Dentists Resource Center

Quarterly Commentary - April 2016

After a record rough start to the quarter, global equities rebounded as oil prices stabilized and dovish comments and actions by global central banks, including the Fed, helped lift the markets. The European Central Bank pushed interest rates farther into negative territory and initiated another round of stimulus, adding to its already hefty quantitative easing program. Not to be outdone in the race to the bottom, Japan’s central bank surprised markets by dropping the rate they pay banks on deposits to a minus .1%. At home, our Federal Reserve tempered their recent rate plans by alluding to the fact that they only anticipate two rate hikes instead of four in 2016.

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Remarkably, the S&P 500 managed to finish the quarter up 1.35% while major international markets recovered a good portion of their losses as the MSCI EAFE Index finished down only 2.88%. After a dismal 2015, emerging markets were one of the brighter spots with the MSCI Emerging Markets Index finishing up 5.75%. Despite the continued commentary by “experts” to stay away from fixed income, bonds benefitted from the dovish actions of central banks causing global interest rates to fall once again. In the US, the Barclay’s US Aggregate Bond Index finished the quarter up 3.03%.politics-flag

As we head into the final stages of the Republican and Democratic primaries and ultimately the Presidential election, the political rhetoric continues to escalate with no end in sight. This battle for the hearts and minds of voters has heightened promises for change, especially in the areas of entitlements and tax reform. While we have already seen some changes in these areas, there is little doubt that more change is on the horizon given the fiscal and monetary circumstances in which we find ourselves. As such, it has never been more critical to understand and measure the impact these changes could have on your personal financial situation and the steps necessary to stay fully prepared.

Social Insecurity?

soc_security_card-2Currently, baby boomers are reaching age 65 at a rate of almost 10,000 per day, which is putting a progressive strain on Social Security and Medicare programs. In the latest trustees’ report, the Social Security Trust Fund paid out $74 billion more in benefits than it received in Social Security tax revenue for 2014 and that figure is projected to be $84 billion in 2015. The Trust Fund currently receives interest payments on debt owed to it by the Federal Government, but it is projected that benefit payments will exceed tax and interest by 2020 and that the trust fund will deplete it’s purported $2.8 trillion of special issue U.S. Treasury securities by 2034. Further, the Social Security disability fund will run out of funds this year, and if the funds earmarked for Social Security are tapped to cover the disability shortfalls, these reserves will be depleted by 2029.

This is a politically charged issue, especially in light of the fact that one of the largest and the fastest growing voter segments is receiving or soon-to-be-receiving Social Security benefits. Despite this fact, the reality is that tough changes will have to be made to the Social Security system for it to remain solvent for the long run. We attended an event several years ago where we had the privilege of speaking with former Fed Chairman, Alan Greenspan, about the state of Social Security. To quote Mr. Greenspan, “We can solve our problems with Social Security in about a half hour with twenty minutes of it being pleasantries because we know all the variables. Medicare, on the other hand, is another matter.”

To his point, Social Security has only four moving parts that can change: the tax rate, wages subject to Social Security taxes, the age benefits begin, and the amount of benefits. As the timeline below suggests, the Social Security system has evolved over the years, and we are beginning to witness more of this evolution, which we fully expect to escalate in scope. For instance, effective May 1, 2016, two common claiming tactics known as “File and Suspend” and “Restricting an Application” have been eliminated. These claiming strategies have been popular among married couples, especially where there is a non-working spouse or a difference in age and income. In the “File and Suspend” strategy, the higher wage earner could claim their benefits, thereby allowing the spouse to apply for a spousal benefit equal to half of the higher wage earner’s benefit. The higher earner then “suspends” or delays his/her benefit, which allows an 8% increase per year in future benefit up to age 70 when he/she reclaims the benefit. Meanwhile, the lower earning spouse would collect their spousal benefit while the higher earner’s future benefit grew. A person “Restricting an Application” elects to collect a spousal benefit at full retirement age thus allowing their benefit to grow at 8% per year until age 70 at which time they switch to their larger primary benefit.

SocialSecurityTimeline

What Other Changes Might Be Considered?
Raise Taxes: One option would be to phase in an increase in payroll taxes over the next ten years, or raise the amount of wages covered by the payroll tax to about $300,000. Either option, assuming that benefits are not changed, would address about 40% of the financing shortfall for Social Security.

Raise Retirement Age: Continue raising the age of full retirement. If the full retirement age is gradually raised by two months per year, it would reach age 70 for workers who were born in 1978. This step would solve about 30% of the financing shortfall for Social Security.

Change the Benefit Calculation Formulas: Since people are living longer and will have longer work histories, change the Social Security benefits formula period to the top 40 years of earnings, rather than on the top 35 years. Modify the “regressive benefit accrual” where higher relative benefits are accrued on the first $50,000 of wages and less is accrued on each incremental dollar of wages. Future cost of living adjustments could also be reduced as the amount of benefits is increased.

Fixing Social Security is not complicated, but it will take a political will that politicians on both sides of the aisle have not yet displayed. In light of circumstances, we will undoubtedly see some combination of these changes as the situation becomes more painfully apparent.

Medicare

While many things get better with age, Fidelity’s new research shows the cost of health care isn’t one of them. Nearly three-fourths of couples surveyed said their top concern was being able to afford unexpected health care costs in retirement. Yet, only 22 percent of couples had factored it into their financial plans. These concerns are justified by Fidelity’s Retirement Health Care Cost Estimate which revealed that a couple, both aged 65 and retiring this year, can now expect Medicare and Medigap premiums and out-of-pocket health care expenses to total roughly $245,000 throughout retirement. And this does not include dental expenses and long-term care which are not covered under Medicare. Medicare provides health coverage for Americans once they reach age 65 and has become an essential part of financial security in retirement. This system, as we know it, is in the process of a major overhaul and, much like changes to Social Security, it will have financial implications for us all.

Medicare currently pays for benefits under two different payment structures. Traditional Medicare is fee-for-service where providers are paid directly by Medicare, and Medicare Advantage is run under an HMO structure, where Medicare pays an insurance company a fixed amount of money and the insurance company manages the cost and delivery of care.

The vast majority of people currently use traditional Medicare and purchase a Medigap policy to help with the cost of deductibles and co-pays, although an increasing number of people are choosing HMOs. The HMOs generally require less out-of-pocket money than traditional Medicare, they don’t require Medigap and they often provide additional benefits. While Medicare Advantage Plans are often considered a bargain, those who avoid them cite concerns over having reduced choice of specialists and hospitals.

Over time, with mounting financial strains on Medicare due to rising medical costs, medical services utilization, and aging baby boomers, Congress has made changes to the Medicare tax. In 1993, the cap on wages subject to Medicare tax was eliminated and all earned wages became subject to the Medicare earning tax. Effective January 1, 2013, Congress instituted two additional surtaxes. For households with incomes above $200,000 single and $250,000 joint, wages above these levels are now subject to an additional .9% tax and net investment income for households with incomes above those levels are subject to an additional 3.8% tax. In addition, over the last 10 years, an Income-Related Monthly Adjustment Amount (IRMAA) has been phased in and applied to Medicare Part B and Part D premiums for those on Medicare with higher incomes. The additional Medicare IRMAA premium can be as much as $700/month for a married couple.

In addition to these measures, the Department of Health and Human Services (HHS) is currently working to overhaul the cost and payment structure of Medicare in order to bend the cost curve and ensure its viability. These changes will have a profound effect on the way medical care will be measured and paid for in the future as part of the overall concept of health care reform. For example, HHS has set a goal of converting 30 percent of traditional, or fee-for-service, Medicare payments to quality or value through alternative payment models, such as Accountable Care Organizations (ACOs) or bundled payment arrangements by the end of 2016, and tying 50 percent of payments to these models by the end of 2018. HHS also set a goal of tying 85 percent of all traditional Medicare payments to quality or value by 2016 and 90 percent by 2018 through programs such as the Hospital Value Based Purchasing and the Hospital Readmissions Reduction Programs. This is the first time in the history of the Medicare program that HHS has set explicit goals for alternative payment models and value-based payments. Simply put, HHS is going to impose systems that will only pay for measurable outcomes from the medical community. The new protocols being explored in the Medicare system are part of a more universal plan to fundamentally change medicine to an evidence and outcome based system with an increased emphasis on personal responsibility both financially and behaviorally.

Tax ReformDollar_signs_blue

No commentary in an election year would be complete without a call to action on tax reform. While all of the candidates have their pie-in-the-sky tax ideas, a number of changes are likely to be considered no matter who is elected. With the burgeoning national debt and an annual budget deficit that adds to the balance each year, tax reforms to raise revenue are certain, which will undoubtedly impact future planning decisions. Rep. Kevin Brady, chairman of the House Ways and Means Committee, recently told CNBC that tax reform is “inevitable.” As with entitlement programs, tax reform has been more a matter of political will than complexity. In the absence of political will, the tax code has become absurdly complex and ineffective.

There are a number of reforms that have been included in budget and tax proposals over the last several years and this seems to be a reliable harbinger of future changes. The following changes are the dollar_signmost likely to have an impact on future planning.

Roth IRA: Roth IRA balances can be invested to accumulate tax free indefinitely. It is likely that Roth IRAs will be subject to required minimum distributions that limit the period of tax free accumulation. In addition, Roth IRA distributions may be included in income for purposes of calculating Medicare IRMAA premiums and taxes on Social Security benefits.

IRA Distributions: Currently, IRA balances can be distributed over the life of non-spouse beneficiaries such as children. There is support to mandate that non-spouse beneficiaries must withdraw the entire balance over 5 years or less.

Mortgage Interest Deductions: Mortgage interest deductions cost the federal government $70 billion per year. Seventy-seven percent of the benefit goes to homeowners with incomes above $100,000, while low and middle income taxpayers get virtually no benefit. Recent proposals have varied from eliminating the deduction to capping the interest to the first $500,000 of mortgage balance.

State, Local and Property Tax: Proposals have recently included plans to eliminate the deductions for these taxes.

Value Added Tax (VAT): One of the more fundamental changes to the tax system is the consideration of a Value Added Tax. VAT is a tax on the added value of a good as it moves through the supply chain to the end consumer. In effect, the tax is levied on the gross margin at each point in the manufacturing-distribution-sales process. In simple terms with a 10% VAT, if Apple pays $100 for the parts in an iPhone and sells it to Verizon for $200, Apple would pay a VAT of 10% of ($200 - $100) or $10. When Verizon then sells it to the end user for $500, they would remit a tax of 10% of ($500 - $200) or $30. This embeds the tax in the price of goods and services and does not feel like a direct tax. The VAT tax is usually implemented with a lower flat tax on income and is a form of a national sales tax.

Prepared for Change

The political season reminds us of the inevitability of change and the accompanying threats and opportunities that follow. Understanding and measuring these changes is a vital component of the dynamic process of prudent financial planning. Our goal is to guide you in determining how these changes will impact your personal situation and identify the most important strategies for long-term success.

We’re Growing

We are pleased to introduce two new team members at Wealth Dimensions. Susie Arling joined the firm as member of our client services team in March. She is a graduate of Ohio State University and brings almost 10 years of experience in various roles in the wealth management field. Erik Smith joined the firm in April as a Financial Planning Associate. He earned both his Bachelor’s Degree in Finance and an MBA at Xavier University. He is also a Certified Financial Planner and has worked in the industry for the last 7 years.


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