30 Nov 2012 Manipulation and Influence
Tis the season for crisis in Washington once again. It has become commonplace for our elected leaders to expose their increasingly dysfunctional process by jumping from one emergency to the next. Or is it more functional than first meets the eye? Confusion is a very effective tactic when one wishes to hide the larger truth.
Today we face yet another self-inflicted crisis known as the ‘fiscal cliff.’ It essentially represents a line in the sand drawn by the Budget Control Act of 2011 which is a self-policing action Congress imposed on itself to slow the growth of budget deficits. It mandates automatic across-the-board cuts and tax increases amounting to between $500 and $700 billion should Congress fail to reach agreement on taxes and spending.
The term ‘fiscal cliff’ was coined by Fed Chair Ben Bernanke who had a purpose in doing so. Historically, one of the Fed’s most valuable tools has been that of ‘jawboning’ or “the use of verbal encouragement or discouragement by political leaders or other influential people to achieve particular results” as defined on EconGuru.com. He carefully chose the term to manipulate both the Congress and the American people; in the short term to address the automatic cuts and taxes to prevent recession in his view, and in the long term to close the widening gap in federal budget deficits. It is a manipulation, well intended maybe, but a manipulation nonetheless.
That’s just a small part of the story. The Federal Reserve is manipulating this economy arguably more aggressively than at any time in history. Charged with the dual mandate of keeping inflation under control and employment at optimum levels, the Fed has taken unprecedented actions to drive interest rates to historical lows and to make known the fact (again unprecedented) that they intend to keep rates low for at least another year. Their intent is to drive investors into riskier assets like stocks. The logic is that a 2% dividend yield increasing with inflation looks considerably more attractive than a CD at .3%, and that money moving into risky assets will drive investment and stimulate growth in the economy.
The fiscal cliff has been a huge opportunity for some of the best manipulators of all – the media. They have designed their own special logos for the thing. As traditional media outlets including newspaper, network, and cable fight for survival in an increasingly competitive information age they have resorted to increasingly sensational tactics. Television news is cleverly choreographed to build our interest or anger to a crescendo and keep us hanging through a similarly-crafted batch of 30 and 60-second manipulators called commercials. Want to know how to find peace and contentment in this crazy world? A great start is to cut your cable. We did so six months ago and my blood pressure has dropped easily by 10 points.
Despite all the media hysteria and the dire forecasts out there, it is almost inconceivable that Congress would fail to act in some way before January 1st. After all, that’s how we got to this point. They punted the last time and they will punt again so they can have the time to negotiate taxes and cuts in a more ‘determined’ manner. Even if they fail, we don’t have to assume a recession will result. And if we glide over, President Obama gets his 39.6% tax hike and the government has to cut some spending. And after all, taxes will only go back to the levels they were where President Clinton and Democrats last set them – which brings me to another point of manipulation.
The tax code is Congress’ most politically effective manipulation tool by far. Politicians have made the tax code ridiculously complicated for one reason alone – they can hide all their self-interested back room deals in a book of code that contains a whopping 72,536 pages. When WWII ended the code spanned 8,200 pages.
Put in perspective, the cliff is a relatively minor event. Our attention is being diverted from a much larger and tremendously more significant conclusion in America’s future. As legislators argue over how to close the budget gap by a relatively small $500 to $700 billion dollars, in just ten years the gap will swell to $10, even 13 trillion! Let’s get real here. It’s not the cliff that’s the problem, its the eventual collapse of American fiscal confidence that’s at stake.
Our control over these issues is limited to our vote and whatever political influence we have money and time to spend. Added all up it is frustratingly small, even for billionaire CEO’s. But there are a few areas that you and I can control in this new era of American austerity. It appears inevitable that taxes are going up; whether through rate hikes or through the elimination of some deductions. By the same token, it is also reasonable to expect that government entitlement programs, such as Social Security and Medicare, will be scaled back and adjusted according to wealth and age. Ignored, these changes can have significant impact on lifestyles.
While you may feel helpless listening to the commercial media, there are actually significant things you can do to plan for and avoid what would otherwise result in significant erosion of lifestyle. Planning and efficient management are now more indispensable than ever.
Let’s examine the impact of taxes on lifestyle. Whether you are saving for retirement or spending in retirement, taxes have a tremendous impact on your quality of life – unless of course you are Warren Buffett. For most people, taxes are considered but once a year when they discover whether they will need to contribute more to Uncle Sam’s coffers than they withheld through payroll deductions, or whether they will get a refund (which retailers will eagerly accommodate in May – the masters of manipulation)
Even those of us who invest and plan beyond employers’ and government retirement programs fail to adequately address the full cost of taxes on our lifestyles. Sure we fret and complain about the big tax bites on the significant sales, but I’m talking about erosion much more subtle, but just as damaging to our wealth. It occurs every time a stock is sold in our personal or joint accounts. Whether mutual funds or individual stocks, the IRS takes between 15% and 35% of your profits on every sale, depending on how long you owned it. Gains taxes may rise to between 23.8% and 39.6% whenever the new tax laws go into effect, but the following examples will use current rates.
If you hire managers (mutual fund or stock) to beat market returns, they are going to buy and sell securities virtually indiscriminate of your tax circumstance in order to achieve their/your goal of appreciation. There is no guarantee they will meet their return goal, but there is a certainty they will generate taxes and expenses in their quest. You may be shocked to learn just how significant an impact these often silent, but steady taxes can erode your lifestyle.
To give you an idea of how taxes can unwittingly impact your life, I’ve used the patented Wealthcare system to crunch some numbers for several scenarios designed to speak to the circumstances of many of our readers. We consider both the accumulation or saving phase of retirement planning as well as the distribution phase or the spending from investments typical of the retirement phase. We had to pick an age for our sample couple, but please understand that if you are younger or if you are already in retirement, the tax implications are likely greater than suggested.
Let’s look at John and Mary who are 50 years old saving for retirement in 12 years. They have $500,000 in personal savings and $400,000 in 401Ks. To keep it simple let’s hold their goals to two; an inflation-adjusted level of retirement spending and a specific estate or end goal. Their portfolio is 60% equities and 40% fixed income and cash, known as a balanced account.
John and Mary plan to defer salary (save) of $17,500 and $5,000 annually into their 401Ks and save $10,000 annually into their joint account (increasing each amount with inflation) until retirement. These contributions will not be taxed until the couple begins drawing from their 401Ks, at which point they will pay ordinary income tax rates. The couple will also receive a $500,000 inheritance from their parents in 20 years.
When we run the Monte Carlo simulation we find that the couple has an 83% probability of being able to spend $123,500 for the rest of their lives (increasing with inflation of 3% annually) and leaving an estate of more than $500,000. Our efficient management techniques result in relatively low turnover (buys and sells) of 10% and relatively high allocation of those sales to long term (tax-favorable) gains at 90%.
Lets consider what happens to John and Mary’s plans if their advisor takes the more industry-standard approach of higher turnover and more short-term capital gains. When turnover is increased from 10% to 60% (average among growth mutual funds) and 60% of those gains are taxed as short-term ordinary rates, John and Mary’s estate drops from $500,000 in our model to $200,000 in the industry-standard one. That’s a $300,000 reduction in their estate required if they want to maintain spending at $123,500. Alternatively, if they wanted to preserve their estate level at $500,000, retirement spending would need to drop to $119,000 per year to maintain their confidence of 83% – that’s a vacation, or gift to a child, lost to taxes every year.
Suppose John and Mary decide they want to buy a vacation home in five years by paying $50,000 down and financing the remainder for the next 15 years. They want to maintain their goal of spending $123,500 in retirement, but they will reduce their estate goal to $350,000. Their advisor designs a plan that will accommodate a $255,000 vacation home in five years (it appreciates by 3% annually) with confidence of 83% of meeting or exceeding their spending and estate goals.
With the more common industry approach John and Mary’ 60%/40% portfolio with higher annual turnover and more short-term gains held to a confidence level of 83% would offer the couple a $182,000 vacation home, not a $255,000 home as before. Instead of a walk to the beach, they would now be driving.
It is clear that the tax drain caused by portfolio turnover is dear when measured in lifestyle. But what about simple dollar terms? The Fidelity Balanced Fund is currently the largest balanced fund in America. If John and Mary had owned this fund in a taxable account for the past ten years starting with their $500,000, they would now have $1,253,145. They would have also paid over $80,000 in federal taxes, according to Morningstar’s analysis. These taxes can largely be avoided with a more disciplined management focused on efficiently capturing capital market returns with low turnover significantly reducing taxes and expenses. Remember too, even if the Congress extends the Bush tax cuts another year, it is almost certain that capital gains will rise from 15% to 18.3% with the Obamacare surcharge. Taxes are becoming a bigger part of investment decisions.
It is unknown how or if our legislators will attempt to fix Social Security and Medicare. Both will require adjustments to our clients’ plans as we know more. One thing seems clear so far; any changes will likely be for people under 50. The idea is that this group has planned with specific benefits in mind and would not have time to replace lost benefits.
Social Security is expected to deplete its reserves by 2036 if there are no remedies. At that point the payments will be reduced to just the dollars received from those still working. It is anticipated that the system can still support roughly 70% of current levels if nothing is done.
Much remains unknown about our future, even that of next year. But despite it all, we don’t have to be manipulated by politicians in Washington or the media. We are confident in our clients’ ability to accomplish the things they value most in their lives for very good reason. We use a tightly integrated and robust system that is designed specifically for times like these. By controlling what we can of the investment process and planning for what we cannot, we help people accomplish significantly more with their lives and resources than they imagine possible.
Have a great weekend.