Wealth Management is Crisis Management

If you are like most, you’re experiencing quite a bit of anxiety right now as we grapple with a pandemic health crisis. The human, economic and market fallout are unnerving. Unfortunately, we know the headlines will get worse before they get better. Confirmed COVID-19 cases will grow exponentially, and dismal economic data resulting from the economic shutdown will be jarring. Fear is a very natural response when faced with a crisis. However, despite the emotional response that may feel natural in the moment, maintaining discipline during periods of uncertainty is the most reliable course for preserving and growing long-term wealth.

While we do not have all the answers as to when the current situation will stabilize, one thing we can say with certainty is that the future will not look like today. History has consistently repeated itself with respect to how bear markets, pandemics and financial crises end. No matter how different these events have started out in the beginning (with each event’s seemingly unprecedented nature at the outset) or how destructive the events may have been as they ran their course, they eventually wind down and pass, things regrow and life returns to normal.

Navigating The Crisis – Have A Plan

Studying the navigation of prior crises reveals that the success formula almost always includes having a plan. In fact, a plan is foundational to successful wealth management. Understanding goals and objectives, cash flows, balance sheets, time horizons, and unique circumstances ensures a purpose-built plan weathers various economic environments and market gyrations. At Greenleaf Trust, financial plans are created for clients at the onset of each relationship and are reviewed regularly. Comprehensive wealth management plans serve as the rudder to navigate through choppy financial waters.

The plan identifies what’s most important and what measures can be used to protect in periods of extreme uncertainty. Of which, asset allocation and diversification are the most powerful tools. While these tools are our best allies in the war against volatility, it does not mean one is immune to major drawdowns. Stress tests via advanced Monte Carlo modeling help provide assurance of goal attainment in the midst of a crisis. As evidenced by recent markets, the short term can be exceedingly unpredictable. Over the long term, however, we know to expect numerous shocks along the way and create financial plans as well as the investment portfolios supporting those plans to achieve each client’s very specific goals with these unnerving periods in mind.

Historical Perspective

Over the last 150 years, we’ve been through wars, pandemics, recessions, depressions, natural disasters, man-made disasters, political upheaval, etc. What happened with each crisis? The market met its floor and recovered. Even the worst market declines have generally been followed by a significant recovery. While no one knows exactly when major market drawdowns are going to occur, or how painful they will be, we do know that they will occur. In fact, they are part of being a long-term investor. From a historical standpoint, they also tend to lead to outperformance in the months and years that follow. In an ideal world, investors buy low and sell high. In the real world, investors often do the exact opposite—buy high and sell low—especially during volatile times.

History tells us that investors are much better off staying disciplined rather than trying to jump out, then back into, the market. This is because timing the market is incredibly difficult if not impossible. Selling after a major drawdown ensures that capital is destroyed unless one can perfectly time when to get back in. It is important to consider that when you take inflation and dividends into account, the re-attainment of prior bear market portfolio peaks takes just over two years on average from the market’s bottom. Even in the case of the great depression, this equates to about 4.5 years when you take into account dividends and inflation according to Ibbotson data from Morningstar. Sitting in cash and missing the first month of a recovery can often be just as devastating from a long-term wealth perspective as enduring the first month of the bear market decline. For example, the first month of the 2008 financial crisis recovery saw a 30% equity market return.

What If This Time Is Different?

In short, it is always different. Successful investors know that it is best to stay disciplined to a purpose-built wealth management plan in order to achieve financial goals and objectives. However, stay the course is not the same as set it and forget it. It is simply a disciplined approach to meet specific goals. It works because it is really hard to do. It is hard to stay disciplined. It is hard to keep your head when others are losing theirs. It is even harder to rebalance out of investments that do well in crisis like US treasuries into investments that have been hardest hit like stocks. Conviction in this approach and discipline to execute it characterize historically successful investors. Not saying be calm and carry on. Not trying to provide short-term emotional comfort. Simply suggesting historical perspective reveals discipline has been the best approach to position for long-term goal achievement.

What Actions Should I Take Now?

We are not advocating wholesale changes like going to cash or doubling down on stocks. However, we do recommend reviewing each investor’s situation and portfolio in light of their guiding financial plan for prudent moves to make in the current environment. Barring changes in your unique circumstances, your long-term strategy generally should not change. However, short-term tactics certainly will. Some timely tactics to consider may include:

• Focus on Cash Flows – Having an emergency fund is at the foundation of financial planning. Additionally, one should not invest short-term money into long-term investments. This is a given, but even more critical to remember during times of crisis. Surveying one’s cash flow needs is often a good starting point to find comfort to stay disciplined. Demand on capital is the term typically used in this context. It is defined as simply the amount of capital you need from your portfolio on an annual basis to support your current lifestyle. For example, if you require 4% of the portfolio to sustain your current annual spending and hold at least that much in cash, you would have a year’s worth of living expenses covered. Next, consider your allocation. For example, a 60/40 portfolio represents an allocation of 60% long-term growth oriented equities fully subject to the market volatility, and 40% principal preservation oriented fixed income and cash with return of principal as the primary objective and return on principal as secondary. In the above scenario, cash and fixed income would be sufficient to cover approximately 10 years of living expenses. So, unless the economy is permanently impaired and incapable of recovering in the next 10 years, you would not be forced to sell equity to sustain your current lifestyle at depressed prices in this scenario. If, after assessing cash flows, you find them more than adequate, you might even consider directing a portion of your emergency fund to help with the emergencies of others. Options to help the most vulnerable in your community might include local food banks, community relief funds and non-profits providing medical supplies to front-line responders just to name a few.
• Rebalance – Simple rebalancing is a proven value-add technique that realigns the portfolio with your long-term target asset allocation. It rotates out of investments that have performed relatively better and into investments that performed relatively worse. Over-time, disciplined rebalancing forces the buy-low, sell-high practice that characterizes successful investing.
• Tax Loss Harvest – This strategy involves swapping into similar investments to capture losses that can be used to offset future capital gains. It is an easy way to generate tax alpha in highly uncertain environments. However, look at tax loss harvesting as an opportunity to reposition portfolios to better options as opposed to just a way to capture losses. This could mean better managers, more tax efficient vehicles, establishing asset location strategies, facilitating distribution sequencing, exiting legacy holdings, reducing concentration risk, etc.
• Shop The Sale – Compelling investments at relative bargain prices often accompany a crisis. While “cheap” stocks usually come to mind in this context, don’t overlook other asset classes as well. In late March, for example, we sold a number of US Treasury positions for clients at sizable gains in favor of pre-refunded municipal bonds yielding up to 10 times that of the corresponding Treasury. The pre-refunded status translates into essentially the same credit risk because US Treasuries are backing the full value of the municipal bond. Despite the same credit risk, however, the market disruption meant you could swap a two-year Treasury yielding almost nothing for a two-year pre-refunded municipal bond offering a relatively generous 3% yield. Given the preferential tax status of municipal bonds, this makes the investment for those in the upper income tax brackets comparable to a 5% after-tax equivalent bond – an incredible opportunity for the minimal level of risk brought to us by the crisis, but it was only available for a short window.
• Consider a Roth Conversion – For many investors, calendar year 2020 may represent an opportune time to consider converting a traditional IRA to a Roth IRA. Relatively lower portfolio levels translate into lower taxes due upon conversion compared with just a few weeks ago. When the recovery takes hold, the assets grow on a tax-free basis as opposed to a tax-deferred basis. Additionally, calendar year 2020 may represent a lower income year for many given the depressed economic activity. This presents additional opportunities to manage tax brackets and convert a portion of an IRA to a Roth while staying within a targeted marginal tax threshold.
• Take Advantage of Low Interest Rates – The Federal Reserve has lowered interest rates and also increased the amount of short-term loans it offers banks to keep cash flowing smoothly. Refinancing a mortgage may be advantageous at this time. However, it does not always make sense to refinance debt, nor does this mean that mortgage rates will necessarily go down, so do your research and make sure you understand your options carefully. Low interest rates also present a number of estate planning opportunities that may help those with sizable estates shift wealth to future generations in a tax efficient manner. These strategies are outlined in detail within my colleague George Bearup’s article entitled “Is Your Estate Plan In Order?” also found within this issue of Perspectives.
• Leverage Policy Responses – In response to the growing coronavirus pandemic and its resulting impact on the US economy, Congress passed the Coronavirus Aid, Relief and Economic Security Act (CARES Act) on Friday, March 27. This stimulus package, estimated at more than $2 trillion, is the most expansive to-date. While the Act’s nearly 800 pages are still being fully digested, a few of the potential tactics we believe investors should be aware of include:
  • Small Business Support: The Act guarantees up to $349 billion in loans towards businesses with under 500 employees. Most appealing is the fact that loans may be fully or partially forgiven. Any portion of the loan used to make payroll, pay for utilities, rent, mortgage, and existing business debt may be forgiven, dollar-for-dollar. Among other qualifications to receive this dollar-for-dollar loan forgiveness, however, workers need to remain employed through the end of June.
  • Taxable Distributions: Required Minimum Distributions (RMDs) have been suspended for calendar 2020 from qualified defined contribution plans and IRAs. In most cases forgoing these previously mandatory distributions and instead withdrawing from taxable accounts for living expenses may lower your tax bill. If you were considering a qualified charitable distribution (QCD) to satisfy your RMD, it might also make sense from a tax efficiency perspective to instead use appreciated assets or cash from a taxable account to satisfy the charitable intent in 2020. If you completed your RMD within the last 60 days, you may even be able to refund the amount to take advantage of this tactical opportunity via IRA rollover rules.
  • Charitable Deductions: Adjusted Gross Income (AGI) limitations have been suspended in calendar year 2020 for charitable contributions made in cash to 501(c)(3) public charities (except supporting organizations and donor advised funds). This allows taxpayers who itemize deductions to elect to deduct up to 100% of their AGI remaining after accounting for all other charitable contributions subject to AGI limitations. For taxpayers that do not itemize deductions, the CARES Act provides for a new “above-the-line” charitable deduction up to $300.

While the current crisis is certainly unprecedented, humanity has an undeniable history of persevering and ultimately conquering seemingly insurmountable challenges — time and time again. So too will we get through this as life eventually returns to normal. While tactics evolve to fit the landscape, comprehensive wealth management plans are purposefully built for times like these. Maintaining discipline in the pursuit of financial goals and objectives will prove prudent as this crisis subsides.