Now that the 2012 election is behind us, we finally have some certainty about which political parties will control which branches of government. The fiscal landscape, however, remains to be decided, as both Democrats and Republicans are expressing a desire to avoid the looming Fiscal Cliff but have very different visions on how best to accomplish that.

Whatever path the negotiations take, we believe it is safe to assume that some changes to the taxes levied on investment income are coming in 2013. The Affordable Care Act imposes a new 3.8% Unearned Income Medicare Contribution Tax in 2013; meanwhile, the potential expiration of the Bush tax cuts and tax hikes to capital gains and dividends are looming.

The table below shows both the current and expected rates for 2013.

For all investors, increases in tax rates will make tax-efficient investing more important than ever. Prudent asset location, portfolio structure and investment selection will be critical to maximizing after-tax returns. For investors with significant capital gains, they now also have an important and complex question to answer:

Is it better to realize a capital gain today in a lower tax environment or continue to defer the tax liability and risk liquidating in a higher tax environment?

This question can be addressed by understanding what we call the “Liquidation Hurdle”. The Liquidation Hurdle is the amount by which the future capital gains tax rate must increase in order to justify selling today.

The Liquidation Hurdle is affected by three factors:

1. Expected Future Tax Increase
2. Expected Future Return
3. Expected Future Investment Horizon

By calculating the differences in an investor’s terminal wealth by making assumptions about these three factors, we can help clarify whether it makes sense to “Pay Now” or “Pay Later”.

In Example 1 below, if the expected return is (2%) and the investment horizon in (5 yrs.) the hurdle rate is relatively low at just 1.3%. In other words, the capital gains rate would only need to increase from 15% to 16.3% to justify selling today.

In Example 2, if an investor has a 20 year investment horizon and an 8% expected return, Long-Term Capital gain rates would have to increase 30.1% to 45.1% from the current 15% to justify selling today.

As you can see, making a decision to “Pay Now” solely on the basis of a pending hike in tax rates is misguided. We must make that decision in conjunction with expectations on future expected returns and investment horizon because the benefits of tax-deferral remains very powerful.

The power of tax-deferral is generated by the compounded earnings on the monies you didn’t pay in tax. If you pay $50,000 today in taxes, that money will not be there to generate a return for you in the future. The longer that money would have been invested or the higher the return it would have earned, the more valuable it becomes and the more beneficial it is for you to hold on to.

But enough theory. The question is, what should you do now?

If Congress adopts a do-nothing strategy and the Bush tax cuts expire, the long-term capital gain tax rate will increase to 23.8% from its current 15% rate. Investors with short time horizons or very low expected return assumptions (inside the yellow dotted line) may find it beneficial to pay taxes now at the lower rate. For those outside the outlined area, it is likely more beneficial to stay put and pay later.

This table is a great starting point but is no substitute for a thoughtful conversation with your advisor about your unique situation. Please do not hesitate to call to discuss whether Pay Now or Pay Later makes sense for your situation.

“The Market seems uncertain to me right now; maybe I should take some equity investments off the table”.

This statement, or a derivation of it, is commonly put to advisors such as me. The evidence is strong that many investors share this feeling and are acting on it as they continue to flee equity investments for cash and bond investments despite yields that will deliver a negative real return (yield minus inflation) for the foreseeable future.

The first thing I like to point out is that the market is always uncertain. And the funny thing about uncertainty and the market is that when there is more uncertainty it generally means good things for near-term equity returns.

Think back to March of 2009. Was there a lot of uncertainty in the market? Probably more so than at any time since the Great Depression, and yet since that point the S&P 500 has gained 130%. And recall the fall of 2011, when the U.S. had just seen its credit rating downgraded and the stock market had plunged 20% in short order. Anxiety and uncertainty filled the air, and yet since November 2011 the S&P 500 has gained 28%. To be a successful investor you have to accept that the only certainty in investing is uncertainty.

The second thing to keep in mind is that it’s natural to wonder and worry about how the crisis of the day (election, debt/deficit, gridlock, Iran, Spain etc.) will impact our economy, our investments and our ability to achieve our goals. The heart of the matter is what we do with that worry.
For me it helps to view these crises like the old arcade game “Whac-A-Mole.” You will recall that the game really has no point other than to try and whack as many moles that pop out of their holes as fast as you can. The moles never stop popping up until the game is over, when you are left exhausted and wondering what the whole point was. Meanwhile the girl you were trying to win the stuffed animal for got bored and is walking around the park with some other guy. (But I digress…)

In the same way, investors who attempt to respond to every crisis that pops up will find all their energy and emotion devoted to an endless loop of crisis and response, with the response usually coming too late to do any good. Meanwhile, life passes you by as you worry about the short-term things beyond your control instead of trusting in the long term ability of the market to weather the never-ending storms.

My advice is that the next time you find yourself emotionally wrestling with the crisis of the day, step away from the Whac-A-Mole game and talk to the girl instead.

The political clashing that is occurring over our country’s entitlement programs highlights an ideological divide in our country over how to solve our deepening debt crisis. But it also highlights an important facet of Comprehensive Wealth Management: assumptions about the future are just that – assumptions – and should not be set in stone. True wealth management is a dynamic process and must revisit assumptions and expectations periodically to ensure they continue to be valid.

This has been contrary to the way much of the financial planning industry has operated over the years. Too often, financial planners are obsessed with the creation of “The Plan,” and giving their clients dozens of tactics to implement. Often these plans span more than 100 pages and overwhelm clients with mind-numbing detail and regimented action steps. (I won’t even mention the faux plans generated by the commission-based planners that always seem to lead back to the same conclusion: “You need to buy a variable annuity.”)

Today, the growing realization among serious wealth managers is the need to focus on the planning process, rather than be obsessed with the plan itself. That doesn’t mean, of course, that a wealth management plan isn’t important. What it does mean is that, in a world of rapidly changing facts and circumstances, a wealth management plan should be a living document that is evaluated frequently and revised as needed to reflect the evolving needs of the client, and the evolving world around them.

Assumptions about expected future income must be revisited regularly, particularly as they relate to pensions and entitlement programs such as Social Security and Medicare. Many pensioners have seen their companies head into bankruptcy and have received vastly reduced pensions that were only guaranteed for pennies on the dollar by the federal government. And although the politicians seem to be nearly unanimous in agreement that Social Security and Medicare will be protected for those who are in or near retirement, the same is not necessarily true for those in their mid-50s and younger. Much will be determined about this issue in the elections of 2012 and beyond, and a wealth management plan for someone in their 40s or 50s that assumes a significant benefit from Social Security and Medicare – particularly if those assumptions are inflation-adjusted – may well be unrealistic in its conclusions.

The other issue that is changing rapidly is the lifestyle of people in their 70s, 80s and even 90s. A generation ago, 65 was considered “old.” Many people smoked heavily, drank excessively, and exercised infrequently. As a result, average life expectancy for a U.S. male was 66 years old in 1960. For women, it was 73.

Fifty years later, in 2010, average life expectancy for a U.S. male had advanced by a full decade, to 76, while the average U.S. female had a life expectancy of 81. Today, most 65-year-olds who haven’t had the misfortune of being hit with a chronic condition or disease are active and in good health. Cancer and heart disease are much more treatable today than they were even 30 years ago.

All of this is good news from a quality of life perspective, but it also raises significant wealth management challenges. The old assumptions that a 75-year-old will need little more than food, shelter and a comfortable rocking chair are a cliché. Many people in their 70s and 80s are continuing to travel, dine out, play golf and tennis, etc. At the same time, many people are retiring earlier than ever, in their early 60s or even late 50s. This means many people will live more active retirements with much higher expenses than past generations, and will do so in many cases for 25 or 30 years!

These challenges are not insurmountable; they simply require an effective planning process. That’s why it is vitally important to be sure your wealth management plan is being revisited, evaluated and revised at least annually by your advisor.

I continue to be astonished and frustrated at the media reports of how much collective cash investors hold as a percentage of their investable assets. Incredibly, the percentage of cash that investors hold relative to stocks actually increased during 2010, despite two years of strong equity returns: 

The source of my frustration is that I know investors have little hope of achieving the retirement they expect when they avoid an allocation to stocks in favor of cash. Why, in the face of all of the political and economic uncertainty we are confronted with today, am I confident that a healthy allocation to stocks is necessary for investors to achieve their retirement goals?

Consider what has happened to the noble postage stamp over the past 30 years:

Since 1980, the price of postage has increased almost three-fold – despite a low-inflationary environment that persisted for all but the first few years of that time period! This is a powerful illustration of “inflation risk” – the risk that your assets don’t grow enough to make up for the loss of purchasing power due to inflation. Inflation risk is very subtle but very real. It doesn’t hit you all at once like a sudden drop in the stock market. Instead, inflation risk slowly works away at your purchasing power like termites in the foundation.

Remember when a $20,000 car was expensive? When a $200,000 house was a mansion and not a fixer-upper? When college tuition was four figures? It seems quaint now, but that’s the way it was back in 1980.

Now imagine – even if we maintain the historical 3% - 4% inflation rate going forward – how much things will cost 30 years from now. Will you be able to afford a $100,000 Ford Taurus? Or an annual college tuition bill of $150,000? If history is any guide, stock investors will be just fine in such a world, but cash investors will not.

Despite relatively poor returns over the past decade, stocks historically have been the best way to combat the real danger of losing purchasing power during a long retirement. Yet millions of investors made a decision to bail out stocks in the last few years and continue to do so today despite the fact that the S&P 500 is basically breakeven since Lehman’s collapse in September 2008 (not to mention the fact that small stocks and real estate stocks have very nice gains over this same period).

These investors have let emotions rule their investment decision-making process instead of a solid plan. This is a crucial mistake that has caused those investors to miss out on the nearly 100% gain that stocks have logged since they bottomed out in March 2009!

Don’t make the same mistake. Be sure a solid wealth management plan – not emotion – is at the foundation of your investment decision-making process.