Slides from the Asset Dedication webcast

1. The Fiscal Cliff
Implications for Your Clients
Presented By:
Stephen Huxley, PhD
Brent Burns

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For Advisor Use Only
Not intended for use with
individual clients

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Client Talking Points
1. Uncertainty
2. Taxes will rise
3. Spending cuts will negatively impact the
economy
4. Interest rates will likely stay low
5. Financial planning matters

4. Higher Taxes Spending Cuts

5. C+ I +G +(X – M) = GDP
Consumption
Investment
Government Spending
Net Exports

6. C+ I +G +(X – M) = GDP
Consumption
Government Spending

8. Income Tax
Capital Gains Tax
Tax on Dividends
Estate Tax
© Copyright Asset Dedication 2012

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Income Tax Increases
Note: All figures subject to
change, depending on negotiations
Tax Brackets (2012 Dollar Amounts) Marginal Rate
Unmarried Filers Married Joint Filers
But Not But Not
Over Over 2012 2013
Over Over
$0 $8,700 $0 $17,400 10% 15%
8,700 35,350 17,400 70,700 15% 15%
35,350 85,650 70,700 142,700 25% 28%
85,650 178,650 142,700 217,450 28% 31%
178,650 388,350 217,450 388,350 33% 36%
388,350 ... 388,350 ... 35% 39.60%

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Other Tax increases
• Many changes - Capital Gains, Payroll, AMT,
dividend, estate, 20/20 cap on 401(k), etc.
• More details:
– http://www.bankrate.com/finance/taxes/fiscal-cliff-expiring-tax-laws.aspx
– http://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newslet
ters/Articles_2012/CPA/Aug/2013taxincreases.jsp
– http://www.journalofaccountancy.com/Issues/2012/Nov/20126172.htm
– http://www.forbes.com/sites/kellyphillipserb/2012/11/10/tax-increases-
looming-in-2013-who-pays-how-much-and-will-they-stick/
– http://www.ebri.org/pdf/briefspdf/EBRI_IB_11-
2011_No364_RetTaxRfm2.pdf

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Government Spending

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Baseline Plan
Cut $ 110 billion per year over 10 years
½ Defense
½ other
Cuts for 2013:
1. $55 billion from Defense (about 8% of its
budget)
2. $55 billion from non-defense (varies)

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Projected 2012 Federal Budget
Revenues: $2,443 billion*
Expenses: $3,540 billion
Deficit: -$1,097 billion
*All figures approximate. Source: Congressional Budget Office
http://www.cbo.gov/sites/default/files/cbofiles/attachments/08-22-2012-
Update_to_Outlook.pdf

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Federal Budget
Federal Revenues $ Billion As % Federal Revenues $ Billions
Income Tax,
Income Tax $1,130 46% $1,130
$1,200
Payroll (Soc. Sec./Medicare) Tax $844 35% Payroll Tax,
$1,000
Corporate Tax $240 10% $844
Other $229 9% $800
Total $2,443 100% $600 Other
Corporate Revenues,
$400
Tax, $240 $229
Federal Spending $ Billion As % $200
Soc. Sec. $760 21% $0
Medicare/Medicaid $725 20%
Defense $652 18%
Income Security (Unempl. Comp. Soc. Sec., Federal Spending $ Billions
$760
Food Stamps, etc.) $359 10% Medicare+,
$800 $725
Net Interest on Debt $258 7%
$700 Defense, $652
Federal Pensions $212 6% Income Other, $574
$600 Security, $359
Other $574 16% Net Interest
$500
Total $3,540 100% on Debt, $258
$400 Federal
$300 Pensions,
Deficit for FY 2011 -$1,097 $212
$200
$100
Accumulated Deficits - National
$0
Federal Debt: $16,400

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Incentive to Keep Rates Low
Current debt service =
7% of the budget
Source: Treasury Direct - Average Interest Rates on Marketable Securities as of 11/31/2012 and Daily Debt Held by Public as of 12/5/2012

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Incentive to Keep Rates Low
1% Interest rate rise
Debt service =
10% of the budget
Source: Treasury Direct - Average Interest Rates on Marketable Securities as of 11/31/2012 and Daily Debt Held by Public as of 12/5/2012

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Details – Spending Cuts
• More details:
– http://bipartisanpolicy.org/projects/budget-control-
act?project=39&keys=Budget+Control+Act+series
– http://bipartisanpolicy.org/blog/2012/01/three-
reasons-why-12-trillion-isn%E2%80%99t-really-12-
trillion
– http://en.wikipedia.org/wiki/United_States_fiscal_cliff

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10 Year US Treasury Bond Yields, 1800-2012
1.93%
1.72%
Source: Asset Dedication, U.S. Treasury, and Global Financial Data. Data through 12/16/2012

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Total Return Long Government Bonds, 1980-2012
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
1950 1960 1970 1980 1990 2000 2010
Source: Morningstar Long-Term US Government Bond Index 2006-2012, Ibbotson And Associates Long-Term US
Government Bond Index 1927-2005

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The Yield Curve
• The decline in interest rates affects all
maturities, though not to the same degree
• Short term maturities usually have lower rates
than longer maturities
• Changes over time - the “living yield curve:”
http://www.smartmoney.com/investing/bonds/the-living-
yield-curve-7923/

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Treasury Yield Curve 2012, 2011
Source: www.treasury.gov 12/16/2012

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Treasury Yield Curve 2012, 2008
Source: www.treasury.gov 12/16/2012

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Treasury Yield Curve 2012, 2003
Source: www.treasury.gov 12/16/2012

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Japan 10-Year Govt. Bond Yield
1994-2012
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Source: Reuters as of 12/19/2012

28. "We expect to keep the short-term
interest rate at exceptionally low
levels to at least mid-2015... so
long as price stability is
preserved, we will take care not to
raise rates prematurely.“
-Federal Reserve Chairman Ben Bernanke
10/3/2012

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Advantages of Individual Bonds
1. Predictable
2. Known worst case
3. Safe
– Treasuries, agencies, CD’s
– Corporate and muni bonds have
predictable probabilities

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Default Rates, 1970-2011

31. Other Income Producing Investments
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32. Dividend payments from
companies in the S&P 500
dropped by…
23.9%
January 2008 to January 2009
Source: Standard and Poors; S&P 500 Market Attributes Snapshot; January 2009

33. According to Cohen and
Steer’s, publicly traded REITs
cut their dividends by
26%
in 2009
Source: Cohen and Steer’s; A Case for REITs as a Hedge Against Inflation; June,2011

34. The risk to principal from
currency fluctuations can reduce
or eliminate any yield advantage
for international bonds
€ 1,000 ≈ $1,205
€ 1,000 ≈ $1,316
€ 1,000 ≈ $1,470
-22%
Source: Yahoo Finance 12/19/2012

35. Junk Bond Defaults Tend to Spike
When the Economy Struggles

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Waiting for Rates to Rise

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Waiting in Cash for Rates to Rise
Consider the cost of buying an 8-year income
stream starting at $100,000 plus 3% inflation.
• Sum of all cash flows = $889,234
• Can buy income stream now or wait two years to
see if it will be cheaper due to rising rates
– Current cost of 2013-2020 stream: $841,219
– Current cost of 2015-2022 stream: $807,539
– Future cost of 2015-2022 stream: $841,219
(assuming no change in yield curve)

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Why Buying Now is Cheaper

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Probability of Rise in Rates
Rates will have to rise fast enough and far enough
to make the future cost of the 2015-2022 stream
less than its current cost ($807,539)
• The probability of this happening is below 10%
based on the history of rate changes (1927-2012)
• Given Bernanke’s statements, the probability is
probably closer to 0%.

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How Fast Interest Rates Change

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Cost of Waiting Evidence
In our white paper of November, 2010, white paper
“Cost of Waiting for Interest Rates to Rise,” cost of
a 2013-2020 portfolio would have been $770,896.
1. Our recommendation then: Don’t wait!
2. Estimated cost if rates did not rise - $820,088
3. Cost now is $841,219 – $41,000 higher!
4. Our recommendation now: Don’t wait!

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