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 IHA Quarterly
April 2010 
In This Issue
First Quarter Commentary
Asset Class Returns
Roth Conversions
What We Have Been Reading
What's New
Quick Links
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 History Speaks
On April 10th the New York State legislature passed "An Act to Prevent the Pernicious Practice of Stock-Jobbing, and for Regulating Sales at Public Auction." 
That was April 10th, 1792 of course. The act banned the public auction of securities and specifically outlawed certain futures and derivatives transactions. It was in response to a financial crisis that had struck in February and March of that year as the share prices of the Bank of New York and other financial institutions collapsed 25% in two weeks time.  A direct result of the legislative act was the signing of the Buttonwood Agreement, an arrangement between 24 brokers and merchants to effectively circumvent the law against publicly traded securities by only trading with each other.  That trading club is better known today as the New York Stock Exchange. So as Senator Dodd and his cohorts in Washington attempt the newest fix to the financial system perhaps they will give some thought to how their actions are less likely to stop malfeasance on Wall Street than direct its flow on another path.
Market Commentary
Let's get right to it: U.S. equities were best in class -returning over 5%- as most worldwide indexes rallied following a slow start to 2010. Two major economic indicators showed modest improvement with GDP (after adjustments for inventories) turning positive and the government's broadest measure of total employment, the CPS survey, showing job growth in each of the last three months. There is a new twist in the Wall Street vs. Main Street story as rising financial markets could lead to a broader economic recovery with the economy picking up steam throughout the year.

For the next few months financial markets should have some positive momentum as economic conditions have improved, corporate earnings have been rising and the year over year comparisons are still relatively benign. At the same time we see very little evidence of inflation..
However, calling an end to the recession now seems to us like declaring victory at halftime. As we explain in this section of The IHA Quarterly- signs still point to debt loads as the biggest headwind to worldwide economic recovery.
Sovereign Default
We are back on Greece with apologies to our Hellenic-American readers. European markets were weighed down by the crisis surrounding Greece's financial condition. As things currently stand, the European Union in conjunction with the International Monetary Fund has promised emergency financing of up to $60 billion dollars in the event Greece cannot obtain funding in the open market. At the time of publishing Greece had not tapped that financing. We expect they will very soon but we believe it will not be enough. It is very difficult to both cut current deficits and grow an economy at the rate needed to pay the debts. The ultimate decision in Europe will be whether or not the richer northern countries provide outright aid to their more spendthrift southern brethren. Germany would pay the largest price in any bailout with their press comparing it to picking up the tab for someone else's party. Of course the aid would not be an act of charity but an effort to protect the Euro currency and the market it has provided German and French goods, as well as protect European banks which hold billions of bonds issued by Greece, Portugal, Ireland and Spain. We think the answer sometime in the next year or two will be an effective default by Greece as the rest of Euroland decides to sacrifice them in order to place a firewall around their next weakest members. While many countries are in poor fiscal shape, Greece is truly an outlier in terms of its total debt. Default would be extremely painful in the short term but offers the best chance for Greece to quickly rise again to world prominence.
Back Home
While the total debt owed by Greece is impressive they should really come across the Atlantic to learn how to mismanage their budget. California and Illinois alone are over $10 billion in the red this year and expect even larger gaps for the next fiscal year. Most states including New York have postponed addressing budget problems in the hopes of a rapid economic recovery or have used stimulus money to bridge their funding gap. If this strategy of delay and pray does not work out there will be increased demand for the federal government, already saddled with debt and deficits, to step in and provide aid to the states. Which calls to mind an interesting fact: at times over the last month the U.S. government has paid higher interest for some debt issuance than private corporations. We think (hope) that debt is becoming the four letter word in American politics and believe that only a deep worsening of the economy would result in another significant round of federal stimulus.

The global recession was ignited by the collapse in U.S. property values. We still believe losses from the bubble years must first flow through the banking system before we can experience strong economic growth. Following up the previous IHA Quarterly, housing prices have stabilized over the last few months in large part because of the record low mortgage rates through government intervention- including $1.25 trillion in purchases of mortgage securities by the Federal Reserve. (See the chart below to help put rates in historical perspective)
30 Year Mortgage Rate History 
The Fed ended the purchase program in March and thus far rates have continued to stay low, an obvious plus for the housing market. In an era where strategic defaults have become an option for large swathes of homeowners across the country, the banking system has no desire to see what would happen if rates rise as little as 1%. At the same time, banks are under pressure from Washington to aggressively write down the principal on mortgages and home equity loan, which would load banks with large losses. 
The threat posed by sovereign debt loads and banking instability leave us in the position where we are happy to see the economic improvements that are occurring but we will wait a little longer before lauding the demise of the Great Recession.
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Asset Class Returns
1st Quarter 2010
Performance information for asset classes is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.
Asset Class Returns Q4 2009 
Financial Planning Highlight
 Roth Conversions
By far the most common questions we have received on retirement planning have to with the ultra-mysterious topic of converting traditional IRA to Roth IRA. If you are grappling with the decision to convert or stand pat, we are here to help. We have condensed much of the noise down to a few paragraphs and have even included links to two nifty calculators to save you from crunching the numbers by hand.
The origin of the confusion is the tax law change removing income considerations from a person's ability to convert a traditional IRA to a Roth IRA. Now anyone can do it. A further benefit to those who convert in 2010- you can defer the conversion income, applying it in two equal installments in tax years 2011 and 2012.
Four main points to be aware of before we get started:
  • The biggest is that you must have enough money outside your IRA to cover the tax bill for the conversion.While you can technically use the IRA assets for this purpose, we see no advantage to converting if you do so.
  • If you do not need your IRA assets in retirement and plan on leaving them to your heirs then it is probably worth converting to a Roth.
  • If you have reason to believe that your tax bracket in retirement will be higher than your current bracket then it is most likely better to convert. 
  • Finally, make sure you have enough time to recoup the upfront cost to convert. 

Traditional or Roth, What is the Difference?
Your money grows free of both income and capital gains taxes once it is in either retirement account. The chief difference between the two is tax treatment of your money at the time it goes into and comes out. A traditional IRA acts much like a 401(k) in that your contributions are not subject to income taxes but withdrawals are considered taxable income. Conversely, your contributions to a Roth are made with after tax dollars but the distributions are tax free. Another notable difference is that you will be required to take minimum distributions from a traditional IRA after age 70 whether you need the money or not. No such requirements with your Roth. 

Decisions... Decisions
Should You Convert a Traditional IRA?
The short answer is ... maybe. The decision involves weighing your tax cost of today with potential benefits that might not occur for decades. The amount of projection involved means a lack of an easy yes or no. We will highlight a few of the advantages, costs and unknowns regarding the conversion.
The Good

The largest benefit to having a Roth is the possibility of tax-free income during your retirement. This is obviously a huge advantage if you expect to be in high marginal tax bracket upon retirement or if you are worried about significant overall tax increases between now and retirement. Keep in mind that since the degree of taxation on Social Security benefits (that's right, Social Security benefits are taxed) is dependent on your other sources of retirement income, a Roth can lower that tax bill as well since it does not constitute retirement income. A Roth also allows greater flexibility in your IRA distributions. You might require a large distribution in certain years during retirement to pay for a medical emergency, an investment opportunity, or as a gift to child or grandchild. Traditional IRA distributions count as income for that year and large withdrawals could easily move your marginal tax rate to a high level. Also for estate planning purposes, if you will not need income from your IRA during retirement a Roth is one of the best assets to leave your heirs because the asset avoids probate and withdrawals are still tax free.
The Bad
You have to pay the taxes now. It is our belief at InnerHarbor that you should not pay a penny of tax sooner than necessary and conventional financial planning looks for opportunities to defer taxes not pay them upfront. With a Roth conversion you are making a presumption that the upfront price is worth the benefits you will get down the road. If you are in a high tax bracket currently you will be paying a high price for these projected benefits.  A lower than anticipated tax bracket during retirement would call the benefits of your conversion into question. 
The Unknown
What will your tax rate be in retirement? How about in 2011 and 2012? What will be your rate of return until retirement? What tax rate will you be paying on taxable investments until retirement? Where will you reside during the golden years? Making general assumptions on these questions can be a mistake. Many people suppose they will be in a lower tax bracket upon their retirement but this is not always the case.  Gone for most of us will be deductions for local income taxes and mortgage interest. The possibility of overall tax rate increases could mean paying the same or higher taxes on lower income. Forgive our skepticism in these final sentences but please take a moment to consider the security of the tax free status of Roth IRA distributions- the largest assumption of all. While it seems unlikely to us the US government will revoke this provision anytime in the near future, we can picture a tempting scenario where the gains accumulated in a Roth are subject to taxes. Congress could also apply a formula similar to Social Security benefits where distributions above a certain amount are taxed.
Broadly speaking, we are in favor of Roth IRA's due to the flexibility they promise in retirement. If you have enough money outside your IRA to pay the taxes it is certainly something to be considered. We invite you to stop in to see us or call our office to talk through your decision.

Now Try These Calculators...

The links below are to online Roth conversion calculators that will further assist you with your decision. You can play around with factors such as rates of return, time in retirement and tax rates to give you the feel for when a conversion makes sense. 
What We Have Been Reading  
The 15 Money Rules Kids Should Learn
After you teach them to your children perhaps you might have a word with Congress
A graphical representation of the rise in unemployment in the U.S. 
 "The Distilled Spirits Council said the lowest-priced segment in vodka market grew the fastest." An excellent  interactive guide to deflation in the economy.
Basically women are smarter, more educated and have higher income potential than men. In case your wife had not told you.
The Benefits of Tax Shelters 
No, not the illegal kind. Five advantages to 401(k)'s and IRA's you might not know. 
What's New With Us 

We have started launching personal websites for our clients that give a private and secure connection to all their finances. For a short video on some of the features please click here.

Mike and John InnerHarbor Advisors

Contact Info:
InnerHarbor Advisors, LLC
212-949-0494 and