Don’t Forget About Taxes and Inflation

We’re pleased to provide this summary from a recent blog by Jim Koch, RMA®, founder and principal of Koch Capital Management, an independent Registered Investment Advisor (RIA). It includes RIIA®’s Household Balance Sheet℠ to help clients plan for retirement. You can read the full article here.

The Silent Assassins
Rarely do investors factor in the impact of taxes and inflation on their portfolio returns. Given the current tax rate uncertainty regarding both capital gains and ordinary income, it’s no wonder the typical investor has such a difficult time planning for taxes. But both taxes and inflation matter a lot because “real” return is what pays the bills.

Estimate Tax and Inflation Impact
Both state and federal taxes are likely to rise no matter who is in the White House. As for future inflation, who really knows? Medical, college and energy costs are above the long-term average inflation rate of 3.2%, but technology, productivity and cheap global labor keep other inflation items in check, for now.

Determine Investment Hurdle Rate
In an earlier blog post, I introduced the Portfolio Cost Analyzer (PCA) application to help determine the impact of advisor fees, fund fees and transaction costs on portfolio returns.

Now include tax and inflation costs on top of the portfolio fees and it gets truly ugly.

For example, if the combined state and federal effective tax rate is 40% and the expectation is for 3% annual inflation, then the portfolio must earn at least 5% to stay ahead of taxes and inflation. Combine this 5% rate with the 3.5% in portfolio fees, and the investment hurdle rate is now 8.5%. Koch Capital’s free template, based on RIIA’s Household Balance Sheet, is available here to help determine the minimum real return (a.k.a. Discount Rate) that household assets need to generate annually in order to fund a desired retirement lifestyle.

How Lucky Do You Feel?
The figure below is an unsourced, frequency distribution of historical S&P 500 returns by year, overlayed with a crude 8.5% investment hurdle rate line. The investment hurdle rate line divides whether real money (green area) is made in a given year or if the portfolio lost value (red area) to portfolio fees, taxes and inflation.

Past performance is not indicative of future results. Source: Unknown, Koch Capital

There are basically two ways to increase the size of  the green area in order to reduce the frequency of hanging out in the red area: Move the red fees, taxes and inflation (hurdle rate) line to the left by reducing portfolio costs and taxes, or, increase average annual portfolio returns so the personal long-term “mean” moves to the right and further away from the hurdle rate line (a.k.a. increase margin of safety). The former requires good financial planning and discipline while the latter requires substantial investment skill and luck, especially with the current high stock market valuations and low interest rates. To pursue only the latter strategy, ask just one question—how lucky do you feel?

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