Get With The Plan: August 30, 2009

83009Derrick is planning for retirement, aching big-time from the stock market’s fall. He lost $90,000 – on paper.

“I am still invested and haven’t sold any of my major stocks and I am hoping they will recover some or most of their previous value in the next 5 to 7 years,” said the 53-year-old independent contractor. “My tolerance level is low, so even though I have cash in the portfolios, I am hesitant to add to my holdings.”

In the next 10 years, he’d like to spend winters in Florida working part-time, and summers working full-time in New Jersey. By age 67, he’d like to work part-time in both locations and buy a second home in Florida.

Derrick, whose name has been changed, has $200,000 in a money purchase plan, $85,000 in brokerage accounts, $68,700 in IRAs, $539,000 in Certificates of Deposit, $46,000 in money markets and $4,500 in checking. He also owns his New Jersey home mortgage-free.

The Star-Ledger asked Michael Gibney, a certified financial planner with Highland Financial Advisors in Riverdale, to help Derrick strategize through his paper losses to a successful long-term plan.

“Derrick should have an investment policy statement,” Gibney said. “He can benefit from greater diversification of the overall portfolio and better management of the fixed-income portion of the portfolio.”

Generally speaking, having many different stocks does not necessarily mean diversification, Gibney said. Case in point, with just a few exceptions, for Derrick. His stock portfolio is comprised of mainly large-cap, well-established, domestic companies. A small-cap presence is lacking, there are only one or two international stocks/bonds, no government bonds and no alternative investments.

While Derrick hopes to recover the paper losses he suffered, Gibney said it’s important to remember a basic math calculation when “hoping” to recover losses: if an investment drops 50 percent, you need a 100 percent return in order to break even.

“While this is not impossible, it is much more difficult to do in individuals stocks, especially if you own stocks like Citigroup, Strategic Diagnostics or Sirius Satellite Radio, that lost 70 to 90 percent of their value,” Gibney said.

He said Derrick would be better served by employing a plan that includes diversifying and building a long-term portfolio that can benefit from an upturn, but still limit his downside.

Derrick may also benefit from municipal bonds. Although his salary does not put him in a high tax bracket, especially since he is making a generous contribution to his retirement plan, he is receiving a lot of income from his fixed-income investments, Gibney said. This could be adding $17,000 a year to Derrick’s taxable income. Instead, he should compare the tax equivalent yield of a municipal bond or municipal bond fund to what he is currently receiving on his taxable investments.

“This is an essential analysis because most of the taxable bonds or preferred securities are held in his taxable account and not his retirement plan,” said Gibney. “The tax incurred can diminish the returns achieved.”

To compare a taxable bond yield to a muni bond yield, start by dividing the municipal yield by 1, minus your tax rate, Gibney said. If you’re in the 35 percent tax bracket, you would compare a 5 percent muni to a 7 percent taxable bond as follows: 5%/(1-.35) = 7.69%. This calculation compares bonds apples-to-apples.

“If the muni is a New Jersey bond, you will need to consider the 6 percent or so state tax as well, so the calculation would be 5%/(1-(.35+.06)) = 8.47%,” he said. “In both cases, the muni bond has a favorable yield once you consider that you are not paying 35 percent of your taxable coupon back to Uncle Sam and 6 percent back to New Jersey.”

Investors who are in lower tax brackets may not fare as well.

Overall, Derrick has too much of his overall portfolio invested in cash, and his emergency fund only needs to be about $18,000. The $539,000 in CDs may be a safe parking place for a home purchase in the next three years, but Derrick is planning to wait much longer before buying. He may consider other investments to earn a better return.

Derrick should consider his retirement cash flow needs to make sure his investments will yield enough income to support his lifestyle, plus the two houses he hopes to own someday. While he’s conservative, he may need to take on a little more risk to build his nest egg.