Take Tesco’s Prudent Advice: The Magical Power of Compounding

In investing, time is your friend.  The longer an investor can commit funds to a strategy, the greater the possibility of success.  I’m sure, for many of us, we wish we could give our younger selves the advice to start saving earlier. In young adulthood, often times there are many demands on cash flow, and it can feel difficult to get ahead.  Working long hours in an entry-level job with student loans, rent, a car payment, and learning to deal with (gulp) taxes can be overwhelming.  The thought of setting aside precious net earnings for retirement which may be forty years or more down the road seems preposterous.

However, making a very small sacrifice now can have an exponentially powerful effect later in life.  Let’s look at the impact of starting to save and invest early vs later in life.  Assume we have four individuals at different stages of their lives who want to begin a monthly investment strategy with the aim of accumulating $1m by the time they reach age 65.  They are all aggressive investors and want to implement an equity-only strategy that will earn 10% on an annualized basis.  The table below shows the impact of compounding growth and time in the market (gross of costs):

Age 20 30 40 50
Monthly Investment $95.40 $263.39 $753.67 $2,412.72
Total Lifetime Cost of Investment $51,516 $110,624 $226,101 $434,290
Assumed Annualized Rate of Return 10% 10% 10% 10%
Value of Investment age 65* $1 million $1 million $1 million $1 million

 

*No assurance or guarantee can be given that an investment portfolio commenced at any age will reach a specific target value as the outcome will be dependent on various factors, such as market conditions, choice of asset allocation and costs.  The value of investments can go down as well as up.

The difference in the lifetime capital requirement is striking. We are faced with demands on our cash flow every day.  Some are fixed (mortgages, taxes, etc).  However, we all have an element of discretionary spending in our budget. The choice to dine out versus eat at home, buy a name brand vs generic product, fly economy vs business class…the list goes on. By making small changes to our discretionary spending, regardless of the phase of life we are in, we can direct more capital into long-term savings and vastly increase the likelihood of reaching our goals.

If you are reading this and you are in your 20s or 30s, take heed and consider making the choice to invest in your future financial well-being by adopting small changes in your lifestyle.  If you are closer to retirement (or perhaps in retirement), don’t lose heart.  It’s still important to regularly review your expenditure and consider if there areas in which you can reduce costs.  As the Tesco slogan says “Every Little Helps”.

Risk Warnings and Important Information

The value of investments can go down as well as up depending on market conditions and you may not get back the original amount invested. Investments involve risk and your capital is always at risk. Past performance is not a reliable indicator of future results. There is no guarantee strategies will be successful.

The above article does not take into account the specific goals or requirements of individuals. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.

FBAR, PFIC and Other Four-Letter Tax Words U.S. Expats Should Know

Life as an expat in Hong Kong has all sorts of “get out of jail free” benefits – especially when it comes to family obligations.  But there is one family member American expats can’t avoid: Uncle Sam.  If you’re new to filing taxes abroad, here is a list of some four-letter terms and associated tips you should know.

FEIE:  The U.S. is one of two countries in the world[1] that taxes its citizens (or other “connected persons”) on their worldwide income, regardless of where they reside.  News to you? Rather than hurl expletives, get familiar with this four-letter word: FEIE, which stands for Foreign Earned Income Exclusion.  For the 2018 tax year, you can exclude up to USD103,900 of earned income from U.S. tax, subject to certain restrictions.  The FEIE for the 2019 tax year is USD105,900.  In addition, U.S. expats residing in Hong Kong can exclude certain housing costs (notably rent) up to a maximum of USD114,300 (again, subject to certain restrictions).

In order to qualify for the FEIE, you must have been out of the U.S. for a total of 330 days over a 12-month period or deemed a “bona fide resident” of a foreign country.  Don’t fret if you don’t satisfy either requirement, as partial exclusions may be possible.

Additional exclusions: If the FEIE and housing-related deductions don’t fully offset your U.S. taxable income, you may be able to use the income taxes you pay in Hong Kong as an itemized deduction or a foreign tax credit when filing your U.S. taxes.  Make sure to explore what option would be best for you with your tax advisor.

FBAR: FBAR refers to Reports of Foreign Bank and Financial Accounts. An FBAR must be filed if the total amount of your financial interests in or signature authority over financial accounts maintained outside the U.S.  exceed USD10,000 at any point during the tax year and regardless of whether any of the accounts produce any income.  Failure to report in any applicable year can incur some pretty hefty penalties or even jail.  Still not convinced?  Google it.

The filing deadline for FBAR is April 15 (although it can be extended in certain cases) and can be done electronically here: https://bsaefiling.fincen.treas.gov/main.html

Shameless Plug #1: At MASECO Asia, our clients’ assets are domiciled in the U.S., and are therefore not subject to FBAR filing.  This can help reduce the reporting burden during tax time.

PFIC:  I leave you with one more four-letter tax word: Passive-Foreign-Investment-Company (PFIC).  PFICs encompass pooled investments (e.g., mutual funds, ETFs, hedge funds, insurance products) domiciled outside the U.S.  Why care?  Well, Uncle Sam really cares. In his effort to disincentivize investing offshore, PFICs are subject to some rather punitive tax rates.

Take for example a mutual fund that invests in European stocks but is domiciled in the U.S.  Long-term capital gains from this product are taxed at 0%, 15%, or 20%, depending on your tax bracket and filing status.  Now suppose that same European stock mutual fund is instead domiciled in Hong Kong.  Those same capital gains would be taxed at the highest current federal tax rate of 37%.  The PFIC story gets even uglier when considering the taxation of distributions and compounded interest charges on deferred gains.  The good news is that there are several different accounting treatment options (and hence taxation outcomes) for PFICs.

Shameless Plug #2:  MASECO Asia investment portfolios are PFIC-free, lending to a more tax-efficient wealth solution versus for U.S. expats versus other providers.

Need more advice?  Although we are not expert tax advisors, we are expert tax advisor referrers!  Please don’t hesitate to contact us for direction.

[1] Fun fact: the other country is Eritrea, located in East Africa.

Demystifying Social Security

Social Security benefits form a bedrock of retirement income for tens of millions of Americans. And yet, many would agree that the program is mired with unnecessary complexity which makes claiming benefits confusing.  My intent is to use this blog post to help demystify some of the confusing elements of the Social Security retirement benefit.

First, a bit of background and historical context. The Old Age, Survivors, and Disability Insurance (OASDI) program, better known as Social Security, was enacted by Congress in 1935 to help Americans suffering in the wake of the Great Depression. Originally intended as a retirement income program, Social Security expanded over time to include disability benefits and family/survivor benefits in the event of premature death.  Social Security is designed as a pay-as-you-go program which means that the benefits of current retirees are funded by the current contributions of today’s workforce through FICA and self-employment taxes.  As long as an individual accrues 40 credits (done over 10 years in most cases) of eligible employment, they have an entitlement to Social Security income (SSI) benefits.

To determine an individual’s benefit entitlement, the highest 35 years of earnings are averaged (and adjusted for inflation) to arrive at the primary insurance amount (PIA). The PIA is the benefit an individual will receive at their normal retirement age (i.e., 66 or 67, depending on your year of birth). An individual can elect to begin Social Security benefits as early as age 62 or as late as age 70.  The PIA is adjusted up or down depending on when benefits commence.  For individuals or couples with sufficient assets or other pensions, it is often advantageous to delay drawing on Social Security until age 70 because for each year you wait, the benefit increases by approximately 8%.  This is essentially an 8% return backed by the US government.  A strategy involving delaying the onset of Social Security will likely necessity earlier distributions from other retirement assets, but with proper planning, this can be easily managed.

Even if you never worked outside the home, if you are married you may still have an entitlement to a spousal benefit. If both spouses have their own work history, the lower-earning spouse has the option to claim based on his/her own earnings history or take the spousal benefit from the partner, if higher.  However, the timing of making a claim can impact the total benefit payment and the amount of the benefit subject to tax.  In 2018, if a married couple has more than $44,000 in provisional income[1], they will pay tax on 85% of their SSI benefit.  Moreover, if you or your spouse have earnings from a pension a job that wasn’t covered by Social Security (e.g., a state pension from work abroad), you may be affected by the Windfall Elimination Provision (WEP) or the Government Pension Offset (GPO).  These are more nuanced topics that may require the assistance of your accountant.

A key challenge facing Social Security is an aging population. Americans are living longer, meaning they will be drawing on their benefits for a greater number of years.  At age 65, the average man can expect to live another 19 years, while the average woman can expect to live another 22 years[2]. Despite this fact and the incentive of an increased benefit associated with deferring to claim until a later age, approximately 40% of retirees claim their benefit at age 62 or shortly thereafter, resulting in a permanently reduced benefit[3].  We have a tendency to underestimate our life expectancy, but a real crisis could emerge if you outlive your life expectancy and prematurely deplete your assets.  If you begin drawing at 62, the benefit can be reduced by as much as 25% from your PIA or full-retirement benefit.  This is significant for a few reasons:

  1. If your spouse is claiming a benefit based on your benefit (as opposed to his or her own work history), the spousal benefit will also be reduced.
  2. You will have to supplement to a larger degree with other assets to fill the gap in your retirement income, likely resulting in greater depletion of your total wealth over time
  3. If you are still working at age 62, you may be subject to a further benefit reduction due if you breach the annual earnings limit (currently approx. $17,000 in 2018).
  4. Taxes can be imposed on as much as 85% of your Social Security benefit resulting in the need to further subsidize with other assets.

The decision of when to start Social Security requires a thorough break-even analysis of one’s retirement cash flow, including a consideration for longevity, taxes, inflation, and an assumed rate of return on investment assets. If an individual lives into her mid-80s, she is generally better off delaying the commencement of benefits. The above factors considered, there are often strong reasons to elect to claim early benefits, especially if cash flow is a concern immediately upon retiring.  Some argue that Social Security’s solvency or legislative changes could affect future benefits.  This is a valid concern but given how many Americans are reliant upon Social Security income, it is unlikely to see the program materially depleted as it would be very unpopular politically.  It is probable that we will see a restructuring of benefit calculations in order to deal with the growing population of retirees.

To learn more about SSI, visit www.ssa.gov or talk directly with your financial advisor.

 

[1] https://www.ssa.gov/planners/taxes.html

[2] “Calculators: Life Expectancy,” Social Security (2017), https://www.ssa.gov/planners/lifeexpectancy.html.

[3] “Social Security in the New Retirement,” Financial Engines, January 2016.

Simplifying US Tax Payments

Make Paying Your US Taxes Easier

It’s no secret that being a US taxpayer is onerous, especially for those living abroad. Preparing returns, filing supplemental schedules, and completing FBARs is tedious and complicated.  For many overseas taxpayers, the headache doesn’t end when the return is submitted. The “simple” exercise of remitting US tax payments can be challenging.  Often, this involves converting foreign currency, wiring funds to a US account, and/or posting checks from overseas (and hoping they aren’t lost in the mail).

Electronic Federal Tax Payment System®

The Electronic Federal Tax Payment System® (EFTPS) tax payment service is provided free by the U.S. Department of the Treasury. It enables US taxpayers to pay their federal taxes online, and this includes estimated payments. Businesses can also enroll for the service. The user completes an enrollment process and links their EFTPS account to a US bank account. Once enrolled, the user can access the site to make one-off payments, schedule estimates, and view payment history.

By using this service, taxpayers can reduce the risk of lost or mismatched payments and confirm when their payment has settled. For those who find there is nothing easy about US taxes, this just might make your life a little easier!

If you are a US taxpayer who has struggled with the logistical challenges of paying taxes while overseas, visit https://www.eftps.gov/eftps/ to enroll.

ETFs May Not Be What You Bargained For

In a prior blog post, I discussed the performance hurdle that fund costs impose for actively managed strategies, making the case for lower cost solutions. Was this a plug for pure ETF portfolios? Hardly. Yes, ETFs have low direct costs, but there are notable caveats and indirect costs associated with ETF investing.

Pick an ETF, any ETF? The popularity of ETFs was borne out of investor demand for a simple, low-cost way to gain broad exposure to a chosen asset class. But the investor experience can vary widely within seemingly similar ETFs, with a key differentiator being the underlying indexes that the ETFs attempt to track. Suppose an investor has to choose between two US small cap growth ETFs, one that tracks the MSCI US Small Cap Growth Index and the other that tracks the Russell 2000 Growth Index. Despite its apparent randomness, this choice may offer significantly different outcomes, especially over the longer term. Over the 25-year period ending March 2018, the MSCI US Small Cap Growth Index returned an annualized 10.5%, while the Russell 2000 Growth Index returned an annualized 8.1%. The disparity likely stems from differences in index inclusion criteria and how and when indexes are rebalanced (more on this below).

Is Your Portfolio Space Efficient?

The key to Hong Kong survival is efficiency.  We have to be time efficient, cost efficient and – I think we can all agree – space efficient!  Take my closet for example, which is crammed with too many similar and/or “what was I thinking?” items; hardly the model of space efficiency.  It’s time I let go of misguided shopping decisions to make room for a wiser mix of wardrobe choices.  This sounds a lot like portfolio optimization.  Is your portfolio space efficient?  Here are some tell-tale signs that it could use a rethink:

The Hurdle of Higher Costs

Living in Hong Kong has encouraged me to be much more cost conscious than I ever was back in Toronto.  Is that HKD140 cocktail worth it or would Club 7 Eleven do the trick?  If I have legit designer shoes can I get away with a knock-off dress?  Do I really need to grocery shop at Great or can I just devour their samples and hightail it to Wellcome? Despite my expensive tastes, the lower cost solutions usually reign supreme.  Research shows that the same goes for fund selection.

Cash Flow Planning

Cash Flow Planning

Risk tolerance over time

I attended a conference earlier this week and one of the featured speakers, Jeffery Coyle of Monograph Wealth Advisors in California, discussed the role of fixed income over time in an asset allocation strategy. The presentation was thought-provoking because it was, in many ways, contrary to generally accepted industry practices.

Conventional asset allocation strategies often suggest that a person’s risk tolerance may change over time and become less aggressive, particularly as they shift from accumulation to decumulation in retirement. By then, the time to build the nest egg has passed and the key driver becomes income generation and/or capital preservation. Within the industry, we have seen the emergence of target date fund strategies which implement this philosophy. The closer an individual gets to retirement, the more conservative their portfolio becomes as the equity weightings are reduced in favour of lower-volatility fixed income.

Have we got it wrong?

In reality, as we are living longer, many retirees have decades of post-employment years and they require their capital to sustain them. By shifting too much to fixed income or assets with low expected returns, we can sometimes see an increased risk of premature capital depletion. In addition, many individuals have a strong desire to create a legacy or leave an inheritance for their families. This means that, not only do we need to ensure adequate capital growth for the individual, but often we need to account for future generations as well.

The success of an individual’s wealth planning is directly linked to cash flow. If we accurately estimate one’s cash flow, it is much easier to calculate the required rate of return and the appropriate level of risk assets to include in a portfolio. Often, we use current expenditure as the starting point to help ensure one can maintain their present standard of living throughout retirement. However, Coyle suggests that if we consider the minimum required expenditure instead of the current outflows (i.e. stripping out discretionary spending), we can solve how much fixed income is required to cover this baseline need. Over time, this need decreases as one’s life expectancy reduces. This means, using this philosophy, an individual would actually shift toward a heavier equity weighting as they move into retirement. This unique approach could be incredibly powerful for high net worth individuals or families who are looking to maximize their estate or legacy over time.