end of the world” (September to March) to three months of “it’s not the end of the world” (March to June). Now, the time has come to assess the rally. Stocks, commodities (especially oil, up about 100 percent), high-yield debt and emerging markets have rebounded sharply from their lows. Stocks are trading at 15 times their trailing earnings, so the market is near or at fair value. Continued growth in earnings could be a catalyst for the market moving higher, allowing investors even more opportunity over the next 12 to 18 months.