Haitian Charitable Deduction Benefit

I had just posted an article on the changes in tax laws for 2009 when "Pop!" here comes another one courtesy of Congress: Haitian Relief Donations.

Individuals and businesses will be allowed to take a deduction for donations given to charities providing relief to the victims of the earthquake in Haiti. Any donations contributed through February 28th can be deducted either on your 2009 or on your 2010 return.

See your trusted advisor or tax professional for guidance.

Grantham's Latest "Call"

Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co., said U.S. President Barack Obama’s bid to ban proprietary trading by banks is “good stuff” because it serves to rein in unethical behavior.

“Prop trading was indeed the rot at the heart of our financial problems,” Grantham, wrote in an investor letter posted yesterday on the firm’s Web site. “Watching traders take home their $28 million bonus sent a powerful message to lowly salesmen and packagers of asset-backed securities, for example, to get out there and really take some risk.”
.....

Grantham reiterated his forecast for “seven lean years” for the economy. The Standard & Poor’s 500 Index, which closed yesterday at 1096.78, is above what Grantham believes to be its fair value, of around 850.

“The real trap here, and a very old one at that, is to be seduced into buying equities because cash is so painful,” Grantham wrote in his letter. “Equity markets almost always peak when rates are low.”

Grantham's Quarterly Letter can be read here (registration required).

Why do I post this? Well, of all the market pundits I read-- and there are dozens that I do-- Grantham gets the big picture right, doesn't take extreme positions based on his forecasts, only makes forecasts based on the long term, AND HAS BEEN STUNNINGLY ACCURATE. See here. And here.

Can his methods fail? Of course. But who would you rather listen to (if listen you must)? Someone who never saw the crisis coming and failed to act or someone who was clearly warning of the excesses and made prudent changes? Grantham is an example of the latter.

Charitable Giving: Donor Advised Funds

"Charity sees the need, not the cause."- German Proverb

I haven't written much about the topic of charitable giving yet but it's an important one to me and to the blog. 2009 was a year "for the books" and the blog's message track last year was dominated by the markets and, peripherally, by taxes. Let's try to remedy that.

Donor-advised funds are charitable giving accounts offered by a sponsoring organization. Designed to be an accessible, simple, and less expensive alternative to private foundations, they are often provided by community foundations and by for-profit financial services companies.

You, as donor, contribute tax-deductible assets to an account, advise the sponsoring charity on how it should invest the assets and recommend grants from the account to charitable organizations of their choice over time.

The sponsoring organization does the record-keeping and due diligence. The account can even be made anonymous. There's even a website touting their advantages.

In an article in the Wall Street Journal, the shift toward donor advised funds and away from private foundations was discussed. The article read:

Raymond P. Kurlak established a private foundation in 2000 to fund education and literacy programs, joining a growing wave of philanthropy in the U.S. In the wake of the recent turmoil in financial markets, he became part of another trend: He closed the Raymond Foundation about a year ago and rolled the assets into a donor-advised fund.

Mr. Kurlak opened an account with the Schwab Charitable Fund, an independent, nonprofit organization founded by Charles Schwab Corp. Other funds founded by big financial-services firms include the Fidelity Charitable Gift Fund and the Vanguard Charitable Endowment Program, and there are many other choices as well. As the names suggest, these funds distribute money to charitable causes as recommended by the donors. One of their advantages is that they relieve philanthropists of some of the costs of running a foundation.

Mr. Kurlak estimates that he saves about 10% by using Schwab to administer his account instead of paying for his own lawyers, accountants and office supplies, as he did when he ran his foundation. Those savings are particularly important because of the losses his foundation suffered when stock prices dropped. Cutting back on costs makes his depleted assets go further. "I'm very pleased," he says. "It takes much less time and money" to direct the distributions from his Schwab account than it did to run his foundation.
Privacy and Tax Savings

Cost-cutting is one of the factors driving an increase in conversions from private foundations to donor-advised funds. But there are others that aren't so closely tied to the direction of stock prices. Funds also relieve philanthropists of many of the hassles of running a foundation, like filing paperwork, checking out potential recipients or, for larger foundations, managing a staff. Mr. Kurlak says he spends about two weeks a year on his account's business now, down from two months a year on his foundation in the past. And the funds offer tax advantages and greater privacy for donors, among other advantages.

Making the switch from foundation to fund isn't for everyone. Some individuals may prefer the cachet of running a foundation, or the opportunity it gives them to teach family members about philanthropy. Perhaps most important, foundations give donors total control over their contributions, which can be crucial for those who support causes that are out of the mainstream.

Still, the number of accounts at donor-advised funds climbed 11% last year, to 148,588, following a 13% increase the previous year, according to the National Philanthropic Trust, a charity in Jenkintown, Pa. Conversion isn't difficult, and many of the funds have expanded staff to assist donors with the process.

The Schwab Charitable Fund was fielding so many inquiries about converting that it recently devoted additional staff to conversions and developed a questionnaire to help individuals decide whether to make the move, says Kim Wright-Violich, the fund's president.

"As assets have gotten beaten up, people have gotten really frustrated about not being able to do the same level of gifting," says Ms. Wright-Violich. More philanthropists are realizing, she says, that the money that donor-advised funds can save them in administrative and other costs can go toward the causes they support. In some cases, she says, such funds can cut donors' costs by as much as 50%.

Besides cutting administrative costs, funds can reduce donors' investment fees. Small foundations, because of their limited assets, often pay relatively high fees to the firms that handle their investments. But donor funds, working with a much bigger pool of money from all the accounts they administer, often pay much lower fees to invest donors' money.

Donor-advised funds also have certain tax advantages over foundations. Donors get an immediate tax deduction when they make a contribution to a fund, as they would with donations to their own foundation. But the deductions are more generous: Donors can deduct cash contributions to a fund totaling up to half of their adjusted gross income each year; the limit for donations to a private foundation is 30%. Donors can also deduct up to 30% of their adjusted gross income for donations to a fund of securities that have appreciated in value since the donor bought them; for a private foundation, the limit for such donations is 20%.

In addition, investment gains in an account at a donor-advised fund generally are tax-free, unlike a foundation's investment gains, which are subject to a small excise tax.

The funds also handle all the paperwork and due diligence involved in making donations and investments. That may be particularly reassuring to some givers in the wake of the Madoff scandal, which heightened concerns about investment scams.


Donor-advised funds also offer account holders some additional flexibility and help protect their privacy.

There is no requirement for annual distributions from an account at a fund, while foundations are required to distribute at least 5% of their assets each year. That can be especially important when financial markets are tumbling, because many philanthropists may want to hold on to more of their money so that they have a bigger asset base to rebuild from when the markets rebound.

The privacy issue is one that catches some philanthropists by surprise. Many are unaware when they set up a foundation that its tax forms will be made public, exposing details of the foundation's operations and even some personal information. No such information is available for accounts at donor-advised funds. And all donations to a fund can be made anonymously, a strong incentive for many donors to convert, says Sarah C. Libbey, president of the Fidelity Charitable Gift Fund.

James Barnes, chief relationship officer for the Vanguard Charitable Endowment Program, says another reason some foundations are converting is that the founder has died and family members disagree on the direction the foundation should take. Some people in that situation are splitting up a foundation's assets among several accounts at donor-advised funds, and those accounts can then be used for different purposes.

Families also often decide to convert simply because they've grown tired of the time and cost of meeting and of managing a foundation. The economic turmoil of the past couple of years may have helped fuel conversions because philanthropists are having to spend more time tending to their businesses, leaving less time to devote to foundation work.


Of course, there are some potential drawbacks to consider before switching from a foundation to a donor-advised fund.

One of the biggest is that with a fund, "you no longer have the independence and the total control" that you have with your own foundation, says Steve Gunderson, president and chief executive of the Council on Foundations, a nonprofit association of about 2,000 grant-making foundations and corporations, based in Arlington, Va.

That may not be an issue for most philanthropists, because it's rare for a fund to refuse to make a donation as desired by an account holder. But Mr. Barnes at the Vanguard Charitable Endowment Program notes that the funds can only write checks to charities. That means they don't allow donors to provide direct support for individuals or for groups that don't qualify as charitable organizations.

Another possible drawback is that contributions to the funds are irrevocable. So while a fund allows for more flexibility in the timing of donations because it doesn't require distributions of at least 5% annually, it limits flexibility in a different way by not allowing a donor to react to circumstances by putting the money to other use.

For those who choose to make the switch, the first step is to contact the state authorities that regulate charities, says Ms. Wright-Violich of Schwab. Each state has different requirements for terminating a foundation. The foundation must also file a final federal tax form. More detailed guidance is available from donor-advised funds.

So costs, tax advantages, privacy versus some degree of flexibility. Except for the rare individual or family, I believe the shift toward donor-advised giving is going to continue. Here are some of the nation's leading funds where you can find out more:

* Schwab Charitable
* Calvert Foundation
* Fidelity Charitable Gift Fund
* Vanguard Charitable Endowment Program

As always, see your planning professional or tax advisor to see if this is right for you.

Why Many Investors Keep Fooling Themselves

I had intended this next post to be on charitable giving. It's an important topic and relates to the mission of this blog regarding transfer of wealth.I'll get it up next. But I came across this article and it's so good I am putting it up in full. This relates to our previous post. It's written by Jason Zweig of the Wall Street Journal and bolsters my case that when it comes to investing, we don't know what the heck we are doing. Zweig writes:

What are we smoking, and when will we stop?

A nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years.

Robert Veres, editor of the Inside Information financial-planning newsletter, recently asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes, what I call a "net-net-net" return. Several dozen leading financial advisers responded. Although some didn't subtract taxes, the average answer was 6%. A few went as high as 9%.

We all should be so lucky. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. All told, those costs reduce annual returns by five to seven points.

So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

The faith in fancifully high returns isn't just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that can't last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

Even the biggest investors are too optimistic. David Salem is president of the Investment Fund for Foundations, which manages $8 billion for more than 700 nonprofits. Mr. Salem periodically asks trustees and investment officers of these charities to imagine they can swap all their assets in exchange for a contract that guarantees them a risk-free return for the next 50 years, while also satisfying their current spending needs. Then he asks them what minimal rate of return, after inflation and all fees, they would accept in such a swap.

In Mr. Salem's latest survey, the average response was 7.4%. One-sixth of his participants refused to swap for any return lower than 10%.

The first time Mr. Salem surveyed his group, in the fall of 2007, one person wanted 22%, a return that, over 50 years, would turn $100,000 into $2.1 billion.

Does that investor really think he can get 22% on his own? Apparently so, or he would have agreed to the swap at a lower rate.

I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.

Meanwhile, I asked Mr. Salem, who says he would swap at 5%, to see if he could get anyone on Wall Street to call his bluff. In exchange for a basket of 51% global stocks, 26% bonds, 13% cash and 5% each in commodities and real estate—much like a portfolio Mr. Salem oversees—the institutional trading desk at one major investment bank was willing to offer a guaranteed rate, after fees and inflation, of 1%.

All this suggests a useful reality check. If your financial planner says he can earn you 6% annually, net-net-net, tell him you will take it, right now, upfront. In fact, tell him you will take 5% and he can keep the difference. In exchange, you will sell him your entire portfolio at its current market value. You have just offered him the functional equivalent of what Wall Street calls a total-return swap.

Unless he is a fool or a crook, he probably will decline your offer. If he is honest, he should admit that he can't get sufficient returns to honor the swap.

So make him explain what rate he would be willing to pay if he actually had to execute a total return swap with you. That is the number you both should use to estimate the returns on your portfolio.

Absolutely awesome.

Fund Returns vs. Investor Returns

We have written on this phenomenon before. The individual investor does not achieve the same returns from a mutual fund as is indicated by the fund's performance. Is the manager skimming fees? Are investors being cheated? No! Investors simply have the tendency to pile into funds when they are riding high and abandon them when their performance lags. They buy high and sell low.

From the Wall Street Journal:

Meet the decade's best-performing U.S. diversified stock mutual fund: Ken Heebner's $3.7 billion CGM Focus Fund, which rose more than 18% annually and outpaced its closest rival by more than three percentage points.

Too bad investors weren't around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30, according to investment research firm Morningstar Inc.

These investor returns, also known as dollar-weighted returns, incorporate the effect of cash flowing in and out of the fund as shareholders buy and sell. Investor returns can be lower than mutual-fund total returns because shareholders often buy a fund after it has had a strong run and sell as it hits bottom.

At the close of a dismal decade for stocks, the CGM Focus results show how even strategies that work well don't always pay off for investors. The fund, a highly concentrated portfolio typically holding fewer than 25 large-company stocks, offers "a really potent investment style, but it's really hard for investors to use well," says Christopher Davis, senior fund analyst at Morningstar.

The gap between CGM Focus's 10-year investor returns and total returns is among the worst of any fund tracked by Morningstar. The fund's hot-and-cold performance likely widened that gap. The fund surged 80% in 2007. Investors poured $2.6 billion into CGM Focus the following year, only to see the fund sink 48%. Investors then yanked more than $750 million from the fund in the first eleven months of 2009, though it is up about 11% for the year through Tuesday.

"A huge amount of money came in right when the performance of the fund was at a peak," says Mr. Heebner, the fund's manager since its 1997 launch. "I don't know what to say about that. We don't have any control over what investors do."

Well, I know what to say about that. Most people aren't wired to play the investment game successfully. Those that are head to Wall Street. You and I suffer disproportionately when we lose as opposed to when we win. Hence our tendency to stop the "pain" by taking losses, never to recover them. These tendencies are well known.

Ken Heebner has had great returns for a decade. It doesn't mean he is about to repeat them. The tendency of hot funds to cool off is well known also. His may or may not. He had a so-so 2009.

What I am saying is that for most people diversification among strategies and asset classes likely holds the key to an investor sticking with the program. Every effort should be made to smooth returns. The less bumpy the ride, the less desire to panic at bottoms. How that is done- for you- is up to your advisor. I believe it CAN be done. Sometimes you will lag in bull markets. In bear markets you will make that back and probably then some. Since the bull part of market cycles tend to be twice as long as bear portions it can be uncomfortable at times. It's not for everyone. It takes away some of the thrills. It also takes away a lot of the pain. See your advisor for a full discussion.

2010 Tax Planning

It's that time of the year! We all wait anxiously beside the mail box to see if the new year's tax forms have arrived. (Sarcasm warning.)

So when should your mail-person bring those welcome missives? Well, W-2 Forms reporting your wages and tax withholding normally arrive January through mid-February. Employers can either mail out or deliver the Form W-2 by January 31st. If you haven't received your W-2 by mid-February, I'd call and ask for a replacement.

Documents reporting bank interest, student loan interest, mortgage interest, dividends, and other types of income or deductions also get mailed out at end of January. One exception, however, is Form 1099-B, the reporting of proceeds from stocks, bonds or mutual funds that you sold. It isn't mailed out until February 16th. Last year brokers were sending out two Forms 1099-B, the first to meet the IRS-imposed deadline, and a corrected 1099-B about a month later. A declaration of the fact that it could be corrected was included in the first mailing, thereby necessitating a wait before you filed. Irritating but necessary.

For a 2010 Tax Calendar of important dates, see here.

Now That We Have Rallied, Where Do We Stand?

"Those who cannot learn from history are doomed to repeat it." - George Satayana

I have certain beliefs about the markets. Every investor does despite frequent proclamations by the wizened to "remain agnostic" or better yet "let the markets tell you what to do." I believe that markets cycle between overvaluation and undervaluation. Periods of strong returns are followed by periods of weak ones. We have gone through such a decade of weak returns in the S&P 500, the large cap index of stocks.

At its March 9, 2009 nadir the S&P 500 had declined 57% from its peak. It has rallied 67% since then to finish Friday at a new interim high of 1145. Now what?

Well I won't join the list of prognosticators who attempt to tell you at this time of what the market will do in the next twelve months. This is the wrong forum for that. We are interested in the topic of investing in the context of FINANCIAL PLANNING. Earning "Top Forecaster" status is for someone else.

So other than the raw numbers I cited above, where do we stand? I am going to point you to the work of economist Andrew Smithers again of Smithers & Co. He has published two fine works on the markets "Valuing Wall Street" and "Wall Street Revalued" both of which I urge you to read. You can't get a better dissection of much of the nonsense that Wall Street and analysts peddle in the hopes of selling you stock. Here is what Smithers thinks:



Forty-eight percent overvalued.

If you need help in figuring out what to do with this information (if anything) please re-read my piece on "^The Duration of Stocks".

And, as always, see your trusted advisor or tax professional for advice.

ADDENDUM:

Reader "Sleepless" submitted a comment containing a link to a great interview with Andrew Smithers performed by Jim Puplava of Financial Sense Online. Have a listen. The link is here. Look for the entry in the January 9th program for Guest Expert and choose your media player of preference.

Planning Basics: The Time Value of Money

"Money is better than poverty, if only for financial reasons." - Woody Allen

It approaches hyperbole to state that the most fundamental concept in finance and hence of financial planning is that money has a “time value.” Money in hand today is worth more than money that is expected to be received in the future. “A bird in the hand…” and all that. Why is that so? Well, a dollar that you receive today can be invested such that you will have more than a dollar at some future time. If only our Congressmen knew this, but I digress.


First an example to show what we mean. Let’s say you have 100 dollars of money today and you invest it for one year and earning 5 percent interest. It will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient assuming 5 percent interest.

But the method is robust enough that it also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are “discounted” and then added together, thus providing a lump-sum "present value" of the entire income stream.

All of the standard calculations for time value of money derive from a basic algebraic expression for the present value of a future sum, discounted to the present by an amount equal to the time value of money. For example, the future value FV to be received in one year is discounted (at the rate of interest r) to give the present value PV thusly : PV = FV − r•PV = FV/(1+r).

Some standard calculations based on the time value of money are:

Present Value

The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.

Present Value of an Annuity.

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due.

Present Value of a Perpetuity

An annuity with an infinite and constant stream of identical cash flows

Future Value

Future Value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.

Future Value of an Annuity

The future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

Basic Equations, Identities and Combining Equations

Several basic equations that represent the equalities listed above. The solutions may be found using these formulas or, since we are in the twenty-first century, a financial calculator or a spreadsheet using Microsoft Excel for example. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT).

The equations are identities. For any of the equations below, the formula may be rearranged to determine one of the other unknowns. (Note: In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate although financial calculators and spreadsheet programs can “force” the solution through rapid trial and error algorithms).

These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond.
An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate.

The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless. I can't stress this enough.

For calculations involving annuities, you must decide whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation.

Finding the Formulae

Here is where I would naturally present all the formula regarding each of the concepts listed above and explain what each of the abbreviations ( i for interest rate, PV for present value, etc) meant. But I am not going to waste the pixels. You can find this in any finance textbook or in numerous sources on the Web. Instead I am going to give you a few links where you can find all of the relevant formulas and even examples.

From Investopedia

From StudyFinance.com

From GetObjects.com

I know some critics who have claimed that "this is all there is to" financial planning. I don't agree but even some practicioners have claimed as much. This knowledge IS however extremely valuable and study of it and its application is invaluable. That is why I have started the New Year with this post.

Good reading.

Out With the Old

HAPPY NEW YEAR TO ALL!

This is not a blog for these kind of ruminations, but I tend to think the ground shifted beneath us in 2009. I believe that the 2010s will be a decade of great change, but not in the manner that most people once expected. We have some serious issues to work through as a nation. At the same time, the changes occurring around us will affect our ability to control our own destiny.

There is a tremendous amount of hard work to do and our leaders are faced with many, many difficult decisions. You must take control at the individual level and your personal financial plan is one aspect of that. Let's work on that together in 2010.