Donor Advised Funds: Maximizing The Tax Benefit of Charitable Contributions

Do you make charitable contributions but find that you can’t deduct them for tax purposes because the standard deduction exceeds your itemized deductions?  If so, you can use something called a Donor Advised Fund (DAF) to group multiple years’ of future charitable deductions into one year for tax purposes and realize an immediate tax benefit.  This isn’t just shifting tax from one period to another as is the case for many tax strategies.  This will result in reduced taxes… more of your money kept in your pocket, or alternatively, more money you can give to those charities.

The Tax Cuts & Jobs Act (TCJA) imposed a limit of $10k per year that can be deducted as an itemized deduction for State & Local Taxes (SALT) paid each year.  Note that is true for both single and joint filers (i.e. the cap is not doubled to $20k for joint filers).  Additionally, TCJA doubled the standard deduction from $6k single & $12k joint to $12k single and $24k joint (inflation adjusted each year).  Finally, with depressed interest rates, many have been able to refinance their mortgage in recent years, leading to less of a mortgage interest deduction.  The combination of these factors has led to more and more filers taking the standard deduction rather than being able to itemize, meaning no additional tax benefit for charitable contributions.  With another wave of refinancing in 2020, even more taxpayers will find themselves in this situation. 

Let’s use some real numbers to demonstrate.  For 2020, the standard deduction is $12,400 for single and $24,800 for joint filers.  Let’s say that you’re married and your state income taxes and property taxes paid exceed the $10k limit, so you’d get $10k for SALT deductions in total due to the cap.  Let’s also say you have a $350k mortgage at 3% fixed, resulting in ~$10.5k of mortgage interest for 2020.  Finally, let’s say you give $4k per year to charity.  Since the SALT (10k) + mortgage interest (10.5k) + charitable contributions (4k) only total $24,500 of itemized deductions vs. the $24,800 standard deduction, it means that whether you made the charitable contributions or not, you’d still take the standard deduction.  You therefore get no tax benefit from the charitable contributions.  In fact, even if your total itemized deductions exceed $24,800, if the SALT + mortgage interest alone don’t exceed it, then some portion of your charitable contribution will provide no tax benefit.

If only there were a way to group several years’ worth of charitable contributions into a single year so you’d exceed the standard deduction (by a lot!), get a large tax benefit in that one year, and then take the standard deduction in the future years.  Enter the Donor Advised Fund.  A DAF is just an account with a DAF provider to which you make a lump sum contribution in a given year.  Since the contribution is irrevocable, and the DAF is a non-profit itself, you get to take the full amount of the contribution as a deduction in the year in which it’s made.  The money then remains in that account (it can even be invested) and you can make grants out of the account at any time to the charities of your choice.  Almost all charities, non-profits, and religious organizations are supported, though check with the DAF to make sure the organizations you want to support are allowed before making your contribution.

Back to the numerical example…  Instead of donating $4k each year for 5 years, you contribute $20k to a DAF in 2020 and then use the DAF to make $4k per year grants to the organizations you wish to support from 2020 – 2024.  In this case, your total deductions in 2020 amount to $40,500 (10k SALT + 10.5k mortgage + 20k charity) allowing you to itemize.  You’d then still take the standard deduction for the next four years.  The benefit is over $5500 of tax saved!

Even better, if you have highly appreciated assets, you can donate those and take a deduction for the fair market value of the asset, without ever having to pay capital gains tax on the asset’s appreciation.

Now, you may say that you don’t give to charity for the tax benefit, so who cares.  And it’s true.  No one gives to charity for the tax benefit because at most, you’d save $50 cents of tax for every $1 you donated which is clearly not a winning strategy.  But if each $1 you donate only costs you $0.50 cents with a tax benefit, then you could afford to donate twice as much with the tax benefit than without.  Therefore, whether you’re doing it to reduce your tax bill and keep more money in your pocket, or you’re doing it so you have more to donate to the charities (think of it as a government match facilitated by the tax code), there is a clear benefit to donate in a way that will allow you to take a tax deduction.

The typical DAF does charge an asset-based fee, but it is fairly low, in the 0.6-1.0% per year range.  The tax benefits of the DAF almost always outweigh any costs involved.  DAF providers typically cut off new account openings in early to mid-December in order to make sure they can get everything done by the end of year tax deadline, so if you’re interested in opening and funding a DAF, it is best to do so well in advance of end of year. 

In summary, DAF’s have low costs, allow you to reap substantial tax benefits, and still allow you to support the organizations that you typically support.  If your SALT deduction + mortgage interest deduction are below the standard deduction, and you make charitable contributions, you would almost certainly benefit from a DAF. 

Recent Executive Actions On Unemployment Benefits, Payroll Taxes, Student Loans, & Housing Assistance

On August 8, President Trump issued executive orders related to the extension of expanded unemployment benefits, the deferral of employee payroll taxes, an extension to the waiver of student loan payments and interest, and a directive to various cabinet members to take action to prevent residential evictions and foreclosures resulting from financial hardships caused by COVID-19. These orders were an attempt to circumvent the need for congressional action on additional COVID-19 assistance, which seems to have at least temporarily, resulted in a standoff in the Senate. The provisions in these orders are complicated and may result in legal challenges. There has been some additional guidance issued by the Dept. of Labor and FEMA, both of whom are involved in implementation. Below is a quick summary of what I understand so far related to these orders.

Unemployment – the CARES Act provided $600 per week of federally funded unemployment insurance benefits, in additional to standard state funded unemployment benefits. The additional $600 per week benefit expired on July 31, 2020.  This executive order and supplemental guidance authorizes states to voluntarily apply for aid from FEMA to fund an additional $300 per week benefit from August 1 through December 27, not to exceed $44 billion (which would only last about 5 weeks given the number of currently unemployed people). While the original order called for a $400 per week benefit, only 75% was to be Federally funded, with states picking up the additional 25%. Given fiscal issues at the state level, additional guidance was provided that states could treat their $100 per week as additional unemployment compensation or as a portion of their existing unemployment compensation paid (i.e. make the additional benefit $400 by taking the FEMA $300 and adding $100 to the current amount they pay OR make the benefit $300 by taking the FEMA $300 and treating $100 of the current unemployment benefit calculation as part of the program). Participation is up to the states and many seemed to be waiting for the supplemental guidance on their $100 per week portion before applying. To date, SD has announced it will not participate and AZ, CO, IA, LA, MO, NM, and UT have applied and been approved. It is unclear when payments will be able to begin for participating states due to administrative delays in changing unemployment systems to comply. Some states may begin in late August, with others starting payments in September. Some states, like SD, may choose not to participate at all. In order to receive the $300 or $400 supplement, individuals need to be collecting unemployment at a rate of at least $100 per week and must certify that they are unemployed or partially unemployed due to the disruptions caused by COVID-19.

Payroll Taxes – this order directs the Treasury Secretary to defer the collection of the employee portion of social security taxes (currently 6.2% of the first $137,700 of wages earned in 2020), for Sepember 1 – December 31 without interest or penalties. It also directs him to “explore avenues, including legislation, to eliminate the obligation to pay the taxes deferred” (i.e. forgive the taxes, rather than just defer them). This would apply for workers earning less than $4000 per bi-weekly period (adjusted equivalently for other payroll periods). Additional guidance is required from the Treasury Secretary as to how this program will work. In practice, employers collect Social Security taxes as the FICA portion of payroll taxes. If they fail to collect these taxes, they are generally responsible for paying them on behalf of the employee. That means that if an employer allows an employee to defer the tax to post-12/31 and the employee cannot pay, the employer could be on the hook for these taxes. From an employee perspective, deferral of the tax for a few months isn’t a big help if the bill then comes due in January for the whole deferral period. However, if the deferred taxes are forgiven, that would be a huge help. Payroll taxes can’t really be forgiven without Congressional action though, so forgiveness seems uncertain. Without additional guidance, it would be difficult for an employer to stop collecting the social security taxes. Even if they did participate and offer it to employees, it may cause financial stress in early 2021 for those employees that participate and need to pay the deferred taxes. Of course if there is any chance of forgiveness that is dependent on deferring the taxes to 2021, then employees have a strong incentive to participate as much as their employers allow them to. We’ll have to wait for further guidance to understand how (if) this order will ultimately work.

Student Loans – the CARES Act provided for deferral of student loan interest and payments through September 30, 2020. This order effectively extends that (voluntary) deferral period through December 31, 2020.

Housing Assistance – the CARES Act issued a moratorium on evictions that expired on July 24, 2020. This order does not extend that moratorium. Instead, it directs various cabinet member to take action to find ways to minimize residential evictions and foreclosures during the ongoing COVID-19 national emergency, to review existing authorities that can be used to prevent evictions, to identify funds that could be used to help renters and homeowners, and to consider whether any further halting of evictions are reasonably necessary to prevent further spread of the virus.

Congress has adjourned through Labor Day, so barring any emergency callbacks, which look to be a very low probability at this point, guidance on the programs above is all we’re likely to get from now till then. I suspect there will be another stimulus act passed in September/October, but these executive orders are likely to be it until then.

Q2 2020 Returns By Asset Class

This post contains the usual returns by asset class for this past quarter (by representative ETF), as well as last twelve months, last five years, and since the financial crisis lows of 3/9/2009.  I also added a year-to-date version to show how Q2’s recovery did a fairly good job at offsetting most of the Q1 damage.  While there is still no predictive power in this data, I’ll continue to post this quarterly for those of you that are interested.  Charts shown in the link below, with each on a separate page, legend at the bottom, zoom to your liking):

2020Q2 Asset Class Performance

A few notes:

  • Q2 was a hugely positive quarter, recovering a lot of the Q1 losses. US Small Caps (the worst performers in Q1) led the way in Q2 with a 26% return. US Large (+20%), Emerging Markets (+19%), and Foreign Developed (+17%) weren’t too far behind. REITs (+14%), Emerging Market Bonds (+10%), US “Junk” Bonds (+7%), and Commodities (+6%) were also strongly positive. Even the more conservative US Aggregate Bonds and US Short-Term Corporate Bonds were up 4% and 5% respectively, largely due to support from the Federal Reserve’s bond buying programs.
  • While US Large Cap stocks briefly went positive for the year in late May, the other major equity asset classes have not fully recovered their Q1 losses. With the recent pullback, year-to-date, US Large Cap is down ~3%, with US Small Caps, Foreign Developed and Foreign Emerging Markets all still down 10-12%.
  • US Bonds are now strongly positive year-to-date as interest rates have fallen and Federal Reserve support has offset credit quality concerns in the corporate sector. The Fed continues to buy both corporate bond ETFs and a diversified set of individual company bonds subject to their self-defined constraints.

Setting Contingent Beneficiaries Of Retirement Plans When You Have Young Children

***This post describes some of the complexities in choosing the contingent beneficiary of a retirement plan for parents with young children.  It is intended to help explore options and set up conversations to be had with a qualified attorney.  It is NOT intended to be legal advice.  Please consult a knowledgeable estate planning attorney before making any decisions around your estate plan***

Note: Throughout this post, I refer to the Will as the document that sets the rules for distribution of probate assets and the establishment of any Trusts.  Rather than repeatedly mentioning a Living Trust, which could contain this same language in a Living Trust and Pourover Will setup, I will exclusively refer to the Will.  The complexities and decision points apply to both situations.

When someone with a retirement account dies, that account passes to the decedent’s primary beneficiary as stated on the account.  If the primary beneficiary is already deceased, the account passes to the stated contingent beneficiary instead.  If no beneficiary is stated or no stated beneficiary is alive, then the account passes to the decedent’s estate and goes through probate, following the provisions of the decedent’s will or state intestacy laws if there is no will.

Most parents would want their assets to pass to their spouse if that spouse is alive.  Hence, naming the spouse as primary beneficiary is often an easy choice.  But what if the spouse is not alive?  Generally, the parent would want the assets to pass to the children.  If the children are all old / mature / educated enough to manage their own affairs, naming children outright as contingent beneficiary(ies) make sense.  Some issues arise when the children are not old / mature / educated enough to manage their own affairs.  This is the case I’ll discuss in this post.

The typical estate planning setup that I encounter for parents with young children is a Will for each spouse containing provisions for the establishment of a Trust for any assets left to the children at death of the second parent.  That Trust has formal rules set by the parents describing when the Trustee is allowed to use the funds for the child’s benefit (typically health, education, maintenance, and support), and when the principal remaining in the Trust is to be distributed outright to the child (typically in a lump sum or in stages at the attainment of certain ages or levels of education, or at a particular life event).  This works well for assets that pass through the estate, but retirement plan beneficiary settings supersede any provisions in a Will.

If a child is named as contingent beneficiary of a retirement plan, the rules in the Will that establish a Trust for the benefit of the child are bypassed and instead the child will own the retirement account outright, via a custodian either specified in the retirement plan beneficiary form, if applicable, or as appointed by a court.  In these cases, when the child reaches the Age of Majority (18 in most states), he/she will have 100% control of the assets in the account with no restrictions.  If parents were satisfied with this result, they wouldn’t have set up a Trust for the child in their Will that would prevent unrestricted access to assets until the child is old/mature/educated enough to handle the money.

So what are the other options here?  The parents could name their estate as the contingent beneficiary, or they could name the Trust that is created by their Wills as the contingent beneficiary.  Let’s examine each of these.

If they name their estate, the account will pass through probate and follow the terms of the Will.  If the Will is constructed properly, it will be able to pass a retirement account that is inherited by a child into the Trust that is created by the Will for that child.  That means preserving the structure that prevents unrestricted account access by the child until qualifications (as defined by the Trust) are met to receive that access.  However, leaving a retirement account to an estate can have negative tax consequences.  That retirement account will need to be distributed out of tax-advantaged status over a maximum of five years.  If the account is sizeable, that could mean distributing large amounts of pre-tax income each year, or worse, into the last year if distributions aren’t taken every year.  Since tax rates are progressive, and pre-tax income becomes taxable when distributed, that could mean paying higher than necessary income taxes, thereby foregoing an unnecessary portion of the inheritance to taxes.

If the parents name the Trust that is created for the child in their Will, then again, the structure that prevents unrestricted access by the child at the Age of Majority is preserved.  Additionally, if that Trust qualifies as a “look-through” trust, then the retirement account won’t have to be distributed until 10 years after the child reaches the Age of Majority.  This gives much more time to spread out the distributions of pre-tax income so that they’re not all lumped into one or a few years, causing a high tax-rate to apply.  Note that prior to the passes of the SECURE Act in December of 2019, the distributions could have been spread (or more commonly “stretched”) over the lifetime of the child by taking a small Required Minimum Distribution (“RMD”) each year after the death of the account owner.  The SECURE Act eliminated this “stretch” for most beneficiaries, replacing it in the case of a child inheriting a retirement account by eliminating the RMD requirement, but adding a requirement that the account be distributed within 10 years of the child reaching the Age of Majority. 

So naming the Trust that is created by the Will preserves the restricted access that most parents desire and gives a better tax treatment than naming the estate would.  This seems like the best option for most people, but it too comes with some complexities.  First, as noted above, the Trust created by the Will must be a “look-through” trust.  That means it must 1) be valid in your state of residence, 2) it must only leave assets to a living person (no charities or complex provisions where the ultimate beneficiary of the Trust cannot be ascertained), 3) the Trust must be irrevocable at the death of the retirement account owner (so the terms can’t be changed) and 4) the retirement account custodian must have a copy of the Trust on file.  While not overly difficult, this means the attorney that creates the Trust language must be aware of your intention to name the Trust as beneficiary of a retirement account while still preserving tax-advantaged status for as long as possible. 

Another complexity is in how the Trustee of the Trust will ultimately distribute the retirement account into the Trust and then to the child.  Prior to the SECURE Act, two types of trusts could be used.  One, known commonly as a “conduit trust” would receive RMDs each year from the retirement account and distribute them to the child as income.  This had the advantages of avoiding trust tax rates, which are higher than individual rates, by passing each year’s income to the child, who is typically in a low income tax bracket.  It also meant that only a small amount of the account would be distributed each year, thereby applying the lowest marginal tax rates possible to the inherited amounts.  Remember though that the SECURE Act eliminated RMDs for inherited accounts.  Without RMDs, there is nothing to distribute each year under the conduit trust structure which would leave only one big distribution to the child in the 10th year after reaching the Age of Majority!  If you have a conduit trust structure that doesn’t provide the Trustee with the ability to distribute principal from the retirement account, you have a real mess on your hands.  Those with estate plans already in place should consult with their attorney to make sure this won’t impact them in the post-SECURE Act world. Those building their estate plans now clearly want to avoid a conduit trust setup.  The other type of trust that was used pre-SECURE was known as the “discretionary trust”.  This type of trust would receive RMDs each year but hold them in the Trust rather than distributing them to the child by default.  If the child needed money from the Trust for valid reasons as defined by the Trust, then the Trustee would have discretion to distribute it.  A discretionary trust can still work post-SECURE Act, but the Trustee needs to balance taking distributions from the retirement account to minimize a large bill later with the needs of the child in any given year and the high trust tax rates for any retirement account distributions that are retained in the trust.

A final complexity in naming the Trust that is created by the Will as contingent beneficiary of a retirement account is the skill/experience required of both the attorney that sets up the estate plan and the trustee that is left as responsible for making the distribution decisions.  From my experience, not every estate planning attorney knows how to best create a look-through trust in a will that is capable of preserving tax-advantaged status while maintaining a structure that will prevent the money from reaching the child in unrestricted form too early in life.  Additionally, parents often choose a relative or family friend as the Trustee of the Trust.  That person may not have the experience or understanding of all these complexities to minimize taxes each year and over the life of the Trust.  While an outside advisor can surely be hired to assist, the Trustee may not even realize the complications and the inefficiencies that will result from poor optimization.

Options, pros & cons

Now, you may note that all of this only comes into play if both parents die while the child is still young.  That’s true.  The complexities of a child inheriting a retirement account are only an issue at the death of the second spouse if there are still young/inexperienced children at that time.  That makes the ultimate event where the child actually inherits the account before they’re capable of dealing with it properly a low probability event.  Unfortunately, parents are building assets in retirement plans while their children are young and the possibility of early death still exists, regardless of that low probability.  This means the creation of estate planning documents and naming of beneficiaries in a thoughtful, coordinated way is necessary for all parents that don’t want to risk giving children unrestricted access to large sums of money the day they turn 18 or losing substantial amounts of the child’s inheritance to income taxes.  In other words, you won’t know if your estate planning documents and beneficiary selections are important until exactly that time when it’s too late for you to do anything about them.  Therefore, it makes sense to set them up in a way that will handle this worst case, rather than pretending that the worst case can’t happen to you.

One final note…  I’m often asked if it’s ok to create estate planning documents via an online service that uses templates and fills in the blanks with your answers to interview questions.  If the service is capable of guiding you through the complexities described above such that you can thoughtfully answer the relevant interview questions, and capable of creating documents that address these complexities, then have at it.  Or, if you understand these complexities enough to choose simplifications that will work for you such that the service’s offering can handle your requirements, then again, go for it.  Technology is amazing, but I’m skeptical of this approach.  In my opinion, there is little/no point to an estate plan that doesn’t work and leaves a mess to be sorted out by your heirs.  In some cases a bad estate plan can even be worse than no estate plan at all.  If you’re wealthy enough to have (or assume you will have in the future) sizable amounts of money in retirement plans, then it’s probably worth spending some money to get your estate plan in order with the help of an actual attorney.     

Q1 2020 Returns By Asset Class

For the last several quarters, I’ve posted returns by asset class (by representative ETF), as well as last twelve months, last five years, and since the financial crisis lows of 3/9/2009. While there is still no predictive power in this data, I updated those charts as of the end of Q1 2020 for those of you that are interested.  Charts shown in the link below, with each on a separate page, legend at the bottom, zoom to your liking):

2020Q1 Asset Class Performance

Given all the recent blog posts explaining what’s going on, I’ll provide limited commentary on this.  What started as a fairly positive quarter turned ugly at the end of February and downright brutal across risky asset classes in March.  A few notes:

  • Bonds (many of which are now backed by the Federal Reserve’s purchasing power) acted as dampeners of the poor returns, as expected.  The more aggressive your portfolio, the more stocks and less bonds you have, the more magnified negative returns are for Q1.  The aggregate bond index was up 2% for the quarter while short-term corporate bonds were down about 2% due to the slightly worse, but still investment grade, credit quality of corporate bonds vs. treasuries.
  • Junk bonds and emerging market bonds outperformed equities, but still took a beating in Q1 (-12% and -16% respectively).
  • US Large Cap stocks continued to outperform small caps and foreign stocks.  But while the relative performance was better, the overall returns were still -20%.
  • US Small Cap stocks were the worst performers (-30%) and that was after a spectacular final week of the quarter.  Some portions of the Small Cap world (not shown) were even worse.  Micro Cap stocks (-35%+), US Small Cap Value (-40%+) (not shown).
  • Foreign Developed and Emerging Markets took it on the chin as well, down ~24% each.
  • Commodities in aggregate were down ~30%, but energy had it’s worst quarter of all time after Saudi Arabia & Russia decided to start a price war, pumping extra supply into the middle of the covid-19 global economic shutdown.  Energy as a whole (via Vanguard’s Energy ETF) was down 53% while Oil & Gas Equipment & Services were down a whopping 72% in Q1 alone.

 

Coronavirus Aid, Relief, and Economic Security (“CARES”) Act

This week Congress passed and the president signed into law the CARES Act. This 335-page (840 under bill format), $2 trillion dollar piece of legislation contains a LOT of complicated provisions. I’ve skimmed through it and read multiple commentaries in detail to try to create a summary of the financial pieces that are most important to PWA clients. As always, there will be a lot of interpretations, details, and guidance that will follow from the IRS, the Dept. of Labor, the Treasury, SBA, etc. Here’s what I understand at this point:

· Direct Payments to Individuals – $1200 for individuals ($2400 for joint taxpayers) that are not dependents of another taxpayer + $500 for each child under age 17. The payments are reduced if income exceeds $75k (single), $112,500 (head of household), or $150k (joint), by $5 for every $1k in excess of the threshold (see the Tax Foundation’s excellent graphic on how this will work). For threshold income, the IRS will use 2019 adjusted gross income (AGI) for the initial payment. If you haven’t filed your 2019 return by the time the payment is calculated, they’ll use 2018 instead. The amounts you receive with then be reconciled against income on your 2020 tax return. If you should have received a payment based on 2020 income but did not, you’ll get the excess as a credit on your 2020 return. If you received more than you should have based on 2020 income, my understanding is that you will not have to repay the difference. Because of this, it may be best to make sure you get your 2019 tax return in ASAP if you’d qualify based on 2019 income, but not 2018 income, or to delay 2019 if you’d qualify based on 2018 but not 2019. These direct payments will be made by 4/6/2020 via direct deposit on file with the IRS as of the latest filed tax returns, or along with Social Security payments if you receive Social Security, or by check if you don’t receive Social Security and there is no direct deposit information on file or if the direct deposit information cannot be used for some other reason. The IRS is going to provide a phone number for issues around payments that aren’t received but should have been received. If you just cringed/laughed at the idea of millions of people potentially calling one IRS number and sitting on hold for days, so did I. It is what it is.

· Expanded Unemployment Benefits – $600 / week increase in benefits + 13 more weeks of benefit available + an expansion of benefits to those who normally don’t qualify (self-employed, independent contractors, and those with limited work history) + elimination of the one-week waiting period. Note that the average unemployment compensation amount prior to this expansion was only $372 / week nationwide, so an additional $600 / week is significant. For some workers, it may even be more than they were earning while working.

· Partially Forgivable Small Business Loans – The “Paycheck Protection Program”. $350 billion authorized. Businesses (including sole-proprietors and independent contractors) with 500 employees (full or part-time) or less, can borrow up to the lower of $10M or 2.5x monthly payroll (avg of the last year), excluding any amount over $100k per year for each individual. Self-employment income supposedly counts as payroll. I would venture to guess that S-Corp profits do not, since they don’t pay payroll taxes. Loan proceeds can be used for payroll support, employee salaries, mortgage payments, rent, utilities, and any other debt obligations incurred before the covered period. Loans are non-recourse (no personal guarantee or collateral needed) unless the proceeds are used for a non-approved purpose. Interest can’t exceed 4%. Loans can be for up to 10 years. Borrowers will be eligible for loan forgiveness for an amount equaling payroll (max $100k per employee) and operating costs for the first 8 weeks after the loan is issued. However, the loan forgiveness is subject to maintaining the same number of employee equivalents (FTEs) from 2/15/2020 to 6/30/2020 as it had in 2019 or from 1/1/2020 to 2/15/2020 and not cutting salaries/wages for those earning $100k or less by more than 25%. If you don’t maintain payroll, loan forgiveness is reduced / eliminated by a very complicated formula that isn’t clear to me. Please see this brochure produced by the Chamber of Commerce with more details on these loans. More great information is available in this Forbes article from 3/28, including some of the unanswered questions, specifically around how all of this works for businesses with no employees (like independent contractors). There are lots of open questions. If you own a small business, stay tuned for more info soon from the SBA, along with a list of eligible lenders that will facilitate the loan. These loans are going to be administered by the SBA which currently has nowhere near the manpower to handle what’s being asked of them (my opinion). The CARES Act recommends that SBA direct lenders to “prioritize small business concerns and entities in underserved and rural markets, including veterans and members of the military community, small business concerns owned and controlled by socially and economically disadvantaged individuals, women, and businesses in operation for less than 2 years.” I suspect there will be a lot of “first-come-first-served” prioritization as well, so getting to the front of the line once lenders are ready to accept applications could mean a lot if your business is dependent on this program for survival. You must apply by 6/30/2020 to be eligible for one of these loans. Keep in mind that there is an existing program via the SBA that has nothing to do with the CARES Act which is already available to provide loans up to $2M to small businesses impacted by covid-19. You can find more information at https://www.sba.gov/page/coronavirus-covid-19-small-business-guidance-loan-resources, under the topic for Economic Injury Disaster Loan Program. The CARES Act also provides funding to lenders who agree to forbearance on existing SBA loans during the covid-19 emergency.

· Larger Business Loans – $500 billion authorized. Direct loans to corporations or via purchase in primary or secondary markets. Directed by Treasury with oversight from a bipartisan congressional oversight committee. A limited portion is made available for airlines, air cargo carriers and businesses critical to maintaining national security. Borrowers must be created, organized and have a significant presence in the United States. All loans are supposed to be secured and are intended for businesses that don’t have reasonable access to other credit. Borrowers can’t buy back their own stock, issue dividends, or reduce their workforce during the term of the loans. There are also compensation caps for highly-paid employees during the term of the loan. While the terms of the loan are at the discretion of Treasury, they must come along with a warrant (long-term term right to purchase stock at a fixed price), equity interest, or senior debt instrument. These are intended to compensate the government for the loan. Proceeds pay for the program, with any excess going to Social Security. Any company where a controlling interest (defined as over 20 percent of controlling stock) is held by president, the vice president, executive department head, or Member of Congress or their families is rendered ineligible for financial assistance in the form of loans or investments provided under the CARES Act.

· Employee Retention Tax Credit – Credit for businesses that were impacted by covid-19 (government stay-at-home orders, restrictions on operations, or at least a 50% decline in year-over-year revenue for at least one quarter). The credit is for 50% of the first $10k of qualified wages paid to employees between 3/12/2020 and 12/31/2020. For businesses with more than 100 employees, qualifying wages are those paid to employees while they’re unable to do their job. For those with 100 employees or less, qualifying wages are all wages paid. Employers who receive a loan under the “Paycheck Protection Program” are not eligible for this credit.

· Employer Payroll Tax Delay – employers can delay paying their half of payroll tax on wages for the remainder of 2020 to 2021 and 2022 (half each). Does not apply if the employer receives forgiveness of any loan made under the “Paycheck Protection Program” provisions described above.

· Retirement Plan Early Distributions – new hardship withdrawals up to $100k allowed for those with covid-19-related needs. The 10% penalty is waived. Tax is still due, but it can be spread over three years (it will be spread over three years by default, unless you elect out). You can also recontribute the amounts that were withdrawn within three years and face no additional tax. The re-contributions are not subject to the IRS contribution limits for any given year. To qualify, you have to get the virus, a spouse or dependent does, or you have to have virus-related financial difficulty which is pretty liberally defined (laid off, furloughed, hours reduced, income reduced, can’t work due to childcare needs, etc.).

· Retirement Plan Loans – increases the size of allowed loan to 100% or $100k, whichever is less from the current 50% or $50k, whichever is less. Loan payments due between 3/27/2020 and 12/31/2020 can be delayed for up to a year.

· Retirement Plan Required Minimum Distributions – these are suspended for all retirement plans and inherited retirement plans for 2020.

· Employer Payments For Student Loans – Up to $5250 of employer payments toward employee student loans would not be considered taxable to the employee.

· Individual Student Loan Payments – Federal student loan payments can be suspended, interest-free, through Sep 2020. Borrowers may need to take action though to stop any scheduled recurring payments (if desired). They may not be stopped automatically. No credit reporting impact.

· Mortgage Forbearance – individuals/families impacted by covid-19, with Federally-backed mortgages (FHA, Fannie, Freddie, VA, etc.) can request forbearance (no payments) for up to 180-days. If necessary, this can be extended by an additional 180-days. No penalties apply during forbearance, though interest continues to apply as scheduled.

· HSA/HRA/FSA Qualified Expenses – modified to allow over-the-counter drugs, not just prescription drugs, as qualified medical expenses. Also adds various feminine products to the allowed list of eligible expenses. I’m not sure that the broad inclusion of over-the-counter drugs was intended, but based on the changes made to the tax code by the CARES Act, it seems like that’s what happened. More to come on this as clarification emerges.

· Charitable Contributions – previously only allowed for those who itemize, a new, seemingly permanent tax deduction has been added for up to $300 of charitable contributions for those who don’t itemize. It’s what is known as an “above the line” deduction.

· Net Operating Loss (NOL) – losses in 2018, 2019, or 2020 can be carried back 5 years (have to elect out of that treatment if you don’t want it). TCJA previously eliminated carrybacks of two years so that all losses had to be carried forward. For individuals, losses can offset up to 100% of income vs. TCJA’s 80% limitation.

There are many other provisions providing funding for and modifying regulations dealing with health (including requiring that insurers cover all covid-19 treatments and vaccine and make all testing free to individuals, funding for hospitals, telehealth, drug development and access, the CDC, the VA and the building/rebuilding of the strategic national stockpile of medical supplies), education, state & local government, the arts, and banking.

Monetary Stimulus Bazooka

Over the past two weeks, we have seen unprecedented, by size and speed, Central Bank action. Here’s just some of what I’ve been able to capture:

· US cuts the Fed Funds rate target range to 0-0.25%, down 1.5% via two emergency cuts between scheduled meetings.

· US cuts the discount rate, the rate that it charges banks for loans from its discount window, to 0.25%, lower than during the great financial crisis.

· US re-launches quantitative easing (QE) of at least $700 billion with no cap on total or monthly purchases. In the past, they’ve always capped both. This includes at least $200 billion in mortgage-backed securities. It is purchasing both at ludicrous speed and on Friday, just five days after announcing the program and publishing a planned schedule, announced plans to accelerate from the planned purchases.

· US opened twice-daily short-term repurchase operations of up to $1 trillion. This basically tells banks “if you need any money at all for any reason, we will provide it.”

· US eliminated the bank reserve requirement, the amount of deposits that need to be on hand at any time (which is fine b/c banks can borrow from the discount window if needed), and encouraged banks to temporarily dip into regulatory and capital buffers if needed.

· US reduced the rate of interest on swap lines with foreign central banks in Canada, England, the Eurozone, Japan, and Switzerland (we give them dollars, they give us foreign currency, we charge them interest… now less interest) to ease any dollar shortages that result from a flight to safety.

· US opened swap lines with Australia, Brazil, Denmark, Korea, Mexico, New Zealand, Norway, Singapore, and Sweden.

· US launched the Commercial Paper Funding Facility (CPFF) which allows the Fed to buy commercial paper and for the treasury to cover up to $10 billion of losses. Read this as the Fed is backstopping the short-term corporate lending market.

· US launched the Primary Dealer Credit Facility (PDFC) which effectively provides low-interest loans to primary dealers in return for collateral which now includes corporate debt and municipal bonds.

· US launched the Money Market Mutual Fund Liquidity Facility (MMLF) which provides loans to money market mutual funds in exchange for loans that the funds hold. As individual and businesses liquidate money market funds during the current cash crunch because of the economic pause, this prevents the funds from having to sell illiquid short-term loans in a fire sale. Instead, now they can give them to the Fed for cash to handle fund redemptions and not “break the buck”. Treasury provides $10 billion for any losses.

· In summary, the Fed is either outright purchasing or accepting as collateral: treasuries, mortgages, commercial paper / corporate debt, and municipal bonds (state/local government debt). There are limits on term and quality which can be expanded. There are limits on who can borrow with collateral (banks and primary dealers), which can also be expanded further. As of right now, the Fed cannot purchase preferred stock or common stock under their current powers. I say “current” because powers can be changed by Congress or, in some cases (maybe with legal challenges) by Executive Order in times of emergency.

· Bank of Japan (BOJ) doubled its ETF purchase plans (that’s right, the BOJ actually prints money to buy funds that hold stocks, and they’re buying more!!!) for 2020. They increased their corporate bond buying plan by almost 50% for 2020.

· European Central Bank (ECB) expanded QE, is allowing banks to borrow cash at -0.75% (that’s right, the ECB will pay their banks to borrow money from them). They also launched a 750 billion euro Pandemic Emergency Purchase Programme to purchase the debt of EU countries, as well as lower quality debt. That’s ON TOP OF their existing purchase plans.

· Canada cut rates to 0.75% and launched QE via mortgage purchases.

· UK cut rates to 0.1%, increased existing QE bond purchases, eliminated their bank reserve requirement, and launched a new term funding arrangement that provides up to 100 billion pounds of 4-year loans to banks to provide low interest loans to individuals and companies.

· Australia cut rates to 0.5% opened a fund for lending to banks, and launched QE via purchases of government debt to controlthe 3-year borrowing rate at 0.25%.

This doesn’t even take into account the fiscal response across the world as virtually every government spends money it doesn’t have to help their economy get through this. The buying of government debt by central banks via quantitative easing is what makes that possible. So what’s the end game here? Central banks and national governments have shown their respective hands. In a coordinated manner, they will do everything to not let the global economy spiral into deflation. Deflation causes the price of everything to come down, encouraging anyone who wants to buy or invest to wait until prices fall further, which inevitably makes prices fall further due to lack of demand. It is a chain reaction that can lead to long-lasting depressions. If they print money to afford government spending and cash to individuals as support for this economic pause, they can offset the economic damage the pause would cause. This risks massive inflation in the future since increasing the supply of money and giving everyone their share of it, just increases demand for everything, thereby pushing up prices. In the simplest example, imagine if the government decided to match dollar for dollar, what everyone has in net worth. Everyone would feel richer. Bids for homes would rise immediately. Stock prices would rise due to flood of investment. Commodity prices would rise as global demand for everything increased. Everyone would be spending money at a pace never before seen leading to shortages everywhere from increased demand. The only response will be prices increasing sharply and dramatically until they are about double where they were before the government’s action. Then everything stabilizes (gross oversimplification) right back to where it was before with two times the money available and everything costing twice as much. In a sense, government and central bank action is walking a tightrope of trying to offset reduced demand due to the economic shock without causing too much demand that creates inflation. On which side will they land? Like I said, they tipped their hand already. Expect more from central banks as needed to get through the crisis. At some point, financial markets will realize what lies on the other side… a whole lot of money looking for a place to go.

Note: As I wrote this, the Financial Times announced that the UK plans to buy stock in their airlines and other companies affected by the pandemic. The bazooka keeps getting bigger, from the monetary and fiscal sides.

Families First Coronavirus Response Act

The Families First Coronavirus Response Act (Act) was passed this week and signed into law on 3/18/2020. This is the first of what looks to be many rounds of legislation aiming to provide fiscal stimulus and relief for individuals and businesses during the Covid-19-related slowdown of the economy. This particular piece was intended to provide expanded paid leave for sick workers and workers who need to miss work to care for family, if they work for a business with fewer than 500 employees, via emergency expansion of the Family Medical Leave Act (FMLA) and a new federal paid sick leave law. Details are below as released by the IRS. Full text of the law and summaries from Congress can be found on congress.gov (https://www.congress.gov/bill/116th-congress/house-bill/6201). I hesitate to link to an external source for interpretation of the details in here, but Fisher Phillips LLP seems to have a great write-up on this. They are employment attorneys and I have no prior experience with them, no knowledge of their bias or business practices, and am not making a recommendation that anyone should contact them. They just specialize in this area and so their write up seems more valuable than what I could put together with limited expertise. Please consider this un-fact-checked, but believed to be reliable, summary of the Act.

There’s a lot in here and it was passed in a hurry, which will undoubtedly lead to implementation questions and a need for further guidance. I don’t have a lot of answers and these bills are going to be coming fast and furious over the next few weeks so I’ll be doing my best to keep you informed without a ton of my own commentary for now. I’m sure there will be more to come on this…

***Copying directly from the IRS***

WASHINGTON – Today the U.S. Treasury Department, Internal Revenue Service (IRS), and the U.S. Department of Labor (Labor) announced that small and midsize employers can begin taking advantage of two new refundable payroll tax credits, designed to immediately and fully reimburse them, dollar-for-dollar, for the cost of providing Coronavirus-related leave to their employees. This relief to employees and small and midsize businesses is provided under the Families First Coronavirus Response Act (Act), signed by President Trump on March 18, 2020.

The Act will help the United States combat and defeat COVID-19 by giving all American businesses with fewer than 500 employees funds to provide employees with paid leave, either for the employee’s own health needs or to care for family members. The legislation will enable employers to keep their workers on their payrolls, while at the same time ensuring that workers are not forced to choose between their paychecks and the public health measures needed to combat the virus.

Key Takeaways

  • Paid Sick Leave for Workers
  • For COVID-19 related reasons, employees receive up to 80 hours of paid sick leave and expanded paid child care leave when employees’ children’s schools are closed or child care providers are unavailable.

Complete Coverage

  • Health insurance costs are also included in the credit.
  • Employers face no payroll tax liability.
  • Self-employed individuals receive an equivalent credit.

Employers receive 100% reimbursement for paid leave pursuant to the Act. Fast Funds

  • An immediate dollar-for-dollar tax offset against payroll taxes will be provided
  • Where a refund is owed, the IRS will send the refund as quickly as possible.
  • Reimbursement will be quick and easy to obtain.

Small Business Protection Employers with fewer than 50 employees are eligible for an exemption from the requirements to provide leave to care for a child whose school is closed, or child care is unavailable in cases where the viability of the business is threatened.

  • Easing Compliance
  • Requirements subject to 30-day non-enforcement period for good faith compliance efforts.

To take immediate advantage of the paid leave credits, businesses can retain and access funds that they would otherwise pay to the IRS in payroll taxes. If those amounts are not sufficient to cover the cost of paid leave, employers can seek an expedited advance from the IRS by submitting a streamlined claim form that will be released next week.

Background

The Act provided paid sick leave and expanded family and medical leave for COVID-19 related reasons and created the refundable paid sick leave credit and the paid child care leave credit for eligible employers. Eligible employers are businesses and tax-exempt organizations with fewer than 500 employees that are required to provide emergency paid sick leave and emergency paid family and medical leave under the Act. Eligible employers will be able to claim these credits based on qualifying leave they provide between the effective date and Dec. 31, 2020. Equivalent credits are available to self-employed individuals based on similar circumstances.

Paid Leave

The Act provides that employees of eligible employers can receive two weeks (up to 80 hours) of paid sick leave at 100% of the employee’s pay where the employee is unable to work because the employee is quarantined, and/or experiencing COVID-19 symptoms, and seeking a medical diagnosis. An employee who is unable to work because of a need to care for an individual subject to quarantine, to care for a child whose school is closed or child care provider is unavailable for reasons related to COVID-19, and/or the employee is experiencing substantially similar conditions as specified by the U.S. Department of Health and Human Services can receive two weeks (up to 80 hours) of paid sick leave at 2/3 the employee’s pay. An employee who is unable to work due to a need to care for a child whose school is closed, or child care provider is unavailable for reasons related to COVID-19, may in some instances receive up to an additional 10 weeks of expanded paid family and medical leave at 2/3 the employee’s pay.

Paid Sick Leave Credit

For an employee who is unable to work because of Coronavirus quarantine or self-quarantine or has Coronavirus symptoms and is seeking a medical diagnosis, eligible employers may receive a refundable sick leave credit for sick leave at the employee’s regular rate of pay, up to $511 per day and $5,110 in the aggregate, for a total of 10 days.

For an employee who is caring for someone with Coronavirus, or is caring for a child because the child’s school or child care facility is closed, or the child care provider is unavailable due to the Coronavirus, eligible employers may claim a credit for two-thirds of the employee’s regular rate of pay, up to $200 per day and $2,000 in the aggregate, for up to 10 days. Eligible employers are entitled to an additional tax credit determined based on costs to maintain health insurance coverage for the eligible employee during the leave period.

Child Care Leave Credit

In addition to the sick leave credit, for an employee who is unable to work because of a need to care for a child whose school or child care facility is closed or whose child care provider is unavailable due to the Coronavirus, eligible employers may receive a refundable child care leave credit. This credit is equal to two-thirds of the employee’s regular pay, capped at $200 per day or $10,000 in the aggregate. Up to 10 weeks of qualifying leave can be counted towards the child care leave credit. Eligible employers are entitled to an additional tax credit determined based on costs to maintain health insurance coverage for the eligible employee during the leave period.

Prompt Payment for the Cost of Providing Leave

When employers pay their employees, they are required to withhold from their employees’ paychecks federal income taxes and the employees’ share of Social Security and Medicare taxes. The employers then are required to deposit these federal taxes, along with their share of Social Security and Medicare taxes, with the IRS and file quarterly payroll tax returns (Form 941 series) with the IRS.

Under guidance that will be released next week, eligible employers who pay qualifying sick or child care leave will be able to retain an amount of the payroll taxes equal to the amount of qualifying sick and child care leave that they paid, rather than deposit them with the IRS.

The payroll taxes that are available for retention include withheld federal income taxes, the employee share of Social Security and Medicare taxes, and the employer share of Social Security and Medicare taxes with respect to all employees.

If there are not sufficient payroll taxes to cover the cost of qualified sick and child care leave paid, employers will be able file a request for an accelerated payment from the IRS. The IRS expects to process these requests in two weeks or less. The details of this new, expedited procedure will be announced next week.

Examples

If an eligible employer paid $5,000 in sick leave and is otherwise required to deposit $8,000 in payroll taxes, including taxes withheld from all its employees, the employer could use up to $5,000 of the $8,000 of taxes it was going to deposit for making qualified leave payments. The employer would only be required under the law to deposit the remaining $3,000 on its next regular deposit date.

If an eligible employer paid $10,000 in sick leave and was required to deposit $8,000 in taxes, the employer could use the entire $8,000 of taxes in order to make qualified leave payments and file a request for an accelerated credit for the remaining $2,000.

Equivalent child care leave and sick leave credit amounts are available to self-employed individuals under similar circumstances. These credits will be claimed on their income tax return and will reduce estimated tax payments.

Small Business Exemption

Small businesses with fewer than 50 employees will be eligible for an exemption from the leave requirements relating to school closings or child care unavailability where the requirements would jeopardize the ability of the business to continue. The exemption will be available on the basis of simple and clear criteria that make it available in circumstances involving jeopardy to the viability of an employer’s business as a going concern. Labor will provide emergency guidance and rulemaking to clearly articulate this standard.

Non-Enforcement Period

Labor will be issuing a temporary non-enforcement policy that provides a period of time for employers to come into compliance with the Act. Under this policy, Labor will not bring an enforcement action against any employer for violations of the Act so long as the employer has acted reasonably and in good faith to comply with the Act. Labor will instead focus on compliance assistance during the 30-day period.

For More Information

For more information about these credits and other relief, visit Coronavirus Tax Relief on IRS.gov. Information regarding the process to receive an advance payment of the credit will be posted next week.

***End of copy from IRS***

Market Update & More (3/15/2020)

Q. How about that stock market rally on Friday? It has to mean Thursday was the bottom right and this was that quick turn you’ve talked about before?

A. Honestly, I doubt it. And I don’t mean that stocks are going to immediately just give that all back, though they certainly could. What I mean is that the stock market is constantly adjusting to price in all known current information and all opinions of those who are invested in it. If the average investor thinks that prices for a company, sector, asset class, country, index, or the market as a whole are too high, then that average investor will be buying less at the current price than selling. That makes prices fall, sometimes rapidly, to a lower point where equilibrium is established again. The reverse of course is true as well. If the average investor, known all they know, thinks prices are too low, then there will be more buying than selling at the current price, thereby pushing prices up. Right now, markets are getting lots of new information daily, sometimes minute-ly (don’t think that’s a word, but let’s go with it anyway). Opinions form, sometimes overreacting, sometimes underreacting, though we never know when that’s the case. Friday’s snap back from Thursday’s ~10% move down is more shifting opinions, more new information, and more projecting the future beyond covid-19 and an oil price war. The odds are good that the market is still fairly priced and if it’s not, we don’t know whether it’s overpriced (near term shock will be worse than expected, recovery longer, long-term impacts) or underpriced (near term shock will be better than expected, recovery shorter, few/no long-term impacts). The key part of that last sentence is “than expected”. We can’t simply read the news, say that covid-19 cases and deaths increased, and think that would cause stocks to lose value. What causes stocks to lose value is when things are worse “than expected”, in aggregate, and that worse than expected result is validly projected into the long-term future. No one can tell you when the stock market is going to bottom or has bottomed, just like they can’t tell you when it is going to top-out or has topped-out. It would be much wiser to say that the best guess is that the market is fairly priced, is most likely to produce average returns from here, but that the likelihood of a wild swing in one direction or the other remains.

Q. Well, that’s disappointing. Everything’s so depressing right now… can you give me a few positives as a result of what’s happening?

A. Absolutely.

  1. Long-term interest rates are extremely low. That’s not just great for refinancing personal debt (e.g. mortgages), but it also means something important about asset prices. A company’s value today is determined by a projection of its future profits, but typically the short-term profits are weighted much higher than long-term profits because of the interest rate you can earn on those profits each year as they’re collected. If interest rates are high, say 10%, you’d rather have a dividend right now and reinvest it at 10% than get it five years from now. That makes the short-term much important relative to the long-term in determining current value. When interest rates are as low as they are now, the value of the next year’s profits is a much smaller portion of a company’s total value. This is extremely important in the sort of scenario we’re living in now where the disruption to profits seems temporary. Losing year one of profits with minimal/no impact on years 2 thru infinity should not change current value by that much, at least not in aggregate (individual company’s might have debt which forces them out of business if they can’t make payments, but then another company that survives takes their revenue going forward). Warren Buffett invested in an airline yesterday. I suspect, he’s using this kind logic in buying the worst possible investment for news flow (ex-cruise lines), at exactly the worst possible time looking at near term profits.
  2. Gas prices will likely be in the ~$1.50 range nationwide in the next couple of weeks. Most people aren’t doing a lot of commuting / traveling right now, but when they do, those cheaper prices at the pump add up to more money in consumer pockets.
  3. More on interest rates… I don’t know if we’ll do this, but the country has an opportunity to extend the maturity of short-term debt to the very long-term without paying much higher (and sometimes even lower) interest rates. Some countries have 50-year and 100-year bonds. For some reason, we don’t go beyond 30. If we could refinance our national debt at low, fixed, long-term rates, it will give some leeway to fixing our fiscal issues.
  4. We’re going to be able to refill the strategic petroleum reserve for the US at prices that seemed unimaginable 10 years ago. The next time there is an oil supply shock, we’ll be much better positioned as a result. (Aside: shouldn’t we also have a strategic medical supply reserve? *sigh*).
  5. For those who are still adding to their portfolios, which are generally the ones that will take the biggest hit from stocks falling in value since retirees don’t have all their money in stocks, the opportunity is substantial. I don’t mean that stocks are a fantastic opportunity now and they should pour money in at current prices. But, investing steadily through the rollercoaster will get you to a higher ending portfolio value than investing the same way in a market that just moves steadily upward. See https://blog.perpetualwealthadvisors.com/2013/06/20/the-value-of-volatility/ for examples.
  6. The worldwide fiscal and monetary response to our current challenges is going to be enormous. This has some long-long-term consequences, but for the medium term, it can’t be anything but a positive. The last decade has also made it much more commonplace and acceptable for the Federal Reserve to pump money into the economy to replace a lower velocity of money due to forced deleveraging. Quantitative Easing (QE) takes a lot of credit for keeping us out of Great Depression II following the financial crisis. There’s a fair chance an even stronger response could come this time if things get dire. Did you know that Japan’s equivalent of the Federal Reserve purchases equity ETFs (i.e. stocks)? Our Fed doesn’t have that mandate from Congress, but I wonder what happens when a national emergency is declared and the president has broader executive order powers? Hmmm…

Q. I feel a little better. Still though, from a financial standpoint, there are tons of people on CNBC and other stations saying they don’t want to be in stocks right now and haven’t been in stocks while this was happening. What do they know that we don’t know?

A. There are lot of doomsayers out in the press right now, taking victory laps because the market is down, even though many haven’t been bullish since before the great financial crisis. Maybe some of you reading this fall into that camp internally as well, feeling like you knew this was going to happen, but thinking back, you’ve felt that for so long that if you had acted at that point, you would have missed out on much more growth than you have lost in the last month. Still others may have nailed their “top” call at exactly the right moment. Surely you will be hearing from them at times like this. There are a lot of people in the world making predictions though and if you frequently make bold ones, you’re bound to be correct and may even find yourself on TV celebrating it. CNBC presents cheerleaders when markets are doing well, calling on people to buy hand-over-fist and perma-bears proclaiming the end of the financial world during a crisis. It’s what gets ratings. It’s also the people who are willing to come on their shows since they’ve been recently correct. It’s not hard to find people who are correct, even several times in a row… If you flip 10,000 coins 10 times, odds are that about 10 of them will come up heads every time. It doesn’t mean the coin has an advantage over the other coins. It means you’re not hearing from the other 9,990.

Q. How do you stay calm about all this? Aren’t you worried at all?

A. In all honesty I have my moments of personal freaking out at times like these, just like many of you that are reading this. Like the old Hair Club For Men commercials for those of you who remember them, I’m not only an advisor, I’m also a client. It’s ok to let yourself feel emotion. It’s just not ok to act on that emotion and do something that you planned specifically not to do exactly in a case like this. I know I signed up for riding a long, upward-sloping roller-coaster the first time I invested. I know with almost certainty that there will be dips of 50% on this ride, with the possibility of more from time to time. I know that it won’t look upward sloping during those dips. I also know that investing in aggregate in the ingenuity of humans and the ever-rising productivity and technological growth of our society is the best way to build long-term wealth. It is the reason why the roller-coaster slopes upward over the long-term. I also know that money I may need in the short-term isn’t invested all in stocks and in matching that return/risk profile with my family’s goals, there’s really nothing to worry about over the short-term. I still worry because I’m human, but my plan gives me comfort. I also sometimes feel like I know what the stock market is going to do (especially in hindsight!!!). During the financial crisis, I convinced myself I knew it was going to happen (in truth, I knew real estate couldn’t rise 15% forever, but I had no idea the depths that we’d be going to in early ’09). I knew after the sharp rise in stocks in spring of ’09, that we were going to revisit those lows again (we didn’t). I knew that the Fiscal Cliff disaster was going to crash the market (it didn’t). I knew that the financial system was going to crack when Europe ex-Germany was inching closer and closer to defaulting on their government debt (it didn’t, and not only didn’t it, but that government debt turned out to be one of the best investments ever for those who bought at the brink of disaster). Now, I’ve had good internal calls as well over the years, but I remind myself frequently about that coin flipping that I mentioned above. In short, I give myself time to freak out, I moan and groan, I remind myself of the futility of market-timing, I pull myself together, and I get back to regularly scheduled life. If any of you, my clients, find yourself stuck between freaking out and getting back to regularly scheduled life, please call me. I’m also a client and I know what it feels like. It’s the reason I write these posts when times are tough. I’m talking to me as much as I am to you. And, I’m listening.

Market Update (3/11/2020)

Continuing the new Q&A format…

Q. I heard the stock market is now down 20%+, so we’re officially in a bear market. That means stocks are going down, right?

A. No. It means stocks have gone down. There is no magic switch that flips when stocks go from down 19.99% to 20.00% that tells everyone that stocks will now fall for some time period. Rather a “bear market” is a description of the past, telling us that the value for a particular asset or index has fallen 20% from it’s high. It is like describing a losing streak when a sports team has lost several games in a row. It doesn’t tell you about the next game. By the way, while the most well-known indices just marked 20% down, other asset classes have been down more than 20% for much longer. The Russell 2000 (US small caps) is down more than 25% from its all-time high and the Russell 2000 Value (US value small caps) is down more than 30%. You’re just hearing about the “bear market” now because the Dow and S&P500 have joined in.

Q. Is this all due to the coronavirus (covid-19)?

A. No. Last weekend, disagreements among OPEC members and between OPEC and Russia led to the kickoff an oil price war. Oil prices, which were already down sharply from levels of a year ago, crashed on Monday to below $30 per barrel. While low oil prices means lower prices at the pump, lower energy costs for consumers, businesses, and energy importing countries in general, falling oil prices now hurt the US due to the abundance of oil we produce. Much of that oil is costlier to obtain than middle eastern oil and while we can do quite well (we’ve actually become a net exporter of oil in recent years) with prices in the $50+ range, down near $30 essentially puts our shale oil companies out of business. There are over 6M jobs in the US directly related to energy and due to the capital investment required to get new oil extraction started, most oil companies have a large amount of debt. Debt with little or no revenue spells bankruptcy. The surviving companies will gobble of the assets of those that fail, and will be well-positioned if there’s ever an oil boom again, but many jobs will be lost in aggregate and the holders of all the bad debt will take losses.

Q. Will the price war go on long-term?

A. No one knows. Saudi Arabia started the war with massive price cuts to try to increase demand for their oil after other OPEC countries and Russia would not agree to supply cuts to try to keep oil prices stable in the midst of falling demand as covid-19 slows down world economies. All sides remain open to talks and there is pain for Saudi Arabia with oil at these prices as well. So it is plausible they will reach an agreement that will return prices to previous levels and potentially cut supply. But the damage to US shale may already be done. As I noted above, it takes major capital investment to start the extraction process and knowing that Saudi Arabia can drop the price of oil at their whim may prevent that capital investments and/or the financing needed for it in the future, even if prices do rise from here. The energy sector of the stock market and the high-yield debt markets both immediately reflected the new reality on Monday will many stocks down near 50% that day alone. An agreement to cut global supply and thereby boost prices worldwide will obviously help on the margin, but job losses and defaults are likely no matter what and that will hurt the US economy somewhat.

Q. Speaking of hurting the US economy, things seem to be getting pretty bad with the coronavirus impact. How bad is this going to get?

A. Like I said in my last message, the fear of the fear of the unknown is the biggest issue. We still don’t have mass testing available in the US, so it’s hard to track places trending toward an outbreak level and take action to curb the spread. Until today, not much action was being taken nationwide. Now we’re seeing large cancellations and postponements including the suspension of the NBA season, travel restrictions from Europe, etc. Work must continue and critical services have to be maintained, but luxuries, hobbies, sports, and leisure travel really have to be restricted. This makes total sense.  With an incubation period of 5-14 days, we’re looking at the past right now, so taking immediate action to stop mass gatherings and travel is necessary, but will take a while to slow the spread. Meanwhile, the economy will suffer from the loss of all that activity. This is what the stock market sees and why it has fallen. Remember though that as the infection count rises (based on per capita cases from other countries, we’re likely in the 10-20k range already… just not counting them yet) , the death toll rises, the economic activity slows, and the news flow worsens, those are all items that the stock market already knows is coming. No one believes the US has 1100 cases of covid-19 infection right now. No one believes this is just going to miraculously go away tomorrow. The stock market is a realist and reflects the best guess at the future news from everyone who buys and sells. That’s why it’s impossible to know when stocks have bottomed. We’ll all see terrible news flow and suddenly the market’s participants in aggregate will begin to see past the pandemic and into the future. Stocks will turn well in advance of the worst times, just as they have in past crises. Because fear & despair usually cause the market to overshoot to the downside (as it did in 2009), when the market turns, it often turns quickly right as the news is hitting its worst.

Q. So you’re saying that selling into the downturn due to the news flow won’t work?

A. I’m saying that selling at any time guessing that the market is going down short-term vs. going up short-term is about a 50/50 bet. Even if you get it right though and sell at the right time, you then have to win another 50/50 bet in the right time to reinvest. Many learned that lesson the hard way selling toward the bottom of the financial crisis in early 2009 and then waited for the news flow to turn to want to buy back in, but by then the market had already moved up past where they sold. We want to avoid that whipsaw and instead do the reverse. Use your target asset allocation (the one that reflects your goals and risk tolerance) as a literal target for your portfolio. As I’ve said previously, that means that if stocks fall, we sell bonds and buy stocks to rebalance back to the target percentages. When stocks rise, as they did strongly in 2019, we did the reverse, selling stocks and buying bonds. There is no guessing or betting or predicting involved. It’s systematic and emotionless.

Q. Ok, so long-term, odds favor a return to recent highs?

A. Of course, though we never know how long that will take. It’s already a distant memory for most, but in Q4 2018, the S&P 500 fell nearly 20% with small caps and international stocks down even more. Over the course of the last 7 days of 2018 and Q1 of 2019, the S&P had recovered almost all of its Q4 losses. By the end of 2019, the S&P 500 was up 30%+ for the year. Other times, 20% losses have been just the beginning of a much bigger, longer slide. We never know the depth of a pullback or the length of time to return to recent highs in advance. But, unless there is a major decline in world population (and even the worst estimates of covid-19 come nowhere near projecting such a thing), then when this is behind us, the world will return to normal, as it always has after a traumatic event. There will be bankruptcies, there will be defaults, and there will be financial dislocations for a while. But ultimately, if there is the same number of people and the same aggregate demand for goods and services, the same technology, the same capacity, the same real assets (even if financial assets are worth less temporarily), how would we not get back to business as usual? That’s what the stock market will eventually see ahead of the turn in the news flow.

Q. Should I then be investing some of my cash emergency fund to take advantage of the temporary lower prices?

A. Absolutely not. An emergency fund is there for emergencies and especially in uncertain times, emergencies like a job loss, medical need, family need, etc. could come up at any time. We never advocate investing the cash that you’ve set aside for emergencies due to the recent movement of financial markets.

Q. What about taking on leverage (loans) via a home equity line of credit and investing that to try to catch the rebound?

A. We don’t recommend investing on leverage whether via a margin loan, a HELOC, or leveraged investment products. Again, we don’t know how long this will last or how deep the downturn will go. If you have $100k and borrow $100k to invest $200k in total into stocks and stocks fall 50%, you have lost all of your $100k. There is no coming back from a 100% loss. Even 1000% returns don’t increase a zero-balance portfolio.

Q. Any other general words of advice for times like this?

A. First off, do what you need to do to keep yourself and your family safe especially if any of you are in poor health or are elderly. You have to stay tuned to the news in some way to know what’s developing and what’s required of you as policies change. Try to tune out the financial part of it as much as possible. Think of all the times your financial advisor has told you that at some point, stocks will again lose 50% of their value. I’m not saying that will happen now, but you, your portfolio, and your plan were then, and are now, prepared for it to happen.  Put the energy you’d spend worrying about it toward better uses in your health, your job, and your family, as much as possible.