With Halloween upon us, there are lots of scary bats, witches and monsters about. And with the election just a couple of days away, we once again see the issue of the privatization of Social Security surface in the election ads. We don’t like to take sides politically in our blog and won’t debate issues around how such a concept would actually be implemented, but we do think it’s important for people to know that it’s not as scary and radical as it’s often made out to be.

We’d like to discuss here, the basic idea and show that it could have merit, if it’s implemented in a common sense way that considers the concerns of all of the Social Security stakeholders, future and present.

At the heart of the issue is whether one could earn more by investing in “the market”, a portion of what is now going into the Social Security system. Part of the controversy involves what one means by “the market”. If “the market” means just investing in U.S. common stocks, then we would be concerned about such a concept. If “the market” means a broadly diversified portfolio which becomes more conservative as the owner ages, that becomes a more agreeable concept.

Even so, a recent article in the Wall Street Journal titled “Private Social Security Accounts: Still a Good Idea” by William G. Shipman and Peter Ferrara, showed how investing in stocks alone over a long period would provide far better returns than Social Security. The article cites the following example:

“Suppose a senior citizen ‘Joe the Plumber’ –who retired at the end of 2009, at age 66, had been able to set up a personal account when he entered the work force in 1965, at the age of 21. Suppose that, paying into his personal account what he and his employer would have paid into Social Security, Joe was foolish enough to invest his entire portfolio in the stock market for all 45 years of his working career. How would he have faired in the recent financial crisis?”

The article goes on to say that if you assume Joe and his wife invested in a portfolio consisting of 90 percent large-cap stocks and 10 percent small-cap stocks, they would have accumulated $855,175, even taking into consideration a 37% loss in 2008. According to the article, this was equivalent to a 6.75% return, annually from 1965 until 2009. Note also that their portfolio would have been severely impacted by the tech stock bubble and the 9/11 terror attack fallout. Their return would be 75% greater than what they would have earned, had their funds been invested in the Social Security system.

A large number of Americans are invested in the market in their 401(k) plans and outside of those plans. If they could invest part of their Social Security contributions in “the market” in an intelligent manner (yes, that may be the problem!), stay broadly diversified, rebalance frequently and take a more conservative stance as they approach retirement, it is highly probable that they can beat the returns of Social Security. If not done properly, it could be very scary. If done right, it could be very rewarding.

Our first two “Words of Wisdom” posts were quotes from the famous investor, Warren Buffet. This time we thought you’d like to here from that famous person “Anonymous”. He/she is often quoted regarding all sorts of topics. Sometimes it is more than one person, the oft-referred to experts, “they”. Everyone wants to know who “they” are. No one seems to know.

In this case “Anonymous” is credited for an old Wall Street adage: “No tree grows to the sky.” This is an important fact for all investors to remember. Too often we let our emotions get the best of us. We often buy investments we don’t really know that much about, and then hold on to them longer than is prudent.

While we don’t recommend individual stocks to clients (we utilize low-cost, no load mutual funds, primarily), our clients often like to dabble in this or that stock they heard about over the backyard fence or at the cocktail party last week. We advise them to set a target price at which to sell. They seldom do. Often the stock they buy is one that’s been on a meteoric rise for some time. Surely it will continue? What’s to stop it?

They hang on and hang on until suddenly there’s a market correction or the company’s earnings fall short of over-zealous expectations and the stock drops ten or twenty percent, overnight. The tree they thought would grow to the sky, suddenly was blown over by an unexpected storm. To make matters worse, they often continue to hold on while their stock continues to plummet in price. Surely it will bounce back, they think!

Unfortunately, too often, investors let their emotions drive their investment decisions. We can learn a lot from “Anonymous”. He or she is really quite smart.

For those who have struggled while preparing their tax returns to determine the cost basis of investments sold during the tax year, there’s good news on the way. For those who cheat on their returns, it will soon be more difficult to fudge on the gains they’ve received.

In 2008, new rules were passed by Congress that will require investment companies to track the cost basis of their customers’ assets and report them to the IRS on form 1099, when those assets are sold. The new rules will be phased in starting this coming January.

Many investors have difficulty determining the cost basis of investments they have sold, in part because they have not kept good records. In some cases they have the data but don’t understand how to accurately calculate the cost basis.

Cost basis is generally not an issue in retirement accounts such as IRAs and 401(k)s, since distributions from those accounts are typically all taxable at ordinary income tax rates. (Note that after-tax contributions to 401(k) accounts and non-deductible contributions to IRAs require special handling when taking distributions).

Gains from the sale of taxable assets must be classified based on how long the asset has been held as either a long-term or short-term capital gain. Long-term capital gains are currently taxable at the maximum rate of fifteen percent. Short-term gains are taxable as ordinary income.

Re-investment of dividends and capital gains are often handled incorrectly by investors when preparing their tax returns. Re-investments add to the original cost basis of an asset and are taxed in the year received. If the cost basis is not adjusted upward for the amount of re-investment, an investor will end up paying taxes twice on the re-invested amounts. The new rules will help investors avoid this problem.

Many investment companies have been keeping track of investors’ cost basis for some years now. Starting in January, they will all have to do so, when they will have to keep track of the cost basis data for newly acquired stocks (both domestic and international) and real estate investment trusts (REITs). Mutual funds will have to start keeping track of the data, starting in January of 2012.

While the new rules make things easier for investors, they will still have to pay close attention to cost basis issues. Assets acquired prior to January 2011, that are not held in an account at a firm that has been tracking cost basis, will still require that you do your own calculations. And, assets for which you have multiple lots will require you to specify which lot or lots you are selling. Those bought at lower prices will generate higher capital gains taxes. You may need to specify which shares you are selling if you want to minimize the taxes.

In summary, it will eventually be easier to determine your cost basis for asset you acquire in the future. For those you already own, the burden still falls on you.

As everyone hopes for a turnaround in the economy, few people probably realize that more bailouts have been promised by the government and will continue to increase the country’s already huge debt.

Who’s going to get the bailouts you ask? None other than Fannie Mae and Freddie Mac, who, as of 2008, owned or guaranteed 56.8% of the U.S.'s $12 trillion mortgage market. Neither Fannie Mae nor Freddie Mac was included in the massive new package of regulations passed by Congress a few months ago. Many felt that Fannie and Freddie bore much of the blame for the “Great Recession” we found ourselves in, and were dismayed that Congress refused to include them in the legislation.

An article in the Wall Street Journal titled “Fannie, Freddie Elicit a Grim Forecast” (Saturday, Sunday October 23 -24) by Nick Timiraos, reported that “propping up Fannie Mae and Freddie Mac will cost taxpayers $154 billion under the most likely scenario for home prices, the mortgage giant’s regulator said Thursday.” The article went on to say that the cost may be higher, “nearly double the $135 billion already spent – if grimmer projections prove true and the economy slides back into recession”.


In 2008, the government took over Fannie and Freddie and promised to provide unlimited funds to keep them solvent, in turn for 10% dividends to the government. According to the article, the dividend expense itself will likely be from $67 billion to $91 billion and “will likely keep them from ever returning a profit”. And if home prices continue to drop, the government will have to cough up much more to keep Fannie and Freddie afloat.

It’s hard to imagine how Congress could ignore the inclusion of Fannie and Freddie in the new regulations recently introduced. We can only hope the economy turns around soon. If not, we’ll all be paying substantially more to bailout Fannie and Freddie.

For many people, buying long-term care insurance is a difficult decision to make. It gets about the same level of attention as planning for one’s funeral. Few like to even think about going to a nursing home. Many just rationalize that they will never need it, putting off what they know is an important decision that could severely impact their financial future.

With people living longer and longer, the odds of needing long-term care are increasing. We provide in-depth information about long-term care insurance to all of our clients who contract for a comprehensive financial plan.

Long-term care should not be considered by those who are either too poor or too wealthy. If you are struggling to just get by in meeting your expenses, you likely can’t afford long-term care insurance. If your net worth is two or three million dollars, you possibly can cover the cost of long-term care yourself (i.e. self insure). If your net worth is somewhere in between, you may be a candidate for long-term care insurance.

Unfortunately, recent news has made the decision even tougher. In the last few months, a number of large insurance companies have either significantly raised premiums for many of their existing policy holders or are planning to (from 10% to as high as 40%). John Hancock Financial has also stopped selling long-term care plans to employer-benefits programs.

According to an article in the Wall Street Journal titled “Long-Term-Care Premiums Soar” (October 16 -17, 2010), the increases are the result of people living longer, generating higher cost claims and canceling fewer policies. The article states that low interest rates have also resulted in less income on investments used to fund the long-term-care policies.

As a result, a decision that’s always been a tough sell is now even tougher. The only option to combat the higher prices seems to be to reduce coverage or increase the waiting period before benefits kick in (i.e. assume more of the cost yourself). What ever you do, be wary of low-cost providers who may not be large enough to be around for the long-term. The way things are going, we worry that even the large companies will stop selling long-term care policies.

On more than one occasion, we’ve worked with clients who had 401(k) plans that were hard to evaluate. Often, the real costs were not easily discerned. In many cases, we discovered that clients were paying very high fees that ate away at employees’ annual returns. Now, it will be easier for everyone to evaluate just how much they are really paying for their 401(k) plans.

Recent articles by both the Wall Street Journal (“Investors in 401(k)s to get More Details”, October 15, 2010) and the Associated Press (“Labor Dept. Releases New 401(k) Fee Disclosure Rules”), discussed new rules just released by the U.S. Labor department.

Often, investors have overlooked the impact that taxes and investment expenses have on their investments. With 401(k) plans, the data has been generally difficult to ferret out, even if one made an effort to find out what they were paying. According to the Wall Street Journal article, companies will be required to provide details about their 401(k) plans’ performance, fees and expenses starting in 2011.

According to the Journal article, “the fees and expenses associated with the funds that a worker chooses must be explained as a percentage of assets held, and also represented as a dollar amount for each $1,000 invested.” An easy-to-understand glossary of terms must also be available to help workers understand the fees, expenses and other information about their plans.

The two articles contained conflicting information about when the new disclosure rules will take affect. The Wall Street Journal said the new data will be available in 2011, while the AP article mentioned both July 2011 and January 2012 as effective dates for the new disclosures.

We wrote recently about avoiding large tax refunds (see our post titled “Are Your Tax Refunds Too Large” (October 6, 2010). Any planning you might try to do in that regard will be difficult due to Congress’ inability to finalize the tax rates for 2011.

According to an article in the Wall Street Journal titled “Delays to Tax Tables May Dent Paychecks” (October 7, 2010), workers may pay significantly more for withholding, starting with their first paycheck in January, if Congress doesn’t act quickly following the November 2nd election.

As most people know, Congress adjourned recently without addressing the issue and won’t return to Washington until November 15th. According to the Journal article, the Senate plans to address some non-tax issues first, when they re-convene. It’s possible they won’t be able to address the tax issues before they adjourn for the Thanksgiving recess. That would push the decision on the Bush tax cuts to early December.

Such a late decision on the taxes creates a real problem for the Treasury Department, which normally releases the tax-withholding tables for the upcoming year in mid November. Employers and payroll processing companies may find it difficult to change and test their systems prior to the first January paychecks being issued.

The Treasury Department has a couple of options. They can just tell employers to continue to use the current tables. In that case, taxpayers may end up being significantly under-withheld for the year. Another option is to provide a one or two-month grace period for the implementation of the new rates. A third option would be to assume Congress will extend the Bush tax cuts for those joint filers making less than $ 250,000 ($200,000 for single filers). However, they have never published tax tables based on assumptions before.

Whatever happens, we recommend you stay tuned to our blog for an update on how the issue is resolved and what you should do.

We recently posted a blog titled “Words of Wisdom from Warren”. We like financial quotes of all types, especially those from famous investors or well-known people. Warren Buffet, known as one of the savviest investors of all time, is often quoted for his thoughtful words of wisdom.

This is the second of our “Words of Wisdom from ……..”. that we will post from time to time. It’s unlikely the quotes will focus on something we haven’t written about previously. Many however, will give us the opportunity to re-emphasize an important concept.

Warren’s quote today is attributed to his “oft-repeated response when asked why he doesn’t invest in high-tech stocks”, as noted in The Quotable Investor (The Lyons Press, 2001). Prior to the tech-stock bubble, Warren’s Berkshire Hathaway stock was avoided by many investors because he hadn’t participated in the tech-stock buying frenzy. His response as to why he hadn’t was: “We will never buy anything we don’t understand.”

Because of his views on tech stocks, Warren’s Berkshire Hathaway stock price was significantly depressed at the time. Some were saying that he had lost his touch. Like everything else, Berkshire Hathaway stock dropped in price when the tech-stock bubble burst, yet it proved to be a great buy at the time, since its price drop was small when compared to many of the tech-related investments. We’re sure a great many investors wish they’d bought Berkshire Hathaway stock back then.

The lesson is simple: To be a successful investor, you have to do your homework. Don’t be taken in by hype, flashy commercials or promises of inordinately–high yields. And if you don’t have the skills to ask the right questions, take the time to find a trustworthy, qualified professional who can do it for you. It will be well worth the time and money.

We are constantly talking about the importance of diversification in your portfolio because good diversification can actually increase your returns and at the same time, lower risk. How is that possible you may ask, when normally, higher returns bring with them higher risk? It’s due to the fact that effective diversification is achieved by including asset classes in your portfolio that have low correlation to one another.

The correlation between two investments measures how closely the prices of the two investments move in tandem with each other. If two types of investments have high correlation, their prices will move up and down together. With low correlation, their price movements are unrelated. If they are strongly negatively correlated, they will move in opposite directions.

Investments that have low correlation tend to achieve their highs and lows at different times. Thus, some will be down in bad markets while others may be up in value.

It turns out that commodities (oil, precious metals, corn, soybeans, etc.) exhibit low correlation to many of the traditional asset classes people own in their portfolios (stocks and bonds). Because they have low correlation, adding commodities to your investment portfolio can improve your portfolio’s diversification. As noted above, improving diversification can increase your portfolio’s return and lower its risk (volatility).

In addition, many investment advisors believe that commodities are a good hedge against inflation. At the present, inflation is quite low and many economists expect it to remain that way in the near term. Others, however, worry that our high national debt will lead to high inflation in the long run. Including a small amount of commodities in your portfolio can help protect you from increasing prices.

We all know that our natural resources are limited. As we use more and more of them and they become scarcer, their prices will rise dramatically. This is another reason to consider owning commodities. The problem is, there are limited ways to invest in commodities and commodity prices can be very volatile. If you are interested in investing in commodities, we highly recommend that you seek professional advice on the best way to invest. We’ll talk more about ways to invest in commodities in the future.

We’ve written before about powers of attorney (POAs) being ineffective. If you don’t take some action with respect to your POA, your designated representative may have great difficulty helping you with your investment accounts, should you become incapacitated. We decided it would be beneficial to our readers to review this subject, once again. In addition, we conducted a short survey with three mutual fund companies to determine their policies with respect to POAs.

In a previous series of articles we have covered the basics of estate planning. The articles are no longer available on the Oakland Press website but may be viewed on our website by going to our “In the News” web page and clicking on the “Estate Planning” topic.

In those articles we pointed out that at a minimum, everyone needs a will, patient advocate form and power of attorney. Should you become incapacitated, and unable to conduct your own business affairs, a durable power of attorney gives authority to another individual or individuals to act on your behalf. Or does it?

A phone survey of Fidelity, Schwab and Vanguard discovered different procedures regarding POAs:

Fidelity: Your POA may be affective but you need to complete an Affidavit and Indemnification form and then send your POA to Fidelity along with the Affidavit form for their review. If approved, your POA will provide the authority you desire.

Schwab: With Schwab, you just need to send a copy a copy of your POA along with a list of the non-retirement accounts to which the POA pertains, to Schwab Operations Center, P.O. Box 628291, Orlando Florida 32862. Schwab will review your POA to determine if it meets their requirements and notify you if the POA is approved.

Vanguard: Vanguard has its own POA form that you must complete.

If you’ve invested with other financial institutions we recommend that you call them to see what their policies are.

We suspect that all three firms will honor existing POAs, should a customer become disabled without previously taking the steps noted above, but probably not without having to jump through several hoops. We believe it’s wise to make sure you have taken the necessary steps in advance of needing a POA. Few people know of these requirements. If you haven’t done so, make this a priority on your “To Do” list. While you’re at it, it’s probably a good idea to check to see if your bank will honor your POA too.

If you receive a large tax refund each year, you are in effect loaning money tax free to the Federal government. People with irregular income: sales people, people earning bonuses, and those with large tax deductions such as rental losses, capital losses, large itemized deductions, etc., often receive large tax refunds.

Often the large tax refunds are caused by a common misconception regarding payroll tax withholding. The number of allowances you claim on your payroll withholding form W-4 does not have to match the number of exemptions you are legally required to claim on your tax return. What you put on your W-4 is only a guide to let your payroll department know how much to withhold from your paycheck.

Consider a specific example, a married couple with two children who have been getting refunds between $7,000 to $10,000 each year. They are feeling very pinched each month. But since they have large deductions and/or credits such as a rental property at a loss and a college lifetime learning credit, they are getting large tax refunds each year. Instead of each of them claiming “Married with four allowances”, they should change their withholding to seven allowances in order to get more money paid to them each payday.

How do you determine how many allowances to claim? Prepare a tax plan to determine the estimated refund you will get if you don’t change your current withholding (Note: if you use Turbo Tax or some other tax preparation software, you can create a pro-forma tax return for the current year by estimating the same types of income, deductions, etc that you included the year before).

Take that refund number and divide it by the number of paychecks remaining in the tax year. Don’t forget that if you are paid every two weeks, you receive 26 pay periods per year instead of 24 (paychecks twice every month). Then obtain the IRS Circular E (Publication 15). Find the chart that corresponds with your filing status (single, married, etc.) and the frequency of your paychecks. Find the amount of gross income from each paycheck and match it with the corresponding row in the chart. Then, in the columns to the right of that row, find the dollar amount of withholding you want to change your withholding to. The number at the top of that column is the number of allowances you need to claim. Remember, the higher the number of allowances, the less withholding from each paycheck. If your income is higher than the charts show, follow the formula included in the Publication.

For many, the method above may be a bit complicated. Here’s an alternative method. It’s also possible to tell your payroll department to withhold a flat dollar amount from each paycheck. You’ll need to check with your payroll department first, but generally they recommend that you claim 9 allowances (the equivalent of $0 withholding) and then an added dollar amount equal to the total withholding you want per paycheck. This can be a much easier way to control your withholding without having to follow the IRS payroll withholding charts. Again, make sure you contact your payroll department first to make sure they can accommodate these types of requests.

Many people find themselves spending their big tax refund every year instead of saving it. The above approach is a good way to force yourself to save. You’ll find that automatically investing the increased amount of your paycheck each pay period will prove to be an easy way to set aside funds for retirement, college, or your next car. And, don’t forget to change your withholding back to an appropriate level when the New Year comes.

Many have been pulling their money out of the low-paying money market funds and buying into bond funds in order to increase their income. With the market downturn in 2008, many investors have shied away from equities and are searching for yield. Money market funds and savings accounts are paying next to nothing.

What investors need to understand, however, is that bond funds are not without risk. Two types of risk are particularly important: credit risk and interest-rate risk. Credit risk involves the risk of the issuer defaulting on the debt. If you buy high-quality bonds (AAA or AA) you can minimize the credit risk.

Interest rate risk involves the risk of rising interest rates. The prices of bonds decline when interest rates rise,. You can measure the interest rate risk by taking note of what is called a bond’s “duration”. A bond with a duration of 3 years will lose approximately 3 percent when interest rates rise one percent (e.g. one percent loss for each year of duration). Obviously, if you hold a bond until it matures, you can eliminate interest-rate risk. With bond funds, however, you are subject to interest-rate risk because you can’t control the maturity of the bonds they purchase or whether or not the fund manager holds the bonds until maturity. You need to take care to note the duration of a bond fund before purchasing. That information is readily available on Morningstar.com.

We just attended the Financial Planning Association of Michigan’s Fall Symposium this last week. There seemed to be a general consensus of the speakers that interest rates will stay fairly low for the near term. Nevertheless, you need to take care to ensure you are not taking on too much risk with your bond investments. You can lose principle when you invest in bonds!