What makes a portfolio “good”

What are the ingredients of a good portfolio?

If you do a little research, you will likely discover the three characteristics or criteria of a ‘good’ portfolio: (1) it should be diversified, (2) uses indexes, and (3) keeps costs low. All valid characteristics, to a point. In reality, this amounts to an over simplification that tells only part of the story. Applied to a poorly constructed portfolio, these characteristics will not help you create a good portfolio and you will not feel the confidence you need to see you through a market downturn. So, what is the best recipe for a ‘good’ portfolio—one that doesn’t cause you anxiety and keeps you up at night while generating long-term reasonable returns?

Here is my list of five ingredients for an effective long-term portfolio:

1.      HAS A STRATEGY. First and foremost, your portfolio should follow a strategy that you believe will be effective. You need to understand and believe in it enough that you can allow it to capture value over time (while others are off chasing the latest trend). At AIKAPA we use a global investment strategy that leans towards value (rather than growth) allocations.

2.      IS DIVERSIFIED. Select a diversification that represents your strategy and provides exposure to asset classes that behave significantly different from each other. In AIKAPA’s portfolio we are diversified across equities (that include large and small US and non-US equities) and across bonds, each global asset class providing opportunities to capture value. Using the chart below, you can compare global asset classes and how their volatility and returns differ from each other.

august_nibbles_asset-class-return-risk-for-2000-2005

3.      IS LOW-COST/HIGH-QUALITY (i.e., often an index fund). Implementing your diversified strategy needs to be completed using low cost, high quality securities. Use of baskets of securities (such as proven index funds) to represent chosen asset classes in your portfolio will permit the needed diversification while eliminating the risk associated with the failure of any one company (mutual funds or exchange traded funds are the baskets we use for your portfolio).

4.      IS LOCATION SENSITIVE and TAX MINDFUL.  Being mindful and “tax sensitive” when purchasing securities and locating them in the appropriate type of account can result in higher NET gains. Tax free, tax deferred, and taxable accounts should hold securities that will provide needed diversification, but will also yield the best AFTER tax returns. This approach is termed asset LOCATION selection. Taxable accounts are particularly valuable in the short and long-term but should hold assets that will not dramatically increase personal tax liability (particularly for those already in the higher tax brackets). As an example, two similar US Small capitalization funds can create very different tax liability simply by the level of “turnover” inside the fund. This turnover is often caused by frequent trading by the fund managers and can significantly reduce after tax net returns.

5.      IS REGULARLY REBALANCED. Finally, we have rebalancing of a portfolio. Rebalancing by conventional wisdom is what enhances your long-term returns by periodically selling what is overpriced (over-valued) and buying those that are underpriced (under-valued). The reality is not quite that simple. Automatic rebalancing software, for example, is tempting owing to its simplicity, BUT can lead to high turnover and reduced gains. Keep in mind, rebalancing has at least two different purposes. Rebalancing across unlike return assets (for example between equities and bonds) will result in a decrease in long-term returns, while reducing volatility (or risk). Yes, you trade some upside to reduce the downside. On the other hand, rebalancing between similar return assets (such as, between equity funds of large and small capitalized companies) will capture gains and lead to enhanced long-term returns as long as you don’t trade too often.

Assuming you’ve got all the correct characteristics in place, a ‘good’ portfolio ensures you’ve got adequate exposure to the market while assuming a measured level of risk, tax sensitivity, and an appropriate degree of rebalancing.

At the end of the day, a good portfolio can only succeed if you believe in the strategy and, most importantly, allow it to perform as designed over the long-term. To do this you, you must be certain that it is a good portfolio for you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Ready for College? – timing & planning finances

All college applicants that need a loan, scholarship or a grant must complete a financial-aid application. The process isn’t solely for those who have low enough income to qualify for aid. If you would  like to be considered for the 2017 education financial process you will need to complete the “Free Application for Federal Student Aid” or FAFSA (www.fafsa.gov). The process begins again on October 1, 2016.

Ideally, you will work closely with someone that is immersed in this process and aware of the 2015 changes enacted by President Obama. These changes will sync the timing of funding with college decisions for the 2017-2018 academic year. Though this timing is for federal financial calculations, individual institutions agreed to match up with the process for the 2017 school year. Even so, always double check with the specific college that is under consideration.

The process will now be based on 2015 year-end taxes (even if extended) for the 2017-18 school-year. There will no longer be estimating and re-adjusting as in past years. Parents and working students are encouraged to file taxes by the summer and to defer income (as much as possible) during college funding years.

Controlling the recognition of income (for both parent and student) will make it easier for students to obtain loans that have reasonable terms of repayment. In some cases, it is not possible and other ways of paying for higher education will be needed. Year-end tax planning should have a high priority starting two years before the intended college start.

So how does the 529 College Savings Plan affect your ability to receive loans or aid from the FAFSA system?  If the 529 plan is owned by the parent or dependent student it is an asset in the application (FAFSA) process, BUT qualifying distributions are not counted as income (i.e., tax free). Though grandparent owned 529 are not counted as part of the FAFSA calculation, distributions to pay for a student’s education does count as child’s income (but it is tax-free). The best way to handle grandparents’ distributions from 529 plans for students is to hold back distributing from grandparents until the last two years of a student’s college education.  So, keep in mind, it is best to take 529 distributions (from parent and student owned 529s) during the first two years and grandparent funded 529 during the last two years.

Though 529 plans are useful if your child has more than three years to go before college, they are not really effective as a short-term strategy. If you’ve little money saved and your child is to attend college within 3 years you need to consider other strategies. Consider paying the tuition yourself directly – you are allowed without tax consequences (but also no tax benefit) to pay for  higher education tuition costs directly without triggering gift tax (gift tax is triggered if you gift more than $14K in 2016). These tax-free gifts will not count as a student asset or income for financial aid purposes. This strategy works well for grandparents who can pay directly for a grandchild’s tuition and/or provide annually a gift towards expenses not exceeding the limit that year (limit of $14K in 2016).

Another strategy often quoted is gifting of appreciated assets which can be a double-edged sword since it can cause a student’s income/assets to exceed the FAFSA limits and result in the loss of access to loans or aid awards. We recommend close and careful monitoring and it is best if these tactics are reserved for the last two years of college so that there is little to no impact on the FAFSA annual calculation.

Sometimes parents have purchased Uniform Gifts to Minors Act (UGMA)/ or Uniform Transfers to Minors Act (UTMA) assets since they can be used for pre and post college funding, BUT these accounts are considered part of a student’s assets in the FAFSA application and have a significant impact on the availability of loans or aid. We recommend transferring to a 529 account, BUT this is not always a good strategy since it triggers capital gains taxes. The best strategy is to spend the account two years prior to college. These accounts have a much looser definition of how they must be used. Any expense that benefits the child other than those that a parent is required to pay are permitted. Ways we’ve seen these accounts used include: summer camp, highschool tuition, an electronic device (laptop or Smartphone) and academic tutoring.

The most important take away is that you must plan for a college account distribution two years before your student will attend college. The new rules do simplify the application process but it also means that your tax planning needs to be ahead of the student’s decision on higher education.

Finally, (like any complex financial decision) college planning can frankly add a level of discomfort and conflict to the family. But, it can also provide an opportunity. The experience, if inclusive, can be part of a shared life experience, an educational moment, and an opportunity to fulfill your goals. It is a chance to learn how to make financial decisions and feel good about them.

Stay connected with your financial advisor and discuss how to best deploy your available resources to benefit both you and the student.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Money Battles and the pitfalls of financial infidelity

Let’s face it, making important financial decisions can be stressful at the best of times. When life partners fail to see eye-to-eye on finances it can lead to discord if they don’t have a way of working through their differences. It’s no secret, when compared to other types of marital disagreements, arguments over finance are the strongest predictors of divorce.  Financial decisions get even harder to make as we grow older—the habits of the past increasingly difficult to break. Add a touch of procrastination to the mix and you’ve got the potential for real trouble. It’s no wonder then, how easily decisions affecting retirement can turn into a battle over money, when so much is at stake. The best way to avoid unpleasant (and generally unnecessary) confrontations over money is to have a process in place. Let me explain . . .

Ideally, couples will create a money decision-making process early enough in their relationship that it becomes almost second nature—ensuring financial discussions are honest, frank, frequent and cordial. Both partners must be kept up-to-date on the family’s financial dealings and how those dealings align with understood and accepted goals. From our experience, monthly or at least quarterly meetings to discuss/review finances are invaluable.

This isn’t to say, every penny must be accounted for. Each partner must feel that they have reasonable autonomy and freedom to act within an allotted budget, BUT both must be clear that there are boundaries. Some couples set a specific dollar amount above which they must check with their partner and/or reach out to their financial advisor when especially tough financial decisions arise. For example, couples are well advised to discuss in detail funding a child’s college education, their retirement budget, or when to cease working.

Fights over money can be avoided if both partners have a handle on household finances, and moreover, feel their voice is included in all financial decisions.

If one partner pays all the bills and takes care of all the investments, the other partner over the long-term will begin to feel they are not a full participant in the relationship (or at least, they ought to feel that way). To counter this possibility, some choose to exchange roles for part of the year. Others have a regular monthly meeting to be sure that both are indeed aware of the family’s finances. AT A MINIMUM, all couples should go over how to access the family’s financial information (bank accounts, retirement plans, insurance, and investment accounts, etc.) AT LEAST ONCE PER YEAR.

When one partner takes on the financial responsibility for the family the inequity can (unintendedly or not) lead to “financial infidelity.” Financial infidelity occurs when one partner hides their spending on things they feel strongly about despite a clear agreement to the contrary by the couple. As an example, one partner might secretly fund their child’s business venture. I’m aware of one case where this actually happened. The situation was not revealed until the death of the offending life partner. The surviving partner’s betrayal was made all the worse by the fact that their retirement assets were depleted without his/her knowledge. The child that benefited from the covert funding, moreover, was not in a position to repay the surviving parent.

To avoid or at least reduce the likelihood of conflict over money, here are a few helpful guidelines:

  1. Communicate on expenses early, frankly, openly and honestly
  2. Meet regularly to review finances
  3. Update goals and ensure all parties are on the same page

When speaking of goals, articulate them out loud (i.e., verbally or in writing) and be sure to include your goals for both the present and the future.

The decision-making process itself should be reviewed as part of your conversation. For example, how do you determine your life-style budget, your savings goals, and what happens when you encounter expenses that fall outside of your budget for some reason?

As large financial decisions approach (such as retirement funding), the reality will undoubtedly generate much needed discussion. This conversation can turn into conflict if one side of a partnership is not in touch with family finances and family goals. Those who opt to avoid financial conversations will invariably find themselves in “money battles” that can seriously erode trust and faith in the relationship.

Facing major financial decisions, such as when, how and where to retire, needn’t be a source of discomfort or conflict. Far from it. If there is a reasonable process in place, the experience can be part of a shared life experience, an opportunity for optimism and mutual support.

I should add, in closing, that being single and unattached, doesn’t make you less susceptible to the stress imposed by major financial decisions like those discussed above. In fact, the “internal conflict” may be worse without someone to bounce things off of. If you are on your own, the same guidelines apply, but your “partner” in this is your trusted financial advisor.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Should you be a landlord in retirement?

As you would expect, we often think about ways to supplement client retirement income and diversify a client’s finances beyond their market portfolio.

Owning one or more rental properties (commercial real estate) can provide a steady source of income and cash flow during retirement, with the added advantage of building owner equity (owner wealth). Once established, rental properties can also be a great resource to meet both planned and unexpected life events. And since they can be depreciated on your income tax, rental properties can provide a significant tax advantage while the asset actually gains in value. All this said, owning a rental property, let alone more than one, is not for the faint of heart. Without regular attention and constant re-appraisal, they can become a major headache and a huge liability.

The path to becoming a commercial real estate investor (a fancy way of saying “landlord”) often begins, innocently enough, with owning a single family home and then, for whatever reason, deciding to convert it to a rental. In this case, the property may need to be adapted in some fashion to accommodate renters. Others will approach a real estate agent with the deliberate intention of purchasing a rental property, in which case the property may be “turn key,” requiring little, if any, alteration. Whichever way you start out, the following are just some of the things you need to take into account before you commit to becoming a landlord in your golden years.

Commercial real estate requires at least 20%-30% down payment and an ongoing source of cash flow to fund expected and unexpected expenses. This means your equity will be locked in your property and only available through the available cash flow stream.

Real estate can be a great addition to an investment strategy, but rarely prudent as a sole investment. Unlike your portfolio, which will have fixed expenses, be liquid and globally diversified, your real estate will be impacted by local conditions with unexpected expenses and periods of poor liquidity. Expenses that are predictable include mortgage, taxes, landlord-specific insurance policies (both property and liability). Less predictable expenses are maintenance and repair costs as well as tenant related expenses. For those in control of their family cash flow, it is this difference that makes rentals a good consideration as a secondary investment and as part of their financial plan.

Like all investments it takes time and due diligence to generate a stable positive cash flow from rental properties – luck alone will not suffice. The price you set for rent is all important as are the expenses you incur. You need to be sure to cover your operating expenses which can include mortgage, property tax, insurance, maintenance, bookkeeping and accounting fees, utilities and if you use a management company you must also include their fee. In addition, the rent must provide you with a reasonable return based on cash flow, not just property appreciation, since you can’t sell the property to pay for ongoing expenses. The property must remain competitive with the local rental market and your cash flow able to cover expenses that may not be deductible in the year they are spent (a roof is an example of an expense that is depreciated and not deductible).

In addition to the financial considerations cited above, you will have legal obligations that are based on local laws and regulations pertaining to rental housing. A broken water pipe, furnace or refrigerator? Round-the-clock availability for emergencies is your responsibility. You can, of course, assign or pay for someone to take care of such things, but the legal responsibility will still be yours (always have sufficient liability and property replacement insurance). You are likely to be held liable for tenant or visitor injuries if due to unsafe conditions, especially in the common areas. Safety and habitability is paramount. On a regular basis, you must make sure structural elements are safe, the electrical, potable and wastewater infrastructure is sound, that trash containers are provided, that any known or potential toxins (such as mold or asbestos) are properly managed, that rodents or other vermin are kept clear off the premises.

However you come by your rental property, you will have to choose whether you should be your own property manager (directly overseeing and paying for maintenance yourself) or to take a more arms-length approach by contracting with a property management firm. Some clients hand these tasks to a family member who wishes to work part-time while others hand it over to a professional. A property manager can help those who wish to limit their day-to-day responsibilities, especially if you aren’t the handy sort or aren’t physically up to the task, but then you will have to cover the additional expense. Property managers, in simple terms, are hired to find tenants, maintain the property, create budgets, and collect rents. You will want to hire someone who knows about advertising, marketing, tenant relationships, collecting rent, maintenance, plus local and state laws in the location that you have the property. As the property owner, you can be held liable for the acts of your manager. It’s prudent, therefore, to hold the rental property in an entity that can provide some legal protection. Costs for contracting a property manager will usually run about 8% of rental income for management and about the same for engaging new tenants—this can eliminate your profit but if properly priced will provide you with a sustainable model well into retirement.

Finding reliable tenants is always a challenge, even if you employ a property manager. Tenants need to be able to pay their monthly rent, keep the property in good condition, and follow policies in the lease or rental agreement. You’ll find it easier to find good tenants if you select a property in an area experiencing low vacancies and high demand. Unfortunately, this means the property will also cost you more.

You should be prepared to have to deal with (or have someone deal with) evictions, wear and tear on your investment, unauthorized sub-lets, termination without proper notice, smoking, illicit drugs, pet odor and damage, parking and waste management issues, advertising, noise (including sometimes difficult neighbor relations), and other eventualities. Or, you can get lucky and find perfect long-term tenants! Realistically, as you age these tasks may become too stressful, eventually requiring you to hire a property management company or engage a (younger) interested and motivated loved one to take on this role. Either way, you must put this in writing as part of your purchase plan—including when you want this to happen, who this person should be, and finally, when the property should be sold.

During retirement some will love the ability to work part-time at managing their properties (even if only in a limited manner) whereas others will find it too complicated for their ideal retirement life. Invariably a well-managed property can generate ongoing income and create owner equity that will be a godsend in retirement or as an alternative to your market portfolio. Unfortunately for some, the process can become too complicated and stressful. So much so, that they avoid the tough decisions and derail their entire retirement plan. Being a landlord is very much an individual decision.

The bottom line is that rental property cash flow can generate a stable income during retirement, and can provide needed equity to fund contingency plans (such as disability, long-term care, health care needs, legacy) but profiting requires planning and annual review. It is a business that needs your ongoing attention or it will become a major liability. Even with the help of a property management firm, you may wonder in what way you can really consider yourself “retired” owning and managing rental properties.

Like any other financial investment, do your homework, and moreover, make sure it fits with your long-term financial goals and vision for a rewarding life.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

HARP and Traditional Refinance

Refinancing your mortgage may seem ideal and particularly pressing when you are contacted by a “HARP specialist” anxious to point out that the rates are better than ever and the deadline to apply fast approaching. If you are considering such a move, let us first check to see if refinancing makes sense AND if you even qualify for or should use the HARP program.

Let’s begin by reviewing when and why we would take the time, make the effort, and incur the cost of a refinance. Refinancing is often done with the intention to lower interest paid, lower the monthly payments, or to change the terms of the mortgage. You may not realize that refinancing also restarts your amortization and could cost you in hidden ways by having you pay more interest over the mortgage period. A refinance is really a new mortgage where the new mortgage pays off your old mortgage and you work with the new product. The refinance may be ideal for the lender, but not always appropriate for you.

Traditionally refinanced mortgages are either for the balance of the previous mortgage OR for a higher balance by taking cash out. These are referred to as a “simple” or a “cash out” refi. Every time you do a refinance, your finances have to be in tip-top shape and you must select the right lender. Too often clients, for convenience, will use their current bank to refinance their mortgage, which may not offer the best terms or the easiest process. Regardless, you will be asked to verify your income. Moreover, you must have at least 20% equity (home-to-loan value, or LTV) if you don’t want to pay the mortgage insurance. The process for ALL refinancing will require that you gather documents and find the right lender, then submit an application, which the lender must respond to within 3 days with a good faith estimate (citing all costs). Once you accept, it may feel like ‘hurry up … and wait’ since the lender now has 2-3 months to respond. They will often come back to you for more information or clarification, so it turns into a back-and-forth experience. Eventually, you’ll lock-in a rate for another 30 days while verifying the final paperwork.

In the 2008-9 crisis, properties were valued lower (in most areas) and in some cases homes were worth less in the market than the mortgage debt (i.e., “underwater”). Since this was only a paper lose, it was only a problem for families with high-rate mortgages, an immediate need to sell, and with strained budgets. Sadly, these home owners were often denied a refinance to take advantage of much lower interest rates, reduce monthly mortgage costs or provide a more stable fixed-interest mortgage. It was to address this stressful financial situation that several programs were created. One, discussed below, is the HARP program.

“HARP” is the Home Affordable Refinance Program, a federal-government program established after the last housing crisis to assist homeowners with refinance (at today’s lower mortgage rates) even if their current mortgage is underwater. The goal of the program is to allow borrowers to refinance into a more affordable or sometimes a more stable mortgage product.

The HARP program ends December 31, 2016 and, as happens often before a deadline, we find an increased flurry of lenders trying to convince every home owner that they are the ideal candidate for this government program. HARP mortgages are not for everyone.

The first version of HARP had too many limits and in 2012 the HARP 2.0 program was created eliminating some of those limits. Notably, the underwater limits were removed, appraisals no longer needed, the refinance process streamlined, some fees for being ‘underwater’ eliminated, and allowance made for less stringent verification of income (to include not just W2 statements but also 12 months of saved mortgage payments).

The biggest difference between the traditional and HARP mortgages is that you don’t have to have an LTV ratio lower than 125%—the HARP program eliminated this limit. You could obtain a lower rate mortgage even if your home is still worth much less than your own mortgage.

As I’ve stated, HARP is often used to reduce mortgage interest and reduce monthly payments, but others use HARP to convert adjustable rate mortgages (also referred to as ARM-loan) into a more predictable, fixed-loan program (usually 30 years) or if it fits within your budget, a 15- year mortgage that helps you build equity faster.

HARP was never intended for individuals who are near bankruptcy or who have not paid or can’t pay their mortgages. Rather, it is intended for those who have managed to stay current on their mortgage payments, and yet, are not able to change to lower rates since they no longer qualify for a traditional refinance either because of lower income or decreased equity.

In my experience, HARP is a difficult option to pursue because the home owner not only needs to be current on their mortgage, the mortgage needs to be under Fannie Mae or Freddy Max and therefore must be “conforming.” Conforming loans have maximum limits of $415K to $625.5K depending on the location of the single family dwelling. Most Bay Area homes have mortgages that easily exceed these values. They are also only valid if the mortgage was acquired by Freddie Mac or Fannie Mae before June 1, 2009 (an arbitrary date stemming from the crisis).

Because the regulations are rather document heavy and include many exceptions, some lenders have adopted their own versions, so you may need to change your lender to obtain the best HARP loan. Even though the process was to be streamlined, implementation fell far below expectations. The lender’s representative often lack enough knowledge, causing a great deal of frustration to an already stressed individual/family. For example, clients thought they had to use the same lender and that it only applied to their primary home—this is not the case. You can use any lender and HARP can be used on any mortgage that is backed by Fannie Mae and Freddie Mac. The goal is to support those underwater because of the 2008-9 crisis.

Regardless of whether you are considering refinancing through HARP, other government programs or a private lender, you must always examine the total costs AND the purpose for the refinance. If you’ve recently completed a refinance then you need to have a really compelling reason before considering yet another refinance. If you need to increase cash flow then look for low closing costs but expect you’ll pay more interest in the long term. BUT if your purpose for the refinance is to cash out equity or to change some other aspect of your mortgage, then the upfront closing costs may be acceptable. At times, clients appear interested in refinance every few years largely because of lender contacts or advertising. Refinancing every few years can be a costly mistake. It is important to remember that each time you refinance you are starting with a brand new mortgage which will restart the amortization. Restarting amortization is good for the lender, but, not always good for you.

There are a couple of lessons here. First, to truly take advantage of opportunities like HARP you need to be on top of your finances. You also need to understand the product/plan that is offered. Ask yourself is this good for my financial situation? If unsure, drops us a line and we’ll check out the product and provide you with a product neutral opinion that is appropriate for your financial plan.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Medicare—Surprising facts and critical changes

The goal in retirement (or financial independence after age 65) is to be able to support our lifestyle using accumulated assets, Social Security and Medicare. It has become evident that Social Security and Medicare had to change to continue to sustain future retirees. The loss of the Social Security ‘file and suspend’ strategy for anyone who is not 66 by the end of April, 2016 has received a lot of media attention. Yet, major changes in Medicare have garnered much less publicity although no less important to retirement planning.

From our retirement planning vantage point, we believe the new Medicare changes will add a significant wrinkle to what is a already a very fine balance between distributions from portfolios, income tax liability, and funding our client’s ideal retirement lifestyle.

This short educational article outlines a few surprising (even shocking) facts that everyone should know about Medicare. For more details (particularly those approaching 63 or are two years from switching to Medicare from employer plans), I recommend that you read, in detail, the annually released official US Government Medicare Handbook. The 2016 version of this booklet is available at https://www.Medicare.gov/pubs/pdf/10050.pdf

  • Medicare Alphabet Soup (A, B, C, D) are not all free – The 2.9% current premium paid to Medicare on your earnings while employed only provides for free Medicare Part A coverage. Part A only covers hospital insurance, not comprehensive health insurance. Medicare Part A participation, however, does provide access to the other Parts that, when taken together, can constitute a comprehensive health insurance plan able to meet specific needs. Part B is basic medical insurance. When combined with Part A it is termed “Original Medicare.” A and B combined isn’t enough to cover everything you’ll need. Part D is a premium paid for drug insurance. It is incredibly complex as specific drugs fall in and out of favor within each plan. On the other hand, Part C is an integrated health plan that usually includes Part A, B, and D. It is often called “Medicare Advantage.” Finally, you may encounter Medigap coverage (which has its own alphabet soup) to cover areas missed by Medicare A, B, C or D.
  • Basic Costs: Average costs are difficult to estimate and are often not as low as many expect. Part B would seem very well priced at less than $1,500 per year and yet in the real world we seldom find these ideal rates. Instead, we find health insurance through Medicare averages around $4K-6K per person per year. Moreover, rates are expected to rise significantly in 2018 because of surcharges.
  • Enrollment in Medicare is not all automatic and requires strict attention to timelines. Timelines appear long (for example, 7 months for the initial enrollment) but to avoid penalties and loss of coverage you will need to act early in the timelines (most wait until their birthday month and may find that they have a gap in insurance coverage even though they make the enrollment timeline). To avoid penalties, initial enrollment into Medicare is 3 months before your birthday month and extends to three months after. If you have approved coverage (for example, from an employer health plan) and need to transition to Medicare you will have a “Special Enrollment Period” with its own timelines that must be initiated prior to leaving your employer approved health coverage (excluding COBRA).
  • There are hefty penalties that stay with you for life if you miss an enrollment timeline – Penalties for missing enrollment timelines into Part B are currently an additional 10% of your normal premium cost for every 12 months delayed. Part D penalties are 1% per month delayed. These penalties continue throughout your enrolled life, meaning that you’ll pay more for the same coverage. For example, if you enroll 3 years later than required, the premium you pay for the same Medicare Part B coverage is 30% higher. If you also missed enrolling in Part D, the premium is 36% higher.
  • Once you enroll in Medicare you can no longer make H.S.A. contributions. Once you begin collecting Social Security you are required to enroll in Medicare Part A, which eliminates your ability to participate in certain plan features. For example, it disallows the annual tax-free H.S.A. contributions.
  • There is free personalized health insurance counseling. You should use it to design the best plan for yourself and to fully understand what you need to do each year to make the most of the health care plan you chose (given your expected annual health care needs). In addition, work closely with your Wealth Manager to ensure that you distribute your wealth in the least costly manner given your lifestyle and available assets.
  • Not all health insurance plans are available in all locations. When planning your Medicare health plan, use the community you are planning to retire into to get the most accurate list of health plans available. There is also a 5-Star rating website, provided by Medicare, to help you choose the best available plan in your area.
  • Since 2007 Medicare has been MEANS tested (i.e., dependent on income). Additional income-based premiums can come as a surprise, but what is perhaps more shocking are the new income limits that will begin in 2018. For the moment, surcharges to Medicare premiums begin at $85K and $170K MAGI (Modified Adjusted Gross Income for those filing as single or married filing jointly). Currently, the surcharges top out at $390/month or $4,700/year for Part B for those with MAGI greater than $214K and $428K (single versus married filings). Separate surcharges apply for other Parts. But take note—starting in 2018, the surcharges will apply to a lower MAGI. The largest surcharges will be for those with MAGI over $160K and $320K. An additional surprise is that the earnings that will be used to calculate your Medicare Premium surcharge (also known as the annual “Income Related Monthly Adjustment Amounts” or IRMAA) will be based on your income tax filing from two years earlier. For example, if you enroll in Medicare in 2018 they will use your 2016 taxes to estimate your IRMAA (there is a process to appeal surcharges).
  • The income included in determining additional premiums is based on your adjusted income PLUS any tax-free income (such as Muni bond interest) – MAGI (in these scenarios) includes all ordinary income (work earnings, pre-tax withdrawals, pensions, etc.), plus 50% of Social Security collected, plus tax exempt interest. It doesn’t include H.S.A. or Roth distributions or loan proceeds. Annual distribution will now need to be tightly connected to your MAGI.
  • A “cost of living” gift from the ‘Hold Harmless’ rule – For some, the “Hold Harmless” rule provides additional premium savings. This benefits those who have their Medicare Part B deducted directly from their social security. This rule prohibits increases in Medicare Part B premiums when there is no similar increase in Social Security benefits. The ‘Hold Harmless’ rule evaporates for anyone not deducting their premiums from Social Security, or if they pay additional premium surcharges (because of income limits), or if it is their first year in Medicare (plus a few other exceptions).

These changes to Medicare (and likely new changes in the future) will make it essential that your accumulated wealth be deployed in a manner that will allow you to have the necessary cash flow for your chosen lifestyle while maximizing the various MEANS adjusted benefits.

It has always been our recommendation that clients have more than just pre-tax savings, Social Security, and a pension to support their retirement distribution. Going forward, Roth and H.S.A. savings will unquestionably become even more powerful adjunct retirement planning tools since they are tax free and not part of Medicare MAGI Means testing.

Know the facts about Medicare. An educated consumer is better equipped to make sound choices leading up to retirement and much more likely to secure the retirement lifestyle they have in mind.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Important Changes To Social Security That May Impact Your Retirement Plans

As you may be aware, significant changes to the Social Security program were signed into law November 2nd by President Obama (see news items in November “Nibbles”). As your financial advisor, I believe it is important to keep you abreast of these changes as they are likely to impact your retirement plans. Some clients will be required to take appropriate action over the next 5 months.

To be clear, the two Social Security planning strategies that were eliminated on November 2nd are still available to those older or turning 66 by April 29th, 2016 for “file and suspend” and those who are at least age 62 by December of 2015 for “Restricted Application.” These individuals are not affected by the November 2nd changes. However, anyone else will no longer have these strategies available in retirement.

At Aikapa, we will give priority to those that need to act immediately to retain ending benefits and then methodically work our way through the retirement plans of our other clients.

DETAILS ON THE ELIMINATED SOCIAL SECURITY PLANNING STRATEGIES

Two widely-used Social Security planning strategies were eliminated by Congress without much discussion, notice, or fanfare, impacting the retirement plans of many Americans.  The two strategies were “File and Suspend” and “Restricted Application for spousal benefits”.  The two strategies usually operated hand-in-hand, but could be employed separately. There are always tradeoffs to retirement planning strategies, but these two strategies typically added 3 to 5 years of additional coverage in retirement.

“File and Suspend” involved one person filing for Social Security at full retirement age (currently, it is 66 years old) and then suspending this filing. The net effect was that they’d file to collect on their Social Security record and then decline to collect.  These two actions allowed other family members to file for benefits based on the that person’s Social Security record while they continued to let their own Social Security benefit grow, often until age 70. Four years at 8% per year would have increased the Social Security benefit substantially. For those that didn’t immediately need the benefit, the option was an obvious “no brainer.”  According to the new rules, the option to File and Suspend ends for anyone that is younger than 66 by April 29th, 2016 (in other word, anyone born after April 29, 1950).

“Restricted Application for spousal benefits” allowed one person to file (i.e., the “filer”) based on their spouse’s record, but only after their spouse’s record was activated.  The spousal benefit was always ½ of the benefit entitled by the person who paid for the Social Security benefit (at full retirement age). The spousal benefits would be collected based on the spouse’s record allowing the filer to grow their own Social Security benefits.  Though often useful, this strategy of collecting based on a spouse’s Social Security benefits while allowing their own to grow will end for anyone younger than 62 as of December 31, 2015 (or those born after 1953).  According to the new rules, if your spouse files and suspends prior to April 29th or is collecting Social Security then you will be able to file a restricted application IF you turn 62 by December of this year.

If you were born prior to 1954 and these two strategies are relevant to your retirement plan, don’t be surprised to find that we’ll be reaching out to you this month.  If we don’t reach out to you this month, do let us know if you or your loved ones need assistance capturing these ending social security benefits.

For all of us, this is a reminder that all benefits are bound by rules that have planning consequences and require ongoing attention.  For many, this change to the Social Security program will mean either an adjustment to spending during retirement, or more likely, require additional annual savings prior to pre-retirement (or other wealth creation strategies).

Always feel free to call or let me know if you have any question with this or other financial matters.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The skateboard champion and other stories

As a way to put money away and save on taxes we often think of retirement accounts for the self-employed that include a simplified employee pension plan (SEP), an individual 401K-profit sharing plan (401K-PSP), or Defined Benefit (DB) plan. DB plans are the least used and yet the most powerful at reducing tax liability and quickly increasing your tax-deferred savings. To illustrate how DB plans can be used, I want to share with you how creative individuals were able to leverage their DB plan to save maximally and retire early.

  • The Skateboard Champion – A 30-year-old skateboarder plans ahead and saves $130K per year from winnings and endorsements. He will have saved $2.6M by the time he turns 50 (without considering any market growth).
  • The Lobster Fisherman – A 61-year-old fisherman from Maine pays himself $35K in payroll from his C Corporation and saves $60K per year for the last five years before retiring. His reward: an estimated $300K in accumulated additional savings for his retirement.
  • The Clothing Store Sales Rep – At 57 years of age the rep contributes $150K per year for herself and $12K for her young assistant until retirement at age 65. She accumulates another $1.2M not including growth.
  • The Lobbyist from Virginia – Beginning at age 48, the lobbyist contributes $145K/year for 7 years saving just over $1M by age 55.
  • The University Professor & Guest Speaker – Starting at age 54, the Prof contributes $42K per year from guest speaking engagements. He does this for 12 years and adds $502K in savings (excluding growth) to his already substantial university benefit plans.

DB plans provide the highest contribution amounts particularly when combined with a 401K. To take full advantage of this type of plan, a business must have sufficient profit and cash flow. DB plans, like a 401k, must be established in the same year and have specific requirements including annual tax filings. DB plans are not limited by the fixed maximum contribution found in SEP or 401K plans but instead are based on age, payroll and future benefit. This year, the maximum annual future benefit is up to $210K (this can amount to substantially more than a $210K contribution in any one year).

If you have a side business or are starting your own full time business consider the DB plan. Even though these are powerful, the best type of retirement savings plan for you is dependent on your business’ current and projected cash flow. As you can tell from the stories above, a well-designed DB Plan is not just for those over 50 or those with large earnings. It can be a very smart way to defer taxes today and provide for your lifestyle in the future.

Defined Benefit plans are not appropriate for everyone but I’ve seen them work for so many different people in unexpected situations that I thought I’d share some success stories with you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Start of the Year Planning

I’m often asked “how do I make sure that I (and my family) stay on track with
our finances?” Following are a few pointers to start the New Year off right.
Keep in mind, this isn’t about making resolutions (we all know how that goes), but
rather, building sound financial habits that will set you, and your family, in
good stead, now and in the future.

(1) TAKE STOCK. If you haven’t done so already, the first place to start is to
take stock of what was actually accomplished in 2015. This will be easier if you combine it with your preparations for filing your income tax. As a family, tally all of your statements (we send you a summary of the investments we manage but we’re willing to help you summarize your other assets as long as you send a year-end statement). This shouldn’t just be one person’s job – the point is to use the opportunity to enhance everyone’s awareness of how the money was earned and spent last year. It is also a time to see how well the reality matched the goals set at the start of 2015. Before you move forward you need to take stock of those items you can control. Don’t get too hung up on performance—the markets behave as they will and you’ll come out ahead as long as you have a low cost, high quality, diversified portfolio. Once you have such a portfolio, it is MORE important to determine how well you enjoyed the year than just
analyzing your spending habits.

Was this a good year for you? If so, what made it good or what made it less
enjoyable? As a family, what would you keep and what would you avoid
earning/spending if you had a choice? Life is about learning from what we do
and what we value but it should be based on your reality and your values.
Come away knowing how the year met with your expectations for a good life.

(2) DON’T GO IT ALONE. Think about how you can include others in this
process. This is particularly important in families where one person takes a
larger share of the family’s financial responsibilities. This “Start of the
Year” planning is an opportunity to develop closer communication
with anyone who is important to your financial future. First share
what was accomplished in 2015 and then decide what the family might want
or need in 2016. Do not forget that once you have set your goals you might
want to include financial professional(s) to ensure that you maximize and
implement all that is available. The power of building a strong financial
rapport over years will become evident during annual planning and when life
reveals unusual financial challenges.

You might also want to use this opportunity to share relevant annual decisions
and your process with any dependents so that they become participants in
helping the family attain goals for each year. For children this can be an
excellent learning experience and evidence of how finances are discussed and
handled in a family.

(3) GET BUY IN AND ACCOUNTABILITY. It is best to commit to
writing what was accomplished in 2015 and what you are targeting
in 2016. You should set a quarterly check-in to be sure that everyone is
committed throughout the year to what is decided at the start (this is most
important for the first couple of years and until this process becomes habit). The aim is to keep everyone on track and to determine if the goals and objectives are indeed
attainable.

(4) TRACK YOUR PROGRESS. Ideally you’ll let us help you track your
progress throughout the year by checking in with us, but we also encourage
you to make it a habit in your home.
Making financial decisions can be challenging at the best of times, if only
because they tend to have a ripple effect that isn’t always predictable.
Remember—when taking stock and making plans, it helps to keep the lines of
communication open, control what you can and target those things you value.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Caregiving for a Parent or Elder Can be Rewarding

As I read the latest survey which found Americans unprepared for the complex and unpredictable realities of longevity and caregiving, I thought about my own experience. In my case, planning with parents for their wishes has allowed for open and frank conversations that helped to develop trust and understanding. It provided a chance to resolve and express unspoken sentiments and a time to see parents/in-laws as peers. It was also a time for them to share life enriching experiences. In the process of helping them plan for their lifestyle choices and care, I learned something more about them, myself and my family. In my situation it allowed me to recognize how much value I place on having intellectual and meaningful activities.

It was interesting to read, in the survey of caregivers, (called C.A.R.E.—Costs, Accountabilities, Realities, and Expectations) that 60% said caring for two aging parents can be more demanding than caring for two children (ages 3-5). It also found that 66% said that the extra costs involved would have a large financial impact on them, and, perhaps more significantly, 38% said they had not planned for these costs. Most respondents believe the shortfall would be offset from cuts to discretionary living expenses, retirement savings, or from another source of income.

This survey is particularly worthwhile because it reveals a disconnect between the perception and the reality of caring for an elder. The perception is that caregiving is mostly about grocery shopping, cooking and laundry. Whereas, experienced caregivers know that although chores and emotional support play a large part, it is financial support and personal hygiene that are the most stressful and anxiety building aspects of caregiving. The lesson here is that you can best assist your parent or elder by pointing out this disconnect—help with chores is fine and may be necessary, but thinking through how caregiving will be financed and how their physical needs will be met is paramount to avoiding serious challenges.

As they plan their caregiving you should encourage them to agree on the signs that will be used to indicate it is time to seek further assistance with their finances and physical care. It is during these caring conversations about their wishes that you can volunteer ways in which you are willing and able to be of help (but only after you’ve examined your own retirement plan).

As the off-spring of a parent that raised a family, that may have managed a firm and made countless complicated decisions during their careers, it can be difficult to envision your mother or father sometime down the road when logging onto the Internet or even frying an egg seem onerous tasks. A key ingredient to helping them along is to examine honestly what lies ahead and plan accordingly. Encourage them to remain connected to family (they will benefit from increased meaningful contact with a loved one) and to build a fiduciary team for their physical, mental and financial wellbeing. With the right type of built-in support along the way, their retirement can truly be the “golden years,” an immensely satisfying and productive time.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com