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Today's Commentary: 01.22.05
Understanding Your Investments
After You are Gone

Far too many households have a one person financial team. Often, that person is involved in the investments, taxes, and even the day-to-day bills. In my house, this process is split evenly - or at least in my estimation - so that I am the investment and insurance guy; the wife is the taxes and day-to-day girl. It works out well for us on many levels. She controls how the household expenses are allocated and reins in the spending where necessary, mostly involving cell phone bills or more specifically text messaging done by the lone teen left at home. I handle the 401(k) plans, the IRAs and their direction and when the budget allows, the financial decisions about major financing such as autos and appliances.

But what happens when I am gone? What about the investments? How would she protect her money?

We have, unlike many couples, discussed how she should handle a future without me and this is the plan we decided on. Once the insurance money was paid to her, the Social Security checks began arriving, and the pension payouts began, she would have three choices.

She could stay in the house. While she bristles at the notion, insurance would cover any remaining mortgage and the left over could be put into a CD earning 2.5% that would cover taxes for some time. Her income would be covered through the remaining programs I mentioned earlier and further supplemented by retirement savings.

She could sell the house, taking the currently sizable equity and investing it in a CD which would give her enough income for the next twenty years to cover basic living expenses. Her standard of living however, would not rise and inflation, the economic act of making your money worth less, would eventually take its toll.

The insurance policy, however would need to be invested to assure that she would not outlive those moneys and the increasing cost of living to a ripe old age.

But where? Yale University professors Robert J. Schiller and Robert D. Arnott have found that the real return on the stock market over the last two decades or so came largely from what they call a revaluation of stock prices. In other words, investors believed that stocks during the period from 1980 to 2000 were worth more thus driving up their price. Whether these stocks were actually worthy of price increases is debatable, especially in light of the falling prices that followed in the year's after the study. But during those years, stocks on the S&P 500 gained 7.4%.

Should she chase dividends? In the Bush economy, the answer would be yes. The reduction in taxes on dividends and capital gains has fallen under this president's administration and if his promises are kept, they will be eliminated altogether.

Dividends, according to the professors added another 3.3% to the yield. Without those taxes and with the additional shift in corporate transparency - a nice phrase for spreading the wealth to the shareholders and not the officers of the company, some feel as though dividends will continue to increase. Putting a third of her money in this sector may prove enormously prudent but should be done through a segmented approach.

For instance, she should buy into a good index fund with low expenses at the rate of $2,500 a month. This will take over five years to completely invest a third of the $500,000 policy but she will be taking advantage of a principle I have beaten to death called dollar cost averaging. Dollar cost averaging spreads the price risk by allowing you to make purchases of mutual fund shares at different times. When share prices are low, DCA allows you to purchase more shares. Conversely, when prices are higher, you will buy less but those shares bought at the lower price will be more valuable.

While a goal of protecting her principle would lead to a conservative investment like bonds, she will also need to worry about inflation eating away at the returns. This can be a real deterrent to gains and could be protected if she took a third of the investable money and placed into a TIPS bond fund. These Treasury Inflation Protected Securities should be bought in a bond fund because of the laddering advantage these managers have over the common folk. Laddering simply means buying different maturities at different times, keeping your money working. For this portion of the investment, she could do a lump sum approach.

Just a side note about how TIPS work and how to calculate their value against regular Treasury bonds. Inflation that is rising increases the yield of the offering. For instance, a TIPS type 10 year bond might have a yield of 2.50%. A 10 year Treasury might have yield of 4.50%. Subtracting the difference on those yields will tell you how much your TIPS has been adjusted for inflation. If inflation is running 2.5% and this would be over the course of the next ten years - we are comparing decade long securities - a 10 year TIPS would have bested the conventional bond by 0.5%. I expect inflation to keep at about that pace over that period of time. How the 10 year bond performs depends on a wide variety of events, but that's another column.

What she should not do is buy an annuity. Anything placed in such a vehicle would not be inheritable for the kids or grand kids or any other place she wanted to gift her inheritance. Besides, the rates are horrible for the security they provide.

The last third of the insurance money should be invested in her. Of course, this is because I personally know of her unbelievable artistic talents, business savvy and tireless ambition. Using the remaining money to start her own business would not only keep her busy but would provide a good way to grow the money as well. She could draw a salary from it and in turn, save 25% of it in a SEP-IRA. And that should be direct toward REITs.

Even if she decides against the business, she should find a REIT or a fund that invests in them. Real Estate Investment Trusts are baskets of real estate investments from apartments to office space to shopping centers. They do have their ups and downs but the principle is essentially safe. REITs generally don't have price fluctuations the way stocks do but the returns can vary widely. Those returns usually outpace inflation so this portion of the investment may be the best invested third. This investment requires diversification but once again, a good mutual fund designed to hold REITs will provide a good group. She could also put this in as a lump sum.

If she keeps her will up-to-date and her eye on the quarterly statements, she will not outlive her money. All of the above mutual funds, the index, the TIPS fund, and REIT fund should have low expenses and reputable fund management. Her tax rate should be lower so tax management, while important will not be greatly impact her returns. In fact, she will probably be able to leave a good legacy to the grand kids.

Do you have a will?

Do you have a question about wills? Here are some quick answers to help.

Today's Commentary: 01.18.05

Surviving Tax Reform
Four Ways to Cope

You don't need me to tell you that tax reform is on its way. In fact, much of the change was begun in earnest during the first Bush term, the result of a two decade long strategy to make the Republicans the party of smaller government.

To bring you up to speed on what has happened, it is important to understand the objectives of the Bush administration as was laid out during the Reagan tenure and the reforms that were begun there. The belief that supply side economics could do three things if the conviction was strong enough, the policies were enacted, and the code was systematically changed in such as way as to both appease the middle class and create a new tax free capitalist upper class.

Governments, the Americans for Tax reform believe, are too large creating far too many entitlements. This is, in their opinion, an economic dead end. Along with smaller governments should come lower taxes; lower taxes come from a change in rates from the current progressive ones to flatter, more equal assessments. The current system levies different rates on different levels of income, the highest paying the most and lower wage earners, paying less.

Some changes have been made but progressive taxes still penalize savings and investments and this group believes that the necessary capital for investment has not been available to grow the economy for that reason. To believe that thinking, one must also ascribe to the notion that without these burdensome taxes on savings and investments, the American population would change from a nation that saves at the current rate of 0.02% to one that instead is permitted to spend more thus creating a higher standard of living.

Lower tax revenues are only a short term problem that supply-siders argue would disappear as soon as business and consumers realize their new found wealth in a lower tax environment. While this may elicit the cry "bring it on!" and on the surface and in theory it looks great, what is really needed is a survival guide for those who do not understand how encouraging savings and investments would make them better off, lowering tax revenues would somehow grow them, and how growing the government through increased spending would somehow reduce its size.

The first thing you need to ask yourself is basic: If no taxes are collected on savings and investment, estates or on capital gains, all of which are the long term goals of the president's agenda for tax reform, who will keep the government running? Even a smaller less service oriented government, one that currently has embraced spending like a shopoholic, needs money to keep running. Without those sources, the burden of paying will rest on the tax of labor.

Your survival guide would have four basic steps, none of which are time tested nor do I make any promises that they will work. But a strategy of some sort is needed - and soon.

Stop spending. No, really. Your patriotic consumerism, the belief that the economy is somehow rewarding you with your increased debt, leveraged mortgages and jobs that are less secure than four years ago is misplaced. In fact, like never before, a far greater portion of those export dollars you spend at Wal-Mart are widening the surplus to deficit accounts of China. That's right. China is now sitting on a $124 billion surplus. By comparison to the record trade deficit in this country, the shift to an economy that buys more than it can afford, borrows from the suppliers to pay for it, and then cuts revenues to the government using wealthy entitlements is not only economic suicide, it carries the same immoral implications that taking one's own life does.

The changes in the tax code may affect your mortgage. Some say that those sacred deductions will eventually become a consideration . The best thing to do is to rethink how you view your home. It is no longer an investment that can be counted on to produce equity to bail you out of your overspending ways. Nor is it a retirement plan.

If you have an adjustable rate mortgage, you can expect quickly rising rates over the next several years. The reasons are many but specifically the change in the low rate environment will come courtesy of the Federal Reserve Board, the "three steps behind the curve" bankers who have used comforting catch phrases like "moderate" when changing their monetary policy, and from the ever weakening dollar. While the later has many reasons to be lower - and continued weakness will be the nail in this country's economic coffin - the interest rates will do far more damage in the near term to the consumer.

Convert your mortgage to a fixed rate unless you can agree with the following two statements without hesitation: I can afford to be broke, and, although I need a home of my own, downsizing, renting, or moving back with the parents is also an option. A fixed rate mortgage is not the only thing you need to do. If there is even a hint that the interest rate of mortgages will become less deductible, the best thing you can do now is to begin to make additional payments to the principle. The way mortgage interest works, if you were not aware, is based on a calculation on the remaining balance. The sooner you grow your equity by paying additional to the principle, the less of an impact losing this deduction will have on you.

The third thing you as a citizen of a government with outrageous deficits - current accounts are under funded by $600 billion a year - and bloated size - the federal government has not been this large since the Great Depression - is to make it clear to the elected officials in your home state that this dos not create political capital. In fact, political activism may be the only way to assure the president does not get what he wants making his second term a true lame duck affair. Seats in both the Senate and the House are up for grabs in 2006 and any change in the GOP demographic would undermine the loose sand that these proposals now stand on.

The last thing you can do is understand the following concept: There are losers in a revenue neutral tax system. Those loser are at the lower end of the spectrum even as we make up 90% of the tax paying populace. Treat everyday as if it were your last day on your job. Spending as if there were no tomorrow will create a day of reckoning sooner that you anticipate and with the new reforms in place, there will not be any likely help forthcoming from the Bush administration. Entitlements be damned; you are on your own.

The sooner we realize that these changes in tax reform are not for our benefit, the sooner you can prepare for the eventual.

The Blue Money Report
Financial Commentary covering a wide range of topics concerning money, investing, and how it effects the average investor and their financial health.

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