February 8, 2016
What we’re reading this week
Last year several retailers faced lawsuits regarding their us of “discounts” to attract customers. JC Penny and Justice settled to the tune of around $50 million because of allegations they were advertising discounts of 40% when the items in question had never been sold at the above sale price. BuzzFeed News examined America’s obsession with a bargain and how many retailers and outlet stores use “price anchoring” and “high-low pricing” to attract shoppers. What interests me is that these lawsuits started popping up around the same time former Apple retail chief, Ron Johnson, tried to move JC Penny away from their discount model to “every day” low prices. He failed. JC Penny learned the hard way that many shoppers are not looking for the lowest, fairest price on what they buy but are actually looking for the emotional rush they get when buying something “on sale.” When JC Penny moved away from it’s discount model sales dropped 25%. According to JC Penny’s research, in 2011, they held 590 sales events and most of what they sold was marked down 50% or more. Pennys was able to offer these large discounts, not because they were dramatically cutting their profits but because they were artificially inflating the “original price” of their goods. Ultimately JC Penny did bring about the desired goal of transparency but only to the extent that they angered customers who thought they were getting a deal and were not. There are two lessons for retailers here: 1) Do not advertise fake deals because people don’t like being lied to and 2) Sell things at a discount because people like deals.
Vanguard and Taxes
I feel like I have covered this topic in the past but in case I haven’t here is the issue: Vanguard has run afoul of what is called the “Arm’s Length Standard.” In 2013, David Danon, the former in-house tax attorney for Vanguard filed a lawsuit that alleges the firm’s business structure is not in compliance with Treas. Reg. 1.482-1(b)(1) because the Vanguard investment manager (or VGI) offers its services to Vanguard mutual funds “at cost.” Every other mutual fund company operates in a more complex structure, i.e. a fund manager offers their services to the mutual fund company at a profit. The idea behind Vanguard’s structure is that it eliminates conflicts of interest that an investment manager would face by being beholden to the shareholders of the advising company. VGI is a wholly owned subsidiary of Vanguard Funds in proportion to the net asset value or NAV of the fund they operate. The problem is that investment advisors are taxable corporations, not taxable at the fund level, assuming they meet certain requirements. Therefore by not charging fees in line with similar companies, Vanguard is effectively avoiding paying taxed on profits that should be taxed (in theory). The questions still remains, is Vanguard really in violation of tax law? These laws are designed to stop American companies from appropriating income to foreign subsidiaries to reduce domestic taxes and we will have to wait and see if the courts will actually pursue this. However, should it be established that Vanguard is not able to operate under their current structure, what are the next steps? The courts and Vanguard would need to establish an “appropriate” mark-up for Vanguard’s services. The fund company’s competitors currently charge an average expense ratio of .71-.82% of NAV compared to Vanguard’s average expense of .2%. Despite that wide margin, Daniel Hemel, a law professor at the University of Chicago states that a potential Vanguard settlement could result in an increase of no more than .09%. There is a lesson here. Assuming Vanguard is forced to increase its management fees it would result in an increase of 45%! And they are still far cheaper than their peers! The average fund expense is 250% higher than Vanguard. Wow! This is just one reason, among many, why we do not invest in mutual funds.
Every February the President will submit a new budget request to congress. Most of these provisions typically pertain to appropriations for government agencies but sometimes they also include potential tax law changes. Obama has less than 12 months left in office so it is very unlikely any of his proposed tax changes will take place. However, his budget does provide some insight into what may be on the docket in future years. Of note to investors are the suggested changes to the way gains are taxed in a 1031 exchange of real estate, a lifetime Required Minimum Distribution for Roth IRAs after age 70 ½, the elimination of stretch IRAs and step-up in basis at death, and the elimination of the “backdoor” Roth contribution. Again, the odds of any of these being approved now are very slim and it’s important to remember they have been addressed in the past without action. The change with the greatest potential impact to investors (in my opinion) is the elimination of stretch IRAs. Under the new rule IRAs would be forced to liquidate over a 5 year period, the only exception being minors (who would be allowed to wait until the age of majority) and persons not more than 10 years younger than the original owner (they would be allowed to “stretch” based on their own mortality table).
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