Retirement Focus: Spotlight on Good News

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 19, 2009

Retirement Focus: Spotlight on Good News
By Mike Posey

IN THIS ISSUE:

1. Yes, There is Some Good News Out There

2. New Retirement Perspectives

3. New Investment Opportunities

4. A New Opportunity for 403(b) Participants

Introduction

I’m sure that many of you reading the title above think I have lost my mind. What good news could there be when 78 million Baby Boomers are bearing down on retirement with retirement portfolios that have been decimated by the recent bear market? What’s good about the recent Social Security Trustees report that said that Medicare and Social Security will run out of money sooner than expected because of the current recession? And what’s good about the federal government printing money to fund massive bailouts of the financial sector and others?

Granted, there’s more than enough bad retirement news circulating out there, but I’m not going to dwell on that. You can find plenty of gloom and doom articles on the Internet with very little effort. Instead, I’m going to bring out some positive issues related to retirement planning in this week’s E-Letter.

I recently attended an industry conference and one of the speakers really got my attention. She was from a communication firm and noted that many Investment Advisors are focusing too much on bad news and not enough on the positive aspects, and she’s right. Negative news often allows us to identify with others, as in “misery loves company.” However, it can also lead to depression and inaction, which is often the wrong thing to do.

Focusing on the positive aspects of our situations can, on the other hand, lead to taking action to better our financial position. I often tell my wife, a chronic worrier, that she should worry only about things she can do something about. I suggest the same for investors. Like it or not, you can’t single handedly solve the Social Security crisis, nor can you go back in time and replace lost retirement funds.

You can, however, change your perspective and focus on the beneficial things happening in the retirement market, even though they may be a bit hard to find. This E-Letter will focus on some of the positive things going on in the retirement market and show you how you might be able to participate. If you currently participate in a 403(b) plan at your employer, I have especially good news about a new way for you to access active management in your retirement account.

New Retirement Perspectives

Many of the positive things happening in relation to retirement do not involve investments or markets. Instead, they are readjustments of existing programs and ideas in order to fit the new reality facing retirement planning. In the section below, I’ll discuss some of these concepts and how they may help you reach your own retirement goals.

Increased Savings – Lo and behold, it only took two bear markets within a decade to convince Americans that they should save some money. Since the onset of the most recent bear market, the US savings rate has gone from below zero to over 4%, and many believe it will continue to go higher as the economy recovers.

Actually the savings rate turned negative back in 2005, something that hadn’t happened since the economy was in the throes of the Great Depression. A negative savings rate means that savings were actually being depleted in order to finance the purchase of big-ticket items such as homes, cars, boats and other material possessions. Of course, most American’s weren’t worried at the time because their homes were consistently rising in value. What a difference a few years and a credit crisis make.

I learned the importance of savings right out of college. I got a job offer from a company in Houston at a starting salary that was more than my father was making before he retired. He took me aside and told me that when he began his career in 1936, he was bringing home $35 per month and saving $10 of that. Of course, he and my mother lived with my grandparents and didn’t own a car. Still, he left me with an indelible lesson that it’s not what you make but what you save that counts. It now seems that the rest of the country is taking this lesson to heart.

The increase in savings is significant for several reasons. First, it means that individuals are taking charge of their own retirement destiny. Over the years, there has been no shortage of experts calling for Americans to save more, especially those in the Baby Boom generation nearing retirement. However, for a long time, these warnings went unheeded.

Increased saving is also significant in that it means Americans may be spending less for material goods in the future. Ironically, this might make the recovery from the current recession more difficult. Since approximately 70% of the US economy is related to consumer spending, an increased savings rate could have a major impact on future economic growth, a situation sometimes referred to as the “paradox of thrift.”

Finally, the increase in savings usually means that debt loads are being reduced. As Americans have chased material possessions over the past couple of decades, debt loads have increased significantly. Many used the increasing values of their homes as piggy banks through the use of home equity loans and credit card companies inundated all of us with attractive offers of easy credit. Hopefully, those days are gone and family balance sheets will again become healthy.

The question now is whether this new urge to save will continue after the recession is over and jobs are plentiful. In light of the recent warnings about the solvency of Social Security and Medicare, let’s hope so. In keeping with the theme of this article, I’m going to be positive about the future of Americans’ savings habits and believe that this new focus on saving money will continue. After all, you cannot consume your way into a comfortable retirement.

New Savings Programs and Incentives – One thing that our representatives in Washington do know is that the retirement security of many of their constituents is on the line. As a result, there have been a number of proposals to liberalize various rules to make saving for retirement even easier. Of course, with Congress you sometimes have to wonder how good intentions can result in really lousy proposals.

A good example is the proposal to hijack 401(k) plans floated by Democrats last year, which Gary discussed in detail in his November 4, 2008 E-Letter. Fortunately, this proposal got so much negative response that it never saw the light of day. Even though this idea was dead on arrival, I believe that future legislative action should make saving for retirement much easier.

However, it’s also important to make sure that you are already taking advantage of all of the current programs available to you. For example, are you maximizing your 401(k) contributions and employer matching benefit? Do you make a non-deductible IRA contribution even if you’re already covered by a retirement plan? Are you eligible for 403(b) or Section 457 deferred compensation plans where you work? Consult with your Human Resources Dept. to make sure you are taking advantage of all of the opportunities that may be open to you.

A New Look At Defined Benefit Plans – Once the backbone of employee benefits at large companies, defined benefit plans guarantee a pre-determined monthly benefit upon retirement without regard to fluctuations in investment returns. In other words, the employer assumes the market risk for these plans and must contribute whatever is necessary to make sure the plan is fully funded.

As you might imagine, many existing defined benefit plans are under stress right now. Plan investments have suffered losses and employers are being required to pay larger contributions at a time when the recession is cutting into revenues. So how is this good news, you ask?

It’s good news because, in the right set of circumstances, the defined benefit plan may be an excellent way to build back a retirement nest egg with tax-deductible employer dollars. Since defined benefit contributions are based on actuarial assumptions of the amount necessary to fund a guaranteed monthly benefit, deductible employer contributions can be far greater than the maximum contributions allowed under a 401(k) or other defined contribution plan. Plus, the older you are, the greater your contribution must be to fund the benefit.

This weighting of contributions to older workers usually benefits owners and key employees more than rank-and-file employees, since they have less time to accumulate money for retirement. Fortunately, plan provisions and actuarial assumptions are somewhat flexible, usually allowing for a high degree of customization for the specific needs of an employer.

Amounts necessary to fund promised benefits must be calculated and contributed each year. Therefore, these plans should only be adopted by employers with steady cash flows. Defined benefit plans are also usually more expensive to administer than a 401(k) or defined contribution plan. However, for the employer who can direct most of the contributions to owners and key employees, the price may be well worth it.

One of the good things about defined benefit plans is that the funds are invested by the trustees of the plan and not by the individual participants. Since owners and key employees are usually the decision makers and trustees, a wide range of investment opportunities are available, including the actively managed programs that Gary frequently writes about.

New Investment Opportunities

Some of the positive aspects of retirement planning are in the form of new opportunities available to investors, while others are established ideas for which the timing may now be right. Below I will discuss just a few of the opportunities that I see opening up for IRA account holders and retirement plan participants.

Maximize Contributions – Actually, this is an old concept with a new emphasis. In what is going to sound heretical for a firm that promotes active management strategies, younger participants in 401(k) plans should be maximizing contributions and place them into quality mutual funds that have good long-term track records.

Obviously, I would prefer that 401(k) participants include actively managed strategies in their retirement portfolios, but most 401(k) plans do not have such options available. Instead, they usually have a list of mutual funds from which participants can choose. Some plans have more than others, but most usually have some well-known funds with generally good track records as well as index-based funds.

Even though investing in such funds is an exercise in buy-and-hold investing, participants with many years before retirement have several things going for them. First, the period of time between now and eventual retirement means that they will likely go through a variety of market cycles. While the current market malaise may last for a long time, it won’t last forever. The economy and the stock markets will eventually recover which should be good for those with a long enough time horizon to wait around for it.

Younger participants also have the benefit of something known as “dollar-cost-averaging,” or DCA for short. This term simply refers to the fact that your monthly contributions buy shares at different prices over time. When the market is high, you buy expensive shares but when the market is down (like it is now), your contributions buy more shares. When the market does eventually break into a new bull phase, these “cheap” shares tend to have greater gains than those purchased in normal market conditions.

Finally, younger participants tend to have lower account balances in the plan since they are at the beginning of their accumulation phase. Thus, the magnitude of any bear market losses may not seem as great. Think of it this way – it’s usually easier to deal with a $10,000 account dropping to $5,000 when you’re in your twenties than to see a $500,000 account fall to $250,000 when you’re in your fifties. DCA can help young participants rebuild their accounts over time, but may be of little help to an older participant. Active management strategies are usually best at helping to manage the risks in large portfolios, as I will discuss in more detail below.

Thus, even though we have had a market rally as I will discuss below, the major market indexes are still far under where they were in October of 2007 at the peak of the last cyclical bull market. Now is the time to contribute as much as you can each month into your 401(k) and buy shares while they’re relatively cheap.

The Market Has Bounced – In Gary’s May 5 E-Letter, he discussed that the market’s recent bounce may be an opportunity for investors to take some money off of the table by moving it away from failed buy-and-hold strategies. This is especially true for older retirement plan participants who have significant account balances and less time to recoup investment losses. Many account values have bounced back since the market lows in early March and now may be a good time to lock in some of that gain.

The idea behind selling into this rally comes from the possibility that this may just be a temporary bear market rally and not the beginning of a new bull market. As Gary also pointed out in the May 5 E-Letter, historical bear markets have often had substantial rallies only to resume their downward plunge later on.

Of course, the recent rally could mark the beginning of a new bull market. If that is the case, then taking money out of the market will mean you’ll miss out on possible future gains. That’s why we recommend that you consider moving only part of your account to cash and not all of it. You might start with 25% of your account and then see how the market performs in the future before taking any further action.

And I’ll go ahead and warn you that your buy-and-hold broker or Advisor is likely to become apoplectic should you decide to move some money off of the table. He or she will point to the market’s recent rally as evidence that buy-and-hold works (it doesn’t) and that moving part of your account to cash will mean that portion of your account will miss out on the new bull market sure to come. Don’t fall for their line of bull, do what’s best for your future retirement.

New Investment Options – Whether you are already in cash or take the advice above to liquidate part of your buy-and-hold portfolio, the investment options available to you depend upon the type of plan you have. If you participate in a 401(k) plan, your options are usually limited to a set group of mutual funds, with some plans providing more choices than others. For less aggressive investors, cash or fixed income investments may be the best alternative. While earnings will be small, safety of principal is high.

More aggressive 401(k) investors may want to see if specialized “bear market” funds are available in your plan in case the downtrend resumes soon. These funds could act as a hedge of sorts on the remainder of the portfolio since they tend to move in the opposite direction of the market. Thus, if the market goes down, these funds actually have the potential to gain. Of course, if the market goes up, these funds will generally lose money, which is why this strategy is usually best only for aggressive investors.

You can find such funds on the Morningstar database (www.morningstar.com) listed under the Bear Market Fund category. Be aware that most 401(k) plans will not have this type of fund available, and that some bear market funds are better than others. Bear market funds should never make up the bulk of your portfolio, even if you think the market is destined for a downturn.

There are also other types of mutual funds that actively manage their assets, with some even moving to cash in bear markets. Thus, it pays to do some homework on the funds available to you before making a decision on how to allocate your contributions. It’s also a good idea to consult with a qualified Investment Advisor before using any of these specialized funds in your portfolio.

If you are in a self-directed type of account such as a traditional or Roth IRA, you have even more options for money that you may want to move out of buy-and-hold positions. You can also move to fixed rate investments or bear market funds, as noted above, but you also have the flexibility to explore other alternatives that might not be available to 401(k) participants. I have listed just a few of those below for you to consider:

First, several of the professional money managers we recommend are available to manage self-directed IRA accounts. These active managers have become increasingly popular in light of the latest bear market, as you might imagine. Some of these active managers have seen a flood of new accounts in recent months, as an increasing number of former buy-and-hold brokers and Investment Advisors are seeking out actively managed programs to offer to their clients.

Our company is a member of the National Association of Active Investment Managers (NAAIM), which is an organization dedicated to the promotion of active investment strategies. I recently attended NAAIM’s national conference and was surprised to see that a third of the attendees were new members. Most of the new members I talked to were former buy-and-hold believers who are now seeking out new strategies.

What do they know that you may not know? Simple, they know that buy-and-hold strategies only tend to work in bull markets when virtually all stocks are going up. In bear markets, however, the underpinnings of asset allocation and Modern Portfolio Theory fall apart, leaving investors vulnerable to potentially huge market losses.
Another possible alternative available to those with self-directed IRAs or other qualified retirement accounts is that of purchasing real estate. REAL ESTATE!! Are you crazy, Mike??

Well, not quite. It’s no secret that real estate prices in certain markets have been hammered, possibly below what might be considered a reasonable valuation. It’s also no secret that during tough economic times, those with cash can often make very good deals on real estate. Unfortunately, many investors have most of their cash tied up in an IRA and think that direct real estate investments are not possible.

While the subject of buying real estate in an IRA is somewhat complicated and far beyond the scope of this small newsletter section, I do want to make you aware of some ways in which you might use your IRA money to purchase real estate. The first way to do so is to purchase real estate as an asset of your IRA. Since your IRA is a trust entity, it can hold title to real estate just as it can own financial assets. You can even have rental property that spins off monthly income into your IRA.

The trick is to find a corporate IRA trustee or custodian who will agree to hold real estate in a self-directed IRA. To be honest, there are not many firms that will do this, but a few of the more specialized companies will agree to hold real property. The requirements and fees to purchase and hold real estate vary by custodian, and some will even allow you to debt finance property in your IRA as long as you can find a willing bank to lend you the money through your IRA. Just be aware that debt financing property in your IRA may bring about unrelated business taxable income (UBTI) issues.

Also be aware that there are significant restrictions on what you can do with the property held by your IRA. The “prohibited transaction” regulations applicable to IRAs dictate that you or your close relatives cannot use the property yourself and that property management must usually be handled by an unrelated third party.

In other words, you cannot buy yourself or your kids a house with money from your IRA, nor can your kids move into a rent house owned by your IRA. You also can’t buy raw land with your IRA and then build your house on it. Likewise, you cannot use personal funds to pay upkeep expenses, property taxes, etc. on property held by your IRA since doing so is considered to be extending credit to your IRA under the prohibited transaction rules. All expenses must be drawn from your IRA and all income must be paid to your IRA.

I have actually purchased a piece of rental property through an IRA I had with Sterling Trust Company in Waco, Texas. While it was a good investment, I found the hassles of dealing with property in an IRA to be more than I wanted to put up with. However, if you are willing to put up with the paperwork and procedures necessary, this might be an attractive alternative for you to consider.

A second way to use IRA assets to purchase real estate eliminates some of the headaches of having the IRA actually hold the asset. Under what is known as a Section 72(t) distribution, IRA account holders can take distributions from their IRA without the 10% penalty tax even if they are under age 59½ as long as certain conditions are met. The distributions must be calculated over the life expectancy of the account holder and must continue for a specified period of time.

Some savvy IRA account holders have figured out that taking such a distribution and using the proceeds to purchase a second home or vacation property is a beneficial use of IRA funds. Since some wealthy individuals can experience disproportionate taxation on IRA assets upon their death, any way to transfer assets from the IRA to another asset is welcomed.

The mechanics of how this works are somewhat complex, but a thumbnail sketch is that the IRA account holder calculates an amount necessary to fund the purchase of a property. Then, an experienced tax professional helps to determine the amount of IRA assets necessary to be moved to a separate IRA to produce a distribution sufficient to cover monthly payments. While the IRA distributions are taxable, account holders under age 59½ will escape the 10% penalty tax as long as the requirements of Section 72(t) are met. In addition, an offsetting deduction for mortgage interest and taxes on the second home should reduce or eliminate any taxation on the IRA distribution.

The result is a tax-efficient transfer of money from the IRA to a hard asset without penalty taxes and without the prohibited transaction restrictions associated with holding property in your IRA. It can also be a valuable estate planning tool in the right situation. Obviously, your IRA must be a certain size in order to fund distributions sufficiently large to cover the mortgage costs, and you shouldn’t do this if your IRA money is all you have for retirement.

There are a number of drawbacks to using a 72(t) distribution, not the least of which are severe IRS penalties if the rules are not followed, so don’t try this on your own. It’s important to consult with a tax professional who is experienced in calculating these distributions under all of the allowed methods before deciding to proceed. In addition, the tax benefit relies on an offsetting deduction for mortgage interest and property taxes on a second home, which could be eliminated by Congress in the future.

New Flexibility for 403(b) Participants

As I noted above, employer retirement plans can sometimes box participants in by offering very limited investment choices. Nowhere is this more evident than in some 403(b) programs established for schools, hospitals, charitable organizations and other qualifying employers. Many 403(b) participants have a variety of mutual funds and annuity contracts available to them, but with little direction as to how best to use them in a diversified portfolio, much like a 401(k).

For 403(b) participants who are feeling boxed in, we have some exciting news. Potomac Fund Management, our oldest and most established active money manager relationship, has made us aware of a new program that has been especially developed for investors with 403(b) accounts. The only requirement is that the employer must have made the Fidelity family of mutual funds available to 403(b) investors.

The new investment alternative works like this: 403(b) participants move an amount of money that they want Potomac to manage to the Fidelity funds platform. At the same time, they execute an investment management agreement with Potomac Fund Management that authorizes Potomac to trade the account on behalf of the participant. Potomac then uses its trading model based on years of experience and expertise to manage the investor’s account.

Best of all, it is not necessary to have the employer approve Potomac to manage the account. If Fidelity funds are already available under the employer’s program, then Potomac can manage the account without any further approvals. Potomac will manage the account using the same model employed in their Guardian Program that we have been recommending since 1996. The main difference is that Potomac must limit its choices to the available Fidelity funds in the 403(b) program, while Guardian can use virtually any mutual fund family.

We are still in the process of finalizing our due diligence review of this new product, but since we are already very happy with Potomac and their Guardian program, we anticipate that this will take only a short time.

If you have a 403(b) program and the Fidelity funds are offered as investment alternatives, we want to hear from you. Click on this special 403(b) Information Link to register your interest in this program. Once we complete our due diligence process, we will rush information to you with complete details about Potomac’s 403(b) alternative, including a strategy description and actual track record.

If you are unsure about whether your employer has authorized the use of the Fidelity funds, check with your Plan Administrator or your employer’s Human Resources Dept. If you have any questions about this program or would like to see if it may be suitable for you, please give us a call at 800-348-3601, send us an e-mail at info@halbertwealth.com or complete the online request form at our 403(b) Information Link. As always, Potomac’s past performance is not necessarily indicative of future results.

Action Items

As I noted above, my philosophy has always been to worry only about things that you can do something about. While there’s no shortage of bad news today, my article this week provides a number of positive ideas that may apply to your retirement situation. I urge you to seriously consider any of the following items that might fit your individual circumstances:

Maximize your participation in any retirement plan and take advantage of dollar-cost-averaging where available;
If you are older and your retirement portfolio has increased in value due to the recent bounce in the market, consider taking some money off of the table;
Follow congressional action on retirement plan issues to see if new programs are created that might benefit you. If you are an business owner looking to rebuild your retirement portfolio, consider adopting a defined benefit plan for small employers;
When considering the options available to you in your retirement plan or IRA, don’t be afraid to think outside of the box. This means you may want to consider new types of bear market funds, active management programs and even real estate. Just make sure you are comfortable with the risks, special characteristics and administrative requirements for each; and
Finally, if you have felt trapped inside a 403(b) program with limited choices, consider Potomac’s new 403(b) managed account program if your plan offers the Fidelity family of mutual funds.

Very best regards,

Mike Posey