| Amidst Market Turbulence |
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In this issue, Paragon's advisors share insights, strategies, and potential tax opportunities that exist during these turbulent market and economic times. |
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| PARAGON Perspectives:
4th Quarter |
Greetings!
Oh, my goodness what has just happened? Over the last 6 weeks, we have witnessed the largest global economic meltdown since the Great Depression! Fortunately, unlike during the Great Depression, a global, unified financial infrastructure exists to correct the massive problems which caused the meltdown. As of this writing, it appears that we are seeing some of the rescue attempts gain traction and begin to restore functionality to the financial markets. We are extremely optimistic that before too long, this turbulence and the fear of long-term financial loss will be a distant memory! |
Increased Retirement Income for the Ultra-Conservative Investor by Jon Castle
 With the extended bear market of 2001 and 2002 still a painfully fresh memory for many retirees who lost significant assets, and the bear market of 2007-2008 a present reality, keeping a significant amount of their retirement nest egg in CD's sometimes proves to be an irresistible urge. The guarantees of bank deposits and CD's provide a feeling of security that many retirees don't wish to forego. Many of these retirees, feeling at odds with the mass media touting different investment philosophies on a daily basis, sit on the market's sidelines, wishing for higher interest rates so they can receive more income out of their retirement nest eggs.
It can be helpful to remember that for many years before the popularity of mutual funds, discount brokers, and online trading sites, most Americans relied on insurance products for their financial needs. I know, this philosophy may seem antiquated - and who likes to talk about insurance? -- but the guarantees and tax advantages of these products might be exactly what is needed for the very conservative retiree, given the recent craziness in both the stock and bond markets.
Let's take an example of Jim and Mary, 69 and 66 years old, who are several years into their retirement. Daily, they live with the nagging worry of enduring another significant downturn in the market. Understandably unwilling to take the risk of placing all of their assets into stocks and bonds, they have $500,000 of non-IRA assets in FDIC-insured CD's, using the interest earned to supplement their retirement income. Unfortunately, with increasing fuel prices and property taxes, they are now spending several thousand dollars more every year than they had originally planned. Disturbed by this fact, and painfully aware of the meager returns on their CD's, Jim and Mary slowly fall into "self-imposed retirement poverty syndrome" - an all too common tragedy where relatively well-off retirees deny themselves reasonable pleasures and luxuries they can afford - because they fear that they will outlive their money.
And their fears may be well founded. According to the Federal Reserve Statistical Release H.15, CD's provided investors with an average interest rate of 5.13 from 1986 - 2007. This rate fluctuated from a high of 8.7 in 1989 to a nearly unbelievable low of 1.02 in 2003. Jim and Mary, had they held the same $500,000 invested in CD's during this period of time, would have seen their CD's generate a peak annual income stream of $43,500 in 1989, and a very disappointing stream of $5,100 in 2003. Considering that few retirees have expenses that fluctuate exactly with interest rates, many of them would be pleased to find an alternative solution that provides a guaranteed, tax advantaged income stream for the rest of their lives - and has the added benefit of exceeding the average interest payments they receive from their CD's.
In this case, Jim and Mary purchase an insurance product known as a SPIA - a Single Premium Immediate Annuity. They use the $500,000 they have kept in CD's to pay a single premium to an insurance company, and in return, the insurance company promises to pay them a monthly paycheck for as long as either of them is alive. Based upon their current ages and an average of multiple quotes from various insurance companies using industry software, Jim and Mary will receive an annual income of approximately $34,140 per year until the last of them dies. Because of the laws governing the taxation of annuity payments, $21,840 of this is excluded from tax until the full $500,000 has been returned tax-free, giving them an guaranteed income stream of $30,696 after taxes (assuming a marginal tax bracket of 25%).
The annuity's guaranteed, tax-advantaged income stream, when compared to the fluctuating, fully taxable interest payments generated by Jim and Mary's CD's, can be quite comforting. At the time of this writing, interest rates on 2-year CD's are averaging 4.0 %, generating an annual income stream of $20,000 before taxes, and $15,000 after income taxes are paid. Jim and Mary, currently in retirement, have no real desire - or need - to await the possible return of higher interest rates at some unknown point in the future in order to live the retirement of their dreams when they can choose to guarantee two lifetimes of higher income now.
There are, however, potential downsides of using this strategy, and they lie primarily in three areas. First, the annuity payment quoted above offers no inflation protection. Assuming the rate of inflation remains at its 20-year average of approximately 3% throughout the remainder of Jim and Mary's retirement, it is likely the purchasing power of their annuity will gradually be reduced by nearly half over the next 20 years. However,there is a fix for this: Jim and Mary could choose instead to purchase their annuity with an inflation rider, which would reduce their initial annual income to approximately $24,760 (assuming they chose a 3% annual inflation increase) - but this payment would increase by 3% annually to $50,333 by Jim's age 94.
A second possible downside of this strategy lies in Jim and Mary's possible inability to meet unexpected emergencies or spending needs that may require a substantial lump sum payment. Generally, emergencies and unexpected expenditures have a nasty way of arriving in an unforeseen manner, so most financial planners would no doubt agree that if Jim and Mary choose the annuity option, they should not do so with all of their liquid assets, but rather should retain a portion for emergencies. It is important to note, however - that most SPIA products have a cash value that the annuity recipient can tap into in the event of emergencies like these.
The third potential disadvantage of the annuity option is that while Jim and Mary benefit significantly from the guaranteed, tax advantaged income stream that the annuity payout provides, their heirs may be left with nothing from the initial $500,000. If Jim and Mary are concerned about this possible outcome, and desire to leave a legacy, the most cost effective solution may be life insurance - on Mary. Since the annuity pays until both of them die, and Mary is both younger and female, the logical solution is to insure Mary as opposed to either Jim, or both of them.
Assuming she can qualify, an insurance policy on Mary's life provides the most cost effective solution. Again, using industry quoting software and searching multiple insurance companies, $500,000 of permanent life insurance on Mary would cost approximately $8600 annually if she does not smoke and is in average health, and would be less if she is in excellent health. While Jim and Mary might initially balk at the price of the insurance, an analysis of the numbers clearly indicates that this still remains the most cost effective solution if they desire 1) a guaranteed, non-fluctuating income stream for life, and 2) to leave the full $500,000 to their heirs at their deaths.
By utilizing the annuity combined with the life insurance, Jim and Mary guarantee themselves an after-tax income of $22,096, AND the full $500,000 remains income-tax free for their heirs. Should they choose instead to retain the CD's at average interest rates, they can expect to receive an after tax income stream of only $15,000 or so - and they still retain the uncertainty that the interest paid on their CD's will either increase or decrease throughout their retirement.
Perhaps the true value of this strategy cannot be measured in mathematical terms. While this strategy doesn't provide eye-popping returns, and isn't as exotic as investment accounts, it does provide a predictable lifetime income stream that they can plan on receiving, provides peace of mind, and Jim and Mary can spend their dollars without the nagging guilt that they are spending their children's inheritance.
Footnotes:
1 Annuity payments depend upon the claims-claims paying ability of the insurance company. All insurance companies searched were rated A or better by A.M. Best rating service. The industry software used to analyze the insurance premiums is WinFlexWeb. |
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Marking To The Market by Mike Carignan
 A family member recently asked me, "Why is Congress thinking about suspending Mark-to-Market rules?" His follow-on question was "Why would we allow banks to decide what the true values of their assets are? As I tried to explain it, I realized how difficult it is to understand what exactly "Marking to the Market" (MTM) means without putting it into terms we can all relate to.
Let's first start with the definitions of the term "Mark to Market:"
1. The act of recording the price or value of a security, portfolio, or account to reflect its current market value rather than its book (or expected) value.
2. In terms of mutual funds, MTM is when the net asset value (NAV) of the fund is valued based upon the most current market values of the assets it is holding.
So - in other words - your asset is valued based upon the most recent sale price of a similar asset - not what you can get for it if you hold it until better times.
Here's an example of how MTM might feel if it was applied to each of us individually. Imagine, for a moment, that you purchased a home in the summer of 2006 for $500,000 and financed all of it. You've never been late with a single payment and you have great credit.
Now, suppose your next-door neighbors are getting a divorce, and they sell their home for $350,000. You, still happy with your home, have no plans to sell - but here comes the surprise: Your bank calls you and demands $150,000 by the end of the week for the difference between your mortgage - and the recent sale price of a home similar to yours. If you don't pay by the end of the month, the bank will foreclose on your home.
How is this possible? You still have the house as collateral for your $500,000 loan, but your house has been Marked to the Market! You now owe the difference in cash! As most of us would agree, this would be a terrible situation on a personal level, yet it provides a good illustration of what is happening to many banks right now.
This example demonstrates one of the major challenges we have recently seen in the banking sector. Lehman Brothers failed recently, so I will use them as an example. Many people have asked, "How could they fail so quickly?" One component was MTM. All banks are required to keep a certain level of assets available for withdrawal, and if they fall below this required minimum, they must either raise the capital required immediately, or fail as did Lehman Brothers.
Successful investing often requires one to purchase and hold assets that you expect to appreciate over the long term, but will experience occasional short-term slumps. Unlike individuals, financial institutions are required to use recent purchases and sales as the basis for determining their liquid capital requirements. If there are no recent purchases or sales of assets similar to those they are holding, as in the Collateralized Debt Obligation market, they are required to use a "fire sale" or worst case scenario to value even their long term assets.
A temporary suspension of Mark to Market rules may be a great benefit to the financial sector, because it would allow the banks to value their assets similar to how your home is valued relative to your loan. Banks would be allowed to give long term assets a higher value than the market might indicate today, in expectation of their likely long-term return. This, in turn, would free up some of their cash to be loaned out to businesses and individuals and keep our economy from grinding to a halt.
With money flowing freely again, the economy can get back on track to working toward a recovery. The magnitude of the damage is still uncertain but as of October 10th the S&P 500 index had fallen over 30% from the close just five weeks earlier on September 2nd*. The uncertainty and panic of the last month have left the markets (and many investor's emotions) in disarray, but history shows that periods closely following a crisis have often been some of the best times to remain invested for long-term profits.
*The S&P 500 is a representative sample of 500 large stocks in the US economy and is considered representative of the behavior of the US stock market. It is not possible to invest directly in an index. Investment in any security involves potential loss of profit or principal. Past performance is not a guarantee of future performance.
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Year End Tax Requirements and Opportunities by Michelle Ash 
If you're anything like me, it feels as if 2008 just started a few weeks ago. And yet, here we are, nearing the end of the year. If the last quarter of the year goes anywhere as quickly as the first three quarters, it'll be here in no time. With that in mind, let me take this opportunity to mention both tax planning requirements, and opportunities, which must be completed no later than year's end.
First, let me cover a standard reminder. For those of you age 70-1/2 or older, Required Minimum Distributions (RMD's) must be met by year's end. Our office will soon be mailing you information about your required distribution and additional planning necessary to meet the requirement. Since the IRS's penalty for unmet RMD's is 50%, we strongly suggest those required to take distributions do so. If you have questions about what's necessary to meet your RMD's, or whether you need to take action, please contact our office.
Another opportunity that exists only prior to year's end is that of Roth conversions, an action in which one converts dollars from a Traditional IRA to a Roth IRA, which may be a very beneficial long-term strategy. While individuals converting dollars are required to pay taxes today on any previously deducted contributions and growth, once in the Roth IRA dollars grow tax-free. Future withdrawals from a Roth IRA remain tax free provided the IRS's 5-year/age 59-1/2 tests are met. Roth IRA's can be particularly helpful to retirees, since Roth IRA's are not included in Required Minimum Distribution rules. With a Roth IRA you can leave the money in it indefinitely - even into inheritance for your beneficiaries. Beneficiaries inheriting a Roth IRA are required to withdraw dollars based on their life expectancy, but withdrawals remain tax-free like they are for the original owner. For further considerations regarding conversion eligibility and benefits of this strategy, please contact your advisor.
An important opportunity this tax year may be that of a "tax harvest" in your portfolio. A tax harvest involves utilizing realized losses in a portfolio to offset realized gains. It provides an opportunity to sell appreciated assets that you may have previously held off from selling so as not to incur the capital gains taxes. Unfortunately the gains still have to be realized, but losses can be utilized to offset them. As an example, let's say Mary and Bob bought XYZ Stock 10 years ago for a total price of $5,000. Today these shares of XYZ stock have appreciated to $20,000. Mary and Bob have held off in selling XYZ stock because of the taxation on the $15,000 of appreciation, which at their current capital gains rate of 15% (the current maximum rate) would equal $2,250. Mary and Bob look at other holdings in their portfolio and are able to realize $15,000 in capital losses. By doing so, Mary and Bob are able to sell XYZ stock which they may have wanted to divest of, perhaps because they felt the holding wasn't going to perform as well in the future as it had in the past. Selling the positions with losses may also help them trim other holdings which they no longer find favorable. This strategy also helps them get beyond the capital loss carry-forward limitation of $3,000 per year.
As with any tax planning strategy, we recommend you coordinate such recommendations with both your advisor and your tax professional. Please contact our office if you'd like to discuss a year-end tax harvest strategy further.
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