Windsor Brief for March 2023
Investing:Inflation Rains on February's Parade
Planning:Required Minimum Distribution Age
This month’s Windsor Brief reviews market performance for the month of February. Inflation continues to remain stubbornly high, impacting both the fixed income and equity markets. But relief could be ahead.
In our Financial Planning section this month, we review the changes to the required minimum distribution age and provide a few scenarios in which you may not want to delay distributions. If you’d like to talk to us further about these topics or about any of your financial planning or investment goals, please do not hesitate to get in touch.
Investing: Inflation Rains on February's Parade
February could not sustain the rally to the new year, and both the equity and fixed income markets finished down for the month. The S&P 500 finished down 2.44% for the month. However, for the YTD period the S&P 500 is still up a solid 3.69%. The fixed income markets fared slightly worse than the equity markets. Using the US Aggregate as the fixed income proxy, it finished down 2.59% for the month and is now up a modest 0.41% for the YTD period.
The weakness in February can be attributed to the continuing impact of inflation and interest rates. The inflation reading for the month of January (reported in February) came in slightly higher than anticipated and was the highest monthly reading in several months. The month over month CPI reading was +0.5% (6.4% year over year) while the core (ex food & energy) CPI was +0.4% m/m (5.6% y/y). While inflation continues to move in the right direction, it is still running higher than the Federal Reserve would like to see.
U.S. CPI month over month % Change
Source: Windsor Wealth Management, BLS
Once again, we are past peak inflation and inflation continues to roll over on a year over year basis. The problem is that it is not falling at the pace the Fed and the markets would like to see in order to slow/pause interest rate increases. As a reminder, the Fed’s objective is for year over year inflation to be in the 2% -3% range.
U.S. CPI year over year % Change
Source: Windsor Wealth Management, BLS
This higher-than-expected inflation reading, along with continued stubbornly low unemployment numbers, has resulted in the Fed reinforcing their “higher for longer” stance on interest rates. This in turn has forced the markets to recalibrate their estimates for how high interest rates will ultimately go. As shown below, the market’s expectation for the peak Fed Funds rate moved higher by roughly 45 bps from the start of the month (February 1) to late in the month (February 23). The chart shows where the market now expects rates to be post each of the next Fed meetings versus prior expectations on February 1. Interestingly, the market has effectively ruled out any interest rate cuts in 2023 as well.
Expected Forward Fed Fund Rates
Source: JP Morgan, FundStrat
The shift upward in interest rate expectations in February resulted in pressure on the financial markets. Although the overall economy remains strong, higher interest rates risk impacting company earnings and the risk of eventually cooling the economy too much. It should be pointed out that peak interest rate expectations rose approximately 45 basis points, not an excessive amount. But the market’s strong start to the year left it vulnerable to any negative surprises. In other words, January’s strong performance pulled forward performance from February, thus having to give some of that performance back when inflation came in a bit worse than expected.
The fact that this was just a bit of a give back as opposed to a large sell off matters because when you look at inflation in January there are a few nuances that bear digging into. For instance, the January CPI reading includes the above average warm weather experienced in January which drove demand. While at the same time the cost-of-living adjustment for social security went into effect, as well as questionable seasonal adjustments from December to January. However, the most interesting nuance is that the CPI weights were adjusted for the January reading, with shelter (i.e. housing and rent) rising to 43.3% of the total weight, an all-time high.
Shelter Weight Within CPI Core Basket (%)
Source: Fundstrat, Bloomberg
As we have mentioned in prior notes, housing prices and rents have been dropping rapidly. However, there is a long lag for those declines to show up in the reported CPI data. This is important as this will ultimately drive CPI down rapidly with the shelter component now being 43.3% of the weight of CPI.
Case Shiller Home Price % Y/Y (left graph) Zillow Rent Index M/M (right graph)
Source: Fundstrat, Bloomberg, Zillow
In summary, the market reacted to a worse than expected inflation number, but in a measured manner. Part of the reason for that reaction was the inflation number was impacted by some unusual circumstances that should not repeat on a month over month basis. In addition, the increase in weighting in the shelter component is going to eventually benefit inflation when the lower rent and home costs finally starts flowing through to the CPI data. The market and the Fed are in good alignment now with interest rate projections and we believe this should set us up for continued positive performance for 2023. The market now expects three additional interest rate increases this year, up from two prior. If this can hold, it will be a positive development.
As always, we will be seeking out opportunities for your overall financial plan based on the current economy and our outlook. Together, we will continue to tailor your plan to suit your unique financial objectives and a risk level you are comfortable with. Thank you for your confidence in our team and in Windsor Wealth Management.
Planning: Required Minimum Distribution Age
Last month we reported that the SECURE Act 2.0 changed the age in which you are required to start taking distributions from your retirement accounts. For 2023, the age to start taking Required Minimum Distributions has been pushed back to age 73. Starting in 2033, the new RMD age will be pushed back to age 75.
At age 73, the first year RMD is approximately 3.8% of the previous year-end value. The distribution percentage goes up every year based on increased age (example age 74 is 3.9%, age 75 is 4.1%, etc). If you do not need distributions from your retirement accounts, delaying will allow your retirement accounts to continue to grow tax deferred. But is that always a good thing?
During your high-income working years, the mantra was to maximize pre-tax contributions into retirement plans. After spending years in the accumulating phase, we now look to the best way to utilize your retirement savings. Now we try to minimize the long-term tax effects when taking distributions from your retirement accounts. Delaying distributions could cause your future larger distributions to push you up into a higher tax bracket.
Following are five strategies where it may be advantageous to take distributions before RMD age:
- Qualified Charitable Distributions: Starting at age 70 ½, you can take charitable distributions from your IRA for up to $100,000 per year. The distribution must be made payable directly to the charity and follow a few other rules. A QCD removes the funds from your IRA at 0% tax cost. The QCD amount will not be included in your adjustable gross income and therefore not be included in the calculation for Medicare premiums adjustments.
- Roth Conversions: During lower income years, consider making Roth conversions to fill up the lower income tax brackets. Pay the conversion tax while in a low tax bracket and the Roth IRA is free from future income taxes (after satisfying the age 59 ½ and 5-year conversion rules).
- Cash Flow Planning: Utilize retirement account distributions for living expenses in order to delay starting social security retirement benefits until age 70. Waiting to claim social security until age 70 will lock in the highest monthly benefit amount for you (and potentially your surviving spouse if applicable).
- Survivor Income Tax Planning: If tax planning as part of a couple currently using married filing jointly tax brackets and standard deduction, keep in mind that when one spouse passes, the surviving spouse will then need to file using single tax rates and a reduced standard deduction. Or if the retirement account passes to adult children, they will need to take distributions over a 10-year time horizon at a time when they may be in a high tax bracket due to their own income.
- Estate Tax Planning: If your estate is subject to estate tax, then consider doing Roth conversions as part of your estate tax plan. Your estate value is reduced by the income tax paid on the conversion. Your beneficiaries will receive the Roth account and not owe any tax on the distributions (provided the Roth account satisfies the 5-year rule).
The above information is a quick summary of scenarios when you may wish to consider taking retirement account distributions before reaching your Required Beginning Date for RMDs.
Just because you can delay, doesn’t mean you should delay. Plan for the big picture which includes managing your distributions during retirement to obtain the best long-term planning solution. Your Windsor advisor can help you evaluate your alternatives and answer questions you may have.