A rebound in stocks and a pivot for bonds

Now that we are halfway through 2023, it is a good time to reflect on the year’s first six months and identify opportunities available to our clients. The rebound in equities so far this year has been led by developed markets around the globe, with the S&P 500 (U.S. large-cap stocks) entering a new bull market, or an increase of at least 20% from its October 2022 low, along the way. U.S. small-mid cap and international stocks are up 9-10% year-to-date. But the good news doesn’t stop with equities. Total returns for bonds are also positive so far this year. The big story in fixed income is the switch from price appreciation to income as the main return driver. Also, as we get closer to the end of the Federal Reserve’s rate hikes to fight inflation, our clients have new opportunities to take advantage of more income and higher return potential, especially in bonds.

Since the Fed started raising interest rates last year, clients who have been wary of market volatility or want to park cash for upcoming spending needs have found higher rates in money market funds and bank CDs. We have helped many clients utilize TD Ameritrade/Schwab’s money market mutual funds for those purposes, and we believe they are still appropriate for short-term spending needs. However, it won’t be easy for clients who consider their money market funds as investments to maintain those higher short-term rates as longer-term rates begin to increase and eventually normalize. Also, many market analysts expect the Fed to cut rates in 2024 to counter any recession. The intermediate-term, investment-grade, taxable U.S. Core Plus bond fund in our clients’ portfolios has increased its average bond maturity. The managers feel that now is a good opportunity to focus on longer-maturity fixed income. While the Fed could still raise rates higher, the current higher yields can provide a buffer against these increases. Research has shown that the time to shift cash into core fixed income is as the Fed approaches its peak policy rate (i.e., before it pauses or cuts). Please see Figure 1 below, courtesy of PIMCO: 

Over the typical 19-month hiking cycle, rates initially rise and cash (3-month Treasury bills) outperforms Core Plus fixed income. This occurred in 2022 when bonds had a negative return from the Fed’s aggressive rate increases. However, before the Fed reaches its peak policy rate, Core Plus fixed income allocations begin outperforming cash. As always, we are here for you if you have any questions.

Financial Planning Concepts

NEW ROTH PROVISIONS IN SECURE 2.0 ACT

The recent SECURE 2.0 Act creates several retirement planning opportunities, particularly with Roth accounts in previously restricted traditional retirement accounts.

SIMPLE Roth IRAs and SEP Roth IRAs

Beginning in 2023, SIMPLE IRAs and SEP IRAs are allowed to accept Roth contributions.  SEP IRAs are funded exclusively by the employer (i.e., employees are not permitted to contribute to SEP IRAs); therefore, all employer contributions to a Roth SEP IRA are classified as taxable compensation to the employee.  In contrast, employer contributions to a traditional SEP IRA will not be classified as taxable compensation (i.e., employees will not be taxed on employer contributions to traditional SEP IRAs).

As previously mentioned in a prior Brown Financial Advisory Newsletter, in 2024 “ALL catch-up contributions for employees with incomes above $145,000 (i.e., indexed for inflation starting in 2025) will be required to be deposited into a Roth account.”  An exception exists for SEP IRAs and SIMPLE IRAs in that the new catch-up contribution rule does not apply to these accounts.

Matching Contributions in 401(k), 403(b), and 457(b) Defined Contribution Plans

Effective December 29, 2022, employers with 401(k), 403(b), and 457(b) defined contribution plans may provide employee participants in these plans the option of receiving matching contributions on a Roth basis.  Like employee elective Roth contributions (i.e., after-tax contributions), employer matching contributions paid into a Roth account on behalf of the employee will be classified as additional taxable compensation to the employee.

After SECURE 2.0 Act, the employer’s elective contributions and matching contributions are no longer limited to traditional accounts.  Provided an employer’s plan offers the SECURE 2.0 Act’s option of receiving matching contributions on a Roth basis, employees will have additional decisions to make as to the placement of their elective retirement contributions and the employer’s contributions.  Employer-provided retirement education to the plan participants will need to address these new accounts and help guide the employee in making the right allocation of any employee and employer contributions to the proper account type.

Rolling Section 529 Education Savings Accounts to Roth Accounts

After December 31, 2023, individuals that have a Section 529 Education Savings Account for at least fifteen (15) years can elect to make a direct rollover to the beneficiary’s Roth IRA.  SECURE 2.0 Act qualifies this trustee-to-trustee transfer on Section 529 account funds (and earnings on those funds) that have been held for at least five (5) years prior to the rollover distribution to the Roth IRA.  There are several requirements and limitations to this Section 529 strategy; however, it provides a nice financial planning solution for those individuals concerned about overfunding their children’s Section 529 accounts and the resulting penalties that would be assessed for non-qualified education distributions. 

Please contact us to discuss how these provisions may impact you.

The 60-40 investment strategy has rebounded so far in 2023

The 60-40 portfolio, which is generally described as a portfolio made up of 60% U.S. large-cap stocks (S&P 500) and 40% U.S. core taxable bonds (Bloomberg U.S. Aggregate), is considered the classic investment strategy in the wealth management industry. It is based on the theory that over the long term, diversification among different asset classes should smooth out portfolio returns.  For example, bonds can help mitigate downturns in equities, while equity investors who “buy the dip” during those downturns are rewarded in any subsequent upturn. The 60-40 portfolio was down 16% in 2022 as both bonds and stocks were negative (an infrequent occurrence), leading some naysayers to predict its demise. However, the Wall Street Journal did an analysis of annual returns for that portfolio over the past 35 years (Figure 1), and the portfolio was mostly positive, averaging an annual return of 9.3% since 1988.

There is also reason to be optimistic about the prospects of the 60-40 portfolio going forward. So far this year, it is up over 5% through early April. While this is a very short time, Dimensional Fund Advisors produced the chart in Figure 2 that shows the 60-40 average cumulative returns (using 5-year U.S. Treasuries for bonds) following a decline of 10% or more.

There are a couple of differences between this traditional view of a 60-40 portfolio and BFA’s corresponding portfolio, but the outlook is the same if not better. First, our 63-37 portfolio uses more than just U.S. large-cap stocks and U.S. core bonds. We also utilize U.S. small- and mid-cap stocks, Foreign developed and emerging stocks, U.S. REITs (real estate), tax-exempt bonds, and international bonds. Second, unlike our client portfolios, no wealth management fees are applied to the 60-40 returns shown here. We believe we can outperform even taking fees into account. The BFA “Core Plus” investment process provides ample opportunities for outperformance and we are confident in the portfolio’s future. 

Financial Planning Concepts

Unfortunate estate planning mistakes in Wealthy families

In 2002, Harvard University published a book by their then Senior Philanthropic Adviser, Charles W. Collier, called Wealth in Families. It contains several important considerations for passing wealth through generations of families.

“Shirtsleeves to Shirtsleeves in Three Generations”: Missing Purpose

Our first goal in the wealth transfer process should be to support the next generation by helping them discover a calling that will enhance their personal fulfillment and happiness through work. Collier quotes Jay Hughes, Jr., author of Family Wealth: Keeping It in the Family, as saying “In every culture that I’ve encountered – in China, Latin America, and Europe, for example – I run into the same proverb… The proverb means that the first generation makes the money, the second generation preserves it, the third generation spends it, and the fourth generation must re-create it.” According to Hughes, without the experience of work, the third and fourth generations dissipate the wealth because they lose the incentive to work. He says, “Work in its deepest dimension equates to a calling. Discovering your calling is the most important task an individual can undertake”. 

Lack of Communication

A second fundamental goal in the transfer of wealth should be more communication. Collier says, “People are often secretive about family wealth.” Of course, the silence breeds mistrust and misinformation and a lot of time and energy is spent by the family trying to find out the secrets! “More communication is almost always better. Talking to your children early about the meaning and purpose of your family wealth can also enhance your relationship with your children.” The larger the estate, the more significant the importance of discussing your family’s greater vision for the wealth while you are still here. To add purpose, philanthropy should be a critical part of this discussion.

Lack of Experience

Finally, Collier recommends providing the next generation with a pre-inheritance experience. It is a common refrain among wealthy families where the first generation intends to pass the accumulated wealth but they never prepare the children for receiving the wealth. It is a bit like inheriting a football and the next day being expected to start as quarterback for the Green Bay Packers! It doesn’t go well. “They need the freedom to take risks, to make mistakes, and, often, to fail. One approach is to give them a modest amount of money outright at age 21, or 25, monitor their progress, and then give them the balance of the financial inheritance around 35 to 40, often in trust.” Robert Coles, author of Privileged Ones: The Well-Off and Rich in America, takes it one step further by saying, “I feel strongly that parents should not give their children a significant financial inheritance during their career-building years, say ages 22 to 35.” He thinks they shouldn’t receive most until around age 40. “They need to make it on their own if they’re going to achieve any kind of competence,” he said. When combined with an individual purpose and family communication, a little experience can go a long way. 

What effect does being out of the market have on my portfolio return?

Given the challenging year we have all gone through in both the equity and fixed-income markets, it is sometimes human nature to focus on the short term, particularly when it comes to negative returns. However, your BFA investment committee has been through every market environment since the mid-1990s and understands that the markets reward patient investors. First, be very careful in evaluating performance on a short-term basis. If you focused solely on your portfolio’s losses in 2022, you would have overlooked the positive prior three years’ returns. Second, put away any desire to “cash out” to avoid further investment losses, particularly during those periods when volatility is at its greatest and it seems the market only goes down each succeeding day. Missing consecutive days of strong returns by cashing out can dramatically impact your portfolio’s overall performance, especially in its equities.

Our partners at Dimensional Fund Advisors (DFA) looked at the growth of $1,000 in the U.S. equity market over the past 30 years both by all-cap (the Russell 3000, from 1997-2021 in Figure 1) and by large-cap (the S&P 500, from 1991-2020 in Figure 2) including being out of the index (market) over the best week, month, etc. As you can see from the following DFA graphs, the results are sobering. It is too late to decide on a course of action when you are in the midst of the storm, so it is good to have a plan already. You can trust your BFA investment committee and rely on your financial plan to help you avoid these mistakes.

Figure 1 (Russell 3000 Index)

Figure 2 (S&P 500 Index, January 1991 – December 2020)

Financial Planning Concepts

what you need to know about secure act 2.0

On December 23, 2022, President Biden signed into law a $1.7 trillion budget bill that reshapes retirement savings legislation in the U.S. Secure Act 2.0 (“the Act) makes several changes to retirement plans like 401(k), 403(b), IRA and Roth IRA accounts to encourage Americans to save more for retirement. Here are four things that could directly impact your retirement plan strategy:

Required Minimum Distribution Age Increased to 73

Savers in retirement plans are required to make distributions from their tax-deferred savings (401(k)’s, IRA’s, 403(b)’s, etc.) plans when they reach a certain age, previously 72. The new legislation starts with one of the most important of all the provisions by increasing the age at which a minimum distribution is required to 73 from 72 starting in January 2023. It doesn’t help much if you were 72 or older in 2022 but if not, you have one more year before you must begin distributions. In ten years (2033), the Act will move the RMD age to 75.

As a bonus, the 50% tax penalty for failing to withdraw your RMD has now been reduced to 25% in all cases or even to 10% if you take the necessary RMD by the end of the second year.

Emergency Expense Withdrawals from 401(k) and 403(b) Plans

The new legislation now allows an “emergency” distribution from retirement plans. The maximum distribution of $1,000 may be taken once each year. It will not be subject to the 10% penalty typical of withdrawals before age 59 ½ but the money must be repaid within a specified period or no more withdrawals will be allowed for three years.

Catch-Up Contributions Increased

In 2022, savers who are 50 years old or older may make additional contributions to their retirement plans. In 2023, these participants in 401(k), 403(b) or Thrift Savings Plans may defer as much as $22,500 to their retirement savings plus an additional $7,500 catch-up contribution for a total of $30,000. The new Act increases those limits in 2025 for employees aged 60-63 to the greater of $10,000 or 150% of the standard catch-up rate adjusted for inflation. One additional important change occurs in 2024 when ALL catch-up contributions for employees with incomes above $145,000 will be required to be deposited into a Roth account.

Qualified Charitable Distribution (QCD) Limits Set to Increase

Qualified Charitable Distributions are tax-efficient gifts made by those over age 70 ½ directly to charity from an IRA. The distributions are not taxable and help satisfy the required minimum distribution. QCDs are capped at $100,000 per person per year. But starting in 2024, the QCD limit will be adjusted for inflation. Finally, in the past, QCDs were mostly limited to gifts directly to charity. But starting in 2023, the Act allows a one-time gift of up to $50,000 to charitable remainder annuity trusts, charitable remainder unitrusts, or charitable gift annuities. This may be a tax-efficient way to create a lifetime retirement income stream while benefiting a charity at the same time.

As we review your plan, we’ll let you know how Secure 2.0 can help.

What impact could the mid-term elections have on stocks?

Many political and market commentators have been issuing forecasts and analyses regarding the Federal elections in November, particularly the prospect of Republicans taking control of the U.S. House of Representatives and the Senate. While BFA does not take political positions and leaves it in the hands of those better-suited for such prognostications, we know what history has to say about how stocks can act during the lead-up to and the year following mid-term elections, regardless of which party is in control.

In their 2022 Midyear Outlook, LPL Research reports that mid-term election years have not been kind to equities. In the midterm years since 1950, the S&P 500 (U.S. large-cap stocks) has experienced the largest peak-to-trough pullback (down 17.1% on average) during the four years of the Presidential cycle. Indeed, the S&P 500 on a total return basis was down 24% YTD through September 30, 2022. The good news, however, is that once the uncertainty of the election is over after Election Day, stocks generally rebound, and by quite a bit. As shown in Figure 1, the S&P 500 has increased each year after every midterm election since 1950. The average gain is 14.5%.

Furthermore, does it matter which political party is in control? The answer is No.  As seen in Figure 2, the S&P 500’s average annual return since 1950 has been positive, regardless of the party in the White House or the makeup of Congress. In fact, the market seems to prefer a divided government, which may be the result after November. Your BFA Investment Committee is not worried about the outcome.

Financial Planning Concepts

tax incentives for clean energy investments

On August 16^th, President Biden signed into law new tax legislation commonly called the “Inflation Reduction Act of 2022.” The legislation includes tax incentives for businesses to invest in clean energy projects and for individual/family taxpayers who spend money on energy-efficient products. The business tax incentives are easily the most extensive portion of the new tax law but there are a few opportunities for individual taxpayers, too. 

Clean Vehicle Credits

The new legislation changes the tax incentives for purchasing an electric vehicle (EV). First, there is a transition period where if the vehicle is purchased before August 16^th but is not delivered until after, the EV tax credit is based on the prior law: a tax credit of $2,500 + $417 for every kWh over 5 kWh with a maximum credit of $7,500. If the vehicle is purchased after August 16^th but before 2023, the EV must also qualify under a new rule called “final assembly”, a requirement that the final assembly of the vehicle must occur in the United States. There is a 200,000 vehicle sales cap in 2022 and many manufacturers (Tesla, GMC, and Chevrolet) have already phased out. You can find a great resource for additional information here: https://www.efile.com/electric-vehicle-car-tax-credits/

It is important to note that in 2023 there are additional qualifying thresholds that relate to the battery components and critical mineral sourcing for new cars. Because of these additional requirements, far fewer cars qualify for the full tax credit. However, some used cars will become eligible for a tax credit that is 30% of the sales price up to $4,000.

Residential Energy Property Expenditures

There are new credit thresholds for “Residential Energy Property”: geothermal heat pumps, small wind turbines (less than 100 kW), solar water heaters, solar panels (photovoltaic systems), residential fuel cell and microturbine systems, biomass stoves with 75% efficiency ratings, and qualified battery storage technology (residential and >3kWh). In 2022, there is a 26% tax credit for systems placed in service before 1/1/2023. After 2022, there is a credit for 30% for 2023-2032, 26% for 2033 and 22% for 2034.

Qualified Energy Efficiency Improvements

Starting in 2023, there is a tax credit equal to 30% of the costs of all eligible home improvements up to $1,200 per year. The annual limits for specific types of qualifying improvements will be: $150 for home energy audits, $250 for any exterior door ($500 total for all exterior doors) that meet applicable Energy Star requirements and $600 for exterior windows and skylights that meet Energy Star most efficient certification requirements. There is a $600 credit for other qualified energy property including central air conditioners, electric panels and certain related equipment, natural gas, propane, or oil water heaters and furnaces. There is a $2,000 credit for heat pumps and heat pump water heaters, biomass stoves and boilers. This category of improvement is not limited by the $1,200 annual limit on total credits or the $600 limit on qualified energy property. Please consult your tax advisor regarding car purchases, property credits and improvements.

Talk of recession, Part two

High inflation readings and a hawkish Federal Reserve continued to spook the fixed income and equity markets during the second quarter of 2022. The risk of recession is a distinct possibility as consumers have begun scaling back on purchases, mainly in goods and to a lesser degree in services, and dipping into savings to cover essential items such as groceries and gasoline. But what is the definition of a recession, and how do some experts predict its onset with such certainty? Let’s address the last question first. The answer is that it is impossible to know when a recession will start, so be wary of experts and their predictions.

The National Bureau of Economic Research (NBER) is responsible for placing dates on when a recession has started and when it has ended. Thus, a recession could technically end before the NBER confirms it even started, much like the pandemic-induced recession of 2020. According to the NBER, “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.” One measure of a recession touted by the media is when the country’s Gross Domestic Product (GDP), or the value of the goods and services it produces, declines for two straight quarters. Some economists are predicting a decline in GDP for April-June 2022, which would mean two consecutive quarters of decline. However, the current job market is resilient, and unemployment is at its lowest rate in years. This robust employment is contrary to every recession since World War II, with each of those economic downturns experiencing a rise in unemployment. And, even if a recession has already started or will soon, many economists believe it will be short and relatively mild. 

what does this mean for my portfolio?

The stock market is a leading economic indicator. It is too late to make drastic allocation changes or shifts in the portfolio to avoid the adverse effects of an economic decline. However, in anticipation of an eventual economic downturn, your BFA investment committee has re-positioned our client portfolios over the past few years. These shifts included a reduction in over-valued U.S. small-cap stocks in favor of Emerging Market equities with a value tilt. Value stocks tend to hold up better than growth stocks during a recession. Also, U. S. small company stocks are more sensitive to economic changes and have historically underperformed larger company stocks going into recession. We also picked up yield and thus boosted returns by increasing our allocations to U.S. High Yield Bonds and U.S. Real Estate (REITs). And, even though interest rates have picked up, your BFA fixed-income portfolio will benefit over the next few years from rising coupons as income becomes a more significant part of bonds’ total return. Finally, history has shown that the markets should fully recover from an economic downturn.

Financial Planning Concepts

an antidote to volatility? Try tax planning

In a June 10^th, 2022 article in Kiplinger Online, Rocky Mengle and Joy Taylor say, “Americans are facing a long list of tax changes for the 2022 tax year. Smart taxpayers will start planning for them now.”¹ In fact, smart investors also use times of volatility to both reduce their taxes, now and in the future, and enhance their after-tax returns. During the fall semester of the True Planning Cycle (TPC), Brown Financial is laser-focused on providing tax planning strategies that provide both benefits to our clients. Here are a few notable methods you should expect during your upcoming tax review:

Tax-Loss Harvesting: During times of volatility, BFA begins to frequently and actively review portfolios for opportunities to capture tax losses. By selling positions that have declined and reinvesting the proceeds in similar (but not identical) investments, you can avoid future capital gains taxes and even write off an additional $3,000 per year from your ordinary income while remaining invested. So far, BFA has captured almost $4.5 million of tax losses, resulting in nearly $1 million in tax savings for our clients!

Roth Conversions: Roth IRAs provide tax-free growth and tax-free distributions throughout the life of the account, even after your heirs receive them. Unfortunately, most of us have more in traditional IRAs than in Roth IRAs. To “convert” a traditional IRA to a Roth, you must make a taxable distribution from the IRA that will raise your income taxes for the year. However, market declines create opportunities to buy into the Roth account while the market is low. Converting during market drops builds in a quick recovery of your taxes in a tax-free account. It may take a few years to break even on the taxes, but converting your Roth when the market is down can be a great strategy, especially if you are planning for multiple generations.

Avoid “Extra” Taxes: The IRS is sneaky, if you haven’t noticed. As evidence, there are three additional “taxes” that do not show up in the “brackets”: Net Investment Income Tax (NIIT = 3.8%), additional Medicare Taxes (0.9%), and Income-Related Monthly Adjustment Amount (IRMAA) for your Medicare Part B premium. Although none of these taxes fall within the tax “brackets,” they all apply when your taxable income exceeds certain thresholds. However, there are ways around these taxes, and strategies to avoid them should be part of your tax plan every year. As we run your analysis, we will consider the impact of these individual taxes on your overall plan and offer ideas to lower them, too. We will help you become one of the “smart taxpayers” Mengle and Taylor describe and help you save money in 2022 and beyond. We look forward to assisting you! 

talk of recession amid A rough start to 2022

Global supply shocks and higher interest rates and inflation hobbled global markets during the first quarter of 2022. Those same forces have prompted economists to raise the probability of a recession in the next twelve months for both the U.S. and overseas. Your BFA investment committee is not concerned, however. First, while economists at JP Morgan and those surveyed by the Wall Street Journal, for example, have increased their probabilities of a U.S. recession in the next twelve months, the figures are still relatively low (from 20% at the beginning of 2022 to 30% now). Keep in mind that in an average year, there is a 15% chance of a recession in the U.S. Second, there is growing evidence that supply shortages are easing, which should help satisfy the demand of global consumers, especially in the U.S., who have ample cash reserves and a desire to spend. Third, it is difficult to paint the global economy with broad strokes. While Europe has a higher chance of a recession due to its dependence on Russian energy supplies, the U.S. is not as vulnerable as Europe. Also, Latin American markets tend to be more commodity-based and are enjoying an economic rebound due to increased energy and raw material prices. However, further price spikes in oil or an escalation of the war in Ukraine are wildcards that we will monitor.

HOW SHOULD WE FEEL ABOUT BONDS?

Given the volatility and steep drops in equity and fixed income markets so far this year, some investors are in unfamiliar territory and may be unsure how to feel about their bond holdings, particularly those who have only been in the markets for the past 10-15 years. There is no sugar-coating that bond prices have been hit hard with a double whammy of the highest inflation in 41 years and rising interest rates. However, we also believe in the power of compounding and understand that price return is just one component of total bond return. As interest rates go up, bond coupons are reinvested at those higher rates, which means income makes up even more of the total return of bonds over the medium to long term. Your BFA investment committee wants to reassure you that we feel we are positioned correctly in our fixed income portfolio. Our fixed income managers think that we are now past the inflection point and that the “medicine” we are taking will result in healthier fixed income markets and better returns in the future. So, here is the takeaway: Bonds are down year-to-date. BUT, we have already 1) captured higher than average returns during the falling rate environment of a couple of years ago; 2) diversified to bonds that should generate higher yields through floating-rate bonds and provide corporate bond outperformance; 3) diversified the bond portfolio further with short-term high-yield and international bonds that are not as interest-rate sensitive as core bonds and provide higher yields to maturity; 4) chosen managers who can accumulate stabilizing cash if the bond market continues to be uncooperative; and most importantly 5) significantly outperformed core fixed-income last year and are positioned this year to do the same.

Financial Planning Concepts

A simple new process ensures planning success for everyone

In his most recent book, The Psychology of Money, Morgan Housel makes a powerful observation critical for all of us. He says, “Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.” What does he mean? There are two parts to the statement that should ring true for you: First, there is the assumption that there IS a plan. A plan to purchase a home, educate your children, protect your family, retire, reduce taxes, grow your wealth, leave a legacy, etc., etc. Truly, for those without a plan, the end result is a guess at best and a guaranteed failure at worst. We should all have a Plan.

However, the second part is that constant change necessitates revisions to our Plan to ensure its success. Housel goes on to say, “A plan is only useful if it can survive reality. And a future filled with unknowns is everyone’s reality.” Like the sand on the shoreline at the beach, as the wind and waves pass over, the picture changes. Sometimes the changes are dramatic and sometimes they are subtle but they are always changing. Your finances are the same.

To help you maintain peace of mind and a successful Plan in the face of constantly “shifting sands”, we are excited to introduce the Brown Financial True Planning Cycle (TPC), a systematic process to partner with each of you to help you achieve all of your goals in the face of risk, uncertainty and constant change.

the true planning process

The TPC is Simply Effective. The hardest part of financial planning is gathering data to complete the plan. To help overcome this annoying hurdle, the TPC breaks the Plan into manageable component parts for analysis over a continuous, two-year cycle. Retirement, Insurance, Investment, Tax and Estate planning all occur in a repeating cycle to ensure impactful focus on each area. As the Plan encounters shifting scenarios, it is regularly updated and adapts. Even when things are not going “according to plan”, the Plan navigates to compensate. Without a doubt, this process is the most powerful tool that you can have to ensure you achieve your goals. It is also unique in our industry. Many firms claim to provide financial planning but few have a systematic process to ensure your Plan is always on track. We are delighted to have the opportunity to present it to you and will discuss it more in your upcoming reviews. Because the TPC is so amazing at producing the results we all desire, financial security and peace of mind, it is now the foundation of what we offer to all of our clients. So, as we tell our friends who are new to the process, “Come and see what you’ve been missing!” 

Another Banner Year for U.S. Stocks

In defiance of the continuing toll of the COVID-19 virus, 2021 was another year of double-digit returns for both U.S. large- (+28.7%) and small-cap (+14.8%) stocks. This was the third year of double-digit returns for those two sub-asset classes. It wasn’t just mega-cap technology stocks leading the way in 2021, either. The S&P 500 Equal Weighted index is made up of the stocks from the S&P 500 (U.S. large-cap stocks) and applies equal weights to the components, unlike the regular S&P 500 index, which is weighted by market capitalization. The equal-weighted index outperformed the regular index in 2021 by almost a full percentage point. This outperformance shows that the market rally since Spring 2020 now includes more sectors of the U.S. economy, which is good news. The award for best-performing equity sub-asset class goes to U.S. real estate, with the MSCI U.S. REIT index up 43% in 2021. The end of lock-downs and more freedom to move around cities and the country meant that retail, apartments, and self-storage REITs drove returns in the index.

Things were not so good for U.S. core taxable bonds, however. Long-term interest rates finished the year higher than at the beginning of the year. As a result, the Bloomberg U.S. Aggregate Bond index was negative on a total return basis in 2021, only the fourth calendar-year downturn in the index’s 42-year history. The three other negative calendar years were 1994, 1999, and 2013. One bright spot in fixed-income was U.S. high-yield bonds, whose performance is more correlated with equities and ended the year up 5.4%. The performance of foreign equities in 2021 was a mixed bag. Foreign developed stocks (Europe and Japan) finished the year up 11.3%. Foreign emerging stocks were negative (-2.5%), mainly due to a correction in the Chinese stock market and a continuation of lock-downs throughout those countries. Finally, foreign equities faced the headwind of a stronger dollar in 2021.

Inflation is the word

Inflation, including inflation expectations, affects many pricing and spending decisions among securities markets, consumers, and corporations. Inflation has thus muscled its way into the headlines, no small feat considering the continuing struggles with COVID-19. The December 2021 U.S. consumer price index (CPI) reading showed that inflation rose 7% from December 2020, its fastest pace since 1982 and the third straight month of inflation exceeding 6%. The U.S. Federal Reserve has indicated it will be more aggressive in its actions toward taming inflation, with many analysts now expecting a hike in short-term rates in March 2022. Higher interest rates are a headwind for fixed-income and technology stocks as future earnings become less valuable. However, one key market gauge of inflation, the 10-year breakeven rate (the difference between the yields on 10-year Treasury and Treasury Inflation-Indexed bonds), is currently at 2.5%, meaning that longer-term expectations for inflation are much lower. Diversification among your equity and fixed-income holdings will be important given higher prices and interest rates.

Financial Planning Concepts

5 tips to maximize your home insurance

After Hurricane Sally hit the Gulf Coast, many of our friends and neighbors were filing claims on their homeowner’s insurance policies. Unfortunately, a few found that they didn’t have the coverage they thought they had and struggled to settle with the companies. Although Sally was a “mild” hurricane, the damages were real and the coverage a necessity in those circumstances. Following is a quick checklist to help you make sure your coverage is adequate to fully protect one of your most valuable assets.

1. Confirm that you have Replacement Cost Value vs. Actual Cash Value coverage. They sound so similar it is easy to get them confused but the differences are dramatic. Replacement Cost Value coverage provides replacement coverage for any damages on the property to restore it to its original state. A water leak that destroys the hardwood floors (one of the most common claims) results in the company covering the full value (less a deductible) to replace the floors. Actual cash value, however, would only cover what the insurance company thinks the floors are CURRENTLY worth; meaning the Replacement Cost less any depreciation. With ACV, you may only receive a fraction of what it would cost to replace the floors. Confirm with your agent that you have RCV.
2. Consider wind, hail and earthquake coverage. Especially on the coast, wind and hail are not typically covered under your normal homeowner’s policy. So in the event of a storm, wind damage (like the roof blowing off) may not be covered without the additional coverage. This type of coverage also typically carries a larger deductible than your typical homeowner’s policy. If you have a large wind deductible, make sure you also have the liquidity to pay it if you need it.
3. Consider raising your deductible. Raising your deductible from say $1,000 to $2,500 may save you a few hundred dollars in premium each year. However, sometimes a higher deductible doesn’t significantly lower your premium, so it is important to compare. Since you will not file a claim for a small loss, because it could increase the likelihood of a premium increase later, you should set your deductible at an amount that is high but not out of reach for you. 
4. During large storms, place your claims quickly. If you find yourself in a large storm and a leak develops on the ceiling, don’t wait until the next day to file your claim. The sooner you file, the sooner you will be paid. And while others will wait for the storm to pass, you can file your claim right then and be in the front of the line to get paid sooner.
5. Remember that you are not insuring the land. Often when homeowner’s protect the value of their home, they consider the MARKET value if they sold the house. However, that includes the land and you do not need homeowner’s coverage for the land. Insuring the cost to replace the structure could lower your premiums.

Fall’s bumpy ride and China in the news

Since the bottom of the COVID-induced market downturn in Spring 2020, it seems like the equity markets have only been going one way: up. However, analysts and investors are keenly aware that, on average, September is the worst month for the S&P 500 (U.S. large-cap stocks), and September 2021 was no exception. The S&P 500 fell 4.8% in September, its largest monthly drop since March 2020. However, the index still finished the third quarter up slightly by 0.6%, its sixth consecutive quarter of gains. Volatility re-entered the bond and equity markets during the third quarter, as well, driven by talk of higher inflation, U.S. Federal Reserve tightening, uncertainty surrounding the Democratic infrastructure and spending bills, possible higher taxes, and a potential U.S. government shutdown. As a result, investors began to sell Treasury bonds in earnest. U.S. core bonds ended the quarter down almost 2% year-to-date on a total return basis. The resulting climb in bond yields has become a headwind for U.S. mega-cap technology stocks, as well, whose long-term earnings become less valuable as yields go up. China’s overheated property market also caused ripples with news of a possible default by real estate developer China Evergrande on its debt. A potential collapse of Evergrande along with ongoing concerns in China of slowing economic growth, a government crackdown on large technology companies, and continued government interference in the equity markets sector led to negative returns in the third quarter for emerging market stocks. Your BFA Investment Committee reminds you of four things, however:

1. As Scott McLeod’s recent webinar explained, volatility is normal and should be expected as we are overdue for some this year.
2. Our fixed income portfolio goes beyond U.S. core bonds and uses managers with flexible mandates to take advantage of higher yields (non-investment grade corporate bonds), geography (international bonds), and to shelter taxable income when practical (municipal bonds).
3. Equities including real estate investment trusts (REITs) have shown over time to be an effective inflation hedge.
4. Our fund selection in the emerging market allocation has outperformed the index due to its focus on smaller and more value-oriented companies.

tax planning in the fourth quarter for client portfolios.

Mutual funds are required to distribute their realized capital gains by year-end, with most of those distributions occurring in December. We will analyze our client holdings for material distributions (i.e., 5% or more of net asset value) and may take action to avoid those distributions. We will also look for opportunities to harvest further capital losses in client portfolios. Given the specter of higher capital gain taxes, loss carryforwards have become even more valuable. These actions could save on taxes for you.

Financial Planning Concepts

4 tips to living the retirement of your dreams

Running out of money during retirement is a fear that nearly everyone faces at one time or another. Rest assured, your friends across the dinner table or on the golf course are just as concerned as you are (at least, at times) about not having enough. Even those you might consider “wealthy” have similar concerns. Nevertheless, there are specific strategies that successful retirees employ to protect and grow their retirement assets, live fulfilled, and have peace of mind. Here are four proven steps for a successful Retirement Plan:

1. Make sure you always have an up-to-date Retirement Plan. Whether you are still working, saving, and preparing for retirement or living the retirement dream now, you should have a realistic Retirement Plan. By projecting your cash flows and considering portfolio growth and taxes, the best Retirement Plan does two things: First, it ensures that you can meet your expectations and have an action plan to do it. Second, it provides peace of mind by showing the long-term implications of your current actions. When you face your fears head-on, you find peace in knowing that you control your destiny. Your Retirement Plan is the only way to accomplish this goal.
2. Manage your spending around your goal. If you are still working, your Retirement Plan defines what savings will be required to meet your standard of living during retirement. “Pay yourself first” by investing what your Plan requires before you start spending. If you are in retirement, use your Retirement Plan to help you develop a spending strategy. Unfortunately, bond yields and stock returns may be lower in the next few years. Knowing what you can spend by having a cash-flow-based plan is critical. The Plan will account for irregular expenses (car purchases, a home remodel, etc.) and help you control your spending to meet your long-term retirement goals.
3. Manage your distributions during retirement. One of the easiest ways to maximize your retirement spending is by avoiding distributions during market declines. After a fall, allow your portfolio to recover before making your next withdrawal. Waiting will help ensure that you are always “selling high,” a key to a successful retirement strategy. Maintain an emergency fund or use a Home Equity Line of Credit as a spending cushion during market volatility.
4. Protect your savings with insurance. There are many risks to your Retirement Plan, but you can protect yourself with insurance. Use “longevity insurance” to protect your income, long-term care insurance to cover unexpected medical expenses or life insurance to replace your spouse’s income. There are many new tools available to help you mitigate these risks.

Brown Financial Advisory is committed to helping you achieve your long-term goals by updating your Retirement Plan regularly and guiding you through the strategies you need to live the retirement of your dreams. Above all, we want you to have the peace of mind you deserve and are happy to help you get there.

Market Growth and Earnings 

The U.S. stock market was positive through the second quarter of 2021, bolstered by the accelerating economic growth of the U.S. economy. JP Morgan reports that,

“Real GDP numbers for the first quarter showed a strong 6.4% annualized growth. However, April data for consumer spending, inventories, and durable goods orders reinforced our view that this growth is accelerating and that second-quarter growth could be over 10%.” 

Even if the economy should begin to slow in the second half of the year, it is not unreasonable to expect the fourth quarter to grow 7.5% over 2020. Amazingly, this would essentially mark a full recovery from the pandemic-induced recession.

When markets rise to new heights, as they have recently, investors become increasingly nervous that the stock prices may be unsustainable and susceptible to correction. Markets tend to be more fragile when valuations worsen due to the earnings of the underlying companies not keeping pace with the prices of the stocks. But so far this year, earnings have recovered remarkably and year-over-year earnings growth is expected to hit an all-time high. Many sectors in the U.S. economy continued to do well during the pandemic and still show healthy revenues. Other companies are showing signs of recovery. Additionally, some companies have shown increased efficiencies, allowing the increased revenues to result in wider margins and increased earnings per share. Although valuations are historically high in the U.S., strong company fundamentals are supporting the current stock prices.

Inflation 

However, looking ahead, growth in the U.S. stock market may be stifled by external forces. Wage costs, higher interest rates, inflation, and, potentially, higher corporate tax rates could negatively impact future growth. Many factors have led to higher inflation but none more significant than increased consumer spending pulling against systemic supply-chain interruptions across the economy. Economics 101 teaches that an increase in demand and a decrease in supply will often result in higher prices. And while reports of rampant inflation may be somewhat overblown in the short term, there has been a material increase in prices, a 4.9% increase in May. The increase was shocking but not entirely unexpected and was due to the state of the economy in May of 2020 and the significant improvements since then. However, more important is the annualized 2.5% increase in the CPI over the last two years. This means the average consumer has seen noticeable increases in costs of goods and services dating back to 2019. Some of these price increases should be transitory but economists suggest inflation could still be 3.0%-4.0% through the end of 2021 and could remain much higher in 2022 than the Fed’s former inflation target of 2.0%.

Financial Planning Concepts

5 ways to improve your estate plan

It is common knowledge in the financial planning community that very few people LIKE working on their estate plans. And while the process may feel like a necessary evil, there are some fundamental steps you can take to help avoid a mess for your heirs after you are gone:

1. Review your estate plan with your attorney at least every 3-5 years.

A quick meeting with your attorney will keep your plan updated from both the personal and legal perspectives and provide a “tune-up” to ensure there are no surprises for your heirs. A regular review is the most crucial step in improving your plan since, of course, you cannot fix problems with your plan after you are gone.

2. Prepare a personal Net Worth Statement that includes the ownership of your assets and your beneficiary designations.

The Net Worth Statement is an essential tool for helping your Personal Representative settle your estate. It includes all your assets and all your liabilities listed by ownership. Simply knowing locations of accounts, account numbers, beneficiary designations, and ownership speeds up the settlement process and can also help avoid the risk of an account or insurance policy not being claimed and ultimately lost (or significantly delayed) in the process.

3. Regularly review the beneficiaries on all your accounts and add them when appropriate.

Naming beneficiaries on your accounts can be a powerful but sometimes dangerous planning strategy. Beneficiaries on retirement plans like 401(k)s, 403(b)s, and IRAs receive special tax treatment and the proceeds of those plans avoid the probate process when properly designated. Non-qualified accounts like bank accounts and taxable investment accounts also avoid probate when a beneficiary is added. However, a beneficiary designation may supersede the provisions of your will. Reviewing your beneficiaries and your will provisions together is the best way to use this powerful tool wisely.

4. Prepare a personal property list.

As most planners know well, families often break apart when trying to settle the sentimental items in an estate. Mom’s pie plate will always elicit more emotion than her checking account, and a well-crafted personal property list with designated heirs can help avoid the trouble that often arises. Talk with your heirs about your plans, gather feedback and write down everything you hope to designate. Most families do not expect the children to disagree, but unfortunately, it happens often. 

5. Prepare the next generation for the inheritance sooner rather than later.

Wealthy families often make a mistake when they depend on the estate plan to “teach” the heirs how to manage the wealth by creating trusts to limit access, appointing trustees, and using guardians to “protect” the heirs from the hazards of wealth.  “Shirtsleeves to shirtsleeves in three generations” is the adage that describes the curse in these families. Involve the children early and often and empower them with responsibility and challenges to help prepare them to take over the reins. Then, when you need help later, you can rely on your children to know exactly what to do. 

An optimistic start to the new year

With a March 2020 COVID-induced market bottom in the rear-view mirror, global equity markets raced ahead over the next twelve months, setting new highs and finishing a solid first quarter of 2021. The S&P 500 index (U.S. Large Cap stocks) gained 56.4% over the past twelve months and 6% during the past three months. It set 17 new highs in the first quarter of 2021 alone and reached the 4,000 level for the first time. Mega-cap technology companies drove returns at first, part of the Work-From-Home trade that characterized so much of 2020. As the year wound down, it became apparent that the Democrat-controlled Federal government would make good on its promises of increased fiscal spending alongside continued monetary stimulus from the Federal Reserve.  With that uncertainty gone, prospects shot up for a much stronger U.S. economic recovery, and economically sensitive stocks such as U.S. Small-Caps assumed the leadership mantle. As measured by the Russell 2000, U.S. Small-Cap stocks were up 95% over the past year and up almost 13% for the past quarter. International stocks have a greater proportion of cyclical stocks than the U.S. market, which along with increased stimulus from overseas central banks/governments and a weaker dollar, pushed them higher. For the past twelve months, Foreign developed (Europe and Japan) gained 45%, while Emerging Market stocks returned 58%. U.S. real estate (equity REITs) made a strong comeback, as well, up almost 9% and 38%, respectively, for the past 3- and 12-months.

Bonds made headlines in the first quarter of 2021, but not in a good way. Afraid that inflation would pick up with strong economic growth, Treasury bond investors sold off the 10-year bond. This liquidation pushed its yield up to 1.75% at the end of the quarter, an increase of 0.84% and the biggest one-quarter gain since 2016. Prices for broader U.S. investment-grade bonds, including corporate bonds, declined as well, dropping 3.4% during the quarter. U.S. municipal and international bonds (USD hedged) held up much better.

What is your BFA Investment Committee’s outlook for the rest of the year?

Your BFA Investment Committee believes that forecasts for more robust global growth particularly bode well for equities outside of the U.S., which are already undervalued compared to U.S. stocks. Our clients should thus benefit from their allocations to foreign stocks. We will also continue to keep an eye on any rising prices for goods and services. U.S. households are flush with cash from fiscal stimulus.  Those savings, in addition to pent-up demand stemming from COVID-19 restrictions, could unleash inflationary pressures not seen for a long time. We also believe that the Federal Reserve may have to confront increasing bond yields. The Fed has been content to let market forces play out, but a steeper yield curve may force the Fed to push back more forcefully. Finally, our clients should benefit from a diversified fixed income portfolio, going beyond core bonds to take advantage of higher yields, geographical diversification, and the shelter of taxable income when practical. 

Financial Planning Concepts

Biden Tax Proposals – Forewarned is Forearmed!

U.S. tax rates today are among the lowest U.S. citizens have ever experienced. But the newly unveiled $2.3 trillion (with a “T”) infrastructure plan will require some significant revenue to offset the spending. Taxes are once again front and center, so it is time to revisit key components of President Biden’s proposed plan. Nothing is permanent yet but “forewarned is forearmed” and we want you to be ready.

1. Corporate tax increases seem most likely. The President has had a long-standing commitment to increase corporate taxes. The corporate tax rate could increase from 21% to 28% and there could be an increase in taxation of international corporate income earned by U.S.-based companies. These increases could take effect as early as January 2022. According to Forbes, analysts from Goldman Sachs have predicted that Biden’s entire tax plan would reduce 2022 earnings-per-share on the S&P 500 by 9%. 

2. Is your net worth greater than $3.5 million? Unified gift and estate tax exemption amounts could decrease from $11.58M to $3.5M for individuals and $23.16M to $7M for married couples. There is talk of doing away with several common estate planning strategies like GRAT’s, family limited partnership discounts, and limiting dynasty trusts and defective trusts, all very effective tools for high-net-worth families. Planning tip: Consider aggressively gifting now, since there are no claw-backs on the gifts. Review all trusts and estate plans and potential estate tax changes and consider setting up trusts now. Life insurance could help if illiquid assets exist in your estate and taxes remain a concern. 

3. Do you own taxable assets that have appreciated in value? The new plan could eliminate the step-up in basis at death and potentially create a taxable event at that time. While this could be the most challenging of all to pass, it could also be the most impactful. Planning tip: Consider “basis management” as an ongoing strategy to bring down gains in your portfolio, particularly if the step-up in basis is eliminated. This may include paying more attention to annual rebalancing, placing stocks that are anticipated to appreciate into retirement accounts and transferring low-basis stocks to lower-income family members (up or down). 

4. Is your income above $400,000? Watch for an increase of the top ordinary income tax rate for income over $400,000 to 39.6% from 37%. Planning tip: Consider all strategies to bring down income, including funding traditional retirement plans, opening profit sharing/defined benefit plans, bunching deductions, etc. There may be an increase in long-term capital gains rates from 20% to 39.6% on income $1,000,000 and over, plus the Medicare Tax of 3.8% on top of those amounts. 

5. Tax-deferred exchanges for real estate performed under IRC 1031 may no longer be available. IRC 1031 applies to like-kind real estate. Planning tip: Consider performing like-kind exchanges this year to defer the gains, but make sure that any transaction qualifies under any tax law changes.