Thank you for ten years in business!
The year 2004 marks our 10th anniversary as Fee-Only Investment
Advisers. We believe your long-term relationships with us are
responsible for this important achievement, and we wish to express our
sincere thanks. We will endeavor to continue to earn your business in
the years ahead.
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Popular Stock & Bond Indices:
Interest rates remain low compared to previous years, and stocks, as
measured by the Dow Jones Industrial Averages (DJIA), have rallied
substantially from thier low points of 2002.
Should you have a 529 College Savings Plan for your children or grandchildren?
Yes, but not for the reasons the promoters would like you to believe.
• We are in the midst of writing an article comparing various ways to
save for our children’s grandchildren’s college educations. (Contact us
if you would like to receive a copy of this article when it is
complete.) Basically, investors can save for their children’s or
grandchildren’s college education in three ways. 1. Keep the money in
their own accounts until it is needed for college. 2. Establish a
Unified Gift To Minors Act brokerage or bank account and fund it
annually to the tune of $11,000 ($22,000 for a married couple). 3. Make a
donation to a 529 Plan of up to $55,000 ($110,000 for a married
1. By keeping the money until college, parents or grandparents retain
control of the money. Taxes on the interest, dividends and capital
gains will be paid by the parents or grandparents in their respective
tax brackets. By saving in this manner, investors can use the money for
any purpose. For instance, if the child gets a scholarship to pay for
college, the parents or grandparents can use the savings to help the
child buy a car or house, or even start a business. There are no
restrictions because the money was always the investor’s.
2. Establishing a UGMA passes the ownership of the money to the
minor. The trustee (usually a parent or grandparent) controls the
account until the minor is legally an adult, then the money belongs to
the child. If the child wants to use the money for college, he can; but
he is not obligated to do so. It is his money and he can use it to buy a
car, house, etc. So in comparison to the first alternative, the
flexibility stays in place, but the control passes to the student
(whether or not he decides to go to school). Taxes on interest,
dividends and capital gains receive very favorable treatment during the
For children under age 14, the first $750 of investment income is not
taxable. The next $750 is taxable in the child’s bracket, so the first
$1,500 of investment income may generate income tax liability of only
$75. Investment income for children under age 14 that exceeds $1,500 is
taxed in the trustee’s bracket. However, with today’s new tax rates for
dividends and capital gains, it is possible that the maximum tax on this
investment income would be 15%.
When the child reaches age 14, all the income is taxable in the
child’s bracket, which ordinarily would be lower than the parents or
3. Contributing to a 529 College Savings Plan, it is possible to
carry the tax treatment of the UGMA one step further and eliminate
income and capital gains tax altogether. We emphasize the word POSSIBLE,
because everything has to work out just right for this to happen.
Income and capital gains taxes are deferred while the funds remain in a
529 Plan, and if distributions from these plans meet their respective
requirements (used for tuition, room and board, etc at qualified
institutions of higher learning) they are not taxed.
529 funds can be transferred to another family member if the original
member does not use the money. This control element is lost under UGMA,
but of course it is retained under the first scenario, wherein the
parents or grandparents keep the funds in their own account.
Larger sums can be invested. As described, initial contributions can
be as much as $55,000 for a single parent or grandparent, or $110,000
for a couple.
Some states allow Plan contributions to be deducted from reported income when figuring state income tax liability.
Be careful. These added features that characterize 529 Plans can be costly if everything doesn’t work out just right.
529 Plans are administered by states. A recent article in Financial
Advisor reminds us that there are over 80 state plans in operation
today. Each state has its own definition of what expenditures qualify
for higher education, and each selects the money managers for its plans.
529 Plan contributors need to examine these different plans in an
attempt to find the best match for the student. Of course, this can
never be done with certainty, and the ability to change plans is
hampered by additional rules and regulations. Additionally:
While some states give tax deductions for residents, other states
levy state income taxes on distributions for non-residents, or other
If your children or grandchildren don’t go to college, liquidation of
529 Plans triggers income taxes and additional tax penalties. Ditto if
you need the money for an emergency.
529 Plan advantages depend to a large extent on investment rates of
return. As the rate of return declines, the attractiveness of 529 tax
advantages decreases: at some point, Plan benefits do not offset the
disadvantages outlined above. For example, the Virginia College Savings
Plan, using the American Funds family (we like this mutual fund group a
lot), in promotional literature, uses the example of investing $50,000
for ten years at 8%. Compounded semi-annually, this return would
generate a lump sum of $109,556, available tax-free if used according to
specifications. In a 27% tax bracket, the same investmentwould grow at
5.04% [8%X(1-.27)], resulting in approximately $81,930 in a taxable
account. So the 529 Plan would create an extra $27,626 for college
However, using the 15% tax on the investment income to reflect the
new capital gains and dividend tax rates, the after-tax rate of return
for taxable investments could approach 7%: [8%X(1-.15)]. This scenario
would generate approximately $99,489 after taxes, reducing the 529 Plan
advantage to just $10,067 ($109,556-$99,489).
8% may not be a reasonable expectation. Consider the risk-free rate
of return, in this case 10-year Government bonds. They yield
approximately 4%. At this rate, our imaginary–529 Plan–investment would
grow to $74,297 in ten years. Assuming a tax rate of 25% for the sake of
brevity, this 4% rate translates to 3% in the taxable world:
[4%X(1-.25)]. Three percent growth results in $67,342, reducing the
advantage to $6,955 ($74,297-$67,342). Yes, adding risk to the
investment portfolio may be appropriate with a ten-year time horizon.
However, remember the lesson of 2000-2002 in the stock market: risk has a
downside as well as an upside. Unlike in the taxable world, losses in a
529 Plan cannot be deducted for income tax purposes. If the promoters
use a rate of return that is 4 percentage points higher than the
risk-free rate ofTtreasury bonds, should we also consider a rate of
return of 4 percentage points lower than the risk-free rate? IF THERE IS
NO RETURN, THERE ARE NO ADVANTAGES.
Time also can be an important influence on potential advantages of
529 Plans. Just as rates of return can enhance or reduce Plan
advantages, the time the money compounds tax-free has a great influence
on the outcome. In the above example, money growing semi-annually at 8%
for five years instead of ten, for instance, reaches $74,012, while a 5%
rate would generate $64,005, and a 7% rate would generate $70,529. So
the Plan advantage shrinks to $10,007 in the first instance
($74,012-$64,005), and just $3,483 in the second ($74,012-$70,529). When
you think about it, college savers if they EVER have $50,000 to invest
for college are much more likely to have this much to invest five years
before college than ten years before college. So the time factor is
important and should be taken into consideration when examining 529
The statute granting 529 Plans is scheduled to expire in seven years.
Of course, the general expectation is that it will be extended or even
made permanent, but we don’t have to remind you that predicting anything
in seven years is next to impossible, and as far as what the Government
• Bottom Line: YOU ARE IT! You are the advantage. Who will benefit
from a college savings plan, regardless of whether it’s in your
investment account, or a UGMA or a 529 Plan? The child. That’s what we
need to keep in focus. When all of the considerations are analyzed for
the different ways to save for college, it is really impossible to
document that one way is better than another. The choices are complex
and can be quite personal. The important thing to remember is WHY. You
are benefiting the child. The child is lucky to have you. From the
child’s perspective, having someone who cares is a lot more important
than how they save. So we would say, should you have a 529 College
Savings Plan? Yes. Should you have a UGMA account? Yes. Should you save
for your grandchild’s college in your own account? Yes. The method you
choose is up to you.
• In review, choosing a college savings plan can be a complex
activity. It can involve income tax accounting, estate planning,
investment analyses and even politics. Contact us if you would like
• our input on some methods you may be considering for your children
or grandchildren. Please just remember to treat our income tax and
estate observations as incidental to our work in investments, and
consult with these professionals when you need to.
Are you involved in a mutual fund scandal?
Probably not. Our use of mutual funds has changed significantly during the past few years.
• Few active managers are delivering better results than their
benchmarks, which are indices to measure fund performance. Literally
hundreds of benchmark indices have been established to measure mutual
fund performance, but few funds have shown the ability to give investors
as good a return as their respective benchmarks. For example, the
S&P 500 is a widely known benchmark index. The Vanguard 500 Index
Fund, which replicates the investment return of the S&P 500,
regularly outperforms an embarrassing number of fund managers in the
large capitalization category that is represented by the S&P 500.
This is the bad news about fund performance.
• The good news about fund performance is that today’s technology
allows investors to bypass the actively managed funds and buy the
benchmarks. The Vanguard 500 Index Fund is the most widely known example
of this. There are numerous other, low-cost funds that provide
investors with the ability to participate in diverse investments ranging
from short-term Government bonds to long-term Government bonds to
corporate bonds; or biotechnology, or foreign countries, or small
capitalization stocks (like the Russell 2000 Index) or even small
capitalization growth versus value stocks. It goes on and on. The main
point is that investors can buy low-cost index funds to gain investment
exposure to a wide diversity of choices.
• Many of these benchmark funds are EXCHANGE-TRADED FUNDS, or ETF’s.
This simply means the funds are traded on stock exchanges like ordinary
stocks. Because of arbitrage hedging by large investors, smaller
investors like ourselves can buy and sell these funds without having to
worry about the relation of their prices to their net asset values.
Unlike regular, open-end funds, which investors buy and sell directly
with the fund based on the day’s closing prices, ETF’s can be traded
anytime during market hours.
• This difference eliminates the most widely known fund scandal to
date, namely: special privileges given to large investors to trade funds
after market hours. We have been using more of these ETF’s to give you
exposure to special segments of the stock and bond markets. Combined
with the low transaction costs that characterize today’s commission
structure, we believe these new ETF’s will eventually replace many of
today’s regular open-end funds.
This doesn’t mean we’re bullet proof.
• While we would like to believe the mutual fund managers we select
for you are not involved in any wrongdoing, we are constantly surprised
by the number of heretofore highly respected companies that have
participated in illegal and immoral activities. The ongoing
investigations are very broad, and new potential offenders are being
discovered almost weekly.
• For the record, we have sold funds for our clients in the past
because of behavior we deemed inappropriate. We believe our job is to
make selections. We literally have thousands of choices. As far as we’re
concerned, when a mutual fund’s management is implicitly stealing form
its shareholders, this just makes our selection process easier: we can
scratch this choice and go on to the next one.
What is Schwab’s involvement in the mutual fund mess?
• Schwab acquired The U.S. Trust Corporation in 2000. In the
company’s recent quarterly earnings report filed on Form 10Q with the
Securities and Exchange Commission, the firm disclosed that some of U.S.
Trust Corporations’s mutual funds were involved in inappropriate
behavior involving late trades. In the process of disclosing and
correcting these practices, Schwab made the point that, in relation to
the mutual fund business it processes on a yearly basis, these funds do
not represent a statistically significant portion of the firm’s
business, and that the firm should not be judged on the activities of
this very small infraction. Additionally, Schwab said they were
responsible for discovering the improprieties and made full and proper
disclosure, indicating the effectiveness of the firm’s internal
operating procedures. Importantly, the firm also took responsibility for
• Our clients are not involved in these funds because we don’t use them.
• We agree with Schwab that their internal procedures are working
well. In our opinion, the company is clearly the leader in this and many
other industry fields.
Although you are not involved, the odds are that you will be
affected. In the be-careful-what-you-wish-for department, it is
good to remember who pays for regulation. In other words, beware of
politicians offering to fix everything. Remember, we can’t legislate
risk out of the markets; if we could, everyone would be rich. We believe
that proper enforcement of the laws already on the books will/and is
going a long way toward resolving the issues. Unfortunately, some of the
violations are so egregious, coming from individuals and companies in
positions of trust, that some additional regulation will be required.
The sad result is that as a capitalist nation we’ll have more regulation
in our economy: just what we don’t want but what was brought on by the
very organizations that profit from our free-market system. These
regulations will be paid for by consumers and small business operators.
Are we going to continue our reports on the Stick-A-Fat-Hog Portfolios?
No. At least we have no plans to maintain this stock list. The SAFH
portfolio, while interesting to us, does not really apply to our
clients, because the portfolio represents only a small portion of the
diversified approach we take in developing our clients Investment
Strategies. Future letters will attempt to discuss topics that interest
you. Comments and suggestions are welcome.
Sam Dreher & Tom Veleivs, CFP
Copyright 2004, H.S. Dreher Capital Management, LLC. All rights
reserved. This letter is for the information of clients of H.S. Dreher
Capital Management, LLC: 275 SE Broad St, Southern Pines, NC 28387,
#910-692-4330. Information is taken from sources believed to be
reliable, but is not represented to be complete; is not guaranteed for
accuracy by the firm and is subject to change without notice. More
information on specific companies and topics mentioned in this letter is
available upon request.