FIRST QUARTER ECONOMIC OUTLOOK
US & World Economy
A New Year Resolution
Both the stock and bond markets had one of the best years on record in 2019, and this most recent decade was the fourth best decade ever for the US stock market which returned an average of 13.6% (2010-2019) following what is often referred to as ”the lost decade” from 2000-2009 when stocks’ total return averaged only 0.95%. The bond market average over the last decade was not as stellar as it averaged only 3.8%, the lowest average decade for bonds since the 1960’s (bonds returned an average of 6.3% from 2000–2009). This reinforces our investment philosophy that a diversified portfolio is meant to serve you in both good and bad market environments.
While the overall year was strong, 2019 was a year peppered with uncertainty which detracted from confidence, mainly that of CEOs and CFOs. Our US consumers continued to stay remarkably confident. To recap some of the drivers of uncertainty in 2019, we experienced an inverted yield curve, escalating US and China trade wars and tariff imposition, Brexit and a very critical early general election in that country, a drone shot down in the Strait of Hormuz, negative interest rates across many developed countries and the US the Fed cutting interest rates at three consecutive meetings. As we start 2020 and your New Year’s resolution is still top of mind, think of how much worldwide uncertainty is behind us and in the resolution stage – the act of finding an answer or solution to a conflict or problem.
This environment of resolution likely sets us up for continued positive returns and shows the resiliency of our markets and how committed the ECB and the Fed Reserve are to keeping our economies from significant slowdown and the continued yet slowing progress both the US and the world are making 11 years after the Great Recession.
The majority of stock market returns last year came from price gains, not necessarily earnings gains. But we also realize there was a great deal of episodic stress put on optimism and very inexpensive credit to be taken on. We continue to emphasize credit quality in our portfolios and look to capitalize on anything tangible we can following such lofty returns last year. We steer toward clipping high credit coupons, tangible real estate cash flows and stock dividends as we look to mitigate risk in a recovery growing very long in the tooth with building risk coming from ever-growing debt on corporate and government balance sheets.
2020 is an election year and our more pressing concern is following the level and quality of credit issued as well as the consequences of a once again expanding ECB and Federal balance sheets. We see the Fed’s recent move intervening in the overnight lending market (repo market) has an artificial influence on keeping rates low while further encouraging borrowing. This could drive investors to take on increasing risk to find income sources when bond yields look to stay relatively low based on historical levels.
Happy New Year. With the New Year, we have some new legislation changes that affect retirement benefits. We are talking about the “SECURE Act,” which stands for Setting Every Community Up for Retirement Enhancement Act. The SECURE Act was signed into law on December 20, 2019, and effective January 1, 2020. Below we will discuss three major changes.
- Required Minimum Distribution is also known as an RMD
The age for starting required minimum distributions has been raised to age 72 from age 70.5 for people born after June 30, 1949. This will allow people some additional years to defer their RMDs. Keep in mind that anyone who reached 70.5 in 2019 or prior will continue to follow the old rules.
- Traditional IRA Contribution Age Caps
The second major change is the ability for anyone who is currently employed to be able to continue to contribute to a Traditional IRA. They have removed the age cap that previously disallowed any additional contributions after age 70.5. As an example, if you are 75 years old, and you have earned income on your return (or your spouse has earned income), you will be eligible to contribute to a Traditional IRA.
- Stretch IRA Limits
The third change is probably one of the most significant big-picture changes in the law, which is the update in rules regarding “Stretch” IRAs. The law now requires most non-spouse beneficiaries of inherited individual retirement accounts to take distributions over 10-years instead of being stretched over the life expectancy of the beneficiary. This includes both Traditional and Roth IRA accounts.
In addition, previously the law mandated that if you inherited an IRA account that would need to take Required Minimum Distributions (RMDs) annually. The SECURE Act now does not mandate an RMD and instead simply stipulates that the account must be completely distributed by the end of the 10th year following the inheritance of the account. This additional flexibility means you can continue to take distributions as you desire in the first ten years, or you could wait until the last day of the 10th year and then take all distributions in one lump sum.
However, if you already have inherited an IRA from a relative who was deceased prior to 2020 and you are not the spouse, then those previous rules have been grandfathered in and you will maintain the RMD schedule. The SECURE Act only applies to assets inherited from someone who passed on or after 1/1/2020.
There are some exceptions related to beneficiaries. The following eligible designated beneficiaries are still entitled to a modified version of the life expectancy payout method.
- The surviving spouse. § 401(a)(9)(E)(ii)(I). The surviving spouse can still use the life expectancy payout. However, upon his/her death, the exception ceases to apply, and the 10-year payout applies.
- Minor child of the participant. § 401(a)(9)(E)(ii)(II). The life expectancy payout applies to a “child of the employee who has not reached majority (within the meaning of subparagraph (F).” However, upon reaching majority, the 10-year payout rule starts and applies.
- Disabled beneficiary. The life expectancy payout applies to a designated beneficiary who is disabled (within the meaning of § 72(m)(7). Upon his/her death, the 10-year payout rule starts and applies.
- Chronically ill individual. The life expectancy payout applies to a designated beneficiary who is chronically ill (within the meaning of § 7702B(c)(2)). Upon his/her death, the 10-year payout rule starts and applies.
- Less than 10-years younger beneficiary. The life expectancy payout applies to an individual who is not more than 10-years younger than the participant.
The SECURE Act has created immediate ramifications in retirement income and estate planning strategies. When considering the changes with the new law, your previous beneficiary designations and estate planning with regards to your IRA accounts may still work. However, it is important to review with your Wealth Advisor and Estate Planning Attorney how the changes may affect you directly and if there are updates you should make based on your individual circumstances.
Preserving Your Wealth Using Non-Grantor Trusts
As of 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law. This resulted in a number of changes for both corporations and individuals. One of the more notable individual changes were the new restrictions on many of the deductibles related to state income taxes that were previously allowed in the Federal return. As a result of this and the continued increase in state taxes in places like California, a great deal of discussion lately has surrounded the use of the Nevada Incomplete Non-Grantor (NING) Trust.
Unlike grantor trusts such as Family Revocable Trusts, which are taxed to the grantor, a non-grantor trust is a “separate taxpayer.” This means that it can reside in a different state, like Nevada, with no existing state income tax. The NING is an exceptional tool to avoid state income taxes and protect assets. By eliminating state income taxes, the net rate of return on investment can be increased with reduced tax pressure.
For instance, in the case of California, which imposes a maximum 13.3% income tax, the elimination of state tax may mean huge savings and corresponding increase in the net return on investment. It may also mean extraordinary savings upon the disposition of highly appreciated securities and other intangible investments.
Not all Californians or residents of other tax-heavy states can benefit from the NING Trust. Care must be exercised in structuring it. Consider the following three factors:
- State of Residence – First, the trustee needs to be in Nevada or another state with a well-designed asset protection trust statute. If the NING trust is not created in such a state, the grantor’s creditors are able to reach the trust assets and the income is taxed to the grantor. In addition, distributions to resident beneficiaries will commonly be taxed. So, the NING trust is for those prepared to accumulate income over some period of time. Of course, annual accumulation of tax-free income has a cascading effect on the growth of the accumulated amount. This growth can mimic an IRA.
- Type of Assets – Another limiting factor relates to the character of the assets—the NING is for investors who own intangibles like stocks, bonds, mutual funds or other securities. If, for example, the NING holds California real estate or tangible property like works of art, the state income tax cannot be avoided.
- Control of the Trust- A final limiting factor relates to the grantor’s loss of control over the assets placed in trust. Although the grantor of the trust cannot exercise direct control over the assets, this does not mean that the grantor is without access or must surrender total say in the eventual disposition and investment. For example, the grantor can be a discretionary beneficiary. Furthermore, through careful design of powers, the grantor can exercise considerable influence over who gets what when distributions are ultimately made. With respect to investment decisions, the grantor’s involvement can be even more direct.
As an example to show what the benefits of setting up such a trust could be, consider the following example.
Assume the California investor owns shares in a corporation, and the shares he/she owns have a low basis. Perhaps as the result of an 11-year bull market or a takeover event, the stock has now greatly appreciated above his/her basis. Let’s suppose that this actually occurs and our investor will be receiving $20 million above his/her basis in payment for the shares. If the shares are held by a NING, there will only be federal tax on the gain realized and recognized and there would be no California state tax; thereby avoiding the maximum 13.3% state tax. On the other hand, if the California investor owns the shares directly and not in the NING, his/her additional income tax could be approximately $2,660,000. Further, this tax calculation also assumes the investor is already in the maximum 39.6% federal income tax bracket due to other income they report within the transactional year. Please keep in mind, that depending on the particular taxpayer, this amount of tax savings may be somewhat overstated.
- First, there will likely be an offsetting federal deduction for the state taxes paid. However, even the deductions may not be available if the taxpayer is subject to alternative minimum tax, because the calculation of that tax does not allow a deduction for state income taxes.
- Another reason the benefits from a non-grantor or NING trust may be overstated is due to the low level of taxable income of a trust where the maximum marginal rate of taxation for the federal income tax and the net investment income tax come into play. An individual does not hit the maximum state tax bracket until the taxpayer has much more taxable income outside of the stock transaction. On the other hand, if the taxpayer is already in the 39.6% bracket due to other sources of income during the year, the state tax savings could be real.
In the case of the California investor from above, let’s assume a net $2 million savings on the sale of the stock after various offsets and deductions as discussed above. Let’s further assume the proceeds from the sale are accumulated in the trust for 15 years. With an assumed annual rate of return, net of federal tax, of 7%. In this scenario, that original $2 million savings from the NING trust will equal $5,518,063. Without the NING, this significant sum would not be available to the taxpayer or other beneficiaries
The NING trust will not be appropriate for all circumstances. Those that may be in lower tax brackets, charitably inclined, or desire not to lose any control over the assets may look for additional alternative strategies. However, with the coordination of your Wealth Advisor, Estate Planner, and CPA, there may be some alternative approaches that could be considered. This is even more reason to ensure you meet with all of your advisors regularly before taxable events may occur.
What a record year for the equities market! Markets rebounded nicely after experiencing negative return in 2018. For the US, the market still favors large-cap over small-cap stocks. Growth style stocks have outperformed value style stocks. All the international stocks were up as well; emerging markets did better than developed international equities. From a relative valuation standpoint, International and EM equities are still cheaper to US equities. We maintain our current allocations of US, International and EM equities. This ensures we are not actively timing the market by fully exiting or taking concentrated bets on any region.
Global Real Asset class returned extremely well in 2019. A real estate mutual fund position, focusing on specialty REITs, like Data Centers, returned 4.87% for the quarter, and 31.80% for the year. Having a different mix of strategies within the Global Real Asset class provided a steady return and diversification benefits to the portfolio.
Since there was little news and volatility in the fourth quarter, Global Fixed Income and Alternative asset classes did not have much of a move. Most of them went up between 1 to 2% and ending 2019 with about 6 to 10%. In an upward trending equities market, there will be little return for owning Fixed Income and Alternative assets. However, we will keep those in our portfolios to protect them from the unexpected, inevitably downturn of the equities market.
The bull market trend seems to be still going strong, with few signs of worries. There are trade deals, low-interest rates, and moderate economic growth. However, we are not complacent of the strong return now. We are constantly monitoring the portfolios to ensure we are diversified to many asset classes and return sources globally.
A look back over 2019, the Optivest Foundation family financially, physically and spiritually supported various ministries locally and abroad. 2019 provided enough funding to give substantial support to over 20 ministries worldwide. Our wealth management office also dedicated time to shop, wrap and deliver Christmas presents to 5 local families. It was a wonderful occasion of giving that brought joy to our hearts and help to those in need. Finally, we are happy to announce Shannon Kavlich’s new son, Becker Graham was born in early December.
Don’t hesitate to ask us for guidance if you would like to make generosity part of your family mission statement.
A year following the powerful returns of our Optivest models, our prudent advice is to take some of our profits and derisk; invest for tangible returns like stock dividends and real estate with cash distributions and expect this cash to be a greater percentage of your return than last year’s stretched price returns which lacked the earnings return keeping pace. Furthermore, as the opportunities arise, hard assets like precious metals and value priced cash flowing real estate should be added for downside protection should a mild stock market correction occur or the economy suffer a malaise which could lead to our next recession.
Leslie, Matt, Bart, Letitia & Optivest’s Investment Department