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 IHA Monthly   
March, 2012  
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Market Commentary
February 2012 Asset Class Returns
Roth 401(k) Accounts
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History Speaks
There's More than One Way to Repay a Debt
The Greek government invoked a retroactive collective action clause last week forcing private bondholders to accept a compulsory restructuring, thus triggering credit default swaps on Greek sovereign debt. In other words, Greece has defaulted. Again. Greece has been in default approximately 50% of the time since 1820. Greece is also the home of the oldest recorded sovereign default in history, dating back to the 4th century B.C. when 10 of 13 Greek city-states stopped payments on their loans from the Temple of Apollo at Delos. Eventually those loans experienced an 80% writedown, not much different from where current Greek bonds are trading. In fairness, the Greeks were probably not the first nation to default. Knowing human nature and the nature of states themselves, we expect the first ever default occurred pretty soon after the first ever sovereign debt was issued. The Greeks at Delos happened to be more diligent about recording these things. Also, since the rise of fiat currencies, nations have tended to follow the model of another of the ancient Greeks, Dionysius I of Syracuse, when it comes to handling fiscal crises. Finding himself deeply in debt to his own citizens, Dionysius demanded his creditors bring in coinage equal to what they were currently owed. At which point he promptly took the coins, stamped the number "2" on them and returned the coins to their owners. All debts thus satisfactorily paid. Satisfactory to Dionysius anyway.
Dionysian Drachma, before "upgrade"
Market Commentary

InnerHarbor Advisors is a Manhattan based financial advisory firm specializing in: Financial Planning - Wealth Management - Insurance 
If you would like a fresh perspective on your finances, please contact John O'Meara or Michael Keating at 212.949.0494 ...or simply 'reply' to this email.

 

The hot start in risk assets continues as stocks in the U.S., developed international and emerging markets are all up between 9%-18% this year. Greasing the move has been the input of liquidity from central banks around the globe, most notably the European Central Bank's Long Term Refinancing Operations (LTRO).  In late December and then in February these operations issued $1.3 trillion in three year, low interest loans to European banks. This helps solidify the funding of the banks directly as a significant amount of those funds effectively lengthened the terms of existing ECB loans to those banks. LTRO is also a backdoor approach to addressing the soaring yields in some European sovereign debts as the banks can earn a significant carry by using the cheap ECB money to buy those debts. This has helped calm the market for Spanish and Italian sovereign debt.

ItalySpainSpread

LTRO sounds familiar because it's comparable to the Fed's quantitative easing (QEI and QEII) programs. In those the Federal Reserve bought U.S. treasuries and mortgage backed debt from banks, driving down interest rates and fueling a rally both times in equities and commodities. The ECB is restricted from acting as directly as the Fed due to lack of fiscal or political union in the Eurozone, but by flooding banks in the area with cheap funding they can expect banks to search for higher yielding instruments to invest that money. Euro sovereign debts are an obvious destination and local governments will undoubtedly be applying discrete, and not so discrete, pressure on the banks to buy their bonds. The comparison to the Fed's QE programs also brings to mind that they both ended poorly for the U.S. stock market. The first program ended March 31st, 2010. The S&P lost over 11% the next three months:

 

QEII ended June 30th, 2011, quickly followed by a 14% loss:

QEII 

So for now the European sovereign debt issues are off the emergency screen and have survived the official declaration of a Greek default by the ISDA. However, it remains to be seen if the recovery in Italian and Spanish bonds is the real deal or an artifact of the increased liquidity provided by the ECB. And the recovery seen in those larger nations has not been sustained in Portuguese bonds which have faltered leading up to the Greek bond restructuring.

PortugalYield

Portuguese 10 Year Government Bond Yield

Source: www.bloomberg.com                                                          

Our opinion is that the Euro zone has stretched out the whole Greek crisis to such a point that the market has completely priced in the effects its default would have across the rest of the zone. We do not feel markets have been similarly prepared for a default in any of the other member nations. While the LTRO's have helped buy some time, the Euro currency members will still have to come to terms with the structural chasm between their Teutonic north and Latin south. 

The ECB has been joined by central banks from many of the largest developing nations in recent weeks; Brazil continues to cut rates, China has made cuts in its banks reserve requirement even as the yuan depreciates against the dollar. The result has been a strong start of the year for emerging markets as shown by this year-to-date performance chart for the BRIC countries.

Q1 Bric's

This is a welcome departure from 2011 when these countries significantly underperformed the U.S. market.

In the U.S., we have seen a firming of some economic data, particularly on the labor front with the February jobs report indicating a gain if over 200,000 jobs and upward adjustments to previous reports. Obviously, sustained job growth would be a huge boost to consumer spending, housing and the economy in general so we hope to see that continue. The gains in commodity prices that accompany this data is less welcome, particularly oil prices which are approaching all time records for sustained high prices. Poor macro trends such as this and poor trade data have caused a few Wall Street banks to lower their projections for first quarter GDP even as employment seems to be firming. We think it is unrealistic to expect more than short periods of outsized economic (or job) growth as we still see structural headwinds such as household and, coming soon, public deleveraging limit the upside.

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Asset Class Returns

Through February 29th, 2012 - Monthly and 52 week returns for major asset classes. Performance information is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.    

AssetReturns.2012.02.29

The strong start for international equities continued in February with both developed and emerging markets up nearly 6% for the month. This was driven by better sentiment in Europe, demonstrated by the 200 basis point decline in Italian government 10 year bond yields, and continued easing by central banks, from the ECB to Japan to China. Government bonds were flat to slightly down for the month but remarkably unvolatile given the rally in bonds.

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Financial Planning Highlight

401(k) Roth
 
Companies have had the ability to allow employees to make Roth contributions to their 401(k) accounts since 2006. The takeup by employees has been relatively low however, with approximately 10% of plan participants who have the option of enrolling in a Roth 401(k) doing so. In this month Financial Planning Highlight we will review the ups and downs of utilizing the Roth feature in your retirement planning.
 

Roth vs Regular 

First a review of the difference between a Roth and regular 401(k) account. A traditional 401(k) plan allows employees to contribute $17,000 (2012 limit) of their income to their account. This money is exempt from federal income tax in the year of contribution but withdrawals are taxable in the year they are made. A Roth 401(k) has the same contribution limits but the contributions are not  deductible in the year they are made. However, withdrawals from Roth 401(k)'s are also not taxable.
 
Choosing Between the Two
One of the prime considerations in choosing between a Roth and regular 401(k) plan is estimating what your future income tax rates will be relative to your current rates. If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). This is likely to be the case with young people who are just starting their careers or those who expect to be generating high incomes in their retirement years, due perhaps to a generous pension plan or high net worth.  If you are in your peak earning years, on the other hand, and you figure your tax bracket will be lower in retirement, the current tax benefit from traditional 401(k) contributions may outweigh the benefits of a Roth in retirement.
 
Another group of people who might consider the Roth option, regardless of their current tax bracket, are those looking to maximize their retirement income. Because the withdrawals from a Roth are tax free, all other things being equal, the Roth will maximize the spendable income you have in retirement. To illustrate, let's look at the situation of a 66 year old  with $1,000,000 in a regular 401(k) account. Assuming she would like $40,000  in income from the 401(k) and that she is getting an average social security payment, it is a safe bet that she will be paying at least 15%-25% income tax rate on her retirement plan withdrawals. In other words, that $40,000 translates to $34,000 or less in spendable income. If the account were a Roth, she would have the entire $40,000 in spendable income.
 
What is the Cost?
Within your qualified retirement account, there is no cost to switch to the Roth option. Where you feel the effect is in your current cash flow because a Roth contribution has to be paid for with aftertax dollars. So if you are currently in a 35% marginal tax bracket (very easy in the New York area) and contribute the maximum to your regular 401(k) account, the actual cost to your cash flow is $11,050; $17,000 contribution -  ($17,000 * .35  = $5,950 in tax benefits) = $11,050. If you want to maximize your Roth 401(k) contribution the cost is the full $17,000.
 
For an excellent tool to compare the effects of a  Roth 401(k) contribution to a regular 401(k) contribution on both your current cash flow and your retirement income please check out Charles Schwab's online calculator.
 
 
 
Thank-you for reading,

 

John O'Meara, CFP, MS
and
Michael Keating, CFP
  
  

 

As always, we welcome your comments on style and content.

 

Mike and John InnerHarbor Advisors 


Contact Info:
InnerHarbor Advisors, LLC
212-949-0494
j.omeara@inneradv.com and m.keating@inneradv.com

Website:
www.inneradv.com