Pensions Are Under Attack!

How Do Mutual Funds Pay Out Dividends?

The bulk of mutual fund dividends and capital gains are distributed at the end of the year. This money comes from a few different sources. For instance, stocks within the mutual fund pay dividends, and the internal sales of individual companies generate capital gains. Wherever it stems from, dividends and capital gains must be distributed proportionately to every shareholder of that particular fund.

You might notice that the price per share drops following the payout of dividends and capital gains. However, these profits are usually reinvested back into the same fund, especially in the case of retirement accounts. When this happens, the price usually levels back out.

You might also see a change between the record and payable dates following dividend and capital gain payouts. So if you only track your mutual funds by the number of shares you own, you’ll want to keep that number up to date. Otherwise, it may look like you lost money on a fund on the payable date when nothing really happened in the market that day.

These factors mostly come into play with after-tax, non-retirement accounts because dividends and capital gains are considered taxable income. The good news is that these profits are taxed at preferential tax rates as low as 0 to 15 percent, depending on what tax bracket you’re in. The bad news is that when you have a good market year, like the one we saw in 2021, you can expect to owe more taxes on your dividends and capital gains.

How Can Cross-Reinvesting Help Rebalance Your Portfolio?

While the default option is to reinvest any dividends and capital gains back into the same fund, you have some interesting cross-reinvesting options to consider as well.

First, remember that dividends and capital gains were higher last year, which means your tax bill will also be higher. As a result, you may want to hold onto your dividends and capital gains so you can use these profits to pay higher taxes without dipping into your cash savings.

Second, you can cross-reinvest to help rebalance your portfolio. Rebalancing is when you bring your portfolio back in line with the overall investment allocation that you originally created based on your particular financial situation.

Let’s say you started with an allocation of 70 percent stocks and 30 percent bonds two or three years ago, and you haven’t really checked in on it since. Well, based on market performance, that 70/30 mix might be more like 80/20 or even 85/15 today. As the stock portion has gone up in value, it makes up a larger portion of your portfolio, therefore making it riskier. That’s why regular rebalancing is important, particularly after the run-up in the market that we’ve seen over the past two to three years.

Using your dividends and capital gains to achieve this rebalancing is a great way to utilize the extra profits you earned from last year’s stellar market performance. To rebalance and reduce the risk of your portfolio as you get closer to retirement, we recommend reinvesting into more conservative asset classes, such as money markets and short-term bond funds.

Pension Plans Are Fighting off a Three-Headed Monster!

A shocking number of pension plans today are underfunded relative to where they should be for the benefits they’ve promised their recipients. Just 20 years ago, the Florida retirement system was in great shape. In fact, it ran with a surplus of over $14 billion. However, after the financial decline in 2008 and 2009, it swung the other way to a $15 billion shortfall.

Now, you might expect things to have improved, what with the market’s steady upward trend since then, but that’s not what has happened. In fact, the deficit in the Florida retirement system has only grown to a projected $36 billion.

Florida isn’t alone. Most pension plans across the country these days are running a deficit. There are three factors at play here:

Inflation
The increasing number of retirees
Low interest rates causing low returns

The people who manage the country’s pension funds are scrambling to combat this three-way attack, but in our opinion, the path they’re going down will only make things worse. Here’s a look at the problems we see with each technique they’re using:

Many pension plans are reducing their cash and bond allocations to a seven-year low. This might make sense from a rate-of-return perspective, but cash plays an important part in any investment allocation. After all, cash and bonds won’t go down as much if the stock market takes a hit.
Many pension plans are leveraging borrowed money to try and boost returns. This tactic may be effective (though not recommended) when the market is good, but as soon as things trend downward, it can spell disaster.
Many pension plans are chasing illiquid alternative investments like private equity or real estate. Sure, these can compound a pension plan’s return, but they can also compound the loss if there’s a market decline.

Underfunded pension plans are a problem without an easy solution, but we don’t believe the answer should be to run away from the fundamentals of investing. So if you’re a personal investor looking to emulate proven techniques, steer clear of what today’s pension funds are doing.

Tax Diversification

These days, people tend to focus solely on investment allocation. While this is important, don’t forget to consider tax diversification as well. By doing this early on, you’ll be able to strategically pull funds out at retirement without being taxed at the highest rate.

Maybe you’ll have to pay taxes and take the required minimum distributions on some of your assets. To balance that out, you also want to make sure you have funds you can utilize without limitations and with minimal tax consequences. In a nutshell, the fewer taxes you pay in retirement, the more money you have to spend.

For more financial tips and help managing your retirement plan, please contact Nelson Financial Planning in Winter Park, FL, at 407-307-3061.