Expect Turbulence on the Way to a Smooth Landing - Hilliard Lyons

Spring 2012<strong>Expect</strong> <strong>Turbulence</strong> on the Wayto a Smooth LandingBy: Andrew Means, CFA,Senior Vice President, Director of Investments,Hilliard Lyons Trust Company, LLCMost all of us have experienced an airplane flight with asmooth takeoff and a comfortable cruise when the pilotsuddenly announces to the passengers that they shouldreturn to their seats and buckle their seat belts. The pilotgoes on to say that the flight crew expects turbulenceahead which may cause some uncomfortable bumpinessfor a period of time. After enduring several periods ofchoppiness, the ride once again smoothes out and youland at your destination safe and sound. This tale is analogousto our expectations for the stock market as we lookahead. Let me explain.As a regular reader of this quarterly commentary shouldknow, we have been quite enthusiastic about the potentialreturn from stocks as the economy and the stockmarket have mounted a recovery from the deep recessionand brutal bear market of several years ago. During thisrecovery period, businesses have exhibited considerablefinancial strength, valuations have been cheap, and centralbanks have flooded the world with liquidity. Eventhough the stock market has just completed the strongestQ1 performance in 14 years, we continue to feelthat stocks offer the long-term investor attractive rates ofreturn. Stocks are especially appealing when comparedto the subpar returns one can expect from bonds in thislow interest rate environment. We maintain our expectationof a safe arrival at the final destination of attractivereturns from stocks, but we anticipate the ride will bebumpy at times for several reasons.First, stock prices have recovered a great deal from theMarch 2009 lows. In fact many stock indices have doubledsince that time. As a point of reference, we calculatea target price or intrinsic value for each of the holdingsin our model portfolio of large cap equities. Three yearsago we believed that the appreciation potential of thatportfolio was over 80% based on our calculation of thestocks’ intrinsic value. We thought that the stocks wereextremely undervalued. Today we believe the appreciationpotential is 15%. We believe that our stocks still offerthe possibility of attractive returns but are not nearly asinexpensive as they were over the past three years. Ourinvestment thinking holds that when stocks trade athuge discounts to intrinsic value, they offer investors anespecially attractive margin of safety. As a result of thestock market recovery of the past 3 years, that marginof safety has been reduced to more historically normallevels.Our second reason to sense potential stock marketturbulence ahead is due to the uncertainty of how theeconomy will perform in the coming years. When webegin thinking about what the economy may do inthe future, we always remember noted economist JohnKenneth Galbraith’s famous pronouncement that “thereare two kinds of economic forecasters: those who don’tknow and those who don’t know that they don’t know.”Since we admit up front that we don’t know, we fall inthe first group. What we do know is that the challengesto future economic growth are formidable. Althougheconomic growth has not been robust in recent years,it has in fact been on the mend. The question that willmost likely give investors pause later this year and nextconcerns our gaping budget deficit and whether or notthe government that we elect in November will be capableof addressing this structurally difficult problem. Ourcurrent government has been paralyzed by disagreementand inaction. We expect some level of anxiety on thepart of investors leading up to the election and in 2013as our newly elected officials attempt to stabilize ourfiscal affairs. There are a number of scenarios that couldplay out over the next couple of years but none of us canknow the precise outcome. We do think it is reasonableto expect investors will have some jittery moments asevents unfold.We don’t know for sure when the turbulence will comeor how bad it will be. That is the nature of the stockmarket. But we can be prepared ahead of its arrival.We continuously work with our clients individually tomake sure that their holdings are in line with their risktolerance. That task is especially important today afterstock returns have been strong and assets allocated tostocks may have increased markedly in accounts. Now is

further distributions prior to receiving a closing letterfrom the IRS and any applicable state taxing authorities.Since no distributions were made during 2013, theestate would be subject to the 3.8% surtax on $200,000(the excess of $212,000 net investment income over theMAGI threshold of $12,000 applicable to trusts andestates).• Irrevocable Trust - Carol is the beneficiary of a trustestablished by her parents. The terms of the trustgive the trustee discretion to distribute net incomeand principal of the trust for Carol’s health, education,maintenance and support. Any undistributed netincome is periodically added to principal. As Carol hasother sources of income this trust was intended to providea backup financial resource for her. Since the trustwas also designed to pass on to Carol’s children at herdeath and will not be subject to estate tax in her estate,she understands the benefit of not making distributionsfrom the trust unless it’s necessary. The trust is activelymanaged and has net investment income of $72,000,none of which is distributed in 2013. The trust will besubject to the 3.8% surtax on $60,000 (the excess of$72,000 over the MAGI threshold of $12,000 applicableto trusts and estates).• Revocable Trusts - Since a revocable trust is transparentfor income tax purposes and activity is reportedon the grantor’s personal income tax return, the netinvestment income earned by revocable trusts is simplyadded together with net investment earned on anyassets owned by the grantor which have not been transferredto trust. This aggregate amount is subject to the$125,000 / $200,000 / $250,000 thresholds (and notthe lower $12,000 threshold applicable to non-revocabletrusts).Tax Planning Opportunities and StrategiesGiven the proposed 3.8% surtax on net investmentincome, different tax planning opportunities and strategiesmay prove beneficial, especially those that helpreduce a taxpayer’s MAGI, and include the following:• Investment income does not include distributions fromIRAs and other qualified plans, therefore, contributionsto IRAs, 401(k), 403(b) and 457 plans could beincreased. Note, however, that such taxable distributionsare generally included in MAGI, therefore, asillustrated in the previous examples, IRA or other qualifiedplan distributions could push a taxpayer over theMAGI threshold, thereby still triggering the surtax. Ifa taxpayer has no other investment income, distributionsfrom a traditional IRA or qualified plan can bemade up to the threshold amount without triggeringthe surtax.• Distributions from Roth IRAs or other Roth-typequalified plans are also not subject to inclusion ininvestment income, and, in addition are not subject toincome tax and are not included in the calculation ofMAGI. Therefore, distributions from Roth IRAs orRoth-type qualified plans will not affect calculation ofthe 3.8% surtax, even if these distributions exceed theapplicable threshold amounts.• Avoidance of the 3.8% tax would be another factor infavor of a Roth conversion since it would help reduceMAGI.• Investment strategies that reduce taxable income, andcorrespondingly MAGI, should gain favor, includingincome from tax-exempt and tax-deferred sources,such as municipal bonds, tax-deferred non-qualifiedannuities, life insurance and non-qualified deferredcompensation.• Charitable remainder trusts can help a taxpayer deferincome for a period of time, thereby reducing MAGI.• Charitable lead trusts can help a taxpayer shift investmentincome for a period of time, thereby reducingMAGI.• Installment sales have been successfully used for yearsto help taxpayers spread tax gains on sales across multipletax years, and the surtax will be an additional factorweighing in favor of the technique.We should know more about the future of the HealthCare Reform Act and these related tax provisions oncethe Supreme Court issues its ruling in June 2012. Untilthen, it is likely premature to implement any of the taxplanning strategies discussed in this article unless neededfor independent reasons. Please contact any members ofthe Estate Planning team for additional information.James W. Turner | 502-588-1218 | JWTurner@Hilliard.comWillis W. Hobson | 502-588-8655 | WHobson@Hilliard.comJeff Uhling | 502-588-8466 | JUhling@Hiliard.comHilliard Lyons Trust Company does not offer tax or legaladvice. Please consult your tax or legal advisor prior to makingany decision which could affect your tax or legal situation.Should you have questions about the information contained in this Investment Update or regarding your investments,please contact your Hilliard Lyons Trust Company Portfolio Manager.Hilliard Lyons Trust Company, LLC | 500 West Jefferson St. | Suite 700 | Louisville, KY 40202(888) 878-7845 | Fax (502) 588-8131