October 2015

Recently, Sean Rice, wealth management advisor for our Cherry Hill, NJ region forwarded to me an article concerning a landmark decision in Pennsylvania giving beneficiaries of trusts the power to replace the trust’s Corporate Trustee for any reason.  In our parlance, this is commonly referred to as a portabilityor remove and replace clause. Even though many of our readers are not from Pennsylvania, I thought the decision would be of interest to all.

Previously, when a grantor (the one who establishes a living trust) chose a corporate trustee to administer the trust during his or her lifetime (and subsequently for the next generations) it was because he or she had a strong relationship with the bank or the bank’s trust team that was managing the relationship.  As we all know, with all of the mergers and acquisitions in the banking industry, it became very unlikely that the same bank or team would be managing the relationship in the years ahead.  Then, the beneficiaries of the trust were saddled with a new bank or trust team that had neither a personal relationship with the family or an understanding of family dynamics. This usually ended up being an adversarial relationship to say the least; not what the grantor expected!

Ever since I established my first trust department of a bank and my first independent trust company years ago, it was my belief that if we are not meeting the client’s expectations in terms of service, or the relationship became untenable, we should beremoved as corporate trustee and the beneficiary could replace us with another corporate trustee. Like any other service provider, no matter the service being provided, no one should be locked into a relationship that creates more angst than necessary.  Ours is a relationship business.  I always tell prospective clients that the services we provide are like a commodity. In our industry, the services are the same from institution to institution.  The only differentiators are the people that deliver the service.

We pride ourselves on building lasting relationships with our clients spanning generations.

Looking forward to a happy and healthy holiday season,


Equity Styles

When you buy stocks, are you looking for growth or value?  For the uninitiated the question may seem nonsensical—everyone wants both growth and value, and large portions please!  But these terms have a specific meaning to professional investors.  The terms imply dramatically different risk profiles and expectations for rates of return on investments.

The traditional “value” investor seeks to invest in companies at relatively low valuation levels. These bargain hunters of the investment world typically search for low ratios of stock price to earnings (the price-earnings ratio, or P/E), or the book value (price-to-book value ratio, or P/B).  They are hoping to discover investment opportunities “overlooked” by other investors, by the market as a whole.  Very often these companies are out of favor on Wall Street and may be undergoing a restructuring or other transformation expected to “unlock” great future value. Patience is an attribute most often associated with value investors.  Their patience may be rewarded with higher dividend yields and lower risk of disappointment.

Growth investors, residing at the other end of the spectrum, generally pursue explosive growth of sales and earnings with little regard to price.  The companies in which they invest typically sport high P/E’s, P/B’s and multiples of sales because their superior past records are well established.  These Wall Street favorites can offer excitement and above-market rates of return, and they tend to be younger firms in the fields of technology, communications and pharmaceuticals.  However, these characteristics tend to be accompanied by greater price volatility and risk of loss, especially when earnings soften.

Value investors are generally thought to be more conservative, accepting lower returns in exchange for more stable prices.  Growth investors, in taking greater risks in search of superior rewards over a shorter time frame, are thought to be more aggressive.

Which approach is really better?

There have been a number of indices developed over the years to compare growth and value investments.  Eugene Fama and Ken French developed the Fama-French Index, the results of which are published annually in the Ibbotson SBBI Classic Yearbook.  In the Fama-French index, book value is divided by market capitalizations, with some adjustments. Value companies have a high book-to-market ratio, while growth companies will have a low ratio.  The 30% of companies with the highest ratios constitute the value index, and the 30% with the lowest ratio will be the growth index. The middle 40% is considered a blend of the two styles.

The table below shows the relative performance of the two styles for large-cap stocks in the last ten years.  In this period, growth has slightly outperformed value, with a compound annual return of 8.5% versus 6.7%.

Year Growth Value
2005 2.8% 12.2%
2006 8.9% 22.6%
2007 14.1% -6.5%
2008 -33.7% -49.0%
2009 27.9% 39.2%
2010 15.9% 21.6%
2011 4.1% -9.0%
2012 15.4% 23.0%
2013 34.3% 40.2%
2014 11.32% 9.8%

Source: M.A. Co. Data: Ibbotson SBBI 2015 Classic Yearbook

One would expect that growth stocks would have higher highs and lower lows than value stocks, but the graph shows that this assumption has been wrong in recent years.  Value stocks had the worst single year, in 2008, with a loss of nearly 50%. But they handily beat the growth stocks in both 2012 and 2013, making up for the loss.

(October 2015) © 2015 M.A. Co. All rights reserved.

September Surprise

October 2—The current economic expansion is now over six years old.  For much of that time, investors have been expecting the Fed to begin pushing interest rates upward “soon.” At the beginning of 2015, the emerging consensus seemed to be that the first steps could come as soon as June, but no later than September.

Once again, the consensus was wrong, because no action was taken by the Fed.  Some observers believe that a rate hike by December remains on the table, but the chance of a delay into 2016 can’t be dismissed.

One factor in the Fed’s thinking may have been the extraordinary selloff in global equity markets in August.  On August 24, the Dow Jones Industrial Average fell 1,089 points in the morning, an intraday record.  The market recovered, to close down just 588.40 points, but the volatility revealed flaws in the pricing of ETFs.

The “circuit breakers” were tripped repeatedly that day.  After the 2010 “flash crash,” the SEC instituted circuit breakers for individual securities. (Seehttp://www.sec.gov/investor/alerts/circuitbreakers.htm for details.)  These individual halts occurred nearly 1,300 times on August 24, according to The Wall Street Journal.  The trading halts created some cascading difficulties, as some electronically traded funds (ETFs) could not be valued when trading had been halted in some of their underlying securities.  In fact, according to the Journal’s analysis nearly 80% of the trading halts were for ETFs. Some fine tuning of the system may be needed.

A terrible jobs report

The Fed justified not raising interest rates by suggesting that the economic recovery remained fragile, and inflation remains muted.  That judgment was vindicated by the release of the September jobs report, which came in well below expectations.  What’s more, the rosier August report also had to be downgraded.  Only 136,000 jobs were created in September, according to the Labor Department, roughly 25% fewer than the expected 173,000.

Unemployment remains steady at 5.1%, but that cheery number masks major weakness in the labor market.  The participation rate fell again, from 62.6% to 62.4%.  That means more and more people are simply dropping out of the labor market.  Labor force participation hasn’t been this low since the early years of the Carter administration, in October 1977.  A record 94.6 million people are not in the labor force, compared to 148.8 million workers.  With all this slack in the labor pool, it shouldn’t be surprising that wages remain stagnant.  Fewer workers means lower national income, lower tax collections and higher deficits.

A September report from the Census Bureau confirmed that stagnant wage growth is not an isolated phenomenon.  Across the entire income spectrum, everyone is off of their peak earnings. For example, the middle quintile of workers reached their peak in 2000, and wages in this group are down 6.9% since then.  The second quintile peaked at $90,331 in 2007, and remains 2.8% below that as of 2014.  Even the top 5% are 4.8% below their peak earnings.

The weakness in wages may explain in part why the unconventional candidates for president have proven so popular this year.

(October 2015) © 2015 M.A. Co. All rights reserved.

The Last Resort

A loan from a qualified retirement plan can provide emergency funding during a cash crunch, and be a bridge to a more prosperous time when the emergency passes.  But if the financial pressure is sustained, the plan loan just might make the problem worse, as shown in two recent Tax Court cases.

The layoff

David borrowed $36,248 from his 401(k) account in 2011.  Such loans are typically allowed up to the lesser of $50,000 or 50% of the plan balance, a test David passed easily. Unfortunately, he was laid off later that year.  To avoid “being a burden on society,” David requested a plan distribution of $127,140.  That would be taxable income, so $18,000 in taxes was sent to the IRS, and the plan loan had to be repaid from the proceeds.  David thus received just $73,490. He was 49 years old at the time.

The distribution was reported properly on David’s income tax return for 2011.  However, he did not pay the additional 10% tax that is required for plan distributions that occur too early in life—that is, before reaching age 59 ½. In the Tax Court, David asked to be excused from the additional tax because of his genuine economic hardship.  Not only did he lose his job in 2011, but also the family had over $9,000 in unreimbursed medical expenses that year.  The Court was sympathetic, but it concluded that there is no “hardship” exception in the tax law for premature plan distributions.

But does the 10% penalty apply to the loan?  David thought that it shouldn’t, because the family didn’t get any more cash when the loan was forgiven as part of the distribution.  The penalty does apply to the loan forgiveness as well, the Court ruled.  When a plan loan, even from an earlier year, is offset in a plan distribution, that is a “deemed distribution” from the plan. As such, it is fully taxable in the year of the loan forgiveness.

The boundary

Ralim participated in the New York State and Local Retirement System (NYSLRS), saving a total of $17,017.  He requested several loans over the years.  In 2009 Ralim requested a “maximum loan” from the plan, and he received a check for $5,993.  That brought his loan balance to $12,802.

Small plan loans are permitted to the greater of 50% of the plan balance or $10,000.  Ralim’s loan crossed both of these boundaries.  Accordingly, the IRS said that $2,802 (the amount in excess of $10,000) was taxable income as a deemed plan distribution.

What’s more, the IRS asked for the 10% tax on premature distributions.  Ralim’s age was not included in the materials presented to the Court by either the taxpayer or the government.  The IRS argued that the burden of proving the taxpayer’s age was on the taxpayer, not on the government.

For that assertion to prevail, the Tax Court held, the 10% additional tax on premature distributions must not be a “penalty” as that word is used in the tax code.  With penalties the burden of proof is on the IRS; with taxes it is on the taxpayer.  After close reading of the tax code, the Court sustained the IRS’ position.  Although the taxpayer undoubtedly feels “penalized,” the extra 10% due is a tax, not a penalty. Because Ralim did not prove that he was over age 59 ½, the additional 10% tax also must be paid on the excess loan amount.  Note that the 10% tax also applies to the income tax paid.

Start the clock

The proper taxation of IRA distributions has proved tricky for many taxpayers. When there is a distribution, Form 5329 needs to be filed with Form 1040 to document the transaction.  If the Form is not filed, the IRS may assess additional taxes—such as the excess contributions tax, the failure to take a required minimum distribution tax, or the premature distributions tax—at any time in the future.  It’s also important to keep IRA records, perhaps indefinitely, to help resolve such questions should they come up in the future.

See your tax advisors to learn more on this subject.

(October 2015) © 2015 M.A. Co. All rights reserved.

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