NPR Report on Excessive Fees

Investors have a strong desire to be good stewards of their retirement funds. This often includes seeking out professionals for financial advice.  For the retirement plan sponsor, the Department of Labor (DOL) is helping by creating fee disclosure rules and requirements.  A few years ago, the DOL mandated fee disclosure rule (404(a)5) in an effort to ensure plan sponsors are able to determine if the fees for services rendered are “reasonable.”

NPR ran a story this morning about excessive 401k fees.  See link here.  If I could add to this article, I would suggest plan sponsors review their plan fees and services at least every couple of years, if not more often through a fee benchmarking process.  The generated report should give plan sponsors a general idea of how their plan compares to others of similar size.  Benchmarking has other benefits as well.  Not only will this help to uncover fees and what services are being provided, but also some service providers are willing to re-price their services to lower fees.

While many thought the disclosure rules were a bright spot in a dark corner, we feel that further disclosure and transparency is warranted in this industry.  Since not all advisors are the same, we are thankful that the DOL has re-proposed a Fiduciary Rule which seeks to make anyone giving investment advice to 401k/retirement plans (and also IRAs) to act in the account holder’s best interest.  For RIAs like Parsec, it is business as usual.  However, broker-dealers may have a bit more difficulty with this rule, as they operate under something called a suitability standard.  While not to debate the virtues of the fiduciary standard versus the suitability standard, we do feel that greater disclosure is a good thing and will ultimately drive costs down even further.

Neal Nolan, CFP®
Director of ERISA, Financial Advisor

Neal

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What’s Up (or down) with Commodities?

While stocks have been front-and-center lately given sharp price swings, fewer media outlets are focusing on commodities despite the critical role they play in global markets. They too have experienced wild price swings, although mostly to the downside. Year-to-date, the widely held S&P GSCI (Goldman Sachs Commodity Index) has fallen 20% and declined 41% over the last twelve months. What’s driving these big declines and why do they matter to your portfolio?

Commodities are defined as a raw material or primary agricultural product that can be bought and sold. This includes everything from aluminum to zinc, but also oil, natural gas, coffee, beef, and corn, among others. A key differentiator between commodities and other assets are that commodities are valuable only as an input of the production process. They’re not a store of value or wealth, like a stock, bond, or work of art. Because of their utilitarian purpose (with a few exceptions like gold), commodity prices are closely linked to global supply and demand. Simply put, when demand is strong for a commodity and supply is tight, prices go up. Likewise, when demand is falling and/or supply is abundant, commodity prices tend to fall. This causes prices to be very cyclical and closely tied to the health of the overall economy. In an increasingly globalized world, that means all economies affect commodity prices to varying degrees.

While stocks have surged over the past six years, commodities have languished. The widely-held commodity index, the S&P GSCI, has fallen 35% from 2009 to 2014 while the S&P 500 Index rose 131%. As U.S. stocks benefited from improving economic growth at home, commodities never saw a similar bounce-back given their exposure to the broader global backdrop. Lackluster global demand and excess supply of many commodities weighed on commodity prices. The supply/demand imbalance has worsened recently as China, the world’s largest consumer of commodities, has seen economic conditions deteriorate and is curbing its appetite for input products. Likewise, it continues to produce too much supply and is dumping some commodities, like steel, onto global markets, further pressuring prices. It’s a vicious cycle, one that usually reverses when excess supply is finally worked-off and most investors have given up on the asset class.

As an investor, where does this leave you? Should you include commodities in your portfolio? Is now a good time to buy? According to Dr. Rouwenhorst, a leading expert on commodities, research suggests that commodities do outpace inflation over the long-term. And he’s looked at data going back to the 1800’s. At the same time, commodity prices tend to have low correlations with other asset classes like stocks and bonds; meaning that when stocks go down, commodities tend to go up. Thus, adding commodities to a portfolio can help improve your overall volatility and gives you a good chance of out-pacing inflation.   But…we’ve also learned that during massive global crises, like the one in 2008, commodities tend to move in lock-step with other asset classes. People panic and tend to sell everything. We’ve also seen substantial price declines in most commodities over the last six years, and if you’ve owned these assets you know your portfolio has suffered as a result. What to do?

During most periods, a small position in a diversified basket of commodities such as the S&P GSCI or the Dow Jones Commodity Index can help insulate investors from wild swings in traditional asset classes like stocks and bonds. And commodities can experience periods of strong price appreciation. However, it’s difficult to identify those periods and at the same time, avoid sharp declines like we’ve seen in recent years. If you have a long enough time horizon, of twenty years or more, a small allocation to commodities can make sense, but another option is to own high-quality stocks that derive their revenue from commodities. While these companies are also subject to the cyclical nature of commodities, they often have diversified revenue streams and strong balance sheets that can help provide some insulation during cyclical downturns.

Overall, commodities are important to understand in order to gauge the health of the global economy. Although they tend to be a volatile asset class, owning a small amount can provide diversification benefits in your portfolio. Another and perhaps less volatile option is to own high-quality blue chip companies that deal in commodities and have the resources to weather cyclical downturns. This approach also provides the diversification benefits associated with commodities but often with smaller price swings then owning a basket of commodities directly.

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The “What” of Retirement Planning

Most working-age Americans focus on the “how” of retiring: how to maintain a decent standard of living today while saving enough money for retirement tomorrow, or how to play catch-up and cover their retirement savings shortfall. Sadly, another group of Americans wonder “if” they’ll be able to retire at all. The sobering statistics tell a bleak tale. According to U.S. Census Bureau data, the average 50-year old has just $42,797 in retirement savings while 38% of Americans have no savings at all. This is scary stuff considering that average medical costs alone for an individual over 65 years old are north of $100,000. Clearly we’re not as prepared for retirement as we could be. Despite lots of media doom-and-gloom about the pending retirement crisis, it hasn’t improved retirement savings trends. Thus, I’d like to propose a new approach, one that focuses on the “what” of retirement planning instead of the “how.”

The “what” of retirement planning involves an intentional mental shift, one that approaches the retirement conundrum from a new angle. Instead of focusing on how much more you need to save or how far behind you are versus your peers, try imaging what you want your years in retirement to look like. What new hobbies would you like to explore in retirement? Or what countries do you want to visit? Etc… This approach, coupled with an honest assessment of your current situation, is more likely to help you reach your goals than beating yourself over the head.

Focusing on the problem or what’s missing can increase stress levels and sap your energy – because you need more energy to help manage those higher stress levels. It can also lead to financial paralysis, which only exacerbates the problem and reinforces our old, unhelpful patterns – ensuring we get what we fear the most: not enough retirement savings. In contrast, anchoring your goal to the positive end result – your vision of a relaxing, meaningful retirement – can increase the odds of realizing that reality. Either way, you’ll feel a whole lot better on your journey there.

The point is to look carefully at the way in which you approach your retirement goals, because the methods you use will help determine your success rate. It all starts with taking an honest and sometimes difficult look at your current situation and determining what your goals are. Once you know where you are and where you’d like to be in the future, crafting a plan of action that will reinforce helpful, constructive habits is key. This brings me to one of my favorite quotes from St. Teresa of Avila, “The whole way to heaven is heaven itself.” A lifetime of berating ourselves is unlikely to lead to financial bliss in our twilight years. It will probably just lead to more stress and anxiety. Instead, it seems we’re better off focusing on “heaven” in the here and now. We can do that with a proactive, realistic plan that’s anchored on the positive feelings we’d like to experience in our retirement years. And who knows, we might even start to feel better today.

Carrie A. Tallman, CFA
Director of Research

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THE GREEK MESS WON’T HURT THE US ECONOMY

The International Monetary Fund (IMF) has performed a valuable public service by publishing a detailed “Debt Sustainability Analysis” for Greece on July 2. While this document is written in typically dry “bureaucratese,” it lays bare the failure of the strategy of “kicking the can down the road” that the other Euro Zone countries have been using with Greece for the past five years.

Dr. Carl Weinberg is Chief Economist at High Frequency Economics and a veteran of the mostly successful Brady Plan debt restructuring program of 1989-1992. Those negotiations took debt loads that were impossible and restructured them, in a manner similar to the way failing corporations are restructured in the US. Brady Plan deals were worked out for Argentina, Brazil, Bulgaria, Costa Rica, the Dominican Republic, Ecuador, Ivory Coast, Jordan, Mexico (the first one in 1989-1990), Nigeria, Panama, Peru, the Philippines, Poland, Russia, Uruguay, Venezuela and Vietnam.

Dr. Weinberg suggests that the €323 billion ($358.3 billion) Greek debt be restructured into bonds with a maturity of 100 years, a coupon (interest) rate of 5.0 percent and a 25-year grace period before the first payment is due. This would give Greece “breathing room” and would keep all its creditors (primarily the European Central Bank (ECB), the European Financial Stability Facility (EFSF) and the IMF) from having to take a “haircut” on their holdings of Greek debt.

Not very surprisingly, the IMF analysis does not go this far. However, it rather drily suggests that extending the grace period to 20 years and the amortization period to 40 years (an effective doubling of each) together with new financing, would barely be adequate.

Greek voters went to the polls on July 5 in a hastily arranged referendum to vote “yes” or “no” on accepting terms from the creditors that were withdrawn on June 30. Thus, it’s not really clear what they were voting on. The wording in the ballot was also very confusing. It read: “Should the draft agreement submitted by the EC, ECB, IMF to the eurogroup on June 25, which consists of two parts that make up their full proposals, be accepted? The first document is titled, ‘Reforms for the Completion of the Current Program and Beyond’ and the second ‘Preliminary Debt Sustainability Analysis.’”

Despite that convoluted wording (it can’t possibly be any clearer in Greek), the 62.5 percent of voters who turned out gave a victory by a 61.3-38.7 percent margin to all those wishful thinking people who believe that reality won’t triumph. Greece is being kept afloat by the ECB. If they stop doing that, the banks will all be bankrupt. No one knows where this disaster will go.

Now the creditors need to follow the IMF recommendations, which include another €60 billion ($66.5 billion) of new money through 2018. This is in addition to the restructuring of all the existing debt.

Like so many economic problems in the world, the Greek mess will be finally resolved when there are no other options. If Greece were to leave the Euro Zone (a terribly complicated exercise), it would be hit with horrendous inflation and an even bigger collapse of the economy that the 25.0 percent decline it has already experienced since 2009.

Greece needs debt relief. It also needs to reform its ridiculous pension system to conform to those of the rest of the Euro Zone and figure out ways to collect taxes that are owed.

The Greek economy is about $200 billion a year in real GDP. That’s close to Alabama ($199.4 billion in 2014) or Oregon ($215.7 billion). Both are 1.2 percent of the US total.

A failure to follow something like the prescriptions of the IMF or Dr. Weinberg will condemn the Euro Zone to remain mired in a recession that began in the first quarter of 2008. Some people would argue that a recession lasting that long ought better be called a depression.

Either way, whatever happens to Greece is mainly a problem for the Euro Zone. It is simply too small an economy to have a major impact on the US. Most of whatever impact there might be would come through damage done to overall Euro Zone growth, rather than directly from Greece itself.

Dr.  James F. Smith, Chief Economist.

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The Pitfalls of Maximizing Shareholder Value

According to Ibbotson data, the US stock market has delivered a 10.1% annualized return from 1926 to 2014. I mention this data, which includes two significant market corrections, because the numbers speak for themselves. The US entrepreneurial spirit, along with a vibrant capital markets system, is alive and well. We see this today in the slew of new technology startups, healthy corporate profits even in the face of a strong dollar, and record foreign investments in US companies. That being said, there’s something I believe investors have gotten wrong, and that’s the virtually unquestioned tenet that a company’s main responsibility is to maximize shareholder value.

This seemingly obvious truth is surprisingly, a new idea, conjured up in the early 1970’s by economist Milton Friedman who wrote a scathing rebuke of corporate social responsibility in an op-ed piece for the New York Times Magazine. Shortly thereafter, two business school professors ran with the notion and published multiple journal articles extolling the virtues of maximizing shareholder profits. The idea stuck and today most in the financial industry agree that this is the primary, if not only, responsibility of a corporation.

Perhaps because I started out as a high school science teacher, followed by a stint at a local zoo, I came to my first financial position at an institutional money management firm with a slightly different perspective. My first year as a stock analyst was confusing. I quickly learned that companies reported two sets of financial data, one based on GAAP or Generally Accepted Accounting Principles, and another set called “pro forma” that excluded a lot of recurring “one-time” expenses. Then I realized that while my Chartered Financial Analyst (CFA) studies helped me gauge the health of a company and its growth prospects (among other things), it became clear that the stock market game had more to do with beating Wall Street’s expectations for the upcoming quarter.

What was going on? Roger Martin in his book titled “Fixing the Game” suggests that a misguided focus on maximizing shareholder returns is incenting companies to boost earnings per share in the near-term at the cost of important, and often uncomfortable, investment decisions for the long-term. He notes that executive compensation is now more closely tied to stock and earnings per share (EPS) performance than ever before. This might be one reason why companies in the S&P 500 Index bought back shares at almost record levels in 2014. While reducing a company’s share-count provides a short-term boost to EPS growth, it leaves less cash on a company’s balance sheet for the critical business investments needed to drive shareholder value for the long-term.

So if maximizing shareholder value is not what company management teams should focus on, then what is? As with most pursuits in life, I find that fixating on a certain result often ends badly. No one can know the future, let alone deliver a certain outcome in perpetuity. Sure we can do it here and there in the short run, but in the grand scheme of things, our jobs – as individuals and companies – is to serve our clients and our communities. I believe that when companies focus on their customers, their employees, and their vision for the future, they are much more likely to maximize shareholder value – with the added benefit of contributing to society along the way. But when management teams and investors alike focus on profits for the sake of profits, the whole system becomes twisted and warped. We’re seeing this today in the rampant short-termism on Wall Street, outsized executive compensation packages, and subpar business investment levels – the lifeblood of our economy and capital markets.

While all this may sound discouraging, the good news is that more and more well-regarded financial professionals – among them, Warren Buffet, Jack Welch, and Blackrock’s CEO, Laurence Fin – are speaking up. One of our industry’s leading organizations, the CFA Institute, hosted a distinguished investment professional at its latest annual event whose presentation was called, “Shareholder Value Maximization: The World’s Dumbest Idea?” His research found that companies that focused on responsibility to customers, employees, and communities tended to outperform those that did not. All this to say that investors are starting to wake up the outdated and erroneous notion that corporations exist only to maximize shareholder value. We’re finally starting to put the cart back behind the horse, where it belongs.

Carrie A. Tallman, CFA
Director of Research

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Economic Predictions and Investment Decisions

The economy is an important factor that drives both capital markets and personal financial decisions. While we continuously monitor the latest economic news, have an opinion about the direction of markets, and incorporate these factors into our stock selection process, market or economic predictions do not drive us to make tactical shifts in your portfolio allocation.

We often hear, “What do you think the market will do this year?”

After a hefty caveat that the future is unknowable, and short-term market predictions can be hazardous to your wealth, we usually talk about the current economy, how it might affect markets in the near-term, and then provide a more intermediate-term view of the health of the U.S. and global economies.

Our investment philosophy hinges on the abiding belief that an investor should not attempt to time the market. That’s to say that an investor should not move his or her money in and out of asset classes based on economic predictions, or beliefs about what the market may do over the next few years. Rather, when we make decisions in a client’s portfolio, it is based on two factors: 1) asset allocation – based on the client’s financial goals and risk tolerance; and 2) individual security selection – used to comprise the contents of the asset classes that have been prescribed for the portfolio.

An investor’s asset allocation, if chosen correctly, shouldn’t fluctuate based on changes in the economic landscape. Instead, asset allocation should be reviewed regularly and modified if the individual’s financial situation changes. It’s the second of these two – security selection – where a bit more prognostication comes in. To be sure, we are fundamental analysts. We look at a company’s earnings, growth potential, balance sheet and cash flows relative to its price to determine whether or not the stock represents a good buying opportunity. Understanding the economy helps us understand those companies better. It helps us determine what the growth drivers of a certain sector may be, and what the consumer trends may look like for a given company. Understanding the economy is a critical component of our stock selection process.

jimsmith01

Our Chief Economist, James F. Smith, provides insight to Parsec’s clients regarding the local, national and global economy. We appreciate Jim’s experience and perspective on economic matters, and we believe our clients enjoy getting to know him at various engagements, and of course hearing his entertaining, plain-spoken and informative economic speeches.

Recently, Jim was featured in an Asheville Citizen-Times article called “The Wisdom of Mr. Smith” about his success predicting housing prices. Way to go Jim! You can read that article here:

http://www.citizen-times.com/story/money/business/2015/05/08/asheville-economist-nations-top-housing-forecaster/26975203/

While economic predictions don’t drive us to make tactical shifts in our portfolio allocation, economic factors do play an ongoing role in our security selection process. To see Jim’s economic commentary each quarter be sure to read our newsletters. Back copies can be found here: http://www.parsecfinancial.com/news.html

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Shouldering the Burden of Financial Responsibility

“Atlas through hard constraint upholds the wide heaven with unwearying head and arms.” –Hesiod

My Wednesday morning started with five 400-meter runs, uphill, carrying a 35# sandbag. OK, maybe “run” is a bit of an exaggeration – it was more of a trudge, and there might have been some walking in there toward the top. I hated every second of it, but I kept going because, well, that’s just what you do. When I thought about it later, it struck me as an apt metaphor for the way life feels sometimes – an endless uphill struggle with the weight of responsibility resting heavily on your shoulders. This is particularly true for anyone who is the primary provider for their family. As my colleague Carrie pointed out in her recent blog post, more and more women (including me) are finding themselves in this position, whether by choice or necessity. Most of the time I am able to face each day as it comes and maintain an upbeat outlook on life, but sometimes the enormity of this responsibility is paralyzing and my mind races with worries – what if something happens to me? Have I prepared for the worst possible outcome? What more can I do to ensure that the people who depend on me to keep going will be OK if I can’t?

Since everyone loves a list, let’s break this down into 5 areas that you definitely want to address if you are the primary provider for your family:

  1. Life Insurance – This one is pretty obvious, and I hope most people have some amount of life insurance in order to provide for their dependents should the worst come to pass. But do you have enough? Many companies provide life insurance as an employee benefit, but the standard amount will probably not be enough to replace your salary for an extended time. As a starting point, consider your current salary and how old your children are, so you can estimate how much financial support they will need and for how long. Beyond that, you may want to provide your spouse with your lost income until retirement age. Take these factors into consideration when determining the length of the term and amount of coverage you need.
  2. Long Term Disability Insurance – This one is a little less common, but no less important than life insurance. Think of it this way – if you become disabled and cannot perform the job that supports your family, how will you replace your income? What if your disability adds to the household expenses in the form of ongoing medical care? Now you’ve not only lost your earning power, but you’ve also become a liability to the family you once supported. Don’t let that happen.
  3. Estate Planning/Will – Many times younger people who are still in the asset accumulation phase tend to put off drafting a will, despite its importance. It is especially imperative if you have young children, since it allows you to determine who will become their guardian if both you and your spouse are gone. Make sure your beneficiary designations are up-to-date for any IRAs, 401(k) plans, pension plans or life insurance policies. For more complex estate planning strategies you might want a trust – your financial advisor can help you figure out what you need to do to make sure your estate plan is sufficient.
  4. Retirement Savings – If the worst doesn’t happen and you live to a ripe, old age, you need to be sure that you are saving money to provide for your golden years. As the primary earner, the bulk of this responsibility falls to you to contribute to your company’s 401(k) or another retirement plan, but it is equally important to include your spouse in your retirement projections and contribute to a plan for him or her if you can. Again, your advisor can help you figure out how much you need to be putting aside and how to navigate the ever-complicated IRS rules and requirements for retirement savings.
  5. Education Savings – Though not as imperative as the first four points, saving for your children’s education expenses will relieve them of significant financial pressure when they are in school and will help them avoid taking on massive amounts of student loan debt. You can rest easier knowing that if you predecease your spouse and children, you won’t be leaving them with an insurmountable tuition bill. As with retirement plans, there are several investment vehicles available to you for education savings. Work with your advisor to determine the best plan for you and your family.

Shouldering the burden of financial responsibility can make you feel like Atlas, but it needn’t crush you. With a little planning and preparation, you can weather the uphills, savor the downhills, put down the sandbag every once in a while and live fully in the present.

Sarah DerGarabedian, CFA Financial Advisor

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Why Not Use Margin?

Recent data indicate that margin debt has increased significantly over the past 12 years, although it is currently below the peak levels seen in 2000 and early 2014.

Margin is a feature that you can add to a taxable (non-IRA) brokerage account that enables you to borrow money against the value of your investments in the account. Initial margin, or the amount that you can borrow, is generally 50% of the value of the account. On a $100,000 account, you could borrow up to $50,000. The money can be used to buy more investments, or it can be taken out of the account and used for some other purpose.

Say you have an account that contains $100,000 in stocks. You write a check for $50,000 to purchase a new car. You still have stocks worth $100,000 in the account, but you owe the brokerage firm $50,000. Your net equity in the account is $50,000 (the $100,000 market value of your investments minus the $50,000 you owe).

Maintenance margin is the level of net equity which must be maintained in the account. If the equity in the account falls below this level, usually 30% of the account value, then a deposit must be made to the account or investments will be sold to reduce the margin loan balance.

Say the stock market experiences a correction and falls 15%. Your $100,000 in stocks are now worth $85,000. However, you still owe $50,000 to the broker. Your equity in the account is $35,000, or 41%. If the stock market continues to decline and your equity falls below 30%, some or all of your investments will be liquidated by the broker to reduce your margin loan. This is not good timing because you are being forced to sell stocks when they are down.

There are several other disadvantages to borrowing on margin that investors should be aware of. Interest rates are high; particularly when you consider that the lender is fully secured. Currently, the interest rates at major custodians are in the 5.5%-8% range, depending on the amount borrowed. Also, the interest rates are floating, so there is no protection against rising rates. Tax deductibility of margin interest is complex and more restrictive than other interest deductions such as on your home mortgage.

Using margin always increases your portfolio risk, particularly if you use the proceeds to buy more stock. Let’s go back to the previous example of the $100,000 account, but this time you take a $50,000 margin loan and use it to increase your stock holdings. You now have $150,000 in stock and owe the broker $50,000. Your net equity is $100,000. Say the stock market falls 20%; your stocks are now worth $120,000. You still owe $50,000 to the broker, and you’ve lost 20% of 150,000 instead of 20% of 100,000. In other words you have a $30,000 loss instead of a $20,000 loss. You’ve lost 30% of your initial $100,000 on a 20% market decline. Your loss was 1.5 times that of the overall market, plus you paid interest on the margin loan. Not a good outcome.

There are some situations where margin can be appropriate, say for short- term needs where the amount borrowed is a small percentage of the account value. We generally advise against using margin on a longer term basis.

Bill Hansen, CFA

Managing Partner

Bill

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Gift Stock Yields Better Returns Than Gift Checks

 This article was originally published on NerdWallet.com

When thinking of giving a gift, most people immediately consider writing a check, giving a gift card to a favorite restaurant, or ordering something online.

However, from a financial planning perspective, this is a very inefficient method of giving. Unfortunately, the method that gets you the biggest bang for your buck is usually the most complex, impersonal and inconvenient, as is often the case in financial planning.

Let’s take a look at a few ways to get a little more “bang for your buck” with a gift.

Consider what the alternatives to giving cash might be. It is pretty hard to think of ways to give a gift without using cash.

One way to do so is to gift stock, preferably appreciated stock. It is very common for the individual giving (grantor) to be in a higher tax bracket than the individual receiving the gift (grantee). For this reason, the grantor is able to give more to the grantee because they don’t have to sell the stock, pay the taxes, then give the cash. To make the situation even better, the grantee may not even have to pay taxes when they sell the stock, if they are in the 0% to 15% tax bracket. This isn’t your traditional heart-warming gift from Grandmother, but the tax savings sure are heart-warming to me.

Another play on the same technique is to gift appreciated stock to young children in a custodial account. This allows either the grantor or a parent to act as a custodian over the account until the child reaches age 18 or 21, depending on state law. Appreciated stock can be directed into this account and sold over time with minimal tax consequences. However, you have to be aware of the “Kiddie Tax” for unearned income over $2,000 attributed to the child. Any amount over $2,000 is then taxed at the parents’ highest tax bracket! To extend this gifting strategy, cash produced by dividends and sales from this account can be transferred to a 529 savings plan in the name of the beneficiary. Just don’t forget to give the child something useful or fun at the same time.

Although these techniques are not as easy and straightforward as writing that check, there are some significant tax savings available for those who choose to use them. For individuals who are trying to play catch up on funding 529 plans or gifting to children or grandchildren, the annual gifting limit is $14,000 per year per person for 2014 and 2015.

Daniel Johnson, III CFP®

Financial Advisor

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Call Me….Maybe

I recently saw an article titled, “Use Puts and Calls to Finance Your Holiday Gift Shopping.” It proceeds to explain how you can employ certain options strategies (shorting puts and covered calls), to generate portfolio income – in this case, a little extra cash for purchasing holiday gifts.

“My Parsec advisor hasn’t suggested this to me,” you think. In fact, your Parsec advisor hasn’t suggested any options or derivatives strategy to you! What gives? Aren’t we supposed to be looking out for our clients’ best interests?

Yes, we are. And that is why we typically won’t suggest such a strategy to you. Not that there is anything wrong with it, per se, but most derivatives strategies are short-term in nature, and one of our main tenets is investing for the long-term.

Even though the author of this article is suggesting relatively safe (rather than speculative) strategies, there is risk involved, and the upside is limited. When you short (a.k.a. sell or write) a covered call, you give someone the option to purchase a stock that you own at a predetermined (strike) price, in exchange for payment (known as the option premium). Shorting (selling or writing) puts involves giving someone the option to sell you a particular stock at a predetermined price, also in exchange for a premium. If you enter into one of these contracts, you are obligated to either sell or buy the underlying stock if the owner exercises the option. If the option expires unexercised, you keep the premium without having to sell or buy the underlying.

The objective is to enter into contracts that you think are unlikely to be exercised based on your prediction of the underlying stock’s price movement, and earn income by pocketing the premium. Of course, there’s always the chance that the market will move in such a way that the owner will choose to exercise the option, and you will be forced to make a trade.

So let’s think about this – why would someone exercise a call option? Obviously because the market price has moved above the strike price and they can buy it for less, then turn around and sell it for a profit. So you’re selling a stock that’s going up (at a below-market price), and giving up any potential upside in that stock.

And why would someone exercise a put option? Because the current price of the underlying stock has dropped below the strike price, so they can sell it to you for more than it’s worth in the market. Even assuming that it’s a stock that you want to own, wouldn’t it be better to buy it at the lower market price? If you calculated the breakeven correctly, the premium earned on the option would offset the difference in strike and market price, but then you’re effectively at zero, having earned nothing (such as dividend income) in the interim.

Our philosophy is that the best results occur over a long time period, in portfolios consisting of a well-diversified array of carefully chosen, quality investments. We make buy and sell decisions based on in-depth research of underlying company fundamentals, rather than market predictions. In this way, we seek to avoid the pitfalls of human behavior and emotion, as well as the likelihood of inaccurate predictions. We like to be owners of companies with real earnings and dividends, and participate in long-term, profitable investments because this is how we help you attain your financial goals…such as a long, comfortable retirement as well as the perfect gift for everyone on your list.

Sarah DerGarabedian, CFA  Portfolio Manager

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