Timely Topics - October 25, 2009
What was I thinking? That’s the number one question investors have asked themselves over the past eighteen months according to Meir Statman, a professor of finance at Santa Clara University, in a recent Wall Street Journal article. Here are three of the eight lessons Statman says we should learn about how thoughts and feelings effect investment decisions, usually negatively.
Hindsight is not foresight.
Sandra’s mother-in-law often says that she just “knew” something was going to happen or wasn’t quite right beforehand. Perhaps you also know someone who now says that they knew that financial markets were about to collapse in 2008 despite the fact that it apparently was not obvious to the Fed, most investment professionals, and rank-and-file investors. This is called hindsight error. According to Statman, “hindsight error leads us to think that we could have seen in foresight what we only see in hindsight. And it makes us overconfident in our certainty about what’s going to happen.” It also can make us regret our failure to act.
A fun test of your predictive powers, or those of your wise friend, is to write down your predictions for the next day’s stock market performance every day for a month or longer and compare your predictions to actual market results. Chances are your foresight is not as good as your hindsight.
And just for the record, Sandra says her mother-in-law is a wonderfully wise and gifted woman, but even she didn’t foresee the market crash. Since the beginning of the year, Caves & Associates has heard many market predictors forecast an “L”, “V” or “W” shaped recovery. The truth is we will only know in hindsight which predictors’ foresights were correct.
Fear and exuberance are not good investment guidelines.
Is now is a good time to invest in the financial markets? In February 2000, a time of exuberance, 78% of investors agreed with a Gallup Poll that “now is a good time to invest.” They were wrong, and a huge bubble was about to burst. In March 2003, a time of fear, only 41% agreed that “now is a good time to invest.” It was an excellent time to invest. We doubt that in early March 2009 many investors thought it was a good time to invest. As of this writing, they would have been wrong (Dow up about 60% since then). It is important to understand how fear and exuberance can affect our investment decisions and, as Statman says: “use reason to resist their pull.”
Happiness is … a scratch-free retirement despite the crash.
Statman compares a stock market crash to an automobile crash to illustrate how mental accounting of investment losses can be misleading or reassuring. After an automobile crash, Statman notes “We check ourselves. Is anyone bleeding? Can we drive to a garage, or do we need a tow truck?” After a market crash, a good idea is to check our financial wellbeing by dividing assets into mental accounts and attaching each one to a goal: one for retirement, one for bequests to children or charities, and maybe one for grandchildren’s college education. If a market crash has dented or even wrecked the bequests or education mental accounts but left your retirement mental account intact and “scratch-free,” in Caves & Associates parlance, you can reassure yourself (while perhaps increasing your mental health and happiness) with the knowledge that your portfolio still meets your capital adequacy needs to achieve the retirement goals and lifestyle you have worked and planned for over your own lifetime. Or as Statman suggests, you may need to update that bumper sticker to “I have only lost my children’s inheritance.” On the other hand, if the market crash has damaged your retirement prospects, then you will have to save more, spend less, or retire later.
Starting Jan. 1, 2010 Roth IRA’s will become available to virtually all investors. Building up a Roth account with annual contributions is advisable, but it doesn’t avail much of one’s net worth to the benefits of a Roth very quickly. The mechanism for gaining access in a big way is conversion of a traditional IRA having a high current value. Roth conversions aren’t a slam-dunk for everyone but are typically worth considering. The following provides a brief background on Roth IRAs, an outline of how a conversion works, general tax implications, identifies who might benefit from a conversion, and recommends steps to take to by the end of the year.
The Roth IRA was created as part of the Tax Relief Act of 1997. Like traditional IRAs, earnings inside a Roth IRA are not subject to current income taxes. However, the Roth IRA has two unique benefits: 1) the original Roth IRA account owner is not required to take money out after age 70.5 under the Minimum Required Distributions rules that apply to traditional IRAs, and 2) most Roth IRA withdrawals are not subject to income taxes because contributions were previously taxed. Qualified distributions to beneficiaries of a Roth IRA are also made income tax free. This combination of benefits can make Roth IRAs a powerful savings and wealth preservation tool.
As part of the Tax Increase Prevention and Reconciliation Act of 2006, the income restriction that prevented many individuals from converting a traditional IRA to a Roth IRA was eliminated effective 2010. A conversion involves withdrawing dollars from a traditional IRA, paying income taxes on that withdrawal, and depositing those dollars in a Roth IRA. If you’ve made non-deductible contributions, a pro rata portion of the amount converted will be tax-free (divide the amount of non-deductible contributions by the sum of the balances in all IRA’s). If you convert in 2010, you can choose to report the income on your 2010 tax return or you can spread the amount converted equally across your 2011 and 2012 tax returns.
As a general rule, to be advantageous, your 2010 income tax rate will need to be lower than your expected tax rate when you plan to withdraw funds from the Roth IRA. Those expecting much higher tax rates in the future and/or higher taxable income in retirement should be especially interested in a Roth conversion. Please note a conversion will likely be beneficial only if you can pay the taxes from a source other than your IRA.
A Roth IRA conversion can also be a sound and appropriate tax reduction and wealth preservation strategy for individuals who do not expect to ever need their IRAs, individuals with long expected lifetimes, and wealthy individuals whose estate tax plans involve generation-skipping provisions. For example, an IRA to Roth conversion will reduce the size of the taxable estate by the amount of the income taxes paid on the conversion while providing beneficiaries such as children or grandchildren with income tax-free assets. Conversions for a person with an NOL or other carry forward can make sense. Additionally, Roth conversion analyses suggest conversion is age-sensitive as younger converters can come out better than older ones. On the other hand, if you plan to leave your traditional IRA to a charity, conversion does not make sense.
To maximize the potential benefits from the tax law changes and your particular situation, you can prepare now by making a non-deductible contribution to your traditional IRA by December 31 and determining the amount of non-deductible contributions you have made in the past (check your tax return for Form 8606). To think through all the moving parts, it may help to consult your accountant. The bottom line is you have to consider all of your assets, plans, aspirations, and estate plan. As one retirement specialist put it “in financial and tax advice, it’s one-size fits one!”
A little known strategy for claiming Social Security benefits may be helpful to some soon-to-be retirees. It incorporates a “claim-and-suspend” strategy in a way that is advantageous to both the worker and his or her spouse, especially when the spouse’s potential benefit is considerably lower. Claiming and suspending entails filing for Social Security benefits at full retirement age (generally age 66)and then suspending those benefits until age 70, when their value is highest, thereby providing the best possible hedge against living way beyond one’s life expectancy and running out of money. (More information about retirement age and delaying benefits is available in our Yearend 2007 Timely Topics; we generally recommend delaying benefits).
Further, a person may also claim Social Security benefits based upon the earnings of his or her spouse, which is known as a spousal benefit. Filing for spousal benefits at full retirement age qualifies the spouse to receive up to half of the worker’s individual monthly benefit amount, even if the worker has later suspended those benefits. One cannot apply for and receive spousal benefits until the worker (namely, their spouse) has filed for their own benefits first, however.
It is also important to understand that the spouse will only receive half of the worker’s benefits if he/she waits until full retirement age to file for benefits. If the spouse chooses to receive benefits at an earlier age, Social Security calculates a reduced monthly benefit amount depending upon the length of time between file date and full retirement age. The earlier one files, the smaller the compensation. Filing for spousal benefits at age 62, for instance, may result in receipt of as little as 32.5% of the worker’s benefit, rather than 50%.
These two concepts, claim-and-suspend and claiming a spousal benefit, can be combined to the economic advantage of some couples. The worker claims Social Security benefits at full retirement age and then chooses to delay benefits until age 70. By delaying, the worker ensures benefits will be 32% higher (see below). However, the spouse may now claim spousal benefits and begin receiving a check even as the worker delays their own. This strategy is highly beneficial in the case that half of a worker’s benefits is still higher than their spouse’s own benefits. For example, say a husband is qualified to receive a primary insurance amount (PIA) of $1,200 a month based on his earnings record, and his wife qualifies for $520 (a PIA is the amount a person would receive should he/she decide to claim benefits at full retirement age). The husband may file for his benefits and then suspend them. His wife subsequently files (at her full retirement age) for spousal benefits, and will receive a beginning amount of $600 instead. Claiming spousal benefits in this case will allow the couple to receive the largest benefit possible if they live well beyond their life expectancies because they both wait to claim their own maximum benefit amount at age 70. However, in the meantime, they are able to collect a spousal benefit instead of nothing.
The reason this strategy works is because the primary insurance amount of the spouse with the lower earnings history is quite near the spousal benefit relying on the Social Security account of the spouse with the higher earnings history. Specifically, it is close enough that the spousal benefit will be overtaken by the accreting benefit to which the lower earning spouse is entitled due to the mere passage of time. Under Social Security rules, this benefit amount increases by 8% per year, or a total of 32%, for a benefit starting age of 70 versus a starting age of 66. Assuming a cost of living upward adjustment of 3% per year, and given our example above, the initial spousal benefit of $600 escalates to $675, or a total of 12.5%. But the lower-earning spouse is entitled to about $686 at age 70 (a 32% accretion from $520) and switches to a benefit payment based on their own Social Security account at that point.
Note that this strategy would not be valuable for many couples, such as those with similar ages and earnings records. Claiming benefits based on your own earnings record, rather than on half of your spouse’s similar earnings record, will entitle you to a much larger check. Also, this strategy will not be advantageous if the primary insurance amount of the lower-earning spouse is dramatically lower than for the higher-earning spouse. For the hypothetical couple above, the breakeven PIA for the lower-earning spouse is $511, and there is no advantage for lower amounts, including of course a zero primary insurance amount for a spouse with a negligible earnings history.
Finally, it is important to consider life expectancy and overall financial strength, as both of these issues would determine the feasibility of delaying benefits. For example, those in poor health will almost certainly be better off not delaying benefits, and those without adequate financial resources may not be able to afford a delay.