Retirement Watch : investments

My Hedge Fund Portfolio Keeps Moving Ahead

Bob Carlson — Thu, 29 Oct 2009 14:42:00 GMT

Hedge funds continue to make headlines, and most of them are not good. The big insider-trading case involved a hedge fund firm, and news stories indicate the investment process of the firm was to get an “information edge” that apparently included insider information on a regular basis. Forbes magazine had an article asking “How Dirty Are Hedge Funds?” Its answer was “filthy.”

The latest evidence for Forbes was an academic paper that concluded 21% of hedge funds lie about their legal and regulatory problems and 28% issue either incorrect or unverifiable information about other topics.

You can receive the benefits hedge funds are supposed to have without the high fees, lack of liquidity, uncertainty about investment strategies, and other disadvantages of hedge funds. My portfolio of mutual funds that have hedge fund qualities persists in meeting or surpassing my goals. The portfolio is delivering higher returns than the S&P 500 with less risk. It took a hit in the last half of 2008, but it did not fall as much as the indexes and most portfolios. It lost 13.25% for the last three months of 2008 and 18.49% for all of 2008. Though disappointing, the losses were far less than for the S&P 500.

In the rally, it bounced back faster, widening its long-term return above the S&P 500. It was up 9.88% for the three months ended September 30, 2009, and 4.79% for the prior 12 months. Its performance is ahead of the S&P 500 for all periods but the latest three months, and the portfolio has far less risk and volatility.

My “hedge fund” portfolio is composed of mutual funds that use strategies similar to those followed by the better hedge funds. The strategies include distressed asset investing, deep value investing, and tactical asset allocation. We also have funds that can hedge and leverage their portfolios and funds with "go anywhere" investment strategies. Most can raise cash when they perceive market risks to be high. The portfolio also has special assets such as high yield bonds, international bonds, and real estate investment trusts. What these funds have in common is investment strategies that differ greatly from the conventional approach of only buying stocks or bonds that closely resemble a given market index.

The differences these funds have from each other also are important. Over time different investment strategies have their good and bad returns during different periods. In academic terms, they have low correlations with each other. When a group of funds that are not correlated with each other are put together, they form a portfolio that has much smoother, steadier returns than a traditional portfolio. For example, over 10 years the hedge fund portfolio has about half the volatility as the S&P 500.

Another advantage of the portfolio is its low correlation with the S&P 500. That means our returns and net worth are not closely tied to the returns of the market indexes. While the returns from the stock market indexes have been flat or close to it for the last 10 years, the hedge fund portfolio has returned 8.68% annualized.

The quarter ending Sept. 30 was consistent with the portfolio’s history. Our return was less than the S&P 500 for the quarter, which is not surprising. Because of its diversification, the portfolio trails the stock indexes when there are strong bull rallies. The rest of the time, the portfolio’s returns equal or exceed those of the indexes.

This is a buy and hold portfolio. Because the funds are uncorrelated with each other, there is no reason to make adjustments for the market cycle. The fund managers do that for us. The only changes I make are when there are changes in the funds or when I discover a fund that will enhance the portfolio. For example, Schwab Hedged Equity changed its name and ticker and modified its strategy. Instead of keeping the new version, I recommended selling it and spreading the proceeds among the other funds.

The portfolio includes some non-traditional balanced funds such as Oakmark Equity & Income and FPA Crescent. Among the other funds are Hussman Strategic Growth, PIMCO All Assets, Wintergreen, and Berwyn Income.

The mutual fund “hedge fund” portfolio delivers what traditional hedge funds are supposed to. The portfolio’s fluctuations have a low correlation to the stock market indexes, but the returns equal or exceed those of stocks over the long term. It has the reasonable expenses of no-load mutual funds and their daily liquidity. Even the wealthy who meet the minimum income and net worth requirements for traditional hedge fund investing probably would be better off with this mutual fund portfolio.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

How to Revise Your Retirement Plan

Bob Carlson — Thu, 03 Sep 2009 17:25:00 GMT

Despite the rally in stocks and other risky assets since March 9, many portfolios are still damaged from the events of the last few years. For those who are retired or near retirement, one step you have to take after such an event is to re-evaluate your retirement plan, especially your spending. Specifically you have to check the rate at which you plan to withdraw money from your retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

Financial planners spend a lot of time contemplating the safe or sustainable withdrawal rate. This is the percentage of the portfolio you can withdraw the first year, increase the dollar amount by inflation each subsequent year, and have a high probability the portfolio will at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money.

When portfolio returns are disappointing, you need to re-evaluate the plan to be sure you aren’t on track to run out of money. Bear markets are followed by bull markets, eventually. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures are not needed unless there is another significant downward leg to for your portfolio.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at more objective benchmarks of your spending rate.

One way to evaluate your spending rate is to assume an immediate single-premium lifetime annuity is purchased with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you likely will have a problem sustaining the withdrawal rate unless investment returns increase. Insurance companies spend a lot of resources calculating life expectancies and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate approaching 10%. Surveys continue to show that many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is around the historic average and not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Drop the inflation bump. The studies of the safe withdrawal rate all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. With consumer prices falling, that makes sense anyway.

Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value. More details of the formula are in my book The New Rules of Retirement.

These formulas smooth distributions. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve, and the cuts are not as drastic as the portfolio’s changes.

The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of the year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.

Hedge Funds for the Rest of Us

Bob Carlson — Thu, 23 Jul 2009 15:41:00 GMT

Hedge funds used to occupy a small, obscure part of the investment world. They were out of the public eye; few investors even knew about them. Regulators ignored them, as a matter of law.

Gradually hedge funds became more prominent. A few of the pioneers of the business became billionaires, drawing attention to the business. George Soros received a lot of publicity in the 1990s after winning a big bet against the British pound, a move that British officials lambasted and blamed for the fall of the pound.

Hedge funds really took off after the technology stock bubble burst in 2000. While market indexes declined, many hedge funds held their value or made money. That attracted not only media attention but a flood of money from pension funds, endowments, and other sophisticated investors. It seemed that everyone who did well on the trading desk of a Wall Street firm or who had the confidence of a broker formed a hedge fund and raised tens of millions of dollars to invest. Some hedge funds grew to billions of dollars under management, and some hedge fund owners earned $1 billion and more in a year.

While hedge funds in general did not distinguish themselves in the broad market crash of 2008, they have a reputation for beating the S&P 500 long term and generally have done so in 2009 to date.

The problem for most investors is they cannot invest in hedge funds. By law, a hedge fund can accept only certain investors, known as qualified investors. They also are known as sophisticated investors. These investors are pension funds, endowment funds, foundations, and individuals who meet net worth or income requirements. But there are some safe ways for individual investors to reap the rewards of hedge fund investment strategies.

There is no real definition of a hedge fund, though there used to be. Today, a hedge fund is an investment partnership or pool that is not subject to the regulations that apply to mutual funds, investment advisors, or brokers. Hedge funds are subject to only a few regulations. That is why they can accept only certain types of investors. Those who wrote the securities laws reasoned that these sophisticated investors did not need the protection of the securities regulators and could invest with whatever firm they wanted to.

The original hedge fund was an investment vehicle that took both long and short positions in the stock market. A long position is when an investor buys an investment expecting it to appreciate. A short position is when the investor sells short an investment, expecting it to depreciate. The investor also can use futures or options contracts to take long or short positions in an investment. In other words, a hedge fund actually hedged its investments. It would take a long position expecting an investment to increase but also would take a short position that would profit if the long position did not.

Today the term hedge fund applies to a fund’s legal status rather than its investment strategy. Hedge funds today engage in a wide range of investment strategies. Some have very conservative strategies that aim to earn only a little more than money market interest rates. Other hedge funds employ very risky strategies, even using debt or other forms of leverage that magnify gains or losses.

Hedge funds have several features that attracted institutional investors in recent years.

An important characteristic of a hedge fund is that its investment returns have a low correlation with the major stock and bond market indexes. Correlation is the extent to which an investment rises or falls with an index. Some investors call this “beta.” An investment with a beta of 1.0 to a stock market index rises and falls when the index does and by the same percentage. An investment with a beta of 0.0 to the index has no correlation with it. An investment with a beta of -1.0 moves exactly the opposite of the index.

Correlation is important, because an investor might not want his portfolio’s value to be subject to the ups and downs of the stock market. While the long-term average returns are nice, the investor might not be able to withstand the shorter-term declines of 20% and more, sometimes much more. An endowment or foundation must pay income each year to fund its sponsor. A pension fund must pay pension annuities, and the employer’s annual contribution is based on the current value of the fund. An individual might be paying for retirement or some other expense, and cannot plan well with sharp fluctuations in the portfolio’s value. Each of these investors has good reason to seek an investment that does not have a high correlation with the stock market indexes.

An investment with a high long-term return that does not fit the same pattern as the stock market indexes is a good addition to a portfolio.

Hedge fund investors also like that they can build a diverse portfolio of hedge funds that have low correlations with each other. When some funds are up, others are down. This combination of investments with low correlations to each other also smoothes a portfolio’s returns.

Another advantage of hedge funds is they can be less volatile than the stock indexes. While the stock indexes have wild disparate returns from year to year, a number of hedge funds have much steadier return patterns. This is another way of smoothing the portfolio’s annual changes in value.

Investment returns are another appeal of most hedge funds. The ideal hedge fund has long-term returns that are close to those of the stock indexes but has a low correlation with the index and less volatility than the index.

This is all interesting, but what does it mean for you unless you are a qualified investor? There are ways you can benefit from hedge fund strategies.

A few years ago I set out to build a portfolio of no-load mutual funds that have the same characteristics as hedge funds. The return patterns of the funds would have low correlations with the major stock and bond indexes and also with each other. The funds as a group also would have less volatility than the indexes and would have high long-term returns.

Not too long ago, it would have been impossible to put together such a portfolio. Mutual funds had “long only” portfolios. They did not use unusual strategies, sell short, or hedge. They also did not move from one type of asset to another. In general, traditional mutual funds stuck to one type of investment and strategy, and they did not hedge their investments.

Even better, my “hedge fund” mutual funds do not have the high expenses of hedge funds. A typical hedge fund charges annual expenses of 2% of assets plus an incentive fee of 20% of all positive returns. That is how hedge fund managers make high incomes. You do not need to earn high returns to earn a high income if you have a lot of assets under management and take 20% of all positive returns.

I put the hedge fund portfolio together in 2001 and back-tested its performance. The performance since has been consistent with the back-testing and the goals. The portfolio returns more than the S&P 500 with less volatility and a low correlation to the index.

The key to a long-term successful portfolio such as this one is to avoid the large losses of the indexes. While 2008 was a rough one for my “hedge fund” portfolio, it was better than for traditional mutual fund investors and for many well-known hedge funds.

The big picture numbers of the portfolio are impressive. The volatility, as measured by standard deviation, is 10.75 over three years, 8.7 over five years and 7.73 over 10 years. In each case, the volatility is about half that of the S&P 500. (All the data are as of June 30, 2009.)

The portfolio also has a low beta, or correlation, with the S&P 500, though that has increased the last few years. Over three years the beta is 0.52, and it is 0.51 over five years. Over 10 years the beta is 0.36.

Returns are excellent. Alpha is the extent to which the returns exceed those of the benchmark. The portfolio consistently delivers alpha over the S&P 500. Over three years, alpha is 3.01 annually, and it is 2.93 over five years. Over 10 years, annual alpha is 5.88.

The financial crisis of 2007 and 2008 increased the standard deviation and beta, because all assets were negatively affected by the market meltdown and credit squeeze, except treasury bonds. I expect over time those numbers for the shorter periods will become closer to those of the 10-year period, as they were before 2008.

One of my goals for any investment is to avoid big losses. We cannot avoid all losses, but we want to avoid those 40% and 50% draw downs to which the market indexes are subject. The hedge fund portfolio has accomplished this.

Over the one-year period, the portfolio lost 9.12%. That is disappointing, but it is much better than the 26.21% loss of the S&P 500. Over three years the portfolio has a positive return of 0.30% annualized, versus an annualized 8.22% loss for the index. Over 10 years we have a 7.26% positive annualized return instead of the 2.22% annualized loss of the S&P 500.

Normally a portfolio that avoids large losses also misses out on bull markets. That is not the case with this portfolio. The highest returning period of the last 10 years was the three months ending with May 2009. The hedge fund portfolio earned 16.27% during this period. That lags the historic returns the S&P 500 earned during the period, but it is a strong return and coupled with the portfolio’s loss reduction qualities puts the portfolio well ahead of the index. The worst three-month period for the portfolio, not surprisingly, was the period ending November 2008 with a 20.63% loss. The worst 12 months ended February 2009 with a 22.78% loss, and the worst three years ended Feb. 2009 with a 4.43% annualized loss. Losses of that magnitude are disappointing, but they are well above the index and what most investors sustained. The portfolio bounces back with the markets.

The hedge fund portfolio is diversified among not only strategies but also different types of assets. As of June 30, 2009, the portfolio was 7.37% in cash, 37.52% in U.S. stocks, 9.22% in non-U.S. stocks, 43.04% in bonds, and 2.85% in other assets.

The funds in the portfolio are carefully selected for several characteristics. They must be no-load and have reasonable expenses. They also must use strategies commonly used by the best hedge funds instead of typical mutual fund strategies. The funds also must have low correlations with each other and with the major indexes.

The hedge fund portfolio is designed as a buy-and-hold portfolio. Changes are made when newer funds prove themselves after a few years or when an existing fund has a major change, such as its management or fee structure. But generally we depend on the fund managers to move their portfolios among different asset classes instead of doing it ourselves.

The portfolio has a wide variety of mutual funds. There are traditional hedge funds, such as Schwab Hedged Equity. There also are “asset allocation” funds such as Hussman Strategic Growth and PIMCO All Asset. There are some unique balanced funds, such as Oakmark Equity and Income, FPA Crescent, and Berwyn Income. The portfolio also has funds that can invest in almost anything but specialize in distressed asset investing. Finally, we have some funds that invest in long only strategies but do so in assets that offer good diversification, such as real estate investment trusts, high yield bonds, and international bonds.

Investors have been damaged by following conventional investment strategies of buying and holding portfolios of long-only mutual funds that invest in many of the same assets. There are opportunities to achieve true diversification and construct portfolios that deliver better returns than the S&P 500 with less volatility and risk. These results can be achieved using select no-load mutual funds that avoid the high fees and lack of liquidity of traditional hedge funds while employing traditional hedge fund strategies.

Navigating the Fifth Stage of the Crisis

Bob Carlson — Fri, 26 Jun 2009 13:17:00 GMT

Pilots have a saying, "Any landing you walk away from is a good landing." Even so, some landings are better than others, and pilots always strive for a smooth touchdown.

A type of rough landing is call "porpoising." Instead of gently settling onto the runway, the wheels hit the runway hard and bounce the plane back into the air nose high. Once this happens, it can be tough to get the plane back under control. The plane might bounce nose high a few more times (hence, the name porpoising), or the pilot might give the engine full throttle, take off, and go around to start again.

Last December I summarized for my subscribers the four stages of the financial crisis to date. The fourth stage, which we were in at the time, was an accelerating economic contraction. Panic, a spending freeze, and broken credit markets led to a sharp, re-enforcing decline in both the economy and financial markets.

We adjusted our portfolios at that time to what I call a capital preservation posture. We eliminated most equity and credit risk and went to portfolios that were heavily weighted towards hedged mutual funds, TIPS, international bonds, short-term bonds, and gold. The move was timely. We avoided the steep declines of January and February. We sat out the recovery that began March 9. But our portfolios all have positive returns for the calendar year. That puts us ahead of the stock market indexes, and we did not have to take the wild ride the markets put their investors through.

It appears stage four is behind us and we are in stage five. The worst likely is over, and the doomsday scenario is back to being a low probability event. The controversy now is to identify the current and next stages.

Until the last couple of weeks, investors seem to have bet the next stage is a sharp economic recovery. We'll be back to normal growth by the end of the year with bountiful profits and jobs. Massive stimulation by the Federal Reserve and federal government, newly-profitable banks, and a restoration of the credit markets will turn the economy. That is what investors are anticipating, according to the markets.

I suspect instead the economy and markets are in for something closer to a porpoise landing.

The economy has improved from its dreadful state of late 2008 and early 2009, but it still is very weak. I do not expect the high economic growth that is typical after a recession. I believe economic growth the next few years will be lower than average and certainly lower than the usual post-recession burst of 5% or more.

One concern is the credit market recovery is only partial. There is activity in the investment grade and high yield bond markets. Most of the activity, however, is refinancing of existing debt. Likewise, banks are lending, but the terms are tough and most of the loans are to replace existing debt. The good news is there is a reduced risk many companies will default on debt simply because broken credit markets would not let them refinance. Yet, the securitized loan market that fueled much of the growth in recent years still is stagnant. The bottom line is strong economic growth is not likely without credit growth, and we are a long way from credit growth.

This stage of the crisis is a battle between a continuation of deflationary deleveraging on one side and extraordinary growth of the money supply by the central bank on the other side. The last few months, the monetary stimulus from the Federal Reserve plus the economic stimulus law offset some of the deleveraging—enough to slow the economic decline.

Yet, household incomes continue to decline as continuing unemployment claims reach a new record high almost every week. Lower household incomes continue a cycle of lower spending leading to lower sales leading to more job losses. Declining consumer incomes also will not help the housing market, and the peak in mortgage defaults probably is still ahead.

Business profit margins are likely to stabilize around their historic average rather than the highs of a few years ago. That means there will be a lot of excess capacity in the economy, and businesses will be slow to re-hire.

It appears we are in for an extended period of economic growth below the long-term average. Growth will not be high enough to stop the rise in unemployment for a while or to restore corporate profit margins. The sharp increases in federal government debt and the money supply likely will increase inflation in two or three years and adversely affect the dollar.

The risk to investors now is that the surge since the bottom in March is overdone. Most assets now appear to be around fair value. Stocks went from arguably cheap in March to fair value now. High yield bonds have had such a surge that at least the lowest-rated sectors of that market are overvalued. Investment grade corporate bonds also are in fair value territory.

Most markets now have greater risk to the downside. Markets, especially for stocks, surged on a combination of short sale covering, traders seeing depressed prices in an oversold market, and optimism over the end of the crisis. Gains from this point depend on either a strong economic recovery or continued speculation such a recovery is on the way.

As investors realize we are not returning to the 1982-2005 boom, we are likely to see another round of falling stocks, rising interest rates, widening spreads between treasury interest rates and other rates, more loan defaults, and weak economic growth. The dollar also is vulnerable to decline.

For now, I am not recommending that my subscribers shift out of the capital preservation portfolios. But we are near a point when changes will be made. I don’t think we are likely to return to the edge of the abyss and face another near-collapse of the financial system. But simply buying stocks for the long run will not be a winning strategy in the next stage. Low economic growth will not be great for stocks. Instead, we will focus on nimble investment managers, hedges against the dollar, and some other non-traditional strategies and assets.

A Dangerous Retirement Myth

Bob Carlson — Fri, 17 Apr 2009 14:15:00 GMT

Many retirement plans fall short of their goals because they were built on myths and misunderstandings. Most of my work at Retirement Watch falls into two categories. The first category is determining changes that should affect retirement plans. The second category is correcting the myths that have built up around retirement planning. One of the great myths of retirement planning is: Taxes will be lower in retirement. Last week we had tax return deadlines and tea parties, so this is a good time to discuss the issue of taxes in retirement, and a new survey proves a point I have made for years about retirees and taxes.

There was a time when taxes really did decline in retirement. When income tax rates were higher and there was a heavily graduated tax system, there were 13 tax brackets. Many people received less income in retirement than during their working years, and it did not take much of a drop in income to push a new retiree into a lower tax bracket. In addition, there were numerous tax breaks for seniors.

Things are different now.

We have only a few tax brackets. One needs to have a significant drop in income after retiring to drop into a lower bracket.

More importantly, retirees are making up a larger share of the taxpaying public as the Baby Boomers age. Governments cannot afford to let them pay less in taxes, and they do not.

Social Security benefits once were exempt from income taxes. For a while now, the benefits have been taxable to “upper income” recipients. The number who pay taxes on the benefits rises each year, because the income levels at which the benefits are taxed are not indexed for inflation.

Many retirees also are likely to be caught in the alternative minimum tax. Each year, more middle income retirees pay higher taxes under the AMT than under the regular income tax. That is usually because income declines after retirement but tax deductions remain the same. The combination can trigger the AMT.

In fact, unknown to many pre-retirees, taxes are likely to be your largest expense in retirement. While most people worry about medical expenses and long-term care, the biggest drain of your retirement income will be taxes. Income taxes are likely to take the largest share. There also will be sales taxes, real estate taxes, personal property taxes, and taxes on capital gains.

The new survey of retirees between ages 70½ and 75 with a net worth of at least $1 million, by Securian Financial Group, found taxes were the largest expense by a wide margin. Taxes, in fact, took about 4% of net worth every year. That is 4% of net worth, not of income. The percentage of income taken by taxes is much higher. It is tough to have net worth increase or remain stable when one expense is taking such a large portion.

Tax planning needs to be an integral part of your retirement money management. Strategies that effectively reduce taxes for many retirees include:

Tax-exempt bonds instead of taxable bonds. These won’t help reduce taxes on Social Security benefits, but they will reduce income taxes. Tax-exempt bonds carry attractive yields relative to treasury bonds now, but they also carry extra risks because of the economic distress of many state and local governments. Don’t take high risks to reduce income taxes.

Monitor the stealth taxes each year. Relatively small adjustments in income or expenses in the last part of the year might avoid higher taxes due to the itemized expense reduction, the personal and dependent exemption phaseout, and the alternative minimum tax.

Investments. Simple strategies such as minimizing trading, holding investments more than one year so the capital gains are long-term and not short-term, and buying mutual funds that traditionally make low annual distributions are easy ways to boost after-tax investment returns.

IRA management. Once distributions begin, managing the IRA is more complicated than many people realize. Taxes can be reduced and the life of a portfolio extended by withdrawing money from your different accounts in the right order and carefully calculating which assets are held in which accounts. Some retirees reduce lifetime taxes by taking money out of their IRAs faster than required under the law or converting a traditional IRA to a Roth IRA.

Maximizing deductions, such as those for charitable contributions and medical expenses, also are key to reducing taxes for many retirees.

Many retirees are surprised by the amount of taxes they pay. They believed the myth that taxes decline in retirement. The truth is without some planning taxes will stay the same or even increase during retirement. Tax breaks specifically for seniors are rare these days. Tax traps and a retirement tax ambush are more likely. You need to continue tax planning through retirement to ensure your retirement fund lasts a lifetime.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Dos and Don'ts of IRA Investing

Bob Carlson — Fri, 03 Apr 2009 14:18:00 GMT

Many people own substantial IRAs and have the bulk of their investment portfolios in IRAs. Some of these investors might not realize there are investments that are prohibited from IRAs and others are allowed but incur tax penalties. The issue of how to invest an IRA is more important in today's climate, because "hard assets" and other nontraditional assets—those that investors prefer today—are primarily those prohibited or discouraged in IRAs.

IRA investment disincentives fall into three categories. There are prohibited investments, taxable investments or transactions, and prohibited transactions.

The prohibited IRA investments are labeled “collectibles.” When an IRA purchases a collectible, the amount used to make the purchase is treated as distribution to the owner. It is included in the owner's gross income, and if the owner is under age 59½ and does not qualify for one of the exceptions, a 10% early distribution penalty is imposed on top of the income taxes. In addition, there is a penalty each year the IRA continues to own the prohibited investment.

Collectibles are defined in the tax code as works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS is allowed to define other items as collectibles but has not done so.

Note that an IRA may purchase securities of firms that produce collectibles, such as mining companies and alcohol producers or distributors. But the IRA may not purchase the collectibles themselves.

There are other investments an IRA may own, but those investments could cause the IRA to owe income taxes on income from the investments or the owner might be taxed as though distributions were made.

An IRA is most likely to be taxed when it earns unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns UBTI exceeding $1,000 it must pay income taxes on that income. The IRA might have to file Forms 990-T or 990-W. It also must pay estimated income taxes during the year if the UBTI exceeds $500.

The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax on the IRA does not increase the tax basis of the IRA.

The UBTI rules are supposed to prevent a tax-exempt entity such as an IRA from unfairly competing with tax-paying businesses. The rules are fairly broad, however, and apply to situations in which the IRA is not operating a business. An IRA potentially has UBTI if it does any of the following:

operates a trade or business,

receives certain types of rental income,

receives certain types of passive income from a business entity it controls,

invests in a pass-through entity, such as a partnership, that conducts a business, or

uses debt to finance investments.

A "trade or business" is any activity carried on for the production of income from the sale of goods or performance of service. Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes certain types of income from the definition of trade or business income for UBTI purposes. The exempt types of income include interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt.

Even exempt income, however, can be converted into UBTI.

Real estate rental income generally is exempt from UBTI, but becomes UBTI if the amount of rent is computed as a percentage of the tenant's profits.

Controlling a business entity also can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, any rent, interest, or royalties paid by the entity to the IRA is UBTI if the payments have the effect of reducing the business income of the entity. Another way to look at this rule is that if the business entity deducts the payments to the IRA, they are UBTI to the IRA.

When an IRA owns an interest in a pass-through business entity (partnership or limited liability company), the IRA's share of the entity's income is UBTI. Pass-through entities generally do not pay federal income taxes. Instead, their income and expenses are passed through to their owners' income tax returns.

This rule most often trips up individuals who invest in master limited partnerships (MLPs) or real estate partnerships in their IRAs. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Individuals generally are urged not to purchase MLPs through IRAs.

It is not illegal to own an MLP through an IRA. The ownership, however, triggers the UBTI rules and the requirement to possibly file a version of Form 990 and pay estimated taxes. There is no tax advantage to owning MLPs through an IRA. Some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of filing a separate Form 990 for the IRA.

An IRA also has UBTI when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. Real estate mortgages also are debts that convert exempt income into UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

The prohibited transaction rules are the final category of taboo investments. The rules are fairly detailed and can get complicated. Generally they prohibit transactions between the IRA and its owner or a person related to the owner (including businesses).

The penalty for violating the prohibited transaction rule is severe. The entire IRA will be considered fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized. Other IRAs escape the penalty unless they also engaged in prohibited transactions.

It is easy to state the prohibitions in clear, plain English: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner. Yet, there are some "prohibited transactions" allowed by IRS regulations or rulings, and IRA owners can receive waivers from the Department of Labor for specific transactions.

A detailed discussion of the prohibited transaction rules would be too much for this posting. While it is possible for an IRA to engage in transactions with the owner’s small business, real estate, or other interests, such transactions should not be considered without good tax or legal advice.

IRAs do not have complete investment freedom. IRA owners who prefer investments other than publicly-traded stocks and bonds and mutual funds need to be wary of the potential pitfalls.

How to Revise Your Spending Plan

Bob Carlson — Fri, 27 Mar 2009 15:24:00 GMT

The swift declines in most asset classes in late 2008 and into 2009 damaged many portfolios. For those who are retired or near retirement, one necessary step after such an event is to re-evaluate retirement spending. Specifically you have to check the rate at which you are withdrawing money from the retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

In the past I have discussed the safe or sustainable withdrawal rate, especially in my newsletter Retirement Watch. The safe withdrawal rate is the percentage of the portfolio you can withdraw the first year, increase by inflation each subsequent year, and have a high probability the portfolio will last at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies have been done. They all indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns and the rest in bonds. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Especially with the current bear market, you need to re-examine the decision. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money in the case of a severe bear market. You want to be sure today’s nasty market environment does not tip you into that small percentage of times when even the historic sustainable withdrawal rate is too high.

Bear markets are followed by bull markets. Bull markets restore the retirement portfolio by accumulating gains faster than you spend. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures should not be needed unless there is another significant downward leg to this bear market.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at some more objective benchmarks of your spending rate.

One check is to assume an immediate single-premium lifetime annuity is purchased today with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you are likely to have a problem sustaining the withdrawal rate. Insurance companies spend a lot of resources calculating life expectancies, devising investment strategies, and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Also, insurers usually do not index annuities for inflation. So if you are withdrawing significantly more than annuities are paying and you are increasing that for inflation, you need to re-evaluate the spending rate. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate well above the historic safe rate. Surveys continue to show many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is a little below the historic average but not near historic lows.

Drop the inflation bump. Remember the studies all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. Insurers generally do not increase annuity payouts for inflation because it is very expensive.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value latest year-end value. More details of the formula are in my book The New Rules of Retirement.

Either of these formulas will smooth distributions and their effect on the portfolio. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve and the cuts are not as drastic as the portfolio’s changes.

The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of each year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. The steady annuity income gives your annual income a floor and can prevent you from taking extreme actions with the rest of your portfolio. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in late 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Retirement Watch Managed Portfolios. A long-term buy-and-hold strategy often is not a good strategy, because it puts you at risk of substantial losses during long-term bear markets.

Another possibility is to try to earn higher returns by taking more risk after the markets decline significantly.

Spending cycles. For many people spending naturally varies during retirement. Spending tends to be relatively high during the early years as people are physically active and have a backlog of things they want to do. After a few years they settle into more of a routine. Spending tends to ratchet down a notch in this second phase because of less traveling and other big ticket activities. In the third phase people generally are less active as they get older and that leads to lower spending. In response to the bear market you might reduce spending a bit now but assume it will decline more later in retirement instead of taking a larger reduction now.

The wild cards in that plan are medical expenses and long-term health care. If you are well-insured these might not be issues. Otherwise, they might keep overall spending from declining in the second and third phases.

In our portfolios we reduced risk early and will keep it low until the financial crisis seems to be nearing an end. But we are not permanently switching to safe investments. That is a mistake many people make after a market downturn. Retirement lasts a long time, and your income needs to grow to maintain purchasing power.

The Wealth Effect, Your Portfolio, and Your Retirement

Bob Carlson — Fri, 27 Feb 2009 14:26:00 GMT

The net worth of Americans is declining. That is no secret, though the extent of the decline will surprise many. The decline has affected and will continue to affect the economy, stock market, and your portfolio. The Federal Reserve gives a picture of the net worth of Americans every quarter, in a report known as the flow of funds data, and it is worth periodically studying the report.

The report for the third quarter of 2008 (which does not include the steep declines of October and November) was an eye-opener. It also does not include the losses from the Bernie Madoff scam and other frauds that have come to light, though they are a small percentage of the total.

U.S. household net worth declined by $2.8 trillion in the third quarter of 2008. Not only is that a large number, but it is the fourth consecutive quarterly decline in net worth. When the data for the fourth quarter of 2008 are issued it will be the fifth straight quarterly decline.

Over those four quarters of declines, net worth has declined $7 trillion, a 15.3% decline in net worth in one year. By comparison, the 1974 bear market in stocks generated a 13.8% decline, and the bursting of the technology stock bubble in 2001 led to only a 10.9% fall in net worth.

Remember that this is a report of net worth. All asset values are totaled and liabilities subtracted to arrive at net worth. Despite the high level of debt in the U.S. and substantial decline in asset values, the asset values of Americans still are substantial enough to result in a positive net worth.

Here is the real eye-opener in the report. In the third quarter Americans were so alarmed by the decline in asset values that they actually reduced their debts. This has not occurred since the data were first reported in 1952. In the third quarter, household borrowing, mortgages, and consumer credit fell at a $117.4 billion annual rate. Granted, that is a drop in the bucket compared to the asset values and amount of debt outstanding. But it does show a significant change in Americans' behavior and thinking.

Part of the decline in debt can be explained by defaults shrinking the amount of debt outstanding and by tighter lending standards reducing the amount of new debt. But part of the decline was due to consumer decisions.

For the first time in a while, Americans own less of their home equity than lenders do. A few years ago, homeowners owned roughly 60% of the value of their homes. At the end of the third quarter they owned only 44%. The rest was secured by debt, essentially owned by the lenders.

The decline in debt also reverses a factor that helped boost the economy in the first years of this century. As home equity values increased, Americans borrowed part of the equity and used the proceeds to buy things. These home equity withdrawals allowed spending to increase faster than income. That boosted GDP.

Now that process is in reverse. Shrinking home equity means people cannot borrow against it to increase spending. Paying down debt means there is less spending than income will support. The declines in net worth and debt overshadow by a large amount the recent decline in gasoline prices that many expect to increase consumer spending.

The influence net worth has on spending and borrowing is known as the wealth effect, and it is important to understand.

Many people believe that Americans spend based on their incomes, but a more important determinant of spending is net worth, or perceptions of net worth. As people perceive themselves to be wealthier, they spend more. An increase in asset values stimulates additional spending above income increases. People will spend more than their income if they believe their net worth is increasing. Some analysts estimated that in the boom years Americans were spending about $1 trillion more annually than was supported by income increases.

The key to understanding the wealth effect is that there always is a lag in consumers' perceptions of their wealth. It takes them a while to realize that market prices have changed their wealth. Most people do not follow asset price changes on a regular basis, and they often assume that price changes are temporary. Also, if the decline in one asset is offset with a rise in another asset by the time consumers review their situations, perceptions of wealth won't change.

The lag in the wealth effect is why consumer spending did not decline as much as economists expected after the technology stock bubble burst in the early 2000s. It also explains why consumer spending held up after real estate prices peaked in 2005 and after the credit crunch began in the summer of 2007.

In the third quarter of 2008 consumers finally realized the declines in asset prices were both serious and not likely to be temporary. They reduced debt and increased savings. They will continue to increase savings to make up for these asset declines until asset prices increase.

The wealth effect is another of the ways this economic cycle is different from those of the last 26 years. I believe many consumers will not ignore the recent declines in their homes and portfolios. They won't keep spending in the belief that the net worth decline is short term. Instead, I think we will see changes in consumer saving and spending that will last for at least a few years. This will reduce economic growth below what most models forecast and make it harder for the economy to rebound. It also will be very tough on retailers, luxury goods and services sellers, and others who benefit from high consumer spending.

If you want to know how bad things became in the fourth quarter, the next Federal Reserve Flow of Funds Report is due March 12, 2009.

Because of the wealth effect, we should not expect a sharp recovery in either the economy or equity markets. It also makes it likely that even after the economy reaches a bottom, economic growth and stock returns will be lower than the averages. That means you will want a different portfolio than the one that worked before the markets peaked.

Bob Carlson is editor of the monthly newsletter and web site, Retirement Watch, available at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity - Part 2

Bob Carlson — Fri, 20 Feb 2009 16:46:00 GMT

Last week we discussed how today’s economic distress creates estate planning opportunities. Because of today’s reduced asset values, estate owners can shift assets out of their estates tax at much lower tax cost than they could have a year or two ago. We went over basic strategies for taking advantage of the situation. This week, let’s look at ways to leverage these strategies.

Family loans. Many families like the concept of loans to family members. If you might need the money in the future, a loan lets you provide benefits to family members now while retaining future access to the wealth. The IRS requires you to charge a minimum interest rate on a family loan to avoid income and gift taxes. The minimum rates are based on treasury debt rates. Because the Federal Reserve has been pushing down short-term rates and investors have been reducing intermediate and long-term rates in the flight to safety, the required minimum rates are low. The rates are changed monthly, and depend on the loan's maturity or term. They are known as “federal applicable interest rates” and are published monthly by the IRS in its Internal Revenue Bulletin.

Family loans are very flexible, but here is how one common strategy works. You lend $100,000 to a child for five years. Let's say the law requires you to charge 2% interest. Your child can invest that money for five years. If the investments earn more than 2% annually, the child keeps that excess return. You receive the $100,000 plus 2% annual interest after five years.

Alternatively, you could lend the money to allow a child to buy a home in today's depressed market. You might set the term of the loan at 10 years. There are several actions the child could take by the end of 10 years. The home could be sold at a profit, with the child keeping the return above the interest rate you charge. Or once the credit markets loosen, the child could refinance the home with a traditional mortgage and return the borrowed money plus interest to you.

The benefits of the family loan can be increased with a variation. If you do not need the money to maintain your standard of living, each year you can use the annual gift tax exclusion to forgive the interest and part of the principal. This shifts the money and future appreciation out of your estate tax free over time while enabling your children to benefit from having the cash now.

In some circumstances a minimum interest rate need not be charged on a family loan if the principal is low enough. I won’t go into the details here. They are available in the members’ section of my web site at www.RetirementWatch.com and also from www.irs.gov.

Grantor retained annuity trusts. Today's low interest rates make these trusts a potentially great opportunity.

The grantor creates a trust that pays a fixed income to him for life or a period of years. After that the remainder of the trust goes to the beneficiaries. The present value of the remainder is a gift. The present value is determined by IRS tables, and current interest rates are a factor in determining the amount of the gift. The lower the interest rates, the smaller the value of the gift. If the return actually earned on the asset exceeds the IRS interest rate, the excess becomes a tax-free gift to the heirs.

A GRAT should be created with assets that are expected to appreciate rapidly within a few years or earn high income. Studies show value is maximized by creating a GRAT to last two years. After the trust expires, consider creating a new trust with different assets.

Charitable trusts. If you are inclined to make significant charitable gifts, consider making them now through a charitable trust. In particular, charitable lead annuity trusts are most advantageous when rates are low.

The CLAT pays income to a charity for a period of years. The payments are either a percentage of the trust’s value or a fixed annual amount. After the income period expires, the remainder in the trust goes to the other beneficiaries, usually the children of the trust creator.

The present value of the remainder for the children is a taxable gift when the trust is created. Again, because of today's low interest rates the taxable gift will be less than at other times. In addition, the combination of low interest rates and low asset values create the potential that the appreciation of trust assets will significantly exceed the income paid to the charity and the amount on which gift taxes were paid. The result could mean a significant amount of wealth is transferred tax free to heirs.

The creator of a CLAT can take a tax deduction for the present value of the gift to the charity. Doing so, however, obligates him to pay taxes on the income and gains of the trust. Foregoing the deduction avoids the taxes on the income and gains. The CLAT is irrevocable. Once created, you cannot get the money back or change the terms of the trust.

Today's low interest rates and decline in asset values present estate planning opportunities. Some of these are straightforward and easy to implement. Others, such as trusts and family loans, should be done only with the help of a tax or estate planning expert. Once the current crises end, the benefits from making the moves now could be significant.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity

Bob Carlson — Fri, 13 Feb 2009 19:33:00 GMT

There is at least one silver lining in today's dark clouds—estate planning opportunities are being created. Falling market prices and low interest rates are a great combination for estate planners. If the price depression of the assets is temporary, there is the potential to transfer significant future wealth at a substantial tax discount.

You probably have been postponing estate planning, because of uncertainty about the law and the value of assets. In 2009 or perhaps 2010, the estate tax law probably will be made permanent. The President essentially favors making the 2009 law permanent: A lifetime estate tax exemption of $3.5 million and a top tax rate of 45%. Some details might change, but the final law should be close to that.

Another advantage is that the annual gift tax exemption is indexed for inflation and rose to $13,000 as of Jan. 1, 2009. Each person can give up to $13,000 free of gift taxes to any person in 2009. The tax-free gifts can be made to as many people as you want. A married couple can give $26,000 jointly. In addition, the first $1 million of all lifetime gifts by a person above those sheltered by the annual exclusion are exempt from gift taxes. To the extent the $1 million gift tax exclusion is used, the estate tax exclusion is reduced.

Today's relatively low asset prices highlight a reason to give assets now instead of later through the estate.

Estate and gift taxes are imposed on the value of property. If a mutual fund has declined in value, you can give more shares tax free than you could have before the decline. For example, Dodge & Cox Stock was valued at $132.63 on Feb. 1, 2008. You could have given 90.47727 shares of the fund to someone tax free using the $12,000 annual exclusion. At the recent price of $67.48 you could give 177.8305 shares if you wanted to give $12,000 worth, or 192.6497 to take advantage of the new $13,000 limit. After the financial crisis and economic decline end, the share prices will recover. The future appreciation above the $67.48 price would be out of your estate and into the hands of your heirs with no estate or gift taxes.

This strategy applies to real estate, small business interests, and other assets that have declined in value over the last year or two. If the steep declines of the last year are temporary, this is a rare opportunity to shift assets out of your estate at a fraction of their real or long-term value.

Before giving an asset, however, determine your tax basis in it. Under gift tax law, your heirs will take a tax basis equal to the lower of your basis and the market value at the time of the gift. If the asset has declined below your basis, it makes sense for you to sell it, deduct the loss on your tax return, and give the cash proceeds from the sale. Or if you are concerned that the heirs will spend a cash gift, buy an investment that is not substantially identical to the one you sold and give that new asset. That generates two tax benefits. You deduct the current loss against your income, and all future appreciation is out of your estate.

The best assets to give are those in which you do not have a paper loss but that are likely to appreciate significantly once the financial and economic situation improves. By giving such assets you are likely to transfer the maximum amount of wealth to future generations at the lowest tax cost.

Because of the potential to shift a significant amount of future appreciation to your loved ones at today's relatively low values, it makes sense to give more than the $13,000 gift tax exemption and begin using the lifetime $1 million gift tax exemption. If you do not need the assets to maintain your standard of living and know you eventually will leave them to your children or other heirs, consider making the gifts now. You will be able to transfer far more assets tax free at today's values than you could have in the recent past and than you will be able to after appreciation resumes. Your heirs will end up with far more wealth, because the taxes on your estate will be much lower than if you retained the assets and let them be taxed as part of your estate.

Those are the basics for taking advantage of today's economic distress. Next week we will discuss ways to leverage these strategies and the current economic environment.

What is Ahead for 2009

Bob Carlson — Tue, 10 Feb 2009 19:32:00 GMT

Major structural changes have occurred in the economy and markets, and more changes are on the way. The failure of Lehman Brothers was a watershed event. Investors stopped making even routine transactions, bailing out of even money market funds. The effects froze the economy and greatly worsened the effects of the credit crisis. We moved from the collapse of housing prices to a widespread economic decline. It is clear now that the effects will not be short-term. There also are longer-term effects beyond the credit crisis that should influence your portfolio choices.

Some of the long-term changes from the crisis I have identified include:

Deleveraging by consumers, investors, and business will continue. The trend persists because asset prices still are declining and credit is tight.

After the crisis, the economy will not return to the pre-crisis levels of leverage. Many people and businesses will not want to take on that level of risk. Even those that do will have trouble obtaining credit.

Less leverage means lower economic growth.

Investment returns are likely to be lower than in the past few decades for several reasons. Economic growth is the driver of long-term investment returns, and GDP growth will be lower. Returns from investments are the risk-free rate, or treasury bill rate, plus a premium for taking risk. The risk-free rate currently is bouncing around zero and even after the crisis ends will be below levels of recent decades.

Also, the negative equity returns of the last 10 years will make investors more risk averse. It will be a long time before investor enthusiasm pushes investment prices to extremely high valuations.

The bottom line is the equity risk premium will be lower than since 1982. The ERP is the return of stocks above the risk-free rate. Investors have been burned and are extremely pessimistic, so they will be less willing to pay high prices for stocks. Also, the aging population alone will make investors more income- and safety-oriented and less equity- and growth-oriented.

Stocks have higher dividend yields than the 10-year treasury yield for the first time since 1958. Through 1958 it was normal for stocks to yield more than bonds, because investors believed they needed to be compensated for the higher risks of stocks. I think dividend yields will be more important to investors in coming years.

Much of the world's economic growth is likely to be in the emerging economies, especially in Asia. For many years these have been high risk, low cost producers that depended on the western economies for growth. They are developing middle classes with internal consumption, and over time that will make them less dependent on the western world for growth. Also, they have decreased risk by improving their financial systems and government financing.

There also have been some structural changes in the markets that favor change in your portfolio. There are a host of new tools that allow individual investors to invest in sectors and assets previously closed to them. These tools enable an investor to come closer to producing a portfolio with true diversification, one in which assets are not highly correlated with each other. There also are new analytical tools and approaches to investing that help reduce risk and better balance portfolios.

I recommend changing your portfolio in two stages.

The first stage is to get us through the current crisis by having a high level of safety in your portfolio. I am not anticipating a near-term turnaround in the economy or the financial crisis. You need to be prepared for continued deleveraging, disruptions in the credit markets, and unpleasant surprises from businesses and in the economic data. There will be bear market rallies, and I suggest you take advantage of them to sell riskier assets at prices above the lows and move into a safer portfolio. It is hard to tell how long you should stay in the safer portfolio. I moved Retirement Watch subscribers there late in December. It might last a few more weeks or a few years. It depends on when the credit markets and economy start to heal.

In the second stage, move into riskier investments. But build a more diversified portfolio than many people generally have. There are four major economic trends: falling economic growth, rising economic growth, falling inflation, and rising inflation. You want to be sure part of the portfolio will do well in each of these environments. We are able to do that like never before because of the new investment vehicles. Plan the portfolio now, but wait for the current crisis to be nearing its nadir before implementing it.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Taking Advantage of the 0% Capital Gains Tax Rate

Bob Carlson — Fri, 30 Jan 2009 22:21:00 GMT

For the two lowest tax brackets, the tax rate in 2008 through 2010 is 0% for qualified dividends and long-term capital gains. This compares to the 15% top rate others will pay on those types of income. Single taxpayers with taxable income up to around $33,000 and married couples filing jointly with taxable incomes up to about $65,100 qualify for the 0% rate. The 0% rate applies to any long-term capital gains that qualify for the 15% rate for other taxpayers, not to just to gains on publicly-traded stock.

But there is a lot of confusion and misunderstanding about the 0% tax rate.

It is not an all-or-nothing situation. Because the tax rates are graduated, even some taxpayers with incomes above the threshold could have some income taxed at the 0% rate.

Many retired couples have taxable income below $65,100. Suppose a couple normally has taxable income of $30,000. In 2009 they realize a long-term capital gain of $70,000, bringing their taxable income to $100,000. The first $35,100 or so of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

Keep in mind that interest from tax-exempt bonds is not counted in determining the threshold, so well-off taxpayers can qualify some or all of their qualified income for the 0% rate.

This situation provides opportunities for low-bracket retirees to realize some long-term capital gains on asset they otherwise might not held and pay a 0% rate on at least part of the gains. There also is an incentive to switch some investments to dividend-paying stocks that qualify for the 15% rate for other taxpayers.

Another opportunity presents itself for taxpayers who are supporting parents in a low tax bracket. The taxpayers could give some appreciated securities to the parents, who sell them and pay 0% tax. The amount given should stay within the annual gift tax exclusion amount of $13,000 to avoid owing gift taxes or using part of the lifetime gift tax exemption.

Gifts of appreciated securities also could be made to children in low tax brackets, but the gifts would have to be made to adult children. Congress changed the law on the Kiddie Tax to prevent high income parents from giving securities to their minor children to sell and pay 0% capital gains taxes. To avoid the restrictions, the children must be over 21, or over 23 if they are full-time students. The restrictions also can be avoided if the children do not qualify as dependents on their parents’ tax return by providing more than 50% of their own support and earning income. Youngsters who do not meet those exceptions must have incomes less than $1,800 to qualify for the 0% rate.

Couples receiving Social Security benefits will have to be careful when executing these strategies. Increasing taxable income through the recognition of long-term capital gains also could make more Social Security benefits subject to income taxes.

In most cases, the additional tax on the Social Security benefits will be quite low and will make the effective tax rate on taking the capital gains just a few percentage points. Even so, one should run the numbers to determine the effect such a transaction would have on the full tax picture.

A taxpayer needs to consider the non-tax picture before plunging ahead to take advantage of the 0% tax rate. There must a reason for selling the asset other than to cash in the gains at a low rate. The difference between the 0% rate and 15% rate is going to be small in actual dollars, especially considering that only the gains below the taxable income thresholds for the lowest brackets qualify for the 0% rate.

Yet, if someone planned to sell the asset in the next few years, needs to reposition a portfolio, or has a new opportunity, taking a look at how to qualify at least part of the gain for the 0% rate is worth doing.

When deciding which assets to sell, one strategy is to sell stocks or other assets with the least amount of capital gains. Normally, with a tax-advantaged strategy one wants to maximize the gains taxed at the low rate. But there is a ceiling on the amount of gain that qualifies for the 0% rate each year. The goal should be to generate the maximum amount of cash at the lowest tax cost. By selling assets with the least appreciation, it is possible to free up more after-tax cash than if assets with higher appreciation were sold. This is a good strategy for retirees who are deciding which assets to sell to pay for their expenses the next few years.

The main problem now for most people will be to find assets that have capital gains in them. But those who have held assets for a long time likely have gains they have not recognized.

The 0% tax rate is tricky. But there are many retirees who qualify for it, and they should review asset sale strategies.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com.

Trustee Strategies for the 21st Century

Bob Carlson — Fri, 16 Jan 2009 17:04:00 GMT

Trusts are part of more and more estate plans. Often trusts are used to hold and manage assets for younger generations.

Sometimes the beneficiaries are too young or inexperienced to manage the assets. Other times the older generation is afraid the younger generation might not resist temptations to spend direct gifts.

The success of an estate planning strategy involving a trust often hinges on the choice of trustee and the structure of the trustee’s job. The intentions of many estate plans have been stymied when the wrong trustees were appointed. A trustee can ignore or misunderstand a trust grantor's intentions. Or after a professional trustee or trust company is appointed, the original professional trustee might disappear in a series of promotions, job shifts, or corporate mergers. The new trustees are not as well-versed in the trustor’s intentions. Changing trustees is an increasingly common problem with all the havoc in the financial services industry.

Trust grantors need to give as much consideration to the choice of trustee as they do to the other details of the estate plan.

One strategy becoming more and more popular is to appoint more than one trustee or to divide the trustee duties among two or more trustees. There are different ways to use this specialization approach.

The original way to divide duties among trustees was simple. An institutional trustee would be appointed to handle the administration and "back office" duties. This trustee would retain custody of the assets, implement the investment transactions, prepare tax returns, and perform other duties of this type. The other trustee often would be a family member or trusted advisor to the family. This trustee would decide on the amount of distributions and make investment decisions or hire investment advisors.

A variation is to appoint co-trustees, usually one family member and an institutional trustee. The trustees have equal power. No action can occur unless each trustee agrees to it. In practice, the institutional trustee defers to the family member on issues of distributions and sometimes on investment strategy. The family member reviews the tax returns and other documents but defers to the institution on their preparation.

Still another variation is to appoint a committee of at least three trustees, usually selected from family members, friends or advisors, and an institution. The trustee agreement might require unanimity for any decision or allow an action to proceed after at least two trustees agree.

More recently, trust creators have been carving the trustee duties into separate compartments or roles and appointing a separate trustee for each role. Each trustee has sole authority over his or her sphere of responsibility.

The most logical division of duties is: investments, distributions, and administration and recordkeeping. The administration and recordkeeping (which includes custody of the assets) normally is assigned to an institutional trustee. Sometimes an account is opened with a broker or mutual fund, and the family CPA handles the taxes and recordkeeping. The other two functions can be assigned to either individuals or to committees of trustees. A committee of family members, perhaps with a third party such as a family advisor, might determine distributions. Another committee or perhaps a trusted financial advisor can make the investment decisions or hire investment managers.

The functions also could be split among institutions. A money management firm could be the trustee that oversees investments, while a bank or trust company could be in charge of custody, administration, and recordkeeping.

A variation is to appoint one or more persons as trustee with oversight of one of the functions, but the trustee is allowed to hire or delegate to others the actual performance of the functions. For example, a person or committee could be the trustees who oversee the trust's investments. Instead of making the individual investment decisions, they could hire money managers or consultants or otherwise delegate the details of the portfolio. Delegation does not relieve the trustees of their fiduciary responsibility for the results. They have to hire carefully, monitor the performance, and make changes if performance is unsatisfactory.

The advantage of splitting the trustee duties is specialists oversee each function. An institution likely is best at administration, custody, and tax preparation. Family members and friends probably best know the grantor's intentions regarding distributions. Specialization of investment management should reduce risk and increase returns.

There also are disadvantages with splitting trustee duties.

Costs are likely to increase with multiple trustees. Friends and family members might serve without compensation. Institutional trustees, however, often offer lower fees for a package deal that includes all trustee duties. They won't proportionately reduce costs to perform only the administration, custody, and recordkeeping, for example. An investment specialist firm also might or might not charge more than an institution would to manage the portfolio.

If something goes wrong with the trust the legal ramifications of dividing trustee duties are not settled. It is important to delineate each trustee's duties and responsibilities in the trust agreement. This could increase the cost of creating the trust. Part of the agreement should include a dispute resolution procedure that eliminates or reduces the risk of court action or of actions not being taken because trustees cannot agree.

Several states have changed their laws to encourage split trustee duties. Delaware, South Dakota, and a few others have laws establishing what they call "directed trusts" that allow a split in trustee duties. Under these laws, trustees in one area are not liable for improper actions of trustees in the other areas.

Income taxes also might rise with multiple trustees. A trust is considered resident in the state where the trustee resides. If there are multiple trustees and they reside in more than one state, each state might claim the trust as a resident and impose income taxes. Research on the issue is needed before trustees are selected.

An increasingly popular tool is to appoint a trust protector. This function is common in foreign trusts and recently made its way to the U.S. A trust protector is not a trustee but is a third party who oversees the trust and trustees and has broad power to protect the trust. The protector may remove and replace a trustee, change the trust's home or situs, resolve disputes between co-trustees, veto investment decisions, change trust distributions, change trust terms under unforeseen circumstances, resolve disputes between trustees and beneficiaries, or even terminate the trust.

Not all states have laws recognizing or defining the protector role. There are unresolved issues such as: What are the trustees' roles when the protector has such broad powers? Who, if anyone, oversees the protector? There also needs to be a mechanism by which a successor protector is appointed.

Trustees can mean the difference between the success and failure of an estate plan. Today, trust grantors have far more options than they did only a few years ago. They must carefully consider not only the choice of trustees but also the structure of the job.

A Tricky Year-End for IRA Owners

Bob Carlson — Fri, 05 Dec 2008 14:15:00 GMT

Update Dec. 19: On Dec. 11 Congress passed legislation that suspended the required minimum distribution requirement for 2009. But it did not change the requirement for 2008. the IRS was asked by members of Congress to suspend the requirement for 2008. But on Dec. 17 it sent a letter to key members of Congress saying it would not do so. An IRS official told the Washington Post that it did not have authority to change the rules. Only Congress could do that. In addition, the IRS could not devise a solution that would be fair to those who took their 2008 RMDs before December.

The financial crisis continues to have secondary effects few people anticipated. Decisions are required now, especially with regard to IRAs. Let's take a look at the key issues in question-and-answer format.

Is there relief for IRA owners over age 70½ who have not yet taken their required minimum distributions for the year?

IRA owners must take required minimum distributions by April 1 off the year after they turn age 70½ and by Dec. 31 of each year after they turn age 70½. The RMD is computed based on the IRA balance as of Dec. 31 of the preceding year. The Dec. 31, 2007, balance is used to determine the 2008 RMD. We discussed details of computing the RMD in the April 2008 visit, and that discussion is available on the web site Archive.

The problem for 2008 is that many IRA balances are far below their 2007 levels. Major stock market indexes are down around 35% to 40% from that date. Some investments declined even more. IRA owners who have not already taken their RMDs for the year are required to take RMDs on wealth that no longer exists.

There is only one limited provision in the tax law to reduce the RMD in this circumstance. The RMD is fulfilled when the amount taken from the IRA brings the balance to zero. That does not help many IRA owners. If taking the RMD does not wipe out all your IRAs, you are required to take the full RMD as calculated using the 2007 balance.

Several proposals were put forth in Congress in 2008 to provide some way of altering the requirement for those whose IRAs declined. None was enacted, but there is a possibility of some action in a special session now taking place. If there is a bailout bill for the auto companies there is a chance a waiver for RMDs will be included. But that is not very helpful, since you have to take your distribution by Dec. 31, and IRA sponsors often get backed up this time of year. If you wait to put your RMD order in, it might not be processed by Dec. 31. IRA owners are in a tough spot on this issue, because waiting to see if Congress acts could mean a distribution won’t be made by the Dec. 31 deadline if Congress does not act.

Can the RMD be avoided by converting the traditional IRA to a Roth IRA?

The original owner of a Roth IRA does not have to take RMDs (though beneficiaries who inherit Roth IRAs do). A traditional IRA can be converted to a Roth IRA when the owner's adjusted gross income is no more than $100,000. There are taxes due on the conversion. The converted amount must be included in gross income as though it were distributed. The converted amount and any RMD for the year do not count in determining the $100,000 limit.

This is a good time to convert a traditional IRA to a Roth IRA, because asset values have declined. You can make the conversion at a much lower cost than a year ago, and the future income and gains will be distributed tax free to you and the IRA beneficiary.

A conversion, however, cannot be used to avoid a current required minimum distribution. If the IRA owner is required to take an RMD for the year, the RMD still must be taken even if there is a conversion and regardless of the date during the year the conversion occurred. The conversion, however, will avoid future RMDs.

If I have to take an RMD this year, which assets should I sell to take it?

A common misconception about RMDs is that an asset has to be sold and then the cash distributed from the IRA. In fact, a distribution of either cash or property meets the requirement, as long as the value of the property on the day of the distribution equals the RMD for the year. Or if several distributions are taken over the year to fulfill the RMD, the aggregate of the property values on the dates of their distributions must at least equal the RMD. You don’t have to sell any assets to take an RMD.

Most IRA custodians also offer taxable accounts. It is a simple procedure to set up a taxable account at the custodian. Then, direct the custodian to transfer property from the IRA at least equal in value to the RMD to the taxable account. The transferred property can be bonds, shares of stock or mutual funds, other securities, or any other property in the IRA. The custodian will determine if some of the property is not transferable.

If the custodian does not offer taxable accounts, set up a taxable account at another financial institution that will accept the assets. Then, have the securities or other assets transferred from the IRA to the new taxable account. This transfer might take more time, so the paperwork has to be started earlier in order to meet the Dec. 31 requirement.

If you do not want to sell assets to fulfill the RMD, you do not have to. Instead, distribute property from the IRA to a taxable account. The value of the property at the time of the distribution will be included in gross income and count as the RMD. The tax basis of the assets will be their value on the date of distribution, the same amount included in gross income. Because of the tax treatment, it makes sense to distribute those assets that have declined the most and are likely to appreciate the most in the future. Once those assets are in a taxable account, future appreciation is likely to be taxed as long-term capital gains. If the assets remained in the IRA, future appreciation would be taxed as ordinary income when distributed. Also, if the assets continue to decline in value after being distributed, the assets can be sold and the loss deducted on the tax return. Losses in an IRA cannot be deducted in most cases.

I need at least part of the RMD in cash to pay expenses. How should I determine which assets to sell and distribute? Those that have declined the most, the least, or some other measure?

One step investors fail to take on a regular basis is to rebalance their portfolios. A portfolio should have a target asset allocation that meets your return goals and risk tolerance. Over time the markets move the portfolio out of balance because the investments will have different rates of return. The portfolio should be rebalanced to bring it back to its original allocation target.

RMDs can be used to rebalance the portfolio. Sell or take distributions of assets in ratios that bring the portfolio to its target allocation. Sell assets that are above or closest to their targets. That is the fastest way to bring the portfolio back to target. Other changes can be made within the IRA to bring it back to your target allocation, such as selling those that have declined the least to buy more of those that are farthest from their targets. You can choose to make sales and distributions in other ways, but recognize that those would be a change in your portfolio strategy.

Another approach is to use tactical asset allocation to choose the RMD assets. For example, you might choose to hold the assets that have held their value best. Or you might hold those that have declined the most, believing they are likely to appreciate the most when things turn around. Either move would be a bet on coming market trends. The first strategy would be an assumption that recent trends will continue. The second move would be based on a belief that we are near a bottom and you want to capture the following rally. There is nothing wrong with either move. Be aware that you would be straying from your initial strategy and effectively making a forecast about the market.

I sold an asset in my IRA to take a distribution. Can I buy that same asset in my taxable account?

This question is a reference to the "wash sale" rules which prevent a taxpayer from selling an asset to deduct a loss but immediately buying the same asset so that the portfolio position has not changed. The wash sale rules say that a loss deduction is deferred if a substantially identical asset is purchased within 30 days before or after the sale. The wash sale rules apply whether the substantially identical asset is purchased in an IRA or taxable account.

Since a loss incurred in an IRA is not deductible, however, the wash sale rules do not discourage or prohibit you from purchasing a substantially identical asset in a taxable account after selling it in an IRA.

What are the rules for making charitable donations directly from an IRA?

For most people, there is no good reason to make a charitable contribution from an IRA. If you do, the amount is treated as a distribution and included in gross income. You can take a charitable contribution deduction for the identical amount. But you must itemize deductions on Schedule A to benefit. In addition, if your income is high enough, the itemized deduction reduction reduces the amount of your charitable contribution. So, you might not have a full offset of the amount included in gross income.

Those who are over age 70½ receive special treatment. This provision was in effect for 2007 only but recently was extended to the end of 2009.

The special treatment is that a charitable contribution can be made directly from the IRA without including it in gross income. There is no offsetting deduction, but there is no gross income either. Only the first $100,000 of charitable contributions from IRAs each year receives this treatment. In addition, the contribution must be made directly from the IRA to the charity. You must direct the IRA custodian to make the transfer or issue a check.

Another bonus is that the donation can count as part of your RMD for the year. You still are required to take the full amount of the RMD based on the 2007 balance. But by giving all or part of the RMD to charity, the amount does not have to be included in gross income.

Your Retirement Plan and the New Washington

Bob Carlson — Fri, 07 Nov 2008 17:44:00 GMT

Come January, Democrats will be in charge all over Washington. They campaigned on a theme of change, and we should expect major changes. The questions are which changes and how will they affect your retirement finances?

I will focus on the changes I think are most likely to occur. When evaluating the prospects for change, it is important to keep in mind the tension that will exist in the New Washington. Congress will be run by very liberal politicians who have a long list of legislation they wanted to pass for many years. These wish lists generally involve higher spending, more government control and regulation, rewarding favored activities and punishing others, and of course higher taxes. The new President, on the other hand, wants to be re-elected and probably recognizes that the country is center-right, not liberal, on most issues. There will be tension between the President and Congress, and the great unknown is which one will prevail. I assume that for at least the first couple of years the President will have the upper hand and will be able to move the more extreme liberal measures to the back burner.

Here are things you should prepare for over the next year or two. Other changes might be coming after that.

Medicare: This health program for those over 65 is approaching bankruptcy. Social Security will begin spending more than it receives in a few years. Medicare passed that point long ago. It soon will have exhausted the “trust fund” set up for it and rapidly is taking a larger share of the federal budget.

A few years ago “means-tested” premiums began as we discussed in Retirement Watch. Premiums increase as a beneficiary’s income rises. Similar changes are likely to occur. Premiums for higher income beneficiaries could rise even more and some types of care might not be covered for higher income beneficiaries. Or deductibles and co-payments also might be means-tested. Higher income beneficiaries might be required to cover the first $5,000 to $10,000 of their medical expenses in addition to paying higher premiums.

The government might have a stronger role in “negotiating” drug prices. Medicare prices are a basis for prices providers charge to private insurers. If the government negotiates very low prices, manufacturers might conclude that some drugs are unprofitable to produce or reduce research spending on new drugs.

The government also might take over the Part D prescription drug program instead of allowing private insurers to compete for beneficiaries.

Medicare Advantage plans also might take a hit. Democrats in Congress have targeted these since returning to the majority after the 2006 election. These plans run by private insurers receive higher reimbursements than other Medicare plans but usually offer greater benefits. Democrats want to eliminate them and bring everyone back into traditional Medicare.

Greater use of technology is likely to be mandated across the medical profession, and the government will assume cost savings from this move. It also is a way of pushing costs from the government to the private sector. That could affect the quality or availability of care for a while and increase costs on care not covered by Medicare.

Estate tax: Congress has to address the estate tax soon. The current law eliminates the estate tax for 2010 and returns to the 2001 law beginning in 2011. Congress is unlikely to let either the expiration or return to 2001 law occur.

The most likely outcome is, after a great deal of debate, something similar to current law will be enacted. That means the estate tax exemption will be fixed at $3.5 million and might be indexed for inflation. The top estate and gift tax rate will be 45% or 46%, though it could go up to 50%. It will be interesting to see if the lifetime gift tax exemption remains capped at $1 million or is allowed to rise. Also unclear is whether the current step-up in basis that is allowed for inherited assets will continue or whether heirs will have to take the deceased’s basis and pay capital gains taxes on appreciated that occurred during the deceased’s ownership.

Retirement plans: Here is a sleeper issue that came up only in the last month. Many in Congress do not like President Bush’s “ownership society” concept, and they view 401(k) plans as part of that. They are looking at ways to change qualified retirement plans.

A longstanding goal was to require private employers to provide minimum pensions. That might be replaced by a plan to have the government take over private pensions. Recent committee hearings highlighted a plan that eventually would eliminate tax breaks for 401(k) plans and give individuals a window during which they would receive some benefits for converting their private 401(k) plans into government retirement plans. This approach clearly has support from congressional leaders, but its support beyond that is unclear.

Investing: Anticipate some surprises here. Presidents are not able to implement all their campaign proposals. Congress and circumstances can change the plans. Don’t invest based on campaign rhetoric. Wait until proposals are closer to becoming laws.

There could be a positive surprise in the change of power. The financial problems largely have developed into a confidence problem. People do not trust current leadership or the information it puts out. Financial companies do not know what to expect from the government, so they are hoarding cash to protect themselves. Investors simply are not buying anything with risk, and financial firms are not doing business.

Some shrewd moves by the new President in the next few weeks could start to restore confidence at least temporarily. Appointment of a popular choice for Treasury Secretary and announcement of an effective tax cut and regulatory reform plan could spur optimism among investors.

Of course, stumbles on any or all of these issues could extend the crisis. Further down the road, higher taxes, spending, and regulation could reverse any positive trends. But there is an opportunity now to restore optimism even as the economic slump deepens for the next quarter or so.

Congress also could squander the opportunity. There is a movement to expand the government rescue plan to include a range of industries and to impose very tight regulations on financial and other firms taking government money that effectively nationalizes them. A move in that direction would further diminish investor confidence.

Don’t believe simple analyses of how the new administration will affect investments. It is normal for analysts to look at campaign proposals and target companies they believe will benefit from the proposals. Those forecasts almost never work out. Ignore analysts who recommend that you buy “green companies” and short defense contractors and health care companies. Wait for detailed plans to be proposed and make their way through Congress.

Taking action simply on the new election of politicians can be a risky business. I have outlined what I think are the most likely changes over the next few years. But be prepared for surprises. You need to build a cash cushion in your retirement plan for the possibility of paying a higher share of medical expenses. Be ready to revise your estate plan sometime next year or early in 2010. Keep an eye out for early signs of changes in retirement plans and be ready to move your assets into other types of accounts in case a major change is in the works. With your portfolio, don’t fall for obvious analysis. There is the potential for surprise in the next few weeks.