4th Quarter Client Note – Out with the Old. In with Secure Act 2.0

Well, that was fun. It wasn’t quite the worst ever year for stocks. Thank goodness for that. But bonds had one of (if not) their worst years ever. Consequently, the role that bonds usually play in a portfolio – buffering losses in the occasional bad years for stocks – didn’t happen – and even balanced (60/40) portfolios suffered double-digit losses. However, the drawdowns in balanced portfolios didn’t nearly reach the  negative 30% levels seen during the 2008 financial crisis.

The main culprit was the Federal Reserve fighting inflation by raising interest rates throughout the year. Which causes both stocks and bonds to become less valuable as their prices fall.

The S&P 500 (Total Return) Index fell 18.11% in 2022. International stocks were the winner in the fourth quarter, up 16%, due largely to the dollar reversing course from strengthening to weakening. But still also suffered double digit losses for the year.

Just how bad was it?

Morningstar encapsulates the results here and in these 15 charts.

Value vs. Growth

For over a decade, (relatively expensive) growth stocks outperformed (relatively cheap) value stocks. But growth stocks were pummeled by the 2022 bear market; with Tesla (TSLA) and Meta (Facebook’s parent company) being the poster children, each down over 60%. Tesla as a company – in both sales and profits – has performed admirably, while the stock price has suffered. Its valuation got way, far ahead of itself. The five biggest tech stocks lost $4 trillion in value in 2022.

Value outperformed growth by almost 35% in 2022. Consequently, overweighting value dampened portfolio losses.

Fixed Income

Nobody needs to be reminded what a difficult, virtually unprecedented, year it was in the bond market. The Fed has been battling inflation with one of the few tools at its disposal: raising interest rates. It is axiomatic that bond prices fall when rates rise. The Bloomberg US Aggregate Bond Index dropped 13.01% in 2022.

But there was a silver-lining and the self-correcting nature of bond returns was revealed in the fourth quarter. With rates having risen sharply throughout the year, the index returned 1.85%.

As ever, all the data are captured by our friends at Dimensional Funds in their Quarterly Market Review.

Secure Act 2.0 – Something for Everyone

The details are just trickling in, but tucked into the Omnibus spending bill passed at the end of 2022 are retirement planning changes that will impact nearly all clients. While there is nothing in the bill of the magnitude of the elimination of the Stretch IRA for inheritors that was contained in the original 2019 Secure Act, there are dozens of provisions – and something for everyone. Even the gurus are having trouble absorbing the minutiae of all the changes. Some provisions are retroactive. Others are effective in 2023. Still others are effective in 2024 or 2025. Some highlights:

  • The headline change is another increase in the age at which Required Minimum Distributions must occur. The original Secure Act raised the age from 70 ½ to 72. Effective immediately, the age is raised to 73. And increases to age 75 in 2033.
  • A significant number of provisions apply specifically to Roth accounts. Congress has fallen in love with the Roth IRA because Roth contributions are taxed immediately and don’t add to the deficit. Some are calling the bill “Rothification.” There are both opportunities and incentives for the use Roth IRAs.
    • Forcing “catch-up” contributions into Roth accounts for employees that make more than $145,000 per year.
    • Roth 401(k)s are no longer subject to RMDs.
    • 529 plans to Roth conversions under certain conditions, including a lifetime limit of $35,000.
  • There is a new post-death option for surviving spouses, allowing the spouse to be treated as the decedent for RMD purposes. This works especially well when the deceased spouse was younger than the surviving spouse, delaying for a longer period having to take RMDs.
  • Enhanced access to retirement accounts based on need or disasters under various circumstances.
  • Reduced penalties for retirement plan mistakes, such as missed RMDs.
  • Penalty free IRA distributions up to $2,500 for long-term care premiums.
  • Relaxed rules for Qualified Longevity Annuity Contracts (QLACs) in IRAs.

Where Do We Go from Here?

Of course, nobody knows the answer to that question. And there will undoubtedly be surprises. But if inflation continues to recede – and the possibility of a recession still looms – it seems likely the Fed will begin to back off its rate increases in 2023 in probably even begin to lower them.

Inflation does appear to be turning a corner after peaking last June at 9% and falling for six straight months. Energy prices have fallen considerably. And it remains possible that the Fed can pull off a soft landing.

Longer term, positive interest rates, more reasonable valuations for tech stocks and the collapse of speculative cryptocurrencies bodes well. Supply chains are getting closer to normal. Money will be tighter and that me be a good thing, too. The fight over the debt ceiling is of course a wild card.

It is almost axiomatic that expected returns have gone up as a result of 2022’s results. With bonds, it’s pretty straight forward. The expected return for bonds at the beginning of 2022 were its then current yield of 2.00%. Today’s current yield is around 4%. And almost all major firms, including Vanguard in their 2023 Economic and Market outlook, have raised their long term assumptions for stock market returns over the next decade.

Sticking with Your Plan

2022 was a very good year to test whether you have a solid plan and could stick with it. Crucially, you can plan without predicting what the markets are going to do in the short run. The best strategy remains to capture the returns of the markets – and not try to outsmart them – within the bounds of your need and ability to take risk.

Moderately aggressive portfolios, such as a 60/40 stock bond split are designed to achieve the growth you might need over the long haul and allow you to sleep most nights.

Balanced portfolios have stood the test of time for many decades. Bonds usually have a low correlation with stocks, offsetting stock drawdowns in bear markets. Not this time… But that relationship will likely be restored – as rate increases slow – and maybe has already.

Some years ago, I coined the phrase: Diversification Works. Until it Doesn’t. Then it Works Again. And I stand by it. Actually, while bonds didn’t do their job this year, tilting toward value stocks and including a dollop of commodity exposure did serve to dampen the losses.

As with everything in life, being a successful investor starts with knowing what’s important to you and training yourself to deal with uncertainty.

Here’s a great bit of advice from David Booth, founder of Dimensional Funds, in a piece entitled: People Have Memories. Markets Don’t. Forget about last year. Start the new year off with a clean slate.

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