Advantages of HSA Accounts

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With health care costs continuously increasing, paying for medical expenses has become a concern for all Americans. According to Fidelity Investments, estimates show that an average 65-year old couple will spend approximately $260,000 on health care during retirement.  These high costs emphasize the importance for individuals to prepare and to take full advantage of long-term investment opportunities. Health Savings Accounts (HSAs) can provide an alternative investment option and can be a powerful retirement tool.

A Health Savings Account (HSA) is a tax-exempt trust or custodial account created to help cover qualified medical expenses. They are designed to help individuals manage their current medical expenses and establish a long-term savings plan to use for medical expenses during retirement. If used properly, one can take full advantage of this investment tool and enhance their financial situation. In order to qualify, individuals must meet the following requirements:

  • Covered under a high deductible health plan (HDHP) on the first day of the month.
     
  • Have no other health coverage except what is permitted under “Other health                           coverage.” 
     
  • Are not enrolled in Medicare.
     
  • Cannot be claimed as a dependent on someone else's tax return during the previous year or during the year in which they invest in an HSA.

A growing number of employers offer an HSA-eligible health plan to help cover qualified medical expenses. It provides companies an alternative to traditional health insurance and the ability to better manage health care costs by lowering premiums and reducing payroll taxes. More importantly, employees benefit from an investment standpoint. HSAs offer several advantages to investors. An important characteristic of HSAs is that the “use it or lose it” rule does not apply, unlike FSAs and other health flexible spending accounts. It permits unused funds in the account to grow year after year tax-free to pay future qualified medical expenses. In addition, HSA accounts are:

  • "Triple tax-advantaged."
     
  • Account contributions are pre-tax or tax-deductible. (Annual limits to the amount of contributions for 2017 are $3,400 for individuals and $6,750 for families, while the catch-    up amount for ages 55 and over is an additional $1,000).
     
  • All earnings and interest are tax-free.
     
  • Any withdrawals for qualified medical expenses are tax-free. Plus, once an individual reaches age 65, all nonmedical withdrawals are taxed at the current tax rate, just like a traditional IRA
     
  • Fully portable. As with an IRA, an HSA account is owned outright and can be rolled over to another HSA custodian, subject to some restrictions. https://www.irs.gov/publications/p969
     
  • Designed for the future. Contributions and earnings, combined with the power of compounding help the account grow over time. And unlike IRAs, HSAs do not have required minimum distribution (RMD) rules.
     
  • Not limited by your income. No matter how much is earned, if the account owner meets the other HSA qualifications, they can open an account (annual contribution limits apply).

Finally, HSAs offer the flexibility to use the money once you reach age 65. Although they primarily function to pay for qualified medical expenses, HSAs enable individuals to use the account for other expenses during retirement. Below are four important ways that the money can be used:   

  • Help bridge to Medicare;
     
  • Cover Medicare premiums;
     
  • Long-term care insurance;
     
  • Pay everyday expenses.
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Buffett’s Alpha: How does Warren Buffett Create Wealth?

In May of 2012, members of the team at AQR Capital Management (one of the top hedge fund managers in the U.S.) released a 45-page paper entitled “Buffett’s Alpha.” AQR Founder Cliff Asness is a frequent contributor to CFA Institute publications.  This paper, targeted towards the institutional investor community, seeks to deconstruct Berkshire Hathaway’s remarkable investment returns. According to Morningstar / YCharts, since January 1993, the Berkshire Hathaway Class A stock (ticker symbol “BRK.A”) has a total return of 1,960%, compared to the S&P 500’s return over the same period of 371%. 

Takeaways from the Paper

The AQR paper includes a “rigorous empirical analysis” – its authors are hedge fund managers, after all. Instead of directing you to read the 45-page paper, Phlox seeks to add value for you by summarizing the paper here, and communicating to you how it informs our investment strategy. The main takeaways from the paper are the following:

1. Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors.”

Value: By their reference to “value,” the authors are referring to stocks that generally trade at prices reflecting a lower price to earnings (“P/E”) ratio.  “Value” stocks tend to trade at lower P/E multiples, while “Growth” stocks tend to trade at higher multiples. 

Low-Risk: The authors are referring to a definition of risk in financial markets widely utilized by academics and investment practitioners. Risk by this commonly accepted definition is volatility, or the measurement of variability in price. The two primary measures of volatility in financial markets are a) standard deviation—a measurability of the variability in the investment’s price itself), or b) beta—a measure of the degree to which investment returns deviate from those of a common market index such as the S&P 500. 

By investing in low-risk stocks, Buffett generally favors low standard deviation, low-beta stocks. 

Quality: Buffett invests in earnings quality, meaning companies that are profitable, stable, growing, and with high payout ratios. A stock with a high payout ratio pays meaningful cash dividends to investors. 

2. Buffett has boosted his returns by using leverage.”

The general public may not realize that Buffett was perhaps the world’s first hedge fund manager, utilizing leverage, or borrowed money, to amplify his investment returns. It’s important to note that Buffett utilizes debt in a very judicious and strategic fashion. 

A significant portion of the debt utilized by Berkshire Hathaway is insurance company “float” whereby the company has the right to invest money that is set aside for the payment of future insurance claims. According to AQR, float represented 36% of Berkshire’s borrowing on average, since 1976.

Here are a few specifics on Buffett’s borrowing according to the AQR paper:

  • Including the insurance float, Buffett’s ratio of loan to asset value is approximately 28% (or 1.4 times leverage as AQR explains it). I prefer to convert the 1.4 to “loan to value” for simplicity. 
      
  • Berkshire’s cost of float averaged only 2.2% since 1976, more than 3.0% below the average T-bill rate. In fact, Berkshire’s cost of float has been negative in recent years. 
     
  • Low financing rates: Berkshire maintains a AAA credit rating by the rating agency Standard and Poor’s, resulting in a very low cost of borrowing.
     
  • Berkshire issued the first ever negative-coupon security in 2002, a senior note with a warrant.  
  • Berkshire sells derivatives, which serve as both a source of financing and as a source of revenue.
3. Buffett’s overall stock return is far above returns of both (his) private and public portfolios. This is because Berkshire is not just a weighted average of the public and private components. It is also leveraged, which magnifies returns.”

Berkshire stock has been far more volatile than the overall stock market.  AQR calculates the volatility at 24.9%, higher than the market volatility of 15.8%. Since Berkshire borrows money to invest, it is logical that its stock would be more volatile than the market. 

4. While Buffett is known as the ultimate value investor, we find that his focus on safe quality stocks may in fact be at least as important to his performance. Our statistical finding is consistent with Buffett’s own words: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
— Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1989

It sounds obvious, but at times, investors ignore a patently obvious basic tenet: buy quality investments. Why do we do this?   Because we are reaching for something out of reach. We believe that the investment returns provided by quality companies are too low in comparison to other riskier opportunities. In an effort to earn a higher return, investors devote capital to low-quality investments. While Buffett is not infallible (he admits to his fair share of mistakes), he has enjoyed phenomenal success by staying disciplined and insisting upon quality investments. We must seek to maintain the same discipline. 

Lessons for Phlox and Phlox Clients

1.  We can learn a lot from Buffett, but we should not seek to fully replicate his strategy.

As stated in the paper, Buffett’s strategies result in higher investment returns, but also higher volatility, due to the use of leverage. Most investors do not have a stomach lined with iron as Buffett does. Such a gut is necessary in order to tolerate Buffett’s strategy. Phlox does not utilize borrowing/leverage in client portfolios. 

2.  Buffett understands the inherent value in his investments, so he does not allow market fluctuations to control his emotions.

With a few exceptions, nobody builds wealth by watching the market every minute of every day. Instead, we need to understand the inherent value in our investments. When the market is volatile, it is this understanding that helps us to avoid “buying high and selling low.” As the great investor Peter Lynch said, “it’s not a lottery ticket” (meaning the ownership of stocks).  Quality stocks bought at reasonable prices are solid investments, not lottery tickets. 

3.  While Phlox does not advocate utilizing debt to buy stocks, Phlox does advocate judicious use of debt to buy a home. 

Homes are where we live. They are where we raise our families and build our futures together. At a recent speech in Dallas, Buffett himself said that buying a home with a 30-year fixed rate mortgage is the single smartest investment a person can make. Note his reference to a 30-year fixed rate mortgage: he stipulates this type of financing because he knows that the phenomenon of inflation makes it a wise financial structure. Furthermore, mortgage interest is deductible for most tax payers, further lowering the cost of the debt. 

4.  Buffett creates wealth because he maintains high levels of liquidity

If I could give only one piece of advice from my study of Buffett and my work with many successful entrepreneurs, it is this: the 3 most important concepts in finance are 1) Liquidity, 2) Liquidity, and 3) Liquidity. 

The reason Buffett is cool under pressure is because he has money in the bank and high-quality, liquid assets in the market that can be converted to cash when needed. He also has access to lines of credit and other forms of liquidity.  When the storms roll in, Buffett is not looking for a loan. He has cash at the ready, and in fact, he’s looking to buy investments when others are in a state of panic. 

5.  Buy quality investments that pay cash dividends

Phlox favors a healthy allocation of U.S. blue chip stocks in client portfolios. These stable companies often pay cash dividends that increase on an annual basis. The dividends serve to increase investor liquidity and dampen the downside volatility in the stock. 

 

Joe Martinez, CFA is the founder of Dallas-based Phlox Capital Management, an investment management and financial planning firm. You can read his commentary at www.phloxcapital.com.

Build Your Ship for the Biggest Storm

When a ship builder sets out to design a ship, he or she uses the best structural engineers available to ensure the integrity of the vessel. A well-engineered ship maneuvers confidently and will withstand even the biggest storm.

The same can be said of your investment portfolio and the financial advisor you select to “engineer” it. When the stock market becomes volatile, many investors become anxious and feel the urge to make changes in their portfolio. This anxiety is only compounded by the media, resulting in a cycle of “buying high” and “selling low” that is well documented in academic papers studying individual investor behavior. 

We must free ourselves of the hope that the sea will ever rest. We must learn to sail in high winds.”
— Aristotle Onassis

But oftentimes the wisest thing an investor can do in a market with volatility is absolutely nothing. The best way to weather these intermittent financial storms is by feeling confident in your investment portfolio and your overall financial plan in the first place.

Beware of advisors and firms out there who claim they can predict the future of the market - Phlox isn’t one of them. Instead, we build highly customized portfolios tailored for each client’s unique ability and willingness to bear risk.  Although we pride ourselves on being great listeners, we take an analytical, quantitative approach to managing the risk in your portfolio. As a result, clients have an appropriate amount invested in a mixture of stocks and lower risk investments. In this way, we engineer the financial “ship” that will weather the biggest storm—and keep your anxiety levels at a minimum when those storm clouds roll in. 

Disciplined, long term investment strategies created many of the iconic fortunes of our nation’s great history. A great financial advisor will help you maintain the long term perspective necessary to build wealth. 

We have to think of the future as a range of possible outcomes. We might bet on the one we think will happen, but we should give allowance for some of the others. Now, how much allowance, which of the others—these are the hard questions.”
— Howard Marks

How can we help you answer the hard questions about your financial future? Find out. 

 

Joe Martinez, CFA is the founder of Dallas-based Phlox Capital Management, an investment management and financial planning firm. You can read his commentary at www.phloxcapital.com.

I want to be your offensive line

Offensive linemen are men of few words, performing a dirty job, with scant recognition. And that’s the way they like it. Have you ever heard an interview with an offensive lineman? Answers are brief, to the point, and team-focused. These guys are more interested in hitting the weight room to bench press 500 lbs. than talking with reporters. They’re accustomed to working behind the scenes and in the trenches; if the credit for the win goes to the quarterback or the speedy wide receiver, that’s just fine. Linemen know their role and the importance of it. Keenly focused on their assignment, they look to put a defensive linebacker flat on his back, and make sure the quarterback is protected. They do the grunt work play after play, game after game, and know their success is earned in the weight room and on the practice field. 

I have a similar mentality in my investment management and financial planning business. It’s all about results, not accolades. I’m laser-focused on creating opportunities for my clients, defending the blind side, and the final score. No excuses. I’m here to get the job done—to do whatever it takes to help you create wealth. I’ve trained for it, I’ve succeeded at it, and I’m ready to work. I want to be your offensive line.


Joe Martinez, CFA is the founder of Dallas-based Phlox Capital Management, an investment management and financial planning firm. You can read his commentary at www.phloxcapital.com.