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WHAT IS FINANCIAL AND ESTATE PLANNING? Michael Tove, Ph.D, CEP, RFC February 2015 PLANNING refers to the efficient and effective management of your estate both during your life and after your death. It includes four broad components: • Financial (Accumulation) Planning – The strategies by which a person accumulates wealth for future use. • Retirement Planning – The strategies by which that accumulated wealth is converted into income in retirement and protected from the dangers of loss to unexpected financial, medical or legal events, particularly at a time when those assets are necessary to maintain one’s lifestyle. • Estate Planning for Asset Transfer – The strategies by which assets are transferred to designated beneficiaries, either during life or after death, in the precise way YOU wish with minimal interference from the courts, taxes, fees from third parties, or challenges from anyone. • Contingency Planning – The strategies to protect you in case things happen

that are not what you wish. There are many possible ways handle your financial affairs. Sadly, by far the most common pattern – a variety of personal investments, bank accounts and a Will could be one of the worst possible arrangements for good planning. 1. FINANCIAL (ACCUMULATION) PLANNING Everybody loves wealth accumulation. The saying goes “I’ve done poor I want to try rich If I don’t like it, I can always give it up.” However, too many people try to “get rich quick” and when it fails (as it invariably does), they fault the “get rich” part, not the “quick.” Accumulating a large nest-egg requires a long-term strategy and a commitment to make and stick to that plan. That doesn’t imply financial accumulation plans cannot ever change Quite the opposite. Good planning means reviewing and adjusting over the course of time as appropriate. It also means an investor should not try to judge the results on the basis of a few months or even a few years and it means

people need to rethink their investing objectives at different stages of their lives. A person fresh out of college, starting his/her career has a very different financial planning picture than a person about to retire – and their investing strategies should adapt to reflect those life changes. Few people would argue with the theory of above wisdom – until it comes to them. Then, suddenly, the advice they would have for everyone else, somehow doesn’t apply. They’ll offer all sorts of logic as to why – excuses really, but what they are really saying is that they don’t want to admit that investing has a beginning, a middle and an end. What they want to avoid is the end. In this case, “end” does not death of the person, but liquidation of the money; an end to the investing growth. 1 Nobel laureate and distinguished professor of finance at MIT and professor emeritus at Harvard Robert C. Merton (2014) sharply criticized corporate America claiming “Our approach to

savings is all wrong: We need to think about monthly income, not net worth.” (p.3) In other words, he is advocating for an exit strategy Without a clear exit strategy meaning a plan to spend money that has been accumulated, the accumulation has been only for its own sake and doesn’t do anyone any good. For example, a man grows money his whole life, dies and passes it onto his son, who grows it for his entire life, who dies, passing it on to his son who continues the family tradition. After a few generations, not one dime has been spent and it all begs the question “If nobody ever spends the money, what’s the point in growing it?” Ultimately, each and every investor need ask (and answer) the following simple question: Is all the money for personal income? • If so, its purpose was for future DECUMULATION (meaning conversion of the account to income). The details of when and how much are to be determined • If not, then the purpose of the money is inheritance. There really is

no “gray area” here. Money is either spent by the living or it’s passed to the surviving. Often people say “I don’t need the income The money is for me just in case” That’s a fancy way of saying “I don’t know.” Unfortunately, nobody can build a true plan around “I don’t know.” UNRAVELING THE INVESTMENT RIDDLE. When it comes to investing, everyone wants the same three things: high growth, unrestricted liquidity and absolute safety. Obviously, such a thing does not exist and even though most people would say they agree, they continue to invest as though it did. Within all the world of financial planning, there are only two categories of investments: 1. Those that can lose value – called securities They include stocks, bonds, mutual funds (including indexed funds), variable annuities, precious metals, real estate, collectables, gas and oil leases, mining rights, etc. Almost anything except: 2. Those that cannot lose value – called fixed return accounts They

include bank deposits (CD’s, money market accounts) and fixed insurance products (fixed annuities). Most investors who seek return put everything into securities (risk investments) and “hope” for good times. Conversely, investors who have been burned with that strategy transfer everything to the banks where “at least the money is safe.” Neither strategy is balanced or wise. While there is no such thing as an investment that offers high growth with absolute safety and unrestricted liquidity, it is possible to pair two of these. Sound investing requires accepting trade-offs within these three ideal desires and building a portfolio on purpose where different buckets are chosen for different planning goals. 2 No single product or strategy is always right for everyone – and none is always wrong. The mix that someone should have depends on specific circumstances, time horizons and personal goals. It is also important to recognize that as we go through life, these variables

change and so should the financial portfolio composition. Everyone’s circumstances are unique. However, there are certain “rules” that serve as sound guidelines for balanced financial planning: • The College for Financial Planning recommends maintaining enough “cash” to cover 3-6 months of living expenses. Practical planning suggests in some cases, it should be higher “Cash,” in this case, refers to any account that offers absolute safety with complete liquidity by limiting growth potential. Examples include not only money market and savings accounts but also penalty-free access to fixed (NOT variable) annuity accounts and even available credit from Home Equity Lines. • Avoid risk-investments with money you cannot afford to lose. • Do not invest money you will need for income within the next 10 years. • Seek to minimize the overall risk by long term investing and diversifying the portfolio by consideration of risk-adjusted return, not based on historical

return. • The older you are, the less you should have at risk in the market. An old formula of 100 minus your age is the percent of your portfolio that should be risk-exposed. This formula is not to be taken literally but it does provide a reasonable guideline for suitable portfolio balancing. • Resist greed. It’s not necessary to have high growth with everything you own The financial services world consists of three industries: Securities, Banking and Insurance. Each serves a purpose and each has value depending on circumstances. Market investments are the vehicle of the Securities Industry. Fixed Interest accounts (CDs and Money Market accounts) are the tools of Banking and Annuities are the tools of insurance. And when it comes to the insurance industry, we’re talking about “Fixed Annuities” meaning pure insurance products. Variable Annuities (purchased from a Securities company) are a “hybrid” between Securities and Insurance (even if they have “fixed”

guarantees). None of these industries is “all good” or “all bad.” Each has a place and the vast majority of investors would be better served being diversified across these three industries than seeking diversification entirely within one. There are three variables everyone wants: growth, safety and liquidity. No industry offers all three One must be traded off to have the other two Thus: • Securities offers growth potential and unrestricted liquidity, at the expense of safety. • Banking offers safety and liquidity at the expense of growth potential. • Insurance offers Growth potential and safety at the expense of short-term liquidity. 3 The vast majority of people are more familiar with securities and banking products than insurance. This is unfortunate because the most common thing they want is growth without risk. That is the pairing best served by the insurance industry Seeking to get growth without risk in the securities industry is to turn a blind eye toward the

fact that securities, by their very definition, have risk and that no banking instrument can (or will) offer high growth potential (at least not in a very long time). This is unfortunate because they are looking in the wrong place to get the thing they say they want. No matter what else, it’s the square peg in a round hole thing. MARKET INVESTMENTS VS FIXED INDEX ANNUITIES. The reason more people are familiar with market investments (Securities) than Insurance products (Fixed Index Annuities or FIAs) is familiarity. In the United States, stock market investing is older than the country and the New York Stock Exchange was formed in 1792, a year before the country began minting its own money. Daily reports of the values of major market indexes as well as many individual stocks can be found in most major newspapers, on TV and over the internet. By contrast, FIAs have only existed since 1995 That does not mean “old is good and new is bad.” However to read the myriad of internet

articles on them is to believe FIAs are somehow spawned by the devil. The truth is, NO broad category of financial products can be defined by vague, all-encompassing characterizations any more than a race of people or a religion can be accurately characterized by some negative stereotype. To understand FIAs and why opinion about them can be so polarized starts with an overview of their history. The FIA was invented in the early 1990’s by a group of insurance product designers as a way for people to capture growth from rising markets without the risk of a future correction (meaning “crash”). Above anything else, FIAs are Fixed annuities meaning they are pure insurance products. They are NOT Stock Market investments and have NO Stock Market risk. In 1995 after several years of design effort, the first products were launched. Essentially, these early products offered a proportion (e.g, 75%) of the upside of a benchmark market index (e.g, S&P 500) and no risk of loss on the

downside They should have been the “hottest thing” in the market but they weren’t. Why? Because the mid-to late 1990s was a time of the biggest bull market run in US history and many investors thought they were invincible: “Why get 75% of the market when you can get 100%?” Then the Dot-Com bubble burst and markets crashed. From March of 2000 through October of 2002, all the major US markets plunged. The S&P 500 and the Dow Jones Industrial Average lost half their value. The Nasdaq (the high-tech stock sector) lost nearly 78% of its value. Suddenly, investors were ripped from euphoria of great, expanding wealth and thrust into the depression of poverty. The country hadn’t faced anything like that since the crash of 1929 and the ensuing Great Depression. Even most depression-era survivors had never experienced it first-hand because they were children when it occurred. They weren’t the ones doing the investing. 4 The Dot Com crash impacted more than just the

investors. Advisors who earn a residual from “money under management” saw their personal incomes plunge. Adding insult to injury, investors withdrew their remaining moneys from the market to place it somewhere safe. Suddenly Fixed Index Annuities looked very attractive. Needless to say, this was not well received by an investment industry already reeling from the shock of the market crash. Desperate, they sought ways to discourage the exodus – and they found it. “Follow the money” as the saying goes, is what happened in the financial services world. The market place was inundated by newly licensed annuity agents selling an increasing diverse array of FIA products. Like anything, not all companies or products are equal Some carriers, seeking to increase their market share, offered more commissions to agents. Others promised more “up front” benefits to consumers. A bevy of untrained agents went forth with great zeal, selling FIAs on all sorts of promises, some of which were

not made in the annuity contract. Then, as issuing companies found their overly generous initial offerings were unsustainable, they back-peddled. Complaints flew and the industry – and clients – suffered from the whiplash. It gave detractors fodder to denigrate Even though the vast majority of agents and insurance companies were not guilty of wrong-doing, it didn’t matter. Through guilt by association, they fell victim to self-proclaimed media pundits who loved to hate and had an agenda. In the aftermath of the financial crisis of 2010, the insurance industry took steps to address concerns of product suitability and agent concerns. The result was that modern day FIAs do not resemble what the nay-sayers accuse (if they ever did). To say that market investments (securities) and FIAs are different is an understatement. Securities are direct investment in markets. Specifically when investors purchase either individual stocks or mutual funds, they are purchasing fractional ownership

of one or more publicly traded corporations. As such they are eligible for profit-sharing in the form of capital appreciation (value of the stock increases) and dividends (shared profit payments). Either way, shareholders make money when the company does. However, if the invested company loses money, the shareholder will also lose value in their investment. In a perfect world, this is as it should be because companies that produce better goods and services will be more profitable and consequently more attractive to future investors. In a perfect world, the best survive and the rest don’t. Unfortunately, we don’t live in a perfect world and companies that do nothing wrong can (and do) experience disproportionate losses in stock value through no fault of their own. During the market crash of 2000-2002, the collapse of the “Dot-com” sector caused everyone to plunge, including Coca-Cola Co. which lost over 35% of its value during that time So what does a popular non-alcoholic

beverage that has been around since 1886 have anything to do with high tech computing? Nothing. The company’s stock value got dragged down because everyone was going down. 5 Stock market investing is, and always has been, a game of uncertainty. Fundamentally, investors do it because either they feel their investments will provide a return sufficient to warrant the risk and/or they believe in and want to support the company. Risk – the probability of not achieving a desired return – is mitigated by long time investing horizons: “Time IN the market not TIMING the market.” But what do many investors do? They try to pick the “best time to buy and sell to maximize their return. They’re trying to “beat the market.” In theory, it makes sense: Buy at the bottom and sell at the top. Unfortunately reality does not match the theory. A study by Morningstar (Kinnel 2014) found that from 2003-2013 where the average mutual fund returned 7.3% per year, the average mutual fund

investor gained just 48% per year And that is before taxes on gains are accounted for. The reason is that investors are imperfect in their timing and rather than trying to beat the market, a “buy and hold” strategy would have delivered better results, and with fewer income tax consequences. So why do so many investors continue to actively trade short-term? Because they feel they are “better” than the myriad of others who tried and failed. They believe the rules that apply to everyone else somehow don’t apply to them. To be sure, there are investors who are skilled and can consistently manage portfolios which out-perform the markets. Sadly, the number of people who think they can is far greater than those who can. FIAs were invented to offer an alternative to investing without having to settle for traditional fixed interest returns. Their promise was to permit annuity owners access to high returns through an INDIRECT measure of market indexes without being invested and

therefore not exposed when markets fall. Like anything else, they are financial tools When used appropriately, they provide distinct if not unique benefits. When used inappropriately, they can be a liability. Simply put, FIAs are NOT suitable for everyone, nor for anyone’s every dollar. However, they are suitable when someone seeks: • Growth potential without risk of loss • Guarantees of lifetime income • Tax-deferred growth • Legacy strategies including automatic bypass of probate and income (not lump sum) for heirs • Additional benefits such as guaranteed death benefit or long term care protection, etc. CDS VS FIXED ANNUITIES. As with the securities industry, more people are familiar with bank CDs than annuities. When CDs paid high interest rates (e.g, 5% or more), they were very popular During times of very low interest rates, they are less so. Superficially, CDs and annuities are similar in that you deposit an initial sum for a predetermined minimum time period in

exchange for some promise or estimate of return. Other than that, they are quite different. 6 • Fixed Annuities are actually safer than CDs. Many people feel CDs are safe because they are insured by FDIC. However, FDIC is not absolute First and foremost, the FDIC does not have enough money in its own account to fully insure every bank that they cover. According to the Dodd-Frank Wall Street Reform and Protection Act (2010), the DRR (Designated Reserve Ratio) – meaning the cash reserves FDIC has available to “insure” deposits, is 1.35% In the event that isolated banks fail, FDIC’s total reserves are sufficient to fully insure those deposits (up to the insured limit of $250,000 per depositor). If that fails, the FDIC is backed by the Federal Government through a financial “bail out.” In sharp contrast, Annuity companies must maintain 100% reserves at all time, without limit on the deposit or future size of the account. This is not imply that banks (and FDIC) are

unsafe, only that annuities are more safe. • Interest generated by a CD is taxable as ordinary income in the year it was reported – even if you cannot get to use it. This taxation has a double jeopardy in that not only does it reduce the net earnings of your account, it can also count against your Social Security income for tax purposes. Annuities enjoy tax deferred growth which not only provides relief from taxation during the growth years, they also benefit from tax-deferred growth, sometimes called “triple compounding:” (compound growth on principal plus compound growth on interest plus compound growth on what would have been paid to IRS. • Annuities automatically avoid Probate; CDs do not. • Annuities offer penalty-free access to the money; CDs typically do not. • Some annuities offer deposit bonuses on repeat deposits. The arrangement resembles an employer’s matching contribution in plans like a 401(k); CDs do not have deposit bonuses. • Annuities have

the ability to create permanent lifetime income; CDs do not. 2. RETIREMENT PLANNING At some point, the time will come to spend some (or all) of what you spent a lifetime saving. It can be a tough thing for retirees to start spending all the money they accumulated. After all, spending means an end to growing and nobody likes to see their investment portfolio shrink. But there is a huge difference between losing value due to declining markets and by spending. The first is never a desired result The latter is natural and expected, provided the retiree does not out live the money! Income-generation plans MUST include certain attributes. To be effective, the income payments must: • be reliable and predictable, meaning they are received every month without a miss. • be 100% safe and guaranteed. • account for the effects of inflation. • include a consideration for taxes, including take advantage of any tax-savings strategies possible. 7 3. ESTATE PLANNING FOR ASSET TRANSFER Your

Will or The Court’s? A Will is a document that acts as your instructions to the Probate Court for handling your estate after you die. Probate can be a lengthy and cumbersome process of “Proving the Will” The biggest challenge with Probate is that it is public and places your heirs at the end of the line to receive your inheritance. Ahead of them are: • The Probate Court itself. The court gets paid for its work While not a huge amount in the grand scheme of things, it is a drain on the estate and, for even relatively modest estates, can amount to a few thousand dollars. • The IRS – Even if your estate is not large enough to be exposed to Inheritance Tax, other taxes, including income tax, may be due. Benjamin Franklin famously said nothing is certain except death and taxes and in this case, even your death cannot forgive taxes. • Your state’s Department of Revenue – for state income and/or state inheritance tax. • Other costs of Probate, including fees to a probate

attorney, the personal representative (executor), property appraisers, tax preparers, etc. • Bills from any utility, public service or commercial subscription company (telephone, internet, television, newspapers, magazines, club memberships, etc. for services “provided” after the death. • Other monthly expenses associated with your previous residence: home owner association dues, mortgage or rent payments, insurance, etc. • Creditors – either current or future –including any uninsured bills generated by the medical care facility that treated you at the end. • Any other claim, dispute or challenge that may be filed (and upheld) against the Will by a disgruntled heir, a non-inheriting relative – anyone who claims, truthfully or not, that you owed them money. (Remember: You are no longer around to defend yourself) • The public at large. Wills are Public Record On your death, the court offers this invitation: “If you claim this person owed you money, come forward and

have your say in court. If that should occur, the estate will (necessarily) be represented by legal counsel, as will the claimant and all those attorneys are paid out of the estate in probate. PROTECTING ASSETS FROM PROBATE. Assets that avoid Probate include: • Anything left to a surviving spouse. • Annuity or Life Insurance contracts - provided that living persons, not the estate, are the beneficiaries. • Assets held in many (but not all) types of trusts. • Qualified moneys (IRAs, 401(k), etc.) - provided that living persons, not the estate, are the beneficiaries. • Certain types of accounts and investments with specific beneficiary designations (JTWROS, TIC, etc.) 8 4. CONTINGENCY PLANNING Nobody likes to think about it, but bad things can and do sometimes happen. Disability and/or death in and of itself, causes severe stress on loved ones. When those events occur in the absence of clear planning, the stress is significantly worse. One of the most common mistakes made

is the assumption that adequate insurance solves everything. To be sure, being appropriately insured is a critical component of good planning but all the insurance in the world does no good if responsible parties don’t know about it and more to the point, specifically know where those insurance policies are. Thus, good contingency planning requires having two components: 1. Adequate Insurance This might include: • Life Insurance • Medical Insurance • Disability Insurance • Long-term Care Insurance • Etc. 2. An Emergency Action Plan (EAP) This is nothing more than a record of anything and everything that someone would need to know in case you die or become incapacitated and cannot communicate that information yourself. Your EAP should be archived in a known and secure location and specific instructions of that document’s location should be distributed to whoever would be responsible. All too often, people assume that it’s enough to have “told” your loved ones what

you have and where it is. Asking people to remember more than one thing, especially if it involves instructions of any kind is asking a lot – made infinitely worse because you’re asking them to remember everything in the middle of an emotional crisis. Having everything written and archived, requires remembering and only one thing: where the instructions are located, which is a lot less uncertain than remembering anything more. THE TRUTH ABOUT LIFE INSURANCE. Many people have some form of Life Insurance but few really understand what they have or why they really have it. Life insurance is one of those things that, when done correctly, is a powerful planning tool – and when not done correctly is a hideous waste of money – or worse. There are two basic classes of Life Insurance: Term and Cash Value Term Insurance offers protection for a limited period of time (e.g, 10, 20, 30 years) It only pays if you die within that time allotment. It has no cash value and you get nothing if

you outlive the policy by even one day. However, it is very economical Term is most correctly used for income protection when a specific need exists only for a specific period of time. Cash Value Insurance (including “Whole Life” and “Universal Life”) is a form of permanent insurance. The premiums are more than Term but the policies build cash accounts that are used to keep the policy in force for an extended period of time. That 9 cash value is also available for withdrawal, loans, collateral, etc. In most cases, these moneys are received with some tax advantages. These policies are ideally suited for Estate Planning because they can be made to last as long as you do. In addition, it is possible to use them to transfer enormous wealth to heirs 100% tax-free BUT only if established correctly at the time of application. THE INCREASING NEED FOR LONG-TERM CARE. The average life expectancy of a person born in 1900 was 47 years. In 1990, it was 75 and in 2000, it was 78. The

longer people live, the more likely they will need some form of assisted living care in their lifetimes. In 1990, 22 Million people turned 65 years old Of those, an estimated 43% have, or will enter a Nursing home in their lives – and 21% will stay at least 5 years. In 2000, the average cost of a Nursing Home was $45,000 to $65,000, rising 5-7% per year. Without either adequate Long Term Care insurance or a sophisticated planning strategy, entry into a Nursing Home can result in total loss of the estate. There are a number of strategies, including the use of insurance and advanced Estate Planning that can protect your estate from this sort of disaster. The key to success is planning well in advance of the need. The best results are possible when that advanced planning is completed at least 5 years ahead of the need. PLANNING IS ABOUT PURPOSES, NOT PRODUCTS. Too many people are better able to explain what they have than why they have it. That’s backwards. It’s commonly said that

too many people spend more time planning for a vacation than they do for their financial future. But what if that thought were reversed? If a person planned their vacation the way most people financially plan, here’s what would that vacation be like: “We’ll leave at 6AM to beat the morning traffic and stay on the interstate. We’ll drive at an average of just over 70 MPH for eight hours, stopping every four hours to stretch our legs. At the end of the day, we’ll have driven 500 miles.” What’s wrong with this vacation plan? Almost everything. You don’t know where you’re going, or if you can get there by Interstate or if the destination is even suitable by motor vehicle (suppose your vacation was a weekend in Hawaii starting from New York?). Before picking products, it’s important to pick purpose. Once specific objectives are identified, then (and only then) should products be considered. And for the record, purpose means specific objectives not “I want to grow as

much as I can as quickly as I can for as long as I can.” That’s no different than “I’ll drive as fast as I can, for as long as I can and see where I end up.” Without question, the biggest planning mistake people make is to NOT actually plan – and base that planning on goals, needs and practical expectations. 10 REFERENCES: Kinnel, Russel. 2014 Mind the gap 2014 Morningstar Fund Investor, Online report, February 27. http://wwwmorningstarcom/advisor/t/88015528/mind-the-gap-2014htm Merton, Robert C. 2014 The Crisis in Retirement Planning Harvard Business Review, JulyAugust, pp 3-10 crisis in retirement planningpdf 11