Surviving the Economic Storm:
How to Protect Your Financial Future
Have the recent events in our financial system left your head
spinning and your stomach turning? Have your 401(k), IRA and
other investment accounts taken serious losses? Is your home
worth less than it was a year ago? Have you noticed that just
about everything … food, energy, entertainment … has become
You are not alone. We are in the midst of the greatest
economic storm to hit our economy since the Great Depression.
While we have not experienced the unemployment, poverty and
dislocation that characterized the 1930s, these are
challenging times for our nation.
Unlike the depression, the government has acted quickly and
taken unprecedented measures to save the economy from
collapsing. The Federal Housing Finance Agency took control of
the nation’s two
largest mortgage companies, Fannie Mae and Freddie Mac and
placed them in federal conservatorship. The Federal Reserve
orchestrated the takeover of Bear Stearns by JP Morgan Chase
and provided $30 billion in credit in the process. The Fed
also provided over $123 billion in emergency loan to rescue
multinational insurer AIG.
After allowing investment bank Lehman Brothers to fail and
then concluding that the government could no longer continue
to respond to the crisis through a series of individual
actions, the Treasury Secretary,
the Chairman of the Federal Reserve and the Chairman of the
Securities and Exchange Commission proposed to Congress a $700
billion program that would attempt to stabilize the financial
system. Following a highly charged national debate and much
political maneuvering, Congress passed the legislation. The
Fed has provided liquidity to the money market and the
commercial paper market. More recently, the Fed, acting in
concert with central banks around the world, reduced key
interest rates by 0.5%.
What happens next? No one knows for sure. However, there is a
widespread belief in the economic community that this
storm won’t pass any time soon. It will probably take months,
if not years, for the government’s efforts to stabilize our
Assess The Situation
So, what can you do right now while we struggle through this
storm? “Nothing” and “wait it out” are not the right answer.
It is very natural to be reluctant to confront the damage a
storm like this has inflicted on your financial situation. But
this will not make it go away and it will certainly not repair
it. Now is the time to look very seriously at your situation
and take the appropriate actions to deal with it.
While you will not need to examine every aspect of your
financial situation, there are areas that have been directly
affected by this storm and you need to examine the damage and
decide what to do about it.
The place to start is your budget. But, you say, you don’t
have a budget. Well, really you do. It’s just not written
down. Every entity that has income and expenses has a budget.
A budget becomes useful
when you can use it to achieve your financial goals. So, time
to open Microsoft Excel, Quick Books, an online financial
website with budget tools or simply get out some notebook
paper and a calculator.
A household budget itemizes income and expenses. Traditionally
income goes on the left hand side of the ledger and expenses
go on the right hand side. The difference between income and
expenses is either savings or a deficit. Pretty simple, right?
Hopefully, your budget indicates a savings. You are taking in
more than you are spending. This should allow you to save
money for your future. This is a very good thing, because it
provides resources to pay for unexpected expenses and for
those items you plan to purchase in the future.
In addition, your savings will help you pay for your normal
household expenses when you are not earning an income. This
could happen if you become disabled, you go back to school, or
you take off time from work to travel or care for a family
member. When you stop working and retire, your savings, along
with Social Security and your other retirement programs, will
be an important source of income.
Financial planners suggest that you keep 3-6 months times your
monthly income needs in some kind of emergency fund. So, if
your expenses are $6,000 a month, you need to have $18,000
-$36,000 very liquid. It could be a money market account, cash
value in life insurance or a simple savings account.
If you are like most Americans, your rate of savings may not
all that great. According to the US Bureau of Economic
Analysis the personal savings rate in the country has hovered
between negative 0.5% and
just over 3% since 2000.
Many Americans have been spending more than they have been
earning in income for some time. How? By borrowing or spending
down existing assets. The typical approach to borrowing
involves financing spending with credit cards, auto loans and
other consumer debt. In addition, many people have taken
equity out of their homes through refinancing of their primary
mortgage, the creation of a second mortgage or a home equity
line of credit. Some people have consumed savings and
Regardless of the method, a situation in which expenses exceed
income is not sustainable. Eventually, the debt that is
incurred through excessive spending will overwhelm the
household. Credit will no longer be available and lenders will
So, if you find, upon reviewing your budget, that your
expenses are greater than your income, it’s time to make some
changes. You need to adjust your finances, so that you are
saving. How? Through some
combination of reducing expenditures and increasing income.
There are many ways to reduce or eliminate expenses. Some are
rather modest and simple such as cutting back on visits to
Starbucks. Others are more profound and involved such as
moving into a less expensive residence if you have decided
that you cannot afford to live in your current residence.
What about increasing your income? You could find a better
paying job, take on additional part time work or start a
business on the side. If you are not currently working, you
could return to work.
How much do you need to save? That all depends on your
financial situation and your goals.
The Balance Sheet
This leads us to the next step in the personal financial
assessment. A balance sheet summarizes assets and liabilities.
An asset for the purposes of personal finance is anything that
you own that can be converted to cash. You probably have a
wide variety of assets including a home, savings, and
investments. People have assets because they purchased them
with income they earned or they received them as a gift or
A liability is an amount owed arising from a transaction like
the purchase of a house or a car. Liabilities are settled when
then the borrower pays back the lender the amount owed plus
any accrued interest. Household liabilities include credit
card debt, auto loans, and home mortgages.
To create a balance sheet, you simply list assets on the left
hand side of your ledger and liabilities on the right hand
side. Assets minus liabilities equal net worth. This is your
net financial position.
It is rather likely that if your balance sheet will be weaker
today than it was 1 year ago. Why? Housing values have fallen
and the stock market has declined almost 40%. So, the assets
you own are worth less now. Even if your liabilities have not
gone up, your net worth could be lower.
The significance of net worth becomes apparent when you begin
to contemplate your future. If you would plan to stop working
someday (i.e. retire), you will need to replace the income
from your work with income from other sources. You will
probably have Social Security benefits, but that is not
sufficient for most people.
If you are very fortunate, you will have a pension that you
earned during your working years. This may come from a large
corporation, labor union or state or federal government. While
pensions were more common in the last century, today most
people do not receive pensions.
So you will need to supplement the income you do receive with
income from assets that you accumulate during your working
years. The more assets you have the greater your ability to
create income in retirement. The actual amount of assets you
will need is, of course, directly related to the amount of
income you expect to need in your retirement years.
The process of determining this sum of money, sometimes
loosely referred to as “the number,” is a bit more
complicated. It requires not only projecting your budget
(income and expenses) in your retirement years, but also
making assumptions for important factors such as inflation,
tax rates and investment returns.
If you are proficient with a financial calculator, you may be
able to do the calculations necessary to determine your
number. This will require understanding important financial
concepts such as the time value of money, compound interest
and inflation. You may wish to check your calculations with
someone you trust who understands the math involved.
There are online calculators at numerous websites that allow
an individual to estimate how much money is needed to fund
retirement and how much additional savings is required to
reach that sum.
These calculators really vary in terms of their complexity
and, therefore, their accuracy. Be sure to use several of them
and then compare the results.
Alternatively, you could work with a CERTIFIED FINANCIAL
PLANNER™ who uses financial planning software to model
retirement scenarios for clients. The advantage to this
approach is that you will work with an
expert who has the knowledge and the technical tools to guide
you through the retirement planning process.
Now that you have established your budget, your balance sheet
and your retirement number, it’s time to turn your attention
to your savings and investments.
You probably have money sitting in a bank, a credit union
savings and loan or an online brokerage firm. Given the recent
failure of several of these institutions, you may be concerned
about the security of your holdings.
The Emergency Economic Stabilization Act, which was signed
into law on October 3, 2008, included provisions to increase
deposit insurance through the Federal Deposit Insurance
Corporation (FDIC). The new limit is $250,000 per depositor
per bank. This is a temporary guarantee through December 31,
FDIC insurance covers all types of deposits received at an
insured bank, including deposits in checking, NOW and savings
accounts, money market accounts and time deposit such as
certificates of deposit (CDs).
If you happen to have more than $250,000 in any of these types
of bank accounts, you should seriously consider transferring
it, so that your funds are fully insured. This can be done in
a variety of ways by opening additional accounts with
different registrations inside your existing banking
institutions or by moving funds to a separate FDIC-insured
You should be aware that traditionally money market accounts
held through a securities/brokerage firm have not been insured
against loss. This has been a problem recently as a few money
have fallen below the investment of value $1.00 per share, a
rare phenomenon known as “breaking the buck.” As a result,
several money market accounts have been liquidated and closed.
In response to the disruption this created in the money market
sector of the capital markets, The Treasury Department
announced in that it would guarantee money market funds
against losses up to $50 billion using the Exchange
Stabilization Fund which was established in the 1930s.
However, this is a temporary guarantee program and applies to
shareholders of money market accounts as of September 18,
2008. In addition, the money market fund sponsor must pay a
fee to participate in the program. This federal backing is not
automatic. So, if you own a money market account, you should
contact the sponsoring institution to determine if your funds
fall under the Treasury guarantee program.
Now it’s time to review your investments. This probably won’t
be much fun. But you need to survey the damage. So, gather
your most recent quarterly investment reports for your IRAs,
your 401(k) and your
non-retirement investments. The process outlined below is
relevant to all of your investments in the financial markets
(stocks, bonds, real estate, etc).
The stock market has been in a period of decline since last
October. So, your investments have probably lost value. While
this is disconcerting, it does create some opportunities. For
example, you can sell the investments that have underperformed
the market and buy others that you meet your needs. Before you
consider selling the losers in your portfolio, however, you
should take a broader view of the landscape.
Investment Policy Statement (IPS)
Start by reviewing your investment policy statement. If you
work with a professional investment advisor, you should have
an IPS. If you manage your own investments and don’t have an
IPS, you will benefit greatly from putting one together.
This is the document that outlines your investment situation.
What is the goal? How much will you need? When will you need
it? It describes your tolerance for risk and your capacity to
accept losses. It summarizes your investment objectives: rate
of return, acceptable levels of risk and levels of volatility.
It describes the general investment philosophy that underlies
your investments, such as active or passive. It addresses
investment criteria such as asset allocation, diversification,
and liquidity. It will indicate the kinds of investment
vehicles that are to be used to accomplish your goals and
those that are not. It will provide monitoring procedures,
including frequency of review, performance evaluation
criteria and rebalancing practices. It will provide guidance
relative to trading costs, investment expenses, and taxes.
To create your own IPS you could simply write it using basic
word processing software. You could also use one of the
financial planning web sites that offer tools and templates to
create an IPS. If you work
with an professional advisor to manage your investments, the
creation of an IPS should be part of the process.
Think of your IPS as your flight plan. If you were a pilot you
would formulate a plan about your destination, estimated
flying time, alternate routes, contingency plans, etc. Once in
the air, you would refer to the visual surroundings, the
plane’s instruments and the flight plan to
monitor your progress toward your arrival point.
If, while flying the plane, you found yourself in a storm, the
flight plan would provide critical information about how to
make adjustments so that you would still reach your intended
destination. The IPS serves a similar purpose in a financial
storm. It will keep you on course even if you have to make
significant adjustments to your original plans.
While there are many approaches to investing, there is a
consensus in the investment community that successful
investors follow certain principles. Keep these in mind as you
review your current investment
Asset Allocation refers to the process of spreading your
assets across a variety of asset classes. An asset class is a
kind of investment such as equities/stock, fixed income/bonds,
real estate and cash. Depending on the source, there are
between three and thirty some asset classes.
Considerable academic research indicates that asset allocation
affects investment performance more than any other factor,
such as timing the market or security selection. The reason
for this is that over time asset classes will perform in ways
that are not correlated to each other. As one investment zigs,
another will zag. The process of selecting several asset
classes within a portfolio dampens volatility and enhances
long term performance.
Proper asset allocation is influenced by the various factors
included in the investment policy statement. So, to determine
if your current asset allocation is appropriate, refer to your
If recent losses in your portfolio are causing you to question
the appropriateness of the asset allocation set forth in your
IPS, then you really need to carefully review your overall
approach to investing.
Volatility is inherent in investing. How much volatility (i.e.
declines in value) are you willing to accept in return for
long term gains (i.e. increase in value)?
Too often investors make changes in their portfolios, because
of losses that occur in their holdings over a short period.
This causes them to lock in losses and, in many cases, miss
the recovery that inevitably follows.
Successful investing involves managing one’s emotions in times
of market instability. It requires resisting one’s inclination
to flee the market when the masses are leaving.
Diversification involves spreading funds across a large number
of investments, rather than concentrating them in just a few.
This process generally reduces risk and yields higher returns.
Each asset class inside your portfolio should be diversified.
As an example, if you own large cap stocks as one of your
asset classes, you would own many such stocks, not just one or
two. Most investors
don’t have enough investable assets to achieve meaningful
diversification by investing in individual securities. An
attractive alternative would be to use mutual fund and/or
exchange traded funds inside each asset class to achieve the
If you participate in a 401(k) plan or other
employer-sponsored retirement plan, be particularly mindful of
not having too much of your investments in your company’s
stock. While you may be employed by a
strong company that you admire, prudence dictates that you
diversify. Many of the employees of local companies like
Portland General Electric (remember the Enron story?), Intel
(tech crash), and Washington Mutual (mortgage crisis) paid a
serious price for not diversifying their retirement accounts.
Most investors do not realize how important expenses are to
overall investment returns. The performance of your portfolio
is directly affected, in an adverse way, by the various
expenses you incur. These expenses include trading charges,
brokerage commissions, mutual fund sales loads, internal fund
expenses, management fees, and custodial fees. These expenses
create a significant drag on a portfolio. When totaled they
can amount to 2.0-3.0% of a portfolio.
Unfortunately, when you review your investments, you may not
be able to identify all the expenses you are incurring. For
example, if you own mutual funds, you may need to ask your
broker/advisor about the expense ratio for your funds, because
they will not appear on your investment summary. If you are
managing your own portfolio, you probably know these costs. If
you don’t, you can do some web based
research on sites like Morningstar, FINRA or any of the online
You should be as focused on minimizing your investment
expenses as you are on maximizing your investment returns. If
you were to eliminate 1% of expenses on a $1 million
portfolio, you would save $10,000. If you were able to
maintain this savings over a period of 20 years and earn an
average return of 8%, your savings would amount to $457,620.
That’s a significant sum to any investor.
Deducting Investment Expenses
Most investors do not realize that there are investment
related expenses that they may deduct on their tax return.
Expenses related to the production of income not associated
with the purchase or sale of a
specific security are deductible if they exceed 2% of adjusted
To take advantage of these deductions, you must itemize using
Schedule A of Form 1040. The expenses must be paid or incurred
by you. If you have an IRA, you don’t actually own it. Your
trustee owns it and you are the beneficiary. Therefore, you
may not deduct fees related to your IRA unless you pay for
these fees out of your pocket.
The expenses you may deduct include investment advisory fees,
investment software, investment magazines, investment related
accounting and legal fees, and investment account maintenance
Note that if your income exceeds certain thresholds or you are
subject to the Alternative Minimum Tax, you may lose some or
all of these deductions. So, work with a tax professional and
check the numbers
and your eligibility.
Tax Efficient Investing
Another way to evaluate your investment portfolio will require
you to pull your income tax returns from the past few years.
Look for lines on your returns that show investment income
(taxable interest, tax-exempt interest, ordinary dividends,
qualified dividends, and capital gain/loss). You would have
received corresponding documentation for this income such as
Form 1099-DIV, Form 1099-B, Form 1099-INT and/or Form
Taxes can seriously erode the value of a portfolio and reduce
investment income. Therefore, investments should be evaluated
for their tax efficiency. Mutual funds tend to be fairly tax
inefficient, because of the way they are structured and
operate. Exchange traded funds and index funds, on the other
hand, tend to be more tax efficient.
The issue is how much taxes are you paying relative to the
size of your portfolio and relative to the income you are
actually receiving from your investments. Get out a calculator
and determine your after-tax returns on your investments. The
results may surprise you. During the decade that ended in
2007, for instance, Lipper estimated that fund investors lost
anywhere from 17% to 44% of their returns to taxes.
Capturing Tax Losses
Given that the equity markets have fallen to levels not seen
in several years, you may be able to take some tax deductions
for losses. However, you should follow a disciplined approach
as you consider
capturing these losses.
Investments should not be sold simply because they have lost
value. Rather, each investment should be evaluated
individually and in the context of its place in your
portfolio. If an investment no longer meets
the criteria you established in your investment policy
statement, then it would be appropriate to dispose of it. If
this action creates a loss, then you should take full
advantage of the loss for tax purposes.
According to the Internal Revenue Code, you may use investment
losses to offset investment gains. If your losses exceed your
gains, you may deduct up to $3,000 in investment losses.
Losses in excess of $3,000 may be carried forward into future
If you decide to sell an investment, because it no longer
satisfies the criteria in your IPS, and replace it with one
that does, be careful. The Internal Revenue Service’s Wash
Sale Rules state that an investor
may not claim a loss on the sale of an investment if a
“substantially identical” investment was purchased within 30
days before or after the sale date. While the IRS has not
provided clarification of what this term means, smart
investors will not take actions that jeopardize their ability
to take a loss.
If you have questions about the tax consequences of your
possible investment decisions, you should consult a qualified
Given the volatility of the financial market over the past 12
months, your investments are almost certainly no longer
allocated as your investment policy statement states. Even if
most of your holdings are down, they probably did not fall in
tandem and a few may be up.
Rebalancing is the process of realigning the weightings of
your portfolio so that the allocation once again is consistent
with your IPS. It involves buying and selling across your
holdings. It should be done at least annually and preferably
IRA Tax Planning
If you own an Individual Retirement Account (IRA) and have
been considering converting some or all of it to a Roth IRA,
the current bear market may present an excellent opportunity.
Roth IRAs are attractive,
because not only do the assets inside them grow tax free, but
they may be withdrawn tax free. In addition, there are no
rules requiring that you take distributions soon after turning
Converting from a traditional IRA to a Roth IRA requires
paying ordinary income tax on the amounts converted. Given
that the values in your IRA are probably significantly lower
than they were a year ago, now may be an excellent time to do
the conversion. The income taxes due will be lower.
Keep in mind that there are income limitations that apply to
those considering a Roth IRA conversion. If your gross income
is $100,000 or more, you may not convert. However, this limit
has been removed for
conversions that occur in 2010. In addition, those who convert
in 2010 may pay the income tax associated with the
conversation in 2011 and 2012 (half in each year).
You have probably heard that some of the nation’s insurance
companies have exposure to some of the same problems that have
been plaguing banks. You may be wondering if your insurance
coverage will be affected.
There are several ways you can check on the status of your
insurance company. You can start by contacting your insurance
agent or the service center for your insurance company. Ask
about the company’s exposure to the institutional mortgage
market and what portion of its portfolio is non-performing.
You may also check on the financial strength and claims paying
ability of an insurance company by reviewing their ratings
with the rating agencies: A.M. Best, Moody’s, Standard &
Poor’s, Duff & Phelps, Fitch and Weiss. If you detect a
pattern of rating downgrades and notices of heightened
monitoring, you should be concerned.
Insurance companies are regulated at the state level. So, you
may wish to contact your state insurance department and the
department of insurance in the state in which the insurance
company is domiciled. Ask about the company’s financial
condition and its ability to pay claims.
Cash Value Life Insurance
If you own cash value life insurance (e.g. whole life,
universal life, variable life), you should sit down with your
agent and review your coverage. You need to determine whether
the policy is sufficiently funded to remain in force for as
long as you live. If you stopped paying premiums on the policy
or have a loan against the cash value, the issue is even more
critical. Ask your agent for an “in-force ledger” which will
show you the policy’s values today and what they are projected
to be at (and preferably beyond) your life expectancy. If the
policy is projected to fail, you should act quickly to shore
If you own variable life insurance, you should also review the
subaccounts inside your contract. You can use the same
methodology you use when reviewing your 401(k): asset
allocation, performance, and
expenses. Also, remember to rebalance within the subaccounts.
If you own an annuity, now is a good time to review the
company that issued the contract and the annuity itself. While
annuities are generally either “fixed” or ”variable,” there
are many variations on these two structures.
You want to determine that the company that issued the annuity
is strong and capable of honoring the terms of the contract.
An annuity is really a guarantee made by an insurance that
could well last as long
as you live. It is not covered by FDIC insurance. However,
through the National Organization of Life and Health Insurance
Guaranty Associations, every state provides at least $100,000
of coverage for annuity owners if an insurance company becomes
If you are concerned about the insurance company or if you
have more than $100,000 in an annuity, it may be wise to
explore making a change. Keep in mind that your annuity
probably has a surrender penalty if you move the contract
within some stated period, typically 3-7 years.
Annuities can be exchanged in a tax-free manner called a 1035
exchange. Just be careful to follow the proper procedures to
avoid an unnecessary tax hit.
Home Mortgage Problems
If you find yourself struggling to pay the mortgage on your
home, you are not alone. Fortunately, the federal and state
governments are actively intervening in the mortgage industry
to help homeowners
remain in their homes. In addition, lenders are increasingly
reaching out to borrowers.
The place to start is with the company that holds your current
mortgage. You should contact the company and ask about options
that will allow you to restructure the loan. These may range
from a temporary reduction in the interest rate associated
with your mortgage to an actual reduction in the amount of the
If you are found to be ineligible for relief from the terms of
your mortgage, you may need to consider other solutions. Can
you afford to remain in the home? Are you able to sell the
home for more than you owe on the mortgage? If you are not
able to sell the home, can you move into a rental and lease
the home? Can you rent out a room and use the rental income to
help pay the mortgage?
If you must get out from under the house and you have little
or no equity in it, you may face some unfortunate tax
consequences. The IRS states that if you borrow money from a
commercial lender and the lender later cancels or forgives the
debt, you may have to include the cancelled amount in income
for tax purposes, depending on the circumstances. There are
some exceptions involving bankruptcy,
insolvency and non-recourse loans.
Before you make a final decision, you should obtain tax and
We are in the midst of a serious economic storm. The damage to
portfolios, house prices and other assets has been painful.
U.S. Stocks have lost $7.5 trillion in market value since
indexes hit a record on
October 9, 2007. According to Zillow 77% of U.S homes have
declined in value in the in the past year.
We may be in for more losses before the storm dissipates. But
eventually the economy will stabilize, calm will return and
the recovery will begin. But you should not wait for the sun
to appear before you assess your situation, make adjustments,
minimize your losses, maximize your tax benefits, and position
yourself for the future.
Terry Donahe is a CERTIFIED
FINANCIAL PLANNER™ who works with affluent individuals and
families. His firm, Cascade Wealth Management, is a fee only
Registered Investment Advisor located in Lake Oswego, Oregon.
You may learn more about Terry and his firm at
www.cascadewealth.com. Terry can be reached at (503)
or by email at
This information is not intended nor should it be construed as
legal or tax advice. You may wish to consult with other
professional advisors regarding how this information relates
to your personal circumstances. Commercial distribution of
this information without specific written consent from Cascade
Wealth Management, LLC is prohibited.