Are We Headed for a Recession?

Are We Headed for a Recession?

 

LUTZ BUSINESS INSIGHTS

 

Are we headed for a recession?

josh jenkins, cfa, senior portfolio manager & head of research

 

Each morning I craft a Market Update email that I share with our advisors. This email provides commentary on what is happening in the markets and the economy. It includes data related to asset class performance and economic indicators, and links to some top stories that I think are interesting and relevant.

As I review the daily news flow, I consistently come across articles that suggest we are entering a recession. It’s not surprising the financial media focuses on this topic. Their business model is reliant on attracting eyeballs for advertisers. Nobody is going to click on an article titled “We Don’t Know Why This Happened, and it’s Not Important.” Fear sells. You get people’s attention when you tell them the economy is heading for ruin and it’s taking investors down with it.

In light of the barrage of negativity in the financial news, we frequently field questions from our clients related to recessions. “Is one coming? If so, when? And what does this mean for my investments?” One of these questions can be answered with a level of certainty. The other two cannot. I’ll address each question below.

Is a Recession Coming?

Yes, a recession is coming. We know this to be true with some level of certainty. The economy is cyclical, oscillating between periods of expansion and contraction.

The table below illustrates the 15 recessions the U.S. economy has endured over the last (roughly) 100 years. On average, they have lasted one year and two months. They have been as short as seven months (the early 1980s) and as long as three years and eight months (the Great Depression).

Source: FRED Database. Recession indicators calculated by NBER based on peak through trough. Data from February 1926 through August 2019.

The table also illustrates the average expansionary period has lasted five years and three months. Frequently referred to as “bull markets,” the expansions have varied widely in length. They have been as short as eleven months, and as long as ten years (and still going).

Despite the variation among the bull markets, they do share one common trait. At a certain point, every one of them eventually came to an end. One hundred years of data suggests the current expansion will meet the same fate as those that preceded it.

When Will the Recession Begin?

While it is easy to understand that a recession will come, it is much more challenging to accurately predict WHEN it will happen. A few pundits, economists, or investors may correctly foreshadow a large downturn, but it is seldom the same group from one episode to the next. There is little evidence that it is possible to consistently anticipate change in a system as large and complex as the economy or stock market. A common industry tactic is to call for a recession one to two years down the road. Eventually, they’ll be proven right! But how long are they wrong before that happens? Sitting on the sidelines during an upmarket carries a high opportunity cost.

We have already discussed the media’s pension for alarming headlines. As we pulled out of the last recession, they wasted no time speculating on the next one:

  1. “Dr. Doom Sees Double-Dip Recession Risk, in Remarks Down Under” (WSJ, 8/3/2009)
  2. “Double-Dip Recession Fears Creep Back Into the Market” (CNBC, 2/25/2010)
  3. “On the Verge of a Double-Dip Recession” (NY Times, 9/7/2011)
  4. “Earnings Show Recession May be ‘Fast Approaching’” (CNBC, 7/22/2012)
  5. “U.S. Recession is Nigh… and the Fed Can’t Stop It: SocGen’s Edwards” (CNBC, 11/28/2013)
  6. “Can The Fed Stop The Next Recession? Business Can’t Bank On It” (Forbes, 2/23/2014)
  7. “It’s Time to Start Talking About a U.S. Recession” (Business Insider, 10/11/2015)
  8. “A Recession Worse Than 2008 is Coming” (CNBC, 1/15/2016)
  9. “U.S. Heading for Recession After 2 Years of Unsustainable Growth, Economist Says” (CNBC, 3/28/17)
  10. “Another Warning that a 2019 Recession is Coming” (Forbes, 12/17/2018)
  11. “Parts of America May Already Be Facing Recession” (The Economist, 8/31/2019)

Despite the bad news prompted these stories, both the economy and stocks continued their ascent:

 

Source: FRED Database and Morningstar Direct. The stock market is based on the growth of $10,000 invested in the S&P 500 TR Index. The Economy is based on the Bureau of Economic Analysis’ Real GDP in Billions of 2012 Chained dollars. Data from July 2009 through June 2019.

Earlier this year the current bull market became the longest on record, surpassing the nearly ten-year expansion that spanned the 1990s. The record has sparked a commonly held view the expansion cannot keep going, simply because one has never lasted this long before. On the surface, this view makes sense, but it ignores a critical variable. It considers the length of time the economy has been expanding but overlooks the rate of change. 

 

Source: FRED Database. The Length of bull markets was calculated with the NBER based on peak through trough recession indicators. Start and end dates were rounded to the nearest quarter. GDP is based on the Bureau of Economic Analysis’ Real GDP in Billions of 2012 Chained dollars. Data from Jan 1947 to June 2019.

As it turns out, the economy has been growing at a much slower pace than in past expansions. In fact, it has not even cracked the top three in terms of cumulative GDP growth. This steady pace could suggest the economy has more room to grow before the imbalances that contribute to a recession begin to form.

How Will a Recession Impact My Investments?

What if I told you that I knew with certainty which month the recession would begin? How much do you think you could profit from this knowledge? I think the typical investor would expect to improve their investment returns dramatically with this information. After all, stock prices plummet during recessions, right? A review of history shows us that reality is not that simple. You may be surprised to see equity returns were positive during eight of the last fifteen recessions, and the median return during these episodes was +4.1%!

 

Source: FRED Database and Morningstar Direct. Recession indicators calculated by NBER based on peak through trough. Stock market returns were calculated using the IA SBBI Large Cap Index. Data from February 1926 through August 2019.

It is important to understand that the stock market is a discounting mechanism. Stock prices represent an aggregation of all current information, as well as expectations about the future. As a result, market returns can and will deviate from the real economy.

Amid substantial economic growth, the market may anticipate there is trouble ahead, leading to lower prices before any actual contraction in economic activity occurs. Conversely, during the depths of a recession, the market may anticipate better times ahead, leading to higher prices prior to the resumption of growth.  In the case of a mild economic downturn, the market may assess that the long-term prospects for businesses may not be so impaired that a large (or any) devaluation is necessary.

While recessions share common features, no two are exactly alike. The playbook that was successful during the last contraction may not work the next time. Selling out at the onset may have allowed you to avoid some pretty severe drawdowns, but it also would have caused you to miss out on significant gains.

A third of the recessions in the above table coincided with the stock market generating double-digit returns. This is illustrative of why market timing is so hard. Not only must you accurately foresee the event, but you must also correctly gauge the market’s reaction to the event. You then need to time your entry back into the market successfully. It does you no good to sell your investments ahead of a 20% drawdown, to then miss out on a subsequent 30% recovery.

Preparation is Key

It is critical for investors to prepare for the next recession. Preparation, however, may not entail what you think. It has nothing to do with forecasting when a recession will hit or standing ready to sell out of your investments ahead of the next big drawdown. Preparation means sitting down with a financial advisor, mapping out your goals, and devising a plan you can stick to.

At Lutz Financial, we believe the best approach is to hold a low cost and well-diversified portfolio that is appropriately calibrated to your goals and risk tolerance. The beauty of this approach is you don’t have to play any guessing games. Although your investments will experience volatility from time to time, you can take comfort in knowing it can weather the storm. While we don’t know when it will begin, the next recession is inevitable. Are you prepared?

 

 

IMPORTANT DISCLOSURE INFORMATION
PLEASE REMEMBER THAT PAST PERFORMANCE MAY NOT BE INDICATIVE OF FUTURE RESULTS.  DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT THE FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT, INVESTMENT STRATEGY, OR PRODUCT (INCLUDING THE INVESTMENTS AND/OR INVESTMENT STRATEGIES RECOMMENDED OR UNDERTAKEN BY LUTZ FINANCIAL), OR ANY NON-INVESTMENT RELATED CONTENT, MADE REFERENCE TO DIRECTLY OR INDIRECTLY IN THIS NEWSLETTER WILL BE PROFITABLE, EQUAL ANY CORRESPONDING INDICATED HISTORICAL PERFORMANCE LEVEL(S), BE SUITABLE FOR YOUR PORTFOLIO OR INDIVIDUAL SITUATION, OR PROVE SUCCESSFUL.  DUE TO VARIOUS FACTORS, INCLUDING CHANGING MARKET CONDITIONS AND/OR APPLICABLE LAWS, THE CONTENT MAY NO LONGER BE REFLECTIVE OF CURRENT OPINIONS OR POSITIONS.  MOREOVER, YOU SHOULD NOT ASSUME THAT ANY DISCUSSION OR INFORMATION CONTAINED IN THIS NEWSLETTER SERVES AS THE RECEIPT OF, OR AS A SUBSTITUTE FOR, PERSONALIZED INVESTMENT ADVICE FROM LUTZ FINANCIAL.  TO THE EXTENT THAT A READER HAS ANY QUESTIONS REGARDING THE APPLICABILITY OF ANY SPECIFIC ISSUE DISCUSSED ABOVE TO HIS/HER INDIVIDUAL SITUATION, HE/SHE IS ENCOURAGED TO CONSULT WITH THE PROFESSIONAL ADVISOR OF HIS/HER CHOOSING.  LUTZ FINANCIAL IS NEITHER A LAW FIRM NOR A CERTIFIED PUBLIC ACCOUNTING FIRM AND NO PORTION OF THE NEWSLETTER CONTENT SHOULD BE CONSTRUED AS LEGAL OR ACCOUNTING ADVICE.  A COPY OF LUTZ FINANCIAL’S CURRENT WRITTEN DISCLOSURE STATEMENT DISCUSSING OUR ADVISORY SERVICES AND FEES IS AVAILABLE UPON REQUEST.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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October Retirement Plan Newsletter 2019

October Retirement Plan Newsletter 2019

 

LUTZ BUSINESS INSIGHTS

 

OCTOBER RETIREMENT PLAN NEWSLETTER

3(38) OR 3(21): WHICH FIDUCIARY SERVICE IS RIGHT FOR YOU?

Looking to reduce your fiduciary risk as a plan sponsor? A little outside help can yield big reductions in risk, provide the best for the people on your company’s payroll, and help you feel good about your qualified retirement plan. Remember though, what’s good for the plan participants isn’t always best for the company – and as the plan sponsor, the company takes on substantial legal and financial liabilities. If you’re listed as the plan administrator, some of those liabilities accrue to you as well. Best practices suggests that any plan sponsor who doesn’t possess the technical knowledge and experience to manage investments consider hiring an advisor – and your choice of advisor can significantly lower your fiduciary risk.

Why hire a fiduciary?

Hiring an outside fiduciary can reduce some or most of that liability by putting the plan in the hands of a professional that affirmatively accepts fiduciary responsibility in section 3(21) and 3(38) of the Employee Retirement Income Security Act of 1974 (ERISA). These 3(21) and 3(38) fiduciaries are not stockbrokers; instead of taking commissions on investments purchased for your plan, they’re compensated by a stated fee. This helps reduce potential conflicts of interest in constructing and managing your plan’s investments.

What’s the difference between a 3(38) Fiduciary and a 3(21) Fiduciary?

There are two types of fiduciaries recognized under ERISA standards. A 3(21) fiduciary advises and makes recommendations, but as the plan sponsor still have ultimate responsibility for the legal operation of the plan and making plan-level investment choices. A 3(38) fiduciary takes over management of plan investments, makes investment choices, executes investments and monitors their performance. The 3(38) advisor is solely authorized to make (and is responsible for) those decisions. Because they have this responsibility, they can often be in a position to act more quickly in terms of making any changes to the plan, since such decisions need not go through the plan sponsor’s committee for any approval process. A 3(38) fiduciary may also be advantageous for smaller firms with fewer resources in their benefits department. Hiring a 3(21) fiduciary relieves the plan sponsor of part of the labor and part of the investment fiduciary responsibility, and provides the plan fiduciary a professional opinion in decision-making. A 3(38) fiduciary relieves the vast majority of the labor and almost all of the responsibilities. In short, whereas a 3(21) fiduciary advises and assists; a 3(38) fiduciary can function in a broader role for plan sponsors.

Remember – even if you hire a fiduciary, you’re still involved.

With a 3(38) fiduciary, the sponsor is still required to provide oversight of the fiduciary. Also, hiring a 3(38) fiduciary doesn’t relieve the sponsor from liability for poor investment decisions made by participants. However, ERISA Section 404(c) does create a “safe harbor” for plan sponsors if they meet specific requirements that include stipulations regarding investment selection, plan administration and certain disclosures.

What about Full Service Fiduciaries?

Firms that offer both 3(21) and 3(38) fiduciary services may also provide professional investment advice through staff or partnerships along with educational services to help meet the section 404(c) safe harbor standards. With the help of these outside professionals, you can lower your fiduciary risk by doing right by your employees while addressing all applicable regulations.

For more information about hiring a fiduciary, or questions regarding 3(21) or 3(38) fiduciaries reach out to your plan advisor.

THE IMPACT OF AUTO-ENROLLMENT INTO RETIREMENT PLANS

Americans are saving more for retirement, according to a survey released by the Plan Sponsor Council of America.1 In fact, employees put 6.8 percent of their paychecks into 401(k) and profit-sharing plans in 2018 compared to 6.2 percent of their salaries in 2010. Why the increase? One reason may be that 57.5 percent of retirement plan sponsors have included an automatic enrollment feature in their plans.

An automatic enrollment feature in a retirement plan allows employers to enroll eligible employees in their retirement plans unless the employee chooses to opt out of the plan. It’s often used for 401(k) plans, but can also be included in 403(b) plans, 457(b) plans for government employees, Salary Reduction Simplified Employee Pension plans (SARSEPs), and Savings Incentive Match Plans for Employees (SIMPLE) IRA plans. Automatic enrollment clearly boosts retirement plan participation.

Automatic enrollment taps into a basic psychological trait, inertia. The field of behavioral finance suggests that people tend to resist change and don’t always take action even when the action is clearly beneficial. However, behavioral finance can turn that weakness into a strength. Retirement plan sponsors that use automatic enrollment are taking action for their employees, and then that same inertia keeps employees from opting out of the retirement plan.

https://www.psca.org/PR_2018_60thAS 

FOUR WAYS TO INCREASE EMPLOYEE RETIREMENT CONTRIBUTION PARTICIPATION

As a retirement plan sponsor how can you encourage your employees to save and save more? Improving both employee participation and their saving rates is easy when you’re prepared. Here are four simple ways you can help your employees start building a confident retirement.

1. Boost employee participation with automatic enrollment.

Choosing to automatically enroll all new employees in your retirement plan can dramatically improve your participation rates. According to the Center for Retirement Research (CRR) at Boston College, in one study of automatic enrollment, participation increased by 50 percent, with the largest gains among younger and lower-paid employees. While auto-enrolled employees are allowed to opt out of the retirement plan, most generally stay enrolled.

2. Set the initial default contribution rate higher. 

Many companies who use auto-enrollment set their default contribution rate relatively low at three percent, according to the CRR, which is lower than the typical employer match rate of six percent. Workers who might have contributed more to their savings passively accept the lower default rate, which means they’re sacrificing employer matching funds along with saving less of their own pay.

3. Adopt auto-escalation.

Plans that use auto-escalation automatically increase their participants’ contribution rate every year, typically by one percent. Over time, that can significantly improve savings rates among workers. The CRR cites a 2013 study of Danish workers that the majority of workers who experienced automatic increases simply accepted them, and savings rates dramatically increased.

4. Automate investment decisions with target-date investment products.

Investing is complicated, and many employees don’t want to take the time to learn how to manage their portfolios. Target-date strategies automatically adjust an employee’s investment allocations over time, shifting them to a more conservative asset mix as the target date (typically retirement) approaches. The ease of use of target-date funds means their popularity is increasing. The CRR notes that in 2014, nearly 20 percent of all 401(k) assets were in target-date funds, and about half of plan participants used target-date funds.

PARTICIPANT CORNER: RETIREMENT READINESS - PLANNING FOR THE FIRST DAY OF THE REST OF YOUR LIFE

MUCH HAS BEEN MADE OF THE CURRENT STATE IF THE AMERICAN WORKER as it pertains to their retirement savings. According to a recent study by the General Accountability Office, 29% of Americans 55 and older do not have any retirement savings or pension plan and those who have saved are woefully behind with 55-64 year olds averaging $104,000 in retirement assets.

The bleak outlook can largely be attributed to a lack of education when it comes to retirement planning – and more specifically investment allocation. With a growing number of millennials feeling ill equipped to make investment related decisions – even within their own retirement plans, the numbers prove that ignorance is not bliss. 61% of millennials say they want to invest but are deterred because they don’t know how.2

These numbers alone should serve as a call to action for younger workers who are increasingly finding themselves behind the eight ball when it comes to saving for retirement. A sound, long term, roadmap to retirement can be centered on three key areas.

Develop healthy financial habits.

In a society that has become increasingly driven by social media it is very easy to fall prey to a “keeping up with the Jones1” philosophy toward spending. Do you have “friends” that tweet and share every purchase and activity in their lives? Believe it or not, this subconsciously drives the temptation to spend on things we don’t need! Finding a balance and delaying gratification on purchases can single handedly make or break your financial wellbeing and it starts with making tough budgeting decisions.

Live below your means.

Try contributing an extra one or two percent to your company’s retirement plan, or open up an IRA.  You won’t miss the contribution and your standard of living will adjust accordingly.  Seek to live below your means today to ensure a strong financial future tomorrow.

Reduce your debt.

The average American household carries a whopping $15,762 in credit card debt. According to a study this year, the average household is paying a total of $6,658 in interest per year3 – translating to lost dollars that could be pumped in to retirement savings and wealth accumulation. In some situations debt, such as a mortgage or a student loan, can improve one’s financial position long term – however, credit card debt in particular carries the highest interest rates and should be paid off as quickly as possible. Try working with an independent financial planner if necessary to consolidate debt and come up with a game plan to attack it head on.

At the end of the day there’s no magic bullet the can singlehandedly solve the retirement shortfall for millions of Americans. Only you can take steps to educate yourself and make prudent, financially savvy choices in your day to day life which will translate in a significantly healthier financial standing. Don’t just hope that the retirement picture in your life becomes clearer as the day gets closer, because the opposite is true. Take measured steps to build confident savings and investment solutions for your household by starting today!

DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial (“Lutz”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a Lutz client, please remember to contact Lutz, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Lutz shall continue to rely on the accuracy of information that you have provided.

For more important disclosure information, click here.

RECENT LUTZ FINANCIAL POSTS

Are We Headed for a Recession?

Are We Headed for a Recession?

Each morning I craft a Market Update email that I share with our advisors. This email provides commentary on what is happening in the markets and the economy. It includes data related to asset class…

read more

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

 

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Am I Ready to Retire? Finding Your Sweet Spot

Am I Ready to Retire? Finding Your Sweet Spot

 

LUTZ BUSINESS INSIGHTS

 

Am i ready to retire? finding your sweet spot

justin vossen, investment adviser, principal 

If you could trade places with Warren Buffett, would you do it? While you would immediately be worth billions of dollars, you would also be 88 years-old. Perhaps you would consider trading places with a recent college graduate? You may be 22 years old again, but you could also be starting over: career, family, lifestyle, and location, coupled with the fact that the average college graduate has more than $28,000 worth of student loans (Institute for College Access and Success), it may not be worth it for you to go back?

While these are some extreme examples, the point is that your answer probably depends on your current situation and its relationship to the alternative. Factors such as your age, financial situation, and life perspectives affect how you would answer switching places with another. These considerations often factor in financial planning as there is no right or wrong answer, only “your” answer.

We do financial planning for clients every day, and we hear many of the same questions. Many clients come to us asking, “what is normal when it comes to retirement? When is the typical time to retire? What does everyone do in retirement? How much does everyone spend? How much does the average retiree travel? When do people start Social Security? How much do most people save each year?”

Often, clients come in looking for answers based on what their friends, neighbors, and co-workers are doing. However, we view our job as providing the roadmap to get to the “right answer” for their own personal situations. The answers to their individual situations may differ, but their roadmaps may be similar.

Ultimately, one’s roadmap can be viewed as an algebra equation. There are many variables to this equation, some we can control and others we cannot. So, it’s important to isolate the variables we can control, and incorporate the ones we can’t, to get to the right answer. Most of the time, the question of which variable we need to solve for differs with each family.

The Key Variable: Spending in Retirement

Spending is often the last variable solved for in retirement, but it may be the most critical. Many falsely assume that the age or timing of retirement is more important to the success of the outcome. However, your lifestyle may be the biggest determinant on when you can retire, and if you will be fulfilled during retirement. One thing we have consistently found is that most people underestimate what they will spend annually. They also fail to leave any room for unexpected expenses that could come about in the future.

An old rule of thumb was that 4% is the proper amount of your assets that you can spend each year in retirement and maintain corpus. However, there are a few things wrong with this generalization. First of all, if your assets are tax-deferred, you could be losing 10-50% of your distribution to taxes, depending on how much you pull out each year and the state you live. Also, the 4% rule came from a time in history when bonds were paying 5-6% per year. Now they are yielding less than 2% in many cases. These two things alone can cause a massive over-assumption.

On the flip side, many facets of life may bring about reduced expenses in retirement. Rotating on to Medicare may cut your health expenses by 75%. You may eventually pay a mortgage off. Your kids will (hopefully) be off the payroll. Others don’t account for the general slowing in their spending habits because of age and the reduced desire to do expensive activities, such as travel.

Before you take the retirement plunge, it is VITAL that you spend some time examining your current and future spend rate to make sure you can have a successful retirement. It’s challenging for someone to ratchet back their lifestyle to fit their budget into the funds they’ve saved for retirement after the fact. This self-examination may be eye-opening and humbling, but one that you could regret not doing after taking the retirement plunge.

Timing of Retirement

Sometimes the timing of retirement is out of one’s control. Sometimes, due to an unfortunate illness, family issue, or loss of a job forces retirement under duress. In this case, the variable we solve for in the retirement equation is someone’s age. This could potentially require adjustments in the spend or lifestyle to accommodate. Often this is not an ideal scenario and requires some planning immediately so as not to jeopardize the future.

Others who have an exact age in their mind for retirement need to plan as early as possible. Savings rates must be met and monitored to make sure that you are advancing at a pace that will allow for it to happen. If retiring before Medicare eligibility, one of the most significant expenses will probably be healthcare. Is this being factored in? Those who retire “early” may have a lot of changes occur over the years in the tax code. Do their funds have the ability to be flexible upon distribution? This means having the ability to “tax optimize” your funds needed from various accounts such as Roth IRAs, IRAs, 401-ks, and taxable accounts. This allows you to minimize your taxes on distributions in any given year whatever the tax code changes bring.

Sometimes people continue to work because they don’t know if they have enough to retire. It’s essential to, at least, establish a timeline in the future and work back from it. If not, you cannot reasonably plan, and savings becomes arbitrary and lacks direction. Often this leads to more immediate gratification in the present and a lack of savings because one doesn’t know how much it will take in the future. This is an “ignorance is bliss” concept that too many people use in their retirement approach.

Managing to a Number

Often, many people tend to base retirement on getting their savings to a number. Arbitrarily let’s say that this number is $1,000,000. A person saves to the point that their assets reach $1,000,000 and then at that point, they feel that they can retire.

The problem with this is that the number you need has more to do with how much you spend, and how long you will live. One variable is easy to calculate (spending), and one is not (life expectancy). Does the amount saved fit a reasonable timeline?

 

Predicting the Future

Even with advanced planning, you may find that you have over or underestimated some assumptions in retirement. These assumptions and their compounding effect over time may be critical to the success of your outcome. We find that many overestimate the returns that they will receive. For example, since 1926, the S&P 500 has returned 10.14% annually as of 6/30/2019. We see many people use that historical proxy as the basis of their future returns. This proxy is overly simplistic and contains a massive oversight. Generally, we would recommend that your portfolio will inevitably include some more conservative investments like bonds and other asset classes that aren’t the S&P 500. This time period also takes us through the industrial and technological revolution in a country with rapid economic growth. That growth is now decelerating (albeit still growing at a good pace) from its industrial boom period. A reasonable rate of return must be ascertained with more than historical factors in mind.

If you plan to retire, there are many other “future” assumptions that need to be taken into consideration. What are the assumptions for travel, living expenses, long-term care, medical costs, and taxes? On the income side, what are the assumptions for social security, pension, rental income, or even a future business sale? These all have an impact on today and future years as when factoring in assumptions for growth rates and inflation. Many of these assumptions are general, but most can vary from family to family.

YOUR Retirement Sweet Spot

Another thing our experience has taught us is that it’s okay not to know exactly when you will retire, what you need, or even how much you will spend to the penny. What is important is that you make some reasonable assumptions and make sure you leave enough room or “cushion” for the unexpected.

However, to create a roadmap to your destination, you need to pick a starting place on the map. There will inevitably be some forks in the road as time passes, but planning will allow you to navigate those twists and turns easier. Most importantly, planning for everything you know, while leaving some room for error, will give you peace of mind for when you finally decide to retire!

 

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

jvossen@lutzfinancial.com

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JUSTIN VOSSEN, CFP® + INVESTMENT ADVISER, PRINCIPAL

Justin Vossen is an Investment Adviser and Principal at Lutz Financial with over 20 years of relevant experience. He specializes in wealth management and financial planning.

AREAS OF FOCUS
  • Financial Planning
  • Wealth Management
AFFILIATIONS AND CREDENTIALS
  • Certified Financial Planner™
  • Financial Planning Association, Member
EDUCATIONAL BACKGROUND
  • BSBA in Economics and Finance, Creighton University, Omaha, NE
COMMUNITY SERVICE
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  • Nebraska Elementary and Secondary School Finance Authority, Board Member
  • St. Patrick's Church, Trustee
  • March of Dimes Nebraska, Past Board Member

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October Retirement Plan Newsletter 2019

September Retirement Plan Newsletter 2019

 

LUTZ BUSINESS INSIGHTS

 

SEPTEMBER RETIREMENT PLAN NEWSLETTER

INDEX FUNDS - LOOKING BEYOND FEES

The flow to passive management is one of the biggest talking points of the decade. With this shift came the daunting task, and responsibility, to better evaluate the abundance of index funds offered by the marketplace. Index funds seek to replicate the performance of a benchmark, making the idea of comparing returns appear counterintuitive.

 

This notion has led many to focus almost entirely on fees. During this time period the industry experienced significant fee compression, with the difference between a few of the most commonly utilized index funds as small as 0.002%. This amounts to $2 for every $100,000 invested. Relative to the administrative burden to switch funds, investment cost is not the best method of selecting funds especially considering that shortly after, a different fund may be the new lowest-cost option.

 

How else can an index fund differentiate itself from its competitors – If not fees, what should be evaluated? The best index fund managers provide tight benchmark tracking at a reasonable price, and two techniques they can incorporate into their investment process are cross trading and securities lending.

 

Through the application of certain trading techniques, index managers can reduce cost and improve tracking. Over time the composition of indexes change, yet the process funds undergo to match these changes are complex. For example, as companies grow, they may move from the small cap index into the large cap index. For the index, this is a simple process. One day the company is in the small cap index and the next day they are in the large cap index. No trading needs to occur, no commissions paid, no bid-ask spreads crossed, no trades routed – yet funds must overcome these hurdles if they want to match the index’s performance.

 

One technique to overcome these challenges is through the use of cross trading. Suppose a fund company offers a small cap index fund and a large cap index fund and “company X” is being moved from the small cap index to the large cap index. The fund company could sell all their shares of “company X” in the small cap fund. This incurs cost and drives the price down as they sell. Then they buy all the shares back in their large cap fund, driving the price up as they buy. Through cross trading, this process is more streamlined. The fund company transfers their shares of “company X” from their small cap fund to their large cap fund without incurring costs. This leads to reduced tracking error and improved performance. To conduct due diligence on an index manager’s cross trading capabilities examine the index fund company’s cross trading process and review percentages of trades crossed.

 

The second method by which an index fund can be evaluated is through their use of securities lending. Securities lending refers to the temporary lending of a stock, derivative, or bond by one party to another in exchange for collateral. The collateral can be reinvested to produce income for the lender. Securities lending is important to short sellers who profit when securities drop in value. If an active investor is looking to short “stock ABC”, currently worth $100, they can borrow “stock ABC” from an index fund, offering the fund $103 as collateral. The index fund can invest this cash until the stock is returned, generating extra return, helping offset the costs the fund faces.

 

It is important to remember this is not risk-free money for the fund. This process exposes the fund to counterparty risk – which is when the active investor does not return the stock owed. The second is reinvestment risk – when the fund invests the $103 and it loses value. To mitigate this risk many fund companies have adopted SEC or OCC money market guidelines that outline the maturity, credit ratings, and liquidity restrictions on the collateral investment. Well established index providers will furnish information on their counterparty and collateral guidelines.

 

How much extra return can securities lending generate? Looking at the graphs below we can see significant additional return through securities lending, sometimes in excess of the management fee charged by the fund.

 

500 INDEX FUND

Fund Company

% on Loan

Revenue Split (fund/lending agent)

Yield to Fund

BlackRock CIT

6.1%

50/50

0.016%

Fidelity

0.9%

90/10

0.002%

State Street CIT

1.8%

70/30

0.004%

Vanguard

0.13%

95/5

0.001%

 

SMALL CAP INDEX FUND

Fund Company

% on Loan

Revenue Split (fund/lending agent)

Yield to Fund

BlackRock CIT

29.2%

50/50

0.015%

Fidelity

18.9%

90/10

0.20%

State Street CIT

18.8%

70/30

0.15%

Vanguard

1.96%

95/5

0.10%

 

INTERNATIONAL INDEX FUND

Fund Company

% on Loan

Revenue Split (fund/lending agent)

Yield to Fund

BlackRock CIT

2.4%

50/50

0.023%

Fidelity

1.3%

90/10

0.015%

State Street CIT

1.2%

70/30

0.021%

Vanguard

1.32%

95/5

0.067%

 

BOND INDEX FUND

Fund Company

% on Loan

Revenue Split (fund/lending agent)

Yield to Fund

BlackRock CIT

37.8%

50/50

0.063%

Fidelity

<0.1%

100/0

0.0015%

State Street CIT

10%

70/30

0.029%

Vanguard

0%

N/A

N/A

 – 2018 Securities lending information

 

These complex features, prevalent amongst passive managers explain why RPAG tailored the scorecard to evaluate passive managers on analytics and metrics specific to, and important for, passive funds. On the surface it might seem counter intuitive to include an analytic on return rank for a passive fund designed to match the performance of a benchmark. However, by including return rank we evaluate a fund’s effectiveness in securities lending and cost reduction through cross trading.

 

Two analytics dedicated to tracking error may seem unnecessary, however performance matching is a primary objective of passive funds. It is critical for managers to utilize every tool in their toolbox. An emphasis on tracking error allows for better assessment of how well managers are meeting this objective. While fees are an important component of evaluating a passive manager, it is not the only data point, and the RPAG scorecard incorporates all significant components into the analysis.

 

For more information about cross trading and securities lending, reach out to your plan advisor.

 

About the Author, Ryan Hamilton

Ryan is an investment analyst for RPAG. He works closely with advisors and plan sponsors on manager due diligence and conducting market and fund research. Ryan is also a member of the RPAG Investment Committee, where all quantitative and qualitative aspects of the investment due diligence process are vetted and discussed when providing manager recommendations at the firm level for the firm’s entire client base. Ryan specializes in fixed income, cash vehicles, and alternative investments. Ryan graduated magna cum laude with a Bachelor of Arts from UCLA, and is a CFA Level III Candidate.

STUDENT LOAN CONTRIBUTION PROGRAMS: THE NEW WAY TO RECRUIT AND RETAIN MILLENNIALS IN TODAY'S WORKPLACE

As human resource managers begin working on updating their benefits package, it’s important to remember that millennials are quitting their jobs faster than employers can hire them1 – which is especially problematic considering millennials now make up 50 percent of the workforce 2.

 

The reasons for resignations vary widely, but one retention solution may be to consider offering a student loan contribution program. In 1999, the amount of outstanding student loan debt was approximately $90 billion. In 2019, that amount that has grown to nearly $1.6 trillion – held mainly by millennials. It’s fair to say that this population is desperately looking for some relief from this heavy debt burden – which offers a unique opportunity for employers to recruit and retain millennial talent.

 

A recent survey by Laurel Road found that millennials who were offered a student loan contribution program in their benefits package stayed at companies five years longer than those who were not. Some surveys even concluded that a student loan contribution program can be more desirable than vacation days3.

 

A byproduct of the student debt problem is that millennials may not be saving enough for retirement. A recent study from Boston College’s Center for Retirement Research, found that college graduates with student debt, accumulate 50 percent less retirement wealth in their retirement plan by age 30 than those without4.

 

Many employees believe they must choose between paying off their loans and saving for retirement; however, a student loan repayment program allows employees to make considerable contributions to both their debt and retirement savings accounts.

 

Student loan contribution programs are offered at little to no cost by different providers, are fully tailored to most benefit programs and most importantly, may offer a solution to the student loan debt crisis. A majority of these innovative plans are set up in three unique ways:

  1. Refinancing Resources, which offer financial wellness tools as well as access to third-party loan refinancing.
  2. Loan Contribution Programs offer employer monthly contributions to employee student loans in addition to refinancing resources.
  3. Match Contributions, where employers make a retirement plan match when employees make a tuition loan payment. Again, refinancing resources are included.

 

These programs vary in shape and size, allowing companies to integrate this benefit with little interruption to company operations. The more competitive programs will offer refinancing, allowing workers to make smaller payments at less of an interest rate, with little to no cost to the employer. At its core, this program increases employee retention by reducing the financial strain brought on by student loans.

 

Consider implementing a student loan contribution program into your benefits strategy. You may find that your ability to recruit and retain millennial talent increases immensely!

  1. https://www.inc.com/robbie-abed/more-people-are-quitting-their-jobs-than-ever-before-heres-why.html
  2. https://www.inc.com/peter-economy/the-millennial-workplace-of-future-is-almost-here-these-3-things-are-about-to-change-big-time.html
  3. https://www.integrity-data.com/3-reasons-a-student-loan-repayment-benefit-is-a-good-choice-for-employers/
  4. https://crr.bc.edu/briefs/do-young-adults-with-student-debt-save-less-for-retirement/
WHY WE USE RUSSELL INSTEAD OF S&P

Ever wondered why we use Russell instead of S&P for benchmarks in the RPAG system? Here are four important reasons:

  • Russell ranks each company in the investable universe according to its total market capitalization while S&P uses a committee to make these decisions. Market cap is the primary indicator to determine where a company belongs in the Russell Index.
  • Using a float adjustment methodology, Russell creates benchmarks that most accurately reflect the market, and Russell’s indices adjust each company’s capitalization ranking to eliminate closely held shares that aren’t likely to be traded.
  • By updating index holdings on a regular basis and reconstituting them annually, Russell provides a truer representation of the market.
  • Russell indices objectively allow the market to determine the index composition according to clear and published rules. The market determines which companies are included, not the subjective vote of a selection committee.

For more information the importance of a benchmark, contact your plan advisor.

PARTICIPANT CORNER: BORROWING AGAINST YOUR RETIREMENT PLAN: MORE COSTLY THAN YOU THINK

This month’s employee memo informs participants about taking money out of their retirement plan. Download the memo from your Fiduciary Briefcase at fiduciarybriefcase.com and distribute to your participants. Please see an excerpt below.

 

PARTICIPATING IN THE COMPANY’S RETIREMENT PLAN is a smart and important decision. Smart because you are putting away small amounts today for a comfortable retirement later.

 

As your account begins to grow, it may be tempting to “dip into” your retirement savings by taking a loan against your  retirement plan to pay your annual taxes, repair a leaking roof, catch up your everyday pile of bills, and so on. And while the decision to take a plan loan is yours to make, we want to make sure that you consider what it will really cost.

 

With a retirement plan loan, you pay yourself back the amount plus interest. But the true cost can be shown with the loss in your retirement savings. You lose money when you borrow from your retirement account for several reasons:

  • You lose making money on the earnings, or compounding of those earnings.
  • You repay the loan with after-tax dollars.
  • There is (typically) an initial set-up and quarterly loan fee.
  • Most employees decrease or cease the amount they are contributing to compensate for the loan payment.
  • You may not be paying yourself back the same amount you would have earned if you left the money invested.

 

To further illustrate the costliness of taking a plan loan, consider the following hypothetical example*: Jane took a $10,000 loan at 7% interest from her retirement account; her account balance before the loan was $20,000. She previously made contributions of $150 per paycheck (including the employer match). Because she had to repay the loan, she decreased her contribution to $50. Additionally, prior to the loan, she was earning a 10% return. Now she will repay the loan over five years. If you take into account loss of interest, compounding, and tax on repayments, the actual retirement plan loan is costing Jane 13.77%! And don’t forget about those decreased contributions, which can add up to hundreds of thousands of dollars over many years.

*This example is hypothetical and intended for illustrative purposes only.

DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial (“Lutz”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a Lutz client, please remember to contact Lutz, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Lutz shall continue to rely on the accuracy of information that you have provided.

For more important disclosure information, click here.

Q3 FIDUCIARY HOT TOPICS

WILL 2019 BE THE YEAR OF RETIREMENT REFORM - THE SECURE ACT

It has been 13 years since Congress enacted the Pension Protection Act of 2006, the last piece of major legislation affecting retirement plans. Significant provisions affecting retirement plans were included in various versions of President Trump’s tax reform bill enacted in 2017, but Congress ultimately punted, and none of them made it into the final bill.

 

This past May, the House passed, by a near unanimous vote (417 – 3), the “Setting Every Community up for Retirement Enhancement Act” (The “SECURE Act”). Such strong support in the House suggests this legislation has an excellent chance of becoming a law before the end of the year. This is now contingent on Senate action. Although many of the provisions in this bill have strong support in the Senate, under the Senate’s arcane procedural rules, a single Senator could tie this legislation up in committee.

 

 A number of important provisions in this bill have appeared in past bills and have strong bipartisan support. Thus, regardless of whether the House bill becomes law this year, it is almost certain that the majority of these provisions will be enacted at some point in the not too distant future.

 

Some of the more important provisions of this bill include:

  • Multiple Employer Plans (“MEPs”) for Unrelated Employers – The bill would overturn Department of Labor guidance, preventing unrelated employers from establishing multiple employer plans. Many small employers do not sponsor retirement plans and this is yet another attempt by Congress to encourage them to do so by offering them a more efficient alternative to establishing individual plans.

 

  • Notice of Lifetime Income – Sponsors of defined contribution plans would be required to provide participants with an annual notice disclosing the estimated monthly annuity income their account balance could generate at retirement. The intent is to ensure that participants are better informed about how much they need to save for their retirement. Nationally, the average participant in a 401(k) plan is currently saving enough to replace less than 50 percent of his/her projected income at retirement, even when social security benefits are included.

 

  • Safe Harbor for Lifetime Income Option – Few defined contribution plans offer an annuity option that provides a lifetime income stream to participants commencing at retirement. One of the major reasons for this is plan sponsors’ concerns about fiduciary liability in the event that the insurance company becomes insolvent at a future date. In 2008, the Department of Labor published a safe harbor for selecting an annuity provider, but this was not viewed as providing sufficient protection to plan fiduciaries. The bill would specify the steps plan sponsors must take in selecting an annuity provider. If these steps are taken, the plan sponsor would be deemed to have satisfied its fiduciary responsibilities.

 

  • Part Time Employees – Current law permit plan sponsors to exclude part-time employees from retirement plans. The bill would require sponsors to allow long term part-time employees to participate. Long term part-time employees are defined as employees who work at least 500 hours in three consecutive years.

 

  • Tax Credit Increased for Plan Start-Up Costs – The bill would increase the existing tax credit for plan startup costs for small employers with no more than 100 employees. The credit will increase from $500 to $5,000 over three years. There would be an additional $500 credit if the plan includes an auto enroll feature.

 

  • Remove Age Limit for Traditional IRAs – Under current law, individuals cannot make deductible contributions to a traditional IRA after reaching age 70 1/2. There is no age restriction for Roth IRAs. The bill would repeal this age restriction.

 

  • Age for MRDs Pushed Back – The age at which minimum required distributions must commence would be pushed back from age 70 ½ to 72. This is a popular change, but it has been criticized as only benefitting wealthy tax payers with relatively large amounts of deferred tax savings who do not need to make withdrawals to cover living expenses.
SON OF LATE SUPREME COURT JUSTICE, ANTONIN SCALIA, NOMINATED TO BE NEXT SECRETARY OF LABOR

President Trump has nominated Eugene Scalia to be the next Secretary of Labor. On July 12th, Alexander Acosta was forced to resign due to the controversy over a plea deal for Jeffery Epstein, who was recently charged with sex-trafficking crimes by the US Attorney for the Southern District of New York. At the time, Mr. Acosta was the US Attorney. The plea deal has been controversial because many viewed it as too lenient.

 

Mr. Scalia has held several government posts including Solicitor of Labor in the second Bush administration. This is the top legal position in the Department of Labor. He is viewed as more conservative than Mr. Acosta.

 

Before Mr. Acosta’s departure, the Department had announced that it is on track to publish a new fiduciary rule by year’s end, to replace the original rule struck down by the Fifth Circuit of the Federal Court of Appeals. The Fiduciary Rule was a complex regulation where persons working with retirement plans and participants are fiduciaries and may only make investment recommendations that are in the best interests of their clients. If Mr. Scalia is confirmed as the next Secretary of Labor, the possibility of a new fiduciary rule may be in doubt.

PROPOSED NEW PROGRAM ADDRESSES THE FINANCIAL WOES OF MULTIEMPLOYER PLANS

The House is considering a program of government loans and grants for financially troubled Taft Hartley multiemployer plans. Many multiemployer plans are on the verge of insolvency. The American Society of Actuaries estimates that by 2023, 21 multiemployer plans covering about 95,000 participants will be unable to continue paying benefits. The financial troubles of multiemployer plans are longstanding. The primary causes are:

  • most multiemployer plans cover employees in the smoke stack industries that have been in decline, meaning fewer and fewer contributing employers;
  • benefit liabilities have often been calculated using unrealistic actuarial assumptions; and
  • negotiated employer contributions have rarely been sufficient to fund the promised benefits.

 

In 2014, Congress attempted to address this problem by making an exception for multiemployer plans to ERISA’s longstanding rule that plan sponsors can never cut back on accrued benefits. In some cases, plans were permitted to cut benefits by more than 30 percent. However, this relief has not been sufficient. Under the proposed legislation, plans would be allowed to apply for 30-year loans along with outright grants. The most distressed plans would be required to participate in the program. Support for this legislation is sharply divided along party lines. Democrats see this as a necessary and temporary backstop. Republicans see this as a taxpayer funded bailout that does not address the underlying problems, especially mismanagement by plan trustees.

 

If Congress fails to act soon, the Pension Benefit Guarantee Corporation (“PBGC”) will be on the hook for benefits that multiemployer plans are unable to pay. The PBGC is a government agency established by ERISA that guarantees payment of all private pensions. The PBGC’s assets are insufficient to cover the liabilities of multiemployer plans. Thus, if Congress fails to come up with a legislative solution, it will be faced with the ugly choice of bailing out the PBGC to the tune of billions of dollars or standing by and watching a federal agency collapse.

GROWING INTEREST IN VOLUNTARY AFTER-TAX CONTRIBUTIONS TO 401(K) PLANS

Voluntary after-tax contributions are just what it sounds like. These contributions are made in after-tax dollars and the taxes on the earnings are deferred until the year of distribution. Most 401(k) plans do not allow voluntary after-tax contributions because there has been little interest from participants. However, interest in after-tax contributions is growing due to a recent Internal Revenue Notice that allows the rollover of after-tax contributions from a 401(k) plan to a Roth IRA while the earnings on such contributions are rolled to a traditional IRA.

 

After-tax contributions are generally of interest only to highly compensated employees bumping up against the annual limit on deferrals and Roth contributions (for 2019, $19,000 / $25,000 if 50 or older), and whose income level prevents them from contributing to a traditional or Roth IRA. The only remaining opportunity for such individuals to save on a tax-advantaged basis is nondeductible IRA contributions (annual limit is $6,000 / $7,000 if 50 or older). In a 401(k) plan that permits voluntary after-tax contributions, such individuals may contribute on an after-tax basis up to the annual limit on all contributions (for 2019, $56,000 / $62,000 if 50 or older). Thus, if an individual elects pretax deferrals up to the annual limit of $19,000, there is still an opportunity to make up to $37,000 in after-tax contributions.

 

When the individual is eligible for a distribution, the after-tax contributions may be rolled to a Roth IRA and their future earning may escape all taxation. However, there is a significant limit on the ability of highly compensated employees to contribute after-tax because these contributions are included in the actual contribution percentage test (“ACP test”) that applies to matching contributions. Since non-highly compensated employees rarely make after-tax contributions, most plans will fail the ACP test if more than a few highly compensated employees make significant after-tax contributions. Failing this test forces the return of much of the after-tax contributions.

RECENT LUTZ FINANCIAL POSTS

Are We Headed for a Recession?

Are We Headed for a Recession?

Each morning I craft a Market Update email that I share with our advisors. This email provides commentary on what is happening in the markets and the economy. It includes data related to asset class…

read more

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

 

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Family Office Millennial Educational Series: Financial Literacy Basics

Family Office Millennial Educational Series: Financial Literacy Basics

 

LUTZ BUSINESS INSIGHTS

 

Family Office Millennial Educational Series – Financial Literacy Basics: Beginner’s Guide

Nick Hall and Josh Jenkins of Lutz Financial cover savings plans, insurance basics, and credit & debt, along with a Q&A session.

 

RECENT POSTS

Are We Headed for a Recession?

Are We Headed for a Recession?

Each morning I craft a Market Update email that I share with our advisors. This email provides commentary on what is happening in the markets and the economy. It includes data related to asset class…

read more

SIGN UP FOR OUR NEWSLETTERS!

We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

 

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Is Value Investing Dead?

Is Value Investing Dead?

 

LUTZ BUSINESS INSIGHTS

 

is value investing dead?

Josh Jenkins, cfa, senior portfolio manager & head of research

 

Value investing has been around for nearly a century, developing a devout group of followers over time. Some of the world’s most prominent investors employ a variation of the strategy, including Omaha’s Warren Buffett. It’s not just the practitioners filling the ranks of the believers, the approach is also supported by academic research. Value investing has a strong track record with sound economic rationale to back why it has worked in the past, and why it should work in the future.

None of this changes the fact that recently the relative performance of value investing has stunk (please excuse the technical jargon). For over a decade it has lagged behind the broad market, causing some investors and pundits to lose the faith. Here at Lutz, however, we still believe. To understand why, let’s explore what value investing is, how it has performed in the past, and why we are optimistic about its future.

What is Value?

“Long ago, Ben Graham taught me that ‘Price is what you pay, value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – Warren Buffett, 2008 Berkshire Hathaway Shareholder Letter

The above quote illustrates an important distinction that is confusing to many investors. How can you tell if a stock, or a broad market index like the S&P 500, is cheap or expensive? The obvious answer would be to look at its price. This approach feels natural, as many of us do it on a daily basis as we walk through a store or click around Amazon, but it can be misleading. The chart below illustrates the price index for the S&P 500 going back to 1928. If you tried to evaluate its merits based solely on price, you might reasonably conclude it was extremely cheap from the late 1920’s to the 1970’s. Aside from a few painful drawdowns in the 1990’s and 2000’s, the market appears to become more expensive year after year. The question is: If prices are always going higher, can stocks ever be cheap again?

S&P 500 Price Index

Source: MorningstarDirect. The S&P 500 is represented by the S&P 500 PR Index, using monthly data from 1/1/1928 to 6/30/2019. 

This is where Buffett’s quote comes into play. It is evident we have paid more for stocks over time, but has anything changed in what we receive for our money? The answer, of course, is “yes”. Decades of companies reinvesting their profits to expand and develop new technologies has resulted in businesses that are larger, more efficient, and more profitable than ever.

There are many variations of the value approach employed by the investment community. A simple one seeks to evaluate how many dollars you must pay to purchase one dollar of some fundamental metric of a company or market index. Commonly used metrics include sales, earnings (think of earnings as profits), cash flow, or book value. The value approach is centered on making sure the price you pay is reasonable relative to what you get in return. When it comes to buying stocks, what you ultimately get is an ownership stake in a company (the book value), and the right to participate in its operations (its sales, profits, and cash flows). The intuition behind using earnings (profits) as an example, is that returns will increase as you decrease the price paid for the same level of profits.

From here on “value stocks”, or simply just “value”, will refer to the subset of companies where the price paid per unit of the above fundamentals is low, relative to other stocks. If value stocks are those with the lowest price, the flip side of the coin would be growth stocks, or just “growth”. While it may seem counterintuitive to intentionally purchase the most expensive companies available, it’s actually a very popular strategy. The high flying “FANG” stocks (Facebook, Amazon, Netflix and Google), fall into this category. As their name implies, these firms are typically growing at a much faster rate than their value counterparts, and investors are willing to pay more for that future growth. The price may appear high today, but it could ultimately become a cheap purchase if the expected growth comes to fruition. The problem is investors tend to overestimate growth.

The Performance of Value

“In Theory there is no difference between theory and practice. In practice there is.” – Yogi Berra

The idea behind value investing is simple enough, but has it actually worked? To find out, we can compare the historical returns of value versus growth. Using data going back 91 years, the results clearly favor value, which outperformed the more expensive growth stocks by an average of 3.10% per year. While value has delivered higher returns over the long term, it has struggled notably in recent years. Over the last decade, the leadership has reversed with growth outperforming value by 3.44% per year. It is impossible to say precisely what has caused this change, but the massive returns from a small subset of firms (including the FANG stocks) have certainly contributed.

Historical Performance of Value vs Growth

Source: The Kenneth French Data Library; https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Value is represented by the Fama/French US Value Research Index, growth is represented by the Fama/French US Growth Research Index. The indices are not available for direct investment, do not include costs/fees, and are not representative of actual portfolios. Returns are annualized, based on monthly data from 1/1/1927 – 5/31/1927.  

After an extended period of underperformance investors will invariably begin to question whether things have changed to the point the strategy is obsolete. While no one can say for certain if or when value will make its comeback, it is important to recognize the current bout of poor relative performance is not unprecedented. There have been several other notable periods where value has struggled.

Looking at the chart below, value has outperformed on a ten year basis during the majority of the evaluation period, as evidenced by the green line fluctuating above the grey bar marking 0.0%. When the line is blue and below the grey bar (as it is today), it signifies growth has outperformed value. The aftermath of the Great Depression (1930’s), and the run-up of the internet boom (late 1990’s) provide two stark examples of past rough patches for value.

10 Year Rolling Performance - Valus vs Growth

Source: The Kenneth French Data Library; https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Value is represented by the Fama/French US Value Research Index, growth is represented by the Fama/French US Growth Research Index. The indices are not available for direct investment, do not include costs/fees, and are not representative of actual portfolios. Returns are annualized, based on monthly data from 1/1/1927 – 5/31/1927.  

Alas, no strategy works all the time. Value investing, like many other phenomena in the markets, is cyclical. Investors may shun certain companies for extended periods of time. This in turn makes them cheaper, and may set them up to perform better in the future. Conversely, people can get overly excited about the prospects of certain companies. As more investors buy into the ever-rising growth expectations, the price could rise too far, setting the company up to underperform. Even a wonderfully successful company can be a subpar investment by merely delivering great results when the market was expecting perfection.

 

Value Going Forward

“There is no way that we can predict the weather six months ahead beyond giving the seasonal average.” – Stephen Hawking, Black Holes and Baby Universes

Despite its struggles, there is a good reason to expect brighter days ahead for value. Given how well growth has done recently (particularly FANG stocks discussed above), the discount paid for value stocks is currently larger than normal. The chart below illustrates the discount for value companies (large and small) relative to the broad market. The middle grey bar in each section represents the average cost historically, while the green lines represent the current cost over time. The lower the green line moves, the cheaper value stocks are relative to the rest of the market.

Large and Small Cap Values

Source: Morningstar Direct. Valuations are based on an equally weighted composite of price/book value, price/earnings, price/sales, and price/cash flow of each value index relative to the broad market. Large cap value is represented by the S&P 500 Value Index, while small cap value is represented by the S&P 600 Value Index. The broad market was represented by the Russell 3000 index. Data from 1/2001 to 6/2019.

As you can see from the chart, not only are value companies trading at a larger discount than average relative to the rest of the market, they are the cheapest they have been since the early 2000’s! Unfortunately being a better deal than usual is not a guarantee that value stocks are poised to outperform in the near, or even intermediate term. Over time, however, the price paid has been shown to be one of the best predictors of future returns. Generally speaking the cheaper you can purchase stocks, the higher the returns you can reasonably expect (all else equal).

Wrapping Up

While the critics continue to debate whether or not value investing is dead, we believe those investors who are patient will be rewarded. The strategy has weathered many market cycles over the decades and endured other periods of extended underperformance. The opportunity to buy these already cheap companies at a larger than normal discount gives us a good reason for optimism.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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