Compass October 2015

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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Spending vs. Asset Allocation

I have written before about the single most important question in investing. If I am allowed to ask just one question of an investor, it is this:

When do you want the money back?

If we can answer that question, many other pieces of the puzzle will fall neatly into place.

Fundamentally, investing is about giving your money to someone else to use for a while, and then getting it back some time later. Naturally, you want to get back more than you gave. Getting it back sometimes means in a lump sum and sometimes it means receiving it in dribs and drabs over time. retirement or endowment fund fits into this latter category.

In answering this question, we need to know when the investor wants the money back, and on what sort of schedule. A retiree will perhaps decide on a certain amount per month.

The fun part of investing, for advisors and investors alike, is picking the investments. The usual process is to first make an asset allocation decision. The asset allocation is basically a pie chart of how much goes in stocks, how much in bonds, and so on. Once that part is done, we then go about deciding exactly which stocks to buy, or which stock mutual fund, and so on with bonds and other asset classes.

The asset allocation — the simple pie chart — is widely considered the most important part of the program. The asset allocation decision has been shown to account for the vast majority of month-to-month variations in portfolio returns. The actual stocks and bonds purchased have much less of an effect over longer periods of time.

For a static portfolio that will be left alone (i.e., no withdrawals or deposits), this is all true. Asset allocation will be the ultimate driver of risk and return.

But this focus on asset allocation misses an important point. Sure, the asset allocation will have a lot to do with your risk, but the withdrawal rate’s effect is far greater. If an investor plans on withdrawing 7% of a portfolio’s value every year for a long time, the choice of asset allocation makes little difference. Whether invested 70% in stocks or 30% in stocks, the investor has about a one-third chance of seeing their real portfolio value cut by a third sometime in any given 20-year period. Even the safer portfolio with only 30% in stocks exposes them to a high level of risk.

Naturally, investors are encouraged to ignore such declines and stick with things for the long-term. But even longer periods don’t help much. Despite the higher historic returns to a 70% stock portfolio, ending portfolio dollar amounts will be within a 10-15% band compared to a 30% stock portfolio — even after 20 years — if the spending (or withdrawal) rate is high.

The spending rate drives the results in this example, not the asset allocation. If you are spending at a breakneck pace, your asset allocation decision is almost moot. You have a decent chance of running out of money in 10 years; you’re an odds-on favorite to be broke before 20 years. The asset allocation decision will not save you from yourself.

Since this is true, why don’t investors and advisors start the investment process by first establishing a prudent spending rate? You know the answer already – nobody wants to be told how much money they can spend. Not children; not adults. Instead, we investors tell our advisors how much we want to spend, and the advisor dutifully puts together the best investment program available.

In the current financial environment, it is unrealistic to expect stocks to return more than about 5-6%, even over a very long time horizon. Dividend rates are mired at 2%, and our nation’s gross domestic product can’t possibly grow faster than 3-4% for more than a few years at a time. For 200 years, it never has, and I don’t think it ever will. Despite their recent fast growth rates, corporate profits cannot and do not grow faster than the whole economy for very long. Add together dividends and growth and you get 5-6%.

Bonds are only paying 2-3% right now, so to expect any more than that over the next decade is downright irrational.

Mix some stocks and bonds together, and what does it tell us about spending rates from long-lived portfolios? It tells us that the traditional benchmark of a 5% annual spending rate is very risky. I would not be comfortable suggesting that a family plan to spend more than 3.5% to 4% of a portfolio that is expected to last for 20 or more years – such as an inheritance or trust. This is true whether they are conservative or aggressive investors.

The asset allocation decision cannot overcome the risk associated with a decision to spend too quickly.

Taxes are Optional

Contrary to the old saw about certainty and death and taxes, people expecting to leave large estates when they are gone have a choice about taxes. You can pay a lot of tax; you can pay a little tax; you can pay no tax. It all has to do with making choices while you are still young and alive.

Under current law for 2015, amounts exceeding $5,430,000 in a decedent’s estate are subject to a 40% Federal tax.

It is our guess that some form of estate tax is here to stay. With the federal budget deficit forecasted to exceed one trillion dollars over the next several years, more tax cuts are going to be nearly impossible to pass. In addition, there is a rather powerful and compelling lobby in favor of some form of estate tax.

Those supporting the estate tax include nonprofit and religious groups and a consortium of prominent wealthy Americans. Some of the wealthiest, including Warren Buffet, Bill Gates, Sr. and Steven Rockefeller, are among those opposed to a repeal of the estate tax. When Warren Buffet speaks, everyone listens.

It is not our trade to argue for or against various taxes. Our trade is to help people deal with taxes, generally by finding ways to pay the smallest amount. Actually, that is not quite true. What we really do is help people have the most money left over after they pay their taxes. That might or might not mean avoiding taxes.

When making plans for your estate, your options fall into a few neat little categories. The first step for most families is to have the surviving spouse inherit everything since there is no tax due. Generally, we are most concerned with the estate left by that second spouse since that is when taxes come into the picture. It is also when the heirs and charities start lining up at the lawyer’s office for checks.

The most basic and common choices in estate tax planning are:

Give It Away. Give to heirs while you are alive and to charities now and when you are gone. If the estate is smaller, there is less to tax. If the estate is less than $5,430,000, there is nothing to tax.

Life Insurance. Life insurance proceeds are not subject to the estate tax as long as the insured (i.e., the decedent) is not the owner of the policy. In a sense, this is really another form of Give It Away. You give money to your heirs and they use the money to pay for the life insurance. The net result is that money moves out of your estate while you are still alive. For a large estate, it takes a big policy and a lot of premium dollars to make a meaningful dent in the tax bill. Not surprisingly, insurance brokers just LOVE this second strategy.

Each of these options further digresses into myriad combinations and structures such as trusts, family partnerships, foundations, annuities and other sorts of solutions. But at their core, all conventional estate planning strategies involve transferring assets out of the estate in one way or another while the patriarch and matriarch are still alive. For example, you can give property away now, but receive the income from it for the rest of your life. You have reduced the size of your estate, but have retained an important income source.

What every good estate plan has in common is the estate owner’s willingness to make hard choices now, and the willingness to give up some control of current assets. The gift of a life insurance policy to an irrevocable trust means that the donor can no longer change anything about the policy, such as the beneficiaries. Some parents cannot handle that lack of control, and hence choose to pay taxes instead of passing assets to children or charity. Some parents are worried that their heirs will squander gifts made now, and so simply leave the assets to their heirs in their wills or through an ordinary living trust. Unnecessary taxes are paid, and the heirs still might squander the inheritance. At the root of this is a resistance to dealing with the question of one’s financial legacy while still alive.

If you choose to avoid hard decisions and will not make difficult choices today, you will pay estate taxes. If you choose instead to confront reality and give up a little control, you can reduce or eliminate estate taxes. The result of a smaller tax bill will mean more assets for your heirs or for your favorite charity or both.

Taxes are optional. The choice is yours.

Year-to-Date Index Returns (ending 9/30/15)

Total Market U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation (year over year)

-5.59%

-6.87%

-15.07%

1.79%

0.94%

0.20%

Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at info@creeksidepartners.com.