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The S&P 500. It’s been a great 10 years. Don’t expect a repeat.

evanhall — Wed, 15 May 2024 11:00:52 +0000

Updated: May 15

The S&P 500 (the ‘S&P’) has been on a tear in recent years. During the 10-year period ending March 31, 2024, the S&P averaged 13.0% per year (including dividends). That is a great return. With the exception of the NASDAQ, it’s beaten nearly every benchmark out there. As we noted in a year-end letter to clients in December: “Consequently, any equity portfolio holding something other than US large cap stocks has likely not performed as well as the S&P. That has been the curse of diversification over the past few years.”

So, what happens next? Why not just put everything into the S&P today? It’s done so well, right? It has. And that’s kind of the problem.

Because it’s done so well recently, the odds of a repeat performance (another 13% per year for the next ten years), at least in our view, are low. In fact, I think a reasonable expectation for what we’ll get over the next 10 years (starting on April 1, 2024) on the S&P is somewhere between 4% and 7%. I’ll explain why below.

But first, some background.

Stock returns (whether an individual stock or an index) come from the combination of three things:

Dividends
Growth in earnings per share, and
The change in the valuation attached to those earnings, measured by the change in the PE ratio

That third item, the PE ratio, requires a bit of explanation. The PE ratio is just the current price divided by the last 12 month’s earnings. It can be affected by a variety of things (e.g., market psychology, interest rate expectations, perceived business risk) but generally interpreted as the market’s expectations for future earnings growth. If the PE ratio is high, growth expectations are generally high. If the PE ratio is low, growth expectations are generally low.

The PE ratio is kind of the wild card in our little returns equation above. When it goes up, it helps returns and when it goes down it hurts them. There’s a catch though. the PE ratio cannot go forever up or forever down. It moves in a range. And it tends to be mean reverting.

Over the long term, what the PE ratio giveth, the PE ratio tend to taketh away (and vice versa, of course).

So, what did the S&P PE ratio do over the past 10 years? It increased from about 18 to about 27[1]. That helped returns a lot. In fact, I estimate that about one third of the 13% return on the S&P over the past 10 years came courtesy of that increasing PE ratio. Not dividends. Not earnings growth. Just increasing valuations.

The PE ratio has been in giveth mode over the past decade.

Here’s why that’s not likely to continue:

Remember our formula above: returns = dividends + earnings per share growth + PE ratio change (this sum is not exact due to the math of compounding, but I’ve corrected for that in my calculations). Let’s use that formula to see what the PE ratio would have to be 10 years from now to get another 13% per year return over the next decade starting April 1st this year.

The current dividend yield on the S&P is about 1.4%. That’s a reasonable estimate for what we should expect from dividends over the next 10 years.

The S&P’s earnings per share (including inflation) grew a bit less than 7% per year over the past decade so let’s assume we get 7% over the next 10 years (which, incidentally, would be very good – I’ll return to this point at the end).

Add those two and you would get returns of about 8.4% over the next decade. But wait, we want 13%! That means we need an increasing PE ratio.

To get 13%, the S&P PE ratio would need to go from about 27 today to about 41 ten years from now. How likely is that? The only time the S&P PE ratio has been above that in the past 35 years is in the aftermath of the tech bubble in the early aughts and the aftermath of the Great Financial Crisis in 2008-2009.

What if, instead, the PE ratio goes down over the next 10 years? Let’s say it comes back to a more normal-ish value of 20 ten years from now. If that happens, your total return over the next 10 years on the S&P would be about 5.2%. By the way, I picked 20 because about 70% of the time over the past 35 years it’s been between 15 and 25.

Now, could PE ratios stay higher for the long term? Of course. There are good arguments for this (think tech-enabled business models here: less capital intensive, higher return on equity). But assuming they stay higher is a bet against history. Who wants to take those odds?

Let’s look at another measure. Check out the following chart of the Shiller Cyclically Adjusted PE ratio over the past 20 years. The Shiller PE is a widely used modification of the traditional PE ratio meant to average out the short-term noise of earnings volatility associated with business cycles. Like the normal PE ratio, the Shiller PE moves in a range (i.e., it doesn’t go up or down forever, and it tends to be mean reverting).

Note where the Shiller PE is as of March 2024 compared to where it was 10 years ago. It’s increased from about 25 to about 34. Over the past 140 years or so (yes, 140 years), the Shiller PE has been higher than it was on March 31, 2024 on only two other occasions: in 2021 and in the late 90s tech bubble (not shown in the chart).

What would the Shiller PE ratio have to be 10 years from now for us to get another 10 years of 13% annual returns from here? Let’s use the same assumptions as above: dividend yield of 1.4% and earnings growth of 7%. We also have to make an inflation assumption for the Shiller PE ratio calculation, so I’ve assumed 2.5% per year.

Based on my calculations, to get 13% over the next 10 years would require the Shiller PE ratio to hit about 50 ten years from now.

It’s never hit that level. Not in 140 years. Not even in the 90s tech bubble (which was the highest it ever hit). Still, is it possible? Yes. Is it likely? Do I need to answer that?

What if the Shiller PE ratio comes back down to something a little more normal (by recent historical standards)? Let’s assume it’s at 25 ten years from now. If that happens (and using the same dividend and earnings growth assumptions from above), the total annual return on the S&P over the next ten years would be about 5.5% (very close to our estimate using the normal PE).

At this point, it might be tempting to say, ‘well, fine, I get that valuations are high, but I think earnings will grow faster than 7%’. Maybe, but I think that’s unlikely also. Corporate profits are a component of GDP and those are already near historically high levels as a percent of GDP. To have those grow faster, you need GDP to grow faster and/or to have profits become an even greater proportion of GDP. Seems unlikely.

If you’d like just one more data point to chew on, consider this historical tidbit: over the past 30 years, if we look at all of the periods in which the S&P returned 12% or more over any consecutive 120 month period, and then, for those periods, look to see what the S&P returned over the next 10 years, we find the following: the average annual return for those subsequent periods was just 1.6%. And the very best was 7.7%.

The S&P had a great run over the past decade. Just don’t expect a repeat.

To be clear, I’m not saying it can’t happen. Just that it’s not likely.

You know, math and history and all.

[1] I’ve used estimated earnings per share for Q1 of this year (source: S&P) in all calculations since actual results for Q1 have not yet been fully reported.

Disclosures:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index. Past performance shown is not indicative of future results, which could differ substantially. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Setarcos strategies are disclosed in the publicly available Form ADV Part 2A.

Setarcos Wealth Advisors LLC (“Setarcos”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at setarcosllc.com.

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The Two Types of Taxpayers

evanhall — Wed, 17 Apr 2024 11:00:44 +0000

Effective tax planning is an important component of building wealth and is generally split into two time periods: near-term (i.e. the current tax year) and longer-term (beyond the current year). Near-term tax planning is primarily focused on minimizing your current tax liability and avoiding surprises and penalties at the tax deadline. Longer-term tax planning is primarily focused on strategically minimizing your taxes over your lifetime, even if it results in paying more taxes in the current year.

Another aspect of near-term planning is managing your federal and state tax liabilities through your withholdings and/or estimate tax payments. How you actually pay them depends on how you feel about managing your obligations throughout the year and your comfort with surprises come tax time. In general, this tends to push taxpayers into one of the camps when it comes to paying taxes throughout the year.

Those with a preference to avoid negative surprises and penalties (most, but not all taxpayers)
Those whose preference is not giving the IRS an interest-free “loan” (and may not care too much that they may owe taxes and penalties at the deadline)

Most taxpayers don’t like a “negative surprise” when they file their taxes, obviously. There are a lot of reasons why you may find yourself in this unpleasant situation. A common reason is that you may not be withholding enough taxes from your paycheck. This issue is particularly acute with equity compensation such as Restricted Stock Units (or RSU’s) since the federal statutory withholding rate is a flat 22%, which could be much lower than your marginal tax rate of 32% or 37%. Another reason is not withholding taxes for portfolio income (dividends, capital gains, etc.).

Often an unexpected tax liability will also include a penalty for not meeting the required quarterly tax payments. Just because you’re withholding taxes regularly doesn’t mean you’re withholding enough to avoid penalties (you can read more about estimated tax payments here).

Penalties accrue based on required quarterly payments, and while often not significant in dollar terms, penalties can be a source of frustration, akin to getting a parking ticket. However, there is another way to look at penalties. If you think of a tax penalty as a “convenience fee” for keeping your money longer (and possibly earning interest), they can seem much less punitive. Some taxpayers prefer this approach.

You can also have a “positive surprise”, meaning a large refund. A common reason is your tax advisor (or tax software) instructs you to pay the “safe harbor” amount based on last year’s tax liability (generally, either 100% or 110% of the prior year amount, depending on your situation) to avoid penalties. This amount could be much more than this year’s liability; thus, unknowingly paying in too much. While almost everyone prefers a refund versus owing more, again, some taxpayers don’t like to tie up their money with the IRS. And, with the recent spike in interest rates, “loaning” your cash to the IRS is getting more costly.

In an ideal situation, a taxpayer withholds enough taxes quarterly (or makes estimated payments) to avoid penalties and knows the amount of any additional tax due in April. However, tax obligations can change significantly from year-to-year making perfect foresight difficult (if not impossible). Since managing your taxes well can be time consuming and costly, tax preparers will usually keep calculations simple and conservative to avoid negative surprises. Unfortunately, that may still result in a negative surprise though, to the chagrin of the first type of taxpayer, or a large refund, to the chagrin on the second type of taxpayer.

Wealth advisors, however, are uniquely positioned to help both types of taxpayers manage their tax payments as well as strategically plan for both the near and longer-term. These types of advisors typically have not only experience with and knowledge of taxes, but they manage your financial plan and take a more comprehensive view of your overall financial health. In addition, wealth advisors can coordinate with your tax preparer to ensure accuracy and consistency with their tax filing approach.

Give us a call the next time you’re thinking about taxes. We’re ready and willing to help.

Disclosures:

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Bye, Charlie

evanhall — Thu, 30 Nov 2023 11:00:34 +0000

The first time I heard Charlie Munger’s name was in the late 90s. I was working at an actuarial consulting firm starting to develop an interest in financial markets and investing and someone said, ‘hey, you should check out Warren Buffett and read his shareholder letters’. I did both. Warren had the spotlight, but he talked about Charlie in every letter. He was hard to ignore. For the next few years, though, he was just a name to me. Warren’s ‘sidekick’ and Berkshire’s vice chairman. I didn’t pay much attention to him. That all changed a few years later.

In the early 2000s, I decided to start attending the Berkshire shareholder’s meeting in Omaha. If you’ve never been or seen clips from the meeting, Warren and Charlie sit side by side at a table in front of thousands of shareholders and answer questions (not provided to them in advance). Warren speaks first (unless the question is directed at Charlie) and then, most often, asks Charlie if he has anything to add.

That was the first time I heard Charlie speak. Warren is brilliant. Charlie might have been smarter. Warren would give long, insightful responses to each question. Charlie, if he offered a response, was brief and answered with piercing insight. His responses were to the point and perfectly reasoned. He would quote Marcus Aurelius in one response and then apply the laws of thermodynamics in another. I was in awe.

After that, I started paying attention to Charlie. I read everything I could from him and about him. I started paying attention to the Daily Journal annual meetings (in which he also answered shareholder questions for hours). I read old transcripts from the Berkshire meetings. And, like my experience reading Warren’s letters, my mind expanded again.

Like so many in this business, Charlie, along with Warren, has been a mentor to me. Odd to say about someone you never met, but at least one definition of a mentor is ‘an experienced and trusted advisor’. That fits.

I’ve learned a ton from Charlie over the years, both about how to be a thoughtful steward of our client’s wealth and about how to make myself a better person. How lucky to have had someone like this in our orbit for so long.

I will miss his wisdom and guidance, but I’m grateful for everything he left behind.

Disclosures:

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The Tax Benefits of Donating Appreciated Stock to a DAF

evanhall — Mon, 05 Dec 2022 18:00:23 +0000

Updated: December 5, 2022

Donor Advised Funds (or DAFs) are an increasingly popular way to make charitable donations to 501(c)(3) organizations. The reasons for their popularity include:

Being able to donate to the DAF today and recommend which charity (or charities) receive the funds in the future
Receiving a charitable tax deduction in the year that you give to the DAF, not in the year that you distribute the funds to the charity (note: in order to utilize the deduction, you must itemize your deductions rather than take the standard deduction)
Investing undistributed funds while they remain in the DAF
Last, by not least, there can be significant tax advantages when you donate appreciated stock rather than cash to your DAF

Regarding the last point, let’s look at an example. We’ll assume you bought a share of stock for $50 and you held it until it reached $100 today.

Also, we’ll assume the highest marginal tax rates apply:

Federal ordinary income of 37%
California state income state of 12.3% (applicable to both ordinary and capital gains)
Federal long-term capital gains of 20%

Federal investment income tax (ACA tax) on sale of stock of 3.8%

When you donate to charity (or a DAF) you receive a tax deduction in the amount of the donation. You receive the same tax deduction whether you donate $100 of cash or a $100 of stock. However, when you donate appreciated stock, you never pay the tax on the capital gain, which is why donating appreciated stock is usually better than donating cash.

Let’s compare the two options using the assumptions.

As shown in the table below, donating $100 cash (Option 1) will actually cost you $50.70 since you save $49.30 in taxes from the charitable tax deduction. But what if you donate $100 of the appreciated stock (Option 2)? You still receive the same charitable tax deduction, but you also avoid the tax on the capital gain of $18.05. When you add those two benefits, the cost of donating the stock goes down to $32.65. The difference is the result of avoiding the capital gains tax!

Now, what if you assume you donate stock that has appreciated less and lower marginal tax brackets? These assumptions would reduce the tax benefit of donating the appreciated stock. But the larger point still remains: donating appreciated stock is usually more tax efficient than donating cash because you’re avoiding the tax on the gain (assuming you don’t exceed the limitations on stock donations).

You can read more about DAFs here. Let us know if you’d like to further discuss all the benefits of opening a DAF and/or gifting strategies to maximize the tax benefits.

Disclosures:

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Is the Fed Doing the Right Thing?

evanhall — Wed, 09 Nov 2022 18:00:30 +0000

I can’t tell you how many articles, blog posts and essays I’ve read on this topic. The majority seem to be pretty critical. And I get it. The Fed was slow to recognize inflationary pressures that were building and now they seem to be taking a sledgehammer (primarily, short term interest rate increases, but also forward guidance [essentially telling the market what they’re going to do] and balance sheet normalization [essentially a reversal of quantitative easing]) to the problem. Although, in all fairness, a sledgehammer is really the only tool they have. And they do have a mandate to fulfill (maximum employment and price stability). So, you give an entity a tool and mandate and tell them use the tool to fulfill the mandate and guess what, they’re going to do it.

Most of the criticism seems to be that they’re doing too much too quickly because (a) inflation is already peaking and they’re behind the curve again and/or (b) their tools generally affect aggregate demand whereas, the critics say, the current inflationary spike is primarily caused by aggregate supply constraints. Maybe, but supply constraint driven inflations tend to also increase unemployment (giving you stagflation) which clearly hasn’t happened (yet, anyway). In any event, we won’t have a verdict on this criticism of the Fed’s actions until after the fact.

Contrary to the criticism, though, I think there are clear reasons for their forceful action now including one in particular that does not get a lot of attention in the popular media.

Before we dig into that, let’s pause here for context on why the Fed’s actions now even matter. When the economy is relatively stable (i.e., not now), we really don’t pay too much attention to the Fed. Why? Because if you look at the data, the Fed’s actions (again, during normal times) generally don’t strongly correlate with subsequent market returns. In other words, although it makes headlines, it’s usually just noise. In fact, Warren Buffett once said “If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, I wouldn’t change a thing.” Point being, there’s usually not much use in hanging on to the Fed’s every action and word.

But inflation makes things different. High inflation is one of the most corrosive, value-damaging forces in economics. To see an example, just go back to the 1970s. As background, the inflationary spiral back then actually started in the mid-1960s and was accompanied by multiple demand shocks: a large tax cut, significant increase in military spending, enactment of Medicare/Medicaid. In addition, there were significant supply shocks, most notably the 1973 oil embargo. Nixon officially ended gold convertibility in the early 1970s, which was the last vestige of the gold standard (although, contrary to some beliefs, this was more a casualty than a cause of inflation at that time). The point is, there were a lot of inflationary pressures on the economy.

Unfortunately, the Fed, at that time, did not do its job. Between 1965 and 1978, there were two fed chairmen who presided over the economy and neither one appeared to have the fortitude to press hard against inflation. They would raise rates but then pull them down when unemployment ticked up. In addition, the Fed was less independent then than it is now and often appeared to cave to pressure by the White House to ease conditions when the economy appeared to slow down. Because of this, the expectation of high inflation became embedded in the national psyche.

And when inflation expectations go up, you’re in trouble.

When people and businesses begin to expect higher inflation, they make decisions that essentially cause higher inflation. Purchases are accelerated, wages are increased at higher rates, inventories are built up. All increasing prices. Hence the 70s and the economic carnage that resulted. In 2001, Warren Buffett wrote about one victim of this period: the Dow. As he notes, between December 31, 1964 and December 31, 1981 the Dow moved one tenth of one percent… not per year, that was the grand total price gain during that 17 year period. Yeah, inflation is bad.

And so today the Fed is on an inflation-fighting mission with its sledgehammer. And a big part of that is making sure expectations stay in check. Where do expectations sit today? So far, at least, the 10-year expectation appears to be relatively well-anchored around 2.5% (source: 10-year breakeven inflation rate at https://fred.stlouisfed.org/).

That’s good, but clearly the collateral damage is all around. Bonds are having their worst year on record. The stock market is in a bear market. In less than one year, mortgage rates have bounced back to levels not seen in 20 years. All bad, but runaway inflation would be worse. That’s what the Fed wants to avoid. And although the conditions now are much different than they were back in the 1970s, inflation is inflation and the Fed does not want to repeat past mistakes.

So, is the Fed doing the right thing? I don’t know, but at least expectations aren’t out of control. Let’s hope it stays that way.

If you’re interested in reading more about monetary policy in the 1970s vs today, Ben Bernanke’s recent book provides a good summary.

Disclosures:

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Plan > No Plan

evanhall — Mon, 10 Oct 2022 18:00:33 +0000

I was recently having dinner with a friend when she asked me a basic question about her and her husband’s financial situation. They have been saving diligently for years and she wanted to know if it was okay to put off saving for a few years in order to spend on a few large discretionary items.

The question seemed straight-forward enough. If they want to safely retire at a (relatively) young age, they’d had better save as much as possible and be careful not to dip into their savings too much. On the other hand, I thought, if they’ve been putting money away for many years, perhaps they’ve already saved enough for retirement. Wouldn’t that be nice!

Of course, without knowing anything about their financial situation I wasn’t able to answer the question. But I could lead them in the right direction with another question.

So, I asked her a simple follow-up: do you have a financial plan? Well, she said, “we have an advisor who helps us invest, but we don’t have a financial plan.”

Now, I’m not sure why one would pay an advisor who hasn’t helped you develop a financial plan. But, that’s a topic for a different day.

The point I want to make is that even a foundational financial plan would have helped answer my friend’s question. Put simply: even a basic financial plan is better than no plan at all!

A financial plan fundamentally gets you from Point A to Point B (and at a minimum, Point B is a desired retirement age with a comfortable standard of living). Planning is analogous to navigating, which is why it’s so critical. However, often couples and families are directionless because they fail to define and communicate their goals in the first place – determining what Point B looks like!

As advisors, our job is to engage our clients to start planning – what I like to think of as a process of clarity – and to help them successfully reach their goals. While our financial expertise is important, our value is often also behavioral in nature: to help clients take action.

So, the best answer I could give my friend was to take the first step. Engage an independent advisor to develop a plan. The benefits of having clarity and confidence in your financial decisions should far outweigh the costs.

Disclosures:

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Financial Planning in Monte Carlo

evanhall — Tue, 16 Aug 2022 18:30:34 +0000

In my last blog post, I talked about the importance of having a financial plan that gets you from point A to point B. And, at a minimum point B includes your fundamental goals of a desired retirement age and standard of living. A sound plan provides you a high degree of confidence (or, high probability of success) in execution. Developing this confidence is the basis of this post.

First, how do you get from point A to point B in your plan? Generally, you save and invest during your working years to create a portfolio that will fund your living expenses and goals in retirement. A plan assumes a certain level of savings and, just as importantly, a constant investment return that grows those savings. Simple enough, but is a constant rate of return realistic? Not at all, obviously, if you follow the stock market just a little bit.

While returns have historically increased over long time periods, in reality they are not predictable from year-to-year (you can read more about this here). For example, let’s look at the one-year returns for the S&P 500 for three randomly chosen five-year periods:

Years	Sequence of Returns (rounded to nearest percentage point)
1970 – 1974	+4%, +14%, +19%, -15%, -27%
1990 – 1994	-3%, +31%, +8%, +10%, +1%
2005 – 2009	+5%, +16%, +6%, -37%, +27%

Source: Dimensional Fund Advisors “Matrix Book 2018”

Not exactly constant returns! Stock market returns are essentially random in any one-year period. The risk posed by this random up-and-down pattern of returns is referred to as sequence of returns risk and can impact your financial plan in various ways (both negatively and positively). Ongoing withdrawals and bad early returns in retirement could result in a depleted portfolio before the end of your life. As advisors, one of our priorities is to focus on understanding the potential likelihood of negative planning outcomes associated with this sequence of returns risk.

How do we do that? When we develop a financial plan, one tool we use is called Monte Carlo simulation which simulates thousands of random sequences of investment returns over the term of the plan. The result of running these simulations is a set of potential projected planning outcomes. From that distribution of outcomes, we can develop an estimated confidence level of a financial plan being successful (i.e., not running out of money). For example, if 10% of the simulations resulted in your plan running out of money, you have a 90% probability of success – high enough to implement the plan.

What if our client’s plan has a low probability of success? In this case, we collaborate to restructure the plan until we achieve a satisfactory probability of success. Options include prioritizing and modifying financial goals, increasing savings and changing the strategic investment allocation. The plan is not a good plan until we have high degree of confidence in it.

Now, it’s important to keep in mind that, as with all financial modeling techniques, Monte Carlo modeling has plenty of limitations. However, if you are aware of those limitations and can interpret the results within the context of those limitations and the overall financial planning model, Monte Carlo modeling can be an indispensable tool in evaluating the strength of your plan.

So, I’ll pose this question to you: what is the probability of success of your financial plan? If you don’t know, let’s begin the conversation.

[1] I’ve used estimated earnings per share for Q1 of this year (source: S&P) in all calculations since actual results for Q1 have not yet been fully reported.

Disclosures:

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Roth IRA Conversions in Declining Markets

evanhall — Tue, 05 Jul 2022 18:00:54 +0000

Market declines are painful. When they happen (as they are in 2022), you’ll often see recommendations to take advantage of the decline (e.g., tax-loss harvesting). Most of these recommendations are value-adding, however, we often see one with which we disagree: to do a Roth conversion after a market decline.

To make our view on this clear: we do not recommend converting your traditional IRA money to Roth IRA money (i.e., doing a ‘Roth conversion’) solely because markets have declined.

To understand why, let’s first consider the reasoning often used to justify the recommendation to convert in a market decline. It goes like this: when markets decline, your IRA balance is lower today than it was before the market fell; therefore if you convert today, you will pay less in tax dollars than if you converted before the market fell. This is true, but it does not justify a conversion. The focus of a conversion should be on tax rates not dollars paid. If dollars paid were the reason to convert, the following conclusion would be reached:

If the goal is to minimize the tax dollars paid on conversion, then you should convert today if you think your IRA balance might ever be higher
Therefore, since you will obviously assume your IRA balance will grow in the future, you should convert all your IRA money today and never hold traditional IRA money (even if the market didn’t decline!)

To be clear, again, we don’t recommend doing this.

In fact, where the market has been in the past has no bearing on the Roth conversion decision. Instead, the primary driver of this decision is a comparison of your current and future tax rates. Paying less taxes today when the market declines will still be worse economically if your tax rate today is higher than the future. To help illustrate why, let’s first back up and review the tax benefits of IRA accounts and how those relate to Roth conversions.

There are two types of Individual Retirement Accounts (or IRAs): Traditional IRAs (which consist of pre-tax money) and Roth IRAs (which consist of after-tax money). When you contribute to a Traditional IRA, you receive a tax deduction and the account grows tax-deferred. When you eventually take a withdrawal, you’ll owe taxes based on your marginal tax rate in the year of withdrawal. A Roth IRA works in the opposite way. There’s no tax deduction when you contribute, but the account growth and withdrawals are tax free.

If you’re in a higher tax bracket today compared to your estimated tax rate in the future when you plan to make withdrawals, it makes sense to contribute to a Traditional IRA (assuming you’re eligible). For example, if you’re in the 32% tax bracket today and estimated to be in the 22% bracket in the future, you’ll save 10 cents on every dollar you contribute. In other words, for every $1 you contribute today you’ll avoid 32 cents in taxes and then pay 22 cents in taxes when you make a withdrawal – that’s a net 10 percent savings!

If you’re in a lower tax bracket today than you would be in the future, a Roth makes sense. For example, if your marginal tax rate is 22% today but will be 32% in the future, you’d be better off making a Roth contribution (forgo a deduction worth 22 cents for every $1 you contribute) while avoiding taxes in the future (32 cents). Again, you’ll save a net 10 percent if you do this correctly.

For most wage earners near the middle or end of their career, their tax rate will likely be higher while they’re working than when they retire and have lower income.

Now, let’s pivot to Roth conversions, which is transferring funds from your Traditional IRA to your Roth IRA and paying the taxes today to avoid them in the future. The same tax rate logic applies to the decision about whether to do a conversion. If you go back to my example in the previous paragraphs, paying taxes today makes sense when you are in a lower tax bracket than you expect to be in the future. If you’re in a higher tax bracket today than in the future, your savings becomes a loss. Finally, if you’re in the same tax bracket, you’d be indifferent.

As I also said, people are generally in higher tax brackets while they are working. So, converting tends to be a great strategy when you stop working and before you start taking Social Security. For example, if you’ve retired at age 60 and Social Security benefits won’t start until age 67 or 70, then you can likely convert at very low rates!

Throughout this explanation, notice that I haven’t said anything about where the market has been and whether your balance is higher or lower than it used to be. Again, that doesn’t impact this decision. Michael Kitces, an advisor to advisors, has written about this concept here:

There are only four factors that impact the wealth outcome when choosing between a Roth or traditional IRA (or other retirement account). They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes… By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates… The principle of this equation is remarkably straightforward – the greatest wealth is created by paying taxes when the rates are lowest.

Again, to put it simply, you should not do a Roth conversion just because your IRA balance is lower today than it was at some point in the past (all other things unchanged). In fact, if you weren’t planning on doing a Roth conversion before the market declined, doing a Roth conversion because markets have declined can actually cause permanent financial loss.

That final point is worth emphasizing. Investors can make an IRA conversion even worse if the amount they convert pushes them into a higher tax bracket. If, for example, you do a Roth conversion this year because markets are down, but that conversion pushes your tax rate up when your tax rate today is already higher than what you expect in the future, then you’ve paid an additional tax you never needed to pay. We’re pretty sure no one wants that outcome!

In summary, here’s what you should keep in mind when you hear about Roth conversions:

Don’t do a Roth conversion just because markets have declined
Converting too much may needlessly push you into a higher tax bracket and result in economic loss
They are tricky since they require building a financial plan that estimates your tax rate today versus your tax rate in the future
They are a valuable tax strategy when it makes sense to do them
You’ll likely have an opportunity to do them at some point so be patient and make sure you’ve evaluated your current and projected tax situation beforehand

As always, please reach out if you’d like to discuss.

Disclosures:

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Volatility, Shmolatility

evanhall — Wed, 01 Jun 2022 18:30:03 +0000

Updated: June 1, 2022

“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
– Warren Buffett

In the investing world, there are a million and one ways to define risk. Ok, not really. But there are a lot. Get a group of investors in a room, ask them each to define risk and you’ll likely get a handful of different responses. The most common definition is volatility. Stocks, for example, are considered risky because they are volatile. But if you’re a long-term investor, does volatility really matter that much? Aren’t there more relevant ways to think about risk?

Yes, yes there are.

If you’re a long-term investor, another (and, we would argue, better) way to define risk is the probability of having a permanent loss of capital. This happens when, for example, you sell something for less than you bought it. If you buy something and it temporarily declines while you still hold it, you have volatility but you have not had a permanent loss of capital.

Think about this in the context of a portfolio of stocks.

Let’s say you have a ten-year investment horizon and hold a diversified basket of stocks through an S&P 500 index fund. If you have absolutely no need or plan to sell anything from this portfolio over the next ten years, then, using the definition of risk laid out above (i.e., that risk is defined as a permanent loss of capital), this portfolio has low risk. Why? Because, over a ten year period, the probability of having a permanent loss of capital is low. Going back to 1950, there has been only one ten-year period (looking at calendar year returns) in which you would have lost money by selling after 10 years (2000 – 2009, towards the high of the dot-com bubble and low of the 2008-2009 financial crisis). In other words, historically speaking, there was about a 1.4% probability of losing money over a ten-year period. Now, there are a bunch of caveats to this, including that the future could easily be different than the past, that I’ve ignored intra-year holding periods and that inflation will take away part of your return. Still, you can see the odds are strongly in your favor if you have a ten-year holding period. What about other holding periods? Check out the chart below.

As you can see, once you extend out to about 10-15 years, the historical likelihood of having a permanent loss of capital has been quite low.

So, if you’re a long-term investor, don’t fret about the daily, weekly and annual ups and downs of the market. Ignore the silly talking heads who tell you where the market is going this year (hint: they have no clue). None of this matters to you. What matters is where markets are ten to fifteen years from now. And based on history, although there are certainly no guarantees, the odds are highly in your favor.

John Bogle, the founder of Vanguard, was definitely on to something when he said, “The stock market is a giant distraction to the business of investing.”

Disclosures:

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