While my primary focus in this blog is finance, I do have additional interests.  The best article I have read on international relations recently has been George Friedman's take on the American declaration of war.

A vote by the Congress in favor of engaging in a war is required by the Constitution. In World War II, a Congressional declaration of war helped to galvanize the American populace in favor of the war, helping to steel them for the sacrifices the nation would have to make to defeat the Axis. 

But since World War II the requirement of a declaration of war has been ignored or superseded.  Korea and Vietnam were styled "conflicts" partly to avoid the need for a Congressional declaration of war.  And of course, the President didn’t ask Congress to declare war in Afghanistan, Iraq or Libya. 

Certainly it is a complex issue, and arguably there is no Constitutional need for a declaration of war.  Nevertheless, should a President go to war without it?  This article by George Friedman of Stratfor on the subject has a great deal of wisdom to offer. 

This is the best article I've read on the evils of ethanol:  http://www.nytimes.com/2011/06/25/opinion/25Rattner.html.  

If you have been considering strategies for passing some of your wealth on to heirs as tax efficiently as possible, you might want to know about an important window of opportunity for gifting. It’s available right now, but it may not be beyond 2012.

Among the many tidbits found within the December Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 are particularly favorable gift tax exemptions: an increase for lifetime tax-free gifting to $5 million/$10 million for individuals/couples, up from $1 million/$2 million. And if $5–$10 million isn’t enough, the tax rate on lifetime gifting amounts beyond that was set at 35%, rather than the scheduled 55% rate.

It’s important to note that the annual gift tax exclusion, which is separate from the aforementioned lifetime caps, remains only $13,000 per donor per year. Even so, as this helpful Wall Street Journal article notes, taken together, the new estate and gift rates are the most generous since 1931. In other words, for wealthy individuals or couples seeking gifting opportunities, there may be no time like the present for some careful planning with a knowledgeable estate tax planning team. While the favorable conditions may last beyond 2012, they may not.

Need additional advice? Give us a call. Considering and effectively implementing multi-generational wealth management strategies is core to our services.

Lately municipal bonds have also been under scrutiny, with some analysts predicting widespread municipal bankruptcies with resulting defaults on muni bonds. The media has wasted no time giving the scary forecasts plenty of coverage. Will the dire predictions come true? Balanced views are hard to find, but the best I've seen are the articles below from Dimensional Fund Advisors and Larry Swedroe’s CBS MoneyWatch column:

Municipal Bond Worries -- The bottom line: There are risks, as always, but not as great as the recent media attention would make it seem.

Municipal Bonds: Was Meredith Whitney Right? – Additional evidence that the media seems to have overstated its case. 

A May 4 Bloomberg Television “Taking Stock” interview with financial author Larry Swedroe offers insights on housing, commodities and other topics of recent interest. Swedroe’s interview provides light where most others offer only heat.

Q: I have a four-year-old. Is a 529 plan the best way to save for her college education?

A: For most people, a 529 plan is the logical starting point for their college savings because earnings in the 529 plan are Federal (and sometimes state) income tax-free if spent on qualified educational expenses at a qualifying educational institution. But for most people the 529 should not be the only funding vehicle, and it can pay to seek some objective, expert advice before proceeding.

What is a 529 plan, anyway?

In brief, a 529 plan can be an attractive college savings vehicle because investment earnings in the plan are tax-free if spent on tuition, fees, books, supplies, equipment (including computers), and room and board, at a qualifying educational institution, for a qualifying beneficiary. This can get technical, but in our brief space here, suffice it to say that the balance in the 529 can be used to pay most college expenses. The term “qualifying educational institution” is very broad, too, and includes almost all colleges (including some colleges in other countries, some trade schools and even a couple of golf schools).

The best thing about a 529 plan is that it enables you to set aside money for a child’s college without losing control of the money. By way of contrast, many people use an UTMA (Uniform Transfer to Minors Act) trust to provide a segregated account for a child’s college expenses, but the balance in an UTMA becomes the unrestricted property of the child at majority (age 21 in Texas). Thus, if the child decides not to go to Harvard and spends her UTMA on a Harley instead, there is nothing to be done about it. In contrast, you control expenditures from the 529 plan, so you can be sure that the balance will be used only as you intended.

By the by, you don’t get a tax deduction for money you contribute to a 529 plan.

What’s the catch?

The biggest catch is that, if the money in the 529 plan is withdrawn but not spent on educational expenses – for example, if you withdraw the balance to fund your retirement – investment earnings in the plan are subject to ordinary income tax plus a 10% penalty. So if your child doesn’t attend college – or selects a lower-cost institution than originally planned – you may have a significant amount of money stranded in her 529 plan. For this reason, I typically recommend saving no more than about 60% of anticipated college expenses in a 529. Yes, it may be possible to designate a different beneficiary but this may or may not work as you’d hoped for either. As any parent knows, including this one, our offspring don’t always perform exactly as predicted!

Where to save the remaining 40% of your anticipated college expenses? You can establish a separate taxable investment account for the college savings, or you can simply blend it in with the rest of your taxable savings and do some mental accounting to track it.

Additional angles

If you establish a 529 plan for a child and she doesn’t go to college, all may not be lost; you can shift the 529 plan to a sibling. Or, you may leave the balance alone, let it grow, and hope that eventually a grandchild can use it for college expenses.

Grandparents’ note: You designate a beneficiary when you establish the 529 plan. People usually designate their children, but the beneficiary can be anyone. Thus a 529 plan offers a great way for a grandparent to give to their grandchildren (and the balance of a 529 plan owned by a grandparent generally will not count against the child for purposes of colleges’ financial aid calculations, so generally the existence of the plan won’t reduce financial aid, as it will if it’s owned by the child or the parent). A 529 plan can even be a way for you to save for yourself, if you’re planning to return to college. Keep in mind, though, that the beneficiary can only be changed to another family member of the original beneficiary. So if you establish a 529 plan for a friend’s child, you can’t change the beneficiary to your own child.

Another tip: Some states offer a state income tax break for contributions to their 529 plans. (Because Texas doesn’t have an income tax, Texas doesn’t offer an income tax break for contributions to college savings plans.)

And an additional caution. Many people assume that the federal income tax break makes every 529 plan a good deal. Not so. Remember if you buy a 529 plan from a broker, a commission will be involved, reducing the benefit of the plan to the beneficiary. And as with 401(k) plans, there are management fees and plan expenses built into 529 plans. These costs are not always so obvious, and sometimes they are destructively burdensome. Say you’re paying 2% to 3% per year among commissions, the program fee and fund fees. You have to overcome all these expenses before you even begin to break even – and a positive return is not guaranteed with any investment. Some 529 plans’ expenses may result in higher hurdles than if you simply invested the same amounts in a taxable account. You can compare costs at www.savingforcollege.com.

Remember, too, that a 529 plan might not be your only college savings option. In Texas, for example, the prepaid tuition plan is worth considering. With it, you buy a block of college time for future use, locked in at today’s prices. An exploration of prepaid tuition plans warrants a separate article, but suffice to repeat that families planning for college have a number of options to consider.

A final caution: This is only the tip of the informational iceberg on 529 plans. The details are complicated. Professional advice from a fee-only financial advisor is a good idea. Call if we can help.

Interested in how and where your Federal tax dollars are spent?  See http://www.whitehouse.gov/taxreceipt.  You enter your 2010 tax payments and the website provides a breakdown of (approximately) where your tax dollars are going.

Question: We’re in our early 60s. I’m afraid our “golden years” are passing us by. I want my husband to retire. But I can’t get him to. What should I do?

Answer:

The retirement decision has two parts: numbers and emotions.

The Numbers

Even if you feel sure you have enough money to retire, don’t skip the number-crunching. A gut sense that you can retire is nice … but it’s an experiment whose result won’t be known for many years. And after the results become apparent, it may be too late to do anything about it.

The numbers side of the retirement decision is complicated. Obviously, an element of the retirement cash flow plan is straightforward: Assume a rate of investment return, consider other income sources, and see if projected expenditures are covered by the result. But this simple method leaves too many crucial questions unconsidered. To illustrate, questions like these can have a profound effect on your retirement:

• How will my investments behave if inflation roars back?
• How much downside is there in my investments? How would a really bad stock market early in my retirement years affect my retirement prospects?
• Are my investment choices right for me? For example, your mutual funds may be costing you more than you realize, which can place an unnecessary drag on your net results. Do you know what constitutes “high cost” in investments?
• Do you know what average annual return you reasonably can expect from your particular investment portfolio? Do you know how much money you reasonably can expect to withdraw from your portfolio each year? Can you adjust that number upwards for inflation each year, and still retire?

Few do-it-yourself investors can do more than guess at the answers to questions like these. That’s not because they are stupid, but because they have made their living another way and gained their expertise in other fields.

A financial planning professional should be able to help offer a valuable perspective on the retirement numbers for you and your spouse. By the way, by “financial planning professional” I do not mean a stock broker or insurance salesmen. They may be fine if you want to buy stock or insurance, but their skill set isn’t what you need to help you make your broad retirement decisions. You can contact me for counsel on that, or the National Association of Personal Financial Advisors has published this helpful guide regarding characteristics to seek in your financial advisor.

The Emotions

In my experience, the retirement decision also is highly emotional. Say the numbers have been crunched and you both know what your retirement funding picture is. But what if your spouse still doesn’t want to retire?

It happens all the time. It’s scary to make life changes. Many successful people derive a sense of personal worth from their work. Many get intellectual stimulation and meaning from their work. Many like helping others through their work. Permanently walking away from this is not an easy decision.

The thing is, life is a balance, and for every choice you make, you sacrifice something. Get a feel for what you are sacrificing with continued work by doing a “Regrets” list. Each of you goes into a room alone for 10 minutes to write down the things you would most regret having not done if you died tomorrow. See if your regrets help put things in perspective for you.

Of course, part-time work or charity work can provide meaning and social interaction in retirement. Retirement doesn’t have to represent a cliff. It may be both possible and sensible to gradually retire, moving from those 60-hour work weeks to 40 hours, to part-time, and so on. Together, try discussing specifically what you would both do with increased free time, and what specific ways life will continue to be important and challenging.

Last but not least, be sure your visions of retirement are, if not identical, at least in alignment. Maybe you visualize back-to-back world cruises, but your spouse has in mind sleeping late and reading the entire paper every day. If your goals are further apart than you realized, an objective, third-party counselor may help you identify some middle ground, so that those golden years you’re seeking can finally come into focus.

Scientific research interests me, especially when it relates to something practical. Sometimes science reinforces conventional wisdom, sometimes not. Here are a couple of interesting, recent illustrations.

Dubious Advice: Don’t Worry, Be Happy

Most successful and wealthy clients spend a good portion of their lives focusing on building their careers and net worth. Many assume the stress they endured has shortened their life expectancy, compared to less-focused, happy-go-lucky sorts of people.

Maybe not. In a 20-year-long “Longevity Project,” researchers at the University of California recently concluded that, on average, people who were the most cheerful and had the best sense of humor as kids lived shorter lives than those who were less cheerful and joking. It was the most prudent and persistent individuals who stayed healthiest and lived the longest. Looks like those dour, project-oriented wealthy folks will need all that money to fund a long retirement.

Sound Advice: Sleep On It

Your mom and dad were right: Academia confirms you should sleep on it before making major decisions, financial or otherwise. In a recent sleep-deprivation study, Duke University researchers demonstrated how even one poor night’s sleep caused study participants to become overly optimistic and take on more risk than their well-rested counterparts. Functional MRI tracking showed increased activity in the sleepy participants’ areas of the brain related to fear, risk and decision-making, resulting in over-confidence in the face of real risks.

So, if you’re considering a change to your investment portfolio, it might make good, common sense to first take two aspirin and think about it in the morning.

In last week’s post on investing and economic risk, I recommended a well-diversified, low-cost index fund portfolio as the best stock and bond investment. For the fixed income portion of that portfolio (which, yes, should be a permanent fixture in your long-term portfolio) I have long recommended the use of shorter-term bonds. This is true across a variety of economic conditions, and becomes especially important when inflationary concerns loom large. Let’s explore why.

In the lingo of investing, there are two primary ways to invest: stocks and bonds. A stock is a small ownership stake in a company. A bond is a loan. The bond is less risky because if the business goes bankrupt, bonds have to be paid in full before the stockholders get anything. In addition, bonds generally offer a steady stream of income.

As a general rule, it is wise to allocate a significant percentage of your portfolio to bonds to temper the risk you’re taking with your stocks. Including bonds in your portfolio reduces overall portfolio volatility.

But why shorter-term bonds in particular? After all, long-term bonds offer higher interest rates. If you’re planning to hold onto them for a long time, why not get the bond that pays the most? Because there’s a catch to stretching for that seemingly “free” extra interest.

Consider this image (click on it to view enlarged version):  

At first glance, they’re just a couple of lines intersecting. What do they mean? The blue, bottom line shows increasing risk. Bond values drop when interest rates go up. The longer the term, the greater the drop (and the greater the risk).

The gold, top line is the interest rate. Since 1964 (based on data available), one-month government bonds have averaged a 5.45% return. Five-year bonds have averaged a 7.27% return. This makes sense – five-year bonds have more risk, so they offer a higher return. By extending the bond term from one month to five years, the investor increases risk but gets an additional 1.82% return.

So far so good. But now look where the lines intersect, at about the five-year point. Past a five-year term, the blue line shows that risk continues to increase dramatically. But the gold line shows that the interest rate increases only by a paltry 0.10%!

You have to wonder, why take on the extra risk, when you can expect very little additional return? Answer: There’s really no good reason to take on extra risk unless there is a commensurate expected return. And that’s why I generally recommend short-term bonds instead of long-term bonds.

I will add one final note. There are times when you’d be glad to have long-term bonds – mainly when interest rates are falling, because long-term bonds increase in value when interest rates fall. But with interest rates relatively low these days, and with inflation likely (in my opinion) to push interest rates higher over the next few years, now seems to be a very good time to follow this rule of thumb: Reduce volatility in your stock portfolio with short-term bonds, not long-term bonds.