The Debt Ceiling and the Road Ahead

 

After all the debate in recent weeks over issues related to raising the nation's debt limit, it's hard to know exactly what might happen after August 2. Borrowing represents more than 40% of the nation's expenses, and any default on the country's obligations would be unprecedented.


As a rule, panic generally doesn't help you make wise financial decisions. That's why now might be a good time to review your portfolio to see if you have more exposure to a particular asset class than you'd prefer, regardless of what happens in Washington. And as the situation evolves, here are some mileposts that bear watching:

Auctions of Treasury securities

The yield on the 10-year Treasury note can serve as a barometer of anxiety levels; the higher the yield goes, the more bond prices will fall, indicating increasing anxiety in the bond markets.

Regardless of whether the debt ceiling stays the same, several significant auctions of Treasury securities are scheduled shortly after the August 2 deadline. Bids for 3- and 10-year notes and 30-year bonds will begin on August 3, and auctions will take place August 9-11. More importantly, the nonprofit Bipartisan Policy Center (BPC) estimates that payment of roughly $90 billion on maturing Treasury securities is due on August 4.

The difficulty in producing an agreement to raise the limit has led two major credit rating agencies to announce they are officially reviewing the United States' historically impeccable credit rating. Even if the Treasury attempts to avoid defaulting on Treasury securities by prioritizing payment of its obligations, the rating agencies have warned that any such move would likely trigger a downgrade, especially if no consensus has been reached on how to tackle the deficit.

A lowered credit rating would mean the United States would have to pay more to borrow in the future, making the national debt problem even worse in the long term. That's because the greater uncertainty about the country's willingness and ability to pay its bills would likely lead both domestic and foreign investors to demand greater compensation for buying Treasuries.

Bonds and Non-Treasury Borrowing

Higher interest rates for Treasury bonds might also result in higher interest rates on other, nongovernmental loans such as mortgages and consumer credit. Since many interest rates are based on Treasury rates, rates generally would likely be affected. And since bond prices fall when rates rise, you should keep an eye on your bond portfolio.

One indicator of investors' assessment of the risks of Treasury bonds compared to other debt is what's known as the Baa/Treasury spread, which measures the difference between the yields of corporate bonds rated Baa and 10-year Treasuries. Normally, investors demand a higher yield for corporates because of their greater risk of default. The narrower the gap between the two, the less risky investors feel corporate bonds are compared to Treasuries.

Higher rates also could mean reduced credit availability. Some observers worry that tighter credit on top of a weak housing market could hamper economic recovery. And even if there were technically no default, the mere absence of an agreement that addresses the issue before August 2 would likely raise the global anxiety level substantially.

Equities

The stock market hates uncertainty, and the greater the uncertainty, the greater the potential impact on stocks. If investors become concerned about the availability of credit, they could punish companies that rely heavily on it. Fortunately, in the wake of the 2008 financial crisis, many companies took advantage of low interest rates to issue new bonds and/or refinance older debt. Also, many companies, fearing a sequel to 2008, have been sitting on a larger amount of cash than usual, which could help cushion the impact of tighter credit.
 
Markets also will be assessing the impact of either severe budgetary cutbacks or prioritization of existing government bills on the already fragile economy as a whole. If either seems to pose a serious threat to consumer spending, equities could feel the fallout.

Payment of Government Benefits, Contracts, and Departments

According to the BPC, the country will have roughly $172.4 billion coming in during the rest of August to pay $306.7 billion of scheduled expenditures. Without an increase in the borrowing limit, the Treasury will have to rely on those revenues and prioritize which of its existing bills to pay. Here are some of the major payments scheduled for shortly after the Treasury's August 2 deadline:

Social Security payments for beneficiaries who began receiving benefits before May 1997 or who receive both benefits and Supplemental Security Income (SSI) are scheduled for August 3. Benefits for recipients with birth dates between August 1-10 are scheduled for the following Wednesday, August 10. Those with birth dates between the 11th and the 20th are scheduled for August 17, and August 24 is the date for birthdays between the 21st and the 31st.

For military service members, August 15 is the date for the scheduled mid-month installment of active duty pay, with the associated "advice of pay" notice set for August 5. And as previously noted, an estimated $90 billion in Treasury debt payments are due August 4.

Medicare, Medicaid, Social Security benefits, defense vendor payments, interest on Treasury securities, and unemployment insurance represent some of the federal government's largest costs for the month. The BPC estimates that covering those costs completely would leave no funds for such obligations as the Departments of Education, Labor, Justice, and Energy; federal salaries and benefits; military active duty pay and veterans' affairs; the Federal Transit Administration, Federal Highway Administration, Small Business Administration, and the Environmental Protection Agency; Housing and Urban Development and federal food and nutrition services; and IRS refunds.

The Outlook for an Agreement

Plans have been put forward to tie increases in the debt ceiling to a balanced budget constitutional amendment, to specific spending cuts, and to a combination of spending cuts and revenue increases. There also has been talk of a fail-safe plan that would give the president authority to increase the debt ceiling in stages before the 2012 election; Congress would be able to vote against those increases but would not be able to effectively prevent them.

One proposal that seems to have a chance of winning at least some bipartisan support is based on months of negotiations by the "Gang of Six" senators from both parties. The proposal is designed to cut an estimated $3.7 trillion from the deficit over 10 years through such measures as shrinking the current six tax brackets to three, eliminating the alternative minimum tax, revising how Social Security cost-of-living increases are calculated, and reducing tax deductions for such items as mortgage interest, charitable donations, and retirement savings.

All parties have agreed it's important not to jeopardize the country's financial health. As the road to a resolution unwinds, it can be helpful to keep calm and monitor the situation.

All investing involves risk, including the risk of loss of principal, and there can be no guarantee that any investment strategy will be successful.

Market Weekly: July 25th, 2011

The Markets

Despite the arm-wrestling both here and abroad over deficits and debt, investors clearly had no problems with risk aversion last week. The Dow saw its best day of the year on Tuesday, gaining more than 200 points, and followed it up on Thursday with a 152-point gain. With investors apparently willing to assume that U.S. lawmakers will reach an agreement on the debt ceiling by the August 2 deadline, the small-cap Russell 2000 and the NASDAQ bested their large-cap brethren. Relief over an agreement on Greek assistance helped the Global Dow recoup the previous week's losses.

Last Week's Headlines

• Heated debate: Despite reassurances all around that lawmakers would not allow the United States to default, the path to raising the U.S. debt limit continued to be elusive. The primary points of contention continued to be how long any increase should be designed to last, and the proportion of spending cuts versus revenue increases. Talks between the White House and House Majority Leader John Boehner over a package that would cut $3 trillion to $4 trillion from the deficit over 10 years broke down Friday. However, congressional leaders continued to explore various stopgap plans that would allow the August 2 deadline to be met.

• Meanwhile, anxieties about sovereign debt overseas eased a bit after European leaders agreed to a second bailout for Greece that they hope will keep the contagion from spreading. According to the agreement, bondholders will exchange their Greek bonds for ones with later maturity dates and possibly lower interest rates--a move that credit agencies have suggested in the past might be considered a "selective default." The European Union's bailout fund and the International Monetary Fund (IMF) will lend an additional €109 billion. The ability of the bailout fund to buy sovereign debt also will be expanded, and guarantees of backing for the bonds would enable the European Central Bank to accept troubled bonds as collateral.

• Housing starts were up 14.6% in June, according to the Department of Commerce. That's almost 17% higher than last June's number. Multifamily buildings showed the most improvement.

• Sales of existing homes fell 0.8% in June. According to the National Association of Realtors®, it was the third straight monthly decline.

• The global uncertainty helped the price of gold briefly top $1,600 for the first time. Oil prices turned back toward $100 a barrel, but the International Energy Agency did not release additional emergency stockpiles.

Eye on the Week Ahead

With the European debt crisis back on simmer, investor sentiment may reflect the week's stream of headlines. Progress or lack thereof on resolution of the U.S. debt ceiling dilemma is likely to eclipse earnings reports and the first look at second-quarter economic growth.

Key dates and data releases: new home sales (7/26); durable goods orders (7/27); pending home sales (7/28); labor costs, initial estimate of gross domestic product (GDP) for Q2 (7/29).

Data source: Includes data provided by Brounes & Associates. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. Equities data reflect price change, not total return.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indexes listed are unmanaged and are not available for direct investment.

Multi-Generational IRA

The term "stretch IRA" has become a popular way to refer to an IRA (either traditional or Roth) with provisions that make it easier to "stretch out" the time that funds can stay in your IRA after your death, even over several generations. It's not a special IRA, and there's nothing dramatic about this "stretch" language. Any IRA can include stretch provisions, but not all do.

Why is "stretching" important?

Earnings in an IRA grow tax deferred. Over time, this tax-deferred growth can help you accumulate significant retirement funds. If you're able to support yourself in retirement without the need to tap into your IRA, you may want to continue this tax-deferred growth for as long as possible. In fact, you may want your heirs to benefit--to the greatest extent possible--from this tax-deferred growth as well. But funds can't stay in your IRA forever. Required minimum distribution (RMD) rules will apply after your death (for traditional IRAs, minimum distributions are also required during your lifetime after you reach age 70½). The goal of a stretch IRA is to make sure your beneficiary can take distributions over the maximum period the RMD rules allow. You'll want to check your IRA custodial or trust agreement carefully to make sure that it contains the following important stretch provisions.

Key stretch provision #1

The RMD rules let your beneficiary take distributions from an inherited IRA over a fixed period of time, based on your beneficiary's life expectancy. For example, if your beneficiary is age 20 in the year following your death, he or she can take payments over 63 additional years (special rules apply to spousal beneficiaries).

As you can see, this rule can keep your IRA funds growing tax-deferred for a very long time. But even though the RMD rules allow your beneficiary to "stretch out" payments over his or her life expectancy, your particular IRA may not. For example, your IRA might require your beneficiary to take a lump-sum payment, or receive payments within five years after your death. Make sure your IRA contract lets your beneficiary take payments over his or her life expectancy.

Key stretch provision #2

But what happens if your beneficiary elects to take distributions over his or her life expectancy but dies a few years later, with funds still in the inherited IRA?

This is where the IRA language becomes crucial. If, as is commonly the case, the IRA language doesn't address what happens when your beneficiary dies, then the IRA balance is typically paid to your beneficiary's estate. However, IRA providers are increasingly allowing an original beneficiary to name a successor beneficiary. In this case, if your original beneficiary dies, the successor beneficiary "steps into the shoes" of your original beneficiary and can continue to take RMDs over the original beneficiary's remaining distribution schedule.

What if your IRA doesn't stretch?

You can always transfer your funds to an IRA that contains the desired stretch language. In addition, upon your death, your beneficiary can transfer the IRA funds (in your name) directly to another IRA that has the appropriate language.

And if your spouse is your beneficiary, he or she can also roll over the IRA assets to his or her own IRA, or elect to treat your IRA as his or her own (if your spouse is your sole beneficiary). Because your spouse becomes the owner of your IRA funds, rather than a beneficiary, your spouse won't have to start taking distributions until he or she reaches age 70½. And your spouse can name a new beneficiary to continue receiving payments after your spouse dies.

Stretching your IRA--a case study

Jack dies at age 78 with an IRA worth $500,000. He had named his surviving spouse, 69-year-old Mary, as his sole beneficiary. Mary elects to roll over the funds to her own IRA. Mary names Susan, her 44-year-old daughter, as her beneficiary. At age 70½, Mary begins taking required minimum distributions over a period determined from the Uniform Lifetime Table. (Mary is allowed to recalculate her life expectancy each year.) At age 79, Mary dies and Susan begins taking required distributions over Susan's life expectancy--29.6 years (fixed in the year following Mary's death). Susan names Jon, her 30-year-old son, as her successor beneficiary. Susan dies at age 70 after receiving payments for 16 years, and Jon continues receiving required distributions over Susan's remaining life expectancy (13.6 years). (See assumptions below.)

Year 1	Mary becomes owner of Jack's IRA
Year 3	Mary begins taking distributions at age 70½ over her life expectancy
Year 12	Susan begins taking distributions the year after Mary's death over Susan's life expectancy
Year 28	Jon begins taking distributions over Susan's remaining life expectancy
Year 40	All of Jack's IRA funds have been distributed

Under this scenario, total payments of over $2 million are made over 40 years, to three generations.

Note:   Payments from a traditional IRA will generally be subject to income tax at the beneficiary's tax rate. Qualified distributions from a Roth IRA are tax free.

Assumptions:

• This is a hypothetical example and is not intended to reflect the actual performance of any specific investment portfolio, nor is it an estimate or guarantee of future value.
• This illustration assumes a fixed 6% annual rate of return; the rate of return on your actual investment portfolio will be different, and will vary over time, according to actual market performance. This is particularly true for long-term investments. It is important to note that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.
• All earnings are reinvested, and all distributions are taken at year-end.
• The projected figures assume that Mary takes the smallest distribution she's allowed to take under IRS rules at the latest possible time without penalty.
• The projected figures assume that tax law and IRS rules will remain constant throughout the life of the IRA.

The U.S. Debt Ceiling: What It Is And Why It Matters To You

The 3 Phases of Your Financial Life

1. ACCUMULATION (years 20-60 approx.)
Phase 1 is titled “ACCUMULATION”. This is the phase of your life where you should concentrate on the accumulation of assets. These assets you are accumulating should be the main focus of what will ultimately fund your retirement years. Since you are younger during this phase and have more time to wait, you can afford to be more risky in your choice of investing.

Experts of Phase 1:

• Brokers: Most brokers deal in primarily managed money, or investments that require constant monitoring. Although you are at the risk of the stock market, you can achieve the highest return from the types of accounts that most brokers specialize in. Brokers (such as money managers from firms like Merrill Lynch, Edward Jones, etc.) make their money by the continued management of the funds they sell to their clients. Without money to manage, they do not make a fee/commission.

Common Investment Vehicles of Phase 1:

• Mutual Funds, ETFs, common and preferred stocks, model portfolios 
• Asset Allocation (diversified portfolios of risk-based investments)

2. PRESERVATION (years 60-through death)
Phase 2 is titled “PRESERVATION”. During this phase, you should concentrate on preserving the assets you have worked all your life to accumulate. Time is growing shorter and shorter and you now have less time to get back what you may have already lost. Since timing is so important, you must understand exactly how much risk you can afford to take on. Based on your income needs as well as the goals you have set for your hard-earned retirement dollars, you must invest accordingly. Keeping your money safe during this phase is a key component to achieve a stable income plan, one that you cannot outlive and can always rely on.

Experts of Phase 2:

• Retirement and Estate Planners: Financial professionals that focus their energy solely on retirees or those soon to be retired, deal with investments that focus on the preservation of assets. Planning for retirement is a tricky business that many investors do not have a sound plan for. Rather than accumulation of assets, the preservation of what you accumulated plays a significant role in providing you with an income plan. Almost 60% of retirees run out of money before they run out of life because they have not altered their investment strategies upon entering this phase of life.

Common Investment Vehicles of Phase 2:

• CD’s, Insured Deposits, Government Bonds, Fixed Annuities, Fixed Indexed Annuities, Fixed Income Models 
• True Diversification (safe investments with risk tolerance according to individual situations)

3. DISTRIBUTION (beyond death)
Phase 3 is titled “DISTRIBUTION”. This phase determines what happens to the money you have preserved throughout phase 2. Depending on your current financial situation, you may or may not have money left over when your retirement plan has run its course. For those who properly plan to have assets left over for their heirs, it is important that you achieve a distribution (or “estate”) plan.

Experts of Phase 3:

• Estate Planning Attorneys and Retirement Planners: The most important objective once you have passed away is the distribution of your retirement assets to your heirs in the most efficient and tax advantageous way possible.

Common Investment Vehicles of Phase 3:

• Wills, Trusts, Power of Attorney, etc. 
• Avoiding probate and estate tax