The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (38 page)

Estate taxes can be complex, but they’re a lot less relevant today than they were in the past. As of 2011, the first $5 million of any estate is exempt from any taxes, and the remainder is subject to a flat 35 percent tax. That means that most people don’t need to worry about this issue. Even some people who have estates above the $5 million limit will simply make a large donation to their favorite charity to get the overall estate below the cap. However, the rules are changing all the time, and it’s difficult to predict how they might change even a few years from now.

A word of caution here: It’s illegal to engage in
any
activity the IRS deems a deliberate attempt to avoid paying taxes. We don’t condone tax evasion and are not recommending it under any circumstances. That said, there are some completely legal ways to pass assets to your heirs while minimizing taxes.

For example, people often minimize their potential tax liability by giving gifts to their heirs while the giver is still alive. The IRS sets a cap each year on the amount one person can give to another without a tax consequence (as of 2011, the cap was $13,000). That sounds small, but if you have multiple children and grandchildren, it can add up.

Another common practice is to put appreciating assets into a generation-skipping trust. This means that heirs are considered “life tenants” of the trust—they can benefit from the interest generated by the trust, but not the principal, which gets passed on to the next generation. In years past, the principal passed through tax free. However, Congress has since created a special “generation-skipping” tax to close this loophole, but again, only for amounts over $5 million.

A more recent development in estate planning is the family limited partnership. This structure consists of a general partner who retains control over the assets (typically a parent), and limited partners who have an ownership stake but no control (typically the children). A limited partnership offers several tax advantages. For example, it allows you to transfer ownership of assets to children over time through the standard annual gifts up to the IRS cap within the partnership, meaning you retain control of the assets. Above that amount, your family will have to pay gift tax only on the “fair market value” of any ownership transfers. And because the limited partners receiving the assets don’t have control over them, this fair market value is often considerably less than the actual asset values. To use this approach, you need a qualified appraiser to assess the value of any gift in a family limited partnership to determine the appropriate taxable amount.

The biggest issue for estate planning in the Aftershock is that most traditional assets—stocks, bonds, real estate, whole life insurance, and annuities—will be worth only a fraction of their former value. For people who lose most of their wealth, estate planning will be moot because they won’t have much left to give to their heirs. Of course, if you’re reading this book, we’re going to assume that you have protected yourself with safe investments and still have plenty of wealth to distribute.

When the government can no longer borrow or safely print money, its only recourse will be to dramatically raise taxes on those who are employed and have assets. That means the estate tax will become a much bigger issue and impact more people. We expect progressive estate tax rates in line with income tax rates, which will be higher than current levels. There will probably still be an exemption—maybe even as high as the current $5 million—but it won’t necessarily be adequately indexed for inflation. And remember, $5 million in the Aftershock won’t be what it is today.

Estate planning is rarely simple, but in an Aftershock environment it gets even more complex, especially for estates with various types of assets. If you have multiple assets you’re trying to protect, you will likely need multiple strategies. For domestic assets, such as a house, car, or furniture, an inter vivos trust is usually the best approach. For assets like a family-owned business or real estate holdings, a family limited partnership is generally the best way to go. You can use joint titling with right of survivorship for assets like bank accounts that you want to be transferred quickly after death. Many of these assets won’t be worth too much, but you will likely still want to transfer them appropriately for other reasons. Finally, you may still need a will for any residual assets.

Many readers of this book will no doubt hold a significant portion of precious metals. While exchange-traded funds are a fine way to invest in gold for now, for security reasons you may want to own gold bullion when the Aftershock hits. One of the advantages of physical assets like gold is that they’re relatively easy to secure in a safe place that no one else knows about. The problem for estate planning is that if no one knows where you keep the assets, they can’t be transferred after you die. And while your heirs may be trustworthy enough to know the location in advance, this is a risk you may not want to take—for these assets, physical possession essentially amounts to ownership. As a result, many Aftershock portfolios will likely be heavily invested overseas in multiple tax-haven countries. Good estate planning in these circumstances generally would require the use of long term overseas trusts to protect the assets and ensure the proper transfer of these assets to heirs.

As a result, many Aftershock portfolios will likely be heavily invested overseas in multiple tax-haven countries. Good estate planning in these circumstances generally would require the use of long term overseas trusts to protect the assets and ensure the proper transfer of these assets to heirs.

Finally, you’ll need to take capital losses into account. Capital losses are an almost negligible aspect of estate planning today, but they’ll be critical in the Aftershock, as all kinds of assets will lose a great deal of their value. Realizing capital losses in your home and other assets could help offset any income from wages or gains and substantially reduce tax liability. There are some fairly restrictive rules on the books today about using capital losses to offset income, but in an Aftershock environment—with such widespread capital losses—these rules could be relaxed. so this strategy has its limits.

As we said before,
The Aftershock Investor
is the guide to investing even if there is no Aftershock. Even if the bond market doesn’t melt down, there are still big long-term problems to contend with. Even if the stock market doesn’t melt down, there are still big long-term problems to contend with there, as well. The same is true for real estate. It won’t take require a big multbubble pop for these assets to fall in the future. So you needn’t buy into our entire point of view to take heed of our warnings.

As we often say, you certainly don’t need hyperinflation to cause major problems for stock, bond, and real estate markets. Even interest rates that were not atypical in the booming 1960s and absolutely benign compared to the incredibly high rates of the 1970s and early 1980s will cause real problems for all these markets at their very high prices today. You need to be prepared for them interest rates to rise.

At the very least, you need to be prepared for lots of volatility. We think there will be an Aftershock at the end of this volatility, but even if there is not, you need to at least be prepared for the volatility in the near future and the likelihood of diminished returns from traditional investments.

So, to do that, let’s summarize what we’ve discussed in this book about a diversified Aftershock portfolio. In particular, what is the overall portfolio strategy, what are its components, and what’s is the best way to implement that portfolio?

The overall strategy of the Aftershock portfolio is:

The term
preservation of capital
should be defined since it is used by many money managers. Most often what conventional wisdom (CW) money managers mean by preservation of capital is lots of safe long-term bonds, some safe blue-chip or high-dividend stocks, and maybe an annuity. We have discussed each of those in detail in the book, so you know by now that keeping those investments for a long period of time will not preserve your capital. It will do just the opposite.

So CW says safe bonds and safe stock are the way to go. We say those aren’t safe for the long term anymore. What we mean by preservation of capital is protection against a long-term decline in the stock and bond markets and high inflation down the road. Those are the real threats to your hard-earned wealth.

The fact that stocks and bonds are not good long term doesn’t mean that they have peaked today. In fact, they probably haven’t. Timing is always an issue in investing, and it’s hard to time the market. We’ll talk more about how to handle the timing issue later in this chapter.

Minimal volatility isn’t too hard to define, although exactly how little volatility you want depends on your financial tolerance for volatility. Also, there’s no free lunch. To get higher returns you will have to accept somewhat higher volatility. But you can shoot for a happy medium that is less volatile than the stock market but still gives you returns that are comparable to a modestly rising stock market today.

Ideally, an Aftershock investor will have returns that look more like a non-volatile upward movement as opposed to the highly volatile and very risky Standard & Poor’s (S&P) index. It should be more of an arrow through a W. Even if you make the same returns as the S&P 500, do you really want all that volatility? And, of course, there is some risk (we think a very big risk) that at some point one of those downward movements on the stock market isn’t going to fully rebound. Once we get to the point where the normal remedy for boosting the stock market (massive money printing and massive borrowing) that has worked so well in the past has increasingly less positive effect (and eventually has a negative effect) a big stock market drop could stay down and not rebound. This market isn’t being kept up by economic fundamentals, it is being kept up by artificial means that the government has used effectively, in combination with stock cheerleaders, to maintain a bubble stock market valuation.

Reasonable returns are hard to define. In the current market, 5% might be reasonable to many. For others it’s quite low. The key is what level of risk you are taking to get what level of return. If you are getting a high return, you are likely taking a high level of risk. In conventional investing this is called the
risk-adjusted rate of return
, which is often expressed as the Sharpe ratio (the higher the Sharpe ratio of an investment, the better the rate of return you are getting relative to the risk you are taking).

Of course, we are seeing certain investments as risky long term that the market is currently not seeing as risky. So our risk-adjusted rate of return would be different from standard investing analysis. Nonetheless, the concept is correct, and we are advising a lower rate of risk taking now for most people and that will result in a lower rate of return. But it’s better than losing your money. Also, you can also make very high returns as we near the Aftershock, but you will be taking more risk and will get higher volatility.

So what are the key components of an Aftershock portfolio, and how do we weight them?

The primary components of an Aftershock portfolio today are given below. Remember, this will change over time, which we will discuss with each component.

This is an important element of any Aftershock portfolio, and it will become increasingly important in the future. When we say gold, we mean physical gold and not gold mining stocks. As discussed in Chapter 8, this can be held via an ETF, such as GLD, IAU, or PHYS, which makes it easier to purchase. The big problem with a very large allocation to gold right now is the volatility. However, gold has been a very stable performer on a year-to-year basis, and the fundamentals of gold have never been better. As the Aftershock comes closer, and you are more convinced it is coming, you should be increasing your gold holdings accordingly. But buy some now even if you aren’t very sure of the Aftershock. It could easily go down for a while after you buy it, but best to get your toes wet. You will need to be more comfortable buying gold eventually. Right now, many people don’t buy gold because they missed it at a lower price earlier. Don’t fall into that trap. Just start now by buying a smaller amount.

Isn’t this one of the assets we said the cheerleaders would suggest? Yes it is. The difference is that we are not recommending it as a long-term hold. It will work well in the current volatile and slow growth stock market. However, like all stocks, you will need to move out over time since high-dividend stocks do go down when the market goes way down. What they do is provide you with a buffer against the volatility of the current market and provide a decent dividend income as well. We particularly like electric utility stocks, but since they have done well in the past year, they likely won’t do quite as well in the near future. However, they are still a better choice now than riskier stocks. One easy way to invest in a diversified group of electric utilities is through the ETF XLU.

This is another temporary asset category. Like high-dividend stocks, which are more defensive in nature, shorter-term bonds are more defensive in nature than long-term bonds. They are not as vulnerable to changes in interest rates as are long-term bonds and they provide you with a buffer against any downward movements in bonds. Again, like high-dividend stocks, they will go down when the bond market goes down a lot, so you will need to move out eventually. But in the meantime it provides a good way to ride the bond bull until it finally turns for good. One easy way to invest in short-term Treasurys is through the ETF VGSH.