Solve problems about finance / need it within 24 hrs

s_1122

PersonalFinancialPlanning2ndEdition.pdf

Home >Business & Finance homework help >Solve problems about finance / need it within 24 hrs

Second Edition

PERSONAL FINANCIAL PLANNING

Lewis J. Altfest

Personal Financial Planning

FINANCIAL MANAGEMENT

Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition

Brooks FinGame Online 5.0

Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition

Cornett, Adair, and Nofsinger M: Finance Third Edition

DeMello Cases in Finance Second Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations

Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Eleventh Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition

Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentials of Investments Tenth Edition

Bodie, Kane, and Marcus Investments Tenth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice Second Edition

FINANCIAL INSTITUTIONS AND MARKETS

Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition

Saunders and Cornett Financial Markets and Institutions Sixth Edition

INTERNATIONAL FINANCE

Eun and Resnick International Financial Management Seventh Edition

REAL ESTATE

Brueggeman and Fisher Real Estate Finance and Investments Fifteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Fourth Edition

FINANCIAL PLANNING AND INSURANCE

Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition

Altfest Personal Financial Planning Second Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An active approach to help you achieve financial literacy Fifth Edition

Kapoor, Dlabay, Hughes, and Hart Personal Finance Eleventh Edition

Walker and Walker Personal Finance: Building Your Future Second Edition

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

Second Edition

Personal Financial Planning

Lewis J. Altfest, Ph.D. Pace University

PERSONAL FINANCIAL PLANNING, SECOND EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous edition © 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 QVS/QVS 1 0 9 8 7 6

ISBN 978-1-259-27718-4 MHID 1-259-27718-6

Senior Vice President, Products & Markets: Kurt L. Strand Vice President, Content Design & Delivery: Kimberly Meriwether David Executive Brand Manager: Charles Synovec Director, Product Development: Meghan Campbell Lead Product Developer: Michele Janicek Product Developer: Jennifer Upton Marketing Manager: Melissa Caughlin Digital Product Developer: Tobi Philips Director, Content Design & Delivery: Linda Avenarius Executive Program Manager: Faye M. Herrig Content Project Managers: Mary Jane Lampe/Karen Jozefowicz Buyer: Susan K. Culbertson Cover Design: Studio Montage Content Licensing Specialist: Beth Thole Cover Image: studiovision/Getty Images Compositor: Aptara®, Inc. Printer: Quad/Graphics

Certified Financial Planner Board of Standards, Inc., is a professional regulatory organization based in the United States of America that fosters professional standards in personal financial planning so that the public had access to and benefits from competent and ethical financial planning. They can be reached at (800) 487-1497, or on the Web at www.cfp.net. CFP® Certification Exam Questions © 2014, 2004, 1999, 1996, 1994 CFP Board. Used with permission.

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Altfest, Lewis J., author. Personal financial planning/Lewis J. Altfest. Second edition. New York, NY: McGraw-Hill/Irwin, [2017] LCCN 2015035267 ISBN-13: 978-1-259-27718-4 (alk. paper) ISBN-10: 1-259-27718-6 (alk. paper) LCSH: Finance, Personal. Financial planners. LCC HG179 .A4484 2017 DDC 332.024—dc23 LC record available at http://lccn.loc.gov/2015035267

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

To my wife, Karen. Her success as a financial planner after receiving a Ph.D. in an unrelated field made her inputs particularly valuable in constructing this text and its second edition. Perhaps more importantly, through her ability to balance a career and dedication to our children and the quality of our lives together, she created an environment that made this book possible.

About the Author Lewis J. Altfest, Ph.D., CFP, CFA, CPA, PFS Lewis J. Altfest has balanced a career in financial planning and investing with one as an associate professor of finance. He began as an accountant working for a then “Big 8” accounting firm and became a Certified Public Accountant. After some shorter-lived ventures, he joined the Wall Street firm of Wertheim and Co. in its investment research department. He held similar positions with Lehman Brothers and Lord Abbett & Co. At Lord Abbett & Co., an investment management firm, he rose to become Director of Investment Research, Chief of Long Range Strategy, and a general partner of the firm. At the same time, he began seriously pursuing a Ph.D. and teaching part-time. It was at Lord Abbett that Lewis Altfest decided to focus on helping individuals instead of institutions. He wanted to become the “Consumer Reports of Financial Planning,” that is, to provide unbiased financial and investment advice and to dedicate himself to instructing students and the public on financial matters. In 1982, he established a financial planning and investments firm along with another individual and in 1983 incorporated a firm performing activities by himself. At about the same time, he joined the faculty of Pace University as Associate Professor of Finance. His wife, Karen C. Altfest, joined him in business shortly thereafter (his son some 20 years later), and together they have established a nationally recognized multi-person financial and investment advisory firm, Altfest Personal Wealth Management Inc., located in New York City. Dr. Altfest has been active in financial planning industry matters for over 30 years, in- teracting with other planners nationwide, and has been an original member and a member of the board of directors of the National Association of Personal Financial Advisors and served on the board of directors of the IAFP New York Chapter, the predecessor of the Financial Planning Association, and on the board of the Educational Foundation of NAPFA as well. He was named one of NAPFA’s 30 most influential advisors in 2013. Over the past 30+ years, Dr. Altfest has been named to Best Planners in the United States lists by Money magazine, Worth Magazine, Mutual Funds Magazine, and Medical Economics. Over the past 10 years and again in 2014 Barron’s named Dr. Altfest one of the “Top 100 Independent Financial Advisors in the Nation.” In 2014, he was inducted into Research magazine’s Hall of Fame, and Dr. Altfest’s firm was named by Financial Times magazine as one of the Top 300. In 2014, he received The Best Practices Award Recognizing Altfest Personal Wealth Management as a Best Managed Firm by Investment News. He has been included among Bloomberg’s “Top Wealth Managers.” He was also awarded the Lifetime Achievement Award by Financial Planning magazine. At Pace University, he has been active in many pursuits, including serving on the University’s employee benefits committee, chairing the Lubin School’s Graduate Division tenure committee, and chairing the finance department’s recruitment and tenure committees. He has published academic research papers in financial planning and investing and has two other books, Introduction to Business (Harper and Row), and Lew Altfest Answers Almost All Your Questions about Money (McGraw-Hill), which he co-authored with his wife. Dr. Altfest participates in many professional and academic associations today, includ- ing the FPA, NAPFA, CFA Institute, and AICPA, and is an original member of the Academy of Financial Services. His advice and research have been quoted in such media as The New York Times, The Wall Street Journal, Newsweek, US News and World Report, Fortune, BusinessWeek, Money Financial Advisor, Financial Planning, Investment News,

About the Author vii

Bloomberg Wealth Manager, and Bottom Line, and he has written a monthly column for Medical Economics for over a decade. He has appeared on CBS, ABC, NBC, CNN, CNBC, and others. For his role in the development of the financial planning profession, the Business and Economics Alumni Society of the City College of New York chose Dr. Altfest as their 2006 Career Achievement Award recipient. Baruch College, the then undergraduate division of City College of New York, provided him with the Alumnus of Distinction Award in 2012. He has been named an Alumnus of the Year by CUNY Graduate Center Alumni Association, where he received his Ph.D. degree. You can catch him on Saturdays and Sundays relaxing on the deck of his weekend home, alternately doing work, talking to Karen, and gazing at the birds in the treetops, which one of his clients assured him would add years to his life.

viii

Preface GOALS OF THE BOOK

Personal Financial Planning is designed to be used for the study of personal finance and financial planning from a planner’s perspective. This text goes beyond the traditional per- sonal finance texts to teach students how to do actual financial planning and integrates the theory and practice of personal finance. This book incorporates a theory of personal financial planning that demonstrates the similarities and differences between personal and business finance and integrates the entire body of financial material presented. It is intended to utilize the theoretical contri- butions over the past half-century, particularly modern portfolio theory, to elevate the level of presentation. At the same time, its goal is to remain easy to understand and use- ful in real life. Instructors of education courses, whether for general or CFP® certification prepara- tion purposes, may consider the text’s practical combination of planning facts, analysis, and frequent step-by-step instructions attractive. Experienced financial planners and other professionals looking for a one-volume reference to the planning field from a prac- titioner’s perspective, or who may be considering pursuing the Certified Financial Planner™ (CFP®) certification should also find the book appealing. Those who would like to plan their own financial future in a comprehensive way also should find the text informative.

THEMES This text is unified by a few themes. One is that the household resembles a business and can profitably use its financial techniques. Another is that decisions for the household, for you, include all operations and all assets and obligations. In other words, decisions are ultimately made on an integrated basis. Whether we are engaged in investment activities or mapping retirement plans, we are performing household operations that fall under personal financial planning’s mandate. Our personal financial planning objective is effective household operations that we achieve through logical, businesslike financial procedures. Households whose activities are financially efficient have the foundation for personal goal achievement. This approach is covered in more detail in Chapter 4.

ORGANIZATION In keeping with its practical emphasis, Personal Financial Planning is largely ordered around the parts of a financial plan. Its parts all funnel into the final section, Integrated Decision Making. The approach is illustrated in Figure A. Many of the chapters that require active planning use a full or modified process- oriented approach that takes the student through the methodology point by point. This approach not only provides an easy-to-follow structure; it also better prepares financial planning majors for more advanced material to come.

Preface ix

Content Personal financial planning is an unusually broad discipline that requires knowledge of topics ranging from mathematics to human interaction. Not coincidentally, there is an introductory chapter in Part One that presents virtually all the mathematical material needed in simple fashion with solved examples for each step. It is a feature of the book that all new concepts are followed by examples using generic calculator solutions where possible and Excel-based solutions in the text and on the website. The human side of the process, which is often overlooked, is presented in Chapter 3 in the sections that stress communications and goal setting. Human actions are expanded on in a separate chapter, “Behavioral Financial Planning” (Chapter 18), which presents the latest thinking on the topic. Practical examples of its contributions are given in each major area of personal financial planning. In keeping with the practical nature of the text there is a final chapter, “Completing the Process,” that truly explores the finishing process. To the author’s knowledge, this is the only textbook to cover PFP integration and overall decision making in detail. The chapter could have been called simply “Completing the Financial Plan.” However, it essentially does more, indicating how certain tools and practices demonstrate the comprehensive na- ture of PFP and improve the completion process. It is this integration that requires overall decision making that differentiates personal financial planning from personal finance and from other professions that offer financial advice. Personal finance and investments courses alike tend to treat financial investments as the centerpiece of investment material. There are other assets, namely human-related and real assets, that importantly enter into decision making. In Chapter 8, “Household Investments,” these investments, often given less emphasis, are described and analyzed in detail. The text has one review chapter in Part Six, “Planning Essentials.” Chapter 16, “Stocks, Bonds, and Mutual Funds,” provides those without a proper background, or students in need of a review, with a quick upgrading in usable knowledge in investment categories. Included is descriptive material on stocks, bonds, mutual funds, and exchange-traded funds.

VII Integrated Decision

Making

I Planning Basics

II Ongoing

Household Planning

III Portfolio

Management

VI Planning

Essentials

IV Specialized

Planning

V Tax and Estate

Planning

FIGURE A Sections of the Book

x Preface

Normal Financial Coursework and CFP® Preparation Current or possible future CFP® candidates can receive credit toward CFP® requirements in a regular financial planning course.1 Personal Financial Planning provides all the specific material necessary to comply with CFP® required content areas. It is an appropri- ate method of presentation for all students, not just financial planning majors. Its emphasis on practical material, theory, case study analysis, and “how to do it approach” provides a broader experience for both one-time students and those headed for CFP® status. Professors who desire further descriptive coverage, including those who prefer enhanced CFP® certification preparation information, will find special chapters for that purpose as well. Suggested syllabi and outlines are provided for classes: 1) intended solely for students interested in a CFP® and 2) for combined regular survey and CFP® students. This will accommodate all students interested in applying for CFP® credit as detailed in the Instructor’s Manual found on the book’s website.

FEATURES There are a number of features throughout the chapters to help bring the text material to life.

The goals of each chapter are stated at the beginning of that chapter. They are most of- ten expressed in action-oriented terms to emphasize the usefulness of the material in daily situations.

A key feature is the use of a single case study that is developed throughout the text. Each chapter starts with a relevant sentence or two from that chapter’s event. Significantly at chapter’s end, Dan and Laura’s day-to-day problems are stated and an- swered from a financial planning practitioner’s point of view. This ongoing case study also reviews the chapter’s material and places it in a broader context. The case permits the student to understand how the chapter’s material can be applied to real-life situa- tions and experience the information-gathering process as a professional interviewer would. Reviewers have said that this case study, which is deeper than a typical academic one, is more interesting and closer to a student’s own experiences.

Almost every chapter starts with a minicase called “Real-Life Planning.” It sets the stage for the educational material to follow. Students have found these “stories,” largely based on the author’s own experiences with clients and told in a nontechnical manner, an interesting, easy-to-relate-to way to begin the chapter.2

Key words are presented in boldface to highlight terms and concepts that are emphasized.

Practical Comments are often used to underscore the situations in which real human actions differ from the way the book tells you it should be done. These highlighted

1 The course must comply with coverage of CFP® required areas. If it does the student can receive credit toward eligibility for the exam and the CFP® within a normal academic curriculum without it being taken through a CFP® Board-Registered Program. “The CFP® Board will consider granting credit toward the educa- tional course work requirement for CFP® certification if: 1. You can submit documentation that you have successfully completed equivalent approved upper division level college or university coursework at a regionally accredited college or university . . .” See CFP® Board education requirement for further details— http://www.cfp.net/become-a-cfp-professional/cfp-certification-requirements/education-requirement. 2 Certain material has been altered in part to protect the identities of the people who are discussed.

boxes’ recommendations, given to meet the issues at hand, carry the tone of a financial planner who has dealt extensively with these circumstances.

Tables and figures have been placed throughout the text. Wherever useful, the tables have presented a summary of factual material in an easy-to-refer-to manner.

As we mentioned, there are many examples given, particularly in mathematical and more-difficult-to-describe concepts. Special efforts are made to provide an answer for every type of problem, often including an explanation of why a particular step is taken.

Excel is explained and solutions are given for all appropriate problems in the appendix to the text and on the website. In addition, calculator solutions are provided on a generic pictorial basis in the body of the text where possible, thereby allowing any financial calculator to be used to solve those problems. Where problems are more complex, key- strokes of two leading calculators, the HP12C and the TI BAII Plus, are illustrated right in the example.

An actual comprehensive financial plan is provided on the website. It is based on the Dan and Laura case study presented by chapter, but this time in a more compact manner after final decisions have been made. Students should gain an appreciation for how an actual financial plan looks and, together with chapter presentations, how it is developed.

There are many end-of-chapter study tools to be used for self-study and/or homework:

The salient points of the chapter are placed here. Together with the goals section and key terms, it can guide the student into a better understanding of the chapter’s points.

This feature provides in one place a useful compendium of important terms introduced in the text.

Selected websites indicate where additional information can be obtained.

A select list of questions is presented representing a mixture of factual and evaluative matters. The problems stress mathematical computation as a practical exercise of the chapter’s numerical material.

A broad list of former CFP® certification examination questions is provided. These demonstrate selected areas of emphasis for those contemplating taking the exam. They also present many practical questions that require students to demonstrate knowledge of the chapter’s topics.

There is a second case study, called Case Application, that is similar in approach to the first one about Dan and Laura. However, instead of having a solution given in the text, this one is to be prepared and submitted by the student and/or discussed in class.

Instructors who wish to schedule a term project for students doing a financial plan for “clients” can do so. In my experience of over 30 years teaching PFP to matriculating

Preface xi

undergraduate and graduate students, this assignment is very popular. The knowledge derived from the two case studies in each chapter and the full financial plan on the web- site enable students to prepare their plans well.

There are also a Glossary and Suggested Readings at the end of the book.

CHANGES IN SECOND EDITION This book goes beyond the presentation of basic facts to teach people how to perform per- sonal financial planning. Since the first edition, the field has become more sophisticated both from the standpoint of the professionals who offer PFP and the consumers who increas- ingly desire broader and deeper knowledge from their financial advisors. At the same time, the public and many students want practical information presented in easy-to-understand terms that don’t speak down to them. Feedback on the first edition indicated that students felt the book was easy to read. The second edition, as described below, adds new sections and text material that significantly enhances the ease of understanding, practicality, and further relatability to college students and provides a lively new Life Cycle Planning section. It also has a subtle new summary of many chapters done in a partly narrative style.

College Age Case Study and Overall Chapter Review A new third case study, called “College Student Case Study and Review: Amy and John,” has two purposes. The first is to provide college-age undergraduate and graduate students, many of whom have not yet established their own households, with issues and interests they can relate to. It presents Amy and John as students with varying challenges and gives instructions on how to overcome them in appropriate chapters. The second purpose is to present a summary of these chapters, whether used as an introduction to or summation of the key points in the text. This partly narrative summary is set in a simpler and less formal style. Those looking for a simple placing together of the major ideas of the chapter irre- spective of their ages should find this case study highly useful.

Professional Advice This new boxed section presented in many chapters adds more news you can use. It presents recommendations on how to resolve common problems people encounter. It is based on the author’s more than 30 years of experience as a practitioner helping literally thousands of people.

Life Cycle Planning This new section placed at the end of most chapters takes the reader through age-related issues ranging from college days to post retirement. It is presented in an action-oriented style from a practitioner’s standpoint. Its approach is intended to be concise and informal.

New Real Estate Chapter It is clear that interest in real estate, whether it be the home or independent properties, has grown sharply in recent periods. This new Chapter 9, “Real Estate and Other Assets,” presents a simplified description of the topic. It also provides a brief description of other alternatives to stocks and bonds.

Revision of Capital Needs Analysis Chapter Chapter 17, “Capital Needs Analysis,” presents the traditional answer to calculating the amount needed to bring about a comfortable retirement. A new, simpler method for calcu- lating that amount is also given.

xii Preface

Modification of Financial Investments Chapter Chapter 10, “Financial Investments,” shifts practical step-by-step information on selecting investments and constructing a portfolio using mutual funds from the background invest- ments in Chapter 16 and simplifies other technical information. It also provides more at- tention to exchange-traded funds (ETFs), which have grown more popular in recent years.

Updating Financial Planning Taxes, economic circumstances, retirement planning, investments, and insurance alterna- tives are among the areas that have changed since the first edition. Taken together, the financial planning field has grown in numbers and sophistication. These new factors have been reflected in the second edition throughout the book.

SUPPLEMENTS Online Learning Center www.mhhe.com/altfest2e The Online Learning Center contains the following assets, which are password-protected for instructors only:

Instructor’s Manual. Includes solutions for end-of-chapter questions, problems, and case studies.

Test bank. Word files containing 30–40 questions, including true-false, multiple choice, and essays, prepared by Aron Gottesman, Associate Professor of Finance, Pace University.

PowerPoint slides. PowerPoint slides for each chapter to use in classroom lecture settings, created by Aron Gottesman, Associate Professor of Finance, Pace University.

New Second Edition Instructor Material:

session provided by type of student (undergraduate, graduate finance major, non- finance major, CFP® prep, combined regular survey and CFP® prep, simpler approach, adult education).

The comments are based on the author’s more than 30 years of teaching the course.

Preface xiii

xiv

I am grateful to the following professionals who read individual or multiple chapters and offered their helpful comments. They verified facts, pointed out discrepancies, added to the material presented, and otherwise contributed to a more polished product.

Roy Ballentine, CFP®

Ballentine, Finn & Co., Inc. Janet Briaud, CFP®

Briaud Financial Planning, Inc. Gayle Buff, CFP®, CFA Buff Capital Management Alfred C. Clapp, Jr. Financial Strategies & Services Corp. Larry Copperman Steve Aronoff PC David Drucker, CFP®

Fieldstone Financial Management Group, LLC Louis Feinstein Louis I. Feinstein, CPA, PC

Linda Gadkowski, CFP®

Beacon Hill Financial Educators, LLC Harvey M. Goldfarb All Risk Insurance Agency, Inc. Gary Greenbaum, CFP®, CFA Greenbaum and Orecchio, Inc.

Family Financial Architects, Inc. Mary A. Malgoire, CFP®

The Family Firm, Inc. J. Michael Martin, CFP®

Financial Advantage Inc. Ed O’Hanlon Kieffer & Hahn LLP

Haseeb Ahmed Johnson C. Smith University M. J. Alhabeeb University of Massachusetts Mike Barry Boston College Conrad Ciccotello Georgia State University Sheran Cramer University of Nebraska—Omaha

University of Akron

Penn State University—Erie J. Jeffrey Lambert, CFP®

University of California—Davis Extension Jennifer LeSure IVY Tech State College in Indianapolis

Ann Perkins North Dakota State University Bruce L. Rubin Old Dominion University Deanna Sharpe University of Missouri—Columbia David Sinow University of Illinois Michael Snowdon The College for Financial Planning Gene R Stout Central Michigan Don Taylor The American College

Texas A&M University—Commerce Glenn Wood Winthrop University

Acknowledgments My personal thanks to all academic reviewers. Each contributed importantly to the final copy. Their knowledge of the material and understanding of what it takes to communicate it effectively significantly enhanced the book.

Acknowledgments xv

Tom Orecchio, CFP®, CFA Greenbaum & Orecchio, Inc. Morton Price Cowan Liebowitz & Latman Alan Romm Independent Broker Bruce Ross, CFP®, CLU, ChFC Ronald Rutherford, CFP®

Rutherford Asset Planning, Inc.

Suzette Rutherford, CFP®

Rutherford Asset Planning, Inc. Harry Scheyer, CFP®, CPA/PFS Pinnacle Financial Advisors LLC Bob Veres Inside Information Henry Wendel, CFP®

Wendel Financial Planner & Investment Advisor

I would like to thank my colleagues at Pace University who assisted me by providing con- structive suggestions, including Michael Szenberg, Ron Filante, Aron Gottesman, Qi Lu, Jouahn Nam, Alan Tucker, and P. V. Viswanath. I am also grateful to my graduate assis- tants over the term of this project. One in particular stands out. Oktay Veliev not only was extremely helpful in production aspects treating the book as if it were his own but was responsible for many of the creative diagrams and software examples. Finally, I am grateful to members of my professional staff. Ekta Patel, Dawn Brown, and Michael Prendergast were of material assistance as were administrative staff members Helen Cummings and Marina Marsillo. However, three others stand out. The first is Karen C. Altfest, who provided a strong contribution in overall advice and chapter reviews. The second is Paul Palazzo, who made a major contribution to the case study and helped in several other areas. Lastly, I want to thank Dr. Abe Fenster for his constructive sugges- tions, pedagogy, and continuing support in the strategy and execution of this book. The second edition benefited importantly from Andrew Altfest, whose assistance in all areas of the book was very valuable. I also received a material contribution from the analytical and updating skills of Don Korn. In addition, members of my professional staff reviewed and made suggestions including Paul Palazzo. Significant contributions were made by Dawn Brown, Boyan Doytchinov, Brett Fry, Steven Cadoff, and Brendan McEwan. Dr. Abe Fenster continued his high level support in the revised edition that was in total very important. Harvey Goldfarb of All Risk Insurance was a huge help with the life insurance example and data, as was Alex Smith of Ashton Benefits with health insur- ance as well and Richard Rothberg of Cooley LLP was invaluable with the Estate Planning chapter. Finally, thanks for editorial assistance to Prateeksha Sabhani, Yisroel Zylberberg, and Matthew Suchow, all of whom made substantive improvements to the book. It is my hope that this book will contribute to the further development of personal finan- cial planning and enhance the stature of the discipline, the instructors who teach the course, the professionals who practice its fundamentals, as well as motivate students in its career possibilities.

Lewis J. Altfest

([email protected])

xvi

PART SIX Planning Essentials 505

16 Stocks, Bonds, and Mutual Funds 506

PART SEVEN Integrated Decision Making 535

17 Capital Needs Analysis 536

18 Behavioral Financial Planning 579

19 Completing the Process 612

PART EIGHT* Further Specialized Topics (Web Chapters) 1

A Educational Planning 2

B Background Topics 30

C Special Circumstances Planning 54

D Career Basics 82

E Regulation 96

APPENDIX* A Modern Investment Theory

B Employee Benefits

C Behavioral Finance—Applications

D Comprehensive Financial Plan—Dan and Laura

GLOSSARY 648

Suggested Readings 661

Index 666

Part One

The Theory of International Trade 1. Introduction to Personal Financial Planning 2. The Time Value of Money 3. Beginning the Planning Process

For centuries people have been fighting over whether governments should allow trade between countries. There have been, and probably always will be, two sides to the argument. Some argue that just letting everybody trade freely is best for both the country and the world. Others argue that trade with other countries makes it harder for some people to make a good living. Both sides are at least partly right. For centuries people have been fighting over whether governments should allow trade between countries. There have been, and probably always will be, two sides to the argument. Some argue that just letting everybody trade freely is best for both the country and the world. Others argue that trade with other countries makes it harder for some people to make a good living. Both sides are at least partly right.

Part One

Planning Basics 1. Introduction to Personal Financial Planning 2. The Time Value of Money 3. Beginning the Planning Process

In this part, Planning Basics, you will learn the preliminaries necessary to perform personal financial planning. Chapter 1 is an overview of the entire PFP process and details the segments of a financial plan. It also introduces a case study that we will develop throughout the book. Unlike many other case studies you may have come across, this one provides the solutions using the facts developed by a financial plan- ning practitioner. Chapter 2 examines the time value of money, one of the basic ideas in finance. It provides virtually all the mathematical techniques you will need to perform the cal- culations required throughout the book. Chapter 3 begins the planning process with what can be called its initial stages. These include goal setting, data gathering, and understanding how to communicate with others. With an understanding of these topics, these topics under your belt, you will be prepared for the financial planning activities that lie ahead.

Chapter Goals

This chapter will enable you to:

Dan and Laura, both age 35, were recently married. Each works, Dan as a systems engi- neer and Laura as a teacher. They want to make major decisions concerning their lives, and they have questions about the cost and the timing of having children, purchasing a house, and maintaining a “great” lifestyle. They have heard that personal financial planning might be helpful. Dan and Laura know little about finance and nothing about planning, so they made an appointment with a financial planner to find out about it. Their questions are basic: What is personal financial planning? How can it help us achieve our goals? Can we do financial planning ourselves? Their immediate concern is the debt they are accumulating. (To be continued at chapter’s end.)

Real-Life Planning Maria stepped into the advisor’s office looking awkward. She appeared to be unsure that she belonged there. Maria wasn’t the advisor’s typical client. She was a young messenger for a national package delivery firm who had occasionally delivered items to the advisor’s previous office location. She arrived in her uniform without an appointment. Her face showed that she was troubled by something and needed an answer right then. The advisor ushered her into his office, offered her a soft drink, and discussed some things they had in common. When she seemed more at ease, he asked why she had come. She said her husband was thinking of purchasing a second house and renting it out. She, on the other hand, was against doing this. It would require almost all of their nonretirement savings for just the down payment and they would have to take on significant additional mortgage debt. She said she could not stop thinking that if this investment soured, it could ruin their savings, expose their existing investment in their home to risk, and, most

Chapter One

Introduction to

Planning

Chapter One Introduction to Personal Financial Planning 3

importantly, jeopardize their plans to raise a family. Maria said that the dispute was seri- ously affecting their relationship and she and her husband fought constantly over this out- lay. She asked the advisor what he thought of the investment for them. The advisor did some data gathering. He found that both husband and wife had full-time jobs that provided moderate sources of income. They seemed to have sound financial oper- ations that generated significant savings each year, and they had accumulated a decent sum. Both liked their work and had opportunities to advance and raise their income. They planned on working until full retirement in their existing jobs even if the government pushed back the retirement age for full Social Security. They had no debt outstanding except for their mortgage. Their employer covered their health insurance and other benefits, and they had purchased additional life insurance on their own. Like many young people, they hadn’t gotten around to making a will. Their goals were not complex. They wanted to start a family within a few years and to continue what was from the advisor’s perspective a relatively modest but comfortable life- style. Maria said they didn’t want to worry about their financial future. The advisor then focused on the real estate investment. He asked her the purchase cost of what turned out to be another house in their neighborhood. A quick calculation indi- cated they could make a significant annual sum by renting it out after expenses, including interest on debt borrowed and maintenance costs. The advisor asked whether she was con- fident of the figures, and she said that she knew both projected rental income and costs. Her husband was handy and would supervise the project. The advisor asked about the outlook for the neighborhood and was told it was one for people with modest incomes but was becoming popular with younger, more affluent urban dwellers. The advisor then thought about what he wanted to say to Maria. Often his recommenda- tions incorporated two factors, a blend of what was financially best and, whenever feasible, what the client’s preferred alternative was. In this case, he believed there was no conflict between the two approaches. The husband was not an irrational risk taker. Purchase of the house made financial sense. What remained were Maria’s concerns. The advisor decided to find out whether Maria had a low tolerance for risk or just needed some advice and support in an area she feared. Despite not having enough notice to analyze the situation in greater depth, he told her that while any investment contained risk, this investment seemed sound. If her figures and appraisal were correct, her husband should be commended for his enterprising thoughts. The investment income from the property could replenish their sav- ings fairly quickly. Moreover, it could bring them closer to realizing their financial goals. The smile that broke out on her face and her more relaxed manner told the advisor that all she needed was some confidence in the idea. He gave her the names of some mutual funds to invest in when their cash was re-established and advised her to make an appointment with a lawyer to draw up a will within two weeks. He told her to review the real estate investment and her savings each year after it was bought. The advisor declined any money for this “engagement.” He said the satisfaction he got from being helpful was pay enough. As he accompanied her out, the advisor realized that he had performed the major steps in the financial planning process. Both he and Maria had established that the planning scope was to discuss the real estate investment. However, in order to make proper recommenda- tions, he had to gather data, establish goals, and analyze a broad range of information. In fact, in the space of a very short time he had composed a kind of financial checkup with selected elements of a mini-financial plan for someone with a fairly simple financial life. He had concluded that the couple was on the right financial path. He made some rec- ommendations and included some implementation steps that extended the original scope. The whole process was completed over a moderately longer than normal lunch period, just in time for his next scheduled client.

4 Part One Planning Basics

OVERVIEW

Personal financial planning (PFP) is a practical activity whose objective is to help achieve your goals. This chapter provides an introduction to it and begins with a look at the overall planning setting including why PFP is important, its history, and its placement within the finance field. The chapter moves on to the heart of planning, describing the fixed process that is used to increase the chance for reaching the objective. The planning process is what defines the profession of personal financial planning. The financial plan itself is discussed with an emphasis on its comprehensive integrated approach. Finally, the chapter discusses financial planning as a career and the practice standards to which planners must adhere. Thereafter, the Dan and Laura financial plan is introduced, which will serve as a unified case study for each chapter in the book. You should find it useful in helping you under- stand how actual planning is performed. Knowing how financial planning operates as described in this chapter will serve as a useful backdrop for the information and techniques to be introduced throughout the book. More importantly, knowledge of this information and utilization of the PFP process should result in better decision making and improvement in outcomes. In other words, it can pro- vide material help in achieving the goals you set out.

WHY IS FINANCIAL PLANNING IMPORTANT?

Financial planning is important because we live in a fast-paced world in which an ever- increasing number of financial alternatives are presented to us. At the same time, informa- tion through all kinds of media, including the Internet, is available to help us make selections. Making wise decisions enables us to achieve our goals. Financial planning, which includes gaining insight into the efficient way to perform a task and then handling it in a logical, disciplined way, enables us to further our objectives. Personal financial planning has become even more important in the twenty-first century because of the extraordinary events that have already transpired. For many people, owning a home has been and continues to be a keystone of their personal finances. Home prices soared at an unprecedented rate in the early years of this century, yet lenders made it all too easy to buy high-priced homes by offering easy credit. When the housing bubble burst, many home- owners learned a new expression—under water—meaning that they owed more than their home was worth. Knowledge of sound savings and borrowing strategies could have helped. In addition, retirement planning is an increasingly important area of personal finance, yet stock market shocks have temporarily, and in some cases permanently, affected retire- ment portfolios including two major declines in 2000 and 2008. In order to confidently prepare for retirement, workers must develop prudent investment strategies that are another component of personal financial planning. Understanding personal financial planning and being comfortable with our own plan- ning efforts have important benefits for society as well. They allow us to dedicate our full efforts to the job at hand at work. They also may make us more effective at that job because the household and the business approach many problems in the same way, and many per- sonal financial planning techniques are useful in work-related situations.

THE HISTORY OF PERSONAL FINANCIAL PLANNING

Personal financial planning (PFP) has existed for many years. Until well into the twentieth century, however, it was generally restricted to very wealthy people who were advised by

Chapter One Introduction to Personal Financial Planning 5

their lawyers, accountants, registered representatives, insurance agents, investment advi- sors, or bankers. Around 1970, these services began expanding to a larger population. Many middle- class people had the discretionary income and desire to seek help with the growing com- plexity of financial instruments and services. The new personal financial planners developed as professionals who could provide solutions to a range of financial problems and coordinate the activities of their clients’ other advisors. Established in 1972, Money magazine and later a wide variety of additional publications and other media helped inform the broad population in financial planning matters and in the usefulness of consulting financial planners.

CHARACTERISTICS OF FINANCE

In this and the following two sections, we will place PFP within an overall setting in the finance field. Finance deals with the management of funds, among other money issues. Individual businesses and government all have concerns over use of funds. We can say that finance is a practical field of study that is based principally on cash flow. Cash flow is the amount of money made available for use. Finance is concerned with such variables as

1. Markets. Places where tangible goods and financial instruments such as stocks and bonds are bought and sold.

2. Capital. The real, financial, and human-related assets that are generated by individuals and organizations or bought and sold in the marketplace.

3. Market structures. The economic operations of the business, the government, and the household that facilitate the purchase and sale of items.

4. Market value. The market-established worth of a product or a financial instrument. 5. Fair value. The inherent worth of nonmarketable assets based on cash flow, risk, and

the time value of money principles. 6. Cash flow. The economic operation of the organization based on the cash it generates. 7. Risk. The uncertainty of outcomes. 8. Investments. Placing cash flow into assets designed to improve an organization or to

provide future funds for consumption.

In an academic program, finance is generally broken down into courses on personal finance and business finance, with second-level courses such as investments analysis and portfolio management, capital markets, and capital budgeting. We will discuss all items above as they pertain to personal finance and personal financial planning. Let’s begin with personal finance.

to personal finance facts to provide you with the tools to analyze and plan for your own financial

a professional financial advisor with hundreds of cli- -

This should help you better understand finance in-

Professional Advice Use of This Book

6 Part One Planning Basics

PERSONAL FINANCE

Personal finance can be defined as the study of how people develop the cash flows neces- sary to support their operations and provide for their well-being. Household finance, the subject of Chapter 4, is the study of how a household and the people in it develop the cash flows necessary to support operations and provide for the well-being of its members. Basic finance tools such as the time value of money, cash flow analysis, investment models of behavior, and risk analysis form the backbone of personal finance and PFP. These tools are discussed in this and subsequent chapters. As you will see, a wide variety of other disciplines have a significant role in the practice of personal finance and PFP. Some of these are listed next.

PERSONAL FINANCIAL PLANNING

Personal financial planning can be thought of as the analysis and decision-making exten- sion of personal finance. Basically, PFP must satisfy four broad categories of personal- finance decisions: consumption and savings, investments, financing, and risk management.

PERSONAL FINANCIAL PLANNING PROCESS

Personal financial planning can be defined as the method by which people anticipate and plot their future actions to reach their goals. When we engage in financial planning, it is usually to solve a problem or to structure a plan for the future. In either case, we go through the following steps of the decision-making process:

1. Establish the Scope of the Activity Establishing the scope answers the question: How broad an area are we analyzing? For financial planning practitioners, the scope defines the specific services that they will

Discipline Explanation

Microeconomics The study of single units in the economy. It helps us understand how people and households allocate scarce resources.

Macroeconomics A broad study of the functioning of the entire economy or a major section of it. Economic conditions often have a strong influence on household actions.

Accounting1 System of recording and analyzing financial transactions. It helps organize and analyze financial data in a logical way.

Law The entire body of rules, practice and customs. They serve as a benchmark of correct rules and regulations for PFP.

Taxation The imposition of taxes to obtain revenues. Taxes are a key factor in decision making for virtually all parts of PFP.

Mathematics The science of numbers and their operations. Mathematics helps develop logical thinking and forms the quantitative basis for efficient decision making.

Statistics A means of collecting relevant data. The examination of accumulated statistics helps establish or verify proposed PFP actions.

Business A purposeful commercial activity. As will be established in Chapter 4, household operations resemble a business in many respects.

Psychology The study of mind and behavior. Psychology can provide one input into appropriate human actions.

Sociology The analysis of the behavior of groups of humans. Along with psychology it helps in understanding how people act as distinct from how they should act.

1 Modified from Webster’s Ninth New Collegiate Dictionary (Springfield, MA: Merriam-Webster Inc, 1988).

Chapter One Introduction to Personal Financial Planning 7

provide.2 For example, are they concentrating on saving money for a down payment on a home, or are they examining the entire financial planning process?

2. Gather the Data and Identify Goals In order to solve the problem as financial planning practitioners, we must gather certain information. We accumulate data on household financial assets and information on income and expenditures. In addition, we develop information on limiting factors such as health, time available, and tolerance for risk. A person or household can have many types of goals at any point in time. Goals that arise from values differ by household. The underlying goal, however, is to have the highest standard of living possible. The time devoted to work and types of leisure activities and expenditures will vary with each individual.

3. Compile and Analyze the Data We funnel the data received into the balance sheet, the statement of assets and liabilities, the cash flow statement, which provides the household cash revenues and expenses/outlays, and any other statements that are relevant. After that is done, we proceed to analyze the statements and establish the client’s overall financial position. What are the resources that are available? For example, does the balance sheet suggest a safe level of borrowing or does the house- hold have a high level of debt? If there is a great deal of debt, does the cash flow indicate that paying it off may be a problem in the future? All major parts of financial planning are considered and any special needs included.

2 When a financial planner is involved, according to the Practice Standards established by the CFP Board, this scope would include the range of services to be provided, how the planner is compensated, how long services will be provided, and so forth. Instead of terming this first step “Establish the Scope of the Activity,” the CFP Board calls it “Establishing and Defining the Client-Planner Relationship.”

Reason Principal Category

1. Inability to save properly. Consuming and saving 2. Need to resolve a debt problem. Financing 3. Desire to retire comfortably on time. Consuming and saving* 4. Desire to improve investment returns. Investing 5. Discomfort with present risk profile. Managing risk 6. Beset by economic turmoil Setting new goals and objectives

and the broad categories of financial planning they fall into are

Practical Comment Why People Seek Financial Planners

The financial hurt and the category it falls into give

Often other financial categories are drawn into the -

cess and the financial plan that often provides the

8 Part One Planning Basics

4. Develop Solutions and Present the Plan There are often many different ways to solve a problem. There are hosts of products that are available and many alternative services or practices to call on. For example, if the client’s goal is to save more money, this can be done simply by placing more money in a savings account, purchasing a whole life insurance policy instead of a term one, or buying a bigger house with a larger mortgage whose payment of principal each month could be considered a form of saving. The best solution is usually the one that solves the problem at the lowest cost. In the case of the savings problem mentioned, the lowest-cost solution, assuming it is followed, would probably be simply to make regular deposits into a savings account.

5. Implement Implementation is the action step. It is taking the best solution and putting it into practice. Although this may sound simple, for many people it is difficult to accomplish. This may be due to simple inertia or the action steps may be painful to carry out (saving money, for example).

6. Monitor and Review Periodically All planning procedures are subject to change. Incomes change, life situations change—some people get married, some of them get divorced, and many have children. In addition, individ- ual goals may need to be altered as a person ages. The environment we live in changes as well. Therefore, all planning procedures must be monitored for material changes and reviewed peri- odically to ensure they remain up to date. This process is summarized in Figure 1.1.

THE FINANCIAL PLAN

The financial plan is a structure through which you can establish and integrate all your goals and needs. It, therefore, can be the practical embodiment of the financial planning pro- cess and the tool to assist in implementing the process. The financial plan may take the form of a detailed written document—particularly if you consult a financial practitioner. It is then

Establish scope of activity

Gather data and identify goals

Compile and analyze data

Develop solutions and present plan

Implement

Monitor and review

FIGURE 1.1 Personal Financial Planning Process

Chapter One Introduction to Personal Financial Planning 9

often referred to as a comprehensive financial plan. Alternatively, it could be summa- rized on a single sheet of paper, even written on the back of an envelope, or could exist just in the head of the person in charge of the household’s financial affairs. The key decision is a commitment to the financial planning process, including its analytical component. In other words, the financial plan is an organizational tool that can aid in financial planning.

Parts of the Plan The plan can be separated into 11 parts, each of which is explained briefly next.

1. Establishing goals. Establishing goals involves deciding on your priorities not only for living not only today but also for the rest of your life. It is the reason the plan is made. Therefore, all the other parts of the plan follow this one. We describe goals more fully in Chapter 3.

2. Analyzing financial statements. Financial statements provide a current picture of your financial condition. They present the resources that are available to fund your goals. Financial statements include a balance sheet, a cash flow statement, and other relevant statements.

3. Cash flow planning. In cash flow planning, household income and expenditures and other cash flows are compiled and analyzed. The goal is to plan income and expense flows so that work, cost of living, savings and investment, and financing issues inter- act in an optimal way to provide the highest returns possible.

4. Tax planning. Tax planning is the practice of attempting to minimize unnecessary tax payments to the government. It is done by applying allowable tax deductions, credits, and other forms of tax benefits.

5. Investment planning. Through investments, you enable your net cash flows to grow as rapidly as possible, subject to your tolerance for risk. Generally households have a portfolio of human, real (ones you can touch), and financial assets to consider in the investment process.

6. Risk management. The objective of risk management is to control the level of risk and consequently of loss for each significant household asset and for the entire portfo- lio of assets. It involves implementing certain risk-modifying practices and consider- ing products such as insurance.

may consider, for example, an investment review or a retirement plan as a financial plan. A financial plan has a defined minimum scope, which is detailed in this section. As discussed, when prepared by a financial planner, the document is often referred to as a comprehensive financial plan.

specific client and deals with all relevant factors of

is to incorporate all the relevant client factors and

Practical Comment Elements of a Financial Plan

10 Part One Planning Basics

7. Retirement planning. Retirement planning focuses on household saving and invest- ing decisions that allow you to retire at the age and lifestyle that you desire. Ideally, the process for this goal, which for many people has a high priority, starts early in the establishment of the household.

8. Estate planning. Estate planning generally deals with planning for yourself and others while you are alive and for current and former members of your household and other people or institutions upon your death. It usually involves a combination of legal, tax, and personal wishes for other members of the household. In addition, it involves planning for future household members such as children, particularly when the monetary goal for ac- cumulation of assets at the time the last member of the household dies is more than zero.

9. Special circumstances planning. Special circumstances planning is a miscellaneous category for handling other goals and activities. Examples include planning for elderly parents, special needs for children, marital or divorce considerations, or business be- cause each pertains to personal financial planning.

10. Employee benefit planning. Employee benefits are the forms of compensation other than salary. The objective regarding them is to understand and integrate the best mix of employer and independently funded products, services, and other planning mechanisms. When applicable, employee benefits can be provided as a separate section but are often listed under the other relevant sections of the plan, an approach that we will follow.

11. Educational planning. Educational planning is preparing financially for the outlays for educating adult and children members of the household. Most commonly, expenditures are for college and graduate school. The objective is to have sufficient monies prior to the expenditure utilizing all appropriate tax-advantaged mechanisms.

The parts of a financial plan are presented in Figure 1.2. Note that goals are placed at the top because they are the reason for the plan. Analysis of financial statements follows as a prerequi- site of the active financial planning segments. Integration is presented toward the bottom of the figure because it serves to ensure that the goals in each section can be accomplished. The following is a practical example of the entire financial planning process and of the parts of a simple financial plan.

Example 1.1 The following situation demonstrates one fairly common financial issue and the process and outcome for dealing with it. Elliot and Marsha went to a financial planner with a specific goal: to save money for the down payment on a home. They had wanted their own home for some time but always seemed to spend all their money each week. The planner went through the

- sources as a whole and at how actions in one part of

holistic is used to refer to the

Practical Comment Integration

Chapter One Introduction to Personal Financial Planning 11

six-step financial planning process to assist them with their needs. First, he established that planning would be limited principally to their down payment goal but that he would make other comments that might be helpful to them. The financial planner then began the data-gathering process. He learned that Elliot and Marsha were recently married; both worked and spent all of their available monies on what they described as enjoying themselves. They had little in the way of assets other than their income-earning ability. Their overall goals were clearly to continue to enjoy life today and to acquire a home. The advisor mentally went through all the parts of a financial plan in connection with his analysis of the data. When appropriate, he asked the couple questions. Elliot and Marsha had a significant combined income and modest liabilities. The planner decided that cash flow plan- ning would be the key to the work in that session. He compiled their incomes and nondiscre- tionary living expenses. The remaining money would be sufficient for the couple to accumulate enough for a down payment to purchase a home in two years yet enable them to continue most of the activities they enjoyed today. There didn’t seem to be any material tax planning issues other than the tax benefits available through home ownership. A preliminary discussion indicated no employee benefits topics that seemed appropriate for this project. Investment analysis would be involved in two ways. The first was to decide where the projected savings would be placed. The second was to incorporate investment information in deciding on the specific home to be purchased. The couple were fairly careful in their per- sonal activities. They had a moderate tolerance for risk, had insurance (including term insur- ance at work), and didn’t want to consider additional sums or types at the present time. Both Elliot and Marsha had a 401(k) pension plan at work but weren’t contributing to it. Retirement planning was a low priority for them at this time. Estate planning was even more remote and neither had a will. There were no specialized planning issues. The advisor decided that a simple two-page written document would be sufficient for them given their goals, situation, and the resources they wanted to allocate to the planning process. The document would embody the solutions to their needs in the form of a list of recommenda- tions. He repeated the goals and scope of the project. They included

1. A recommended savings amount per person per paycheck. Contributions to their 401(k) pen- sion plans at work would come directly out of their paychecks, thus ensuring compliance. A cash flow statement demonstrated that the purchase of a home was possible in two years.

2. An investment approach that was highly conservative. Savings were to be placed in money market funds or bank certificates of deposit (CDs) based on how soon the accumulated sums were to be used. Even though the yields would be relatively low, risk of loss would be scant.

3. A recommendation that the couple begin retirement savings as soon as their home was purchased. If possible, each would contribute the maximum amount to a 401(k) account.

4. A recommendation that each establish a will as soon as possible. The advisor offered to give them the name of some qualified attorneys.

Financial plan for achieving goals

Financial integration

Establishment of goals

Estate planning

Special circumstances

planning

Retirement planning

Risk management

Tax planning

Cash flow planning

Investment planning

Analysis of financial statements

Employee benefit

planning

Educational planning

FIGURE 1.2 Parts of a Financial Plan

12 Part One Planning Basics

The advisor reviewed all parts of the plan and was satisfied that the recommendations were integrated and met the needs of the engagement and of the couple’s overall goals. He presented the written document and discussed it with them. He stressed the impor- tance of the recommendations and the fact that no document was worthwhile unless it was implemented. The three set a date for implementing each step. The advisor told them to monitor their progress in savings and to update the document whenever material changes in circumstances occurred such as a large raise or a desire to retire earlier. They set a date for a review in one year and then a more detailed one when they began looking at actual homes. At that time, the investment characteristics and, if necessary, affordability issues would be considered. A diagram of the origins of personal financial planning that summarizes selected material in the chapter is presented in Figure 1.3.

- Consumption and savings - Investments - Capital budgeting - Financing - Risk management

- Cash flow planning - Tax planning - Investment planning - Risk managing - Retirement planning - Estate planning - Special circumstances planning - Employee benefit planning - Educational planning

*Discussed in Chapter 3.

PERSONAL FINANCIAL PLANNING

PERSONAL FINANCE

- Time value of money - Cash flow analysis - Optimization - Market pricing - Analysis of risk - Investment models of behavior

- Micro and macroeconomics - Accounting - Law and taxation - Mathematics and statistics - Business and government - Psychology and sociology - Communication and relational skills*

OTHER DISCIPLINES AND TOOLS

FINANCE TOOLS

FIGURE 1.3 Origins of Personal Financial Planning

Chapter One Introduction to Personal Financial Planning 13

FINANCIAL PLANNING AS A CAREER The Financial Planner Financial planners are the professionals who practice personal financial planning. They are people with designations, education, and experience who are trained to perform the pro- cedures described in this chapter. They generally provide that service to people who wish to improve their financial activities. For example, a person might consult with a financial plan- ner for structuring an investment portfolio or in preparing adequately for retirement. Although other financial people also may give advice in limited areas, a financial planner should always look at a client’s overall financial situation before making recommendations. The formal training to become a financial planner began in 1972 when the College for Financial Planning (CFP) offered education leading to the CFP® or CERTIFIED FINANCIAL PLANNER™ certification. In 1985 the CFP Board of Standards, originally the International Board of Standards for Certified Financial Planners, was established to regulate CFP® practitioners. In January 2000 the two largest financial planning member- ship organizations—the Institute of Certified Financial Planners and the International Association for Financial Planners—merged to establish the Financial Planning Association (FPA; fpanet.org), a national organization of more than 20,000 financial planners. The CFP® certification indicates that a person has been educated in all major facets of financial planning. Candidates must take at least six courses (often including one intro- ductory course) in financial planning including course material on investments, risk man- agement, retirement and employee benefits, estate planning, and taxation and a Capstone Course. Candidates are then required to pass a comprehensive examination and must have at least three years of practical financial experience before qualifying for the designation.

Types of Financial Advisors Various people offer personal financial planning advice today. The term financial advisor, often used by people offering financial advice, has different meanings to different people and groups. To some it means a sophisticated financial planner and to others it connotes anyone who provides financial advice. In this book, we use financial advisor in its broader meaning except for the background sections that describe a financial planning practitioner. Financial advisors include people who identify themselves not only as independent financial planners but also as accountants, lawyers, trust officers, registered representatives, insurance agents, investment advisors, and employee benefit specialists at corporations. Organizations in addi- tion to the CFP-related associations (FPA, Board of Standards) are the National Association of Personal Financial Advisors (NAPFA) for fee-only advisors, whose members are called NAPFA-Registered Financial Advisors; the American College for insurance agents and others who can receive the Chartered Financial Consultant (ChFC) designation; the American Institute of Certified Public Accountants for Certified Public Accountants (CPAs) who receive the Personal Financial Specialist (PFS) designation; and the CFA Institute, which offers the Chartered Financial Analyst (CFA) designation for people who specialize in investments. All but the CFA designation require a broad educational requirement in financial planning.3

As of 2013, more than 500,000 people were providing financial planning services of some sort. Approximately 68,000 held the CFP® certification with hundreds of colleges and uni- versities throughout the United States providing CFP Board–approved educational courses.

What a Planner Does A financial planner is capable of helping people with virtually all of their major financial activities. These activities are embodied in the operating areas of the financial plan. It is necessary to be knowledgeable about all areas because solutions to client problems, even if

3 An explanation of overall practice standards is provided in Appendix I at the end of the chapter, and a detailed description of CFP Board Practice Standards is given in Chapter E on the website.

14 Part One Planning Basics

role while others supervise related financial activities

- -

required is wide and interesting to a broad cross

- -

® - ®

® 4

individuals in your future interactions with financial

and analytical approach surprisingly useful in financial

Professional Advice Attractiveness of a PFP Career

pertaining to only one activity, must take into account a client’s entire financial situation. However, a large number of financial planners specialize in one or a few financial planning areas. Examples of the activities that financial planners commonly help people with include:

Chapter One Introduction to Personal Financial Planning 15

Life Cycle Planning Intro to PFP

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

The following presents action items related to each relevant chapter from a practitioner’s standpoint. Since many essential individual action items change over a life cycle they are presented by age. It is provided in a simple less formal style.

Digital Vision/Media Bakery

Jacob Wackerhausen/ Getty Images

WiseGEEK

Monkey Business Images/ Shutterstock

Francisco Cruz/Media Bakery

Media Bakery

16 Part One Planning Basics

Example 1.2 The role that a financial planner plays is somewhat similar to that of a doctor. The doctor may be a general practitioner (GP), a professional who is familiar with most common patient medi- cal problems. When the ailment is less common or could otherwise benefit from a more con- centrated focus, the person is referred to a specialist. Often the GP maintains the role of the patient’s principal medical advisor. Many doctors specialize in a particular type of medicine. Although their patients come to them for a particular ailment, they must be familiar with the workings of the entire body. That is true because the symptoms may come from their specialized area, but the cause may lie elsewhere. You may see a financial planner for a comprehensive financial checkup or financial plan, as you would a doctor for a comprehensive physical checkup. Or you may have a particular concern to discuss. In each case the overall state of your health, whether it be financial or physical, must be kept in mind.

For many reasons, including being involved in challenging, rewarding activities, personal financial planning is a popular career path with an increasing number of students selecting it as an undergraduate or graduate major. Financial advisory jobs are expected to be among the faster-growing occupations in the United States with a projected growth rate of 32 percent between 2010 and 2020, according to the Bureau of Labor Statistics. During that time frame, 66,400 jobs are expected to be added to the 206,800 jobs that already existed.5

Back to Dan and Laura The following case study is developed throughout the book with the relevant material pre- sented at the end of each chapter. Both the facts and interpretation of each meeting are presented through the eyes of the financial planner doing the advising.

BACKGROUND—FIRST INTERVIEW

Dan and Laura, who became my clients in January 2015, came into my office. They brought along their new baby son, Brian. Laura mentioned that because Brian was so young she was reluctant to leave him in anyone else’s care. A discussion about Brian seemed to help both Dan and Laura unwind. We then proceeded to talk about both of their backgrounds. Laura, 35, grew up in a comfortable middle-class neighborhood, the only child of an owner of a successful sporting goods store. She was raised in a home in the suburbs and had all the comforts she wanted. She went to a private, all-women’s college where she majored in English. She took a position as a public school teacher when she graduated. She is currently on maternity leave of absence arising from Brian’s birth and is unsure when she will return to work. I noticed that Laura’s body language seemed relaxed and natural. Even though her baby started to cry from time to time, she maintained her participation in the proceedings. In contrast to Laura, Dan still did not seem to be completely engaged. His face seemed strained, his eyes half closed when he spoke, and his arms were folded. I decided to turn my attention to him. Dan, 35, is one of four children. His mother and father both immigrated to this country. Household finances were very tight. Both parents worked, and Dan’s father often had two low- paying jobs. Dan remembers the time that his Dad was laid off and they were almost forced to take a smaller apartment in which Dan would have slept in the living room with his brother. Despite that trouble, Dan described his family life as happy and himself as always having been a “worrier” when it came to money. Dan worked part-time as a teenager and went to a state university where he borrowed the entire sum for room and tuition. He studied computer science

5 Jada A. Graves, U.S. News & World Report, December 18, 2012, money.usnews.com/careers/best-jobs/ financial-adviser

Chapter One Introduction to Personal Financial Planning 17

in college and is currently working as a systems engineer for a computer service company. His job involves above-average risk because he works for a firm on a multiyear project but could be terminated after it is over. On the other hand, he is well compensated for his efforts. In fact, the immediate reason that Dan and Laura came to see me was that they had $20,000 in credit card debt. They had accumulated this debt as the result of higher household expenses and a desire not to touch their marketable investments. They wanted to eradicate the debt as soon as possible. I made a mental note that the debt seemed inconsistent with Dan’s worries about money but decided not to discuss this until later. I told them that I would create a debt repayment plan, but first I wanted to collect some data on their accumulated assets, other liabilities, and goals. The fact that Dan was able to discuss his background and his concern about his debt and that I treated the problem in a matter-of-fact way seemed to lift his spirits. He became more relaxed, turned directly to the table, and even smiled once or twice. The couple had accumulated about $10,000 in pension assets, $34,000 in money market funds, $103,000 in stocks and stock funds, and had $2,800 in a checking account. More broadly speaking, they had $3,000 in current assets and $147,000 in marketable invest- ments. They owned two used cars worth $6,000 each. Their furniture and fixtures were valued at $7,000. Dan had a stamp collection worth about $1,000, and Laura had jewelry worth $4,000. In addition to $20,000 in credit card debt, they had a total of $46,000 in student loans and $20,000 in loans from parents. Next we turned to the couple’s goals. Their most immediate goal was to lift the pres- sure created by their debt. They believed that their current lifestyle was fine and saw no need to raise it. They wanted to have one more child. As Laura said, she always felt lonely as an only child, and Dan liked having siblings. She thought that Brian would want one too. She and Dan believed their current two-bedroom apartment was sufficient for one child but wanted to own their own home. They wanted their insurance checked for adequacy. They were placing money in retirement savings accounts but felt that it wasn’t diversified properly. Dan and Laura had ambitious retirement goals. They wanted to be financially indepen- dent by age 55. In retirement they wanted to maintain their current lifestyle and thought their costs would stay the same as when they were working. In addition, they wanted each child to be left $100,000 in inflation-adjusted terms. Finally, their objective was a plan that laid out their goals, indicated whether they were realistic, and, if so, would provide guidance in achieving them. I explained to them that they had basically described the function and scope of a finan- cial plan. I indicated that the recommendations would reflect their goals and what I believed should be their focus. Laura mentioned that given her preoccupation with her baby, she would prefer frequent meetings by topic rather than in-depth interviews. I gave them a questionnaire to help them focus and to obtain further financial information. The goals, time frame, and cost were set. At just that moment, Brian started to cry loudly and the first meeting was over. I decided to prepare each section of the financial plan discussed after each meeting, and I told them I would send a draft subsequent to the session for them to examine. I rec- ognized that parts of the plan would have to be revised once the total costs of their goals were compared with current and future cash inflows. The introduction to financial plan- ning could be completed right now.

This is how I introduced Dan and Laura to financial planning: Personal financial planning is the process of supervising your financial activities so that you can meet the goals you have set out. In order to accomplish those goals, it is helpful to con- struct a financial plan. This document will consider your goals overall, compare them with your current and future resources, and establish a plan for attaining them. In addition to

18 Part One Planning Basics

outlining your goals and current assets, the plan consists of the following active areas: cash flow planning, tax planning, investments, risk management, retirement planning, estate planning, educational planning, employee benefits planning, and special circumstances planning, sometimes incorporated in other sections for all else that is financially relevant. Let me explain the financial planning process I would perform for you. After our pre- liminary interview we will have established the scope of the activities to be completed. In your case, as mentioned, it is a full financial plan. Based on that engagement, we will gather the data and identify goals. I would have already provided you a copy of my ques- tionnaire to supplement the data gathered in our face-to-face meeting. After that process is completed, we will accumulate and analyze the data. It will be comprehensive, encompassing all major parts of the plan as already indicated and any oth- ers we decide are important. At that point we will develop solutions, which will be inte- grated, meaning they will combine all parts of the plan, giving you what we arrive at as the best use of your money. Given your preference, each part will be discussed separately. Nonetheless, we will have a completed financial plan presentation at the end of the process and a meeting to go over the plan. Planning does not end there. The plan will have to be reviewed and updated periodically. We will construct your financial plan with your goals in mind. As indicated, we will discuss each part of the plan separately and I will develop each. I will explain why I make my recommendations in enough detail so that you can provide me your reactions prior to the final integration stage for completing the plan. We are off to a good start, and I look forward to helping you achieve your goals.

College Student Case Study and Review: Amy and John This case study presents an overall chapter review as an advisor answers the questions of two undergraduate students. It provides the chapter material in a simplified and less for- mal way than most of the book. Some of the material is presented through dialogue and is focused on the facts that college-age adults consider more interesting and more relevant in support of the goals of the course and of the professor. That means that, in relevant chapters regardless of age, you can use this case of Amy and John to help absorb the chapter material. This approach is beneficial whether you employ it prior to beginning the chapter or more commonly afterward as a chapter summation.

BACKGROUND At first it was awkward. Amy says she and her stepbrother John were “thrown together” as stepsiblings by the whirlwind courtship and marriage of their mother and father respectively. Amy’s father died prematurely when she was only 10 years old. Fortunately, between her mother’s successful accounting job and a large insurance payout, Amy grew up comfortably. John’s mother and father had divorced four years earlier. His relationship with his mother was close, but he was even closer to his father and chose to live with him. Although alimony payments restricted some discretionary household expenditures, his father, a midlevel ex- ecutive, made enough money for John to feel he led the same lifestyle as his friends. Their parents’ marriage changed some things. Amy’s mother lost her job in the recession of 2009 and was forced to accept a lower-paying one. Because of his firm’s economic difficul- ties, John’s father’s wages were recently frozen. The result was more emphasis on household budgeting and both John and Amy were forced to take on debt to finance their college costs.

Chapter One Introduction to Personal Financial Planning 19

The combination of “inheriting” a new parent and a new sibling was uncomfortable for both John and Amy. The new siblings were almost exactly the same age but had little else in common. Amy was a cheery, talkative, optimistic young woman. Although fundamen- tally intelligent, she had little time for analysis and was very direct in telling people to get straight to the point unless it pertained to boys or fashion. John on the other hand was fairly quiet, almost introverted. He liked analysis and did well in math classes and other subjects that he found interesting. He was somewhat con- cerned about his future, but he also liked to party and was a big sports fan. At first, living under the same roof was awkward and overly polite for both John and Amy, but gradually they relaxed and bonded over shared family experiences. Over time, they became closer and even went on double dates with each other’s friends. Both were beginning seniors in college and would soon be setting up their own house- holds. Amy thought she might pursue a career doing something creative, perhaps in fash- ion. John was knowledgeable in finance and in addition to doing his own personal financial planning, he wanted to investigate it as a possible career. Fortunately, their parents gave them a series of meetings with a professional financial planner as a birthday gift. Amy said that while she had no objections to a male planner she thought she could relate better to a female one. John said he was indifferent to the plan- ner’s sex, he just wanted one that would be good. After an investigation they both selected a female advisor. They were enthusiastic about the meetings and were happy that they had a planner, who in addition to being highly qualified they thought had a sense of humor. Both came to the meetings with questions geared toward PFP and listened to the planner’s responses. In the meetings, Amy asked many basic questions because of her lack of experi- ence and interest in PFP. John, being more knowledgeable, attempted to help his stepsister and also asked more analytical questions. In each case, the planner presented his thoughts as the discussion unfolded.

Current Background I was impressed with both Amy and John. They were both fairly intelligent and lively people. While John hesitated before speaking, Amy was outspoken, laying her feelings and beliefs on the table. She candidly opened up our conversation by asking me why she should pay attention to financial planning because she felt she hardly had a need for it now. She also asked me whether her parents, who had spoken to me once recently, thought she had frivolous spending habits and invited John so that she could mimic his more responsible financial habits. I assured her that was not the case. I told her that personal financial planning was an activity that would be useful through- out their lives. It would allow them to be more sophisticated purchasers of goods and ser- vices. Its usefulness would become apparent once she began working and established her own household. I impressed on them that I would not only present them with useful facts but also show them how to analyze and reach conclusions on their own. I told them that they were now advisors in training so that they would get the most out of our discussions by becoming more involved and drawing more informed conclusions.

Understanding Financial Planning This first session would introduce them to the topic. I explained that the easiest way to com- prehend PFP is by understanding finance terms. Personal finance is the study of cash flows that support their activities and provide for their well-being. Household finance is similar to personal finance but may place more emphasis on individual households. Each calls on many different disciplines ranging from micro- and macroeconomics to accounting, law, taxation, mathematics and statistics, business and government, psychology, and sociology.

20 Part One Planning Basics

Personal financial planning analyzes personal finance in four areas: consumption and savings, investments, financing, and risk management. I mentioned that I would often use a variation of the following process approaches to explain the topic:

1. Establish the scope of the activity. 2. Gather the data and identify the goals. 3. Compile and analyze the data. 4. Develop solutions and present the plan. 5. Implement the plan. 6. Monitor and review the plan periodically.

The financial plan incorporates all goals and maps out how to reach them. Its common segments are establishing goals, analyzing financial statements, cash flow planning, tax planning, investment planning, risk management, retirement planning, estate planning, special circumstances planning, employee benefits, and educational planning. I stressed that what distinguishes financial planning from other forms of financial advice is its inte- grated approach. That is, it integrates all the goals and needs into every part of a plan to create an overall solution. That solution merges ideal lifestyles with the realities of how much money will be available to finance those lifestyles. Amy asked what happens when your projected life cycle money falls short of needs. I said that there is a compromise in goals such as considering earning more money, retiring later, or more often, cutting back on less important expenditures.

Financial Planning as a Career I glanced at John as I moved on to financial planning as a career. I explained that financial planners assist others with their financial goals and needs and that a variety of organiza- tions provide such services. Many people are attracted to PFP as a career because planners can really help people with their financial lives, receive genuine thanks, and make a sig- nificant living. A selection of some of planners’ most sought after services include planning for retire- ment, improving investment returns, structuring budgeting and other cash flow matters, setting up estate plans, tax reduction, controlling risks, and integrating all major financial needs into a comprehensive financial plan. John found the information to be useful given his possible career interest. However, Amy seemed to be in and out, fiddling with her phone during the career discussion. Both agreed to think of themselves as financial planners in all subsequent meetings.

Summary The chapter introduces personal financial planning (PFP) and its process for your prelimi- nary examination.

reach their goals. It is the action stage of personal finance.

with monitoring and reviewing the plan as set out. -

sive financial plan incorporates all relevant financial areas including cash flow, tax, in- vestment, risk management, retirement, estate, special circumstances, employee benefits, and educational planning.

their financial pursuits.

Chapter One Introduction to Personal Financial Planning 21

Key Terms capital, 5 cash flow, 5 cash flow planning, 9 comprehensive financial plan, 9 educational planning, 10 employee benefits, 10 establishing goals, 9 estate planning, 10 fair value, 5

finance, 5 financial advisor, 13 financial plan, 8 financial planner, 13 financial statements, 9 household finance, 6 investments, 5 market structures, 5 market value, 5 markets, 5

personal finance, 6 personal financial planning, 6 retirement planning, 10 risk, 5 risk management, 9 special circumstances planning, 10 tax planning, 9

cfp.net CFP Board This is the website of CFP Board of Standards, the institution that offers the CFP® exam. It provides information about the CFP® exam and related courses, the financial planning profession, and information on finding a CFP® practitioner. The site also contains links to request a free kit on financial planning and report a complaint against a CFP® practitioner.

fpanet.org Financial Planning Association (FPA) This is the Financial Planning Association’s home page. It features financial re- sources for financial planners and people interested in earning the CFP® certification. You can also find a link to the Journal of Financial Planning, the CFP® practitio- ner’s journal.

napfa.org National Association of Personal Financial Advisors (NAPFA) NAPFA, set up exclusively for fee-only financial planners, has a website that con- tains links for both the public and professionals. Among featured services are finding a fee-only financial planner, consumer tips, press releases, member resources, and career center.

Websites

Questions 1. Why did it take until the 1970s for the field of financial planning to begin? 2. Why does personal financial planning involve other disciplines as shown in Figure

1.3? Give some practical examples of their use. 3. What are the differences between financial planning and a financial plan? 4. Describe the personal financial planning process and relate it to planning procedures. 5. Contrast a segmented and a comprehensive financial plan. 6. Describe some similarities and differences between a financial planning practitioner

and a physician. 7. Why is integration so important in financial planning? 8. List and discuss the parts of a financial plan. 9. Sam went to a financial planner who proceeded to give him written recommendations

in all areas of financial planning. Is that a financial plan? If not, what might be missing? 10. What does a financial planner do? 11. Name some common financial problems with which planners deal with. 12. How do you think the financial planner will be of the most help to Dan and Laura? Be

specific and explain why.

22 Part One Planning Basics

13. What is a contributing factor for the increasing demand for financial planners? 14. Do you think the amount of information available on the Internet regarding advice for

financial planning is beneficial or detrimental to the financial planning career? Support your answer with information from the chapter.

15. Do you believe Maria needed a financial planner? Why or why not? 16. How does household finance tie into financial planning?

CFP® Certification Examination Questions and Problems

You receive a phone call from someone you have not spoken to recently. The caller is ex- cited, having just heard that a brand new mutual fund is positioned to deliver large gains in the coming year. The caller wishes to purchase shares of the fund through you. Keeping in mind the stages of the overall personal financial planning process, which of the following questions that address the first two stages of financial planning should you ask?

1. What are your goals for this investment? 2. What other investments do you have? 3. What is your date of birth? 4. Do you want the dividends reinvested?

a. (1) and (3) only b. (2) and (4) only c. (1), (2), and (3) only d. (1), (2), and (4) only

1.2 Arrange the following financial planning functions in the logical order in which these functions are performed by a professional financial planner.

1. Interview clients, identify preliminary goals 2. Monitor financial plans 3. Prepare financial plan 4. Implement financial strategies, plans, and products 5. Collect, analyze, and evaluate client data

a. (1), (3), (5), (4), (2) b. (5), (1), (3), (2), (4) c. (1), (5), (4), (3), (2) d. (1), (5), (3), (4), (2) e. (1), (4), (5), (3), (2)

1.1

Chapter One Introduction to Personal Financial Planning 23

Case Application This case allows students to develop solutions themselves. It begins with an extensive background that will assist in the decisions that are asked for in subsequent chapters.

BACKGROUND—FIRST INTERVIEW Brad and Barbara arranged to come in to see me. They were both young college graduates and arrived wearing jeans and T-shirts. I soon found out they were recently married and lived with Brad’s parents, Richard and Monica, in the basement of the their house. Brad and Barbara paid for all of their own expenses. His parents got along extremely well with Barbara and treated her as one of their children. Recently the relationship between them had been deteriorating. When they weren’t ar- guing, they were whispering to each other. Both Brad and Barbara had overheard some of their conversations, which seemed to be about money and investing. Brad was very close to his uncle Tim and asked his advice about the situation. He suggested that Brad and Barbara recommend that their parents see a financial planner. Tim thought Brad and Barbara should meet the planner prior to discussing their recom- mendation with their parents. He had one advisor in mind. Tim said that Brad’s parents were both educated and unusually open in their discussions. Brad and Barbara should relay to the parents their concerns, including the fact that the parents’ problems were beginning to affect their own lives. Tim said that Brad and Barbara should suggest handling the finan- cial concerns as a family problem that could be worked out together, one that could bring the four of them closer. He was sure they would respond favorably. In fact the uncle was correct. My meeting with Brad and Barbara was very constructive, and I gained insight into the parents. Thereafter, Richard, the father, called and made an appointment. Interestingly, he mentioned that Brad and Barbara had some financial issues themselves. The detailed planning was to be done for the parents, but the engagement also would cover any planning that Brad and Barbara wanted done. Richard walked tentatively into my office early one evening. He glanced around ner- vously and closed the door behind him. I could sense that there was no need for small talk. He wanted to tell me his story. Richard, age 58, told me he had grown up in a small town and had married the high-school prom queen. He described Monica as a sweet and caring wife, as beautiful at 54 as she was at 18. He indicated that she would be devastated by his news. He became choked up, and we paused for a minute. The news was that he had lost $200,000 in a speculative investment. He mentioned that his $550,000 in retirement assets was down to a current figure of $350,000. He asked me to help them without telling his wife of the loss. I told him that if I took an assignment that involved two people, there would have to be honesty all around. He mentioned again that he thought she would be devastated. My response was that even if we hid it, the true story would come out even- tually anyway. I thought that he and Monica should come in next and we would start the process. At our next meeting, Richard came in first, and we waited for Monica. She entered the room, a tall, elegant woman with a ready smile. We engaged in some small talk, and after a time, I stated that Richard had something to say. When he broke the news, she was not as frail and sensitive as Richard had feared. She was visibly shaken but said their recent argu- ments over money had made her suspicious. She then asked how we could “make it up.” I indicated I would help but first wanted some particulars. Richard was a lawyer who worked in the entertainment industry. When he got out of college, he wanted to be a rock star, but his parents persuaded him to do something “more substantial.” Monica had gone to a state school and majored in English. She did a little writing but spent most of her time raising her children when they were young and the rest of it now in community activity.

24 Part One Planning Basics

They had married when Richard finished college and Monica graduated from high school. Their graduation ceremonies took place on the same day, and fortunately they were able to make both. They had two children, son Brad and a younger daughter Stacy. Both were married, but Stacy and her husband were separated, and Richard and Monica were helping her pay her bills. The couple indicated that they were saving about $20,000 a year gross but admitted that vacations and special expenditures came out of that pool. They wanted to retire when Richard turned 65. In retirement, they wanted the same lifestyle that they currently had. They did mention that it didn’t have to be in the high- cost metropolitan region they lived in then; it could be in a retirement community in Arizona. They wanted to make sure that Stacy was given at least $10,000 per year in i ncome once they passed away. They had approximately $200,000 in life insurance on Richard’s life. They wanted a total review of their assets and to examine the sensibility of that the age 65 retirement. I looked around and Richard seemed relieved that Monica had fully recovered.

Case Application Questions 1. What do you think of Brad and Barbara’s seeking help for Brad’s parents? 2. What prompted Richard to seek assistance? Was it only because of Brad and Barbara? 3. What type of financial plan seems appropriate for Richard and Monica? 4. Why do you think Monica didn’t react more negatively to the financial news? 5. What might the loss tell you about Richard? 6. Do you think I should have met privately with Richard? Why? 7. Complete the introductory section of the financial plan.

Practice Standards Practice standards are the methods by which professionals establish acceptable ways of performing their occupation. These standards are particularly important for financial plan- ners because of the significant role that financial advice often has for achieving client goals. In addition, adhering to high principles can reduce the chance of being sued, and complying with proper practices can be a defense against litigation in the event of loss. Finally, well-thought-out and executed practice standards can differentiate a true profes- sional from the array of people who may call what they do financial planning. Practice standards begin with establishing the client relationship and extend to gather- ing data, analyzing the client’s financial situations, developing and presenting recommen- dations made, and providing for implementation and monitoring. A detailed presentation of CFP Board Practice Standards, along with its Code of Ethics, is provided in Chapter E of this text on the website.

Chapter Goals

This chapter will enable you to:

Dan and Laura e-mailed me and asked if they could set up a meeting to discuss some prob- lems that had come up. I noticed the stern look on Dan’s face as they walked in. They were having a disagreement that they said was about paying government taxes early. Laura wanted Dan to claim seven dependents on his withholding form at work. That would, of course, lead to a higher amount of available cash during the year. I suspected that their argument was not only about early payments and the time value of money but also about their different beliefs about spending cash.

Real-Life Planning June had an ever-present wide smile and looked 10 years younger than her age. This was true even though her husband had died when their children were young, and she had raised them by herself while holding down a full-time job. Her children were all grown now and on their own. As she explained it, they had met and decided to recommend that she see a financial planner. They wanted someone to re- view the performance of their mother’s account. The same financial advisor had managed that account for 25 years. He was such a “nice fellow” and she was one of his first ac- counts. He had done “so well by me,” she said; he had invested the $200,000 proceeds from her husband’s life insurance policy, putting it all into stocks, and turned it into $500,000 currently. Moreover, she was able to save $5,000 each year and now that sum invested in stocks with the same broker was worth $150,000. She didn’t know why her children wanted her account reviewed. The advisor was shocked by the investment results. They indicated a return of 3.7 percent annually for the lump sum and 1.5 percent annually for the yearly deposits. He asked June a second time whether any withdrawals had been made and was told no.

Two

26 Part One Planning Basics

During that 25-year period, stocks with the same risk characteristics had increased 12 percent a year. If she had earned a market rate of return, her $200,000 lump sum would now be worth $3,400,000 and her $5,000 deposits would have increased to $667,000. The advisor decided not to tell June that her current combined accumulated retirement sum of $650,000 could have been worth more than $4,000,000 today. It would have been too upsetting. He would mention that only if she failed to grasp how poorly she had done. Instead he discussed basic time value of money concepts with her. He explained how compounding over extended periods of time can make weak results look favorable. He said that the $300,000 gain from the lump sum was one such instance and that calculating the compounded rate of return was the appropriate approach to use. He told her that many people made mistakes in decisions because of these compounding distortions. He indicated that her results were very weak and that average results could have placed substantially more money at her disposal today. In fact, the results were so weak that in inflation- adjusted terms, her returns were negative. In other words, instead of increasing, her sums, in purchasing-power terms, were worth less than at the time they were originally deposited. The advisor indicated that he was using standard time value of money concepts for lump sums and annuities. They were objective calculations that could speak for them- selves. He then handed her those calculations. June looked at them, then stared straight at the advisor and asked, “What do we do now?” This chapter will enable you to understand time value of money concepts. You will be able to calculate returns yourself, often simply, for example, in June’s case.

OVERVIEW

Financial planning entails making decisions from choices presented. Among the alterna- tives are spending today versus saving for the future, selecting one investment over another, or deciding on the future amount of money needed for retirement. All of the choices use time value of money principles to determine the correct decision. Without these principles, you couldn’t compare the choice of $1.00 today with $1.20 in, say, six years. In this chapter we examine the time value of money, its major principles and methods. We start with compounding and then discuss finding the present value, the future value, and the discount rate and the concept of annuities. You will learn about the importance of differing rates of return and time to compounding, how to handle irregular cash flows, and the effect of inflation on figures and serial payments. The next time someone offers you a choice of income payments over, say, three years, or higher payments over four years, you will be able not only to determine definitively the best choice but also to compute the values for each alternative. The overall objective, then, is for you to be able to use time value of money techniques whenever appropriate to make correct PFP decisions.

BASIC PRINCIPLES

The time value of money can be defined as the compensation provided for investing money for a given period. In sum, under the time value of money, your money has differ- ent values at different points in time. If you were offered the choice of $1,000 today or $1,000 two years from now, you would opt for the money today. That is because you could invest the money and in two years have much more than the original $1,000. From another perspective, what is known as the time value of money is the benefit of having the use of money sooner rather than later.

The Time Value of Money 27

Example 2.1 Suppose that Stacey Anderson finishes her education, goes on a round of interviews, and accepts a well-paying job offer. She wants to make a good impression, right from the begin- ning, so she goes shopping for a new car. Stacey finds an appealing vehicle (attractive, practical, fuel efficient) and negotiates a $36,000 purchase price with the dealer. “I can’t pay $36,000 now,” Stacey said, “but I can afford to pay you $750 a month. That’s $9,000 a year, so I’ll pay for the car in four years.” That might be a good bargain for Stacey but not for the dealer. By accepting, the dealer would be extending a no-money-down, interest-free loan to Stacey. The dealer would rather be paid in full, upfront. Therefore, the dealer insists that Stacey put some money down and borrow the rest of the $36,000 purchase price upon which they had agreed. If Stacey borrows from a third party, the dealer will get cash and have the use of the full $36,000 immediately; if the dealer extends a loan to Stacey, interest will be payable. Either way, if Stacey wants the use of that $36,000 now—so she can drive the chosen car to her new job—she will have to part with some of her own cash and pay interest to a lender for advancing her the balance.

Compounding Compounding is the mechanism that allows the amount invested, called the principal, to grow more quickly over time. It results in a higher sum than just the interest rate—or rate of return on your investment—multiplied by the principal. Once you compound for more than one period, you receive not only interest on principal but interest on your interest. In your multiplication, you add 1 to the interest rate to get the end-of-period value. See the following examples:

1. One-period compounding:

Principal beginning of year: $2,000 Interest rate: 10%

Principal end of year 1 = $2,000 × 11 + Interest rate2 = $2,000 × 11 + .102 = $2,000 × 1.10 = $2,200 2. Two-period compounding:

Principal beginning of year: $2,000 Interest rate: 10%

Principal end of year 2 = $2,000 × 11 + Interest rate2 × 11 + Interest rate2 = $2,000 × 1.10 × 1.10 = $2,000 × 1.21 = $2,420 Were it not for the compounding, or interest on interest, we would have taken a simple interest rate for two years, 1 + .10 + .10 = 1.20:

$2,000 × 11.202 = $2,400 The $20 difference between $2,420 and $2,400 represents the interest on interest. By com- pounding for long periods of time, the interest on interest can amount to a huge sum. Think of a small snowball rolling down a snow-covered mountain. As it moves along it gets larger, not primarily because it is placing snow on the original small snowball but because it is placing snow on top of an ever-larger snowball. That is the equivalent of interest on interest. By the time the snowball hits the bottom of the mountain, it can become a boulder capable of crushing anything in its path.

28 Part One Planning Basics

Legend has it that Native Americans were paid $24 for Manhattan Island in the year 1626. If that was the case and the sellers had placed that money in a blend of bond and stock investments returning 8 percent a year, they would have had more than $220 trillion by the year 2014. They would have had enough money to buy the Brooklyn Bridge and probably all the buildings that could be seen from the top of it. Let’s do a calculation using that $2,000 investment that shows the effect of compounding at a 10 percent interest rate for five years. Notice in Table 2.1 that the compounding contribution has gone from $20 at the end of two years to a cumulative sum of $221 by the end of five years. Note that the total contribution of compounding over simple interest at the end of five years is $221, which is more than one year’s worth of simple interest. The cumulative gain turns out to be more than 60 percent of the beginning principal as compared with 50 percent for simple interest. A comparison of simple interest relative to compounding for a cumulative 5-year and 20-year period is given in Figure 2.1. At the end of 30 years, the amount of simple interest would be insignificant relative to the compound interest. This is illustrated in Figure 2.2.

Using a Financial Calculator In many of the problems that follow, you could receive your answer by looking up a com- pounding factor in a financial table, but that is hardly efficient. Many financial calculators can

Year

Beginning Principal

Ending

Principal

Simple Interest Income

Compound Interest Income

Compounding Contribution

1 $2,000 $2,200 $200 $200 $0 2 $2,200 $2,420 $200 $220 $20 3 $2,420 $2,662 $200 $242 $42 4 $2,662 $2,928 $200 $266 $66 5 $2,928 $3,221 $200 $293 $93

Total $1,000 $1,221 $221

TABLE 2.1 Impact of Compounding— Investment of $2,000

$1,000 $1,221

$4,000

$11,455

$2,000

$4,000

$6,000

$8,000

In te

re st

$10,000

$12,000

$14,000

simple compound simple compound

5-year 5-year 20-year 20-year

Period

FIGURE 2.1 Comparison: Compound Interest versus Simple Interest

The Time Value of Money 29

perform the operation for you. In fact, all financial calculators generally use the same basic keystrokes. They often have special keys to calculate the time value of money and perform many other financial operations. Five special keys—N, I/Y, PV, PMT, FV—allow you to solve all the simple time value calculations in this chapter.1 They are presented in Figure 2.3.

N = Number of years or compounding periods I/Y = Rate of return on an investment or discount rate PV = Present value PMT = Periodic payment FV = Future value

We will use a form of this “all calculator” diagram to solve for all simple time value type problems throughout the book. Basically, as you will see, you enter all the inputs and press the key for the variable you are solving for. Unfortunately the calculators diverge in their approach to more complex financial problems.2 In these instances, we have selected two leading financial calculators—the HP12C and the TI BA II Plus—for which we will supply the individual keystrokes. In Appendix II to this chapter, you will find details on performing the same calculations in Excel.

Present Value The present value of a sum is its worth at the beginning of a given period of time. We may be offered an amount of money in the future and want to know what it is worth today. In other words, we want to know its current value. In financial terms, we call this being given the future value and having to solve for the present value. The amount is obtained

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

1 6 11 16 21 26 31 Year

C um

ul at

iv e

In te

re st

Compound interest income

Simple interest income

FIGURE 2.2 Comparison: 10 Percent Interest—Simple versus Compound

1 Note that HP12C uses i instead of I/Y notation. 2 Our complex problems are mostly internal rate of return (IRR), which will be explained later in this chapter, and net present value (NPV), which is explained in Chapter 8.

N I/Y PV PMT FVFIGURE 2.3 Financial Calculator Keystrokes

30 Part One Planning Basics

through discounting that future value by an appropriate discount rate. In effect, discounting is like compounding in reverse. Just as you may have been surprised at how large a sum of money grew through compounding over many years, you may have the same response to the results of discounting. However, in this case, your surprise would be at how small the present value is relative to the future value when discounting occurs over many years. The formula is:

PV = FV11 + i2n Note: In entering figures or receiving solutions, remember to record cash received as a positive figure and cash payments as negative ones. For the HP12C, mark the negative amounts with the keystroke CHS; use +/– for the TI BA II Plus. Always remember to clear the financial register before starting a new problem (HP12C—press the keystroke f and then FIN; TI BA II Plus—press 2nd , RESET, and ENTER). Also keep in mind that depending on the procedures you follow (for example, the number of decimal points entered), your calculation may differ slightly from the example provided. Generally, those differences are not important.

Example 2.2 What is the present value of $3,270 to be received one year from now if the discount rate is 9 percent?

PV = 3,270 11 + .0921

= $3,000

Inputs: 1 9 3,270

Solution: –3,000

N I/Y PV PMT FV

Note: The present value figure is negative because $3,000 would have to be paid today to receive $3,270 in the future.

Example 2.3 What is the present value of $223,073 to be received 50 years from now if the interest rate is 9 percent (see Figure 2.4)?

PV = 223,07311 + .09250 = $3,000

Inputs: 50 9 223,073

Solution: –3,000

N I/Y PV PMT FV

Calculator Solution

FIGURE 2.4 Present Value

Year 0 i = .09 1 i = .09 2 i = .09 3 49 i = .09 50

$223,073–$3,000

The Time Value of Money 31

Future Value Future value is the amount you will have accumulated at the end of a period. The sum accumulated depends on the amount you invested at the beginning of the period, the inter- est rate, and the number of years and compounding periods involved. It is given by the following formula:

FV = PV11 + i2n Example 2.4 If you were to deposit $7,000 in a certificate of deposit for five years earning 5 percent annu-

ally, you would have $8,934 accumulated at the end of the period (see Figure 2.5).

FV = 7,000 × 11 + .0525 Inputs:

Solution:

5 5 –7,000

8,934

N I/Y PV PMT FV

The future value of a lump sum is simply the present value equation given in the previ- ous section rewritten. The future value of a sum compared with its present value depends to a great extent on the rate of return on the investment. Clearly, the higher the rate of interest, the higher the sum you accumulate at the end of the period. Given the power of compounding, a relatively small difference in the rate can make substantial differences over longer periods of time. Figure 2.6 shows these differences.

Calculator Solution

FIGURE 2.5 Future Value

Year 0 i = .05 1 i = .05 2 i = .05 3 …. 4 i = .05 5

–$7,000 $8,934

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

5% 8% 10% 15% 20% Rate

Fu tu

re V

al ue

FIGURE 2.6 Future Value at Alternative Rates of Return (Payment of $1,000 for 20 years)

32 Part One Planning Basics

SENSITIVITY TO KEY VARIABLES

The interest rate for compounding or discounting and the number of time periods are the key variables for determining accumulated sums given a fixed amount deposited. As you will see, a shift in either compounding time or interest rate, even when relatively modest, can have a material effect on final results. In the following sections, we demonstrate that sensitivity in our description of the use of the rule of 72, compounding periods, and discount rates.

The Rule of 72 The rule of 72 is a simple way to establish the difference that the return on an investment makes in accumulating assets. It tells us approximately how long it takes for a sum to double. It is given by the following formula:

Years to double = 72/Annual interest rate

Example 2.5 Compare how quickly money would double at (a) an 8 percent annual rate of return and (b) an 18 percent annual rate of return.

a. 8%

Years to double = 72/8 = 9 years

b. 18%

Years to double = 72/18 = 4 years

In other words, it would take more than twice as long for the 8 percent investment to double as it would for the 18 percent one. If $1,000 were deposited in the 8 percent investment, it would be worth $2,000 in about nine years, whereas by year 9 the 18 percent investment would be worth $4,435.

Compounding Periods The number of compounding periods tells you how often interest on interest is calculated. Generally, it involves the number of times that compounding occurs per year. The more often interest on interest is calculated, the higher the investment return. For example, if you were offered yearly compounding for your $1,000 deposit at an 8 percent rate for 10 years, you would have $2,159. If, in the same example, you were offered quarterly compounding, you would receive $2,208. In your calculations, assume that yearly compounding is used unless told otherwise. To obtain an approximation of the sum for more frequent compounding, divide the yearly interest rate by the number of compounding periods per year and multiply the number of years you compound by the number of compounding periods per year. Thus:

Yearly Compounding

FV = PV × 11 + i2n n = Number of years

Multiperiod Compounding

FV = PV × a1 + ipbn×p

The Time Value of Money 33

p = Number of compounding periods each year

FV = 1000 × a1 + .08 4 b10×4

= 2,208

Compounding yearly:

Inputs: 10 8 –1,000

Solution: 2,159

N I/Y PV PMT FV

Compounding quarterly:

–1,000

Solution: 2,208

Inputs: 40 2

N I/Y PV PMT FV

Discount Rate As mentioned, the discount rate is the rate at which future values are brought back to the present. Generally, it is obtained by taking the rate of return offered in the market for a comparable investment. It is sometimes called the present value interest factor (PVIF) in discounting and can be referred to by other terms, depending on the calculation being per- formed. The higher the discount rate, the lower the present value of a future sum. For a variety of reasons, discount rates may be higher or lower, which we discuss in Chapters 8 and 10. One reason is the inflation rate. Typically, the higher the rate of inflation, the higher is the discount rate. If the discount rate is 6 percent in a relatively low-inflation en- vironment such as the United States, $40,000 promised in 10 years will have a present value of $22,336. That same amount promised in a high-inflation economy such as Australia’s in the 1980s might have a discount rate of 9 percent. In such a high-inflation country, $40,000 promised in 10 years would have a present value of only $16,896. If you want to solve for the discount rate, you can do so by again moving around terms in the same formula: 11 + i2n = FV

Example 2.6 Susan has promised to pay Paul $40,000 in nine years if he gives her $20,000. What discount rate is Susan using?

11 + i29 = 40,000 20,000

Inputs: 9 –20,000 40,000

Solution: 8

N I/Y PV PMT FV

Calculator Solution

34 Part One Planning Basics

Periods The number of compounding periods is the last variable in the formula you solve for. For example, you may be asked how long it will take for $10,000 to reach $19,672 if the rate of interest is 7 percent.

11 + i2n = FV PV

11 + .072n = 19,672 10,000

Inputs: 7 –10,000 19,672

Solution: 10

N I/Y PV PMT FV

ANNUITIES

An annuity is a series of payments that are made or received. You may make a series of pay- ments to reduce and finally eliminate a loan. Alternatively, you may make an investment that entitles you to receive a stream of income over the rest of your life. In this chapter, we are concerned with ordinary annuities, which are level streams of cash flow over a period of time. All the approaches to solving the problems that we used before can be used here. The difference is that the formulas must accommodate multiple cash flows instead of a single one. Let’s do one.

Future Value of an Annuity

FVA = PMT × 11 + i2n − 1

FVA = Future value of an annuity PMT = The annual payment made at the end of each year by the investor to the

account

Example 2.7 Jack and Alice want to deposit $3,000 at the end of each year to accumulate money for a col- lege fund for their daughter, who was just born. They expect a return of 7 percent on their money. How much will they have at the end of her 17th year (see Figure 2.7)?

FVA = 3,000 × 11 + 0.07217 − 1

.07

Inputs:

Solution:

17 7 –3,000

92,521

N I/Y PV PMT FV

Regular Annuity versus Annuity Due When annuity payments are made at the end of the period, the annuity is called an ordinary annuity or regular annuity. When payments are made at the beginning of the period, the annuity is called an annuity due. It gives you one extra year of compounding for payments

Calculator Solution

The Time Value of Money 35

made. For the calculator solution to have payments at the beginning of the period, set the cal- culator in the BEGIN mode (HP12C—press the keystroke g and then BEG ; TI BA II Plus— use the following sequence: 2nd BGN and 2nd SET ). To avoid mistakes, always remember to switch back to the END mode once you have finished with the BEGIN mode calculations. Unless you are told otherwise, assume that payments are made at the end of the period.

Present Value of Annuity

PVA = an t=1

PMT11 + i2t PVAD = PVA × 11 + i2

= C an t=1

PMT11 + i2tS × 11 + i2 PVA = Present value of an annuity PVAD = Present value of an annuity due ©nt=1 = Sum of a series of payments starting with the present period (time period 1)

and extending to time period n (generally the end of the period)

Example 2.8 Elena was offered annuity payments of $6,000 at the beginning of each year for 30 years. The discount rate was 7 percent. What should she pay (see Figure 2.8)?

PVAD = C a30 t=1

6,00011 + .072tS × 11 + .072 = $79,666

FIGURE 2.7 Future Value of an Annuity

0 1 2 3 16 17

–$3,000 –$3,000 –$3,000 ……

……

–$3,000 –$3,000

i = .07 i = .07 i = .07 i = .07

$92,521

Year

FIGURE 2.8 Present Value of an Annuity Due

$6,000 $6,000 $6,000 $6,000 ...… $6,000

–$79,666

Year i = .07 1 i = .07 2 3 ...... 29 30i = .07 i = .07

36 Part One Planning Basics

Set the calculator in the BEGIN mode.

Inputs: 30 7 6,000

Solution: 79,666

N I/Y PV PMT FV

Example 2.9 We know all the cash inflows and outflows for our annuity streams and can solve for the rate of return. Varda was offered an annuity of $8,000 a year for the rest of her life for a payment currently of $100,000. She and the insurance company assume that she has a 20-year life expectancy. What is her anticipated return on the policy?

PVA = an t=1

PMT11 + i2t 100,000 = a20

t=1

8,00011 + i2t Inputs: 20 –100,000 8,000

Solution: 5

N I/Y PV PMT FV

Periodic Payment for an Annuity We solve for a periodic payment to decide how much we have to pay, assuming a level payment each period. A common type of periodic payment is a loan.

Example 2.10 Fred took out a $25,000 loan, which he promised to fully retire after eight equal yearly pay- ments. The interest rate on the loan is 8 percent. When interest and principal payments are combined, how much will he pay annually?

Inputs: 8 8 25,000

Solution: –4,350

N I/Y PV PMT FV

Perpetual Annuity A perpetual annuity is a stream of payments that is assumed to go on forever. One ex- ample of this type of annuity is a preferred stock. A preferred stock’s value emanates from its dividend, which is generally level and in theory is paid forever. The calculation of the present value of a preferred stock is simply the dividend divided by the appropriate interest rate.

PVAp = PMT

PVAp = Present value of a peretual annuity

Example 2.11 John was considering purchasing a preferred stock paying $5 per share annually. The market interest rate for that type of stock was 9 percent. How much should he pay for the preferred?

Calculator Solution

The Time Value of Money 37

Solution

PVAp = 5

.09

= $55.56

IRREGULAR CASH FLOWS

In the sections on time value of money, we performed calculations based on either lump sums or multiple payments of the same amount of money. But in many instances the pay- ments are for differing amounts. We can call these differing payments irregular cash flows. Often, the procedure for solving problems with irregular cash flows is to bring all in- flows and outflows to the beginning of the period. In essence, each cash flow will be a separate subproblem with a different number of compounding periods. The solution will be to add up all the subproblems as diagrammed in Figure 2.9. Fortunately, you can solve this problem in one step by using multiple registers of the calculator.

Example 2.12 Manny had an investment that would supply him $5,000 in year 1, $4,000 in year 2, $3,000 in year 3, and $1,000 in year 4. He wanted to know how much he should be willing to pay for that investment today if he wanted to earn 10 percent on his investment. (See Figure 2.9.)

General Calculator Approach Specific HP12C Specific TI BA II Plus

Enter initial cash outflow 0 g CF0 0 ENTER ↓

Enter cash inflow year 1 5,000 g CFi 5,000 ENTER ↓ ↓

Enter cash inflow year 2 4,000 g CFi 4,000 ENTER ↓ ↓

Enter cash inflow year 3 3,000 g CFi 3,000 ENTER ↓ ↓

Enter cash inflow year 4 1,000 g CFi 1,000 ENTER ↓ ↓

Enter the discount rate NPV 10 i 10 ENTER ↓

Calculate the net present value f NPV CPT 10,788 10,788

Calculator Solution

Clear the register CF 2nd CLR Work f FIN

i = .1 i = .1 i = .1 i = .10 1 2 3 4

$5,000 $4,000 $3,000 $1,000

$4,545

$3,306

$2,254

$683

$10,788

YearFIGURE 2.9 Present Value of Series of Irregular Payments

38 Part One Planning Basics

INFLATION-ADJUSTED EARNINGS RATES

Earnings is the amount received, and the earnings rate is the return on assets held. Inflation, the rate of increase in prices in our economy or in specific items, can distort earnings results. For example, you may receive $2,000 a year in dividends from stocks today. Those dividends are projected to grow 3 percent a year. Suppose that overall infla- tion, meanwhile, is expected to increase by 5 percent a year. That means the inflation- adjusted return on stocks in the form of dividends will decline each year. We call the inflation-adjusted return on assets the real return. The real return on assets contrasts with the nominal return. The nominal return and nominal dollars are the figures we are accustomed to seeing. They are based on the actual number of dollars received, not those adjusted for inflation. When the nominal number of dollars goes up but the value in real dollars goes down, those dollars can purchase fewer goods and services. As a result, we have had a decline in purchasing power terms. We can calculate the real return:

RR = a1 + r 1 + i − 1b × 100

where

RR = Real return r = Investment return i = Inflation rate

When multiplying by the real return to get a new cumulative sum, we use the real growth rate, which is equal to 1 + r1 + i . We will employ the real return frequently in capital needs analysis in Chapter 17.

Example 2.13 Brad was about to retire. He wanted to live on the return on the $500,000 savings he had accumulated and leave the principal amount to his children. The $500,000, which is increasing 3 percent annually, provided him $35,000 this year. Inflation is projected to rise 5 percent per year. Calculate the amount of cash he has available to spend currently as well as how much he will receive in nominal and real dollars over the next five years.

Cash availabe = $35,000 this year Nominal return year 1 = 35,000 × 11 + Nominal growth rate2

= 35,000 × 1.03 = 36,050

Real return year 1 = 35,000 × Real growth rate

= 35,000 × 11 + 0.03211 + 0.052

= 35,000 × 0.9810 = 34,335

Years 0 1 2 3 4 5

Nominal dollars $35,000 $36,050 $37,132 $38,245 $39,393 $40,575 Real dollars 35,000 34,335 33,683 33,043 32,415 31,791

The Time Value of Money 39

Sample calculation for = Real dollars year 5

Real return = a1.03 1.05

− 1b × 100 = −1.9048% Inputs: 5 –1.9048 –35,000

Solution: 31,791

N I/Y PV PMT FV

Brad’s situation is deteriorating each year. That is because the growth rate of his income is 3 percent while the inflation rate is 5 percent. More precisely, as this solution shows, his re- turns are declining 1.9048 percent in real terms annually. Each year while his cash amounts in nominal dollars are going up, in real dollars, they are dropping. Consequently, his dollars will be able to purchase fewer and fewer goods over time. If he cannot raise the returns on his assets so that they are more in sync with the inflation rate, he will have to accept either a lower standard of living or a reduced amount to be left to his children, even in nominal terms.

INTERNAL RATE OF RETURN

The internal rate of return (IRR) uses time value of money principles to calculate the rate of return on an investment. IRR obtains that rate of return by combining all cash flows including cash outflows (usually initial outlays to purchase the investment plus any subsequent losses) and cash inflows (generally, the income upon the investment plus any proceeds upon the sale of the investment). The IRR is the discount rate that makes the cash inflows over time equal to the cash outflows. We discuss the IRR and a related measure, the NPV, more extensively in Chapter 8. A simple example of the IRR and the keystrokes to solve it is given in Example 2.14.

Example 2.14 Lena had a stock that she purchased for $24. She received dividends one and two years later of $0.80 and $0.96, respectively and then sold her investment in year 3 for $28. What is her IRR?

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

Enter initial cash outflow 24 CHS g CF0 24 +/- ENTER ↓ Enter cash inflow year 1 0.80 g CFi 0.80 ENTER ↓ ↓

Enter cash inflow year 2 0.96 g CFi 0.96 ENTER ↓ ↓

Enter cash inflow year 3 28 g CFi 28 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 7.7% 7.7%

The IRR was 7.7%.

Calculator Solution Clear the register f FIN CF

2nd CLR Work

ANNUAL PERCENTAGE RATE

The annual percentage rate, or APR, is an adjusted interest on a loan. The Federal Truth in Lending Act mandates that this rate be disclosed on all loans so that consumers can compare the rates offered by different lenders. The APR incorporates many costs other than interest that make its rate different from the one included in a lending contract. For example, the APR on a 7 percent mortgage loan would be more than 7 percent because of such items as loan processing fees, mortgage insurance, and points.

40 Part One Planning Basics

By comparing these costs, we may find that two loans that each has a 7 percent interest rate may have different APRs of, say, 7.10 percent and 7.25 percent, respectively. Other costs in connection with that same loan, such as attorney fees, home inspection fees, and appraisal fees, are excluded from the APR. When those non-APR costs in alternative loans materially differ, they should be included in decision planning. The APR is best used to compare similar types of loans for similar periods of time. For example, if you were to compare a 15- and a 30-year mortgage, the results, given the same closing costs, would differ because those costs are spread over different periods of time, thereby distorting your comparison. Adjustable rate mortgage comparisons can be more complicated because their costs can depend in part on other factors such as the benchmark rate determining future expense.3

The benchmark figure must be used carefully, and it is a good idea to separate all costs from alternative lenders and compare them as well as noting their relative APRs. Now that you know and appreciate time value of money principles, you can use them to help make financial decisions. Because all operating parts of financial planning employ financial calculations, these principles and formulas will come in handy.

3 The benchmark is the specific market-developed rate that determines how much the borrower will pay. See adjustable rate mortgages in Chapter 7.

Back to Dan and Laura TIME VALUE OF MONEY Our next meeting was scheduled to be on cash flow planning. However, Dan and Laura e-mailed me to ask if they could have meet about some specific problems that had come up. I, of course, agreed, and, when they came into the office, I noted the stern look on Dan’s face. They had had a disagreement. Ostensibly, it was about tax payments. Laura wanted Dan to claim seven dependents on his withholding form at work because they always had received a large refund when their return was filed. That action could, of course, lead to a higher amount of deductions and therefore more available cash during the year but a po- tential tax payment on April 15. The practice doesn’t change the ultimate cash outflow but does change its timing and therefore involves time value of money. I suspected that their disagreement would not only be about tax payments and the time value of money but also about their differing beliefs about spending money. Sure enough, when I asked why she wanted to do it, Laura said so that they would get more money to spend currently. Dan couldn’t see why they would want to jeopardize their already precarious current cash position. There was the possibility of underpayment, which would result in a large disbursement when the final tax return was due. He said they could end up with even higher credit card debt to finance the tax payment if Laura spent all the cash available during the year. Laura didn’t see the problem. She said, “We aren’t paying any more to the government under this approach.” Both wanted my opinion of this practice. Dan mentioned that he had received an offer to purchase a bond for $15,000 that would pay back $50,000 in 30 years with no interest in the meantime. He thought that sounded attractive. Laura said she saw a study that said $1,000 invested in stocks 75 years ago adjusted for inflation would be worth more than 50 times that of a comparable investment in bonds. Is that true, and, if so, shouldn’t they put all of their money in stocks? They then started to criticize each other’s beliefs about the appropriate level of risk. I had often seen disagreements erupt at meetings concerned with constructing a finan- cial plan. I decided to deal with it directly, early in the planning process. It could make subsequent meetings more productive.

The Time Value of Money 41

I told them that emotionally charged differences of opinion sometimes took place at fi- nancial planning meetings. I believed that in part they came from the stress of having to think about long-term factors and make decisions concerning them. Of course, the funda- mental reason was the differences in personalities and beliefs. I assured them that virtually all the decisions they made could be modified or changed later. I mentioned that I found it ironic that many people selected mates who were dissimilar in certain traits from them- selves and could complement their own “weaknesses” but later came to criticize those very traits. I told them I thought that Dan’s innate conservatism offset Laura’s aggressive investment posture and that his desire to protect household finances as shown by the in- come tax withholding issue and anxious demeanor blended well with Laura’s more laid- back convenience-oriented approach. I reminded them that in my experience people seldom selected mates who were exactly like themselves. That talk seemed to ease the tension, and we moved on to the last point. Laura’s mother had been offered an annuity in which she would deposit $200,000 and receive $15,530 a year over her expected 23-year life span. Laura was already familiar with the advantages and disadvantages of an annuity, and she just wanted to know what the rate of return was and whether I considered the return attractive.

Here’s how I explained the concept of time value of money: All the questions you have raised, to varying degrees, have to do with the time value of money. The literal meaning of this term is that money given or received has a value. The value is generally what you could earn on that sum by investing it in marketable securities. Rather than further describing time value principles, I suggest you read a basic finance textbook or more simply a good manual on the use of a financial calculator. I recommend the HP12C or the TI BA II Plus. Given your desire for information on how I arrived at my financial decision and not knowing whether you already have a financial calculator, I will provide generic calcu- lator keystrokes. I’ll handle the calculations first and the question on withholding at the end. Compounding for an investment involves not only interest on an original sum but interest on interest. If we receive compound interest for an extended period of time, the interest on interest takes on increasing importance. Over longer periods, interest on interest can actually dwarf the original sum. Compounding can make it difficult to accurately assess the return on an investment without calculating it. Sometimes what looks like a great return isn’t. I believe that the proposal that Dan has is an example of something that looks like a good investment, but isn’t. Dan is being offered a zero coupon bond, which just means that all interest and principal are paid at maturity. The fact that he will more than triple his original sum over time makes it look attractive. However, we can reject this investment with a simple calculation.

Inputs: 30 –15,000 50,000

Solution: 4.1

N I/Y PV PMT FV

That rate of return of 4.1 percent compares with U.S. government bonds for that same period of 5 percent. We don’t even have to incorporate risk (the bond being offered is of a medium-quality business) or take into account the negative tax consequences of this type of bond in a nonpension account. This bond is not attractive. The example Laura presented is an illustration of how compounding can make a huge difference in returns over time. The returns she expressed were over a 75-year period. They were adjusted for inflation. I will assume 11 percent per year for stocks, 5.5 percent per year for bonds, and 3 percent for inflation.

42 Part One Planning Basics

The real return for stocks and bonds is the return after adjusting for the negative effect of inflation. It is given by the following formula:

Real return = a1 + r 1 + i − 1b × 100

For stocks:

Real return = a1.11 1.03

− 1b × 100 = 7.77

Inputs: 75 7.77 –1,000

Solution: 273,171

N I/Y PV PMT FV

Compounding $1,000 for 75 years at the real return for stocks is $273,171. Similarly, cal- culating the real interest rate and compounding for bonds yields $4,230.

Real return 1bonds2 = a1.05 1.03

− 1b × 100 = 1.9417

Inputs: 75 1.9417 –1,000

Solution: 4,230

N I/Y PV PMT FV

As can be seen, it is true that alternate compounding rates can make an enormous differ- ence and that the stocks increased more than 50 times than bonds did. Whether stocks or bonds or, more likely, a combination of the two is appropriate for you will be left to our discussions on investments. Your mother’s rate of return on her annuity can be calculated as follows:

Inputs: 23 –200,000 15,530

Solution: 5.5

N I/Y PV PMT FV

The 5.5 percent return on investment offered does not seem attractive relative to the 5 percent return on U.S. government bonds. The government bond will repay principal at the end of 23 years, but the annuity does not provide any principal, only interest payments. Your mother should either seek another estimate or place her money in something else. Finally, you have a difference of opinion on how to handle tax withholding. For Laura, as indicated in this write-up, money over time has worth. The money you give to the IRS early could be invested in a money market fund or some other investment that would provide you some income. So Laura is correct that from a financial standpoint, overwithholding is inefficient. Yet many people overwithhold. They may do this to avoid an abrupt payment on tax day, April 15. Alternatively, they may use overwithholding so that they can receive what they feel is an unexpected bonus from Uncle Sam that they can then spend. These are

Chapter Two The Time Value of Money 43

nonfinancial human reasons. I have explained the advantages and disadvantages as I see them. Whether you want the financial sacrifice for the sake of the comfort and structure provided by overwithholding is up to you. Let me end with a personal note that may not be part of many financial planners’ writ- ten documents but that you have asked me to include whenever I thought it useful. Money matters, like many others in life, can result in differences of opinion. Given my earlier re- marks to you, you have an idea of how I feel. Basically, you can run your monies sepa- rately with differences in assets selected, tax withholding rules, and a host of other decisions. Or, as most couples do, at least for first marriages, you can compromise so that both people make meaningful sacrifices. You should both verbalize your differences and try to reach a settlement of the issues and go forward together in financial matters. If you would like my input on any specific financial problem, please let me know.

Summary The time value of money is one of the basic ideas in finance. As such, it is very important that you understand how to use it in decision making.

amounts need to be established or when deciding which alternative is best. It allows impartial comparison of past or future performance or values.

of return used. For example, using the rule of 72, it will take 12 years for a sum to double in value when the rate of return is 6 percent but only 4 years when the rate is 18 percent.

discount rate for lump sums and for annuities.

that can be approximated by subtracting the inflation rate from the indicated return.

on investments that have differing inflows and outflows over time.

Key Terms annual percentage rate 39

annuities, 34 annuity due, 34 compounding, 27 discount rate, 33

future value, 31 inflation, 38 internal rate of return

39 irregular cash flows, 37 nominal return, 38

ordinary annuity, 34 perpetual annuity, 36 present value, 29 real return, 38 time value of money, 26

teachmefinance.com Time Value of Money This website covers concepts such as the time value of money, future values of un- even cash flows, annuities, perpetuities, techniques involving cost of capital calcula- tions, cost of capital budgeting, and a host of other things.

Website

Questions 1. What is compounding, and why is it important? 2. Why is knowledge of the time value of money useful?

4. What rate is most often used for time value of money calculations?

44 Part One Planning Basics

5. If the discount rate on a proposed investment is raised, what happens to its present value? Why?

6. Would a lump sum today or the comparable amount in periodic payments deposited over time provide a higher FV? Why?

7. Explain regular annuity versus annuity due and give examples. 8. What is rate of return and why do we use inflation-adjusted return? 9. What are the differentiating factors between regular annuity and annuity due? 10. How is the Rule of 72 a helpful tool? 11. What is future value and how is it calculated? 12. What would be the consequence of not accounting for inflation? 13. What is the significance of IRR?

Problems 2.1 What is the present value of a $20,000 sum to be given six years from now if the discount rate is 8 percent?

2.2 What is the future value of an investment of $18,000 that will earn interest at 6 percent and fall due in seven years?

2.3 Jason was promised $48,000 in 10 years if he would deposit $14,000 today. What would his compounded annual return be?

2.4 How many years would it take for a dollar to triple in value if it earns a 6 percent rate of return?

2.5 Marcy placed $3,000 each year into an investment returning 9 percent a year for her daugh- ter’s college education. She started when her daughter was two. How much had she accu- mulated by her daughter’s 18th birthday?

2.6 Todd was asked what he would pay for an investment that offered $1,500 a year for the next 40 years. He required an 11 percent return to make that investment. What should he bid?

2.7 Ann was offered an annuity of $20,000 a year for the rest of her life. She was 55 at the time, and her life expectancy was 84. The investment would cost her $180,000. What would the return on her investment be?

2.8 How many years would it take for $2,000 in savings a year earning interest at 6 percent to amount to $60,000?

2.9 Aaron has $50,000 in debt outstanding with interest payable at 12 percent annually. If Aaron intends to pay off the loan through four years of interest and principal payment, how much should he pay annually?

2.10 What is the difference in amount accumulated for a $10,000 sum with 12 percent interest compounded annually versus one compounded monthly over a one-year period?

2.11 What is the difference in future value between savings in which $3,000 is deposited each year at the beginning of the period and the same amount deposited at the end of the period? Assume an interest rate of 8 percent and that both are due at the end of 19 years.

2.12 Kenneth made a $20,000 investment in year 1, received a $5,000 return in year 2, made an $8,000 cash payment in year 3, and received his $20,000 back in year 4. If his required rate of return is 8 percent, what was the net present value of his investment?

2.13 John had $50,000 in salary this year. If this salary is increasing 4 percent annually and in- flation is projected to rise 3 percent per year, calculate the amount of return he will receive in nominal and real dollars in the fifth year.

2.14 Becky made a $30,000 investment in year 1, received a $10,000 return in year 2, $8,000 in year 3, $11,000 in year 4, and $9,000 in year 5. What was her internal rate of return over the five-year period?

Chapter Two The Time Value of Money 45

Case Application TIME VALUE OF MONEY Richard e-mailed me that he and Monica differed about the impact of his extra spending over the past 15 years. He calculated it at about $3,000 a year. He said the total cost of $45,000 was well within his capability to make up. Monica said the cost was much higher and asked that they compute it. They had been offered an investment of $20,000 that would pay $70,000 in 20 years. They want to know if they should take it. Finally, Richard could sign up for an annuity at work. It would cost $100,000 at age 65 and provide payments of $8,000 per year over his expected 17-year life span. He wants to know if it is attractive. The appropriate market rate of return on investments is 7 percent after tax.

Case Application Questions 1. Calculate what the $3,000-per-year deficit, had it been invested, would have amounted

to at the end of the 15-year period. 2. Explain to Richard what compounding is and how it affected the cumulative amount

received in question 1. 3. Calculate the return on the proposed $20,000 investment and indicate the factors enter-

ing into your recommendation to accept or reject it. 4. Indicate the expected return on the annuity and whether it should be accepted or rejected. 5. Explain the time value of money for the financial plan using your answers to questions

1 through 4 in this part of the financial plan to help you communicate the time value information to Richard and Monica.

Appendix I

Serial Payments Serial payments are payments received or given that increase by a constant percentage each year. The constant percentage is often linked to the inflation rate with other potential figures including the rate of growth in a financial investment or in salary. Savings is a good example of how to use serial payments effectively. As you will see in the following example, devel- oping a required sum over an extended period by saving a constant amount each year may not be practical. That is because salaries go up over time, making it more practical to save an increasing amount as we continue to work. Serial payments can also handle such a situation. Another example is an increasing annuity. The amount we receive as an annuity may increase at a constant percentage. For example, a disability policy may provide a 5 percent increase in payout each year beginning when a person becomes disabled. The intention there is to cushion the effect of inflation. Here is the formula for serial payments:

Steps 1. Calculate the real return. Use the formula given earlier:

RR = a1 + r 1 + i − 1b × 100

46 Part One Planning Basics

2. Develop the base first-year payment. a. First find the cumulative real return, which is the sum of all years’ real returns. The

real return of one particular year is the sum of 1 plus the real return calculated in step 1, and this sum is raised to the power of the number of periods to conclusion of the serial payment.

Mathematically, it is

CRR = 11 + RR2n + 11 + RR2n−1 + 11 + RR2n−2 + p + 11 + RR2n−n where

CRR = Cumulative real return RR = Real return in decimal value n = Number of periods to conclusion

b. Divide the desired ending value expressed in current dollars by the calculated CRR to obtain the base first-year payment (FYP).

FYPb = CST CRR

where

CST = Cumulative sum in today’s dollars FYPb = First-year payment beginning of year

3. Multiply the first-year payment by 1 plus the inflation rate for each year beyond the first.

YP = FYP × 11 + i2n 4. If the amount required is to be paid at the end of the year, multiply each payment by 1

plus the inflation rate.

YPe = YPb × 11 + i2 where

YPe = Yearly payment at end of year

Example 2.A1.1 Dan wanted to save $50,000 in today’s dollars as a down payment on a house in four years. His income was increasing, which would make it possible for him to save higher and higher amounts as he came closer to the down payment date. He decided to increase his yearly sav- ings by the rate of inflation. He wanted to know how much he would have to save each year to reach his goal, assuming that inflation was 3 percent, his investment return was 5 percent, and payments would be made at the end of each year.

RR = a1.05 1.03

− 1b × 100 = 1.9417 1percentage value2 RR = 0.019417 1decimal value2

1 + RR = 1 + 0.019417 = 1.019417

CRR = 11.0194172 14−12 + 11.0194172 14−22 + 11.0194172 14−32 + 11.0194172 14−42 CRR = 11.01941723 + 11.01941722 + 11.01941721 + 11.01941720

= 4.1180

The Time Value of Money 47

FYPb = 50,000 4.1180

= $12,141.82 at the beginning of year

FYPe = 12141.82 × 11.032 = $12,506.07 at the end of year

Successive payments rising by the rate of inflation multiplied by 1.03 were $12,881.25, $13,267.68, and $13,665.72.

1 $12,506 3 $1,971 $51,500 2 12,881 2 1,320 53,045 3 13,268 1 663 54,636 4 13,666 0 0 56,276

$52,321 $3,955 $56,276

Year Required Total

Payments

Number of Compounding

Periods

Returns on Payment at 5 Percent

Required Down Payment Sum

Excel Examples* We have already discussed how you can solve financial problems using a financial calcula- tor. In this appendix, you will learn how to use Excel to solve the problems presented throughout the chapter.

ANNUAL COMPOUNDING We will calculate the principal resulting after one period and two periods of compounding. Notice the difference when we compound for more than one period. (See Figure 2.A2.1.)

Building This Model in Excel 1. Inputs. Enter the input data in the ranges B6:B8 and B15:B17. 2. Compounding. Use the formula for annual compounding to calculate the principal at

the end of the compounding periods:

Principal end of compounding period = Principal × 11 + Inerest rate2Number of years * Troy A. Adair, Excel Applications for Corporate Finance (Burr Ridge. IL: McGraw-Hill/Irwin, 2005), and Craig Holden, Excel Modeling in Investments, 2nd ed. (New Jersey: Prentice Hall, 2005).

Note that the required sum at the end of the period is $56,276, not $50,000 because inflation has increased the required sum. In other words, $56,276 is $50,000 in real (inflation- adjusted) terms at the end of four years. When added, the required payments are also higher than $50,000 and would have been even higher if not for the investment return on the first three years’ deposits. When the required payments are combined with interest on those payments, they add to the required down payment sum.

48 Part One Planning Basics

One-period compounding. Enter B6*(1 B7) in cell B9. This is a one-year period, so don’t put a power to the expression in the parentheses because it is 1. Two-period compounding. Enter B14*(1 B15)^2 in cell B17. This time you use the power of 2 for the two-year period.

PRESENT VALUE We will calculate the present value of a single cash flow in two ways: using the formula for present value of a single cash flow and using the built-in Excel function PV.

Example 2.A2.1 What is the present value of $223,073 to be received 50 years from now if the interest rate is 9 percent? (See Figure 2.A2.2.)

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B6. 2. Present value using the formula. Enter B4/(1 B5)^B6 in cell B9. Use the following

formula to calculate the present value of a single cash flow:

Present value = Cash flow/ 11 + Discount Rate2Number of periods 3. Present value using the Excel PV function. The Excel PV function has five

parameters:

PV1rate, nper, pmt, fv, type2 The first parameter rate is the discount rate per period (year, month, day, etc.), nper is the number of periods, and fv is the future value of the cash flow; pmt and type are used to handle annuities, which we discuss later. In this case, put 0 for pmt and nothing for type, which Excel takes as 0. The type parameter has two values—0 and 1—which indi- cate whether the cash flow occurs at the end (0) or at the beginning (1) of the period. The Excel PV function can be used to calculate the present value of a single cash flow, the present value of an annuity, and the present value of a bond price. We put a negative

FIGURE 2.A2.1 Excel Model for One- Period versus Two- Period Compounding

1 2 3 4 5 6 7 8 9 10 1 1 12 13 14 15 16 17 18 19

A B C D E Annual Compounding

One-Period Compounding

Inputs Principal beginning of year $2,000 Interest rate 10% Number of years 1

Principal end of year 1 $2,200

Two-Period Compounding

Inputs Principal beginning of year $2,000 Interest rate 10% Number of years 2

Principal end of year 2 $2,420

=B6*(1+B7)

=B15*(1+B16)^2

The Time Value of Money 49

sign in front of the PV function because otherwise it returns a negative result. Again, this is somewhat irritating, but it is the way to handle that problem.

Enter = −PV(B5,B6,0,B4) in cell B12. Notice that we get the same result ($3,000) both ways.

FUTURE VALUE We will calculate the future value of a single cash flow in two ways: using the formula for the future value of a single cash flow and using the built-in Excel function FV.

Example 2.A2.2 If you were to deposit $7,000 in a certificate of deposit for six years earning 5 percent annually, how much would you have accumulated at the end of the period? (See Figure 2.A2.3.)

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B6. 2. Future value using the formula. Enter B4*(1 B5)^B6 in cell B9. Use the following

formula for calculating the future value of a single cash flow:

Future value = Cash flow × 11 + Interest rate2Number of periods 3. Future value using the Excel FV function. The Excel FV function has the same for-

mat and parameters as the PV function except for the fourth parameter, which is pv:

FV1rate, nper, pmt, pv, type2 The built-in FV function can be used to calculate the future value of a single cash flow,

the future value of an annuity, and the future value of a bond price. Again, put a nega- tive sign in front of the FV function so that the future value result will be positive. Enter FV(B5,B6,0,B4) in cell B12.

Notice that again that the result ($9,381) is the same using both methods.

SOLVING FOR THE DISCOUNT RATE Some problems have to be solved for the discount rate. There is no closed-form solution for that particular problem, but Excel makes the work easier by offering a built-in function that will solve for the discount rate. The function Rate has the following format and parameters:

Rate1 nper, pmt, pv, fv, type, guess2

FIGURE 2.A2.2 Excel Model for Present Value of a Single Cash Flow

1 2 3 4 5 6 7 8 9 10 1 1 12 13

A B C D E

Present Value of a Single Cash Flow

Inputs Future cash flow $223,073 Discount rate 9% Number of years 50

Present Value Using the Formula Present value $3,000

Present Value Using the Excel PV Function Present value $3,000

=B4/(1+B5)^B6

= –PV(B5,B6,0,B4)

50 Part One Planning Basics

All the parameters were defined earlier except for guess, which refers to your optional first guess at the correct answer. Generally, you can omit it.

Example 2.A2.3 Susan has promised to pay Paul $40,000 in nine years if he gives her $20,000 now. What dis- count rate is Susan using? (See Figure 2.A2.4.)

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B6. 2. Discount rate using the Excel Rate function. Enter Rate(B6,0,B4,B5) in cell B9. Put

0 for the second parameter, pmt, because it is used for annuities. The trick here is that the function works only when the present value and future value have opposite signs. This is the reason for putting a negative sign in front of the present value. Although ir- ritating, this step is necessary to get the proper result.

SOLVING FOR THE NUMBER OF COMPOUNDING PERIODS Sometimes problems have to be solved for the number of compounding periods. That par- ticular problem has no closed-form solution. However, Excel makes the calculation easier because Excel has a built-in function that solves for the number of periods. This function, nper, has the following format and parameters:

Nper1 rate, pmt, pv, fv, type2 You already know the definition of all the parameters.

FIGURE 2.A2.3 Excel Model for Future Value of a Single Cash Flow

1 2 3 4 5 6 7 8 9 10 1 1 12 13

A B C D E

Future Value of a Single Cash Flow

Inputs Amount deposited $7,000 Interest rate 5% Number of years 6

Future Value Using the Formula Future value $9,381

Future Value Using the Excel FV Function Future value $9,381

=B4*(1+B5)^B6

= –FV(B5,B6,0,B4)

FIGURE 2.A2.4 Excel Model for Solving for the Discount Rate

1 2 3 4 5 6 7 8 9 10

A B C D E Solving for the Discount Rate

Inputs Present value of a cash flow $20,000 Future value of a cash flow $40,000 Number of years 9

Discount Rate Using the Excel Rate Function Discount rate 8%

=RATE(B6,0,–B4,B5)

The Time Value of Money 51

Example 2.A2.4 How long will it take for $10,000 to reach $19,672 if the rate of interest is 7 percent? (See Figure 2.A2.5.)

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B6. 2. Number of periods using the Excel nper function. Enter nper(B6,0,B4,B5) in cell B9.

Again, use a negative sign for the present value in order to get the proper result.

FUTURE VALUE OF AN ANNUITY We can calculate the future value of an annuity in two ways: using the formula for the fu- ture value of an annuity and using the built-in Excel function FV.

Example 2.A2.5 Jack and Alice want to deposit $3,000 at the end of each year to accumulate money for a col- lege fund for their newborn daughter. They expect a return of 7 percent on their money. How much will they have at the end of the 17th year? (See Figure 2.A2.6.)

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B6. 2. Future value of an annuity using the formula. Use the following formula for calcu-

lating the future value of an annuity:

Future value = Payment 1 1 11 × DR2NP − 12/DR2 where

DR = Discount rate NP = Number of periods Enter =B4*(((1 B5)^B6 1)/B5) in cell B9.

3. Future value of an annuity using the Excel FV function. Except for future value of a single cash flow, the Excel FV function can be used to calculate the future value of an annuity. The format of the function in this case is

FV1rate, nper, pmt, 02 Put 0 for the fourth parameter because there is no cash flow at the beginning of the pe- riod; hence, the present value is 0. Put a negative sign in front of the FV function so that the future value result will be positive.

Enter =FV1B5,B6,B4,02 in cell B12. Notice that the result ($92,521) is the same both ways.

FIGURE 2.A2.5 Excel Model for Solving for the Number of Compounding Periods

1 2 3 4 5 6 7 8 9 10

A B C D E

Solving for the Number of Periods

Inputs Present value of a cash flow $10,000 Future value of a cash flow $19,672 Interest rate 7%

Discount Rate Using the Excel Nper Function Number of years 10

=NPER(B6,0,–B4,B5)

52 Part One Planning Basics

PRESENT VALUE OF AN ANNUITY We will calculate the present value of an annuity in two ways: using the formula for the present value of an annuity and using the built-in Excel function PV.

Example 2.A2.6 Maria was offered annuity payments of $6,000 at the beginning of each year for 30 years. The discount rate was 7 percent. What should she pay now? (See Figure 2.A2.7.)

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B6. 2. Present value of an annuity using the formula. Use the following formula for calcu-

lating the present value of an annuity:

Present value = Payment × 1 11 − 11 DR2−NP2/DR2 × 11 + DR2 Add the last part (1 + DR) because payments are made at the beginning of each year. In this case, there is an annuity due. Basically, the formula for the present value of a regu- lar annuity is

Present value = Payment × 1 11 − 11 DR2−NP2/DR2 Enter = B4*((1 (1 B5)^( B6))/B5)*(1 B5) in cell B9.

FIGURE 2.A2.6 Excel Model for Future Value of an Annuity

1 2 3 4 5 6 7 8 9 10 11 12 13

A B C D E

Future Value of an Annuity

Inputs Payment $3,000 Discount rate 7% Number of years 17

Future Value Using the Formula Future value $92,521

Future Value Using the Excel FV Function Future value $92,521

=B4*(((1+B5)^B6–1)/B5)

= –FV(B5,B6,B4,0)

FIGURE 2.A2.7 Excel Model for Present Value of an Annuity

1 2 3 4 5 6 7 8 9 10 1 1 12 13

A B C D E F

Present Value of an Annuity

Inputs Payment $6,000 Discount rate 7% Number of years 30

Present Value Using the Formula Present value $79,666

Present Value Using the Excel PV Function Present value $79,666

=B4*((1–(1+B5)^(–B6))/B5)*(1+B5)

= –PV(B5,B6,B4,0,1)

The Time Value of Money 53

3. Present value of an annuity using the Excel PV function. Except for the present value of a single cash flow, the Excel PV function can be used to calculate the present value of an annuity. The format of the function in this case is

PV1rate, nper, pmt,0, 12 The format of this function is similar to the format of the function for the future value of an annuity except for the fifth parameter. If you recall, the PV and FV functions have five parameters, the last of which is type. In this case, set the type parameter to 1 because payments are made at the beginning of each year. If this is a regular annu- ity with payments made at the end of the period, put nothing for type, which Excel takes as 0.

NONANNUAL COMPOUNDING We discussed the annual compounding at the beginning of this appendix. Now we focus on nonannual compounding. We know that investments pay cash flows not only annually but also semiannually, quarterly, monthly, daily, and so on. Nonannual com- pounding deals with periods shorter than a year. As you will see, Excel can handle the nonannual compounding.

Example 2.A2.7 What is the future value of $1,000 if the annual interest rate is 8 percent and the frequency of compounding varies: annual, semiannual, quarterly, bimonthly, monthly, biweekly, weekly, and daily? (See Figure 2.A2.8.) Using the results obtained, build a graph that shows how the future value of an investment increases as frequency of compounding increases (see Figure 2.A2.9).

Building This Model in Excel 1. Inputs. Enter the input data in the range B4:B5. 2. Future value of the investment for various compounding periods. First construct the

table, filling out the data for frequency and corresponding number of periods per year.

FIGURE 2.A2.8 Excel Model for Comparing Various Nonannual Compounding Periods

1 2 3 4 5 6 7 8 9 10 1 1 12 13 14 15 16 17

A B C D E F

Inputs Present value $1,000 Annual rate 8%

Comparison of Various Nonannual Compounding Periods

Frequency Periods per Year FV Annual 1 $1,080.00 Semiannual 2 $1,081.60 Quarterly 4 $1,082.43 Bimonthly 6 $1,082.71 Monthly 12 $1,083.00 Biweekly 26 $1,083.15 Weekly 52 $1,083.22 Daily 365 $1,083.28

= –FV($B$5/B10,B10,0,$B$4)

Nonannual Compounding

54 Part One Planning Basics

Then calculate the future values of the investment for various period lengths in the range C10:C17. Recall the formula for nonannual compounding:

Future value = Present Value × 11 + 1DR/m2 2N×m where

N = Number of years m = Number of periods per year Using this formula, make the necessary changes in the parameters of the FV function. The interest rate is divided by the number of periods per year.

Enter = –FV($B$5/B10,B10,0,$B$4) in cell C10 and copy it down to cell C17. Note that the more frequent the compounding, the higher the future value.

FIGURE 2.A2.9 FV as Compounding Frequency Increases

$1,078

$1,079

$1,080

$1,081

$1,082

$1,083

$1,084

An nu

Se mi

an nu

Qu art

er ly

Bim on

thl y

Mo nth

Biw ee

kly

W ee

kly Da

ily

Frequency

Fu tu

re V

al ue

Chapter Goals

This chapter will enable you to:

This meeting with Dan and Laura was set up to further discuss personal goals that both seemed anxious about and to go over the data-gathering questionnaire they had filled out. Dan, who liked the way I handled our first meeting, asked if I would give him some tips on successful communication and interviewing techniques. He was having difficulty establish- ing rapport with an important new client.

Real-Life Planning Albert walked in with his mother. He wasn’t the advisor’s typical client. A tall, thin boy dressed in hip-hop jeans and a T-shirt, Albert looked like a teenager. The expression on his face said, “What am I doing here?” The advisor wondered how he was going to communi- cate with this person, given their differences in age, interest, and culture. The advisor introduced himself to both Albert and his mother, made eye contact with the boy, and smiled. He offered soda and chocolate chip cookies, which had been placed at the center of the table. He had chosen his office, which had a small round table instead of the large one in the conference room that had the advisor at the head because he thought it would be more personal and friendly. The advisor was familiar with many of the facts that Albert’s mother had discussed with him over the phone. The boy had been in the back seat of a car whose driver was drunk, and the car had crashed into another one coming from the opposite direction. The boy had sustained injuries to his brain and nervous system. The injuries were not apparent but could possibly limit his functioning and therefore his job opportunities in the future. The legal settlement had come to $400,000 net of lawyer’s fees. Albert’s mother had placed the money in a bank account two years ago. Now Albert was almost 18, the age at which he would have full control over the proceeds. His mother had encouraged him to seek assistance.

Chapter Three

56 Planning Basics

A glance at Albert told the advisor a great deal. His arms were folded, he leaned side- ways far back in his chair, and he spoke softly without feeling. To the advisor, it meant that he was uncomfortable being there. His mother was about to say something when one glance from Albert resulted in her complete silence for the rest of the session. The advisor tried to break the ice by asking what Albert’s interests were. He said, “Having fun.” When asked what things provided him with fun, he said hanging around with friends and driving “cool” cars. It was clear that he was beginning to relax. They started to talk about his future. He wanted to join the Army and develop a trade. The advisor decided not to bring up the difficulty his injury might pose in being accepted. He began to see another side to Albert that was more mature and interested in his own well-being. The advi- sor explained how the income on the invested sum, if handled properly, could supplement his job-related cash and raise his standard of living. The advisor told him the investment income also would be available if he became seriously ill. Albert nodded slightly. The advisor decided further questioning would add little and could alienate the boy. Life insurance was out of the question, tax planning was not a serious concern outside of investments, cash flow planning would be taken care of because he lives with his mother for the time being, and retirement and estate planning would seem like it came from another planet. Besides, the advisor was being retained for investment advice. The advisor simply asked what Albert would like to do now that the money would be available. He said he would like to have a huge party that would go on for 24 hours. The next question was how much Albert thought the party would cost. He said $7,000. The advisor asked, “Is that all?” Albert replied that he would like a new red BMW convertible. The advisor asked what model and the cost. His face broke out in a smile as he mentioned the model and the cost—$60,000. The advisor mentioned that he could see how both items could be a lot of fun. Looking at it from the boy’s point of view, the advisor asked whether, if the amount were given to him, Albert would be amenable to having the balance of the money set aside for his finan- cial future. He nodded, and the advisor went over his plan for diversifying his investments according to Albert’s tolerance for risk. The next day, $67,000 was wired into a checking account and the balance to an investment account at a financial institution. The advisor thought about the reasons for what he considered a successful outcome. He decided it was because he had listened to Albert’s expressed feelings, attempted to be non- judgmental about Albert’s preferences, and looked at the situation from the boy’s perspec- tive. The advisor was able to establish himself as an authority on related matters and develop a rapport with Albert. Summing it up, he was able to communicate with Albert.

OVERVIEW

The first step in the financial planning process is to identify household goals and needs. This is usually accomplished through data gathering. It is important that proper communi- cation and interview techniques take place at that time to ensure a firm beginning to the work to be done. This chapter deals with establishing such goals, data gathering, and the communication techniques that bring about sound planning. It details the role behavioral finance and personality differences play in the process.

BEHAVIORAL FINANCE

Finance is typically viewed as a highly structured discipline. People are taught the one “right” way to perform financial operations. Generally, the idea is to make logical decisions with the goal of receiving the highest amount of money possible. This approach can be characterized as the “ideal” person performing as a machine producing the maximum cash flow.

Chapter Three Beginning the Planning Process 57

In reality, of course, people do not act like machines. They act like human beings. They have many shortcomings and differ from each other in many respects, including prefer- ences. Behavioral finance can be defined as the concentration on actual human actions in financial matters. For an example of behavioral finance, look no further than the activities of stock market investors. Research had shown that investors are far more likely to take gains when a stock has increased in price than they are to take losses when a stock’s price has declined.1 When people sell a stock at a gain, they have succeeded, even if it might mean paying a tax. On the other hand, selling a stock at a loss is an admission of failure—of bad judgment— so many investors hold on, hoping for a recovery that will justify their earlier decision. Selling at a loss can provide a tax benefit, but some people hold on to a declining stock sometimes until it becomes literally worthless hoping it will come back. Understanding such compo- nents of people’s behavior can help in developing a reasonable personal financial plan that actually will be put into action. Indeed, behavioral financial planning notes emotional as well as financial consider- ations. This discipline strives to understand and improve people’s decision-making abili- ties so that they can more easily achieve the goals they set. For example, for the strategy regarding holding stock you have a loss indefinitely until the loss is hopefully wiped out is not a rational strategy, it does not assess the chances and time frame for the rise of the stock. Not practicing such an approach can lead to improved performance, the goal of be- havioral financial planning. Behavioral finance and behavioral financial planning are dis- cussed more fully in Chapter 18. So, as we can see, personal financial planning (PFP) is a very practical activity. It must requires analyze analyzing how people actually act to help them come closer to how to make decisions should be made. Knowledge of people’s behavior patterns and how they influence PFP are required parts of curriculua such as those that prepare individuals for the CFP® exam. PFP must take into account a variety of differences among people. In the next section, we examine some of these behavioral differences.

Cultural Background To some extent, our actions are influenced by our culture, the social, ethnic, and religious backgrounds that contribute to our beliefs, material possessions, values, and goals. Peer groups—groups of friends and associates with similar backgrounds—are those people against whom we measure ourselves. Together, culture helps create the personal- ity characteristics and attitudes that determine the lifestyle that we have established for ourselves. For example, one peer group may stress outward signs of achievement, such as material possessions, while another may emphasize balanced living or intellectual self-realization.

The Life Cycle Age is also a strong influence on our interests and preferences, as we can see by consider- ing the life cycle in terms of age categories. Three are proposed here. The age range for each category described can vary, depending on age at marriage and having children, time of retirement, and type of lifestyle. Thus, the ranges given here are somewhat arbitrary. Longer life expectancy, improved health, and increased options have all created changes in self-perception and this, in turn, affects both preferences and interests.2

1 The approach taken is one for traditional couples. Clearly, people who remain single, who choose not to have children, or who otherwise differ will have an alternative pattern. Meir Statman, “The Mistakes We Make— And Why We Make Them,” Wall Street Journal, August 24, 2009, wsj.com/news/articles/SB100014240529702 04313604574326223160094150. Statman is professor of finance at Santa Clara (California) University. 2 Life cycle planning is presented more specifically by age and topic in relevant chapters of the book.

58 Planning Basics

Young: 18–42 For the young, planning often takes a back seat, at least until they establish lasting personal relationships. Young people tend to place great emphasis on their current standard of liv- ing and fairly often on their career advancement. Thus, savings is sometimes given lower priority. Risk tolerances often can be high. When these people marry and have children, the major concern is the accumulation of real assets for a home and its possessions and life insurance to protect other household members. Borrowing to purchase these assets, and sometimes to finance graduate education, is fairly common.

Middle Aged: 43–67 For many people, the onset of middle age is an occasion for increased planning, particu- larly in regard to saving for retirement. With middle age may come better-defined parameters for careers and a more consistent cost of living because the home and its pos- sessions and the car may have already been improved. Financial assets are accumulated and expended for children’s educations and increased sums saved for retirement. Debt as a percentage of assets generally declines for two reasons: Debt on the home is being paid off and real and financial assets have increased, so the debt percentage goes down even if total debt had remained stable. In middle age, risk taking tends to decline. For some, the use of whole life insurance now replaces cheaper term life insurance. Once people have funded their children’s college obligations, their annual savings often increase markedly. They also begin to think more seriously about estate planning.

Seniors: 68 and Beyond It is a mark of change in our society that the term senior has replaced old to describe people in this age bracket. Often, seniors go through a period of active retirement, perhaps maintaining some part-time job, followed by a slower pace. Accumulation of wealth during youth and middle age gives way to spending down assets. Risk tolerance declines sharply and so does the use of debt. Taking care of others through estate planning is given a high priority. Tax rates may decline and help contribute to a decline in the cost of living when uninsurable medical and elder-care costs are not excessive.

Family Your family background can have a strong pull on how you establish your lifestyle. Those who have had a happy childhood and a strong family bond may continue the patterns set by their parents. Others who have not had them may move in the opposite direction. Some people believe that birth order is another influential factor with the eldest child more likely to be conservative, following the parents’ point of view, and the younger children more likely to become more creative and rebellious.3

Personality Your personality is the sum total of all the attributes—emotional, mental, and so on—that distinguishes you from other people. PFP views personality narrowly because our innate traits have formed or are currently being “built.”4 For example, given the same trying event, one person may be highly emotional, another more analytical; one more confident, another more anxious; one more independent, another more dependent.

3 Joshua K. Hartshorne, Nancy Salem-Hartshorne, and Timothy S. Hartshorne, “Birth Order Effects in the Formation of Long-Term Relationships,” Journal of Individual Psychology 65, no. 2 (2009), joshuakhartshorne.org/papers/BirthOrder.pdf. 4 A broader definition would include environmental factors as well.

Chapter Three Beginning the Planning Process 59

Our personality affects our tolerance for risk, which influences our planning actions. It and other factors help create our values, which determine our goals. Financial planning based on differing goals is discussed in Chapter 18. Finally, behavioral finance covers human weaknesses. One of the most fundamental weakness is a lack of knowledge of a subject, a common problem in financial planning. Ways to meet these weaknesses are developed in Chapter 18. In sum, the characteristics we have listed are covered under a broader definition of behavioral finance, one that goes beyond a focus solely on emotions. These characteristics are important in both understanding ourselves and assessing others. Some characteristics may contribute to shortcomings that we will want to overcome to reach our financial goals. Other characteristics may cause us to have goals that are different from a singular empha- sis on monetary achievement. Before we deal with goals and data gathering, we should understand the importance of communication in relating to others professionally and to other household members and in understanding ourselves.

SOME PRINCIPLES OF COMMUNICATION

Communication is very important in any activity we undertake in life. Often being honest, knowledgeable, and concerned is not good enough for all situations. We must be able to have others believe that we possess the required traits so that we can be successful in the task we have set for ourselves or the relationship we wish to establish. Communication can be defined as the ability to transmit a message successfully to another person. That success is indicated by having someone receive and understand your message in the manner you intended it to be conveyed. Communication is more complex than you may think initially. Verbal communication is a way of transmitting your thoughts and emotions through the spoken word. When you speak, you communicate in many ways. One way is through the content of the message. We can call that content the verbal message, which often contains specific information. It also can convey a message that extends beyond the specific information. For example, the tone of voice and intensity as well as the passion with which you speak also convey information, but that information is nonverbal. Through nonverbal communication you transmit your thoughts and emotions with- out or in addition to the words you use. Whether intentionally or unintentionally, your fa- cial expressions, body movements, hand gestures, use of eye contact—even the way you dress or the appearance of your office—can transmit a message. For example, through your body language, you may communicate an entirely different message than the one you’re speaking about. Thus, folding your arms across your chest and other tight gestures and facial expressions may convey a lack of receptivity even though you nod your head in agreement. This is illustrated in Figure 3.1. A movement of your body toward the speaker in a relaxed manner may signify interest in or assent to the idea being discussed whereas a shift back in your seat away from the speaker with loss of eye contact could indicate the opposite reaction. The rise in tone in your voice often conveys a strong feeling about a subject. In contrast, a weak vocal response could signify a lack of interest in or conviction about what is being discussed. As is shown in Figure 3.1, a person who expresses agreement with a message in a free, animated way with eyes focused on the other person is clearly more likely to receive, pro- cess correctly, and agree with the content of that message. There are many reasons for communicating with another person. You may want to express your opinion or feelings about a matter. You may wish to convey some specific facts or to persuade someone to hire you or to follow your advice. In some instances, your

60 Planning Basics

goal is not to communicate a message but to develop a relationship with another person. If you are acting as an advisor, your intent can fall into any of those categories. Whatever the reason, conducting meetings face-to-face is generally much more effective than doing so at a distance. You can develop important skills for improving communication.

Listening Listening allows you to gather the information that you are interested in. It has many facets that enable you to develop an understanding of another person’s thoughts and feelings beyond the facts given. Very importantly, it can transmit your interest in the person or the topic at hand. Some rules that can help you to become a more effective listener are

1. Focus your full attention. 2. Do more listening than talking. 3. Try not to be judgmental; instead, be understanding. 4. Try to get into the other person’s way of thinking. 5. Keep your responses to the topic being discussed. 6. Try to respond occasionally. Wherever possible, speak positively about the person’s

strongly held beliefs. 7. Look for the principal points of the topic from both your own and the speaker’s points

of view. Acknowledge your understanding of the topic from time to time.

Showing Empathy Empathy means attempting to place yourself in another person’s position, trying to iden- tify with what he or she is experiencing—his or her thoughts, feelings, and attitudes. It means listening, understanding, feeling, and communicating with increased sensitivity to someone else’s perceptions. Showing empathy has the potential to help you not only estab- lish a relationship with a person but also provide appropriate expert advice.

Establishing Trust Trust is the belief that you can rely on someone or something to perform as expected. Creating trust in financial planning comes from expertise—having a strong educational background and experience in a given area. In addition, it is generated by being truthful, by putting aside potential conflicts of interest, and by acting in the best interests of a person. Presenting a confident manner and appearance also helps. Finally, trust comes from attention—demonstrating your particular understanding and concern for the other person.

FIGURE 3.1 Nonverbal Communication

Source: clipart.com.

Chapter Three Beginning the Planning Process 61

When trust in another person is present, communication and effective planning can proceed smoothly. It can cause a client to believe that the result will be predictable with a low chance of a loss or an otherwise disappointing outcome. The use of empathy and value-free judgments also can help a client to be receptive to the planner’s advice. Having rapport with a client can often increase the client’s trust in the planner’s advice.

Example 3.1 The advisor knew many marketing representatives from financial services firms. They all had products to offer him, some attractive, some not, and the representatives varied in their degree of effectiveness in presenting the advantages of their offerings. When they came in, the advisor was polite yet aware of the representatives’ generally narrow sales focus. Dennis, a marketing representative for a major mutual fund company, was different. He asked to spend some time alone with the advisor to learn about his operations and goals for the future. At that meeting, the representative was very attentive and interested, asked for elaboration of certain points, and seemed to understand the advisor’s approach thoroughly. He conveyed knowledge, genuine interest, and even empathy for certain prob- lematic situations. Surprisingly, when asked how his firm’s products fit the advisor’s investment goals, Dennis said he would rather devote the time to focus on helping with the advisor’s overall business operations. A discussion of products could come later in the relationship. By the end of the meeting, the advisor was impressed. He was no longer wary of the interchange and made a mental note to give careful consideration to any recommendations Dennis would make. He asked himself what it was that distinguished Dennis from many other representatives and con- cluded it was the fact that Dennis truly listened and was focused on the advisor’s best interests.

INTERVIEWING

The client interview can be the first activity performed in the financial planning process. The current use of widespread video calls might tempt both parties to hold the initial meet- ing remotely. Nevertheless, face-to-face interaction is suggested for the beginning of what might become a long and valued relationship. With a personal meeting, the client and the advisor can pick up more verbal and nonverbal cues that can help each decide whether to enter into an engagement. Going forward, video conferences may become practical if time demands prevent a physical meeting. It is at the first advisor–client meeting that goals are discussed and often established and data gathering begins. The interview process often has another purpose. Many advisors offer a free initial interview. This meeting allows the clients and the advisor to establish whether they wish to work together and to begin the relationship.

Professional Advice Communication

62 Planning Basics

Fortunately, the interview process allows both relationship screening and data gathering to take place at the same time because both focus on clients’ interests. This interview process calls on the communication and listening skills and the establishment of trust nec- essary for a strong relationship. Counseling involves providing support for people. Interviewing is an integral part of the process; it helps frame the problems, interests, and background information required. To be successful, the interview process must have certain ingredients.

Preplanning Advisors should identify the purpose of a meeting. To be prepared, they should select top- ics to be covered and outline the questions to ask in advance. The interview room should be neat and free from distraction. Any background information about the person should be reviewed to help direct questions and establish rapport. Advisors should review techniques they have found to be effective. For example, they should plan to use desirable communi- cation techniques such as making reality checks at key points to ensure that the client, not the advisor, is doing most of the talking. Advisors must acknowledge that effectiveness often arises when clients believe they have a personal relationship with the advisors. Thus, fostering the relationship can be more important than demonstrating competence over and over again.

Beginning the Interview The interview should begin by making the client feel comfortable and relaxed. It may involve “small talk” that has nothing to do with the topics to be discussed but places the person at ease and, if possible, establishes rapport and common interests. The planner should mention the purpose of the interview, perhaps the approach and topics to be dis- cussed, and invite two-way communication that is as frank as possible.

Substance of the Interview To place the client in the appropriate framework for the rest of the interview, its substance should begin with a simple question. Generally, a variety of questions will then be asked. Open questions are those that permit answers that can go in any direction—for example, “What interests you in your life?” or “What are your goals?” Closed questions are shorter and ask for a specific answer, such as “How much money are you making currently?” or “Do you expect to go to graduate school?” Primary questions are the first ones in a new area—for example, “How much life insurance coverage do you have?” or “Do you have a list of your investments?” Probing questions seek to develop further information about a primary question—for example, “What types of life insurance do you own and why?” or “What does money mean to you?” Leading questions are those that guide a client toward an intended answer. Asking someone whether he or she would like a better-performing investment portfolio or is satisfied with current financial planning can lead that person to make a decision about hiring an advisor. There should be several advisor questions seeking elaboration to clients’ answers and, wherever possible, verbal exchanges that stress client interests. Interruptions of any type other than for clarification should be discouraged. Advisors should focus on listening to the client’s answers to their questions. These answers should lead to additional questions. By paraphrasing answers, advisors can con- firm that they are on the right track for proceeding. Feedback should be asked for at all points during the session. Although client interviews need structure, a certain flexibility is called for. When a client’s verbal answer and body language seem to conflict, further

Chapter Three Beginning the Planning Process 63

questioning is needed. It is often advisable to let clients continue their line of thought even though the answer to the question asked may range over several topics—the under- lying motivation and character of the client can come out in that reply. As mentioned, it is often best to be nonjudgmental about the client and to develop genuine interest and empathy in the exchange. Advisors should refrain from such counterproductive questioning techniques as allow- ing their questions to roam widely without establishing informational goals and structure, not using the time allotted efficiently, or allowing meetings to extend beyond schedule without good reason, which can be frustrating to both clients and advisors. In addition, advisors must avoid being either too shallow, too detailed in information gathering, or too direct in the line of questioning and not adjusting for sensitive subjects. Finally, advisors make sure the meeting isn’t too structured with the line of questioning entirely preplanned; with too much structure, clients’ wishes may not be revealed and information that is un- covered may not be developed.

Example 3.2 John was an excellent financial planner. He was bright, well qualified, and cared about his cli- ents. However, his interviews were inevitably too long, and he did not read the client’s frustra- tion with their length. After he adhered to a time limit on a first interview and left some questions to be handled later or eliminated and as he became more aware of his client’s body language, John became an effective questioner.

Conclusion Every meeting should have a conclusion. It may happen after advisors have asked all ques- tions intended or by indicating that the time is drawing to a close. A signal of the conclu- sion may be asking the client whether anything else should be covered at that time. Advisors should sum up the points covered during the meeting and establish a date for the next meeting or another plan for action.

FINANCIAL COUNSELING

Clients may request financial counseling at all stages of the planning process. At the begin- ning of the process, clients often ask planners what type of service they need. They may also request interim assistance. Financial planners may at any time suggest that clients not make any further investments with available cash until a specific part or all of the planning is completed. Financial counseling can be defined as the mechanism for assisting people in making their financial decisions. However, financial advising is sometimes considered to involve making the decisions for the client. Telling a client to buy a home with a fixed-rate, 30-year mortgage to lock in low monthly payments might be considered financial advising. Financial counseling might be thought to involve explaining the differences between fixed and adjustable rate loans and various loan repayment options, and then leaving the deci- sion up to the client. The thought in counseling, then, is to provide personalized service, perhaps including nonfinancial support and to leave the ultimate decisions in the hands of the client. As a practical matter, counseling and advice often are combined with little distinction between the two. The advice should not be abstract but tailored to the client’s interests. When clients show some resistance to the advice, the planner should attempt to under- stand fully the cause of the resistance and, when appropriate, persuade those clients that their ways of viewing the matter may not be in their best interest. The planner should give specific reasons as to why this is so.

64 Planning Basics

Alternatively, it may be best to change the advice. Sometimes when clients’ resistance is received, just listening and acknowledging that you understand the client’s point of view is all that is needed. Frequently, “venting” or just talking about the situation is the client’s only intention. Resistance indicated by either words or body language should generally be dealt with politely but discreetly with a question about where the difficulty comes from.

Example 3.3 Doug was conducting an interview with a new client. At the end of the interview, the person had the choice of taking pension monies in the form of a lump-sum distribution or an annuity of yearly payments for life. Doug stressed the benefits of a lump sum, which he believed would provide higher income over the longer term. He noticed that the client’s face tightened when he mentioned this and that the client spoke of the safety of an annuity. Doug then checked himself, recognizing that perhaps he had let his own interests concerning the lump-sum option color his thinking. He immediately shifted his approach, presenting the benefits of an annuity to the client with a low tolerance for risk.

Thus, advisors should be aware of their own biases and ask themselves whether their advice is extending beyond hard financial practices and the client’s wishes to their own preferences. If so, advisors should question whether their own preferences are in the cli- ent’s best interests. Whenever possible, planners should make strong efforts to regard the client positively and to demonstrate this in interactions. At the same time, planners must be genuine be- cause forms of communications such as body language often indicate their true feelings. If a client feels the advisor is not genuine, the entire relationship, which is based on trust, can be undermined. At a minimum, any unfavorable judgments should be set aside for the bal- ance of the consultation.

GOALS

Goals are the results that we would like to achieve. Financial planning activities are under- taken based on stated goals. In this chapter, we provide a broad overview of the topic. In Chapter 18 we deal more extensively with life planning—a goals-oriented approach that extends beyond money issues to strategic matters for verification and realization of life- time objectives.

counseling advising

advisor

Practical Comment Counseling versus Advising

Chapter Three Beginning the Planning Process 65

Approaches to Goals How do we establish our goals? The answer depends in part on which discipline we choose.5 Sociologists are concerned with the study of groups, so it should not be surprising that sociologists believe that our goals are influenced by the way we were raised by our families and other groups of people in our environment. Sociologists might theorize that we strive to maintain our status relative to our peer groups—our friends, families, and business associates. In contrast, biologists might say that, to some extent, we are programmed by our genetic makeup to strive for certain objectives. Psychologists who study motivation might assume that the underlying goal of most human behavior is to have as many pleasurable experi- ences as possible. Clearly, different people take pleasure from different activities. Some work to achieve the most money or fame. Others strive to allocate the greatest proportion of their life to leisure activities or to have fulfilling personal relationships. Moreover, our goals can change over time. For example, some goals have a life cycle component. We may want to play as hard as we can when in our 20s and strive to relax by a pool in our 70s. Economics translates goals into utility (pleasure) terms and then attempts to quantify them in objective terms by placing a dollar value on them. Quantifying goals helps to bring scientific measurement to the discipline. Finance also expresses most things in money terms. For example, in financial terms, the goal of business is to make the most money possible subject to a given level of risk.6

To demonstrate the wide array of interpretations according to a specific discipline, con- sider the following analysis of possible reasons for having a child:

1. Sociologically, it is what the group expects. 2. Biologically, it is an inner need that has to be fulfilled. 3. Religiously, it is what is expected by a higher power. 4. Psychologically, it provides happiness. 5. Economically and financially, it can be considered a major long-term overhead cost

similar to a capital expenditure or the need to have someone to care for us in old age. 6. In ordinary terms, it can be viewed as a way to form a lasting, enjoyable, emotional

relationship.

At first glance, the economics and finance approaches might seem somewhat narrow and unfeeling. Economists and finance people know that they are simplifying human motivations by translating them into common dollar terms. But doing so permits scientific measurement to go forward and enables us to gain additional insight into how human beings operate and how to improve their operations.7 Because this is a financial text, in most instances we use a finance business approach. In the discussion that follows, we take a broad perspective concerning goals. For example, the psychologist Abraham Maslow believed that people first try to satisfy their basic, or physiological, needs—food, shelter, and clothing. If these are taken care of, people move on to satisfy their need for safety. The next level involves social needs, such as the desire for belonging. If people have enough resources, they attempt to satisfy their higher needs of both self- esteem and esteem from others. The highest-level need, according

5 For a review of how other disciplines approach goals, see Michael Jensen, Foundations of Organizational Management Strategy (Cambridge, MA: Harvard University Press, 1998). 6 Publicly owned companies’ goal is to maximize the stockholder wealth figure that combines profit and risk. 7 For a discussion of simplifying assumptions, see George Stigler and Gary Becker, “De Gustibus Non Est Disputandum,” American Economic Review 67, no. 2 (March 1977): 76–90.

66 Part One Planning Basics

to Maslow, is for self-actualization, which involves achieving personal goals in life. Figure 3.2 shows an illustration of Maslow’s hierarchy of needs in a pyramidal form.8

On a more pragmatic level, you might establish three levels of goals in each part of the financial plan: minimum goals, satisfactory goals, and higher-level goals. If you don’t reach your minimum goals, you would be distinctly disappointed. Reaching goals that you target and would be pleased to attain provides satisfaction. Higher-level goals, if you achieve them, would give you pleasure beyond your expectations. For example, your minimum goal could be to rent an apartment in a good neighborhood in the suburbs. Your satisfactory goal may be to live in an attractive home in a similar neighborhood. Your higher-level goal might be to have a luxurious vacation home in addition to the suburban house. The approach is termed the money ladder.9

This book often uses the term standard of living or economic well-being as finance’s practical imple- mentation of the word money. The goal of financial planning is to help people achieve the highest stan- dard of living possible. Standard of living has two meanings. In strict financial parlance, as you’ve seen, it means making the most money possible. In more common usage, it can mean achieving an attractive balance of life’s factors. Financial planners know that their clients’ goals extend beyond just acquiring material items. For example, planners don’t often recommend that a client take a permanent second job to earn more

money. Planners rely heavily on financial numbers because that is frequently what they are hired to do and because money often has a strong place in overall goal achievement. Yet many financial planners manage to blend money with other goals. In its second—broader— meaning, standard of living is a relative term that depends on individual values. In this instance, the term quality of life is perhaps closest to the meaning of standard of living. The goal, especially when material comforts have been achieved, can be one of satisfac- tion with lifestyle and accomplishments.

Practical Comment Goals and Standard of Living

SELF- ACTUALIZATION

(the need for achievement of personal goals)

ESTEEM (the need for self-esteem, recognition by others)

SOCIAL (the need for belonging)

SECURITY (the need for safety)

PHYSIOLOGICAL (the need for food, shelter, and clothing)

FIGURE 3.2 Maslow’s Hierarchy of Needs

8 For an extensive discussion of Maslow’s hierarchy see Lewis J. Altfest, “Chapter 10: Motivation and Satisfaction,” 171–188. 9 Lewis J. Altfest and Karen C. Altfest, Lew Altfest Answers Almost All Your Questions about Money (New York: McGraw-Hill, 1992). A variation of this approach is used in Chapter 19, Appendix III of this text.

Chapter Three Beginning the Planning Process 67

Goals can be separated into three time frames. Short-term goals are those you intend to achieve within one year—for example, being more selective in purchasing goods and appli- ances that may not be needed or saving for a vacation. Intermediate goals are completed in one to four years—saving for the down payment on a car or a home, for example. Long- term goals are those you expect to accomplish in five years or more. Examples would in- clude saving for a child’s college education and having enough money to retire comfortably. The following list is one financial planner’s method of helping a person select the life values that are important to him or her. He suggests that that the individual choose three to five of these items and rank order them.10

Life Values Achievement: to accomplish something important in life. Aesthetics: to be able to appreciate and enjoy beauty for its own sake. Authority: to be a key decision maker directing priorities. Adventure: to experience variety and excitement. Autonomy: to be independent, have freedom. Health: to be physically, mentally, and emotionally well. Integrity: to be honest and straightforward, just and fair. Friendship: to have close personal relationships, share with family and friends. Pleasure: to experience enjoyment and satisfaction from activities in which I participate. Recognition: to be seen as successful, receive acknowledgment for achievement. Security: to feel stable and comfortable with few changes or anxieties in my life. Service: to contribute to the quality of life for other people. Spiritual: to grow to have harmony with the infinite source of life. Wealth: to acquire an abundance of money/possessions; to be financially independent. Wisdom: to have insight, to be able to pursue new knowledge.

As you can see, people’s goals in life can differ greatly. Moreover, your goals can be altered over time by practical experiences—for example, the degree of your success in reaching previous objectives and your attraction to new ideas. Many people who are com- fortably in the middle class find that money goals diminish in importance as they age. We will examine the issue of goals further in Chapter 18.

10 Adapted from Ken Rouse, Putting Money in Its Place. Dubuque, IA: Kendall/Hunt Publishing, 1994.

Goals may not always come to mind easily. You may need to think them through. Sometimes what you think of as your goals are just short-term consider- ations. For example, you may seek professional assistance to help save for a car; your real goal, how- ever, may be to establish a savings structure to allow

you to maintain the same lifestyle both before and after retirement. At other times, your goals and needs may be in conflict. Your goal—continuing to spend, for example—may be unrealistic, whereas the consequences—taking on debt—suggest a different need and course of action.

Practical Comment Analysis of Goals

68 Part One Planning Basics

DATA GATHERING

Data gathering is accumulating the information that is needed to perform personal finan- cial planning objectives. Therefore, before beginning our tasks, we must establish the particular goals that determine the type of planning to be done. For example, an investment review will require much more specialized and less extensive material than a comprehen- sive financial plan.11 We also must ascertain needs where they differ from goals and develop a sense of priorities among goals and needs. The data to be received may come from written documents or obtained by questioning other advisors retained by the client, such as an accountant, lawyer, and insurance repre- sentative or in reviewing an appropriate questionnaire that has been filled out. Many plan- ning firms have a form or a set of forms for new clients to complete, and those forms will indicate what information the client needs to provide. When the work is being performed for clients, an interview of the person or couple is a highly significant part of the process. We look at interviewing procedures for financial planners in the next section. The information categories for a comprehensive financial plan or comprehensive review fol- low the major parts of a plan. Even with a segmented financial plan (one that covers a lim- ited or specialized portion of all financial activities), the household’s overall financial condition should be established. Some of the key areas and information needed are outlined in Table 3.1. The interview and the data-gathering process have other objectives as well. At this point in the process we want to establish how financially sophisticated the clients are. For ex- ample, are they able to understand the workings of common financial instruments such as stocks and bonds? Can they distinguish the risks of various investment alternatives? Do they know the differences among the various types of life insurance? A preliminary assessment of their risk tolerance can be established. A completed ques- tionnaire is often used to determine whether clients think of themselves as conservative, moderate, or aggressive with their finances. This evaluation may be a self-assessment of risk preference either overall or relative to the “average person.” Risk should be viewed not only in terms of investment—stock and bond risk—but also in terms of overall house- hold risk, including such things as need for insurance, personal practices, and career goals. Toward the end of data gathering, the advisor should be aware of any factors that distin- guish this client’s situation from that of others. For example, is there a particular focus on client education or on providing children who have severe learning disabilities with life- time support? Will there be a particular difficulty in obtaining reliable revenue and operat- ing cost figures? Do the clients have particular personal problems, such as excessive gambling, drinking, or perhaps excessive spending habits? Full data gathering can take some time. At the completion of an initial interview and prelimi- nary data gathering, however, the advisor is ready to indicate, based on client’s interests and needs, what he or she thinks is the appropriate scope of the engagement and what the cost will be. If the engagement calls for the client’s investment assets to be managed, percentage-of- assets fees may be charged at regular intervals. Alternatively, an hourly rate can be established, sometimes with a minimum and maximum cost indicated. In some cases, a flat fee is provided for a fixed service. The client ultimately decides, generally in consultation with the advisor, whether the scope indicated should be accepted or modified. Clearly stating the specific terms of the engagement, what is included and what is not, is very important.

11 Sometimes establishing goals is a part of the preliminary data-gathering process. The approach may be to ask some preliminary questions that help develop the scope of the work and then develop the specific goals. Detailed data gathering then follows. Alternatively, goals may come from an advisor’s comprehensive review and assessment of needs or from modifying preexisting goals.

Chapter Three Beginning the Planning Process 69

Practical Comment Tolerance for Risk

TABLE 3.1 Selected Data Gathered for Comprehensive Financial Plan

Source: Levin, Ross. Implementing the Wealth Management Index Tools to Build Your Practice and Measure Client Success. Vol. 144 of Bloomberg Financial. Hoboken, NJ: John Wiley & Sons, 2011.

Type Selected Information Needed

Background of household members Personal information: name, number, and ages of household members; educational attainment; type of job; personal traits and beliefs; advisory services used; and so on.

Balance sheet Current assets and liabilities.* Cash flow planning Current projected income and expenses, both for daily items and for capital

outlays. Income tax planning Income tax return for the past year and perhaps the past three years. Debt Existing home mortgages,credit cards and credit lines, such as home equity

loans. Investments A detailed list of bank, brokerage, mutual fund, and other investment

accounts and specific holdings. Current market value and projected outlays for home and details of other

investments. Establishment of investment risk tolerance. Retirement planning Retirement accounts and retirement savings. Rates of inflation and rates of return, retirement goals, government benefits. Estate planning Copies of wills and trusts. Establishment of titling of assets. Intended gifting

policies and those for estate distribution at death. Risk management Copies of all insurance policies. Intended insurance coverage. Other risk

management procedures. Determination of overall household risk tolerance. Employee benefits Copies of description of all company benefits. Amounts and investment alternatives for pension plans. Family planning Current number of household members. Marital and children planning versus

household members today. Educational planning Types of plans and amount of assets in place. Prospective costs for college and, in the case of children, the amount or

percentage to be funded by the parent. Specialized planning Description of particular planning needs for the individual household. Other Health, possible inheritances, broader family responsibilities and obligations,

personal nonfinancial problems.

* Pro forma future statements will come from planning procedures.

70 Part One Planning Basics

When data gathering, goals, and needs have been established, at least preliminarily, and a time horizon determined to satisfy each individual, the advisor is able to identify how the household operates and the ways that financial planning activities can help. In analyzing each part of the plan, the advisor must always keep in mind the overall goals. That process is some- times referred to as determining where we want to be as compared with where we are now. The activities given in the next sections of the book provide the building blocks for how to get there.

Back to Dan and Laura DATA GATHERING, GOAL SETTING, AND COMMUNICATION This meeting with Dan and Laura was set to further discuss personal goals that both seemed anxious about. They brought with them what they said was the completed question- naire. Both were enthusiastic about the coming planning process. They thought that I had handled the initial interviews very well. Dan said he particularly liked the way I had moved the meetings along smoothly and handled their recurring differences of opinion easily. He said he was having difficulty com- municating with an important new client and would like me to give him some tips on suc- cessful communication and interviewing techniques after discussing goals.

My response to them was: Thank you for your kind comments about our initial interviews. I will strive to meet your expectations. Before I discuss communication matters, let me mention that data gathering is an arduous, detailed process. I know that filling out the questionnaire isn’t fun. However, it must cover all parts of the financial plan and anything financial that you care to add. The questionnaire you sent back wasn’t complete, and I frankly thought you hadn’t given it your full attention. The questionnaire encompassed a large part of the information that I will need to process. Because a financial plan can only be as good as the figures and forethought that goes into it, I am asking you to review it again—this time more carefully. If you have any questions about it, please let me know. If you prefer, we can sit together while you fill it out. Now, let me turn to goals. Goals can be looked at in specific money terms. For example, how much will it cost for a vacation or a down payment on a home? Goals also can be viewed in terms of completion over a time frame—for example, short versus long term. For some people, goals change with income or education so that basic goals are transformed into the fulfillment of higher needs, such as self-esteem and self-actualization.

Notice that the initial steps in the financial planning process can sometimes be shifted. Traditionally, set- ting the terms of the engagement is thought of as being performed first, followed by setting the goals, and then data gathering. From a legal standpoint, this approach is correct. When no fixed service is being offered, however, the advisor may not know what is needed and what the cost will be. Many advisors, of course, offer free

initial consultations whose purpose is to establish not only the particulars of the engagement but also whether the two parties desire to work together. What can happen, therefore, is a preliminary or even fairly detailed session on goals and data gather- ing prior to establishing contract terms. Certain goals then can come from data gathering. Once a contract is signed, the goals are often examined in more depth, and more detailed data gathering begins.

Practical Comment Steps in the PFP Process

Chapter Three Beginning the Planning Process 71

Finally, the process of setting goals can be expressed in minimum, satisfactory, and higher-level forms—often based on how hard we want to work and sacrifice today’s stan- dard of living for tomorrow’s. Your financial plan will provide the best way for you to achieve your goals. Goals mo- tivate you to plan your financial future in an orderly way. As you indicated to me in our first meeting and the one we just had, your goals are as follows:

1. To get out of credit card debt and repay student loans as soon as possible. 2. To be less concerned about the future by planning now. 3. To have two children and maintain the standard of living you have today. 4. To purchase a house in the not-too-distant future. 5. To be financially independent by age 55. 6. To have your insurance needs examined. 7. To provide money for both children to go to college. 8. To leave $100,000 to each child in your will. 9. To develop an overall asset allocation for your investments.

We will construct your financial plan with these goals in mind. As you requested, I will develop each part of the plan separately. I will explain why I made my recommendations in enough detail so that you can provide me your reactions prior to the final integration stage for completing the plan. Be aware that goals are often modified as more information on fi- nancial capabilities becomes available. Therefore, we are likely to return to this subject. Dan, as far as communication and interviewing strategy are concerned, I used many established techniques in our first interview. I attempted to make my office very quiet and hospitable for frank discussions. Our first conversation was not related to business; rather, it was designed for us to get to know each other and establish a relationship. The questions that followed were simple and open ended so that I could become familiar with your inter- ests and personalities. I was very much aware of your gestures and facial expressions. Laura, yours were very natural and free of tension. Dan, your face and folded arms suggested that you weren’t comfortable with the process of open communication or perhaps with me. That is why I spoke to you in depth first. Perhaps the singular thing I did to win you over and make you relax was to listen intently. You may have noticed my comments and gestures, which sought elaboration and expressed a nonjudgmental approach to what I was hearing. I knew right away that the two of you had different opinions. I listened to you both and tried to empathize with what I heard. In other words, I tried to look at your problems from your own perspectives. I’ve found that if I do that, both parties with conflicting opinions believe they have had a hearing, are taken seriously, often sympathetically, and are then ready to engage in open communication. Although it is early in the process, I tried to counsel you and to support you in making your own decisions. My comments were simple and clear and encouraged feedback on how I was doing. I will continue to counsel you, but I’ll also express my opinions as an advisor, which I believe you want me to do. You may notice that our first interview had a beginning, a substantial content-contained body of discussion, and a conclusion with my summation of what had been covered and what the next steps would be. Dan, I believe that if you follow these steps, particularly the ones that concern listening and focusing on your client’s needs ahead of your own, you will do just fine. I hope this helps.

72 Planning Basics

College Student Case Study and Review: Amy and John BEGINNING THE PLANNING PROCESS At this meeting, I told Amy and John that the preparations for the actual planning process would begin. Behavioral finance, communication, interviewing, goals, and data gathering were up for discussion.

Behavioral Planning First I mentioned that behavioral finance was a much-maligned area of financial planning. Some people thought it was bringing a “shrink” mentality into a numbers-oriented profes- sion. However, people don’t always function logically, like a machine; they act, well, like humans. Behavioral finance concentrates on human behavior as it pertains to finance. Behavioral financial planning takes it a step further and indicates how people can modify their behavior to operate more efficiently to better meet their goals. Amy, you finally seemed engaged and asked to hear more whereas John attempted to check his e-mail with his phone “discreetly” under the table. I mentioned we would later devote a whole session to the topic, but at that time we would discuss a few things. Our behavior is shaped by our culture as represented by our social, ethical, and religious backgrounds. Our peer groups strongly influence how we behave. Our age and positioning in our life cycle are extremely important. Our interests and preferences change over our life cycle as we go from young (age 18–42), when we are interested in relationships and careers, to middle age (43–67), when we engage in more refined planning, especially for retirement, and to seniors (68 and be- yond), when we retire, spend down our assets, and engage in estate planning. Finally, our particular personality influences how we react to our environment and, for planning purposes, how much risk we are willing to undertake. As we can, see behavioral planning extends well beyond just how much money we expect to make.

Communication Communication, defined as the ability to transmit a message successfully to someone else, is highly important in all personal interaction, financial planning included. The two main types of communication are verbal and nonverbal. Verbal communication includes trans- mitting messages through the human voice and nonverbal communication is everything else. Body language, which transmits messages through gestures such as a frown or a shrug, is one example of nonverbal communication Proper communication helps in ex- pressing facts, sharing opinions, and developing a relationship with a person. Listening is the most useful tool in understanding and persuading someone as well as for gathering information. Effective listening requires a person’s full attention. Being empa- thetic means placing oneself in someone else’s shoes; it allows personal financial planners to understand and relate to their clients. Aside from having financial expertise, planners must develop trusting relationships with their clients through being truthful, confident, and devoting attention to them. These traits are highly effective communication tools.

Interviewing Interviewing is often the commencement of the financial planning process. It combines a discussion of goals and data gathering in a multipart process consisting of:

1. Preplanning—Determine what should take place. 2. Beginning the interview—Make people feel comfortable and explain the process.

Chapter Three Beginning the Planning Process 73

3. Substance of interview—Start with simple questions and progressively ask more in- depth ones.

4. Conclusion—Give a signal that the interview is ending, sum it up, and set future steps.

Goals Goals are the results you desire to achieve. Goal setting is often established or at least started in the initial interview. One overall approach was set by Abraham Maslow, whose hierarchy of needs moves from the simplest to the most complex goals. The simplest needs must be satisfied first before moving up the hierarchy to more complex aspirations. The categories in order are:

1. Physiological—Food, shelter, clothing 2. Security—Feeling of safety 3. Social—Need for belonging 4. Esteem—Need for self-esteem and recognition by others 5. Self-Actualization—Need for self-achievement

Data Gathering This is the process of accumulating basic information needed in the PFP process.

Selected Data Gathering This procedure includes getting basic personal information including, among other things, a household balance sheet showing assets and liabilities, income and expense figures, tax return, debt, investments, retirement savings, wills, trusts, insurance policies, and em- ployee benefits. Often this basic information is sketched out initially and then filled in later.

Summary Communication, data gathering, and goal setting are interrelated topics. The objective of these three topics is to begin the planning process smoothly so that goal establish- ment and data gathering occur correctly and the required information is received. This involves

to be done. They differ because of such variables as culture, age, family background, and personality.

- fully, and placing oneself in another person’s shoes.

the client.

the topics intended, and have a conclusion that includes summing up and establishing the next step in the planning process.

depend, to a great extent, on a person’s life values.

the plan contributes.

74 Planning Basics

Key Terms behavioral finance, 57 behavioral financial planning, 57 body language, 59 communication, 59 data gathering, 68

empathy, 60 financial counseling, 63 nonverbal communication, 59 personality, 58 segmented financial plan, 68

standard of living, 66 trust, 60 verbal communication, 59 verbal message, 59

1. What is behavioral finance? 2. How does behavioral finance differ from quantitative finance? 3. Contrast the interests of young people and seniors. 4. What does nonverbal communication mean? 5. Why is listening important in the financial planning process? 6. What are four techniques that are helpful in becoming a good listener? 7. How do you establish trust? 8. Why is preplanning for an interview important? 9. What are some attractive interviewing techniques? 10. How does financial counseling differ from financial advising? 11. How should resistance to a question or recommended course of action be handled? 12. Why are goals important for financial planning? 13. What are some of the broad financial goals of people with whom you will come in

contact? 14. How can financial planning goals be broken down into minimum, satisfactory, and

higher-level components according to parts of the financial plan? 15. What does standard of living mean to you? 16. How do financial and personal interpretations of financial planning differ? 17. Are goals more short-term or long-term oriented? Explain your answer. 18. How is Maslow’s hierarchy of needs related to income? 19. What is data gathering? 20. Why is data gathering important? 21. What are two pieces of data that are needed in each of the six financial planning

areas? 22. Which types of data should be gathered at an initial interview and which should be left

for future meetings? 23. How do commission communications vary from other types? 24. What is the difference between feeling sympathy and empathy for the client? Is one

more valuable than the other? Why? 25. What would you consider to be the financial equivalent of Maslow’s hierarchy of

needs? What are the basics? What comes last? 26. What is the significance of choosing to construct a segmented financial plan? 27. How would you interact and advise a client with goals you personally find

outlandish but that the client values greatly. Creating a mock dialogue could be helpful.

Questions

Chapter Three Beginning the Planning Process 75

Case Application DATA GATHERING, GOAL SETTING, AND COMMUNICATION Brad and Barbara made an appointment to see me concerning their own financial situa- tion. They were a newly married couple in their early 20s. Barbara came from a family whose parents had children early in their lives; the women were full-time mothers until their children were in college. Barbara had no career ambitions of her own and wanted to have children. Brad was an artistic person who had graduated with a B.A. in English. He was thinking of a career in the arts but didn’t yet know which area. He wanted time to pursue the alternatives and have children later when he is in his 30s. Brad and Barbara seemed to get along well, and both showed unusual understanding of their and their spouse’s personalities.

Case Application Questions 1. As a planner, what communication techniques would you review to prepare for the

meeting with Brad and Barbara? 2. How would you open the interview? 3. Assuming you didn’t know any of the information about Brad and Barbara, what data-

gathering questions would you ask? 4. Assuming that you knew the information, how would you question the couple about

their goals? 5. Would you take sides on their differing goals? Why? 6. What approach would you use for the meeting? Would you be closer to a counselor or

to an advisor? 7. Suppose that before the meeting, Brad and Barbara said they weren’t sure that you

were the right person for the position and that they might interview others. How would that influence the interview process? Give some examples.

8. Suppose you found yourself doing most of the talking. What might that mean? What would you do?

9. How would you end the meeting? 10. What are Brad and Barbara’s goals? 11. What type of information would you ask them for in their first meeting? 12. Assume that you were doing a financial plan for Brad and Barbara. Complete the

goals section of the financial plan.

Part Two

Ongoing Household Planning 4. Household Finance 5. Financial Statements Analysis 6. Cash Flow Planning 7. Debt

This section discusses basic household operations. In that discussion, Chapter 4 presents financial planning theory with its two major themes: the household enterprise with its businesslike characteristics and the decision making that integrates all assets and obligations. You will learn that the household produces goods and services and generates a kind of profit. Keep in mind that the goal of the household enterprise is to operate as productively as possible. Doing so leads to the highest standard of living you can achieve. The mandate of personal finan- cial planning (PFP) is to help make that happen. Chapter 5 details the analysis of financial statements. By constructing and analyz- ing financial statements, you can make an appraisal of where you are financially at the time. The statements also can be financial projections used to help point the way to necessary future actions. Methods of developing financial statements and evaluating the results are both discussed. Chapter 6 presents cash flow planning. Cash flow is the resource generated that is used in virtually every personal financial planning activity. When we are operating efficiently, we generate the highest cash flow possible given time and risk limitations. The focus in Chapter 6 is on savings, a difficult process for many, and financial ratios, several of which are cash flow–generated, that help deter- mine our financial health. Chapter 7 describes debt and the ways it is and should be used in the household. For many, incurring debt through the use of credit cards has become a normal household function for obtaining cash and affecting ordinary transactions. The advantages and disadvantages of credit card debt is presented. Knowledge of daily household operations and planning for them, as presented in this section, will set the stage for more sophisticated analysis throughout the book.

Chapter Goals

This chapter will enable you to:

Dan and Laura were intrigued by their friends’ comment that the key to their financial suc- cess was that they ran their household as a business. Dan liked the idea of operating the household in that way and wondered if there was any theory of personal financial plan- ning. Laura didn’t understand why her husband was interested in all that “theoretical stuff.” Wasn’t financial planning just a straightforward process?

Real-Life Planning Henry Henry was a sports star known for his talent and temperament. He was a “control freak,” unable to delegate any but the most technical matters to others. Henry’s first meeting with the financial planning advisor was held in Henry’s sports car in the parking lot after a game. Unfortunately, Henry was as frugal and unschooled in personal financial matters as he was flamboyant and sophisticated in sports. He wrote all checks himself and could never find the time to pay his bills when they were due. Unopened bills lay on his floor. He never reconciled his bank statement, and sometimes large sums of money lay dormant in non- interest-bearing bank accounts. The advisor told Henry to think of himself as running a business enterprise. The main asset of his business was his own revenue-generating ability through competing in games and serving as a spokesperson for various products. His expenses were the food, cloth- ing, shelter, and other costs necessary to keep his own household operating smoothly and healthily. The remaining cash flow would be used for fun activities and savings to continue to generate revenue for the time when his athletic abilities would no longer be in demand.

Chapter Four

Household Finance 79

The advisor said that Henry was missing out on two opportunities. The first was the op- portunity to earn higher sums by investing his money judiciously and through handling day-to-day financial functions properly. It would require money to hire the proper finan- cial people to help him with this. While his operating costs would rise, his enterprise would likely provide higher returns for use after athletic retirement. The second opportunity was the chance to eliminate his fear of the future. The advisor would provide a financial plan that would detail ways to both raise his quality of life today and protect him in the future. The advisor had already concluded that these goals were achievable. To take advantage of these opportunities, Henry would have to relinquish some control to others although he would still be in the financial driver’s seat. The advisor told Henry that, in effect, there was a cost to the time he was devoting to his household activities. He could use the time freed from this process to earn more money or to relax more. Henry didn’t immediately say whether he was retaining the advisor. Instead he turned on the igni- tion, drove out of the parking lot, and, when he got to the highway, launched into a broader discussion of his financial concerns. The advisor took notes and thought of the challenge associated with setting Henry on the right financial path.

Mary Mary owned a successful web design business. She started it in college in her apartment after interning for a large firm during her freshman year. The business grew rapidly be- cause of her ability to accept both large and small clients and deliver high-quality creative work on time and at reasonable prices. Pretty soon she had both full-time employees and independent contractors working for her. She had accumulated large profits that she used to set up a pension plan and to purchase a home. The income was so large that they cov- ered her frivolous expenditures and large credit card liability. Then came the 2008–2009 recession, and Mary at age 25 was facing a crisis. She saw herself as an artist and had little experience in financial matters. When the stock market declined sharply, she became nervous and sold all her equities that were riskier than average at a 70 percent loss. She had bought her home at the top of the market in 2007 with only 5 percent down. She was well “underwater” on the home with a large mortgage to pay each month. Perhaps worst of all, her business deteriorated sharply because of the recession. After laying off her entire staff, Mary did some soul searching. She decided to invest in herself by pursuing an MBA; her interesting personal history enabled her to get significant scholarship money. Although she kept her business functioning, she examined other alter- natives including part-time work in two new activities. In her finance and management courses, she began to see the parallels between her business and household activities. Both required logical structured thinking and acting with the goal of generating the highest free cash flow for her benefit over time. She decided that none of her other career alternatives could compete with her interest in her own business. Helped by a marketing course that discussed the principles of product differentiation and branding, her business gradually began to recover. She placed her pen- sion back into equities and resolved not to try to time the market. She gradually paid off her debt. Her new mantra was to see herself as a creative person with smart business in- stincts and who operated her household as a business.

OVERVIEW

Personal financial planning didn’t emerge full blown from a shell. This chapter traces the development of household finance and personal financial planning theory. It begins by establishing that the household is the proper organizational structure for an individual’s

80 Part Two Ongoing Household Planning

financial activities. We then look at the economic theories that have led to the household financial approach. You will learn about the cost of time and how household outlays can be separated into two parts: maintenance and leisure. With this material as background, we discuss the household as an enterprise with similarities to a business. Household finance as an approach that embraces the entire book is then described and linked to personal financial planning. A theory of personal financial planning with its active arm, total portfolio management, extends and com- pletes the chapter. Knowledge of these topics will enable you to have greater insight into PFP and its inte- grated core and to increase your understanding of the material to come in future chapters. It also can result in your making better decisions in practice.

THE HOUSEHOLD STRUCTURE

The household represents an organizational structure that unites its occupants. We are interested in the household structure because it can best describe the combined financial actions of its occupants. Just as structure or form affects a business, so too the form of a household can affect its financial operations.1 The household also can provide an opportunity for logical decision making by its members, which is, of course, a principal goal of personal financial planning and of this book. The household can be described as a structure for one or more people who live in the same home. This definition is very broad and can include people who share nothing other than the same roof.2 A similar definition is often used by the U.S. Census Bureau, which publishes many economic statistics by household. For our purposes, a more meaningful definition of household is an organization of one or more people who share a dwelling and share financial and other resources intended for the well-being of its members.3 This definition requires more involvement and sharing to qualify as a household with multiple members. In other words, the household is the princi- pal organization intended to handle the financial and other personal activities of one or more people and to foster the achievement of their goals.4

The household comes in many organizational forms, which, as with a business organiza- tion, influence its financial, legal, and tax situations. For example, financial efficiencies can result from a multiperson household through reduction in income fluctuation, specialization

1 Many introductory texts in business finance incorporate a description of a business structure, and the CFP curriculum requirement does as well. 2 John B. Taylor and Akila Weerapan, Principles of Microeconomics, 7th ed. (Mason, Ohio Cengage Learning, 2011). 3 For a discussion of qualifications for a household, see W. Keith Bryant and Cathleen D. Zick, The Economic Organization of the Household, 2nd ed. (Cambridge: Cambridge University Press, 2005). 4 In traditional economic theory, all members of the household are assumed to have interests identical to those of the overall household (see Paul Samuelson, “Social Indifference Curves,” Quarterly Journal of Economics 70, no. 1 [February 1956]: 1–22), or the outcomes are as if they did (Gary Becker, “Altruism in the Family and Selfishness in the Market Place,” Economica, n.s., 48, no. 189 [February 1981]: 1–15). For an update, see Susan M. Bianchi, “Family Change and Time Allocation in American Families,” The ANNALS of the American Academy of Political and Social Science 638, no.1 (November 2011): 21–44. Thus, it is possible to speak of household and individual interests interchangeably—a procedure that, for the most part, we follow in this book. In the book’s final two chapters, however, we consider an alternative view. Any alternative view of household interest that does not incorporate a one-voice theory can be considered roughly similar to an approach that does not align worker and owner interests in a business in its traditional goal of maximization of profits.

Household Finance 81

of tasks, and economies of scale. If two people work, they reduce the risk of a stop in income in the event of sickness or job layoffs. Specialization in household activities can allow tasks completed more quickly and with higher quality. Sharing fixed costs for shelter and other goods offers greater economies of scale. This thought is reflected in saying, “Two can live as cheaply as one.” A summary of types of household structures and their effect on financial, legal, and tax matters is presented in Table 4.1. Over the past half century, the composition of households in the United States has changed. For total households, the percentage of stereotypical nuclear families—married couples with children—has declined; the nuclear family now accounts for a little less than 25 percent of all households. Households with single divorced members and those with no prior marital relationship have increased in number. As mentioned in Chapter 1, from a strictly economic standpoint, the single-adult-person household with or without children can be a less efficient organization than a household that has more members. The average growth of the single-adult-household category (including households with children) may be one reason that household savings in the United States has declined since peaking in 2010 after the financial crisis of 2008–2009.5

Consider the comparison of household formations in Table 4.2. In sum, we have identified a structure, the household, for individuals in their personal activities that is broadly equivalent to the structure of the business in its operating activities. Instead of having a corporation, partnership, or individual proprietorship, we have households of one person or multiple people, married or unmarried, with or without children.

Type of Household

Financial Benefits

Taxation

Legal

Life

Single person Few Can be an advantage for income taxation*

No responsibility for others

Limited to person

Married persons Specialization Economies of scale Possible reduction in risk of income fluctuation

Can be a disadvantage for income taxation

Marital responsibilities set by the government

Limited to last surviving spouse

Unmarried persons

Specialization Economies of scale Possible reduction in risk of income fluctuation

Can be an advantage over married persons for income taxation

Few legal responsibilities unless set by contract recognized by state or local municipality

Last surviving member

Each type with children

None extra Extra tax deduction— favorable tax treatment for single-adult head of household in income taxation

Additional responsibilities set by state

Last surviving adult member

* In some income circumstances, the opposite is true—for example, getting married can be less taxing than staying single.

TABLE 4.1 Household Organizational Summary

5 Organisation for Economic Co-operation and Development, Household Savings Rates, oecd-ilibrary.org/ economics/household-saving-rates-forecasts_2074384x-table 7, June 13, 2013

82 Part Two Ongoing Household Planning

This structure, which implies more logical thinking for people and shared goals for multiperson households,6 is one of the building blocks for household finance and personal financial planning theory.

THEORY: AN INTRODUCTION

Theory underlies the personal financial planning process. However, theories don’t usually completely represent how people act. In many cases, the assumptions made seem unrealistic. Theory leaves out parts of reality in order to simplify key points that will help us understand deeper aspects of behavior. Without theory, the generally recognized activi- ties of personal financial planning—cash flow and tax planning, investments, risk manage- ment, retirement and estate planning—would be thought of solely as a mechanical process. With theory, we can attempt to explain why people do what they do. Moreover, theory can enable us to think more logically and to make sound decisions, both of which can lead to higher cash flows. Let’s begin with the basic economic theory of choice and work our way to the theory of financial planning.

THE THEORY OF CONSUMER CHOICE

Household finance had its roots in economic theories. Perhaps the simplest approach is the theory of consumer choice that describes the method by which people select goods and services to satisfy their needs.

6 Martin Browning, Francois Bourguignon, and Pierre-Andre Chiappori, “Efficient Intra-Household Allocations and Distribution Factors: Implications And Identification,” Columbia University, May 8, 2008, columbia.edu/~pc2167/bbcresresubmissionpacs.pdf

Family Households

Year

Average Size

Total Households

(in thousands)

Married Families (in thousands)

Other Families* (in thousands)

Total Nonfamily

Households (in thousands)

1950 3.37 43,554 34,075 4,763 4,716 1960 3.33 52,799 39,254 5,650 7,895 1970 3.14 63,401 44,728 6,728 11,945 1980 2.76 80,776 49,112 10,438 21,226 1990 2.63 93,347 52,317 13,774 27,257 2000 2.62 104,705 55,311 16,715 32,680 2005 2.57 113,343 57,975 18,882 36,485 2010 2.59 117,538 58,410 20,423 38,705 2011 2.58 118,682 58,036 20,578 40,069 2012 2.55 121,084 58,949 21,557 40,578 2013 2.54 122,459 59,204 21,698 41,558 2014 2.54 123,229 59,629 21,724 41,877

* Other families include male and female householders with no spouse present.

TABLE 4.2 U.S. Household Formations

Source: U.S. Census Bureau, “HH-6. Average Population per Household and Family: 1940 to Present,” www.census.gov/population/socdemo/hh-fam/hh6.xls; “HH-1. Households by Type: 1940 to Present,” www.census.gov/hhes/families/files/hh1.xls; “AVG1. Average Number of People per Household: 2014,” http://www.census.gov/hhes/ families/files/cps2014/tabAVG1.xls; “AVG1. Average Number of People per Household: 2013,” http://www.census.gov/hhes/families/files/cps2013/tabAVG1.xls; “AVG1. Average Number of People per Household: 2012,” http://www.census.gov/hhes/families/files/cps2012/tabAVG1.xls

Household Finance 83

Today, a great number of goods and services are offered to consumers. However, we don’t have enough resources to purchase them all. How do we decide which items to buy? The answer is that each person has certain preferences. Those preferences come from the utility—a term used in economic theory to quantify satisfaction—that an item presents. We often use two terms in connection with economics and financial matters: maximization and optimization. These terms refer to the mechanism through which individuals obtain the highest possible satisfaction from an activity. Faced with a host of preferences and limited resources, we make purchase decisions designed to maximize utility. In other words, we attempt to optimize—we try to use our resources to get the most satisfaction we can. People select goods and services from those made available in the marketplace by grouping them into consumption bundles and ranking the bundles in order of attractiveness. For example, you could oversimplify what you intend to spend money on by separating goods and services into alternative combinations of food, clothing, shelter, transportation, communication, and “fun” items. Your choice of the most attractive combination is called your consumption bundle. Attractiveness is measured by satisfaction in relation to price. Our wealth gives us the limit on the amount we can consume. This limit is called our budget constraint. We naturally select the bundle that provides us the greatest enjoyment given our budget constraint. Our selections are made not only for this year but for future periods as well. Savings allow us to consider the wide range of multiyear consumption bundles. Savings in the theory of choice represent future spending. Our choices in a more realistic multiyear time frame are made by considering all current and future consumption bundles as compared with current and future wealth.

Example 4.1 Shirley was always very serious. She came from a large family that had few resources. She was forced to go to work and set up her own household after graduating from high school. She attended college at night. While her friends spent all the money they made, she managed to put away some money for the future. Shirley had just completed a course in microeconomics and thought about her spending options in theory of choice terms. Her best friend, Jane, had an expensive apartment and loved to entertain and eat out. Most of her spare money went for those activities. Another friend, Suzanne, had a moderate rental apartment but spent all her cash left over on vacations. All three were making the same amount of income and except for the expenses noted, spent about the same amount of money. Shirley looked at Jane’s consumption bundle and found it appealing. She was also drawn to Suzanne’s interesting vacations. However, she made a decision to save 10 percent of her salary per year to ensure that later on in life she would not be placed in her parents’ weak position. She chose a modest but cozy apartment, ate out once a week, and took a moderately priced vacation each year. Given her budget constraint, she had chosen the consumption bundle that pleased her the most. In Figure 4.1 you see the differences in expenditure pattern and their utilities according to Shirley’s lifestyle preference. Be aware that utility is subjective and that as associated with similar activities will vary by person. Notice that although expenditure levels for all three friends are the same, from Shirley’s perspective, one has the best mix in her lifestyle terms. On the right-hand side of Figure 4.1, you see Shirley’s evaluation of her lifestyle and the lifestyles of her two friends.

THE LIFE CYCLE THEORY OF SAVINGS

As formulated by Franco Modigliani,7 an economics and finance professor, the life cycle theory of savings builds on the theory of choice. It shifts from the theory of choice’s hard-to-measure utility to concrete money terms. Like many economics and

7 Franco Modigliani, The Collected Papers of Franco Modigliani, vol. 2 of The Life Cycle Hypothesis of Saving (Cambridge, MA: MIT Press, 1980).

84 Part Two Ongoing Household Planning

finance theories, the life cycle theory assumes that utility can be measured in money terms. It also presents a specific theory about how people actually make decisions. It says that our spending decisions are based not on the amount of income we currently earn but on the total amount we expect to earn over our life cycle. According to this theory, once we have established our lifetime resources, we try to maintain a constant

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

Jane’s Outlays

Suzanne’s Outlays

Shirley’s Outlays

Shirley’s Satisfaction with Jane’s

Lifestyle

Shirley’s Satisfaction

with Suzanne’s Lifestyle

Shirley’s Satisfaction with Own Lifestyle

C on

su m

pt io

Rest Eating Out Vacation All Other Savings Utility

FIGURE 4.1 Expenditures and Utility

- -

Practical Comment Life Cycle Approach Evaluated

Household Finance 85

Age

Amount of

assets

Beginning of household

DeathRetirement

Household debt Savings Household assets line

Consumption expenditures line

FIGURE 4.2 Demonstration of Life Cycle Theory

level of expenditures throughout our life cycle. In other words, we try to maintain the same standard of living over our lives. The life cycle approach has great significance for households. It says that we are not impulsive consumers who spend all the money that we generate. Instead, we are planners whose actions extend beyond our current resources and pleasurable activities to our future needs and assets. The simple form of the theory assumes, as does the theory of choice, that risk and inflation are not present and that people act logically to pursue their goals. According to life cycle theory, borrowing generally takes place early in the household’s life when income is low. In that way, people can raise their consumption expenses and then attempt to even them out over their lives. Then, as the income rises, people pay off their debt and save for retirement. In retirement, when work-related revenues have stopped, sav- ings are steadily liquidated to maintain the people’s cost of living. At death there are no assets remaining. In essence, the goal is to “die broke.” The life cycle theory is illustrated in Figure 4.2. The formula for calculating the life cycle model is provided in Appendix III.

THE THEORY OF THE FIRM

It may seem strange to read a brief discussion of business in the middle of a chapter about the household, but, as we’ve said, we will soon be looking at some of the many ways in which household and business activities are related. According to the economic theory of the firm, the firm or business is an organization that produces goods or services. It purchases inputs—raw materials, labor, and capital in their respective markets—to produce its offerings. The goods it offers are sold to households or other businesses at a price established in the marketplace outside its control. Therefore, the business concentrates on production revenues and costs It does so to find the optimum level of production that provides the highest profits. Maximization of profits, then, is the firm’s goal. It achieves its goal by making intel- ligent decisions on its use of its funds for the basic materials needed during production and in its mix of production investments. Its workers, including top management, help make those daily operating and investment decisions. Its operating costs are separated into those that are fixed and those that vary with the level of production. Profits are

86 Part Two Ongoing Household Planning

revenues minus fixed and variable costs, which can be called nondiscretionary and discretionary expenses. Remember this broad model as we begin to examine house- hold operations.

THE COST OF TIME

The theory of the firm describes choices in monetary terms. Gary Becker, an economics professor,8 employed a monetary framework to develop a theory of the cost of time. Households and the people living and working in them are limited, as we have seen, in the amount of money they can spend. People also are limited in the time they have available. As we all know, there are only 24 hours in a day. Fundamentally, our time can be viewed as being spent either in work-related or leisure activities. How do we decide how much time to devote to each? We compare the utility we receive from leisure time with that from the money we receive from work time. The fewer leisure hours, the greater their pleasure per hour; the higher the wage rate, the more enticing further work time is because it can purchase additional goods and services that we enjoy. Obviously, the preference for work over leisure or vice versa at any level varies from one person to another. (For a further explanation of leisure, see Appendixes I and II.) Of course, not all work is for pay. For example, we work around the house cleaning and we allocate time to get to work. Neither pays us any money, but we must perform these activities. We perform other activities, or work-related tasks, because they can be viewed as making us fit for work. When we engage in any activities that don’t provide us money, we can say we have an opportunity cost of time, Opportunity cost can be defined as a comparison and a calculation in money terms of the difference between a current use from an item and the alternative use.9 Normally, this cost of time would be our hourly wage or its equivalent.10 By placing a monetary value on our nonearning time, we can better evaluate efficiencies in many areas. For example, it can help us in making decisions about working at home by doing housework ourselves versus working longer hours for pay and hiring someone else to perform certain household duties. Or it can simply help us recognize that our leisure time is valuable and measurable.

Example 4.2 John, who earned $25 per hour after deducting tax and transportation expenses, worked four 8-hour days instead of five. He chose to bicycle through the countryside on Fridays. His cost of time for the fifth day was $200 ($25 per hour 8 hours). Clearly, the pleasure from bicycling exceeded that wage rate or he would have worked that fifth day.

THE HOUSEHOLD ENTERPRISE

We can now begin to put these economic theories to use. According to traditional economic theory, the household is merely a supplier of labor to business and a purchaser of its goods. But it is more than that: in fact, in many ways, the household resembles a small business. The household produces goods and services for its own consumption.11 It does this by combining items purchased with the time it takes to process them. For example, it

8 Gary Becker, “A Theory of Allocation of Time,” Economic Journal 75, no. 299 (1965),: 493–517. 9 The opportunity cost of time can be extended as well to not working at the maximum level of income. 10 Becker, “A Theory of Allocation of Time.” 11 William A. Lord, Household Dynamics: Economic Growth and Policy (New York: Oxford University Press, 2002), p. 286.

Household Finance 87

“ manufactures” cooked food to consume by combining raw materials bought at the super- market, an oven, and the production time spent preparing and cooking that food. The household product manufactured is the meal to be eaten.12 The cost is that of items pur- chased plus the opportunity cost of the time. We can extend the classical household production approach to include those items created for consumption by others. We combine business-related costs such as that of busi- ness attire with long-lasting capital goods expenditures, such as an automobile to transport us to a destination with our time at work. The resulting product manufactured, our services, is sold in the marketplace for a salary or hourly fee. In fact, the household can be viewed as producing goods and services 24 hours a day. Some add directly to revenues. Others support revenues if only by keeping us healthy and ready to provide our best during the time we allocate to work. The rest of our time and money is devoted to activities that we enjoy doing. The structure we are describing can be called the household enterprise. An enter- prise can be defined as an entity that engages in certain tasks for an end result. When people refer to an enterprise, they often think of a business, which is organized to handle a specific task—to make as much money as possible for its owners. The household enter- prise attempts to run the household as efficiently as possible in order to provide as much time and money as possible for pleasurable activities. The broader form of household production is presented in Figure 4.3.

THE TRANSITION TO FINANCE

Thus far we have dealt primarily with economics. That is because, in the past, economics has been the principal provider of broad-based information about household resources. Historically, the information was descriptive, a series of recipes for good household practices, sometimes called home economics. Becker’s work in the 1960s made home economics more scientific by introducing the cost of time and household production for internal use.13

12 Becker calls these products commodities. 13 Becker, “A Theory of Allocation of Time.”

Purchase of goods and services

Time on individual

goods

Production of Household Commodities

Sold in marketplace

Consumed internally

FIGURE 4.3 Household Production: Establishment of Household Goods and Services

88 Part Two Ongoing Household Planning

Finance has lagged behind economics in this area. There is no integrated theory of household finance or personal financial planning. Most work in finance has concentrated on marketable securities, such as stocks and bonds, and on research on businesses and financial markets. This book sets forth an integrated theory of personal financial planning. We actually started the process by presenting the household as a leisure-seeking enterprise. In estab- lishing this theory, we view items in a financial rather than an economic framework. Although the line between the two can sometimes be blurred,14 finance places more or exclusive emphasis, relative to economics, on the following four factors that are relevant to our discussion:

Practicality. Finance places more stress on practicality in its analysis. Cash flow. Finance describes most processes in tangible money terms. Portfolio solution. A portfolio is a grouping of assets. Finance is able to look at how

those assets interact so as to provide an integrated solution to a problem. Risk-return analysis. Finance more often incorporates risk in decision making and can

offer outcomes in combined risk-return terms.

We start by expressing the household in financial terms. Given finance’s emphasis on cash flow and the cost of time not being an actual cash charge, we reserve its use in the book for relevant decision making.

HOUSEHOLD FINANCE

Household finance is the financial counterpart of the household enterprise. It can be viewed as personal finance placed in an organizational framework. The household is the structure that reflects all the financial activities of its members. Financial planners know this to be true from experience because financial advice is not usually requested on a person-by-person basis. Instead, personal financial planning is typically performed on an overall household basis. The goal of household finance is to have the cash flows of the household’s members managed as efficiently as possible given the household’s financial and nonfinancial objectives. In our suggested theory of household finance, a household has three types of day-to-day financial activities: revenue production, overhead costs, and leisure outlays. The most common revenue-producing activities are jobs and investment income. Overhead costs, which we can call maintenance costs, include those that directly support employment such as commuting costs and business lunches; housing support costs such as mortgage interest and utility expenses; and personal support costs such as food, nonbusiness cloth- ing, and personal care. They can be perceived as fixed costs, at least over the short term. Leisure outlays are defined broadly to include all nonwork, nonoverhead-related items. These may include eating out, watching television, playing tennis, and even shopping if the shopping is not for necessities. According to classical economic theory, all consumption expenditures are generally grouped together. In household finance, however, we can separate them more precisely. We particularly want to distinguish between maintenance and leisure costs. It is fairly easy to differentiate between them, at least for simple items. Maintenance costs are made for necessities. Leisure items provide us with utility, which, as we noted, is another word for satisfaction.

14 This especially concerns finance and financial economics.

Household Finance 89

Given our financial orientation, this distinction is important. We want to spend as little time and money as possible on overhead-related items. Few people get pleasure from washing the dishes. As far as most of us are concerned, the more time and money we can spend on leisure activities, the better. Of course, the choices of types of activities and whether they are time or money intensive varies by person.15

The remaining household activities are not day-to-day ones. They include capital expenditures, other types of investments, and debt financing. Capital expenditures are cash outflows that provide household operating benefits over an extended period of time. A washing machine and a car are two examples. We want to separate capital expenditures because including these often expensive cash outflows with daily costs can distort our analysis of the financial performance for the year. Additionally, merging them could result in failing to recognize the extended-period worth of the purchases for our household. Because they have ongoing worth, capital expenditures are a form of investment. Other investments, most commonly financial investments such as stocks and bonds, also are treated separately. Borrowing money or paying it off also can distort financial performance if we don’t segregate it. It is of little use to say you have $5,000 more cash in the bank this year than last if you haven’t paid attention to the fact that your credit card debt is up by $7,000 during that period. The balance of your funds is those not being used or planned for use in current operations. This free cash flow can be saved and invested for future purposes and is often where investments in stocks and bonds are placed.

THE HOUSEHOLD AS A BUSINESS

By now, those who are familiar with businesses will recognize that the household is managed in many ways like a business and that household finance is similar to business finance. Both have revenues and operating expenses. Both have assets and make capital expenditures that help improve operations. Each has a goal. The goal of a business is to earn as much profit as it can.16 The goal of a household is to maximize utility. Much is made of the difference between household and business goals. Many people would object to limiting household goals to the business goal of making the most amount of money possible. Yet, few would disagree with the view that money is one of the sig- nificant factors in achieving personal goals. The relative importance of money, of course, varies by household. Our approach—segregating daily outflows into maintenance and leisure expenditures— can help to identify the similarities between a household and a business. As we have seen, maintenance expenditures are household overhead expenses and are equivalent to business operating expenses. The household’s resemblance to a business can extend to profits and dividends. Business profits paid out to owners for their choice of use are called dividends. Household cash flows after overhead charges are the equivalent of business profits. The amounts of these cash flows paid out to household members to be used in any way they wish resemble business dividends. You can think of leisure outlays as dividends for our efforts.

15 Sometimes there is more than one reason for purchasing an item. This topic is discussed in Chapter 8. 16 Or, more precisely, to maximize shareholder’s equity, particularly in the case of a publicly owned company.

90 Part Two Ongoing Household Planning

* Net of addition to or repayments of debt and, in the case of Business, any additional equity financing as well.

Household Finance

–

+ +

–

Business Finance

Revenues from work-related output reflected in salary and pension + Investment returns

Revenues from output of goods and services + Investment returns

Nondiscretionary expense Fixed and variable cost

ProfitsProfits–Amount available for current and future needs

Savings reserved for future use Reinvested earnings intended to help generate future dividends

Cash to be distributed currently to stockholders for their use

Cash to be distributed currently to member-owners for their use for pleasurable activities

Cash flow after maintenance

expense

Cash flow from operations

Additions to investments*

Leisure outlays Dividends

Income Income

Expense Expense

FIGURE 4.4 Household versus Business Financial Process

Viewing the household as a business implies that its activities are more complex and its decisions more logical than many people acknowledge. It is true that instead of making a correct financial decision, people may make it emotionally. But so do busi- nesspeople. Nor can one or two household members bring the same depth of knowl- edge to a topic that a specialist at a large corporation can. Household members are largely generalists. As we shall see, however, household members often make the right choice. They have an advantage over many businesses because they are able to make a decision quickly and integrate all relevant facts, which a complex organization may find dif- ficult. This ability of the household’s “owners” to make decisions rapidly without going through various levels of management and employees improves their ability to use an overall portfolio decision-making approach. This approach is explained later in this chapter. Our use of sophisticated business techniques that help with measurement can assist the household in making more logical and better-informed decisions. The similarities between the household and a business are shown in Figure 4.4. The household’s activities can be viewed a divisions as described in Appendix IV.

Household Finance 91

- -

Practical Comment Incentive to Operate Efficiently

MODERN PORTFOLIO THEORY

Modern portfolio theory (MPT) has a key place in personal financial planning. MPT, as introduced by Harry Markowitz, a finance professor, helped turn corporate finance and investments from mere words into an operating theory.18 As is true of many theories, it has proponents and critics that can point to real-life inconsistencies. We give three key principles of the theory here. The first is that investments should be viewed as part of a portfolio, not individually. What counts is how the pieces fit together. Second, in making a decision about whether to purchase an investment, don’t analyze return alone; analyze return in relation to risk. According to MPT, the higher the risk, the higher the potential return. A third principle of MPT is that overall risk is influenced by the degree of diversifica- tion among assets in the portfolio. The more dissimilar the assets are—that is, the lower the correlation among them—the lower the risk for the portfolio. For example, McDonald’s and Microsoft, when combined in a portfolio, will provide greater diversification than a combination of Ford and General Motors. These principles and their relationship to per- sonal financial management are discussed at great length in Chapters 10 and 16. Finally, keep in mind that MPT is generally limited to marketable financial investments such as stocks and bonds.

THE THEORY OF PERSONAL FINANCIAL PLANNING

Having discussed existing theories and presented some new ideas, we can now put every- thing together and construct a theory of financial planning. It will be expressed as a series of statements that serve as building blocks for the theory.

1. PFP goal. Personal financial planning can have many goals, but overall its primary one is to enjoy the highest standard of living possible. This goal is equivalent to the theory of choice’s maximization of utility.

2. Life cycle approach. Life cycle theory provides an appropriate model of individual actions. It says that people plan for future events using current and future financial resources with the objective of smoothing fluctuations in their standard of living.

18 Harry Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91 and Portfolio Selection—Efficient Diversification of Investments (New York: John Wiley & Sons, 1959).

92 Part Two Ongoing Household Planning

3. Household structure. The household is the appropriate structure through which to ana- lyze one or more people and their goals and operations.

4. Household enterprise. The household acts as an enterprise. It manufactures goods and services for internal and external use. Its objective is to become as efficient as possible.

5. Household finance. Household finance is the financial component of the household enterprise. It represents the structural counterpart of personal finance. Its function is to convert household efficiency into achievement of the highest cash flow possible given the time allocated to work-related activities. In performing operating tasks, the house- hold in many ways resembles a business.

6. Household portfolio approach. The household can be viewed as a portfolio, an accumu- lation of assets and liabilities. Decisions concerning these assets and liabilities are made on an integrated basis by household members. From a household finance standpoint, the household can be expressed as a portfolio that uses a modern portfolio theory approach but with a broader grouping of assets.19

7. Portfolio solution. The goal in financial terms is to manage the portfolio as productively as possible by allocating resources in the proper weighting to the most attractive invest- ments. In other words, its objective is to get the highest return for the risk the household is willing to undertake.

8. PFP goal achievement. Personal financial planning is the analysis and implementation arm of household finance. By generating the highest cash flow possible, household portfolio optimization satisfies the PFP goal of enjoying the highest attainable standard of living.

Put most simply, the theory of financial planning views the household as a financial enter- prise that uses a portfolio risk-return framework to provide solutions to financial planning goals. Using this theoretical approach transforms home economics into household finance. As previously stated, a suitable theory can lead to logical thinking, thereby creating higher cash flows. A theory is even more helpful when its approach can be applied in real- life circumstances without a large number of assumptions, simplifications, and modifica- tions. A practical approach to the theory is the subject of our next section.

TOTAL PORTFOLIO MANAGEMENT

Total portfolio management (TPM) is the active arm of personal financial planning the- ory. The household has many assets it can call on to help it earn money. Your financial assets such as stocks and bonds represent one category. Your earning power in your employment is another. The home of people who are owners, not renters, is a significant asset. The house- hold equipment you purchase to save time and money and to provide pleasure is another. Certain obligations are also relevant to TPM. Financial liabilities, such as mortgages and credit card debt, are the easiest to identify. We can consider maintenance a fixed- expenditure obligation because we have no choice but to satisfy this obligation. After all, if we don’t pay our utility bill, buy food, or put gasoline in our car, we don’t have the foundation to live the lifestyle we have established for ourselves. As mentioned earlier, these assets and obligations form a portfolio—our household portfolio. The returns we receive on this portfolio—our revenues less our overhead expenditures—are our “profits.” Our household financial projections of revenues and expenses are made on a longer-term basis as broadly structured by the life cycle theory.

19 Including liabilities, which in theoretical terms can be viewed as negative assets.

Household Finance 93

Because we can’t predict the future precisely, our projections are subject to unexpected occurrences, which we can call risk. TPM’s focus, then, is to provide the highest return possible for the household portfolio given the household’s resources and risk preferences. All household assets work together toward this goal. The TPM approach attempts to select the best mix of assets to achieve this objective. As you saw earlier, the higher the degree of diversification among assets, the lower is the household’s risk. Of course, the higher the return on the portfolio, the higher the standard of living household members can enjoy. TPM provides specific ways of solving household problems, which we present in the final part of the book. However, TPM does not depend on the validity or lack of appropri- ateness of any one practical interpretation of its principles. It is the veracity of the overall approach that counts most. The TPM approach is unique because it uses all household assets and obligations. Other fi- nancial models are generally limited to marketable financial assets alone, which may be appro- priate for their purposes. However, people think about all their assets and obligations in making important household decisions, and financial planners do so in making their recommendations.

BEHAVIORAL FINANCIAL PLANNING

Behavioral finance is the human side of money. Much of the information this book gives you teaches you the right way to plan. It suggests how people should act; how they actually do act can be very different, of course. For example, sound financial planning often ad- vises that you begin to save money for retirement as soon as you start working. The dollars saved then are much more “high powered” for accumulation purposes than identical amounts saved later in your life. Yet, many young people do act very differently; they postpone retirement saving, pre- ferring enjoyment today to what they perceive as a distant concern. When the decision to spend today is caused by imperfect mental processing of information and later regretted, behavioral financial planning enters into consideration. The approach of behavioral financial planning is to educate and establish practices that close the gap between actual and ideal planning, thereby bringing people closer to their own goals. More broadly speaking, behavioral financial planning can also provide insight into and help foster the achievement of nonfinancial goals. Many of the practical comments throughout this book concern behavioral issues, and in the final part, it has a separate chapter on this topic. This material is presented early in the book to familiarize you with several of its themes. They help to integrate the separate financial planning topics. The concepts presented here are a road map to understanding the rest of the book. Each chapter that follows relates its subject to overall household operations and, when appropriate, to TPM. The final section of the book integrates all the material presented, and Chapter 17 describes TPM in detail. Figure 4.5 presents a summary of personal financial planning theory. In this form, TPM is integrated into PFP theory; a few steps in the building process have been slightly modi- fied or combined. In sum, we have two approaches to PFP theory. The first approach, which uses mainte- nance and leisure, is consistent with pure financial planning theory and presents a more straightforward, logical approach to household finance. The second approach, which uses a nondiscretionary and discretionary approach, is more practical. Because this is a practical text, we generally use the nondiscretionary and discretionary approach for the balance of the book (e.g., for cash flow statements). We are careful to retain the basic thought that only certain outlays qualify as pleasure-producing ones. PFP,

94 Part Two Ongoing Household Planning

The individual’s search and decision process for consumption is based on maximizing utility over a life cycle. A financial planning approach is used for efficient decision making.

The household is the designated organizational structure for an individual’s economic and financial actions.

The household acts as a factory producing commodities for internal use and for others.

The household performs as an enterprise much like a business enterprise with revenues and expenses. It has a goal of maximizing operating cash flows for the amount of time it allocates to work-related activities.

The household can be portrayed as a portfolio of all assets and liabilities that provide the cash inflows and outflows to operate the enterprise.

The decision process is done on a portfolio basis. The household portfolio solves for the optimal asset mix, which reflects maximum returns in relation to the risk the household is willing to take.

The total portfolio generates returns that provide the household with cash flows for its standard of living as represented by its leisure outlays.

The optimal return on the portfolio satisfies the financial planning goal of efficient decision making and the highest standard of living possible.

Total Portfolio Management

Personal Financial Planning Goal Achievement

Household Enterprise

Theory of Choice +

Life Cycle Theory

Portfolio Returns

Household as Organization

Household Production Theory

Household Portfolio

FIGURE 4.5 Summary of Personal Financial Planning Theory

Household Finance 95

whose ultimate goal is maximization of utility, has an obligation to call attention to the maintenance-leisure separation so that planning can be effective. For example, a perceived need for a dependable means of transportation actually may be a cover for a pleasure- producing new car. For a further discussion of PFP theory issues, see Appendix III. For a further discussion of separating expenses into divisions see Appendix IV. In Example 4.3, a practical application of TPM is shown.

Example 4.3 Jan and Jen wanted advice on doing the best they could with their assets. They had $225,000 in stocks and $80,000 in bonds. They had a home worth $200,000 and were thinking of trad- ing up to a new one costing $350,000. Jan worked in the back office of a stock brokerage firm and earned $100,000 a year; Jen was a manager with a local real estate company and earned $75,000 a year. They had $90,000 left in mortgage debt and about $120,000 in overhead expenses. They described their tolerance for risk as aggressive. They were referred to an investment manager by a couple with whom they were close. The investment manager had performed some satisfactory investment services for the couple. The investment manager told Jan and Jen that he practiced modern portfolio theory. He took into account their tolerance for risk and entered their stocks and bonds in a portfolio model. The output was a reshaping of their stock and bond portfolio with recommendations on specific purchases and sales. The investment manager indicated that he had optimized their portfolio using the best market-based investment methods. Jan and Jen wondered why he hadn’t included their current and proposed real estate investments. They noted that they had the same mix of stocks and bonds as their friends. Although both couples had a similar overall risk tolerance, the other couple held relatively safe employment in contrast to the much riskier positions held by Jan and Jen. Then Jan and Jen went to see a financial planner whose services encompassed comprehen- sive planning and who practiced TPM. He told them he would include all their assets and major debt in his recommendations. He took into account their securities, real estate, and projected life cycle job-related income. He proposed an asset allocation and encouraged them to purchase the more expensive home because the projected returns would be favorable and would further diversify them, thereby reducing their overall risk. He provided a stock and bond breakdown and specific recommendations. The planner mentioned that his recommendations included a reduction in the allocation to stocks because Jan’s job at the stock brokerage firm could be affected by a decline in the stock market. A similar relationship between the home and Jen’s job was incorporated in calculations of the overall portfolio. The planner told them that the relationships among these

nondiscretionary

and discretionary expenses. -

- ary and discretionary categories are both consid-

Practical Comment PFP Theory—A Practical Modification

96 Part Two Ongoing Household Planning

factors, which he called their correlations, reduced household diversification and therefore raised its risk. He explained that because of this, he had raised the bond allocation. The planner recommended a figure for overall living costs going forward based on the long-term returns on this total portfolio. His figure included portfolio risk and represented the highest possible living cost given their tolerance for risk. Jan and Jen found the planner’s approach and recommendations attractive. The advice was clearly based on their own personal characteristics. The financial planner had considered all their assets, not just stocks and bonds. They particularly appreciated that both financial plan- ning and investment management were integrated in one seamless operation. They decided to proceed with the recommendations and to use this planner for all their future work.

Back to Dan and Laura HOUSEHOLD FINANCE Dan and Laura had called and asked for an appointment. I thought to myself that previous discussions about financial planning and the form it had taken evidently had been insuffi- cient. Both still seemed to be concerned about their financial future. They wanted an in- stant solution to their problems, while I was offering a methodical financial plan. The trigger for a disagreement between them was a casual comment by a couple with whom they were friendly. The other couple had no financial concern; they just ran their house- hold like a business. Dan liked the idea of operating the household as a business and asked if it could be related to his college economic training. He vaguely remembered his economics profes- sor discussing home economics and wanted to know if financial planning could be related. Was there any theory of personal financial planning? Or was it just a series of financial facts? Laura, on the other hand, didn’t understand why her husband wanted to know all that “theoretical stuff.” Wasn’t financial planning just a straightforward process? Wasn’t the “cost of time” to which she had heard Dan repeatedly refer just theoretical jargon? After all, no money passed hands. Didn’t theory provide a mental headache without any useful result? She asked if they should just concentrate on the facts and the ways of reaching correct decisions and forget about economic principles and financial planning theory. By this time, Dan and Laura were glaring at each other. I wondered whether this fight was really about another more serious dispute they were having. Or perhaps they were just tense given their current financial difficulties. It obviously didn’t help that baby Brian cried intermittently as the discussion progressed. I decided to end the meeting and prom- ised to get back to them soon. That seemed to break the mood, and they left holding hands with Brian in a baby carrier that was attached to Dan’s shoulders.

Here’s my follow-up report: Both of you have raised interesting and important questions. Before I begin to answer them, let me say that it isn’t unusual for couples to differ in their take on planning and problems. Dan appears to approach problems conceptually. People who do this start with the broadest possible view and gradually narrow to the specifics. Laura, on the other hand, is very practical and wants to get to the solution as quickly as possible. It’s often an advan- tage to have both viewpoints when tackling a problem. Let’s start with an explanation of your friends managing their household as a business. We know that in some respects, our perception of a household is far from the image of a business. That is principally because the household represents more than just money fac- tors. For example, a multiperson household can represent affection and common interests

Household Finance 97

and a commitment to stay together. But, as you know, our interest is principally financial. Wherever possible, we attempt to express things in dollar terms. It should come as no sur- prise to you that even a business can extend beyond money interests. For example, workers may seek to further their interest sometimes to the detriment of the business, and some- times closely held business owners have goals other than just maximizing profits. Looking at the household as a business means treating household actions in a carefully thought-out way so that you get the “biggest bang for your buck”—in other words, trying to work hard in order to receive large wages. It means treating household internal opera- tions with thought, weighing whether to perform them yourself or to get machines or peo- ple to substitute for you. You would do so if it would free up enough valuable time for work or leisure to make it worthwhile. Keep in mind that the more the cash generated after overhead expense in the time allotted to work-related activities, the more choices you will have. It’s clear that your friends have picked up on that approach and its benefit. Dan, personal financial planning has grown out of home economics. Finance is more practical and uses more advanced analytical tools than the old home economics. There’s no established personal financial planning theory yet, but I’ll propose one. In it, all your re- sources and your risk preferences will work together in one portfolio to provide efficient decision making and the highest cash flows to achieve your goals. Of course, that is why we are doing this financial plan for you. Household finance is the term that can express your overall financial activities, and PFP is the strategic-results-oriented process to achieve them. Laura, you’re right that theory alone won’t achieve your goals. But theory can help you understand why we’re doing what we do and which tools to use to solve your problems. I agree that theory is of little use to you currently unless specific practical steps are taken that result in progress toward your objectives. I know you would prefer action, but in your case a more systematic step-by-step approach is best. The first action steps will come soon. As far as the opportunity cost of time is concerned, it is true that no money passes hands when we calculate it. However, the calculation could result in cash flow if you chose to replace your work at home with time in the workforce. The cost of time forces us to recog- nize that time has value as well, whether in work-related cash flow or leisure terms. Let me reiterate that both of your approaches to planning have merit. You’ll learn more about the process and about financial planning theory and its offshoot, TPM, as we go along. I’ll provide a recommended portfolio incorporating TPM principles at the end of the financial planning process when all separate planning activities will be integrated.

College Student Case Study and Review: Amy and John HOUSEHOLD FINANCE When John and Amy came in, I told them to put on their thinking caps because we’d be going over the theoretical underpinnings of PFP. John immediately asked, “Why should we go over this area? I thought PFP was a process with heavy number crunching. Isn’t this just a waste?” I replied that theories provide valuable insights and perspectives. No theory is exact, but they’re helpful in encouraging reasonable actions. In this session on house- hold finance, we’ll develop the broad overview of the concept from current established economic and financial theories. Let’s start with the household. As the organizing structure for the individual, couple or family, it is the equivalent of the corporation in business finance. The household can be defined as an organization of one or more people who share a dwelling, share financial obligations, and share other resources intended for the well-being of its members.

98 Part Two Ongoing Household Planning

Amy needed some clarification so she asked, “Does that mean that any two people who live together are considered part of the same household?” I replied, “No, they have to have a close relationship that involve sharing financial and other resources.” I elaborated that there were three basic types of household structures: single person, married persons, and unmarried persons. The financial benefit of a multiperson struc- ture is specialization in household duties that allows more expertise to be used in economies of scale. For example, two people might live in one apartment instead of paying two rental costs. Similarly, if a household includes two people with job-related incomes, the impact of sickness or layoffs will be reduced. There are also differences in taxation and legal responsibility in the three arrangements. To go from these house- hold structures to the discipline of household finance, it’s vital to understand several theories of consumer behavior.

The Theory of Choice Within all types of household structures, the theory of choice is perhaps the most basic way to look at consumer behavior. This theory says that individuals have different pref- erences in the bundle of goods and services they buy to satisfy their goals. One person may place more emphasis on an apartment and clothing whereas the other may get more pleasure from traveling and eating out.

The Life Cycle Theory Another vital concept, the life cycle theory of savings, underlies all personal financial planning. It indicates that people are farsighted. They establish a cost structure (quality of life) based not on their income today but on their projected life cycle income and other resources. The pure theory assumes that consumption expenditures stay flat over time. The life cycle theory clearly provides planning for a retirement during which assets are worked down; the goal is to have no assets remaining with the death of the last household member. This theory has certain weaknesses but remains the most popular economic approach to consumer spending and saving patterns being taught.

The Theory of the Firm The theory of the firm is a business theory. It indicates that the firm can be segmented into the purchases of inputs, raw materials, labor, and capital for production purchases. The goods produced are sold to the household, thereby creating revenue and profits. The firm’s goal is to maximize profits, calculated as revenues minus fixed and variable costs. Variable costs are also called nondiscretionary costs.

The Cost of Time The cost of time says that people’s alternative activities are limited by a 24-hour day. What people do with their time has value whether at the margin they decide to work or to select among different leisure time alternatives based on the pleasure each brings. Each unit of time spent is called a production activity. The value of each hour of work or leisure is mea- sured by the amount of money 1 additional hour of work would provide. Looking at it in this manner can make it easier to select between working harder or, say, having more fun eating out. The choices offered that don’t produce money directly are called the opportu- nity cost of time. Each consumer selects the optimal mix for his or her self.

The Household Enterprise Understanding these theories can help us put the theories together. The household enterprise acts like a firm by producing produces goods and services to sell to others and to consume internally. Each item can be priced separately, using the opportunity cost of time. The house- hold enterprise attempts to maximize the utility of its activities by selecting the optimal mix.

Household Finance 99

Household Finance We now shift to finance from what was principally an economics framework. There is no inte- grated theory of household finance, but the textbook I gave you to read sets up such a theory. Finance differs from economics in being more practical, expressing itself in money terms, hav- ing a portfolio solution (grouping of assets), and more frequently using risk–return analysis. Household finance provides a framework for looking at the household enterprise with much more emphasis on money. The household is equivalent to its structure, not the indi- viduals that comprise it. In anticipating your question, based on your quizzical nonverbal communication, yes, Amy, the individual can still be the sole owner and occupier of the household. The goal is to plan cash flows so the household operates as efficiently as possible, given both financial and nonfinancial objectives. The three types of day-to-day financial activities are revenue production; overhead costs, which are also called fixed costs or maintenance costs; and leisure outlays, which are nonover- head items. Leisure items produce pleasure whereas overhead costs, while necessary, do not. Non-daily activities are capital expenditures (which provide benefits over an extended period of time), other types of investments, and debt financing. Combining cash flow from day-to-day activities with that of non-day-to-day activities provides a free cash flow that often is placed in stocks and bonds.

The Household as a Business Both Amy and John commented that PFP theory sounded in many ways like business fi- nance. I agreed and said that the household is very much like a business. It attempts to maximize its revenues in the time devoted to it. The household tries to reduce its fixed costs because it derives no pleasure from it. It attempts to maximize its profits by optimiz- ing its leisure activities—a combination of time and cash flow to full life cycle leisure activities. One difference of the household business is that money alone is not its goal but also includes the quality of life, which differs for each household. John then joined in, saying, “We shouldn’t disparage money because for many people it leads to or importantly influences whatever goal people select.” I agreed with John’s comment.

Modern Portfolio Theory Modern portfolio theory (MPT) incorporates these three principles:

1. Looking at a portfolio as a whole, not just component by component. 2. Viewing not only return but risk as well—the higher the risk, the higher the anticipated

return. 3. Addressing overall portfolio risk by diversification, which includes correlation, and is

the degree to which items in the portfolio move together. All other things being equal, the lower the correlation, the lower the risk is. Unfortunately, MPT generally is used only for stock and bond analysis. We’ll return to this point soon.

The Theory of Personal Financial Planning This theory is a construction of all that we have discussed before. PFP’s goal is to enjoy the highest standard of living possible. It is equivalent to the maximization of utility in the theory of choice. PFP combines the household structure and the life cycle approach into the household enterprise. Limit it principally to monies, and you have household finance. When performing household tasks, the household operates in many ways as a business. The household is viewed as a portfolio with assets and liabilities. Decisions on adding or selling assets are made on an integrated portfolio basis. In financial terms, the portfolio solution comes from allocating the proper amount to assets and liabilities. PFP is the implementation arm of personal finance. When the proper allocation has been determined, it satisfies the PFP goal of attaining the highest standard of living possible.

100 Part Two Ongoing Household Planning

Total Portfolio Management TPM, a proprietary program, is the active arm of PFP. It incorporates in its analysis of as- sets not only stocks and bonds but also human assets (valued by bringing all future cash flows to the present), and real estate—including the home and household equipment. TPM also includes all liabilities, not just financial ones including mortgages and credit cards, but also nonfinancial ones such as the fixed costs that are required to run your household. The result is a full array of all household assets and liabilities. TPM also considers the risk preferences of the individuals, which, of course, varies by household. TPM searches for the best mix of assets that is likely to provide the highest return. The highest return on the portfolio produces the highest standard of living possible. We’ll return to TPM throughout our discussions.

Behavioral Financial Planning Behavioral finance is the human side of money. Humans make mistakes, and that ten- dency creates a gap between actual and ideal planning. Behavioral financial planning at- tempts to close that gap. It also deals with helping achieve nonfinancial goals as discussed in Chapter 3.

Summary Household finance and PFP theory reflect the basic thought that a household can be per- ceived as a business and include all resources in making its decisions. Specifically:

group’s financial activities.

draws their personal financial planning objectives together.

and generating the highest cash flows for the time allocated to work is analogous to a business.

a person’s entire financial life. Its origins are in economics and financial concepts such as the theory of choice, life cycle theory, the cost of time, the theory of the firm, modern portfolio theory, and risk–return analysis.

don’t actually provide money to the household. Assigning a value to time makes it easier to include it in planning and decision making.

maintains that people include thinking about their future in their actions today. The strict form of the theory says that people try to even out their resources over their life- time. However, the approach can allow for more flexible interpretations.

- lays usually provide us pleasure, and we strive to increase the money and time con- nected with them.

It uses TPM as its underpinning. TPM says that all household assets should be included in decision making. The best mix of those assets leads to the largest cash flow possible within risk and time allocated to this task. This optimal mix satisfies the personal finan- cial planning goal of achieving the highest standard of living possible.

Household Finance 101

Key Terms behavioral financial planning, 93 budget constraint, 83 capital expenditures, 89 consumption bundle, 83 discretionary expenses, 86 firm, 85 household, 80 household enterprise, 87

household finance, 88 leisure outlays, 88 life cycle theory, 83 maintenance costs, 88 modern portfolio theory (MPT), 91 nondiscretionary expenses, 86 opportunity cost of time, 86

overhead costs (maintenance costs), 88 theory of consumer choice, 82 total portfolio management (TPM), 92 utility, 83

1. Define the household in financial terms. 2. What makes the household the financial structure for the individual? 3. List some of the advantages and disadvantages of various organizational structures for

the individual. 4. How do people choose their goods? 5. How are spending decisions made according to the life cycle theory of savings? 6. What does life cycle theory say a household should have in savings at the end of its

life? Is that practical? Explain your answer. 7. Define the term opportunity cost of time. 8. The cost of time is a noncash charge, so why is it important? 9. What makes the household an enterprise? 10. How do finance and economics differ in emphasis? 11. Describe household operations according to household finance. 12. Why is it important to differentiate among the various types of household expendi-

tures? 13. Outline the similarities and differences between a household and a business. 14. What is the importance of the theory of financial planning? 15. Are any of the outlays in Table 4.1 preferable to the others? Support your answer. 16. When would it be beneficial for the household enterprise to outsource some activities,

for example, cooking? 17. If operating efficiently is the main goal of a household enterprise, are there any draw-

backs? 18. What is TPM and why is it valuable in the framework of household planning? 19. What is to be gained by incorporating both theory and practical tools, such as oppor-

tunity cost of time, into household planning?

Questions

102 Part Two Ongoing Household Planning

Case Application HOUSEHOLD FINANCE Richard and Monica asked if they could come in to discuss an issue. At that meeting, Monica seemed worried, and Richard sunk back in his chair. Monica said Richard was hav- ing second thoughts about going ahead with the financial plan. He wanted to know what the specific benefits of financial planning were. As far as he was concerned, he said, people’s planning took place one paycheck at a time. I could tell by Monica’s way of explaining this that she disagreed. She asked for my help in dealing with this problem.

Case Application Questions 1. What do you think is the difference in philosophy between the two? 2. How does the life cycle theory enter the discussion? 3. Based on the original interview with Richard and Monica and this one, how can looking

at the household as a business help? 4. What are the benefits of financial planning for these people? 5. Write your explanation to their issues and your recommendation.

Leisure Time Our discussion of leisure time includes how we use the opportunity cost of time to measure leisure as well as how leisure-time decisions relative to work decisions are made. Doing so can help us reach better financial conclusions. First, let’s briefly review. From a classical economic standpoint, we can define leisure time activities as expenditures for goods and services that provide utility. If we consider the opportunity cost of time, we can define leisure outlays as expenditures for goods and services plus time spent on activities that provide utility. The combination of expenditures and time form a leisure commodity. For example, buying a ticket to a movie plus the time spent watching it result in a leisure commodity. So, we can think of leisure as time and money spent on things we enjoy doing. The view of leisure as a commodity that includes an opportunity cost of time has an important benefit: the ability to include all costs, not only cash expenditures, in computing leisure outlays. Having a fairly gauged standard for calculating leisure outlays allows us to place utility on a plane we can more easily understand and measure in economic and finan- cial terms. We generally cannot calculate total utility per person, but we are able to analyze mar- ginal utility at equilibrium. Marginal utility is the pleasure we get from one additional unit of an item we consume. Equilibrium is the state at which two forces—in this case utility and goods purchased—are in balance. At equilibrium, the marginal utility or plea- sure from each good or service relative to the price we pay for the good or service is equal. At the same time, the ratio of marginal utility to price for each leisure good is equal to the benefit in cash flow (to be spent on future utility) relative to the cost in displeasure

Household Finance 103

from one additional hour of work. In other words, if we call our benefits-to-cost ratios relative values, in equilibrium all of our marginal actions provide us equal values. If they didn’t, we would alter the selections. The equation can be expressed as

MUx Px

= MUy

Py = p =

MUn Pn

where

MU = Marginal utility P = Price in resources of each and time x, y, . . . n = Leisure goods

We illustrate the method of measuring leisure costs and considering those costs in affirm- ing our equilibrium analysis.

Example 4.A1.1 Jack rents a tennis court three times a week, spending $10 each time. He plays tennis for 1 hour each time. He earns $12 an hour in his job. Therefore, his cost of time is $12 for each visit. He goes to the theater once a month, which costs him $34 for each three-hour perfor- mance. Jack decides to set up a utility scale that starts at 100 units. The money he earns by working provides him 132 units of pleasure per hour. He estimates that the theater gives him 770 units of pleasure each week. In contrast, tennis gives him 242 units of pleasure each day. He wants to know whether he has a logically placed equilibrium between tennis and theater outlays and whether he should replace leisure activities with additional work.

At equilibrium:

MUTE PTE

= MUTH

PTH =

MUW PW

where

MUTE = Marginal utility of a unit of tennis MUTH = Marginal utility of a unit of theater MUW = Marginal utility of an hour of work PTE = Cost of a unit of tennis PTH = Cost of a unit of theater PW = Cost of an hour of work

Because

Marginal price of tennis = Cash outlays + Cost of time = $10 + $12 = $22

and

Marginal utility of tennis = 242 MUTE = 242

PTE = 22

MUTE

PTE = 242

22 = 11

104 Part Two Ongoing Household Planning

Marginal price of theater = Cash outlays + Cost of time = $34 + $36 = $70

and Marginal utility of theater = 770

MUTH = 770 PTH = 70

MUTH

PTH = 770

70 = 11

MUW = 132 PW = 12

MUW

PW = 132

12 = 11

Jack spends more than 3 times as much money for the theater as for 1 game of tennis. However, the utility per unit of cost of 11 is the same for tennis and the theater. Jack has se- lected his leisure activities properly. His benefit-to-cost ratio for work is equal to that for leisure activities. He should not alter his labor-leisure ratio because he is at equilibrium. Note that any leisure item considered would have as its benchmark the comparison of the utility in earning cash from 1 more hour of work.

Our analysis can be extended so that we can compare decision making among individu- als for the same leisure opportunity. The consumption pattern of a person with a low cost of living and great satisfaction from “doing nothing” will be different from that of a person who enjoys “keeping up with the Joneses.”

Example 4.A1.2 Kate and Evelyn are computer programmers, both employed by the same company. Each earns $35 an hour and works 2,000 hours a year. Both are offered some additional work on Saturdays at $50 an hour. Kate has a modest cost of living and spends Saturdays with her fam- ily. She rejects the additional pay, even at $50 an hour, as insufficient to compensate for the pleasure of relaxation and family interaction. Therefore, her marginal utility for current leisure exceeds $50 an hour. Kate has actually requested a reduced work schedule of four-days. Evelyn, who has a high cost of living and would like to retire at age 55, accepts the Saturday offer thinking that her leisure time today is less important than the consumption of leisure time starting at age 55. Her marginal utility for current leisure is less than $50 an hour. Notice that each is optimizing her own choices or bundles of consumption commodities.

Our discussions using the cost of time have enabled us to take a seeming intangible, consumer satisfaction, and describe it in money terms. In this way, we are able to main- stream leisure into the financial decision-making process. By using dollars to describe leisure alternatives, we can accommodate virtually any lifestyle including one that empha- sizes keeping dollar earnings to a minimum. In other words, the marginal utility of leisure can help us come to better personal finan- cial planning conclusions concerning work and leisure, including which leisure activity to select. It can do so by incorporating time as well as cash outlays in the decision framework and placing a cost on each. Equilibrium analysis is provided in Appendix II. Table 4.A1.1 presents how the average man and woman spend their time.

Household Finance 105

Mothers Fathers

1965 2008 1965 2008

Total Paid Work 9.3 23.2 46.4 42.6 Work 8.4 21.6 42.0 39.1 Commute 0.9 1.5 4.3 3.4 Family Care 49.5 38.9 11.9 21.2 Housework 31.9 23.6 4.4 9.5 Childcare 10.2 13.9 2.5 7.0 Shopping/Services 7.4 7.1 5.1 4.8 Personal Care 74.4 74.9 74.7 71.9 Sleep 55.4 59.6 55.7 57.1 Meal 8.9 7.0 10.5 7.8 Grooming 10.1 8.2 8.5 7.0 Total Free 34.8 31.0 35 32.3 Education 0.7 2.0 1.2 1.4 Religion 1.1 1.0 1.2 0.8 Organizations 1.4 1.5 1.0 1.4 Event 1.2 0.9 0.6 0.9 Visiting 9.0 4.1 8.4 3.4 Fitness 0.6 1.2 1.3 2.1 Hobby 2.8 0.8 1.2 1.2 TV 10.3 13.5 13.4 15.4 Reading 3.4 1.5 4.2 1.2 Stereo 0.3 0.1 0.6 0.2 Communication 4.0 4.5 2.0 4.3 TOTAL TIME 168.0 168.0 168.0 168.0

TABLE 4.A1.1 Time Use Trends of Mothers and Fathers*

Source: Suzanne M. Bianchi, “Family Change and Time Allocation in American Families, Alfred P. Sloan Foundation WorkPlace Flexibility, 2010. http:// workplaceflexibility.org/images/ uploads/program_papers/ bianchi_-_family_change_and_ time_allocation_in_american_ families.pdf

Equilibrium Analysis: Labor and Leisure Hours The assumption of constant labor and leisure hours makes decision making for the household simpler to describe and quantify. Clearly, in a business, the goal is to earn the most money possible. We can call its objective the maximization of cash flows. The business produces and expands as much as possible as long as it is profitable to do so. Equilibrium is set, and the business stops when the revenue it makes from an extra unit of output exactly equals the cost of producing that unit. Similarly, equilibrium is set, and households want to maximize their operating cash flow given a certain amount of time devoted to work. The household stops working when the benefit it receives from an extra hour of work revenues equals the cost in forgone leisure pleasure. The difficulty is in fixing the amount of work time. For example, if a person were to receive a raise in salary, the labor-leisure ratio cannot be precisely determined. Higher pay could result in more hours worked because working more hours would increase the financial reward. Economists call that the substitution effect. Alternatively, the raise could lower the hours worked and increase leisure time because, if the same income is desired, it can now be received with less work effort. Economists call this the income effect. The household’s choice will depend on the marginal utility of work versus that for leisure, given the higher income. The process was described in Appendix I. By assuming no change in overall labor or leisure hours, we can express the outcome in exact dollars. A $10,000 increase in after-tax salary is equal to a $10,000 rise in cash flow from operations. A fixed labor–leisure ratio highlights internal household operations. It suggests a focus on making the household operate as efficiently as possible.

* Hours per week.

106 Part Two Ongoing Household Planning

Many people work in one job in which their salary and work hours are determined. The emphasis then is entirely on household efficiency. The focus is similar to the business fo- cus on efficient operations. Think of it as an eyewear store in a shopping mall in which the prices of a visit and a pair of glasses are set by the market. By mall contract, the store can stay open only for 12 hours a day, and it is currently at capacity—that is, the store is unable to accept more than its current volume of clients each day. Therefore, the store can gener- ate higher cash flows only by becoming more efficient in its operations. As a practical matter, although the fixed labor–leisure assumption makes outcomes clearer to measure, the assumption is not necessary. The point is that the household will attempt to operate as efficiently as possible and maximize its operating cash flows both before and after a change in incomes and at whatever labor-leisure ratio it establishes.

III

The Life Cycle Theory of Savings The classical approach to savings comes from Modigliani in his Life Cycle Theory of Savings.21 As we saw, consumption decisions for Modigliani are based not on the amount of income we generate currently but on the amount of income we expect to earn over our life cycle. Household income may fluctuate from year to year, but we seek to maintain a constant standard of living throughout our lifetime. According to this theory, the value of all household assets is assessed at a given point in time. Assets are separated into work-related and other assets. The stream of work-related income is brought back to the present using a market-provided discount rate to establish an asset value. Other assets, assumed to be marketable assets that are owned by the house- hold, also are evaluated. We then plan to consume the income and principal from those assets in a way that will result in level expenditures over our lifetime. Given the desire for level expenditures over our life cycle, we might create negative savings in life by borrowing money when income is low; then, as our income rises, pay off the debt and save for retirement. In retirement, when our work-related revenues have stopped, we would liquidate savings steadily to maintain our cost of living. At death no assets would remain. The implication is that a change in one year’s income—for example, a large bonus received—will not alter our spending habits. Spending patterns will be changed only by a permanent shift in expectations of future income. The Modigliani life cycle formula is

c = y + 1N − t2 × ye + a

Current Expected Current Projected Current income

+ a retirement age

– age

b ×

yearly income +

assets

Remaining life span Current consumption

21 Franco Modigliani and Richard Brumberg, “Utility Analysis and the Consumption Function: An Interpretation of the Cross Section Data, ” in Post-Keynesian Economics, ed. K. Kurihara (New Brunswick, NJ: Rutgers University Press, 1954); Franco Modigliani and Richard Brumberg, “Utility Analysis and Aggregate Consumption Function: An Attempt at Integration,” in The Collected Papers of Franco Modigliani, Vol. 2, ed. A. Abel and S. Johnson (Cambridge, MA: MIT Press, 1980). For a variant on the theory, called “the permanent income hypothesis,” see Milton Friedman, A Theory of the Consumption Function (Princeton, NJ: Princeton University Press, 1957).

Household Finance 107

where

c = Current consumption y = Current income a = Current assets t = Current age of the household ye = Projected yearly income N = Expected retirement age (N − t) = Expected remaining earning span in years L = The life span

The formula indicates that consumption is developed by taking current income y, plus the value of total future income (N − t) × ye, plus the value of current assets a, and dividing the sum of the three by the remaining life span in years. Put more simply

Current consumption = Current income + Projected future income + Current assets

Remaining life span

By dividing all our income and assets by the number of years we have remaining, we arrive at the maximum consumption we can afford. This model assumes that we know many variables, such as the date of death with certainty. The critical underlying assump- tion of the model—that consumption today is not related to current but projected future life cycle income—is illustrated in Example 4.A3.1.

Example 4.A3.1 Jamie, 35, worked as a medical resident for Techno Corporation. She made $45,000 a year but knew that she would make $90,000 a year in real terms starting next year and there- after as a full-fledged physician; she had $255,000 in assets accumulated today. Assume that Jamie knew she would work until age 65 and die at age 84 and that the discount rate was equal to the growth rate in future salary. Therefore, her salary can be considered flat over time. Assume that Jamie would not be eligible for Social Security benefits. What will her cost of living be?

c = y + 1N − t2 × ye + a

= 45,000 + 165 − 352 × 90,000 + 255,000

84 − 35 + 1

= 45,000 + 30 × 90,000 + 255,000 50

= 3,000,000 50

= $60,000 per year

Notice that her cost of living does not significantly depend on her current salary; it is related to her current assets and projected lifetime income. Jamie’s cost of living throughout her life- time must be adjusted to plan for 20 years of expected retirement with no income at retire- ment time other than the amount accumulated from prior investments.

108 Part Two Ongoing Household Planning

Divisions As you have seen, household operations consist of the generation of revenues, the payment for household expenses supporting revenues that include basic human needs, and the out- lays of time and money on pleasurable activities. We can call them divisions. The first one can be termed the production division. It produces the resources the household needs to sustain itself and includes the expenses that support it. The second can be termed the dis- tribution division. It spends resources on things that we enjoy doing. This setup is not unlike a business that has multiple divisions. Its use can provide information on the idea of the leisure dividend. Like a business, the household can declare a dividend. However, business operations stop with the payment of the divi- dends. The household’s activities are broader and include decision making on how to spend the dividend. The household enterprise uses business techniques in both production and distribution activities. Both need to be as efficient as possible in pursuing their objective. Money gen- erated from the production division not reserved for future use is paid to the distribution division in the form of a cash outflow, a dividend. The distribution division records this money as revenue available to spend. When the two divisions are consolidated, the produc- tion outflow and the distribution inflow drop out. On a total household basis, we are left with revenues less overhead costs from the production division and outflows on leisure activities from the distribution division. In common financial parlance, broadly speaking, overhead costs and leisure outlays are called nondiscretionary and discretionary expenses. We generally use that terminology throughout the book. However, we retain the idea of a dividend. It helps focus on the difference between the two types of expenses, one for a necessity and the other for a pleasurable activity. The leisure dividend is far different from a maintenance cost. That is why in this book we have generally called leisure an outlay instead of an expense.

109

Chapter Goals

This chapter will enable you to:

Laura had dropped in alone one afternoon seeking an explanation of financial statements. She felt a little lost during conversations about financial statements with their friends and was looking to become more aware about balance sheets, cash flow statements, and so on.

Real-Life Planning Todd and Julia were a young couple whose lifestyle was on a fast track. Todd was a lawyer with a nonprofit company and enjoyed his work for it. Julia was a writer whose novels were only modestly successful. They entertained lavishly and were known in their small town for the parties they had. Neither Todd nor Julia had large work-related incomes. Julia’s parents had both passed away at an early age and had left her a significant inheritance. When the advisor inter- viewed them, it became apparent that they had no idea about their finances. When asked about their yearly savings, they said they were strong savers but didn’t know the amount. Then they mentioned that they had a home equity loan and borrowed money and paid off debt all the time; sometimes they sold some of the securities from Julia’s inheritance to pay off some debt. They wanted to do even more entertaining and asked how much they could afford. The advisor decided to begin by constructing a balance sheet and cash flow statement. The balance sheet showed that they had assets that chiefly consisted of a house worth $400,000 and securities from the inheritance amounting to $250,000. They had no idea what the market value of these securities was. The advisor asked the amount of the original inheritance and found out it had been $450,000. The decline in investment assets despite a favorable stock market was surprising, and the advisor made a mental note to use it as a check against the results of the cash flow statement. However, nothing prepared him for the $410,000 combined mortgage and home

Five

Analysis

110 Ongoing Household Planning

equity loan on the house. Because the home was worth $400,000 in effect, the couple had no equity in it even though their original mortgage was for much less. The only reason the home equity line was extended for so much money was that Julia’s assets were pledged as collateral against the loan. The cash flow statement disclosed a large negative cash flow each year. The couple made up the negative cash outflow from operations through both additional borrowing and liquidating securities. The advisor showed them the balance sheet and cash flow statement. The balance sheet indicated what their assets, liabilities, and net worth were now as compared with two years ago. It confirmed that their assets had declined and their obligations were higher now. Julia mentioned that their net cash flow had been positive in recent years. She asked, “Why the concern?” The advisor explained that the only reason for the positive amounts was the combination of asset liquidation and increased borrowing. Their true operating figures a few lines up on the cash flow statement showed large deficits. If they continued the way they were going, they would run out of money before too long. Both Todd and Julia were visibly shaken. Todd mumbled that he had no idea things were so bad. The advisor wasn’t surprised. In his experience, many people were finan- cially unsophisticated and didn’t even know the purpose of a balance sheet and cash flow statement. He wondered what percentage balanced their checkbooks. The advisor spent some time educating them in basic finance, presented options, and recommended that they be placed on a budget. They said little and left. Three weeks later, all three sat down again. Todd and Julia said that their plans for future parties would be scaled down sharply. Todd was looking for a new position with a law firm that would pay considerably more money. Not so surprisingly, they wouldn’t adhere to a detailed budget but agreed to hard figures for debt reduction and cash savings. They called it their “financial diet.” They scheduled the next meeting, and the advisor noted they had their old enthusiasm back. When given some financial knowledge, in part through examining financial statements and keeping to a financial regimen, even a loosely structured one, positive things could happen.

OVERVIEW

Financial statement analysis is a key part of the planning process. Our objective often is to make a preliminary assessment of the financial health of the household early in the data- gathering process. With some experience, we may be able to obtain a rough indication of assets and liabilities accumulated. We should then draw up an accurate balance sheet as part of the planning process. The second financial statement we are usually interested in is the one that presents the household’s cash flow. Cash flow is at the heart of PFP. It is difficult for many to balance current living needs and preferences with savings. The cash flow statement tells you how you are doing today and sets the stage for any steps that need be taken to alter future activities. A projected cash flow statement can provide further structure and insight. This chapter shows you how to construct both statements and discusses related issues.

THE BALANCE SHEET

The balance sheet is a statement of financial position at a given point in time. When describing personal statements, it is often referred to as the statement of financial position. It consists of all your assets, your liabilities, and your net worth. The first assets listed are generally cur- rent assets. Current assets are those that are expected to be or can be converted into cash in

Financial Statements Analysis 111

the current year. They include checking accounts, money market funds, and refunds due such as those on catalog purchases. Marketable investments are those that are traded publicly— for example, stocks and bonds. Retirement investments that are not available for current use are treated separately. Real estate typically refers to the home; household assets—a vehicle, furniture, and appliances, for example—are those used in day-to-day household activities. Other assets are a miscellaneous category that can include such things as jewelry and art. The most prominent asset for the household is typically the future income stream of its wage earners, called human assets. Because they cannot be sold, however, human assets are not usually placed on balance sheets. Human-related assets is a broader term that includes other forms of resources in addition to human assets that are omitted from the bal- ance sheet. The term human-related is used because the value is derived from human-related work efforts or human relationships. Included are pension plans that pay out yearly income upon retirement such as Social Security or company pensions. Expected gifts and inheri- tances based on relationships are other examples. Liabilities are items the household owes. They are placed on the right-hand side of the bal- ance sheet. Credit card debts, taxes outstanding, and mortgage debt are all liabilities. They too can be separated into current and long term based on whether they are due within one year or beyond that period. The mortgage payment due within the year is expressed as a current liability. Household equity, another name for household net worth, is the difference be- tween its assets and liabilities. It is intended to show how much the household is worth at that point in time. Household equity can be relatively small or even negative when house- hold members are young and college debt and other obligations are high. Net worth gener- ally increases as the marketable investment portion rises. The process of generating net worth is shown in the simple Example 5.1.

Example 5.1 Tricia had a $20,000 savings account, owned a car valued at $12,000, and owed $9,000 that she had borrowed to help finance the car. Calculate her net worth and explain the process.

Assets $32,000 Liabilities (9,000) Net worth $23,000

Although Tricia has assets of $32,000, there are $9,000 of obligations against those assets. Consequently, her net worth, the equity she has built up over time, is $23,000.

The balance sheet has many formats. A common one is shown in Table 5.1. Example 5.2 uses that balance sheet.

Example 5.2 Shirley had $500 in cash, $12,500 in stocks, and $2,500 in bonds as well as a car worth $12,000. She had debt of $2,000 in credit card payments, an education loan of $8,000 with payments not due to begin for three years, and a mortgage loan of $144,000 with $5,000 due this year. She owned a home worth $175,000, furniture and fixtures of $3,000, appliances with a value of $4,000, and jewelry of $5,000. She expects to pay her mortgage and other obligations from current year’s earnings. Her balance sheet follows.

(continued)

Household Balance Sheet 12/31/15

Assets Liabilities

Current Assets Current Liabilities Cash $500 Credit card payment $2,000 Total Current Assets $500 Current portion mortgage loan $5,000 Total Current Liabilities $7,000

112 Ongoing Household Planning

A summary and explanation of balance sheet items appears in Table 5.2.

Marketable Investments Bonds and bond funds $2,500 Long-Term Liabilities Stocks and stock funds $12,500 Mortgage loan $139,000 Total Marketable Investments $15,000 Education loan $8,000 Total Long-Term Liabilities $147,000

Real Estate Home $175,000 Total Real Estate $175,000 Total Liabilities $154,000

Household Assets Autos $12,000 Furniture and fixtures $3,000 Appliances $4,000 Total Household Assets $19,000 EQUITY

Other Assets Jewelry $5,000 Household equity $60,500 Total Other Assets $5,000 Total Equity $60,500 Total Assets $214,500 Total Liabilities and Equity $214,500

Household Balance Sheet 12/31/15

Assets Liabilities

(Concluded)

TABLE 5.1 Household Balance Sheet 12/31/15

Assets Liabilities

Current Assets Current Liabilities Checking accounts Credit card debt Money market funds Other current debt Refund due on returned clothing Current portion

Total Current Assets Total Current Liabilities

Marketable Investments Long-Term Liabilities Bonds and bond funds Mortgage Stocks and stock funds Other long-term debt

Total Marketable Investments Total Long-Term Liabilities

Pension Assets Total Liabilities 401(k) plans IRAs

Total Pension Assets

Real Estate Home

Total Real Estate

Household Assets Vehicles Furniture and fixtures

Total Household Assets

Other Assets EQUITY Jewelry Stamp collection Household equity

Total Other Assets Total Equity

Total Assets Total Liabilities and Equity

Financial Statements Analysis 113

THE CASH FLOW STATEMENT

The cash flow statement is perhaps the single best measurement of the financial perfor- mance and therefore the health of a household. This is so because it represents how much cash has been generated over a period of time. When describing personal statements, it is sometimes referred to as the statement of cash flow. All household operations that re- quire financial resources are included. The word flow indicates that it measures results between two periods, say between the end of last year and the end of this year. The cash flow approach contrasts with that of the balance sheet, which provides figures as of a specific time—for example, as of the end of this year. The amount of water in a pond is constant at any point in time like a balance sheet, whereas a stream has water enter- ing and leaving like a cash flow statement with change measured by the strength of its flow from the beginning to the end of the period. The cash flow statement is fairly simple to understand and measure. Your cash gener- ated is the difference between the cash you started and ended the period with. As you might expect, it is determined by totaling the sources of cash—your cash inflows—and subtracting from it the uses of cash—your cash outflows. For example, revenues you re- ceive from your job are a source of cash whereas rent you have paid would result in an outflow of cash. Under our household finance approach, which entails running the household as a busi- ness, we can benefit from a detailed cash flow statement. We can call that document a functional cash flow statement. This functional statement separates cash flows by type of household activity into basically three types: operating, financing, and investment ac- tivities. Investments are separated into capital expenditures, which are shown separately, and financial investments, which are grouped last with remaining cash flows, which are our savings for the period. Use of a functional cash flow statement permits a clearer description of household re- sults for the period and an easier comparison with other periods. It is structured as a blend of the business income statement and its cash flow statements.

TABLE 5.2 Balance Sheet Items Explanation

Category Definition Examples

Assets

Current assets Those intended to be liquidated within the year. Checking accounts, tax refunds, merchandise refunds not yet received. Marketable investments Financial assets that can be turned into cash. Stocks, bonds, mutual funds. Retirement investments Financial assets in individual or company plans. Stocks, bonds, mutual funds. Real estate Property attached to land. Generally, the land and Home, investments in other property. property on it are given a combined valuation. Household assets Assets used in household operations. Car, furniture, household, appliances. Other assets A miscellaneous category. Jewelry, stamp collection, etc.

Liabilities Current liabilities Those expected to be paid within the current year. Those expected to be paid currently, taxes due, current portion of mortgage on house. Long-term liabilities Due beyond the current year. When there are few, they Mortgage, home equity loan, may be clustered together. long-term credit card debt, amounts owed to parents.

Equity Total equity Generally a one-line category representing net worth. Combined assets less combined liabilities.

114 Ongoing Household Planning

Example 5.3 To see the difference between traditional and functional cash flow statements, consider Caitlin, who funnels all of her financial transactions in and out of her checking account. Her salary goes in there; the same is true of any bonus, birthday or holiday gifts, refunds, insurance payouts, and so on. Caitlin pays all of her bills from this checking account by writing checks, arranging for autopay, or using her debit card. If she needs to draw on her savings, she’ll trans- fer an amount from her money market fund or her brokerage account to her checking account. She’ll withdraw pocket money from that checking account via an ATM. Thus, month-to-month or year-to-year activity in that checking account serves as Caitlin’s cash flow statement for that month or those 12 months. If she has $12,000 in the account on January 1 of one year and $16,000 in that account on January 1 of the next year, Caitlin’s traditional cash flow statement shows that she had $4,000 of positive cash flow. If the balance had fallen to $10,000, Caitlin would have had $2,000 of negative cash flow. Now, such a process is certainly simple and hassle free, but for financial planning, it leaves unknown a lot of desired information. Caitlin may think she’s doing fine with a $4,000 positive cash flow even while she’s drawing down her savings, just as we saw with Todd and Julia ear- lier in the Real-Life Planning section in this chapter. Caitlin’s financial picture would be clearer if she used a functional cash flow statement instead. She could still keep things simple, as described, but she also would keep track of cer- tain types of inflows and outflows. Those would be financing (increases or decreases in her debt levels) and investments (purchases of long-lived assets, home improvements, increases or decreases in her personal savings). Removing financing and investing activity from her net cash flow gives Caitlin her cash flow from operations, which is a good indicator of how well she is managing to bring in enough cash to support her lifestyle. Not so incidentally, the cash flow statement for a business is also separated by function. The major parts of this household functional cash flow statement—operating activities, capital expenditures, financing activities, and savings—are discussed more fully in the following sections.

OPERATING ACTIVITIES

Operating activities are the day-to-day financial functions of the household. This part of the household functional statement closely resembles a business income statement. The principal difference is that the household statement is recorded on a strict cash basis, while the business one includes noncash items. The operations segment can be segregated into cash inflows and outflows that we call income and expenses. Income consists of salary, investment returns, and other sources of operating cash. Expenses can be divided into nondiscretionary and discretionary items. Nondiscretionary expenses are the household’s overhead items such as interest expense,

Practical Comment Cash Flow and Debt

Financial Statements Analysis 115

rent, household, food, clothing, and taxes.1 These are largely fixed costs: We can’t alter them easily, particularly over short periods of time. Discretionary expenses are those you choose to make, principally because you get pleasure from them. Examples are entertain- ment, eating out, and vacation outlays. The difference between income and expenses is the cash flow from operations.

Capital Expenditures Capital expenditures are outlays on household-related matters that provide benefits be- yond the current year. They are a form of investment, as we will see in Chapter 8. Included are such items as cars, furniture, fixtures, and appliances. We want to display them sepa- rately because these cash outflows don’t occur regularly, so to include them with other costs could distort the operating figures. For example, a comparison of this year’s operating cash flow with last year’s would be clearer if it excluded a $20,000 payment to buy a car. The purchase of a car is a once in, say, five-year occurrence. By placing it in a separate section of the cash flow statement, we can more easily compare this year’s operating activities with last year’s. In addition to their positioning on the cash flow statement, the individual capital expenditures, particu- larly if they are large, also are placed as assets on the balance sheet.

Financing Activities Financing activities are responsible for the cash flows that come from changes in debt. Borrowing money has a favorable impact on cash flow because it increases the cash avail- able. Repaying debt has a negative effect on cash flow because it reduces cash resources. Additions to or subtractions from debt are reflected in the total debt outstanding, which is placed as liabilities on the balance sheet.2

Savings Savings is the cash left over after your operating, capital expenditure, and debt activities. It is also known, for financial statement purposes, as cash flow, representing prior cash inflows minus cash outflows. Investments that are not in the form of capital expenditures are treated as part of the savings section. Thus, savings placed into vehicles such as stocks is handled here.3

Savings can be outlaid for specific purposes such as retirement or a down payment on a home. The amount of cash available after such targeted investing is called net cash flow; it is the bottom line on the cash flow statement. It is the savings available for further investing or for spending in the next period. When the net cash flow figure is negative, it can be due to targeted investing. Alternatively, the figure may be positive only because of borrowing during the period. When there is a sig- nificant negative net cash flow figure before targeted investing or a positive one only because of borrowing, further analysis and possibly changes in household operations may be needed. Savings applied to investing, such as amounts for stocks and bonds, add to the amount shown under marketable securities in the balance sheet. Savings left in cash are included under cash at period-end on the balance sheet. Balance sheet cash at the end of the period less cash at the beginning of the period equals net cash flow on the cash flow statement for that time frame. A functional cash flow statement is provided in Table 5.3.

1 Taxes are sometimes shown as a separate category following nondiscretionary and discretionary expenses. 2 Capital expenditures are also a form of investment, but in people’s thinking and in practice, they are segregated from financial investments on the cash flow statement. 3 Keep in mind that interest on the debt is not placed in the finance section. It is a nondiscretionary over- head cost. It must be paid until the debt is retired. Interest expense is not included on the balance sheet.

116 Ongoing Household Planning

Traditional Household Cash Flow Statement In practice, many people currently use a cash flow statement that groups all inflows and out- flows together and makes few or no distinctions between flows based on operating, capital ex- penditures, and debt repayment. In that statement, pay down of debt and interest payments are lumped together and income tax payments are often placed at the bottom, just before the net cash flow figure. This approach, which we can call a traditional cash flow statement, ends up with the same net cash flow figure; its advantages are simplicity and custom. However, it is less useful as an analytical document for financial planners and individuals. This type of cash flow statement, using the same categories that appear in Table 5.3, is shown in Table 5.4.

TABLE 5.3 Functional Cash Flow Statement

2015 2016 2017 2018 2019

Operating Activities Income

Salary Business Investment Other Total Income Expenses Nondiscretionary Housing upkeep Health care Insurance Interest Alimony Food Clothing Transportation Personal Taxes Total Nondiscretionary Expenses Cash Flow before Discretionary Activities Discretionary Recreation/entertainment Personal Vacations Gifts and charitable contributions Hobbies Interest Other Total Discretionary Expenses Cash Flow from Operating Activities Capital Expenditures Discretionary Nondiscretionary Total Capital Expenditures Financing Activities Total repayments Additional debt Total Financing Activities CASH FLOW Targeted for retirement Targeted for other Net Cash Flow

Financial Statements Analysis 117

TABLE 5.4 Traditional Cash Flow Statement

2015 2016 2017 2018 2019

Income Salary Business Investment Other Total Income

Expenses Mortgages and property taxes Housing upkeep Food Clothing Health care Transportation Insurance Recreation and entertainment Vacations Hobbies Gifts and charitable contributions Contributions to pensions Net additional debt proceeds Capital expenditures Interest Other Taxes Total Expenses

CASH FLOW

Practical Comment Estimating Expenditures

In Table 5.5 you can see the differences between a functional cash flow statement and a traditional one; Example 5.3 follows as a practical example of the use of a functional statement.

118 Ongoing Household Planning

TABLE 5.5 Household Statement of Cash Flows

Traditional Functional Statement Statement

Calculates net cash flows properly Yes Yes Develops separate operational income statement No Yes Resembles business cash flow statement No Yes Segregates capital expenditures and financing activities No Yes Separates nondiscretionary and discretionary costs Sometimes Yes Handles revenues properly Yes Yes Is more simple Yes No Is more informative No Yes

Last Year This Year

Salary $120,000 $140,000 Investment income 4,000 3,000 Discretionary expenses 45,000 55,000 Nondiscretionary expenses 50,000 52,000 Capital expenditures 10,000 18,000 Debt—increase/decrease 8,000 (13,000) Retirement investments 12,000 14,000

SPENCER Functional Cash Flow Statement

Last Year This Year

Income Salary $120,000 $140,000 Investment income 4,000 3,000 Total Income $124,000 $143,000

Expenses Nondiscretionary $50,000 $52,000 Discretionary 45,000 55,000 Total Expenses $95,000 $107,000 Cash Flow from Operations $29,000 $36,000 Capital Expenditures ($10,000) ($18,000) Financing Activities $8,000 ($13,000) Cash Flow $27,000 $5,000 Retirement investments (12,000) (14,000) Net Cash Flow $15,000 ($9,000)

Example 5.4 Spencer had the following statistics for the past two years. Construct his functional cash flow statement and calculate his cash flow for the year.

As you can see, Spencer had a positive cash flow of $15,000 last year and a negative one of $9,000 this year. The $9,000 negative figure is somewhat misleading, however. The functional statement allowed us to see that cash flow from operations actually rose from $29,000 to $36,000 in the new year. The increase in capital expenditures and, most importantly, the de- crease in debt this year in contrast to the increase in borrowings last year led to the negative cash flow figure. As we discussed, the reduction in debt this year is actually favorable.

FINANCIAL STATEMENT PRESENTATION

Financial statements are intended to make the household’s financial circumstances as clear as possible. A number of situations call for either the separation of figures on the statement or, more frequently, footnotes to them. Some typical areas that require separate treatment, often in- volving taxation matters, are discussed below for the balance sheet and the cash flow statement.

Financial Statements Analysis 119

Balance Sheet Retirement Assets Retirement assets that are in pension accounts typically consist of marketable assets such as stocks and bonds.4 They should be listed separately for two reasons. First, unlike per- sonal ones, retirement assets often cannot be turned into cash immediately or at least not without penalty. For example, many firms impose limits on taking money from pension plans, and the government generally imposes a 10 percent penalty on qualified pension withdrawals prior to age 59½.5

The second reason is that normal withdrawals from pensions are taxable. It can be use- ful to know what pensions would be worth on an after-withdrawal, after-tax basis. Where such withdrawals are scheduled to be made over a relatively short period of years, it is helpful to footnote the potential impact of taxation.

Life Insurance Much life insurance has no current value or a low cash value relative to its face amount. If it has a significant cash value, it belongs on the balance sheet. The face value, the amount to be paid in the event of death during the period the policy is in effect, should be given in a footnote.

Taxation and Unrealized Appreciation Investment assets are expressed on the balance sheet at their current value. It is useful for a footnote to the balance sheet to give their cost individually or, if there are many assets, a total cost figure. In that way, the effect of taxation on the gain upon ultimate sale can be estimated.

Liquidation Cost When we expect the proceeds from a sale of assets to be materially lower than the value placed on the balance sheet, it is a good idea to footnote the amount of liquidation costs and net proceeds. For example, if a large amount was placed in an asset that had an 8 percent redemption fee and there was a reasonable chance for liquidation, the footnote could say “subject to an 8 percent redemption fee.”

Cash Flow Statement The footnotes on this document often provide additional information on special charges for the year. For example, the housing category could footnote a large $3,000 repair on a home. When the other category is used for all miscellaneous expenses, the footnote could explain the substantial components of that category year by year. For example, the other category on the statement could consist of $2,000 including a $1,000 loan that may never be repaid and another $1,000 for a settlement on a disputed billing.

PRO FORMA STATEMENTS

Pro forma statements are statements that include projections. The term is Latin for “as a matter of form.” Today, the use of pro forma refers to a presentation of data with some hypothetical numbers. A business eyeing an acquisition, for example, produces

4 Pensions from companies or the government that provide guaranteed income at retirement generally are not listed on the balance sheet. 5 Several exceptions to the 10 percent penalty on premature distributions exist, including distributions be- cause of permanent/total disability, payment for health insurance premiums while unemployed, purchase of a house (a penalty-free withdrawal of up to $10,000 for first-time home buyers), distributions made after a person over age 55 separates from service, receipt of money as part of substantially equal pay- ments for a person’s lifetime, distributions required as part of a qualified domestic relations court order (QDRO), and money withdrawn for educational purposes or for widows or others aged 59½ or more.

120 Ongoing Household Planning

6 Those that don’t occur in a steady yearly stream.

Practical Comment Concern about Projections

pro forma statements that indicate how the company might look and perform after the deal goes through. A household might not acquire another, but its members can anticipate future income and expenses. The two statements we have been concerned with in this chapter, the cash flow statement and the balance sheet, can include projected amounts. The previous tables that showed functional and traditional cash flow statements and provided for future year figures in addition to current year actuals were, therefore, in part, pro forma. A written household budget and a statement providing projected retirement or insurance needs are also examples of pro forma statements. We include projections in a statement to better anticipate needs, to forecast resources to meet those needs, and to adjust our plans accordingly. For example, projections of the need to renovate a home over a period of years at a cost of $50,000 can lead to focusing atten- tion on this in the household savings rate and living costs.

Pro Forma Cash Flow Statement There are two principal approaches to making projections for a cash flow statement: the common rate and the separately estimated rate or amount.

Common Rate The common rate is the rate of annual increase that many household expenses share. As financial planners know, that increase is often based on an assumed future inflation rate. In the absence of specific information to the contrary, this rate is employed for much of the anticipated revenue and the majority of projected increases in expenditures.

Separate Rate Certain inflows and outflows cannot be estimated by using a projected rise in inflation. Increases in salaries, particularly among younger workers, are projected using a separate rate. Investment income can be projected based on an assumed return. Insurance costs are based on contractual rates, and mortgage interest and principal payments also are stated in that contract. Lumpy outlays6 or capital expenditures may be preplanned at a set amount. On the other hand, certain child costs including those for college are established in current terms and may rise at a rate that differs from inflation. In Table 5.6 you can see a breakdown of common projections.

Financial Statements Analysis 121

Pro Forma Balance Sheet The balance sheet can be a more difficult statement to forecast than the one for cash flows. That is because some of its figures include the impact of cash flows and outflows on them. For example, the investment account includes not only the growth rate on existing assets but also the deposit of new savings. Liabilities include the impact of cash inflows to re- duce the amount outstanding or the absence of cash flow, which results in a higher debt figure. For this reason, projected balance sheets are used less frequently than those for cash statements.

TABLE 5.6 Projected Cash Flow Statement

Explanation for Projections

Operating Activities

Income Salary As separately estimated or rate of inflation Business As separately estimated or rate of inflation Investment Assumed rate of return Other Total Income

Expenses Nondiscretionary Housing upkeep Rate of inflation Health care Rate of inflation Insurance Per contract where fixed; otherwise, rate of inflation Interest Per debt outstanding Alimony As stated Food Rate of inflation Clothing Rate of inflation Transportation Rate of inflation Personal Rate of inflation Taxes Based on separate tax calculation Total Nondiscretionary Expenses Cash Flow before Discretionary Activities Discretionary Recreation/entertainment Rate of inflation Personal Rate of inflation Vacations Rate of inflation Gifts and charitable contributions Rate of inflation Hobbies Rate of inflation Interest At stated rate Other Rate of inflation Total Discretionary Expenses Cash Flow from Operating Activities Capital Expenditures Discretionary As separately estimated or rate of inflation Nondiscretionary As separately estimated or rate of inflation Total Capital Expenditures

Financing Activities Total repayments Per contract Additional debt As separately estimated Total Financing Activities

CASH FLOW Targeted for retirement As stated Net Cash Flow

122 Ongoing Household Planning

FINANCE VERSUS ACCOUNTING

Finance and accounting are different disciplines, which have alternative ways of present- ing transactions and results. Formal accounting employs GAAP, or generally accepted accounting principles. Most large businesses use GAAP accounting. Often the difference between finance and accounting lies in the importance placed on cash flows.

GAAP versus Household Accounting Businesses, which typically use generally accepted accounting principles (GAAP), and households have different ways of recording transactions. Household accounting is similar to a basic finance principle: Changes in cash generally determine results for a period. Business accounting is more sophisticated. Under GAAP, the business attempts a proper matching of revenues and expenses. Its goal is a fair presentation of business results for a period—say, within a year. Its results can involve cash and noncash items for a particular period. A simple example may be instructive (see Example 5.5).

Example 5.5 Under household accounting, when Dwight receives a $3,000 cash advance for a website de- sign project at year-end 2015, he would include that $3,000 in his household cash flow state- ment for 2015 even though he won’t actually earn the money until 2016. On the other hand, if BetterWebsitesRUs, Inc., receives a similar $3,000 advance from a customer, the company wouldn’t treat the money as income on its financial statements until the following year. The company would wait until it had expended the costs—say $2,500 in 2016—necessary to com- plete the transaction, thereby matching related revenues and outlays. By following GAAP procedures, the company’s results for 2015 wouldn’t look exceptionally good with $3,000 higher profits. Similarly, 2016 wouldn’t have lower profits from the costs of production without any revenues against it. The business accounting process would record a $500 profit ($3,000 revenues - $2,500 costs), matching revenues and expenses in 2016 when the transaction was completed. That reporting procedure is followed even though the cash was received in 2015, one year earlier. Most households don’t need to make the effort to follow GAAP principles in their record of cash flows. As a practical matter, though, Dwight might want to request the cash advance in January 2016 rather than in December 2015, to delay the receipt of taxable income to the next calendar year.

Household results for a period are provided on a cash flow statement, whereas business results are given on an income statement. For information on an income statement for busi- nesses, see Appendix I in this chapter. In sum, business accounting under GAAP attempts to report income and expenses, whether or not in cash, for a fair presentation. For house- hold reporting of the results for a period, only cash matters. Capital expenditures are outlays that have benefit for more than the current period. We’ve seen that households often combine them with other outflows on the traditional cash flow statement. Businesses capitalize them as assets on the balance sheet instead of expensing them on the income statement.7

Depreciation is the projected reduction in asset value due to wear and tear or obsolescence. It is a tax-deductible expense on the business income statement. Because the decline in asset value didn’t involve a cash transaction, it isn’t recorded on the household’s cash flow statement. Finally, GAAP generally requires that businesses record transactions on the balance sheet at original cost less accumulated depreciation. Households generally record assets at their fair market value. Consider Example 5.6.

7 The business would use accruals amounts due and amounts owed business accounts, which aid in the matching of revenues and costs.

Financial Statements Analysis 123

Example 5.6 Sally and Henry bought identical cars. Each paid $24,000 for their assets. Sally used the car for business purposes to travel to clients. Henry used it personally to transport his family. Sally took $7,200 of depreciation8 on the car in the first year. According to GAAP methods, the tax de- duction on $7,200 created a $2,400 tax benefit for Sally. Show the difference between Sally’s business and Henry’s personal treatment of the transaction assuming that the car had a fair market value of $26,000 at the end of the year.

8 Depreciation amount equals 30 percent of the car’s depreciable basis or purchase price.

Henry—Household Sally—Business Treatment Accounting Treatment

Income statement $7,200 pretax depreciation Generally there is no separate $2,400 tax benefit income statement. $4,800 deduction in net income Cash flow statement Noncash depreciation of $7,200 added to net $24,000 cash outflow placed income to obtain cash flow from operations. on statement.1

Capital expenditure section will reflect $24,000 outflow. Balance sheet Original cost $24,000 Recorded at $26,000 fair Less accumulated depreciation 7,200 market value.

Net amount on balance sheet $16,800

1 On regular statement grouped with other cash charges; in functional statement included under capital expenditures.

Recording Transactions In Table 5.7, you can see a summary of the differences between business and household meth- ods of recording transactions as well as the definitions of various financial statement items.

TABLE 5.7 Recording Transactions: Business versus Household

Item Explanation GAAP Business Finance

Balance sheet Assets and liabilities at Based on original cost Based on current fair a given point in time market value of assets Performance for period Cash flow statement giving A proper matching of Cash inflows and outflows operating performance revenues and costs for only in a cash flow state ment for the period the period in an without regard to income statement proper matching Revenues Sale transactions Recorded when fairly Recorded when cash is represents a transaction received Expenses paid Cost transactions Recorded as necessary Recorded when cash is for proper matching disbursed with revenues Profits Earnings for period A “fair” presentation of No exact equivalent; results for the period replaced by cash inflows minus cash outflows Capital expenditures Outlays providing Capitalized as asset on Recorded as outflow on extended-period benefits balance sheet, not as flow statement; recorded an expense on at fair market value on income statement balance sheet Depreciation Amount an asset has Recorded as an expense on Not recorded declined in value for income statement based on the period original cost; deducted from asset on balance sheet Asset value on balance sheet The assigned worth of an Recorded at original cost Recorded at fair market item at a point in time less depreciation value

124 Ongoing Household Planning

Back to Dan and Laura FINANCIAL STATEMENTS ANALYSIS Laura had dropped in alone one afternoon seeking an explanation of financial statements. She felt a little lost during conversations about financial statements with their friends and was looking to become more aware about balance sheets, cash flow statements, and so on.

Here’s what I told her: Laura, I’m glad you were forthright about your lack of knowledge of balance sheets and cash flow statements. The truth is that many people aren’t that familiar with them. Let me see if I can enlighten you in a brief time. As you’ve learned, financial planning is a process that sets goals. But goals cannot be set abstractly. Instead, they must be set in connection with resources. The balance sheet indicates the resources that are available. It is a statement of assets, liabilities, and house- hold equity at a point in time. Assets are items that have value to the household going forward. Assets are placed on the left-hand side of the balance sheet. They can be separated into current assets and long-term assets. Current assets are those that are likely to be consumed within the year whereas long-term assets extend beyond a one-year time frame. The balance sheet is separated into current assets, marketable investments, retirement in- vestments, real estate, household assets, and other assets such as household overhead and lei- sure time. The most prominent business asset for the household is typically the future income stream of its wage earners, called human assets.9 But because human capital can’t be sold, it isn’t usually placed on balance sheets. Other business assets could be a computer or business car. Marketable assets might include stocks and bonds. Retirement assets are, of course, seg- regated for use when you’re no longer earning a salary. Real estate is your home. Household assets might include a car, a refrigerator, a television, a VCR, a stereo, a boat, and so on. Liabilities are items the household owes. They are placed on the right-hand side of the balance sheet. Credit card debts, taxes payable, and mortgage debt are all liabilities. They too can be split into current and long term based on whether they are due within one year or beyond that period. Household equity is the difference between assets and liabilities. It is intended to show how much the household is worth at that point in time. Household equity can be relatively small or even negative when household members are young and generally increases as their marketable investment portion rises. Net working capital is a figure reached by subtracting current liabilities from current assets. It represents the cash that will become available over the next 12 months to pay li- abilities that will fall due over that period. Consequently, a strong balance sheet will have a positive net working capital.

Balance Sheet Your current financial condition as shown in the following statement is fairly positive. Your biggest strength is having $137,000 in marketable assets. On the negative side, you have $27,000 in current liabilities and only $3,000 in current cash. When your long-term liabili- ties of about $59,000 are added in, your net worth is a positive $88,000. In addition, both

9 For a discussion of human capital, see Theodore W. Schultz, “Capital Formation by Education,” Journal of Political Economy 68, no. 6 (December 1960): 571–83; Gary Becker, “Investment in Human Capital: A Theoretical Analysis,” Journal of Political Economy 70, no. 5 (October 1962): 9–49; Daron Acemoglu, “Human Capital Theory,” Bilkent, July 2013. econ.bilkent.edu.tr/wp-content/uploads/2013/08/Lecture- Bilkent-20131.pdf. Daron Acemoglu is Elizabeth and James Killian Professor of Economics at Massachusetts Institute of Technology.

Financial Statements Analysis 125

you and Dan have strong future income prospects that aren’t included as assets in the cur- rent statement. The only negative is a weak net working capital position if we exclude your money market funds under marketable investments as you like us to because you don’t want to dip into them. Excluding those assets, your current liability exceeds your current assets. The important thing to recognize is that your balance sheet is currently fairly strong. However, it doesn’t reflect your human assets, your future earning ability. With the proper care, these human assets will bring about an even stronger future financial position. The cash flow statement is sort of an income statement for the household. However, it is broader than a business income statement. It includes not only cash inflows such as job- related income and day-to-day expenses, but also capital expenditures—larger outlays for items that last for more than one year—and debt indicating whether borrowings have in- creased or declined for the year. A functional cash flow statement separates these catego- ries to make it simpler to analyze them. Once cash outflows have been deducted from cash inflows, you have the net cash flow for the year. That is the amount of cash that you’ve received or expended during the year. Under the finance disciplines approach, cash is often the focus and is most easy to identify. All you do is look at your cash at the beginning of the period and compare it with the end- of-period figure. The difference should be net cash flow for the year. I hope this is helpful. If there is anything you’d like to ask, contact me or we’ll talk about it at our coming cash flow planning meeting. At that time, I’ll show you your cash flow statement.

College Student Case Study and Review: Amy and John FINANCIAL STATEMENT ANALYSIS It was apparent that there was a dichotomy in knowledge of financial statements between John, who was a business major, and Amy, who was studying liberal arts. This topic was important in personal financial planning (PFP) analysis, so I decided to start with the basics.

Assets Liabilities

Current Assets Current Liabilities Checking accounts $2,800 Credit card debt $20,000 Refund due on returned clothing 200 Educational loan—current 7,000 Total Current Assets $3,000 Total Current Liabilities $27,000 Marketable Investments Long-Term Liabilities Money market funds* 34,000 Educational loan—LT portion 39,000 Stocks and stock funds 103,000 Loan from parents 20,000 Total Marketable Investments $137,000 Total Long-Term Liabilities $59,000 Pension Assets Total Liabilities $86,000 401(k) plans 6,000 IRAs 4,000 Total Pension Assets $10,000 Household Assets Autos 12,000 EQUITY Furniture and fixtures 7,000 Other 5,000 Household equity 88,000 Total Household Assets $24,000 Total Equity (Net Worth) $88,000 Total Assets $174,000 Total Liabilities and Equity $174,000

*Not considered part of the current assets because the amount won’t be used currently. Instead, it is set aside under marketable investments for long-term use.

126 Ongoing Household Planning

Only two financial statements for the household really count: the balance sheet and the cash flow statement. The balance sheet is a statement of assets and liabilities at a certain point in time. This statement shows household equity, which is also called household net worth. Except for the type of assets, it is similar to a business balance sheet. The cash flow statement reports the cash inflows and outflows for a particular period of time, often a year. In contrast to a business cash flow statement, it incorporates the income statement. Therefore, all inflows and outflows are included, arriving at a net cash flow. There are two methods of presenting the household cash flow statement: traditional and functional. The traditional household cash flow statement groups all cash flows together. A functional cash flow statement separates the flows into four basic activities as shown in the following table.

Functional Cash Flow Statement

Type Explanation

Operating activities Household’s day-to-day activities. Records of these activities is equivalent to the income statement of a business.

Income Cash inflows such as salary and investment income. Expenses Cash outflows separated into nondiscretionary and discretionary. Nondiscretionary Basic expenses for items such as food and housing maintenance. Discretionary Expenses chosen because they provide pleasure. Obviously, they vary

from person to person. Examples are vacations and entertainment. Cash flow from operating activities Difference between income and expenses. Capital expenditures Outlays for items that benefit the household beyond the current

year. Purchasing a car and installing a roof are two examples of capital expenditures.

Financing activities Cash inflows and outflows that come from changes in debt such as borrowing or repaying debt. Examples are taking out a mort- gage or paying off a credit card balance.

Savings Amount remaining after the three items just mentioned. Targeted savings is the amount put away for reasons such as retirement or down payment on a home. Savings is another name for cash flow after expenses are deducted from income.

Cash flow = Operating activities - Capital expenditures + Financing activities Net cash flow = Cash flow - Targeted savings

Note that borrowing money, which some people think of as a negative, actually adds to cash flow. The functional statement presents a clearer explanation of household results for the period and an easier comparison with other periods. A projected cash flow statement is used to reveal future financial needs or anticipate excess funds. The projections in such statements generally use an expected rate of inflation as the growth rate of future flows. In certain cases, however, items such as salary income are separately estimated in order to include a calculation for estimated tax obligations. Contractual terms can be used to project expenses, such as rent. It is important to recognize that finance in general and personal finance in particular use cash only as their benchmark for financial reporting. Unlike accounting, personal financial state- ments have no accruals, prepaid expenses, or depreciation as are found in generally accepted accounting principles (GAAP). For example, if you bought a car for $30,000 that you knew had a useful life of 10 years and at the end of the period would be junked and you then bought a new one for $40,000, GAAP could show depreciation of $3,000 for each of the 10 years you had the original car. Finance, conversely, would show an outflow of $30,000 at the beginning of the period and another outflow of $40,000 10 years later, when you buy the next car.

Financial Statements Analysis 127

As you can see, Amy, personal finance doesn’t try to match revenues and costs “prop- erly.” Instead, in PFP, reports of revenues and costs simply record the impact of cash flow items. In addition, the balance sheet for PFP is stated at fair market value whereas a busi- ness balance sheet shows original cost.

Summary Financial statements can provide an objective way to assess your financial condition.

indicates how well it is operating, but its coverage is broader than an income statement for a business.

net cash flow figures.

and expenses even when cash isn’t received or paid. In forming a balance sheet, finance uses fair market value; accounting uses original cost.

Key Terms assets, 124 balance sheet, 110 capital expenditures, 115 cash flow, 115 cash flow statement, 113 current assets, 110 depreciation, 122 financing activities, 115 functional cash flow statement, 113

household assets, 111 household equity, 111 household net worth, 111 human assets, 111 human-related assets, 111 liabilities, 111 long-term assets, 124 marketable investments, 111 net cash flow, 115 net working capital, 124

operating activities, 114 pro forma statements, 119 savings, 115 statement of cash flow, 113 statement of financial position, 110 traditional cash flow statement, 116

studyfinance.com/lessons/finstmt StudyFinance.com This site provides an introduction to financial statements and financial statement concepts.

sba.gov/ombudsman/7046 U.S. Small Business Administration This site offers information on the basics of financial statements. You can learn to un- derstand and prepare the different parts of a balance sheet and an income statement.

hoovers.com Hoovers Online This site provides an online database for company information including financial statements and stock performance.

sec.gov/edgar.shtml SEC’s EDGAR This is the link to the Security and Exchange Commission’s EDGAR (electronic data gathering, analysis, and retrieval system) database where SEC filings on a company’s fi- nancial performance and other operating information such as 10-Ks and 10-Qs are posted.

Websites

128 Ongoing Household Planning

1. What is a balance sheet, and why is it important? 2. Why segregate a balance sheet by type of asset and type of liability? 3. What is a cash flow statement, and why is it important? 4. Detail the sections of a functional cash flow statement. 5. Contrast a functional and a traditional cash flow statement. 6. Is an increase in debt a plus or minus from a cash flow standpoint? Explain. 7. What is a pro forma statement? What is its use? 8. Outline some expenses of a pro forma statement that cannot use inflation to project

their growth and indicate what rate should be used. 9. Contrast the views of finance and accounting on recording operating results. 10. In your opinion, which presents results more fairly, finance or accounting? Explain. 11. What are reasons that a person may have a poor net cash flow yet be considered to be

in good financial health? 12. What is the major difference between household accounting and business accounting? 13. Elaborate on the two approaches to making projections for a cash flow statement. 14. What is household equity, and how do you calculate it?

Questions

A client provides a current balance sheet to the financial planner during the initial data- gathering phase of the financial planning process. This financial statement will enable the financial planner to gain an understanding of all of the following except

a. Diversification of the client’s assets. b. Size of the client’s net cash flow. c. Client’s liquidity position. d. Client’s use of debt.

A cash-basis taxpayer includes income from a service business when

a. The services are performed. b. The client is invoiced for the services. c. The client’s check is deposited in the bank. d. The client’s check is received.

The estimated value of a real estate asset in a financial statement prepared by a Certified Financial Planner licensee should be based upon the

a. Basis of the asset, after taking into account all straight-line and accelerated depreciation. b. Client’s estimate of current value. c. Current replacement value of the asset. d. Value that a well-informed buyer is willing to accept from a well-informed seller where

neither is compelled to buy or sell. e. Current insured value.

5.1

5.2

5.3

CFP® Certification Examination Questions and Problems

Financial Statements Analysis 129

Case Application FINANCIAL STATEMENTS ANALYSIS The Balance Sheet Richard called and said that he had compiled a list of assets and would send it. It came a few days later. His assets included a home worth $300,000, approximately $350,000 in securities, two cars worth $40,000 with loans of $15,000 against them, and other assets including jewelry (worth $5,000), art ($5,000), and furniture ($7,000). Richard and his wife had money market funds of $2,000, a bonus due of $5,000 net of taxes, and credit card payments due of $12,000. Their house had a $130,000 mortgage.

Case Application Questions 1. Construct the balance sheet. 2. Does it look substantial? 3. Would you tell Richard and Monica that it was strong? Why? 4. Complete the balance sheet section of the plan.

Income Statement An income statement reports on profits for a fixed period of time. A publicly held business often identifies net income for a quarterly or yearly period. The household statement of profitability can be said to be shown following the cash flow statement, particularly under the functional cash flow statement. As discussed in this chapter, business reporting under GAAP is more complex, which necessitates a separate income statement. An income statement can take many forms depending on the industry or reason for its compilation, but it often can be separated into the following parts:

Parts of Income Statement Explanation

Sales Provides all the inflows that give the company its inflows from direct operating activities for the period. Often called “Revenues,” which are transactions for goods and services sold to customers.

Cost of Goods Sold These are outlays that are directly related to the goods and services sold to customers. For example, a beverage company would include such items as the glass or aluminum container and the cost of the beverage ingredients.

Gross Profit This is the sales less the cost of goods sold. It indicates how much profit has been generated before other necessary costs are deducted.

Selling, General, and These are the costs that are outlaid to help support operations. They include such items as sales or Administrative Expenses marketing expenses, salaries, rent, and research and development costs. Other Expenses This category includes interest expense and miscellaneous expenses such as nonrecurring write-offs. Pre-Tax Income Profits for the period before taxes. Tax Tax expense to be paid to the government based on profits. Net Income The benchmark for determining profits for the period. It is revenues less all expenses.

Notice that outlays for capital expenditures and inflows or outflows for debt borrowings or repayments aren’t included. These are included in a separate cash flow statement along with one figure from the income statement: net income.

130

Chapter Goals

This chapter will enable you to:

Dan and Laura had a problem. They were operating on two tracks: Dan was saving money and at the same time Laura was spending it. The net impact on the household was unfavor- able. Something would have to be done fairly quickly.

Real-Life Planning The advisor was asked by clients of his to see their daughter and her husband. The clients were conservative people who pronounced themselves “depression babies,” which meant they grew up in a poor economic climate in the 1930s when a dollar really had to be stretched. They felt their daughter’s family was irresponsible, that they were spending money on things they couldn’t afford and not saving a penny. Would he see them? The parents would pay for the visit. Eileen and her husband Phil were a young couple with two children. She was a teacher, he a social worker. They lived on relatively modest incomes and had high special costs for their children. When the advisor met with them, they appeared to be vaguely depressed, perhaps because they knew why Eileen’s parents had suggested the visit. Their living costs did not seem extravagant to the advisor, and the “splurging on a vacation” mentioned by her parents turned out to be a $1,000 trip to a local resort town, all costs, even children- related outlays, included. The advisor thought to himself this wasn’t the first time there was a difference in finan- cial approach between parent and child. People of the parents’ generation often saved automatically because of their fear of the unknown, while the children’s generation was often more optimistic about the future and needed a reason for saving. In addition, if Eileen stayed at her current job, she would receive a government pension, which would help cover retirement needs. The advisor asked them whether they would like to have their own home instead of the inexpensive apartment they lived in. They said very much but that it wasn’t possible given their current finances. They said they were stuck in their current small apartment. The advisor thought they weren’t only stuck in an apartment, they seemed stuck in a rut.

Chapter Six

Chapter Six Cash Flow Planning 131

The advisor asked if he could make it feasible, they would like to own a home now. For the first time their faces brightened and they looked at each other and said yes. He explained how it could involve some sacrifices and that they would all work together to identify them. The couple mentioned they had no savings at all. The advisor mentioned that he would speak to Eileen’s parents about helping fund a down payment and made a mental note to assure the parents that they could afford it. The advisor looked over at Phil, who then volunteered to ask his parents. Both sets of parents agreed to help. The advisor and the couple worked on some areas of spending that could be cut back mod- estly. Phil mentioned that he could offer therapy sessions in the basement of a home if it had a separate entrance. A cash flow statement with its current breakeven payment was con- structed and a pro forma one for a budget with higher income; higher after-tax housing-related costs, particularly mortgage costs; and lower other expenses was drawn up. The figures fit. With some direction by the advisor on affordability and the bidding process, Eileen and Phil selected a house. Although local housing prices had recovered somewhat from the plunge during the financial crisis, the market was still reasonably priced; so, the young couple were able to find a desirable place they could afford. Their new home turned out to be close to Eileen’s parents’ home, a great advantage to all of them. The next time the ad- visor saw Eileen and Phil, they talked about how grateful they were. The advisor smiled and thought to himself that the ability to positively affect people’s lives is what makes financial planning so worthwhile. It wasn’t the compensation, which was modest. To the couple, the advisor was almost a magician, producing a home where none seemed possible. To the advisor, he had set people on a new course; they now had both a new investment and a higher quality of life. He wished cash flow planning for household goals was as simple for all his other clients.

OVERVIEW

The heart of personal financial planning is cash flow, which is literally the amount of cash generated from household activities. It includes those items, such as our jobs, that produce cash flows and those items that utilize them, such as our living costs. The reason cash flow planning is often the first part of financial planning to be analyzed is simple. Cash flow underlies all major household decisions. Thus cash flow has the same status that food has for the individual or energy has for business. Cash flow is the lifeblood of household activities. A good supply of cash flow enables us to operate and plan for the future. A poor supply of cash flow provides us few or no choices: We are constantly trying to catch up with our obligations. Often a weak cash flow arises from poor planning and control of expenditures. All parts of a financial plan must incorporate cash flow considerations. After all, financial planning deals with how we allocate limited resources. Whether we are deciding how much to spend on finishing the basement or the amount to put away for retirement, cash is involved. In this chapter, we concentrate on one segment of the financial plan: current operating needs. We briefly discuss lifestyles and provide reasons for saving and using sound bud- geting techniques. Cash flow planning is a matter of projecting the sources of cash and the household uses of it, thereby determining available cash flow for both identifying savings needs and generating free cash flow. When targeted savings have been planned properly, free cash flow can be used for additional spending today, invested for future spending, or put aside to reduce household risk. This chapter discusses purchasing power, emergency funds, liquidity, and marketability as parts of the planning system. It next provides a step-by-step description of the budgeting

132 Ongoing Household Planning

process. The chapter also discusses financial ratios, which provide an objective way of helping determine financial health. The chapter’s planning objective, then, consists of three parts: recognizing the impor- tance of cash flow to achieving goals, learning how to identify savings problems, and establishing what can be done in practical terms for personal financial planning (PFP).

CASH FLOW PLANNING AND CURRENT STANDARD OF LIVING

Cash flow planning refers to the scheduling of current and future cash needs to achieve household goals. Cash flow planning can include such objectives as supporting a current lifestyle, paying off credit card debt, and saving for a vacation. More sophisticated and long-term goals that can be achieved through cash flow planning include reducing tax lia- bilities and planning for retirement. When we discuss cash flow planning, we are interested in what we do with our money. Lifestyles vary significantly. Some people live simply; the identities and goals of others involve spending on visible signs of achievement and status. In very basic terms, we have a choice between spending and saving. To spend is to add to our standard of living today. To save is to provide for future needs. Establishing how people differ in the way they spend their money is generally not of con- cern to advisors; people typically have no difficulty in spending. However, many people have difficulties in generating the amount of savings they need despite a host of good rea- sons for doing so. Example 6.1 discusses lifestyles and spending and savings strategies. It is followed by a fuller exploration of savings, often the focus of households and advisors alike.

Example 6.1 The Smiths and the Joneses were two couples who lived on different sides of town. The Smiths lived in a big house financed mostly through debt and had many obligations connected to it. The Joneses lived more modestly than the Smiths. The Smiths never seemed to have enough money, and one day Mr. Smith had to ask his firm for an advance because he didn’t have enough money to make the mortgage payments on the luxury house he bought at the peak of the real estate boom. Mr. Jones, who made less money, let his cash flow dictate his spending policies, including his home purchase. He always had a number of spending alternatives be- cause he always generated a positive cash flow.

Reasons for Savings In reality, there are a number of reasons for savings. We start with the classical, pure life cycle motive:1

1. Pure life cycle motive. To provide monies to even out differences in earnings over time. A key motivation is to build up resources for retirement when work-related earn- ings are no longer available.

2. Investment motive. To take advantage of investment opportunities that can make achieving financial goals easier.

3. Down payment motive. To provide funds for the down payment or full purchase of longer-lived assets such as durable goods or educational expenditures.

1 Adapted from Martin Browning and Annamaria Lusardi, “Household Savings: Micro Theories and Micro Facts,” Journal of Economic Literature 34, no. 4 (1996), 1797–855, which, in turn, was adapted from J. Maynard Keynes, The General Theory of Employment, Interest and Money (London: MacMillan, 1936). See also Patricia J. Fisher, “Saving behavior of U.S. households: a prospect theory approach” (doctoral dissertation, Ohio State University, 2006), etd.ohiolink.edu/ap:0:0:APPLICATION_PROCESS=DOWNLOAD_ ETD_SUB_DOC_ACCNUM:::F1501_ID:osu1155590726,inline.

Chapter Six Cash Flow Planning 133

4. Precautionary motive. To provide a fund to cover future uncertainties such as fluctuat- ing income, sickness, inflationary effects on expenditures, and so forth.

5. Improvement motive. To sacrifice today so that your future lifestyle can improve. 6. Independence motive. To accumulate sufficient wealth to be able to be financially in-

dependent after working until reaching a certain age. You may not want to retire but to derive pleasure from a sense of independence, power, and prestige.

7. Bequest motive. To accommodate funds to provide for nonhousehold members whether they are children, other relatives, friends, or charities.

8. Hoarding motive. To accumulate investments with no intention of converting them into purchases in the future. In effect, pleasure comes from the accumulating the money itself or the power and cachet that having it brings.

People don’t usually calculate the amount of money they need to save and then do it. Instead, many need assistance. Next we describe several ways to help people save by im- proving budgeting practice.

FORMAL AND INFORMAL BUDGETING

Budgeting is a method of planning current and future household cash flows to determine needs and adhere to desirable allocations of resources. There are two types of budgeting techniques: formal and informal. Informal budgeting involves less detailed planning, sometimes just simply thinking about household planning such as a down payment on a car. The majority of budgeting planning is done this way. In general, many people dislike formal budgeting, which in- volves enumerating specific household figures in detail. They find it time consuming and do it only when highly motivated. Formal budgeting reflects all categories of household expenditures; usually in the form of a document, it is said to be a household budget. This budget is a type of pro forma cash flow statement with a purpose. (For an example of a formal budget, see the projected cash flow statement for Dan and Laura on page 144.) Because little can be done about fixed expenses, budgeting tends to focus on discretionary items. By thinking about and writing down the amount planned for each category, house- holds have several goals. Some of them include prioritizing outlays based on household preferences and needs, reducing or eliminating impulsive purchases that may be regret- ted later, not being caught short of cash funds, and saving enough money for future needs and contingencies. In theory, saving is a mechanical process. People decide how much savings they require to fulfill their objectives and then they mechanically implement the plan. In reality, human

Steady savings has an underappreciated advantage. Stocks fluctuate over time. Dollar cost averaging sig- nifies buying portions of intended investment amounts over time or as new savings become avail- able, thereby obtaining a price that averages out its highs and lows. To investors, it can prevent worrying

so much about purchasing at a time just before an initial or a further drop in the market. To advisors, it can help overcome a tendency for their clients to stay out of investments for a period of time, and some advisors believe for the wrong period of time when the market has already declined.

Practical Comment Steady Savings

134 Ongoing Household Planning

SIMPLE STRUCTURAL APPROACH

PROVIDE MOTIVATION: “THE BUCKETS APPROACH”

ELIMINATE OPTION TO SPEND -

REDUCE TEMPTATION

MINIMIZE DISCOMFORT

OTHER REASONS FOR NOT SAVING

Practical Comment How to Increase Savings

behavior intervenes. We know that many people have trouble saving money. That can be true even in higher-income households that some would say have the resources to save comfortably. Detailed written budgets are often a means of establishing financial structure for those who need it. These budgets may be drawn up in response to special circumstances such as planning for a specific large outlay, material debts, or a general inability to save.

Chapter Six Cash Flow Planning 135

The budget, then, can become a detailed framework for the future. Projected figures are compared with actual ones once the time period being measured has been completed. When there are notable differences, the reasons for them are analyzed and subsequent bud- get figures may be adjusted or spending patterns altered to bring actual performance in line with projections. Consider the case of Dorothy in Example 6.2.

Example 6.2 Dorothy had a problem. She planned to save some money each month. At the end of each month, however, she found herself a few hundred dollars further in credit card debt. She set up a rough budget for the year. As you can see, at the end of the year, the actual figures were different:

Difference (Actual – Budgeted Actual Budgeted)

Salary $66,000 $66,000 $0 Nondiscretionary expenses (43,000) 43,000 0 Discretionary expenses (15,000) (25,000) (10,000) Debt repayment (3,000) 2,000 5,000 Retirement savings 5,000 0 (5,000) Net cash flow $0 $0 $0

Dorothy looked at the difference between budgeted and actual figures. Her discretionary expenses were well above the budget amount. As a consequence, she was not able to save any money and, in fact, went further into debt. She decided to set up an item-by-item household budget. She made what she thought were realistic projections. Her cash flow statement pro- vided for both savings and repayment of debt. She vowed that she would not spend a single new dollar in the new month unless the prior month’s actual cash flow met expectations. There are a number of items that need to be considered when establishing pro forma bud- geting operations in general or a detailed household budget.

Purchasing Power Purchasing power is the amount of goods and services a fixed sum of money can buy. Because of inflation, a single dollar is expected to buy fewer and fewer goods the longer the time period before purchase.2 In making projections of salaries and household costs, inflation must be taken into account.

Emergency Fund In making cash flow projections, it is important to have liquid assets. We want the ability to turn assets into cash quickly without a high transaction cost or loss of principal. Cash flow

with purchasing power risk,

Practical Comment Conservative Projections of Income

2 Of course, if our country were to undergo deflation—that is, a continuing decline in the rate of overall prices—the opposite would be true.

136 Ongoing Household Planning

projections are subject to the risk of unexpected circumstances; we may need unplanned-for cash quickly. Often such cash comes from a liquid emergency fund set up specifically for that purpose. There are many reasons why we may need to use an emergency fund. For example, we may unexpectedly be laid off in our jobs or receive a lower-than-anticipated bonus. Alternatively, our costs may rise due to health or extensive repairs to the house or car. The amount that you place in an emergency fund depends on the degree of risk you face and the availability of your borrowing alternatives. Risk would be higher for a one-wage- earner household when the person works in the fickle entertainment industry than when two people work in more stable industries. Other considerations in a decision on the size of an emergency fund include projections of future free cash flow to be generated; the amount of debt outstanding; and the availability of other assets such as stocks and bonds to be tapped under emergency circumstances.

Liquidity Substitutes Businesses often prefer to keep as little in liquid assets as possible consistent with their risk requirements. In that way, they can put their monies into higher-earning assets in their business. We saw that households likewise often desire to place their funds into higher- earning assets, or they can choose to spend a higher sum today. As an alternative, house- holds have liquidity substitutes, which provide another way of raising cash, often in connection with unplanned-for developments. Two types of liquidity substitutes are debt and marketable securities. The access to and use of debt is growing in the United States. Cash needed for short-term, small emergencies can be accessed through credit card debt whereas large cash resources needed for extended periods of time can be generated through bank debt— particularly home equity loans, when applicable. (However, many home equity credit lines were frozen or abolished in the wake of the 2008–2009 financial crisis, so they may not be a certain source of liquidity.) We examine the advantages and disadvantages of using such debt in Chapter 7. Marketable securities are publicly traded financial assets for which a current market value can be determined. Examples include stocks, bonds, and mutual funds. Marketable securities are typically easy to sell in order to raise cash, but they don’t qualify as fully liquid because the household might incur a loss on a sale.

- -

Practical Comment Size of Emergency Funds

Chapter Six Cash Flow Planning 137

STEPS IN HOUSEHOLD BUDGET

With these separate issues that affect budgeting out of the way, the household budget can be constructed by following the steps.

Establish Budgeting Goals People may have a variety of goals in establishing a budget. These include targeting sav- ings for a particular expenditure such as a new home entertainment system, vehicle, or vacation. On the other hand, savings may be needed for larger investment purposes, such as the down payment on a home or retirement. However, often a budget is established be- cause the household is in a negative cash flow situation and debt is accumulating. The goal then is to reverse the cash drain and repay the debt. Whatever the immediate goal, the objective of the budget is to ensure that the household generates enough cash to meet its operating needs and over time to provide resources for emergency funds if current assets are insufficient. Finally, by providing hard numbers to household members, the budget can help to reduce inefficient spending.

Decide on the Budgeting Period Budgets can be made weekly, bimonthly, monthly, or annually. The period can follow the natural income and spending cycle, which can be linked to how often a paycheck is paid and when bills are paid. Many people pay bills on a monthly basis. For review purposes, this period of time represents a balance between too frequent and too little examination of actual versus intended results.

Calculate Cash Inflows Cash inflows for budgetary purposes for working people are typically the amounts re- ceived from paychecks. Monies received from investments and nonrecurring sources should be displayed in a separate section or otherwise noted. The segregation of sources of cash is significant because, for active workers, the measure of savings for the period is often based on job-related inflows only. The cash from investments is for a separate pur- pose, and including nonrecurring inflows can distort the figures. To simplify matters, after-tax inflows received from paychecks often are used. Of course, when a person in the household retires, investment principal and income payments should be incorporated as a primary source of revenues. Care should be taken to include anticipated raises in salary and increases in any Social Security payments.

Project Cash Outflows Outflows should be separated into nondiscretionary and discretionary items. Key catego- ries should be separately stated. (See Chapter 5.) To have accurate projected amounts, economic status from the checkbook or software should be used as a guide for past figures whenever possible. When that is not possible, a significant miscellaneous category should be used for projections for unanticipated expenses, including those for unforeseen circumstances. A typical breakdown of expenses is provided in Table 6.1.

Compute Net Cash Flow Net cash flow is simply projected cash inflows minus projected cash outflows. If invest- ment income and nonrecurring items have not been separated, adjustments should be made to get a fairer comparison. The resultant figure should be net cash flow after adjustments, the amount that truly represents a household’s cash generated during the period.

138 Ongoing Household Planning

Compare Net Cash Flow with Goals and Adjust At this point, projected cash flow figures should be compared with goals. When the figures show a shortfall, the household must determine how to eliminate it. Basically, there are three ways to do this: find additional income, for example, by working overtime; cut back costs, which is the most common way; or change goals. Alteration in goals—say, by post- poning savings—can, of course, undercut the reason for establishing the goal.

Review Results for Reasonableness and Finalize the Budget This step assesses the reasonableness of projections. Do they seem realistic? Do they take into account inevitable nonrecurring expenses? The outcome may be an adjustment in projections and, in some instances, more cutbacks in expenses. At this point, the budget can be finalized.

Compare Budgeted with Actual Figures Comparing actual with projected results is an important part of the budgeting process. Results seldom come out exactly as projected. When there are differences, the reasons must be ascertained. Four common reasons for differences are impulse purchases, income that differs from projections, unusual occurrences, and gifts. The insights developed as a result of this step should be incorporated in future projections. For example, a figure for nonessential purchases may be added to future expenditures.

FINANCIAL RATIOS

Using financial ratios is a way to gauge the current state of the household’s assets and operating activities. Frequently, figures from both the balance sheet and cash flow state- ment are used to develop the ratios. Comparisons are made with absolute standards of good performance and with relative results for that particular household over time.

Example 6.3 Len wanted to know whether he was saving enough money. He calculated his current savings as a percentage of total income and found that it was 6 percent. His financial planner had said that for someone Len’s age and with his goals, 10 percent seemed appropriate. Len then cal- culated his savings rates over the past two years and found they were 3 percent and 5 percent. Although Len was pleased that his savings rate was rising over time, he decided to redouble his savings efforts to reach the 10 percent standard.

TABLE 6.1 Average Annual Household Expenditures

Source: Adapted from Bureau of Labor Statistics, Consumer Expenditures 2013, http://www. bls.gov/cex/csxann13.pdf

Complete Reporting of Income

Total Complete Lowest Middle Highest Item Reporting 20 Percent 20 Percent 20 Percent

Average annual expenditures 100% 100% 100% 100% Food and beverages 14 17 14 12 Housing 34 40 35 31 Apparel and services 3 3 3 3 Transportation 18 15 19 17 Healthcare 7 8 8 6 Entertainment 5 4 5 5 Personal insurance and pensions 11 2 8 16 Other* 9 10 8 10

* Other includes personal care products and services, reading, education, tobacco products and smoking supplies, miscellaneous and cash contributions.

Chapter Six Cash Flow Planning 139

Now we take a closer look at selected liquidity ratios and operating ratios. (For exam- ples, see the ratios provided to Dan and Laura on page 181.) In Chapter 7 we describe ratios that have to do with liabilities.

Liquidity Ratios Liquidity, as we have said, is the amount of cash and the ability to turn assets into cash with relative ease and without loss of principal. We next consider two ratios: the current ratio and the emergency fund ratio.

Current Ratio The word current generally refers to actions to be taken in the present year. It is here that day-to-day assets and liability transactions reside.

Current ratio = Current assets Current liabilities

The current ratio measures your present resources available to pay current debts. This ratio should exceed 1.0×, which means that current assets are higher than current liabilities. Having a lower ratio could represent an inability to pay debts when due. The ability to bor- row money through credit card purchases and to delay payment on existing card debt has somewhat reduced the concern of running out of cash to pay current liabilities.

Emergency Fund Ratios The emergency fund ratio measures how many months of living expenses can be supported by available liquid assets such as money market funds and savings accounts.

Emergency fund ratio = Liquid assets

Total monthly household expense

Total emergency household expenses include all expected cash outflows, both nondiscre- tionary and discretionary outlays. Often a ratio of at least 3.0 × is called for, signifying that three months of cash or perhaps other somewhat liquid, less volatile securities are available. But, as we discussed, there is no hard-and-fast rule as to amount. The higher the uncertainty for income and expenses, the higher is the ratio.3

Operating Ratios Operating ratios measure the overall costs of the household and its components as a percent of total income. We are interested in how these percentages change over time.

Current ratio = Current assets Current liabilities

Nondiscretionary Cost Percentage The nondiscretionary cost percentage provides the proportion of day-to-day overhead costs to total revenues. When this percentage changes significantly from year to year, we would

3 When a decline in income of extended duration is a significant possibility, marketable securities such as stocks and bonds could be included in the numerator along with liquid assets. Households with expected declines in real income were more likely to have adequate emergency fund reserves. Also, financial planners on average recommended three months of living expenses be saved. See Y. Regina Chang, Sherman Hanna, and Jessie X. Fan, “Emergency Fund Levels: Is Household Behavior Rational?” Financial Counseling and Planning Journal 8, no. 1 (July 1997): 47–55; Janine Scott, Duncan Williams, John Gilliam, and Jacob P. Sybrowsky. “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” Journal of Financial Planning 26, no. 9 (2013): 56–62.

140 Ongoing Household Planning

look at the individual components of nondiscretionary costs to find the reason. Our goal should be to reduce the nondiscretionary percentage over time, which can represent a mea- sure of efficiency in household activities.4

For example, telephone (including smartphone) expenses may be considered nondiscre- tionary because household members need to communicate for career and social purposes. These outlays might fall into a utilities category in a budget, such as Dan and Laura’s. Finding a better phone plan can cut the costs, absolutely and as a percentage of total out- lays. The lower the percentage, the higher is the amount available for discretionary costs and savings and investment.

Nondiscretionary cost percentage = Total nondiscretionary costs

Total income

Discretionary Cost Percentage Discretionary costs represent the benefits of household efforts. Assuming appropriate savings for the future, the lower the percentage of household fixed costs and the higher the percentage of optional expenses, the higher are the household’s satisfaction and standard of living.

Discretionary cost percentage = Total discretionary costs

Total income

Total Operating Percentage

Total operating percentage = Total nondiscretionary costs + Total discretionary costs

Total income

The total operating cost percentage5 provides an overall measure of day-to-day household expenses. The percentage indicates how much of household revenues are being spent to- day on nondiscretionary and discretionary costs. It can serve as a control on expenses and as a guide to the amount available for capital expenditures and savings; the lower the per- centage, the higher is the amount available for these items.6

Payout Ratio When applied to households, the payout ratio views discretionary outlays as a kind of dividend. As with a business, the household must decide how much of available cash flow to pay out today for enjoyable activities and how much to save.

payout Discretionary

percentage =

Discretionary expenses + Discretionary capital expenditures Cash flow before discretionary expenses

Cash flows before discretionary expenses indicate the amount of money available about which household members have choices. The discretionary payout percentage combines dis- cretionary expenses and capital expenditures for leisure items such as a television. It mea- sures the percentage of available cash flow that is actually expended on all leisure outlays.

4 Unless the increased overhead costs come from a pleasure-producing commitment such as interest on debt used to finance a vacation home. 5 The formulas exclude capital expenditures. To include them could distort year-to-year comparisons. In multiyear groupings of cash flow statements, however, these capital items should be included. A case could be made for incorporating an imputed expense based on the rental value during the year or per- haps including the depreciation in the value of the capital expenditures each year in the expense ratio based on the useful life of the asset, but that would be closer to an accounting or economic as opposed to a finance approach. 6 As well as for paydown of debt.

Chapter Six Cash Flow Planning 141

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Cash Flow Planning

©Don Hammond/Design Pics, Inc.

142 Ongoing Household Planning

The higher the payout percentage, the lower is the percentage going into traditional ef- ficiency-enhancing capital outlays for the household and other forms of investment, such as mutual funds. A high payout percentage can reflect a desire for a higher standard of living today as opposed to improved household efficiencies and a higher, more secure standard of living in the future.

Savings Percentage Savings represents the amount set aside for expected outcomes such as retirement, emer- gencies, and improvements in the household’s future standard of living.

Gross savings percentage = Net cash flow + Targeted savings + Change in debt

Total income

The savings percentage7 indicates the total combined percentage of total income that is being put away for future needs. The amount expended to pay off debt is considered sav- ings whereas an increase in debt reduces the savings rate.8 The objective for saving depends on individual circumstances and goals, but saving 10 percent of the household’s gross income is often a desirable rule of thumb.

7 Employer contributions to retirement plans would be added to savings figures. 8 Amounts for certain types of capital expenditure, such as those that increase the value of investment property, may be considered savings as well. One example might be the renovation of a kitchen or bathroom that, in particular, can enhance the value of a house.

Back to Dan and Laura CASH FLOW PLANNING At our next meeting, it became even clearer that I was dealing with two different spending philosophies. Dan was more frugal, preferring to save to have monies available for future contingencies and to begin to fund retirement. Laura said her parents never gave having enough money a thought and everything worked out. Laura enjoyed taking trips to the regional mall to purchase fairly expensive clothes for Brian and herself. Now that Brian was around and she wasn’t working, she also spent more time at the health club. Both she and Dan ate out and spent considerable money on entertainment, which created high babysitting bills as well. The combination of the lack of Laura’s salary, higher living expenses, and their intent not to touch the investments had produced the cash shortfall and the $20,000 in credit card debt. I noted that, in effect, they were operating on two tracks with Dan saving money at the same time that Laura was spending it. Both knew the system had to change and invited my comments on how to do this. When I told them that it was important to determine when Laura might go back to work, she replied, “In five years.” Just before they left, Laura smiled and said sweetly that she would have difficulty sub- jecting her spending to a fixed written budget. Then, after thinking about it for a minute, she said unless it was absolutely necessary.

Here’s the advice I presented to them: Cash flow planning is the scheduling of cash outflows to meet near and long-term resources. It is often at the heart of a financial plan. Generally, without cash flow, you can’t meet household goals. Cash flow planning is particularly important for couples like yourselves. You have to establish the structure to live within your means. That entails

Chapter Six Cash Flow Planning 143

saving enough money to fund your goals: these extend from buying a home to educating your current and child and anticipated children, to retirement. When cutbacks are called for, as they are here, it’s important to retain those expenditures that each of you believes are particularly important for an enjoyable life. You began running a cash flow deficit before borrowing this year after Laura stopped working. As you are aware, these deficits have to end. They must be replaced by saving. There are a number of areas that appear to be particularly suited to being examined and perhaps cut. Clothing is treated as an overhead item called nondiscretionary expenses. However, it’s clear that you spend more than is necessary to dress yourself adequately. In fact, the act of shopping and finding interesting items is an enjoyable leisure pursuit. Despite that obser- vation, to simplify things, I’ve included all clothing outlays under the nondiscretionary category. Vacations and eating out are true discretionary expenses. Note that one year ago, all these expenses were considerably lower, which suggests that they could be reduced without dramatically affecting your lifestyle. Laura, I believe cutbacks are absolutely necessary for you to realize your goals. In cer- tain cases, the figures even with cutbacks are not that different from those outlays you had last year. I’ve attached a schedule of cutbacks. Notice that they are focused on delivered food, clothing (even though they are placed entirely under the nondiscretionary column for convenience purposes, both of them have a discretionary component), recreational and personal outlays, and vacations. If there’s an objection to any area of cutbacks, substitute another that provides the same amount of savings.

Schedule of Cutbacks

2015

Before Plan After Plan

Nondiscretionary

Groceries $ 5,800 $ 6,800 Delivered food 3,000 0

Total food 8,800 6,800 Dan’s clothing 4,000 3,000 Laura’s clothing 7,000 5,000 Baby’s clothing 2,500 4,000

Total clothing 13,500 12,000

Discretionary

Recreation/entertainment $ 6,000 $ 3,000 Personal 6,500 4,000 Vacations 8,000 4,000

Total savings $13,000*

* This figure is the sum of the cutbacks as represented by the differences between the After Plan and Before Plan columns.

The result of these efforts will be to place you on a better financial footing, including an ability to continue making pension payments. I recommend that, as a structuring mechanism and to put you in the “savings habit,” you do the following:

1. Establish separate savings accounts for anticipated educational needs and contingencies. Placing these in separate “buckets” for each item can better relate savings to a tangible goal. It also can make you more reluctant to withdraw monies for nonessential needs.

144 Ongoing Household Planning

You are fortunate that Laura’s parents have volunteered to gift you $65,000 provided it is used for the down payment on a home. One bucket down already.

2. You can begin funding these buckets immediately out of your marketable investments, which now total $137,000. With Laura not working, you are projected to run a deficit of close to $90,000 over the next five years. We recommend that you set aside $90,000 in a bucket to cover those deficits. The remaining marketable securities can be used to create an emergency fund, begin a college savings bucket, or fund 401(k)/IRA contribu- tions each year because funds won’t be available from Dan’s salary.

3. Write a check to each account at the beginning of each of Dan’s bimonthly pay periods. We project, however, that you won’t be able to begin doing so until 2020 Not going be- yond the remaining amounts in your checking account can be an important structuring tool.

4. Be aware of your spending habits, particularly in the area discussed. However, as long as you don’t do it too often, reward yourself occasionally with a spending “treat” when you have accomplished savings-spending goals for a period of time.

Recognize that your cash flow concerns should ease considerably once Laura goes back to work. The cash flow statement is attached. It includes the purchase of a home next year. As I’ll detail later under nonfinancial investments, I believe the home to be an attractive investment now. I’ve included other capital expenditures that we’ll discuss in a separate meeting. This cash flow statement is likely to be revised as your other financial goals come into better focus. However, for now, notice the difference in cash flow between the before and after cutbacks columns. Finally the statement includes projections for seven years as opposed to the three or four years I usually display. That is done for you to see the difference in cash flow begin- ning in year 6 when Laura goes back to work.

Projected Cash Flow Statement

2015 2015 2016 2017 2018 2019 2020 2021

Operating Activities Before Plan After Plan

Income

Total compensation $100,000 $100,000 $110,000 $121,000 $133,100 $146,410 $240,882 $259,352 Total investment income 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 Total other income 0 65,000 0 0 0 0 0 0

(gift from parents)

Total Income $104,000 $169,000 $114,000 $125,000 $137,100 $150,410 $244,882 $263,352

Expenses

Nondiscretionary Rent $15,000 $15,000 $0 $0 $0 $0 $0 $0 Property tax 0 0 2,500 2,575 2,652 2,732 2,814 2,898 Upkeep and insurance 2,000 2,000 3,000 3,090 3,183 3,278 3,377 3,478 Utilities 3,600 3,600 3,708 3,819 3,934 4,052 4,173 4,299 Furnishings/moving 1,000 1,000 12,530 1,061 1,093 1,126 1,159 1,194 Mortgage interest 0 0 17,219 17,066 16,902 16,727 16,538 16,336

Total housing 21,600 21,600 38,957 27,611 27,764 27,914 28,061 28,205 Insurance 2,050 5,950 7,090 7,183 7,278 7,377 7,478 7,582 Professional fees 0 4,000 1,030 1,061 1,093 1,126 1,159 1,194 Child care (babysitter) 3,000 3,000 3,090 3,183 3,278 3,377 6,956 7,164 Food 8,800 6,800 7,004 7,214 7,431 7,653 11,361 11,702 Clothing 13,500 12,000 12,360 12,731 13,113 13,506 13,911 14,329 Health care (out of pocket) 1,350 1,350 1,648 1,697 1,748 1,801 1,855 1,910

Chapter Six Cash Flow Planning 145

Projected Cash Flow Statement

2015 2015 2016 2017 2018 2019 2020 2021

Operating Activities Before Plan After Plan

Transportation 4,500 4,500 5,408 5,570 5,737 5,909 9,564 9,851 Credit card interest 0 0 0 0 0 0 0 0 Income and payroll 25,080 25,080 23,917 27,209 30,835 36,956 71,900 78,410

Total nondiscretionary $79,880 $84,280 $100,503 $93,458 $98,277 $105,617 $152,245 $160,347

Cash Flow before $24,120 $84,720 $13,497 $31,542 $38,823 $44,793 $92,636 $103,005 Discretionary Expenses Discretionary Recreation/Entertainment $6,000 $3,000 $3,090 $3,183 $3,278 $3,377 $6,956 $7,164 Personal 6,500 4,000 4,120 4,244 4,371 4,502 7,535 7,761 Vacations 8,000 4,000 4,120 4,244 4,371 4,502 9,274 9,552 Gifts and charitable 2,000 2,000 2,060 2,122 2,185 2,251 2,319 2,388

contributions Hobbies 2,750 2,750 2,833 2,917 3,005 3,095 3,188 3,284 Total discretionary $25,250 $15,750 $16,223 $16,709 $17,210 $17,727 $29,272 $30,150 Cash Flow from ($1,130) $68,970 ($2,726) $14,833 $21,613 $27,066 $63,365 $72,855

Operations

Capital Expenditures

Purchase of home $0 $0 $250,000 $0 $0 $0 $0 $0 Total educational expenses* 2,666 2,666 24,924 26,046 27,234 28,494 1,458 1,170 Household maintenance† 1,000 31,000 1,030 1,061 1,093 1,126 1,159 1,194 Leisure 2,000 2,000 2,060 2,122 2,185 2,251 2,319 2,388 Total capital expenditures $5,666 $35,666 $278,014 $29,229 $30,513 $31,870 $4,936 $4,752 Cash flow before ($6,796) $33,304 ($280,740) ($14,396) ($8,900) ($4,805) $58,429 $68,103

financing activities

Financing Activities

Total repayments‡ $6,463 $23,463 $5,783 $6,162 $6,567 $6,998 $7,458 $7,948 Mortgage 0 0 (237,500) 0 0 0 0 0 Additional credit card debt 0 0 0 0 0 0 0 0 Total financing activities $6,463 $23,463 ($231,717) $6,162 $6,567 $6,998 $7,458 $7,948 Cash Flow ($13,258) $9,842 ($49,023) ($20,558) ($15,466) ($11,802) $50,972 $60,156 Targeted for retirement $0 $0 $0 $0 $0 $0 $50,000 $60,000 Targeted for college 0 0 0 0 0 0 0 0 Net Cash Flow ($13,258) $9,842 ($49,023) ($20,558) ($15,466) ($11,802) $972 $156

* Includes expenses for Laura’s master’s degree program and student loan interest. † Includes $30,000 for Dan’s new car. ‡ Includes mortgage, student loan, and credit card principal.

Finally, I’ve provided your financial ratios. They point to a fairly weak cash position and weak savings ratio. Although the gross savings of 20 percent is high, it is due to the parental contribution. After our discussions, this weak cash flow situation shouldn’t be a surprise. However, following my advice will have a substantial positive effect on these ratios.

Current ratio = Current assets Current liabilities

= 3,000 27,000

= 0.11

Emergency fund ratio = Liquid assets

Total monthly household expenses

146 Ongoing Household Planning

= 37,000 8,336

= 4.44

Nondiscretionary cost percentage = Total nondiscretionary costs

Total income

= 84,280 169,000

= 0.50 × 100% = 50%

Discretionary cost percentage = Total discretionary costs

Total income

= 15,750 169,000

= 0.09 × 100% = 9%

Total operating percentage = Nondiscretionary costs + Discretionary costs

Total income

= 100.030 169,000

= 0.59 × 100% = 59%

Discretionary payout percentage = Discretionary expenses +

capital Discretionary

expenditures Cash flow before discretionary expenses

= 17,750 84,720

= 0.21 × 100% = 21%

Gross savings percentage = Net cash flow + Targeted saving + Change in debt

Total income

= 9,842 + 0 + 23,463 169,000

= 33,305 169,000

= 0.20 × 100% = 20%

College Student Case Study and Review: Amy and John CASH FLOW PLANNING Cash flow is the heartbeat of an individual’s activity. Without positive cash flow, normal ac- tivities can’t continue. Both Amy and John understood. They said their cash flow had turned negative because their parents weren’t able to fund as much of their college costs as originally planned. As stepsiblings, I was glad to see they weren’t competing with each other for their parents combined income. I mentioned that a positive cash flow—savings—is normally what was desired but wasn’t possible because they were investing in their future at school.

Chapter Six Cash Flow Planning 147

I mentioned that there were many reasons for savings including:

1. Pure life cycle. For use over their remaining lives, particularly during retirement. 2. Investment. To grow assets. 3. Down payment. To segment for future purchase of an asset. 4. Precautionary. To save for an emergency. 5. Improvement. To sacrifice today for a higher standard of living in future. 6. Independence. To become financially independent. 7. Bequest. To leave for others. 8. Hoarding. To savor money with no intention of using it.

Budgeting is the method of allocating future cash flows generally with the idea of effi- ciently allocating it. Informal budgeting involves less detail with a broad net cash flow objective. Formal budgeting involves setting up a detailed budget for major or all catego- ries: Its goals are to prioritize outlays, reduce or eliminate impulsive purchases, avoid be- ing caught short of cash, and save enough for future needs. Ways of increasing savings include:

Structural Approach

Buckets Approach

to make unplanned withdrawals. -

culty for taking it out.

credit cards at home when you shop.

The steps in household budgeting include:

1. Establish goals. Place a total expenditure limit or total savings goal for a specific future expenditure or for general future use.

2. Decide on budgeting—period. 3. Calculate cash inflow. 4. Project cash outflows. 5. Compute net cash flow. 6. Compare net cash flow with goals and adjust. 7. Review results for reasonableness and finalize the budget. 8. Compare budget with actual income and expenses.

Financial Ratios Ratios are used to gauge the state of current household assets and operating activities. They can be compared with industry standards or with the household’s own ratios over time to determine whether they are getting stronger or weaker. (The financial ratios are given in a textbook I gave them.)

148 Ongoing Household Planning

Summary Along with financial statement analysis, cash flow planning is often performed near the beginning of the financial planning process. Both help to set the tone for other areas to come.

about acceptable savings rates. -

viding motivation, eliminating an option to spend, reducing temptation, and minimizing discomfort.

- hold’s financial condition.

Key Terms budgeting, 133 cash flow planning, 132

financial ratios, 138 household budget, 133

purchasing power, 135 purchasing power risk, 135

investopedia.com Investing Glossary The site provides a general online investment dictionary. It also features financial ratio definitions as well as articles and tutorials regarding cash flow planning.

Website

Questions 1. What is cash flow planning? 2. Why is cash flow planning so important? 3. List five reasons for saving. 4. Why do some people have difficulty saving? 5. Provide five methods for helping people to save. 6. Why do people construct a budget? 7. What is a liquidity substitute? When should it be used? 8. Why are financial ratios important? 9. Chris’s current liabilities exceeded his current assets. He said not to worry; he could

use his credit card if he needed extra funds. What do you think of this practice? 10. Maya had a low nondiscretionary cost percentage and a high discretionary one. Is that

good or bad? Explain. 11. What are the reasons that a person’s gross saving percentage may be low, while his or

her net cash flow may be high?

Problems April made $50,000 in year 1 and $60,000 in year 2. She had the following yearly outflows:6.1

Year 1 Year 2

Nondiscretionary $25,000 $27,000 Discretionary 10,000 12,000 Capital expenditures 5,000 13,000 Debt repayment 0 6,000

Calculate April’s operating cash flow and net cash flow for each year.

Chapter Six Cash Flow Planning 149

Jamie had the following figures over the past four years.6.3

Using the following statistics, calculate Jackson’s current and emergency fund ratios.6.2

Current assets $2,000 Current liabilities 1,000 Liquid assets 8,000 Marketable securities 20,000 Monthly household $6,000

Nondiscretionary Cost Discretionary Cost Total income

Year 1 $56,000 $7,000 $60,000 Year 2 54,000 8,000 60,000 Year 3 52,000 9,000 60,000 Year 4 $50,000 $10,000 $60,000

a. Calculate the nondiscretionary cost percentage and what the change in the ratio demon- strates over time.

b. Calculate the discretionary cost percentage and what the change demonstrates over time. c. Calculate the total operating cost percentage and what the change demonstrates over time. d. Indicate what your recommendation might be.

Sharon had gross income of $120,000 and nondiscretionary expenses of $32,000. She also had discretionary expenses of $10,000, and her capital expenditures on leisure items were $5,000. What is her discretionary payout percentage? Abby had the following statistics. Calculate the gross savings percentage.

6.4

6.5

Net cash flow $6,000 Nondiscretionary expenses 35,000 Discretionary expenses 8,000 Targeted retirement savings 5,000 Repayment of debt $2,000

Robert Smith asks for your help in preparing his cash flow statement. He tells you that his salary before taxes is $250,000 and that he has no mortgage on his home. Which of the following statements is true about Robert’s cash flow statement?

a. The value of the home would be an income source since there is no mortgage. b. The value of the home would be an asset. c. The taxes on his salary would be a liability. d. The taxes on his salary would be an expense.

Six months ago, a client purchased a new bedroom suite for $6,500. For purposes of pre- paring accurate financial statements, this purchase would appear as a(an)

1. use asset on the client’s net worth statement. 2. investment asset on the client’s net worth statement. 3. variable outflow on the client’s historic cash flow statement. 4. fixed outflow on the client’s cash flow statement.

a. (1), (2), and (3) only b. (1) and (3) only c. (2) and (4) only d. (4) only e. (1), (2), (3), and (4)

6.1

6.2

CFP® Certification Examination Questions and Problems

150 Ongoing Household Planning

Case Application SAVINGS AND THE CASH FLOW STATEMENT Richard came in with his cash flow statistics and very helpful notes on projections. His list included

Revenues

Salary $100,000 Investment income $8,000

Outflows Home related $20,000* Food 5,000 Clothing 8,000 Health care 6,000 Transportation 2,000 Personal 3,000 Recreation 4,000 Cars, entertainment 9,000 Hobby 1,000 Gifts and charitable contributions 2,000 Insurance 6,000 Taxes 26,000†

* Includes mortgage interest and principal payments, property taxes, home maintenance, and home insurance. † Net of $3,000 allowable tax loss with $191,000 tax loss carryforward on original 200,000 loss.

He said to assume that his salary will rise 6 percent a year, and his investment income is 11 percent a year (the investment loss came a year ago). His expenses should rise 3 percent a year except for medical, which will grow at a rate of 6 percent yearly, and taxes, which will grow at about 7 percent a year. Richard said he was not worried about the losses taken. He would make them up, but Monica insisted that they save additional monies. He wanted to know what I recommended to help him save. He said he knew Monica was secretly putting away part of her household money into an account in her own name.

Case Application Questions 1. What observation do you have about the couple’s expenditures? 2. What might the conversation above tell you about Richard? 3. What might Monica’s actions tell you about both Monica and Richard? 4. What recommendations would you have to help them save more? 5. Construct their cash flow statement for this year and the next two years. 6. What do the future cash flow figures indicate? 7. Complete the cash flow section of the plan.

151

Chapter Goals

This chapter will enable you to:

Dan hated the thought of debt, yet here he was owing $20,000 on credit cards. Laura was very blasé about the borrowings. Not only financial issues were involved in our delibera- tions. Their differing points of view on debt were affecting their personal relationship.

Real-Life Planning The advisor faced a new situation. Instead of presenting the results of his analysis to a couple in the privacy of his office, he was to broadcast it to millions of people. A major network had contracted with him to provide a financial plan for a young couple. The results would be taped and televised on a newsmagazine show in prime time. The couple agreed to have their financial situation aired, and the taping took place in the advisor’s office. When the advisor analyzed the couple’s financial situation, it became apparent that it was dominated by debt. The husband and wife both had comfortable jobs with moderate incomes. There was nothing moderate about their credit card debt, however. It had been climbing steadily and now stood at almost six months’ combined salary for them. The ad- visor remembered what one financially unsophisticated college graduate called her student loan, which had a 7 percent rate. She had called it an “evil loan” because it continued to climb in the amount outstanding each year even though she had not borrowed any more money. If unpaid, this couple’s loan at an 18 percent rate would climb much more rapidly, doubling in four years. When questioned about the use of credit cards, the woman said she wanted to live the “American dream.” She said she was going to make a large amount of money in a key ex- ecutive position. The spending beyond her current means was just a down payment on her future lifestyle. The advisor thought about her comment. On the one hand, it reflected a valid economic approach. It was consistent with Modigliani’s life cycle theory of spending and saving,

Seven

152 Part Two Ongoing Household Planning

indicating people’s desire to even out their standard of living over their lives. On the other hand, there was no indication that either person was on a fast track because recent raises had been fairly modest. When asked in a follow-up interview about the modest raises and in- creasing debt, the woman repeated her comment about the “American dream” and expressed a great confidence in her ability to become important. When questioned separately, the husband, who had his own credit cards and spending pattern, merely said he wasn’t worried. The advisor had seen this pattern of spending and debt before, and it often led to financial difficulty and even bankruptcy. Modigliani or not, he decided to present the findings in a sober way. At the taping he did so. He mentioned the amount outstanding and the potential for bank- ruptcy, and then outlined a method of gradually clearing their debt. It turned out that neither person was aware of the debt the other had amassed. Each literally pointed a finger at the other as the source of blame. (The producer told the advisor at the time that everyone in the room knew that this dramatic scene would definitely be aired.) Despite that animated moment, the advisor felt the woman was not buying into that part of the plan’s recommendations. Weeks after the show was aired, the advisor spoke to the woman to find out how implementation of the plan’s recommendations was going. She mentioned she had taken a position as head of an office of a U.S. subsidiary that would take advantage of her bilingual abilities, at five times her former pay. Her debt strategy had paid off. The “American dream” had come true. The debt wasn’t a problem after all. The advisor thought about his cash flow recommendations. Were they inappropriate? He decided the answer was no. For every client like her, there were ten others who needed to hear the sobering advice. Perhaps he had failed to consider the ability of the woman to utilize the power of a nationally televised show to market herself. In any event, it was enjoyable to see that the “American dream” was alive and well. Of course, not every such story has a happy ending. When things don’t work out so well, the American dream can turn into a nightmare. In the early years of this century, home prices rose at an unprecedented pace. Lenders became lax in screening borrowers because mortgages secured by appreciating houses seemed like safe loans, and many people found that they could buy expensive homes with little or no money down. The downside to a low- or no-down payment arrangement, of course, is that borrowers had to take on large amounts of debt. When the housing market declined sharply, trigger- ing the recession of 2008–2009, unemployment soared and many of those highly leveraged homeowners saw their incomes sink. Keeping up the payments on a $200,000 or $300,000 mortgage became impossible or at least impractical, if such homes now were worth, say, only $150,000 or $250,000. Countless homeowners had to strain to make their mortgage payments or else default on the loan and thus impair their credit rating. Suddenly, the world became aware of the concept of a “short sale,” in which the only way to sell an unaf- fordable home was to accept a bid for less than the mortgage balance, assuming you could get permission from the mortgage holder to sell at the depressed price. You might even owe income tax on any forgiven debt, although the Mortgage Forgiveness Debt Relief Act provided relief to some sellers. It’s true that buying a home with borrowed money can be a winning move. If you buy a $200,000 home with $40,000 (20 percent) down, for example, a $50,000 (25 percent) increase in property value over time will be a 125 percent return on your cash down payment. However, the flip side of using leverage is that unfavorable events can have negative consequences.

OVERVIEW

Debt represents many things. To financial planners it often represents risk. Too frequently they see abusive use of credit leading to financial difficulties. They recommend that debt be limited to investment items such as the purchase of a home.

Debt 153

To consumers, debt represents opportunity. Borrowing money allows people to pur- chase items they don’t have the current cash resources to buy. At its extreme, it can sym- bolize a preference for pleasure-producing goods today over consequences for the future—in other words, overspending. This chapter, then, is about the many faces of debt. It considers how debt should be reviewed, when it is good or bad. It provides ratios that indicate acceptable financing practices. It details how to obtain and maintain proper credit and calculate its costs, and it discusses the advantages and disadvantages of various financing alternatives. The chapter also will explain what to do when in financial difficulty and includes an evaluation of bankruptcy. All these topics can be incorporated under the broader heading of debt management. Under household finance, the household enterprise can have spending needs that exceed its current resources. Borrowing presents a ready source of cash flow. Debt management leads to the proper utilization of financing alternatives for efficient household operations. Just as there is an appropriate amount of debt in a business capital structure, the household must decide how much debt it wants to contract for. The decision includes not only return alternatives but the household’s tolerance for risk. Borrowing helps by providing funds to raise homeowners/standard of living today or to make investments such as those for the house and its possessions or to contribute to the financing of a business. As you can see, debt is used for many purposes. It can allow homeowners to enjoy a product that they could not yet afford to purchase outright. It may make it possible to balance the peaks and valleys in the homeowners’ spending pattern within each year such as when they borrow to fund high annual vacation expenditures. It also may help homeowners to even out their life cycle style needs or enable them to make an outlay for a significant capital expenditure or other investment opportunity. Borrowing theory is presented in Appendix I of this chapter. In sum, borrowing is a tool that we use to accelerate consumption or to help finance investments. Our financial planning objective is to use debt wisely, selecting the lowest- cost source and proper amount of borrowing consistent with our goals and tolerance for risk. In order to do so, we will first examine risk more closely.

RISK AND LEVERAGE

As our preceding discussion indicates, debt is often associated with risk. The higher the debt, the higher is the household’s risk. People who have too much debt are said to be overleveraged. Few recognize that there are two types of leverage and two types of risk: operating and financial. Although much time is spent on this subject for business, it is often neglected for households. By explaining and distinguishing between operating and financial factors, we can better understand household risk and be more effective in planning for it. Operating risk arises from uncertainties in connection with household activities. People may spend considerable time and resources investing in a job only to find that the company they work for has limited growth prospects. The washing machine that a house- hold invested in may turn out to require constant repairs. The house purchased may decline in value. In contrast, financial risk comes from the amount of debt outstanding relative to an individual’s assets. If debt rises from 10 percent to 50 percent of total assets, financial risk has increased substantially. Although frequently used to refer only to financial leverage, leverage can actually be separated into two components: operating and financial leverage. Operating leverage is the degree to which people have fixed costs in their budgets that come from household operating functions. The higher the percentage of their nondiscretionary costs—high fixed

154 Part Two Ongoing Household Planning

costs that cannot easily and quickly be cut back—the higher their operating leverage. These nondiscretionary costs are ongoing obligations.1

When households have high fixed costs, a modest increase or decrease in their income can have a material impact on their free cash flow. For example, enrollment of a child in an expensive private college is a fixed cost that could give a household significant operating leverage. A planned outlay on an expensive vacation would not increase its leverage be- cause its cost could easily be cut back. The higher fixed costs are as a percentage of total costs, the higher is the operating leverage. Operating leverage in business and investing is commonly illustrated with the example of a gold mine.

Example 7.1 A mine can bring an ounce of gold to market at a total cost of $1,000. Assume that gold sells for $1,200 per ounce. The profit would be $200 an ounce. A $100 increase in the price of gold to $1,300 would be a 8.33 percent increase in revenues ($100/$1,200). The profit is now $300 an ounce. By how much would the company’s profits be affected?

= Current profit − Previous profit Previous Profit

= 1$300 − $2002

$200

= 50%

Because the company’s profits would rise by 50 percent, its stock price might increase by more than the 8.33 percent increase in the gold price and revenues. Conversely, an 8.33 percent decrease in the price of gold from $1,200 to $1,100 per ounce would drop profit- ability by 50 percent, from $200 to $100 per ounce, and might cause a sharp decline in the stock price. The same principal applies to a household. Assume $3,000 in monthly income and $2,700 in monthly fixed costs, including groceries, utilities, insurance, and so on. A $300 increase (10 percent) in monthly income would double the household’s free cash flow from $300 to $600 per month whereas a 10 percent decline in monthly income would eliminate the household’s free cash flow.

FINANCIAL LEVERAGE AND RETURNS

Financial leverage arises from the amount of debt outstanding and its contribution to household fixed costs. The higher the amount of the household’s interest expense and debt repayment commitments, the greater its financial leverage. As with operating leverage, when a household has high fixed financial costs, a change in income can have substantial effects on its free cash flow. For example, a decline in income can put the household in great financial difficulty. Putting debt and financial leverage together, the higher the amount of debt is, the higher the financial leverage is, and the higher the risk is. Financial leverage can increase potential rewards for the household and can allow it to purchase and enjoy the benefits of a car or television set earlier. Many first-time homebuy- ers undertake significant financial leverage by making an expensive purchase of a dwell- ing. For example, 80 percent or more of the purchase price of a house may come from debt and 20 percent or less from personal savings. Should the home subsequently rise sharply in

1 They are treated as such in the pure form of total portfolio management. Capitalized nondiscretionary costs and financial debt are both employed in the intent to move toward the optimal asset allocation.

Debt 155

price, that financial leverage can enable the member-owners to make a high return on their household investment. In sum, we have illustrated a basic financial principle. Undertaking additional debt has two effects: It not only raises risk but also increases potential returns. We will expand on this risk-return concept in Chapter 10 on financial investments.

Example 7.2 Matthew had no savings and had borrowed $40,000 to purchase new furniture and furnish- ings in his home and to buy a car. His income is $80,000 per year including an $8,000 bonus. In a good year for his company he can double the bonus whereas in a poor year the bonus could be eliminated. Using the following figures, note the change in free cash flow given the same outlays but differing levels of income and indicate his degree of financial and operating leverage.

Expected Good Year Poor Year

Income $80,000 $88,000 $72,000 Nondiscretionary costs* 59,000 59,000 59,000 Discretionary costs 4,000 4,000 4,000 Cash flow before debt 17,000 25,000 9,000 Interest cost 7,000 7,000 7,000 Repayment of debt 8,000 8,000 8,000 Free cash flow $2,000 $10,000 ($6,000)

* Excluding interest.

Matthew has high financial leverage. A 10 percent increase in his income to $88,000 results in five times as much free cash flow: $10,000 versus $2,000. On the other hand, a 10 percent decline in his income could result in a $6,000 deficit and an inability to pay debts when due. The fact that he also has high operating leverage because most of his household costs are nondiscretionary gives him little room to cut back on his lifestyle to meet his debt repayment in the event of a bad year. High operating and high financial leverage could place Matthew in a potentially vulnerable situation.

DETERMINING SIMPLE INTEREST RATES

The interest rate is the cost of borrowed money. In order to make a proper borrowing decision, we need to know the interest rate being charged. To calculate the real interest rate, we must know the time period for the loan and the actual amount of money that is made available. That calculation isn’t always as simple as it looks. The difference in costs is exemplified by the following three alternatives for a $5,000 loan with a $600 yearly cost to borrow.

Payment of Interest at the End of the Period The household obtains use of the money for the entire period, in this case for an entire year. The interest rate paid is given by the formula

Interest rate = Interest paid Cash made available

= $600 $5,000

= 12%

156 Part Two Ongoing Household Planning

Payment of Interest at the Beginning of the Period When interest is deducted at the beginning of the period, the amount paid in interest is the same, but the cash made available is reduced.

Interest rate = Interest paid Cash made available

= $600 $5,000 − $600

= $600 $4,400

= 13.6%

Payment of Installment Loan Under an installment loan, repayments may be made in equal sums throughout the year. The key point is that the cash made available decreases constantly through the period of the loan. Assuming a one-year loan retired in 12 equal monthly installments of interest and principal of $466.67, the cash available would decline by that amount per month.

Monthly Installment = $5000 + $600 12

= $466.67

The interest cost can be approximated by estimating the average amount of cash available, taking the amount at the beginning and the end of the period and dividing by 2 where:

Interest rate = Ip1CABP − CAEP2/2

IP = Interest paid CABP = Cash available at the beginning of the period CAEP = Cash available at the end of the period

Practical Comment Importance of the Reason for Borrowing

Debt 157

= 60015,000 − 02/2 = 600

2,500

= 24% The actual cost can be calculated in the following manner:

Inputs: 12 –466.675,000

Solution: 1.7882

N I/Y PV PMT FV

Press i = 1.7882% (Monthly interest)

Annual interest = 1.7882 × 12 months = 21.5%

The actual annual rate is 21.5%.

Annual Percentage Rate The annual percentage rate (APR) must be given to borrowers under a federal law that requires lenders to provide an effective interest rate on consumer loans2 and the total amount of finance charges. The APR includes all defined costs such as closing fees, points, and appraisal fees on mortgage loans on a time-weighted basis. It serves as a useful method for comparing costs on loan alternatives.

BORROWING FACTORS

In recent decades, the use of debit cards has exceeded that of credit cards. Home equity loans and lines of credit soared in popularity until the housing market crashed, resulting in the tightening of credit. As these fluctuations indicate, many issues are involved in borrow- ing money. We consider several of them next.

Sources of Debt Many financing sources are available to consumers. They differ by such factors as the interest rate charged, whether the interest cost is tax deductible, whether the loan is secured by specific assets, and whether it is a closed-end or open-end credit loan. Closed-end retail credit is generally limited to a specific loan with a specific repayment schedule. One example is an auto loan. Open-end credit provides a loan limit that can be utilized for multiple purchases over a period of time. Part payments on scheduled retirements of debt owed may be allowed. An example of an open-end loan is a credit card loan.

Interest Rates Charged by Lenders In theory, lenders should present an array of interest rates with the rate offered appro- priate to the risk of nonpayment that the individual household presents. Instead there

Calculator Solution

2 Exceptions include margin loans on securities, loans of more than $25,000 not collateralized by real property, and loans from sellers’ as former occupants of house.

158 Part Two Ongoing Household Planning

often appears to be one interest rate offered per lender. Loan applicants are placed into two risk classes,3 with one rejected and the other accepted. The lender may be basing the interest rate on the average quality of the loans, with lenders who have lower- quality borrower pools charging higher interest rates. There is some indication that for certain types of loans, the interest rate charged may not be highly sensitive to changes in market rates.4

Types of Borrowers The balance sheets, cash flow statements, and preferences for spending today differ for borrowers. The variation can be thought of as indicating two types of borrowers: unra- tioned and rationed.5 Unrationed borrowers have sufficient internal cash flow and assets to be able to select the loan maturity offering the most attractive rates. When rates change, their decisions on amount, type, and repayment period for credit may change. Rationed borrowers, on the other hand, are short of internal cash flow and would like to borrow more credit at comparable interest rates than is available.6 These borrowers, who are constantly seeking more funds, may have to take any payment terms offered.

Credit Standards A number of items are used to assess whether credit should be extended to a household; these include the amount of income earned, the amount of debt outstanding, the history of timely repayments of debt owed, and whether the loan is secured by an asset such as the durable good being purchased. Often, lenders rely upon a numerical credit score to deter- mine whether a borrower is creditworthy.7 We will return to this subject later in the chapter when we discuss credit reports and credit scores.

Outcome The outcome is that households often have a variety of borrowing alternatives at vari- ous interest rates. The ultimate selection is generally to take the lowest-cost alternative.

3 The approach may be a practical embodiment of Modigliani and Miller’s risk classes. See Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48, no. 3 (June 1958): 261–297. See also Liran Einav, Mark Jenkins, and Jonathan Levin, “The Impact of Credit Scoring on Consumer Lending,” 2011, finance. wharton.upenn.edu/~mjenk/Credit_Scoring.pdf,” for a look at the impact of credit scores on the lending process. 4 D. Brito and P. Hartley, “Consumer Rationality and Credit Cards,” Journal of Political Economy 103, no. 2 (April 1995): 400–433. For a discussion on how mortgage rates relate to bond rates, see Christopher Mayer (Columbia Business School and National Bureau of Economic Research) and R. Glenn Hubbard (Columbia Business School and NBER), “House Prices, Interest Rates, and the Mortgage Market Meltdown,” 2009, law.yale.edu/documents/pdf/cbl/Mayer_Hubbard_House_Prices.pdf 5 Thomas Juster, “Consumer Sensitivity to the Price of Credit,” Journal of Finance 19, no. 2 (1964): 222–233. 6 For an explanation, see David Cox, and Tullio Jappelli, “The Effect of Borrowing Constraints on Consumer Liabilities,” Journal of Money, Credit and Banking 25, no. 2 (May 1993): 197–213, Eun Young Chah, Valerie Ramey, and Ross Starr, “Liquidity Constraints and Intertemporal Consumer Optimization: Theory and Evidence from Durable Goods,” Journal of Money, Credit and Banking 27, no. 1 (February 1995): 272–287, and Orazio P. Attanasio (UCL, IFS and NBER), Pinelopi K. Goldberg (Yale University and NBER), and Ekaterini Kyriazidou (UCLA), Credit Constraints in the Market for Consumer Durables: Evidence from Micro Data on Car Loans, Yale University, 2007, econ.yale. edu/~pg87/creditc.pdf 7 See “Key Dimensions and Processes in the U.S. Credit Reporting System,” Consumer Financial Protection Bureau (2012), files.consumerfinance.gov/f/201212_cfpb_credit-reporting-white-paper. pdf; Jane Bryant Quinn, Making the Most of Your Money (New York: Simon and Schuster, 2009): 219–221.

Debt 159

This approach is consistent with centralized decision making; the decision is not neces- sarily made to link the borrowing to the item purchased but is usually made on an over- all basis. For example, instead of taking an auto loan, a household could take a home equity loan to finance the purchase of a car. As the amount of debt increases, the household will qualify for fewer loan alternatives, and the cost of credit will increase. At some point, the cost of credit discourages further borrowing or, in some cases, it can reach a government- imposed limit. Auto loans, for instance, can’t exceed the state usury rate, which might be in the 12 to 22 percent range, depending on the state.

Long-Term versus Short-Term Debt Long-term debt involves financial obligations whose terms call for final payment to be made many years from now. Although for accounting purposes it is any debt not due in the current year, it can be thought of as debt payable in four years or longer.8 Examples are home mortgages, bank debt, and other loans such as those from friends and family members. Short-term debt is money owed that is payable in a relatively brief period. For accounting purposes it is debt due within the current year whereas in investment usage, it is debt payable within three years. Examples of short-term debt are general credit card debt and credit extended by particular stores for purchases of clothing or durable goods such as a television. The length of the financing period should be matched to the size and benefits of the item creating the need for the borrowing. A house that serves as an investment will not normally be financed over a few years whereas the purchase of clothing or short-lived household goods should not result in long-term debt. In fact, many would say that the use of credit for items other than capital expenditures should be limited to repayment within 30 days or for cyclical peaks in outlays to be paid off when demand for funds lessens, generally within the year.

Secured versus Unsecured Debt Secured debt is debt that has a specific asset serving as collateral to be sold by the credi- tor for repayment in the event the debtor is unable to do so. Examples of secured debt are a mortgage and an auto loan, which are secured by the house or the automobile for which credit is extended. If someone cosigns for a loan, the loan can be thought of as secured because it obligates the cosigner to pay if the debtor does not. Unsecured debt is debt whose repayment is based solely on the full faith and credit of the debtor. Of course, in the event of default the creditor can sue to recover the money owed. Naturally, most creditors prefer secured debt because it lowers their credit risk, and they typically offer a lower interest rate for this type of loan. The disadvantage of a secured loan to the borrower is the higher probability that the asset will be repossessed in the event of financial difficulty. There are many types of borrowings. We will discuss each of the major types, starting with real estate mortgages.

MORTGAGES

Mortgages are loans secured by real property. The U.S. government has placed a priority on housing availability and affordability for the average American. The government allows interest on debt used to purchase real estate to be deductible for income tax purposes. Tax

8 In investment usage a third category, intermediate-term debt, is employed; it extends from 3 to 10 years. Debt due beyond ten years is called long-term debt.

160 Part Two Ongoing Household Planning

deductions are allowable for up to $1 million of debt for the purchase of homes and up to another $100,000 in home-backed loans for any other purpose. Because these loans have tax-deductible interest and are secured by real estate, they are often the least expensive form of borrowing available to the average household. Two government-sponsored enterprises—the Federal National Mortgage Association (FNMA), known as Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), called Freddie Mac—were created to purchase mortgages from lenders such as banks or to guarantee such mortgages. During the mortgage meltdown of 2008, the U.S. government provided financing to these two companies. Consequently, Fannie Mae and Freddie Mac remained publicly traded companies but became controlled by the federal government. In return for the financial help during the crisis, Fannie Mae and Freddie Mac pay billions of dollars in dividends to the federal government each year. These two companies bundle mortgages into bondlike securities that can be sold, primarily to institutional inves- tors. The role of Fannie and Freddie in mortgage securitization supports lenders’ efforts to make fixed-rate mortgage loans to home buyers. Another entity, the Government National Mortgage Association (GNMA), known as Ginnie Mae, provides the full faith and credit of the U.S. government as a guarantee of payment for buyers of bonds secured by real estate loans, called mortgage-backed securities. The Federal Housing Authority (FHA) and the Veterans Administration (VA) insure selected mortgages against default. The net effect of these government- supported organizations is to broaden credit and offer it at a lower rate than might otherwise prevail. Obtaining a mortgage allows people to purchase a property well before they would be able to do so through cash resources alone. Applicants go through the following process in obtaining a loan.

Loan Process The Loan Application People seeking a loan fill out an application that includes such factors as current job, current income, bank accounts, and assets owned.

Assessment of the Borrower The characteristics and past history of a person as a proposed borrower are appraised. Factors include household income in relation to size of loans; household assets, particu- larly marketable ones; other debt outstanding; and credit history. Whenever possible, it is a good idea for people to clear up any blemishes on their credit records well before apply- ing for a loan. (See page 185 for a discussion of credit scores, which lenders generally use to assess borrowers.)

Home Appraisal Each house is generally given an appraised valuation based on its current market value.

Example 7.3 Craig and Dee Brown, the buyers, have offered to purchase Phil and Robin Smith’s house for $300,000. The Browns have $60,000 for a 20 percent down payment, and they apply to Jones National Bank for a $240,000 mortgage loan, which will be secured by the home. The bank will not want to extend a $240,000 loan that’s secured by a property without knowing its market value. so the bank selects an experienced appraiser to estimate it. (The buyer typically pays the appraisal fee.)

Chapter Seven Debt 161

The amount of the loan is compared with the assessed valuation; lenders often provide a maximum of 80 percent of the home’s value. If the appraiser finds the home is worth, say, $300,000, the bank can make a $240,000 mortgage loan with an 80 percent “loan-to-value” ratio. This may be considered a safe loan, so the Brown’s loan application will be accepted. If the appraised value is, say, $275,000, the bank may offer a $220,000 mortgage loan to maintain its estimated 80 percent loan-to-value ratio. Then the Browns would need an $80,000 down payment to buy the home for $300,000. Some lenders make mortgage loans for 85 percent or 90 percent of the purchase price, and the buyer will be able to make a smaller down payment. When the down payment is lower than 20 percent, the borrower may have to purchase insurance against default and/or pay a higher interest rate on the mortgage loan.

Commitment The lender finishes its credit screen and agrees to supply the agreed-upon sum to the bor- rower. Generally, the interest rate on the loan is not set until closing unless the borrower paid an additional sum to lock it in at an earlier time.

Other Other factors and other people have a role in the real estate purchase and finance process. The buyer will inspect the home, probably with an expert, to identify potential problems such as structural ones. A title search and title insurance must be implemented and prop- erty insurance purchased. The realtor, if any, who helped find and negotiate the price will be getting a commission. Attorneys coordinate the process in many respects; often each party—buyer, seller, and lender—has a separate attorney.

Closing All parties to the purchase of the house meet, and all terms, including the interest rate, which is based on market factors at the time, are set according to the contract. The contract is signed, and title is passed to the buyer. Points are fees paid at the closing to the bank to cover their administration fees. Each point is 1 percent of the sale price: It would be $3,000 on a home sale whose contract price is $300,000, for example. Borrowers are often allowed to reduce the interest cost on the loan by selecting the number of points they will pay at the time of closing. The more points, the lower the inter- est rate will be; sometimes there will be a one-quarter-point decrease in the loan’s interest rate for each point paid at the time of closing. The points can be tax deductible in the year the house is purchased as the buyers’ first-time financing of a home. Otherwise, points are deductible in equal amounts over the life of the mortgage. The vast majority of mortgage loans are amortizing loans, as is true of most long-term consumer debt. This means that both interest and principal are paid off over time. At the beginning of the term of the loan, the largest part of the payment is interest, but as prin- cipal is paid off and interest cost is reduced, a rising portion is applied to the pay down of principal. Toward the end of the mortgage, the overwhelming amount is usually applied to repayment of principal. The most common period for mortgages is 15 or 30 years. The breakdown of total cash outflow into payments of principal and interest is shown in Table 7.1. The impact of mortgage payments on most households’ cash flow tends to lessen over time. Incomes tend to rise, but mortgage costs often are fully or approximately level. Therefore, the household mortgage burden usually declines over extended periods. Moreover, as the portion of the monthly payment that is principal increases, the net equity in the house rises more quickly. Example 7.4 shows how to calculate monthly mortgage payments.

162 Part Two Ongoing Household Planning

Inputs: 360 0.6 200,000

Solution: –1357.58

N I/Y PV PMT FV

Press PMT = ($1357.58)

Prepayments on Mortgage Debt Any household generating the necessary cash flow can consider prepayments of mortgage debt. For example, some households think about paying their mortgage every four weeks instead of monthly, which in effect results in one extra payment a year. Their goal is, of course, to eliminate their debt earlier. The prepayment decision for mortgage or any other debt should be looked at as an alter- native investment decision. The after-tax interest cost on the debt retired should be compared with the after-tax return on investment alternatives. For a fair comparison,

Calculator Solution

Mortgage amount $200,000 Annual interest rate 7% Monthly interest rate 0.5833% Loan term (in years) 15 Loan term (in months) 180 Monthly payment $1,797.66 Annual payment $21,571.88

Year Total Payment at End of Year* Principal Interest

1 $21,571.88 $7,819.60 $13,752.28 2 $21,571.88 $8,384.88 $13,187.00 3 $21,571.88 $8,991.02 $12,580.86 4 $21,571.88 $9,640.98 $11,930.90 5 $21,571.88 $10,337.93 $11,233.95 6 $21,571.88 $11,085.26 $10,486.62 7 $21,571.88 $11,886.61 $9,685.27 8 $21,571.88 $12,745.89 $8,825.98 9 $21,571.88 $13,667.30 $7,904.58 10 $21,571.88 $14,655.31 $6,916.57 11 $21,571.88 $15,714.74 $5,857.14 12 $21,571.88 $16,850.76 $4,721.12 13 $21,571.88 $18,068.90 $3,502.98 14 $21,571.88 $19,375.10 $2,196.77 15 $21,571.88 $20,775.73 $796.15

*Mortgage payments for a $200,000 loan at a 7 percent interest rate for 15 years (using payment schedule).

TABLE 7.1 15-Year Mortgage Payment Model

Example 7.4 Max just closed on a house and has taken out a 30-year fixed-rate mortgage for $200,000 at a 7.2 percent rate. What is the monthly mortgage payment?

Change annual rates into monthly figures.

Amount Explanation

Monthly interest rate 0.6% 7.2%

12 months Number of compounding periods 360 30 years × 12 months

Debt 163

prepayment and the investment alternative should have approximately the same risk, or the returns should be adjusted for difference in risk. One other factor to consider is liquidity risk. Paying off debt can reduce the amount of money available in the event of an unforeseen need for cash. An investment in marketable securities can be liquidated within a few days if circumstances make borrowing money difficult—for example, the loss of a job.

Example 7.5 Alex was a conservative investor with a considerable amount of available cash. He invested all of his money in taxable bonds, which at the time were yielding 4 percent annually. He had a mortgage with a 6.5 percent interest rate. He was considering investing his current year’s savings in the bonds. Then he realized that prepayment of his mortgage could be considered as an alternative investment vehicle. Alex thought about the tax savings he would lose on the tax-deductible interest expense if he prepaid. On the other hand, investing in the bonds instead would subject him to taxation on the interest income received. What it came down to was whether the interest saved on the mortgage exceeded the rate of return on investing in the marketplace with securities of approximately the same risk. He already had plenty of cash for emergencies. Assume that Alex’s marginal income tax rate is 30 percent, and that he itemizes deductions on his tax return. Receiving 4 percent on taxable bonds earns 2.8 percent (70 percent of 4 percent), after tax. Paying down a 6.5 percent mortgage is equivalent to earning 6.5 percent, before tax, or 4.55 percent (70 percent of 6.5 percent), after a tax deduction in a 30 percent tax bracket. Thus, the 6.5 percent expense saving from the mortgage prepayment substantially exceeded the 4 percent hurdle rate, and he began prepaying the mortgage.

Types of Mortgages Basically, there are two types of mortgages: fixed and variable (adjustable-rate) mortgages. Each has distinct advantages and disadvantages.

Fixed-Rate Mortgages The interest rate remains stable over time with fixed-rate mortgages (FRMs). They offer the certainty of a level rate of interest over the life of the mortgage. Because interest rates don’t fluctuate, there is no interest rate risk9 for the borrower. Many homeowners are attracted to fixed-rate mortgages, which have two benefits. They lock in a rate of interest that will be unaffected by a rise in market rates. They also provide the opportunity to refinance (replace the existing mortgage with a new loan) should market rates decline. On the other hand, homeowners pay a price for these benefits because the interest rate will generally be higher than the rate on an adjustable mortgage.

Adjustable-Rate Mortgages Adjustable-rate mortgages (ARMs) are those whose interest rates to the borrower fluc- tuate yearly based on overall market rates of interest at the time. They are based on a benchmark rate of interest, such as the rates on one- or three-year U.S. Treasury obligations or the Federal Home Loan Bond Rate, which tends to be less volatile. The mortgage rate is equal to the benchmark rate plus an additional amount, often 1 to 3 percent. Adjustable-rate mortgages often have lower rates of interest than fixed-rate mortgages over the term of the loan. To compensate for assuming the risk of fluctuations in interest rates, the borrower receives a lower rate. The most pronounced difference in rates occurs within the first three years, when borrowers are frequently offered below-market interest rates as an induce- ment to get them to take an adjustable-rate loan. The lower initial rate makes it easier for homeowners to qualify to purchase a larger house or larger loan. This is true because lenders tend to look at total interest costs in relation to household income in the first year of the loan.

9 Except for the cost of refinancing.

164 Part Two Ongoing Household Planning

The materially lower interest cost in early years can prove attractive for homeowners who expect to move within a few years. They have the comfort of knowing that should interest rates decline, their cost will be adjusted down without the need to refinance. Fixed- rate loans often require significant costs to refinance. On the other hand, adjustable-rate mortgages are disadvantageous when rates rise. They don’t allow homeowners to lock into a rate, although it is possible to switch to a fixed-rate loan when interest rates are low. With an ARM, it is impossible to calculate the true cost of the loan because homeown- ers don’t know how long they’ll own the home or how interest rates will move over time. An extended stay during a period of sharply rising interest rates can make an ARM a very expensive loan. Many adjustable-rate loans provide interest rate limits called caps. The caps limit the increase for any one-year period and provide for a maximum rate that can be charged over the life of the loan. If rates rise sharply, borrowers of ARMs can be subject to negative amortization, which means that the monthly payment does not cover the higher interest cost. Consequently, the amount of the mortgage outstanding increases rather than declines. In response to borrower concerns about interest rate fluctuations, many lenders offer what can be termed a hybrid ARM. This is a mortgage that offers a fixed rate for a fixed period of years and then reverts to an adjustable rate. The so-called 5/1 ARM has become the most popu- lar type in many markets. It is a fixed loan interest rate for five years, after which there will be an annual adjustment to market rates. Clearly, such a mortgage is actually a fixed-rate loan for a buyer who expects to move within five years, perhaps after starting or expanding a family. Table 7.2 summarizes the advantages and disadvantages of the two types of mortgages.

Fixed Rates Variable Rates

Interest rate risk Lender assumes the risk of increase in rates

Borrower assumes risk of increase in rates

Rates decline Borrower can refinance when interest savings exceed fixed cost of refinancing

Rate changed automatically and declines on yearly benchmark date

Relative interest cost Higher due to flat-rate guarantee and refinancing option

Lower due to borrower absorption of interest rate risk

Projected holding period

No material advantage or disadvantage Can have advantages in cost if only holding for a few years due to benefits of teaser rate

Qualification for loan More difficult than for ARM Easier due to low initial teaser rate

TABLE 7.2 Summary of Mortgage Characteristics

teaser rates.

other has a 6 percent teaser but is then bench

Practical Comment Analyzing the Adjustable Rate Mortgage (ARM)

Debt 165

Refinancing Refinancing is an alternative when market rates decline. It is most often exercised by hold- ers of fixed-rate loans. Holders of ARMs also may switch to a fixed-rate loan if they per- ceive the current fixed rate to be attractive. This would happen when rates are expected to rise. To determine whether it is profitable to refinance, the savings in interest cost over the term of the loan held is compared against the current outlay for refinancing. Refinancing costs including points, lawyer fees, title insurances, and so on are significant. Thus, whether to refinance becomes a capital budgeting decision. In calculating the cumulative savings from refinancing, mortgage holders should incorporate the possibility of selling the home and repaying the mortgage prior to the end of the mortgage period. The National Association of Home Builders has reported that the average length of stay in a single-family home is a 13 years for all home buyers.10 As mentioned, home mortgages are often for 15 or 30 years. In the years after the housing market collapse of 2007–2008, steep declines in fixed-rate mortgage interest rates made mortgage refinancing more frequent.

Example 7.6 Elena has 15 years left on her 30-year fixed-rate mortgage, which has an 8 percent interest rate. She is thinking of refinancing because mortgage rates have declined to 7 percent. She has $140,000 left on her mortgage and would have to pay $3,000 to refinance. Assume that it is all tax deductible. Elena expects to live in the house for another seven years. She is in the 28 percent marginal tax bracket and can earn 6 percent after tax on an alternative use for the money. Should she refinance?11

10 Paul Emrath, “How Long Buyers Remain in Their Homes,” Special Studies, 2013, HousingEconomics. com, http://www.nahb.org/generic.aspx?sectionID=734&genericContentID=194717&channelID=311 11 Calculation is approximate because, among other things, the savings in interest expense will decline as the mortgage does. 12 For an explanation of the internal rate of return (IRR) evaluation of rates of return generated by it, see Chapter 8.

Calculator Solution12

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN

CF 2nd CLR Work

Enter initial cash outflow 3,000 CHS g CFo 3,000 +/− ENTER ↓ Enter yearly savings 1,064 g CFj 1,064 ENTER ↓ Enter number of years 7 g Nj 7 ENTER ↓ Calculate the internal rate of return f IRR

30%

IRR CPT 30%

Amount Explanation

Cost to refinance $3,000 As given Yearly tax-deductible amount $200 3,000 ÷ 15 years Yearly tax savings $56 200 × 0.28 Yearly savings from rate decline 1% 8% − 7% Yearly interest savings pretax $1,400 140,000 × 1% Yearly interest savings after tax $1,008 1,400 × (1 − 0.28)

Savings

Yearly tax savings $56 Yearly interest savings after tax $1,008 Total yearly savings $1,064

166 Part Two Ongoing Household Planning

The 30 percent rate of return is attractive relative to the 6 percent investment alternative. Therefore, the mortgage should be refinanced. The loan value and interest rate savings will de- cline over the term of the loan. Consequently, this yearly savings is somewhat overstated. For a more accurate figure, use the breakdown of interest cost on the mortgage repayment schedule.

Home Equity Loans A home equity loan is one that is secured by the homeowner’s house. In effect, it is a second mortgage, which means that it has a second priority on the house. In the event of nonpayment, the lender will not be repaid from the proceeds from the sale of the property until after the first mortgage holder is paid off. Because of this higher risk, the interest rate charged will be higher than that on a first mortgage. On the other hand, a home equity loan is secured by a substantial asset, and homeowners are generally reluctant to default on the house they live in. Therefore, the pretax cost of a home equity loan is still among the lowest available to the consumer. Moreover, the outlay for interest on the first $100,000 of borrowing on a home equity loan for single or married persons (or $50,000 if married and filing sepa- rately) is tax deductible regardless of the purpose of the loan. Those tax-deductible interest payments are in addition to the deduction for interest payments on up to $1 million of home acquisition debt, which refers to mortgages used to buy, build, or improve the own- er’s home or homes.

Example 7.7 Emily Foster has a $500,000 mortgage on her primary residence, a $80,000 mortgage on her vacation home, and a $75,000 balance on her home equity loan. All of the interest she pays is tax-deductible. However, if Emily had taken out a $115,000 loan, only the interest on the first $100,000 of the loan would be deductible. It does not matter whether Emily uses that $40,000 to buy a car or to add a swimming pool to her home, she would not receive a tax deduction on the last $15,000.

When substantial loan amounts are needed for work on the house or for other purposes, the homeowner may have the choice of taking out a home equity loan or refinancing the first mortgage for a larger amount. The two relevant factors in making such a decision are the interest rate on the mortgage outstanding and the amount by which the interest rate on the proposed home equity loan exceeds the current market rate on a new first mortgage. It is often best to take out a home equity loan when the rate on the homeowner’s exist- ing first mortgage is well below the market rate and the total sum of the original mortgage is large relative to the total amount of housing debt that will be outstanding after the addi- tional borrowing. Frequently, it is better for homeowners to refinance when current rates are lower than those existing on the first mortgage. Although home equity loans may contain front-end closing costs, competition has sometimes compelled lenders to waive them.

Example 7.8 Martin and Kristin both had need for an additional $4,000 in cash and had to decide whether to refinance their existing mortgage to obtain a larger sum or to take out a home equity loan instead. The market rate on a new mortgage loan is 6 percent whereas the one on a home equity loan is 7.5 percent. Martin has a 7 percent existing fixed-rate mortgage with $100,000 left on it, and Kristin has a 10 percent fixed-rate mortgage with $210,000 remaining to pay. Martin is probably better off with a home equity loan because of the low rate on his existing mortgage and the thousands of dollars in closing costs he’d have to pay to obtain a new first mortgage. Kristin, on the other hand, is better off refinancing rather than taking the home equity loan. She will save money on the new mortgage over the existing one. She would save four percentage points by refinancing a much larger sum than Martin’s. The ability to save so much on her entire borrowings makes it the best choice for her.

Chapter Seven Debt 167

Because a home equity loan is often the only loan that qualifies for a tax deduction, it is often the lowest-cost loan for those who qualify and can be particularly useful in financing sizeable purchases of any type such as those for automobiles.

Home Equity Line of Credit Closely aligned with a home equity loan is a home equity line of credit (HELOC). Instead of providing a fixed sum as a home equity loan does, a HELOC allows borrowers to draw down part or all of a maximum amount as they wish. As with a home equity loan, a HELOC represents a second mortgage on the property. The advantages of a HELOC are the flexibility to take out only what is needed and the ability to pay just interest, not prin- cipal, for an extended period of time. The disadvantages of a HELOC range from a potentially higher level of interest and greater vulnerability to a boost in market interest rates because there may not be an interest rate cap as there is with an adjustable-rate mortgage (ARM). In addition, the lender is given the right to withdraw the line of credit periodically, which, if it did, would necessi- tate either refinancing elsewhere or otherwise finding the funds, or risk losing the home. Indeed, many HELOCs were frozen, reduced, or withdrawn altogether in the years imme- diately after the real estate bubble burst. A HELOC can be viewed as resembling a credit card that is secured by a home. Generally, HELOCs and home equity loans have comparable interest rates;13 both types offer a considerably lower after-tax cost when compared with a credit card loan.

Historically, home ownership has been one of the linchpins of a secure retirement. Often when people have reached their early 60s, the mortgage has been paid off, which reduces the cost of living in retire- ment. Moreover, if people sell their house to move to a smaller residence, or to a less expensive location, they frequently generate free cash. By offering home equity loans, often without extensive paperwork, time, or cost, banks have made it convenient to use the house as a source of low-cost credit. Retirees with no paychecks coming in, may have difficulty qualifying. Therefore, preretirees may want to ac- quire a home equity line of credit (HELOC) while they are still working and have enough income to qualify for the loan. Subsequently, the HELOC probably will remain in place after retirement. The credit terms for a home equity loan or a HELOC may be largely the same for a younger bor- rower whose income will rise and who will have many years to repay and for an older person with fewer years until retirement. The borrowing limits on home equity debt are higher than those on a credit card because the lender has a secured asset.

Although a homeowner could always have refi- nanced a first mortgage or taken out a second one, the up-front processing cost and time to close made it attractive only for major additional borrowings. The home equity loan, on the other hand, can be used in ways that differ little from that of a major credit card. The result can be a slowly mounting accumulation of debt over time that reduces the equity in a home by the time the owner retires. Therefore, the home equity loan in practice has advantages and disadvantages. It is usually the low- est-cost source of debt except for a first mortgage, with fairly easy access to it. At the same time, a home equity loan reduces the benefit of the forced savings component of the house through pay down of debt over time. Consequently, for homeowners with weaker discipline and less foresight, the monthly repayment has the potential to erode their standard of living in retirement. Retirees who are unable to raise cash through an acceptable home sale or receive home equity loans may consider a reverse mortgage for needed credit. (See page 401 for details on reverse mortgages.)

Practical Comment Home Equity Loans and Retirement

13 The APR for a HELOC cannot be compared with the one for a home equity loan because the components entering the calculations for the two differ.

168 Part Two Ongoing Household Planning

CREDIT CARD DEBT

Credit card debt is the most common form of consumer loan debt in the United States. Credit cards can be distinguished from debit cards. Unlike credit cards, debit cards are not a source of additional funds through borrowing cash because the amount paid for pur- chases with a debit card are automatically deducted from bank balances. Credit card debt typically comes from purchasing consumer goods, although withdraw- als for cash are permitted. If repayments are made within a grace period (which must be at least 21 days, under the Federal Credit Card Accountability, Responsibility and Disclosure Act of 2009), no interest is charged. Thereafter, monthly interest is charged using various methods that may be based on the previous month’s closing balance or those sums outstanding, which more accurately reflect payments during the month. Interest on credit cards is often offered at a high rate relative to interest on other con- sumer loans. Selected individuals with strong assets and credit histories may receive below-average credit card rates, but these still may be above that for many other consumer loans. Many advisors, including financial planners and accountants, view credit cards as an “evil lure,” tempting people to spend more than they should and then charging them double-digit rates that can make repaying the loan difficult. The public, on the other hand, uses them heavily. It can be instructive to identify the reasons why they are so popular. First, credit cards can be utilized as a convenience card. As long as the money is paid off during the month, there is no interest cost; in effect, the holder receives free credit. Convenience for some also means using a card instead of carrying large amounts of cash and having to count out payments needed and receiving smaller cash sums as change. Second, credit cards have the advantage of helping people structure their lives. Credit cards can be used to even out flows of expenditures without disrupting normal income and savings patterns. For example, normal monthly savings can continue while the increase during the summer for vacation expenses can be financed by credit cards and repaid over the next several months. Third, credit cards can be employed as an alternative to holding larger cash balances. Large cash balances are used as a precaution against running out of liquidity in the event of unforeseen circumstances. Although the cost of credit card debt may be higher than that for investment alternatives, the debt is used for only part of the year for emergencies or for cyclical spending and is repaid promptly. Thus, the debt can be repaid when cash flow permits14 making the use of credit cards an efficient way to borrow. In this way, the ability

Professional Advice Credit Card Behavior and Consolidating Loans

14 When not repaid according to the repayment schedule, a person’s credit rating could be impaired.

Chapter Seven Debt 169

to use credit cards can permit existing cash funds to be used for a full year at normal in- vestment returns instead of at lower precautionary money market returns. Finally, when credit card debt is compared with regular bank loans, the bank loans are more costly for amounts under a few thousand dollars when fixed costs and transaction costs are included. For larger amounts, credit card debt in some cases may still be attrac- tive versus full-period loans if it is outstanding for only part-period peaks in expenditures. In sum, credit cards do have significant advantages that can help account for their popu- larity. However, as the following Practical Comment indicates, these cards must used with the personalities and behavior patterns of the people in mind.

MARGIN DEBT

Margin debt is money generally offered by securities dealers to help finance the purchase of marketable investments such as individual stocks, bonds, and mutual funds. The securities serve as collateral for the loan. The Federal Reserve sets the maximum amount available for borrow- ing. It is 50 percent of the fair market value of the securities on margin upon original purchase.

Example 7.9 Greg wants to buy $1,000 worth of stock on margin, and so he must commit at least $500 in cash or other collateral, which would mean taking a $500 margin loan. Going forward, broker- age firms and investment exchanges impose ongoing maintenance margin requirements, which generally have a 25 percent minimum. That $1,000 of stock might fall to $667, reducing Greg’s stake to $167, the current value minus his $500 margin loan. With $167 in equity on $667 of stock, Greg’s net value in this position is roughly 25 percent. Any further drop in the stock price would generate a margin call, requiring Greg to provide additional funds to his broker.

Given the advantages stated on page 168, despite the negative opinions among the financial press and many advisors, credit cards sometimes can be an ef- ficient source of credit. Moreover, you can use credit card statements, possibly in coordination with your checkbook, as a fairly simple way to identify your total expenditures, to easily separate them by type, and to plan and execute monthly payments. In other words, credit cards have some distinct advantages in convenience of use and in structuring repayments. Whether they are used efficiently or become an on- going problem depends on the borrower’s personality. Basically, there seem to be two types of people: savers and spenders.15 Savers operate under the life cycle theory, putting away appropriate sums for retirement, unforeseen emergencies, and college expenditures for any children. They use credit cards as a rational finan- cial alternative. Spenders may emphasize pleasure today. In economic terms, they have a high marginal rate of time preference.16 Spenders may have difficulty putting away resources for the future, even when they recognize the importance of doing so. Many spenders seek help through structure, including planned-out actions. For example, they

may prefer that monies be withdrawn directly for retirement savings rather than have money pass through their hands. By contributing to employer- sponsored plans such as 401(k)s via paycheck withholding, spenders can benefit from imposed savings. Credit cards can be the antithesis of what they need. Although credit cards can structure re- payments, consumers must have the ability to make them. Otherwise, the credit card represents an ongoing opportunity to spend without immediate consequence, wherever they go. People also may deemphasize the cost of credit because there is no current impact. Some spend up to the limits that companies offer. Ironically, these credit card users may not be good candidates for a loan to consolidate their debt—for example, a home equity loan. They need the structure of being “maxed out” on their credit cards. It is because of such people that credit cards have developed negative connotations.

Practical Comment Credit Cards and Personality

15 http://www.nahb.org/generic.aspx?sectionID=734& genericContentID=194717&channelID=311 16 See Appendix I to this chapter for an explanation of the term.

170 Part Two Ongoing Household Planning

Because of the ease with which the lender can liquidate the collateral in the event of default, the margin loan rate is often among the lowest pretax rates available to the bor- rower. In addition, margin debt is tax deductible up to the amount of taxable interest and dividend income for the year. The amount of margin interest expense that is higher than this income can be carried forward to the next year for a future tax deduction.17 The deduc- tion is available only for loans made for investment purposes. Therefore, a margin loan intended to finance a noninvestment item would not qualify.

OTHER SECURED DEBT

A loan that is secured by a valuable asset can have a relatively low rate. That asset can be liquidated by the lender to pay off the loan in the event of nonpayment. The most common example is an auto loan. In assessing auto loan rates, a credit subsidy by the manufacturer or dealer should be separated from interest rates for this type of loan. The interest rate can be a disguised discount on purchase of the automobile. If so, in some cases, a higher dis- count may be made available for cash purchase. When a cash purchase has no benefit for discount purposes, the subsidized interest rate can be very competitive. In the absence of a highly subsidized rate, a home equity loan that is available generally is a less expensive way to finance this large capital outlay.

BANK LOANS

Bank loans can be made for purposes other than purchase of a home. They come in many forms and are either amortized over the life of the loan or due by a specific date. Banks qualify borrowers according to the purposes of a loan, household income, assets, and credit history. Bank loans not made through credit cards can be lower than those for many other unsecured borrowings—particularly for qualifying borrowers who borrow significant sums.

CREDIT UNION LOANS

Credit unions, also called credit associations, are set up by individuals or companies that lend money to their members. In some cases, the rates are highly competitive, which can be attributed to such factors as the association’s nonprofit status, the absence of marketing expenses, and, often, the above-average credit quality of its members.

PENSION LOANS

A loan against 401(k) or other pension assets can be taken if the employee plan permits it. Individual companies may set guidelines, but overall limits are 50 percent of the borrow- er’s vested account balance or $50,000, whichever is less. The approach varies from assets withdrawn and interest costs paid directly to the employee’s pension to loans against assets with monies paid to the company and pension assets staying intact. The time frame for re- payments is generally stated; maximum repayment dates are set by the government, gener- ally for a maximum of five years. When repayment terms are not met, loans become distributions subject to income tax and potentially a 10 percent penalty tax. The interest cost to borrow is established by the employer and can vary from plan to plan.

17 There is also the option to use capital gains income to offset taxable interest expense but doing so will reduce the ability to use low tax rates on capital gains.

Debt 171

LIFE INSURANCE LOANS

After certain life insurance policies—for example, whole life policies—have existed for some time, they can develop significant cash values. Those amounts can be borrowed in a process that is somewhat similar to that for loans from pension plans. However, repayment terms, if any, are less stringent than those for pension plans. The rates for borrowing from cash value are stated in the contract. Sometimes taking out loans on policies can result in lower assigned rates of return on the cash value of policies. Older policies at low rates can make attractive borrowing alternatives.

OTHER MARKET LOANS

Various other loans are available, including those from retail establishments to purchase their goods, from consumer finance companies to receive cash, and from pawnbrokers who require assets deposited as collateral. Their costs may be higher in part because the rate of nonrepayment of the debt may be higher than for, say, a bank loan.

EDUCATIONAL LOANS

College loans are often made based on need. The rates on these loans granted by the fed- eral government or a college or university to full-time students can present an attractive alternative for those who qualify. A $2,500 tax deduction is available for student loans, but it is phased out based on modified adjusted gross income (MAGI) of $65,000–$80,000 for singles and $130,000–$160,000 for those filing joint returns. Mandatory payments are set up once income-producing activities begin.

LOANS FROM RELATIVES AND FRIENDS

Loans from relatives and friends can be a significant source of financing. Typically, the personal relationship is a factor in extending the loan. However, the loan itself must con- tain a market-related interest rate. If it doesn’t, the loan can be considered a gift, and the borrower will not be able to deduct the interest paid.

OVERALL PROCEDURE

Once the money has been borrowed, the interest expense is generally considered a nondiscre- tionary cost in the cash flow statement, regardless of the purpose of the loan. For example,

Practical Comment Evaluation of Pension Loans

172 Part Two Ongoing Household Planning

whether the borrowing occurred to purchase skis, food, a house, or common stocks, the interest expense related to these purchases becomes an ongoing nondiscretionary cost for the household. A summary of the relevant characteristics of loan alternatives is presented in Table 7.3. Pay particular attention to the cost column. Wherever possible, it will typically be most beneficial to select the lowest-cost alternative.

CONTINGENT LIABILITIES

Contingent liabilities are potential cash outflows depending on the occurrence of a possible event. For example, a person who cosigns for a loan taken by another person will be obli- gated to pay if the other person defaults. Two examples of contingent liabilities follow. If homeowners don’t eliminate the ice on the sidewalk in front of their homes, they may be vulnerable to a lawsuit if someone slips and is injured. Architects are fully aware of their vulnerability should faulty building design result in injury to people. When the likelihood of payment is high or the exposure very large and not covered by insurance or other prac- tices, the amounts should be incorporated in debt considerations. In the next part of the chapter, we will discuss important specialized topics in debt man- agement. We will begin by explaining credit reports, move to consumer laws in finance, and then consider financial difficulties and bankruptcy. Our planning efforts are intended in part to minimize those difficulties. The last section of the chapter on financial ratios provides ways to measure our current status to help reduce financial difficulties and pro- mote sound borrowing practices.

Loans from friends and family members are often fraught with risk. The problems are due primarily to different perceptions. Communication about the in- terest and repayment terms is often vague. For ex- ample, the borrower may assume that the loan will be paid off in a few years when he or she can afford to do so. However, the lender may come away with the belief that the money will be repaid much more quickly—as soon as the borrower’s liquidity problem has been resolved. Each party may have a different point of view about whether such items as vacations come before or after repayment. Each may be uncomfortable with discussing the terms in what can be a combined business and personal transaction. When it becomes apparent that the two parties understand the loan terms differently, one or both may become frus- trated, but the personal relationship may prevent them from speaking about it. The net outcome can sometimes harm that relationship. To overcome the potential problem, it may be best not to borrow from people with whom the borrower has a close relationship. When borrowing

is to take place, it should be done in a strict busi- nesslike way with the borrowing terms (including the interest rate) and repayment schedule estab- lished. An exception can be made for monies lent by parents to children, particularly for down payment on a new home. This loan has an emotional side in- cluding an attachment that extends beyond financial returns. The sum provided may not truly be a loan but can be an advance against an estate distribution with repayment required only if the parents need the money. When there is true loan intent, it too should be handled in a businesslike way. Indeed, a formal home buyer’s loan from parent to child can benefit both parties, if the parent receives a significant yield while the child pays a competitive interest rate.18

18 Teri Agins, “When a Friend Asks for Money, Try Saying ’No,’” The Wall Street Journal (Eastern edition), August 6, 1985: 1; Eric S. Toya, “Intra-family Loans Can Help Children Get a Home,” Financial Planning Association, 2011, fpanet. org/ToolsResources/TipoftheWeek/PastTips/HomeOwnership/ IntrafamilyLoansCanHelpChildrenGetaHome/

Practical Comment Loans from Friends and Relatives

Debt 173

CREDIT REPORTS

Credit reports are factual printouts that include an evaluation of a person’s creditworthi- ness. Creditworthiness is developed using a scoring system. The higher the score, the more likely the person is to receive credit and, in some cases, the lower the interest rate will be. Perhaps the most frequently used system is one developed by Fair Isaac Co. (FICO) for credit bureaus. Each major credit bureau has its own score based in part on FICO. The fac- tors considered in scoring by the companies include these:

Type of Credit

Cost of Credit (pretax)

Tax Deductible

Cost of Debt (after tax) Secured Explanation

First mortgage Closed end Very low Yes Generally the lowest

Yes Tax deduction limited to $1million per home when purchased or redeveloped, $1.2 million per two homes

Home equity: Second mortgage Line of credit

Open end Low Yes Very low Yes Maximum tax deduction limited to building cost plus $100,000 for all purposes*

Credit card debt Open end High No High No Other factors may reduce effective interest rate for noncontinuing debt

Credit association loan

Closed end Low to medium

No Low No

Bank loan Closed end Medium No Medium Varies Pension loan Closed end Low to

medium Not for interest cost

Low to medium

Yes

Insurance loan Open end Low to medium

Not for interest cost

Varies Yes

Educational loan Open end Low to medium

Yes† Low to medium

Loan from friends and relatives

Varies Varies No Varies Usually not

Other Loans: Closed end High No High Varies Finance company Pawnbroker etc.

*Actual tax deduction restricted to the interest on debt equal to the home’s fair market value minus other debt secured by the home or $100,000, whichever is smaller. † Interest on educational loans may be tax deductible up to $2,500 per year.

TABLE 7.3 Summary of Loan Alternatives

Factor Explanation

Past credit history The most heavily weighted item. To receive a high score: No amounts-past-due disputes, charge-offs, bankruptcy; it is not good enough to pay off debt; it must be repaid on time.*

Married Higher score. Two wage earners Higher score. Age Being young or old means a lower score. Children Higher score.

(continued)

174 Part Two Ongoing Household Planning

Generally, the most important items in the score are the person’s past payment history, the amount of money owed, when the person last applied for credit, and how long he or she has had credit and the kind of credit. FICO scores range from 300 to 850; those below 650 may be considered weak while those above 750 are excellent. When credit scores slip, say from good to weak, borrowing rates can be altered. Good credit also can be used as a screen of job applicants and for insurance applications. As we have seen, during the real estate boom earlier in this century, credit was easier to ob- tain than it was 10 years earlier, which resulted in more delinquencies. A person who is rejected for credit must be given a reason. If there is an amount in dispute, the individual has the right to explain the reason for it in 100 words and have the statement placed in her or his credit file. There are three major credit bureaus: Equifax, Experian, and TransUnion. Each uses the FICO data to develop its scores. Because some credit providers subscribe and send credit information to only one or two bureaus, an individual can obtain a credit report from each bureau. This can mean that individuals who want to check their credit should do so with all three bureaus. The credit report provides their credit history, any inquiries about it, and any relevant public information, such as bankruptcy, for a period of time. A free credit report free,19 can be ordered online,20 by calling a toll-free number,21 or send- ing written requests.22 Under federal law, individuals are entitled to receive one free credit report from each bureau for each 12-month period. In addition, they can get one free if they are denied credit, are unemployed and looking for work, think they have or may have been the subject of a fraudulent credit transaction, are on welfare, or have been told by a company that it will be reporting something negative about them to a credit bureau. Additional requests per year are available at a cost. Under Federal Trade Commission (FTC) guidelines provided in the Fair Credit Reporting Act, individuals can obtain a copy of their actual credit score and the way it was developed from any of the credit bureaus for a “fair and reasonable” fee.23

Taking the steps indicated in Table 7.4 can improve credit scores. For an explanation of consumer protection laws including those for credit cards, see Appendix II to this chapter. Privacy and identity theft are discussed in Appendixes III and IV, respectively.

Job The more skilled the job, the more stable it is, the higher the score. Years at job The longer, the higher the score. Mix of credit types Higher score. Years at current residence The longer, the higher the score. Years at previous residence The longer, the higher the score. Current debt obligations The lower the amount, the higher the score. Favorable credit history

At bank granting loan Very favorable for score. At any bank Favorable for score.

*The longer a past due item is outstanding before being paid off, the lower the score.

(concluded)

Factor Explanation

19 Do not contact the three nationwide credit-reporting companies individually; instead see the information in the next four footnotes. 20 The Website for the credit report is annualcreditreport.com/. 21 The toll-free number is 1-877-322-8228. 22 The mailing address is Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281. 23 See “Where can I get my credit score?” Consumer Financial Protection Bureau, August 22, 2013, consumerfinance.gov/askcfpb/316/where-can-i-get-my-credit-score.html

Debt 175

FINANCIAL DIFFICULTIES

Financial difficulties can be defined as problems in simultaneously supporting normal household operations and paying interest and principal on debt owed when they are due. These difficulties may be attributable to lower-than-expected earnings or layoffs, unantici- pated costs, improper planning, investment setbacks, or simply unwise spending. When a cash flow problem is just temporary, a partial liquidation of investments or a consolidating loan may be enough to solve the problem. Under a consolidating loan, the proceeds from one lender are used to repay many loans, such as debt outstanding from a variety of credit card sources. The terms of payment may be extended in time to allow better matching of cash flow availability in relation to interest and principal costs. In some cases, the total interest expense may be lower as well. When the problem is more fundamental, either an additional revenues from sources such as a new or extra job must be found or a cutback in overall expenses must be imple- mented. The cutback can take place in selected significant costs such as entertainment, vacationing, eating out, or, more extremely, housing. Alternatively, an across-the-board percentage reduction in costs can be effected. Typically, an operating budget should be monitored to ensure that it is adhered to. Often it is helpful to restrict the use of credit cards. If the problems are more pronounced, personal bankruptcy may be considered.

BANKRUPTCY

Bankruptcy is a way for people to lessen or eliminate the burdens of debt. It is executed under court proceedings and therefore has legal standing that protects the filer from creditor claims. The number of bankruptcy filings has increased in recent decades but has declined in the past few years. In 1980, the number of bankruptcy filings was 331,264; by 2003, the total was 1.66 million, which then dropped to 1.22 million in 2012 (see Table 7.5). There are two forms of personal bankruptcy: Chapter 7 and Chapter 13. Under a Chapter 7 proceeding, all existing debts are wiped out. Chapter 13 is more complicated. It allows the filer an extension in time to pay off debts and frequently a reduction in the amount of obligations. Although income taxes survive after bankruptcy, penalties for late payment of them are not imposed under Chapter 13. The criterion for filing Chapter 13 is to make “best efforts” to repay creditors; under this proceeding, something approaching normal household operations including living expenditures and household maintenance items (painting, etc.) is expected to continue. There is generally a three to a maximum of five-year repayment period.

TABLE 7.4 How to Improve Your Credit Rating

Steps Explanation and Elaboration

Obtain and review a copy of your credit report These are the logical beginning steps. See whether the report is correct including whether payments have been made on time. If it is not correct, write to the credit bureau.

Pay all bills when due Self-explanatory. Reduce debt outstanding The lower the debt, the higher the credit score.

Do not consolidate debt. Limit the number of credit cards outstanding Having a few credit cards in force can increase

your score; having many more can reduce it. Plan future of credit Limit outstanding credit, for example, by spacing

cyclical purchases.

176 Part Two Ongoing Household Planning

A bankruptcy proceeding is supervised by a bankruptcy judge and involves a private trustee appointed by a U.S. government trustee from the U.S. Justice Department. It is the private trustee’s mandate to find as many creditor possessions as possible because payment is calculated on a fee-and-commission basis. The commission, contingent on the amount of assets found, provides incentive to uncover all assets. A bankruptcy proceeding stops evictions, default, foreclosure, and repossession actions for those notified, at least temporarily. Whether those who file will be able to keep their possessions will depend on the following factors:

The state the person lives in. Most states mandate that a person in bankruptcy be left with a minimum amount of equity in a house, a car, and household possessions. The amount varies by state. The level of security of assets. A secured asset is one for which other assets have been pledged against a loan in case of default. For example, a house is pledged for a mort- gage loan. In the event of default, the creditor often has a legal right to that asset regard- less of bankruptcy. If loans are in good standing, the asset cannot be repossessed by that creditor.

TABLE 7.5 Bankruptcy Statistics Year Total Filings Business Filings Nonbusiness Filings

Consumer Filings as a Percentage of Total Filings

1980 331,264 43,694 287,570 86.81% 1981 363,943 48,125 315,818 86.78% 1982 380,251 69,300 310,951 91.78% 1983 348,880 62,436 286,444 82.10% 1984 348,521 64,004 284,517 81.64% 1985 412,510 71,277 341,233 82.72% 1986 530,438 81,235 449,203 84.69% 1987 577,999 82,446 495,553 85.74% 1988 613,465 63,853 549,612 89.59% 1989 679,461 63,235 616,226 90.69% 1990 782,960 64,853 718,107 91.72% 1991 943,987 71,549 872,438 92.42% 1992 971,517 70,643 900,874 92.73% 1993 875,202 62,304 812,898 92.88% 1994 832,829 52,374 780,455 93.71% 1995 926,601 51,959 874,642 94.39% 1996 1,178,555 53,549 1,125,006 95.46% 1997 1,404,145 54,027 1,350,118 96.15% 1998 1,442,549 44,367 1,398,182 96.92% 1999 1,319,465 37,884 1,281,581 97.12% 2000 1,253,444 35,472 1,217,972 97.17% 2001 1,492,129 40,099 1,452,030 97.31% 2002 1,577,651 38,540 1,539,111 97.56% 2003 1,660,245 35,037 1,625,208 97.89% 2004 1,597,462 34,317 1,563,145 97.85% 2005 2,078,415 39,201 2,039,214 98.13% 2006 617,660 19,695 597,965 96.81% 2007 850,912 28,322 822,590 96.67% 2008 1,117,771 43,546 1,074,225 96.10% 2009 1,473,675 60,837 1,412,838 95.87% 2010 1,593,081 56,282 1,536,799 96.46% 2011 1,410,653 47,806 1,362,847 96.6% 2012 1,221,091 40,075 1,181,016 96.71% 2013 1,071,932 33,212 1,038,720 96.90% 2014 936,795 26,983 909,812 97.12%

Debt 177

As a practical matter, few homes, cars, and relatively inexpensive possessions are said to be repossessed in bankruptcy. Not all obligations are affected by bankruptcy proceedings. In addition to income taxes, divorce-related issues such as alimony, child care, and property settlements remain as do obligations stemming from fraudulent representations. Student loans also continue except for those considered an undue hardship. The federal government passed the Bankruptcy Abuse Prevention and Consumer Act of 2005. The result of this act has made filing for bankruptcy more difficult, particularly for the more lenient Chapter 7 form, which may be one reason for the decline in filings since 2003. Some key features follow.

1. A means test is established. If filers are in the top half in median income for people in their state and have income minus expenses of $100 a month or more, they must file under Chapter 13 and retire the debt over three to five years.

2. Filers must enroll in credit counseling and have a repayment plan from an approved agency within six months of the bankruptcy filing.

3. The act affirms the ability to keep pensions, IRAs, and prepaid tuition and college edu- cation plans.24

4. Under Chapter 13, the bankruptcy judge has the discretion to reduce the amount to be paid by up to 20 percent of the total.

5. The amount of debt for luxury items that can be expunged within a 60-day period of bankruptcy is limited; debts for cash advances that occur within a 70-day period are not eliminated.

6. Only $125,000 of interest in a homestead can be exempted if it was purchased within 1,215 days of the date of filing. (Adjusted for inflation, this amount is now more than $150,000.) Because some people seek to file in a debtor-friendly state, they must have lived there for at least two years prior to filing to take advantage of that state’s generous exemptions from bankruptcy for homes.

The credit counseling and the more expensive filing requirements are believed to discour- age bankruptcy filings. Clearly, bankruptcy is a fairly involved procedure. It has many advantages and disad- vantages, which we list here.

Advantages

1. It provides relief from financial burdens. 2. It can eliminate worry and harassing calls from creditors. 3. It can stop removal of some assets temporarily or permanently.

Disadvantages

1. Some assets may be taken. 2. Bankruptcy has a social stigma from bankruptcy. Information regarding it is a matter of

public record. 3. It can result in employment rejection. Although discrimination because of bankruptcy is

illegal, it could be difficult to prove. 4. It can contribute to a poor self-image.

24 If education funds are contributed at least two years before bankruptcy, an unlimited amount may be retained; if between one and two years, a maximum of $5,000 is allowed.

178 Part Two Ongoing Household Planning

5. A guarantor of the debt will be personally liable to repay it. 6. The money for any preferred repayments, for example, for friends and relatives, that

take place within one year prior to bankruptcy must be turned over to the trustee. 7. Bankruptcy involves costs including legal fees, an expense that is optional but generally

recommended.

Given these distinct advantages and disadvantages, the analysis of whether to declare bankruptcy can have aspects of an investment decision. The financial and behavioral issues in deciding a future course are discussed in the Practical Comment on when to declare bankruptcy.

FINANCIAL RATIOS

Financial ratios indicate the relative degree of financial risk the household has under- taken including its ability to pay off obligations when they come due. In other words, these ratios can help the household to determine whether it is in or approaching a finan- cial danger zone. There are two broad approaches to establishing that risk. The first is based on the household’s assets and the amount of debt outstanding relative to those as- sets. The second is based on cash flow and the amount of interest expense and debt re- payments relative to those assets. Both are useful and, although the amount of debt outstanding is more often used by some as a benchmark of overall financial health, inter- est expense is more of a day-to-day cash flow consideration. The relevant ratios are ex- plained next.

Practical Comment When to Declare Bankruptcy

Debt 179

Percentages Related to Debt Mortgage Cost as a Percentage of Income Mortgage debt is usually the largest obligation homeowners have outstanding. Mortgage payments, including real estate taxes and homeowner’s insurance, are customarily ex- pressed as a percentage of gross income. Lenders often use a 28 percent benchmark as a percentage of gross income as the limit to which they will extend credit (if they add all other debt charges and limit the total to 36 percent of gross income). However, the rate may be adjusted upward depending on circumstances such as living in a high-cost area such as the Northeast or the West Coast.

Installment Debt as a Percentage of After-Tax Income Installment debt is the normal way to repay credit card debt and loans taken for nonbusi- ness, nonmarketable investment purposes. Repayment of this debt is often compared with net salary (gross income minus taxes and other cash deductions from a paycheck). Keeping such debt under 20 percent of so-called take-home pay is often desirable, and a 15 percent limit is even more attractive. These benchmarks are particularly relevant when there are other types of debt outstanding such as mortgage debt.

Installment debt, % = Installment debt repayments Net salary

Total Debt as a Percentage of Income Mortgage debt and related expense payments plus nonmortgage debt payments are com- bined and expressed as a percentage of net salary. Interest payments and real estate taxes are expressed on an after-tax basis with tax deductions assumed at the household’s marginal tax bracket. As we have discussed, most nonmortgage debt is not generally tax deductible and is, therefore, taken on a pretax basis. Total debt payments should be less than 50 percent of net salary.25 When investment income is a substantial contributor to cash flow, it may be added on an after-tax basis to net salary. We discuss the relevant ratios next.

percentage of Total debt as

income =

interest and principal Total nonmortgage

payments + interest 11 − t2 andTotal mortgage

principal payments + and homeowner’s

Real estate taxes 11−t2 insurance expense

Net Salary

where t tax rate and (1 − t) = expense presented on after-tax basis.

Debt-Related Ratios Debt Coverage Ratio This ratio measures contractual debt and payments against household cash flows from op- erations. Thus, its benchmark is the amount available after deducting normal household overhead expenses from take-home pay, not the take-home pay. The ratio measures how much higher available cash flow is than interest and debt repayment cost. The higher the ratio, the safer the household is against negative unexpected occurrences.

25 This figure differs from a bank’s screen for total debt of 36 percent in that it is based on after-tax, not pretax, and income. This formula expresses interest and real estate costs on an after-tax basis.

180 Part Two Ongoing Household Planning

College Age debt, debt, debt, how will I ever repay my college loans over time

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Debt

©Don Hammond/Design Pics, Inc.

Debt 181

The ratio adds back after-tax interest payments because both pretax interest and its effect on lowering taxes were deducted to arrive at cash flow from operations.26

Times fixed payments earned

= Cash flow from operating activities + interest payments 11 − t2

Annual total interest and debt payments

Note: Cash flow from operating activities = Cash flow after nondiscretionary and discre- tionary activities.

Debt as a Percentage of Total Assets This ratio measures debt in relation to assets, not cash flow. It is difficult to develop broad benchmarks for warning signs of excess financial leverage. When people are young, they may place almost all their resources in a down payment on their home and borrow the rest. In that circumstance, debt may compose 80 percent or more of their total assets. The ratio should decline over time because as people age other assets should accumulate, the home should appreciate, and the mortgage should be drawn down.27 If debt payments become onerous, securities could be sold to help repay the debt. For people who are middle-aged or older, a debt figure of less than 50 percent of total assets may be desirable.28

Debt as a percentage of total assets = Total debt Total Assets

Current Ratio The current ratio compares current assets with current liabilities. Because these are assets and liabilities that will fall due within one year, the ratio of the two can measure people’s ability to pay off their debts as they occur. However, as mentioned in the chapter, the use of credit card debt as an alternative to having high precautionary liquid savings has some- what lessened the importance of this ratio.

Current ratio = Current assets Current liabilities

With this knowledge of debt and ratios as background, I can address the Dan and Laura debt situation that follows the Life Cycle Planning section.

26 The formula could be modified to include lease payments or all fixed obligations in the denominator under the assumption that all of them must be funded or the household would encounter difficulties. 27 An alternative ratio would measure debt as a percentage of a house plus liquid assets. Having a significant amount of total assets in marketable securities can serve as support for this formula. 28 The asset to liability measure and a ratio measuring liquidity were the best predictors of insolvency. See Sharon A. DeVaney, “The Usefulness of Financial Ratios as Predictors of Household Insolvency: Two Perspectives,” Financial Counseling and Planning Journal 5 (1994): 15–24.

Back to Dan and Laura DEBT The meeting we had on debt was somewhat charged. Dan hated the thought of debt. Yet here he was with $20,000 in credit card debt at 18 percent cost and about $46,000 in educational loans at 6 percent from his undergraduate days. Both he and Laura under- stood that the house, the car, and Laura’s graduate school enrollment would require additional borrowing. Dan accused Laura of being too flip with money. He said that

182 Part Two Ongoing Household Planning

whenever they were short of capital, she was quick to flash a credit card, particularly for purchasing attractive clothes at the mall, and that she was oblivious to the thought that at 18 percent interest, the cost was very high. Laura appeared very sensitive to the accusation. She said that Dan was very picky and that if they had followed his recom- mendations, they would be living in a one-bedroom apartment in a poor neighborhood, counting their pennies. I was about to intervene. Their difference in point of view seemed to be affecting their personal relationship. Then both people caught themselves, looked at each other, and smiled. I had the feeling that they had been through this type of discussion many times before and that each appreciated that the other had a different point of view. Both were concerned about their debt and felt a little overwhelmed. They wanted me to help them decide how to approach their financing needs. They indi- cated that Laura’s parents were not charging interest on the loan to them and appeared willing and able to help them if they needed more capital—for example, to finance the purchase of a home. Laura mentioned that her parents viewed the loan as a gift and would apply the money against her share of her ultimate inheritance when they pass away. Significantly, I thought, Dan made no comment about this financing source.

Here’s the advice I presented to them: Borrowing can be a positive or a negative force in financial planning. Borrowing for capi- tal expenditures that improve income-earning abilities or for those that reduce ongoing costs can be highly effective. On the other hand, significant monies borrowed to support normal household expenditures over a period of time should be discouraged. It can lead to a dependence on debt and an ever-rising monthly interest and debt repayment schedule that can retard your financial planning. In other words, borrowing can make household operations more efficient more quickly, but it also can add to risk and potentially derail your plans. Your own situation contains both “good” and “bad” use of debt. The borrowing that Dan made for college enabled him to obtain knowledge and a degree that substantially raised his projected lifetime income. The credit card debt you owe cannot be justified in terms of interest cost or probably even the reason for which the money was spent. Over the next several years until Laura goes back to work, your budget will have to reflect more limited income and higher child rearing and educational costs. Here is my thinking. I understand that debt concerns were the reason you came to see me originally. I also know that the need to move on the recommended purchase of a home has only compounded the problem. The most attractive form of borrowing is home mort- gage debt. Its cost is relatively low, and it is tax deductible. I’m going to recommend that you finance 90 percent of the cost of the home when you purchase it, if such a loan is avail- able. (Many lenders require 20 percent down as the result of the 2008 mortgage meltdown, but some accept smaller amounts. You may temporarily have to pay a higher total interest cost to purchase insurance guaranteeing repayment of the mortgage.) That will result in your temporarily paying a higher cost to purchase insurance guaranteeing the lender repay- ment. That extra cost will exist until the combination of appreciation on the home and re- payment of debt works the debt-to-home-value ratio down to a more reasonable level. Even with the extra cost, the home is still your best form of financing. If you can get your parents to cosign the loan indicating that they will pay the mortgage if you don’t, you may be able to get the home at a regular interest rate. The approximate $65,000 gift from your parents should pay for the 10 percent down payment on the say $250,000 home, moving expenses, and half of Laura’s tuition. It can only enhance the return on Laura going back to graduate school. Explain to them that you’re doing this for tax reasons because the cost to borrow on the home is lower than the

Debt 183

cost to finance a nontax-deductible educational loan. Use your existing investments to re- pay the $20,000 of credit card debt due and $7,000 of other debt due. The balance of edu- cational costs in two or three years could be financed by liquidating a portion of your investments. Finally, it was nice that Laura’s parents decided to forgive your loan of $20,000 from them. I believe that your use of credit cards as a form of debt should be limited. The cards should generally be paid off each month. In a few instances when you have a bulge pay- ment, say for an unplanned expenditure, you can keep the debt outstanding for a few months. It may still be less costly than other forms of borrowing for short periods of time. However, if you don’t have the demonstrated discipline to pay it off over a few months, then I recommend no credit card debt be taken out at all. Keep Dan’s existing college debt for now. This is a summary of the transactions in today’s dollars over a period of years,

Cash Inflows

Sale of existing investments $72,000 Parental gift $65,000 Total $137,000

Cash Outflows

Repayment of credit card and other current debt due $27,000 Payment of graduate school costs $80,000 Down payment on home $25,000 Moving expenses $5,000 Total $137,000

Net Cash Flow $0

College Student Case Study and Review: Amy and John DEBT Both Amy and John knew there was no alternative to accumulating debt. However, they still felt that borrowing is not only a future burden but also an unhealthy development. I decided to meet that concern head on. I explained that debt is neither good nor bad; it de- pends on each situation. Taking out debt to finance normal household costs because you’re spending more than you’re earning is clearly bad. Borrowing money to finance your col- lege education as the two of you have done is good. The amount owed should easily be paid back in the future by the higher income most college graduates receive compared with the incomes earned by those without a college degree. Nonetheless, you should become familiar with debt.

Risk and Leverage There are two types of leverage, operating and financial.

Operating Leverage Operating leverage has nothing to do with debt. It has to do with volatile company opera- tions often caused by high fixed costs. If necessary costs are high, a shift in revenues up or down causes cash flows to move sharply. When they decline, they add to risk.

184 Part Two Ongoing Household Planning

Financial Leverage Borrowing monies increases fixed costs as interest expense rises. It also offers the oppor- tunity to make purchases of useful assets more quickly. If the borrowing goes into efficient assets, say a dishwasher that frees income-producing work time, it can raise household returns. However, as fixed costs rise, risk due to unforeseen circumstances rises as well. As discussed in this chapter, financial ratios for debt help compare your figures with overall standards and allow you to measure your current figures against those for prior years.

Mortgages Mortgages are loans secured by real property. That means that the property can be sold by creditors in the event of nonpayment. Therefore, it is safer for lenders than unsecured debt, which is backed only by the borrower’s obligation to repay. The mortgage loan process includes the application, the assessment of the borrower’s quality, the home appraisal, the commitment, and the closing. Principal payments on mortgage debt lessen over time as debt is paid down. Over this period, the percentage allocated to interest payment declines and the percentage for princi- pal payment rises. (The total payment can be calculated simply, as shown in this book.)

Types of Mortgage Amy and John, there are two types of mortgage payments: fixed rate and adjustable rate. A fixed-rate mortgage is one whose interest rates remain stable over time. An adjustable-rate mortgage rate fluctuates with overall market interest rates. The upper limit on the rate may be capped.

Advantages Disadvantages

Fixed Rate stable payments.

are low. Adjustable Rate

that can be charged, no protection against higher interest rates.

initial rates when available.

financing and therefore purchase due to often low initial rates.

Home Equity Loans These are also loans secured by the home. A home equity loan is a second mortgage that allows its lender to follow the first mortgage owner in reclaiming assets if the borrower defaults.

Home Equity Line of Credit This is like a home equity loan but the money does not need to be borrowed at the time of signing. The line represents how much is available to be taken out when the borrower chooses.

Debt 185

Other types of debt are: Credit card debt. Generally used for purchasing consumer goods. Rates are high and non-tax deductible. Margin debt. Debt tied to the purchase of financial securities. Rates are low and tax deductible to the extent of interest and dividend income. Bank loans. Interest on them not tax deductible. Credit unions. Associations that lend money to their members. Rates may be highly competitive. Pension loans. Loans against retirement funds. They are limited to 50 percent of the amount or $50,000, whichever is lower. Life insurance loans. Loans against cash values of insurance. Education loans. Loans from federal agencies and colleges or universities that often have favorable rates, especially those based on need. Loans from friends and relatives. Can be cheap but watch the friendship angle.

Credit Reports A credit report is the factual printout and evaluation of a person’s creditworthiness. The increase in mortgage loans to borrowers with low credit scores in the years 2000–2007 contributed to the 2008–2009 recession. Subsequently, required scores have been raised. Individual credit reports can be obtained annually at no charge from the three credit bu- reaus: Equifax, Experian, and TransUnion.

Financial Difficulties and Bankruptcy There are a few remedies when financial difficulty results in the inability to fund current or projected debt payments. A consolidating “super loan” replacing other small ones may be appropriate. Other alternatives include increasing income with an additional or new job or cutting back on expenses, which is typically the most fitting solution. In some cases, a negoti- ated reduction in interest rates or amounts due may be reached with the lenders. When these approaches are insufficient, bankruptcy may be considered. There are two types of bank- ruptcy: Chapter 7 and Chapter 13. Chapter 7 eliminates all debt. Chapter 13 offers a reduction in debt and an extension of time to repay the balance. Those who are in the top half of their state’s median income may not qualify for Chapter 7. For either chapter, filers must enroll in a credit counseling course and may be able to keep certain assets including their home. Bankruptcy provides relief from financial burden, eliminates worry, stops creditor calls, and can in some situations prevent certain assets from being taken although others are taken. Various fees are required to file for bankruptcy. Entering bankruptcy still has a social stigma although it is not as prevalent as it once was.

Summary Debt is a financing tool that can enhance investment opportunities and provide earlier use of assets when used properly. When overused, it also can result in financial difficulties. The chapter details when and how to use this tool.

variable-rate forms.

inefficiently.

186 Part Two Ongoing Household Planning

borrowers to maintain favorable credit ratings.

ramifications.

regard to debt levels.

Key Terms adjustable-rate mortgage, 163 bankruptcy, 175 closed-end retail credit, 157 credit report, 173 financial difficulties, 175 financial leverage, 154

financial risk, 153 fixed-rate mortgage, 163 home equity loan, 166 hybrid ARM, 164 interest rate, 155 long-term debt, 159 margin debt, 169 mortgage, 159

open-end credit, 157 operating leverage, 153 operating risk, 153 rationed borrowers, 158 secured debt, 159 short-term debt, 159 unrationed borrowers, 158 unsecured debt, 159

bankrate.com Borrowing Sections on mortgages, automobile loans, and credit card debt are included on this Website. It also contains information about rates and trends and has credit and loan calculators.

interest.com Mortgages The Website lets the consumer shop for mortgages and find a lender. It also has mortgage calculators and lets users track mortgage rates. It has sections on refinancing and other types of loans such as auto, home equity, and credit card.

abiworld.org American Bankruptcy Institute This site serves as an online resource for bankruptcy information and news. Bankruptcy statistics, education information, online newsletters and publications on bankruptcy, and a search tool for finding an attorney experienced in bankruptcy mat- ters are provided. (Access to some data requires a paid membership.)

finance.yahoo.com/topics/credit-debt/ Yahoo’s Loan Center The loan center offers information on mortgage, home equity, and auto loans.

creditforums.com Credit Forum A “community of credit and personal finance experts” answers questions on credit- related issues.

nfcc.org National Foundation for Credit Counseling This site provides information to help find member agencies staffed by professional Certified Consumer Credit Counselors who can provide personal assistance to people who need help with stressful financial situations.

Websites

Debt 187

annualcreditreport.com Annual Credit Report AnnualCreditReport.com is a centralized service for consumers to request annual credit reports. On this Website, consumers can request and obtain a free credit report once every 12 months from each of the three nationwide consumer credit reporting companies: Equifax, Experian, and TransUnion.

Other Websites offering online credit reports, credit improving tools, and advice include

equifax.com Equifax

experian.com Experian

transunion.com TransUnion

Questions 1. What is debt’s role in the household? 2. What is the difference between debt and fixed obligations? 3. What is the difference between debt and intangible liabilities? 4. Contrast operating risk and financial risk. 5. Why is operating leverage as it pertains to risk important? 6. Harry was deciding on the separation of outlays into nondiscretionary and discretion-

ary. What advice would you offer him on the division as it relates to risk? 7. What is APR and why is it important? 8. List and explain the borrowing factors. 9. Contrast the strengths and weaknesses of a fixed-rate mortgage with those of a

variable-rate mortgage. 10. Alexis wants to buy a large home relative to her income and thinks that she may not

qualify for a mortgage for 80 percent of the price. She expects interest rates to rise and anticipates staying in the home for many years. Explain the strengths and weak- ness of fixed- versus variable-rate mortgages for her. Indicate which one you would select and why.

11. Why are adjustable-rate mortgages generally cheaper than fixed-rate mortgage loans? 12. When is a home equity loan better than refinancing a first mortgage? 13. Credit cards are a grossly inefficient way to borrow money. True or false? Explain and

discuss their advantages. 14. Why borrow using secured debt? 15. Pension loans save you money because you pay yourself back. True or false? Explain. 16. Are loans from friends and relatives a good practice? Explain. 17. What borrowing mechanism provides the lowest cost. Why? 18. How can you improve your credit? Indicate the specific steps to do so. 19. Jeremy is in financial difficulty. He owes $5,000 and cannot pay it back now. Should

he declare bankruptcy? Why? What do you think he should do? 20. In calculating the ratio times fixed payments earned, after-tax interest payments are

added back in the denominator. Why?

188 Part Two Ongoing Household Planning

Problems Dorothy has the following projected cash flows: income, $65,000; fixed operating costs excluding interest, $44,000; variable outlays, $7,000; interest cost, $5,000; and repayment of debt, $6,000. Does Dorothy have high operating leverage? Calculate what a 15 percent higher and 15 percent lower income would do to profitability. For the $8,000 loan John needed, he was given a choice of in loans with the following characteristics.

a. $1,200 in interest paid at the end of the period. b. $1,200 in interest paid at the beginning of the period. c. $1,200 paid equally over the period with part of the principal retired each month.

Calculate the interest rate paid. In part (c), calculate using both the approximate method and the actual cost method assuming a one-year loan retired in 12 equal monthly install- ments of interest and principal. Melinda has a 15-year fixed-rate mortgage for $150,000 at a 6.5 percent rate. Calculate her monthly mortgage payments. Martha has seven years remaining on her $160,000 mortgage, which has a 7.5 percent rate. She would have to pay $4,500 to refinance. Martha expects to live in the house for another five years. She is in the 33 percent marginal tax bracket and can earn 10 percent after tax on other uses for the money. If the mortgage rates have declined to 6.5 percent, should she refinance? How much would a person save by borrowing money at 6 percent for a home equity loan versus 18 percent for a credit card loan. Assume a marginal tax bracket of 30 percent. Given the following statistics, calculate the mortgage cost percent.

7.1

7.2

7.3

7.4

7.5

7.6

Elena is in the 28 percent bracket and has the following real estate and nonreal-estate- related costs.

7.7

Nonmortgage interest and principal $ 4,000 Mortgage interest 15,000 Mortgage principal 7,000 Real estate taxes 8,000 Homeowner’s insurance expense 2,000 Net salary 70,000

Calculate total debt as a percentage of income. Is it satisfactory? Louis had the following cash flow items:7.8

Cash flow from operations $40,000 Interest payments 6,000 Total interest and debt payments 9,000

If Louis is in the 30 percent tax bracket, how many times are fixed payments earned?

Annual mortgage interest $ 9,000 Annual principal payment 2,000 Annual insurance and real estate taxes 8,000 Yearly gross income 120,000

Debt 189

The Moores recently found out that they can reduce their mortgage interest rate from 12 percent to 8 percent. The value of homes in their neighborhood has been increasing at the rate of 7.5 percent annually. If the Moores were to refinance their house with $2,000 in closing costs in addition to the mortgage balance ($120,056) over a period of time to coin- cide with their chosen retirement age in 22 years, what would the monthly payment be for principal and interest (closing costs are going to be added to the mortgage)?

a. $853.43. b. $895.60. c. $945.34. d. $967.86. e. $983.99.

A young couple would like to purchase a new home using one of the following mortgages:

Mortgage no. 1: 10.5 percent interest with 5 discount points to be paid at time of closing Mortgage no. 2: 11.5 percent interest with 2 discount points to be paid at time of closing

Assuming the couple could qualify for both mortgages, which of the following aspects should be considered in deciding between these two mortgages?

1. gross income. 2. estimated length of ownership. 3. real estate tax liability. 4. cash currently available. a. (1) and (2) only. b. (2) only. c. (2) and (4) only. d. (4) only. e. (1), (2), (3), and (4)

A CFP® professional meets with two new clients who would like advice about their mortgage. In the review, the CFP® professional finds that their essential expenses exceed their income. Mortgage rates have come down significantly and they intend to refinance their current 30-year mortgage to a 15-year mortgage. Their payments will be higher than their current payment. However, they will pay off their mortgage 5 years earlier than the current amortization schedule allows. What should the CFP® professional do?

a. Suggest they stay with their current mortgage, as the higher interest rate is tax deductible. b. Suggest they refinance to a 30-year fixed mortgage and begin funding savings. c. Suggest they refinance to the 15-year mortgage, which would reduce the amount of

interest paid over the life of the loan. d. Suggest they meet with their mortgage broker.

7.1

7.2

7.3

CFP® Certification Examination Questions and Problems

190 Part Two Ongoing Household Planning

Case Application DEBT Part 1 Richard and Monica have diametrically opposite points of view on debt. Richard views debt as an opportunity to generate cash to make up for past investment losses. He has asked you whether he should remortgage his house and place the proceeds in the stock market. He says the present time may be appropriate to refinance because market rates for mort- gage loans of 6.5 percent are well below his mortgage rate of 8 percent. He wants to use an adjustable rate that provides an even lower 4 percent rate for the first year with rates there- after 2 percent above the five-year Treasury rate. Richard wants a 30-year mortgage because he said he doesn’t expect “to go anywhere” and the annual repayments would be low. He said he was thinking about buying a new car. While the existing one worked well, he was tired of it. If cash flows get tight, he isn’t at all averse to using credit card debt. He says that whereas credit card rates are high, the overall impact is not great and “people manage to pay money back.” Monica has listened quietly to Richard with a pained expression on her face, occasionally shaking her head. She says she is afraid of taking on more debt and wants a budget to limit spending of all types.

Case Application Questions 1. What do you think of Richard’s idea of borrowing to place money in the stock market? 2. Do you think the couple should refinance their mortgage? 3. Should they use the adjustable-rate mortgage offered? 4. What is your recommendation on a 30-year loan? 5. Should the couple buy a new car? 6. What do you think of Richard’s view of debt? 7. Do you agree with Monica’s point of view? 8. How would you treat the disagreement between Richard and Monica? 9. Complete the debt and future budgeting part of the plan.

Part 2 Brad and Barbara say they use credit cards all the time. They always intend to pay them off by the end of the month, but they often don’t. In fact, their credit card debt has been rising recently.

Case Application Questions 1. Is this pattern common? 2. What is your recommendation?

Borrowing Theory: Risk and Equilibrium In a world with perfect capital markets without risk, households can borrow or lend at the same rate. Either borrowing or lending or neither will be selected. People borrow when their capital budgeting opportunities or present consumption needs exceed their existing

Debt 191

cash flow. Without risk in the marketplace, a household can borrow as much as it wants at a low risk-free rate. It would borrow until the point that the return from capital expendi- tures or other forms of investment equaled the borrowing cost. Of course, no such world exists. When risk and transaction costs are introduced, the framework changes dramatically. Then the cost of borrowing will be different than the re- turn available on external investments such as marketable securities. What we pay for the money we borrow depends on the amount of risk we undertake. The greater the uncer- tainty, the higher the market interest rate charged. We call the expense we pay in borrow- ing money the cost of debt. Let’s trace how debt is used under these circumstances. Whether the household will be saving and investing or will have a need to borrow funds will depend on its marginal rate of time preference. This marginal statistic is the rate that makes postponed future con- sumption expenditures possible with savings and investing equal in appeal to spending the money today. Each household has its own value system and therefore its own discount rate. Of course, the marginal rate will be influenced by the amount of cash flow that the household generates as well as its desire for additional goods. The marginal rate of time preference will be compared with the cost of debt and the returns on internal and external investments.29 Debt may be used for consumption when its cost is lower than the marginal rate of time preference and for investment when the cost of debt is lower than the projected returns on investment. What makes the analysis more complex is that investment consumption and borrowing patterns will be affected by the household’s tolerance for risk and that tolerances can differ materially among households. For example, even without the need to borrow to buy a used dishwasher from a private party, one household may be willing to pay 50 percent of origi- nal cost. In contrast, another household, more fearful of the possibility that dishwasher repairs would be needed shortly after purchase and therefore are more risk averse, would require a higher return on the durable good. Consequently, its member-owner might offer to pay 25 percent of original cost. The impact of risk on consumption also would vary by household. We might assume that higher risk would result in more saving, but this may not always be true. If two house- holds were to be exposed to the same risk of a possible debilitating illness, one might lower its original marginal rate of time preference to generate savings for this possibility. Another household, however, might raise it, preferring to enjoy life today while its mem- bers know they are still healthy. Borrowing and raising household risk can increase the required return on investments, the extent of which also can vary by household. We can conclude by saying that borrowing may be used when its cost is below the risk-adjusted marginal rates of time preference and of invest- ment return. Clearly, the higher the cost of debt, the less likely it is that borrowing will be used.

Consumer Protection Laws A variety of laws protects consumers in purchasing. They are entitled to fair disclosure of information that is relevant for purchase. Consumers can sue anyone who violates laws. The government helps by reviewing the activities of manufacturers, sellers, and lenders, for example. See the following for the rights of the buyer in selected areas. They are all

29 Those for household production currently versus those for traditionally liquid investments such as stocks and bonds.

192 Part Two Ongoing Household Planning

subchapters of the Consumer Credit Protection Act (CCPA), which is enforced by the Federal Trade Commission.

TRUTH IN LENDING ACT When consumers are provided credit under the Truth in Lending Act, the lender is obli- gated to disclose such things as the cost of credit using the objective APR (annual percent- age rate), annual and late payment fees, the actual amount being provided, and so on. Damages are measured by the difference between actual charges and those indicated misleadingly as a lower charge.

FAIR CREDIT BILLING ACT If there is a dispute about the amount owed, the Fair Credit Billing Act allows consumers to write the creditor explaining the difficulty whether due to errors in calculating amount due, orders never received, returns never credited, and so on. The comments must be re- ceived within 60 days of the bill. Consumers can withhold the amount in dispute. The lender must resolve the claim within 90 days of receipt of the letter. The consumers’ credit isn’t affected during this period. Consumers whose credit cards are stolen or permanently lost are liable for a maximum of $50. If they report the loss before unauthorized transactions are made on their credit cards or if the loss involves their credit card number but not the card itself, consumers have no liability for any unauthorized charges.

FAIR CREDIT REPORTING ACT When applying for credit, the credit reporting agency must check the information, estimate the applicant’s ability to handle the credit, and investigate the applicant’s credit history. Adverse information more than 7 years old should be deleted except for information about bankruptcy, which is available to lenders for 10 years. The credit-reporting agency is obligated to keep this information current and accurate. The information generated may be used for only narrowly selected reasons such as for credit or for employment.

EQUAL CREDIT OPPORTUNITY ACT Under this act, no one can be discriminated against on the basis of race, sex, marital status, or national origin.

FAIR DEBT COLLECTION PRACTICES ACT The Fair Debt Collection Act limits debt collection procedures to those that are fair. The debtor must be notified of background information on the debt and given 30 days to report disputes.

CREDIT CARD ACCOUNTABILITY RESPONSIBILITY AND DISCLOSURE ACT This act amends the Truth in Lending Act to prescribe enhanced disclosures to consumers, limit related fees and charges to consumers, increase related penalties, and establish con- straints and protections for issuance of credit cards to minors and students.

Debt 193

DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT This act creates a new Bureau of Consumer Financial Protection within the Federal Reserve Board as a supervisor for certain financial firms and as a rule maker and enforcer against unfair, deceptive, abusive, or otherwise prohibited practices relating to most con- sumer financial products or services.

ADDITIONAL LAWS Other selected laws are briefly summarized next. They may vary by area.

Canceling a Purchased Item If consumers change their minds about a purchase, a federal cooling-off period allows them to cancel such things as a home improvement loan or sales for more than $25 if the sale didn’t take place at the proprietor’s place of business. States have different cooling-off periods. Exceptions are made for custom purchases.

Warranties Federal law refers to many types of warranties, which are also known as the product pro- vider’s guarantees to consumers. Under implied warranties that are not stated by the provider, the law implies that a product must perform as indicated and fit its purpose.

Consumer Leasing Act The Consumer Leasing Act applies to leases of four months or more for a variety of con- sumer goods. Consumers must receive information that permits comparison with other competing leases and with purchase of an item. Consumers must be given information such as the amount due on signing, total amount of payments, any other expenses, warran- ties on the good, fees for default or late payment, information on normal wear and tear, and the terms of any purchase option at the end of the lease. Advertising of a lease must dis- close some of this information.

Student Loan Defaults When in default, the U.S. Department of Education will notify credit bureaus, tax refunds may be withheld, collection costs may be assessed, borrowers’ wages may be attached, and they may be sued. When there are special circumstances for nonpayment, extensions may be given and, less often, partial or full elimination of the loan may occur.

III

Privacy Privacy is the ability to keep information about consumers free from unsanctioned exami- nation. Privacy has become a more significant problem because of unauthorized tapping into information on computers and through communication via the Internet. One outcome of carelessness about safeguards can be identity theft, which is discussed in Appendix IV. The Financial Modernization Act of 1999, known as the Gramm-Leach-Bliley Act (GLB Act), helps protect people who have information that resides at financial institu- tions. The GLB Act applies to all financial institutions that gather and release financial

194 Part Two Ongoing Household Planning

information, not just those that hold information for their own customers. Financial institutions must design, implement, and shield customer information. The act pro- tects people against those who would acquire this information falsely, called “pretex- ting.” The law requires financial institutions to notify and inform customers of their practices; customers have the right to restrict some institutional dissemination of their information. To protect themselves, consumers should follow the rules discussed under identity theft in Appendix IV. They shouldn’t provide personal information unless they are sure of the legitimacy of a company and the representative’s position with it. Ask companies about their safeguards. If statements don’t arrive on time or are erroneous, take immediate ac- tion. Safeguard personal information and tear up or shred old valuable financial informa- tion including checks, credit card information, and so on. Add passwords to financial information and keep information private by using uncommon password numbers. Consumers should check their credit rating from each credit rating agency every year. If pretexting (obtaining information by using a false identity) has occurred, they must follow the guidelines under identity theft. Financial advisors should have a written plan to safeguard client information. The plan should be appropriate to the amount and sensitivity of the information they have. The plan should include the following:

1. At least one person should be in charge of the effort overall or by area. 2. The risks to the client should be assessed. 3. A safeguard system should be established and monitored with outsiders consulted when

appropriate. 4. The program should be reviewed and updated as needed.

Included in the program are:

1. Checking references for new hires. 2. Training employees in basic safeguards.

a. Lock rooms. b. Require employees to become familiar with and sign a confidentiality agreement that

includes abiding by established security standards. c. Establish passwords on computers and change them periodically. d. Don’t give out information unless confident that the request for it is authorized. e. Implement a “need-to-know” policy for internal employees. f. Impose disciplinary proceedings on violators.

3. For information systems:

a. Store information in secure area. b. Protect information against fire, flooding, and other hazards. c. Keep information away from machines having an Internet connection. d. Keep information transmission secure. e. Erase all data containing customer information that is no longer needed. f. Back up all data.

In line with the GLB Act, the SEC requires that advisory companies notify clients about their policies and implement safeguard policies including nondisclosure of nonpublic personal information to outsiders until clients have an opportunity to refuse its dissemination.

Debt 195

Identity Theft Identity theft occurs when a person or group steals your personal information and repre- sents themselves as you, generally for purposes of financial gain. They can illegally as- sume your name and use your Social Security number, address, credit card number, date of birth, or other information. They can do this by going through trash, stealing wallets and purses, accessing credit card numbers, posing as legitimate service companies, and so on. Their tampering can result when you make a one-time expenditure or withdrawal and sys- tematically use your information until they have been identified. Some actions to protect yourself include:

1. Check your credit and the charges on individual credit cards. As discussed, you can re- ceive one credit report per year from each credit bureau at no charge. Consider purchas- ing a credit monitoring service that has a record of broad-based purchase information.

2. Notify your vendors and other creditors if expected bills have not arrived. 3. Follow up if you are denied credit.

If you have identified illegal activity:

1. Notify credit card companies or other relevant parties immediately of lost or stolen cards. As mentioned, your losses may be restricted to a maximum of $50. If your credit card number but not the card has been stolen, you are not liable for unauthorized use.

2. If checks are stolen or counterfeited, stop payment, change your bank account, and no- tify ChexSystems (1-800-428-9623) or another check verification service with which your individual bank does business.

3. Place a fraud alert on your credit card reports with any one of the credit reporting com- panies listed in this chapter.

4. Refuse to give personal information such as Social Security numbers over the phone or online. To check if it is a legitimate vendor such as your bank, call the general number and confirm the authenticity of the representative.

5. Tear up or shred sensitive material before throwing it out. 6. Don’t carry your Social Security card with you. 7. Take precautions to protect your computer-related files and communications. 8. Change bank accounts, credit cards, etc. Avoid new passwords related to your tele-

phone or Social Security number, mother’s maiden name, or date of birth. 9. File a complaint with the Federal Trade Commission, which is the federal clearinghouse

for identity theft. 10. File a report with the local police in the precinct where the theft occurred.

Advisors’ safety factors include:

1. Avoid receiving or sending sensitive client information via email. 2. Update virus protection software regularly to protect against intrusions. 3. Lock up sensitive hard copies of client information. 4. Shred all discarded client information. 5. Close down computers at the end of the day and use uncommon passwords to access.30

30 For other computer-related protection information on identity theft, such as sample letters and forms for victims of identity theft to limit the damage that is caused, see the Federal Trade Commission’s advice at consumer.gov/idtheft

Part Three

Portfolio Management

1 The home is a household investment as well and as such, is dealt with for comparison to other household assets and for aggregate household decision making in this chapter. However, the homes importance as part of the real estate sector and its link to external real estate investments merited it be treated as a separate chapter.

8. Household Investments 9. Real Estate and Other Assets

10. Financial Investments 11. Risk Management

These four chapters deal with portfolio management, the household’s overall invest- ment function. The household is typically thought of as having two choices in employing its cash flows. The first choice is to spend the money on current living needs and desires. The second is to save and invest the money, keeping it in reserve for future deployment. Actually, there is a third choice: to spend it on capital items. Capital expenditures are outlays that are both used today and benefit future periods. An example is the purchase of a new car, which will last for many years. We can call these outlays household investments, which make the household operate more efficiently or provide extended pleasure for its members. They are the subject of Chapter 8.1

Chapter 9 principally discusses real estate. It is separated into the home and other real estate. The home is often both a capital expenditure in its role as a shelter and a principal long-term investment for the household. Other real estate represents independent investments that generally provide income and price appreciation. The chapter also details and evaluates in summary form other assets incorporating com- modities and gold as investment alternatives. Those cash flows that are not spent currently but are reserved for future use are typi- cally placed in financial vehicles such as stocks, bonds, and mutual funds. They are called financial investments and are discussed in Chapter 10. They stand in contrast to what we can call in aggregate nonfinancial investments as presented in Chapters 8 and 9. Investments cannot be discussed solely in terms of returns. The household is subject to a variety of risks both for financial and nonfinancial assets. The general principles of investment risk and risk-return principles are explained in Chapters 10 and 11. Chapter 11 focuses on insurance, perhaps the best-known risk manage- ment tool. Life insurance alternatives are presented in detail in that chapter. These chapters should enable you to understand financial investments as well as to appreciate the broader scope of investments the household makes and the approach to protecting them. Total portfolio management, a method of resolving household deci- sion-making problems that integrates both financial and household investments and incorporates risk, is discussed in this Part and elaborated upon in Part Seven.

198

Chapter Eight

Household Investments Chapter Goals

This chapter will enable you to:

planning are broader than believed.

management (TPM), the household’s all-asset approach.

Dan felt he has to have a “status car.” Laura was concerned about her family and her career. She thought of pursuing a Masters degree.

Real-Life Planning At a periodic meeting, Ken asked the advisor if he could help him become better informed in financial matters. Ken was a former radio announcer who made his living doing voice- overs on television and radio commercials. He had at least 10 different “voices” and could adjust easily to the needs of the particular situation. His most popular voice was used by major national sponsors who provided him a payment every time it was repeated. Ken went to many auditions and ended up being cast on one of every five jobs for which he applied. Like many creative people, Ken had little interest in financial matters. He was, however, very curious and intelligent and didn’t mind being argumentative. Something he read in a finan- cial magazine had piqued his interest. It was a statement that appliances were household assets. He had always regarded them as expenses. He wanted to know what the advisor thought was the proper answer. The advisor knew that the answer would have to be simple and practical; otherwise, Ken’s eyes would move from side to side, signaling that his interest had been lost. The advisor told him that by one measure, he was technically correct. The calculation of the country’s output, gross domestic product (GDP), doesn’t include appliances or any

Household Investments 199

other individual purchase as a household asset but does include the house itself. The same item purchased for a business (for example, a car or a television set) would be treated as an asset. However, the advisor indicated his strong belief in separating asset purchases (money spent for items that had usefulness over extended periods of time) from other outlays. The advisor explained to Ken the idea and the benefits of treating the household as a form of business. He mentioned that a large part of a household’s operations, those not pertaining to pleasurable activities, closely resemble a business. The appliances purchased could be used to save money or time. Time could be used to earn money. Ken would have more time for auditions, which would likely raise his income. Ken nodded but asked about a television. How isn’t that an indulgence, an expense? The answer was that the television might not boost the cash flow of the household, but it could add to the enjoyment of its members. Even a household work-related appliance not used for earning income could benefit the household by adding to leisure time. In addition, the television was an asset that had an identifiable fair market value. The advisor mentioned that return on investment techniques can be used to decide whether to purchase work-related assets, but more subjective measures might have to be used for those related to pleasure. The advisor said the key for outlays that aid household activities for a longer period than the current one is to treat them as investments. They should be segregated on current cash flow statements and in thinking about when future outlays will become necessary again. In that way, he should treat them separately just as a business does. The advisor said that these expenditures with multiyear benefits could be called capital expenditures. Ken flashed a wicked smile and asked for a financial rule of thumb in deciding whether to make or reject a work-related outlay for an appliance. The advisor responded with a rough rule for appliances that had around a five-year life: If the benefits exceeded the outlays within three years and were expected to continue significantly beyond that period, make it. Ken, employing what sounded like his 11th voice, which was eerily similar to that of former President Reagan, said, “Thanks, I understand what you are saying.”

OVERVIEW

Household investments are the assets the household possesses that are often overlooked or that have less time devoted to them than to more glamorous stocks and bonds. This is ironic because the average household’s assets in this area often exceed those for market- able financial securities. Consequently, efforts to improve decision making in this area can be highly productive for people. Said differently, capital expenditures and capital budget- ing as related to investments are as important to a household as they are to a business. In this chapter, we explain how to identify and value household investments in order to plan properly for their purchase and use. We do so by separating the chapter into four parts: defining and detailing household investments, examining the decision process, ana- lyzing major capital expenditures, and evaluating the leasing alternative. The chapter includes appendixes that extend the material.

DEFINING AND DETAILING NONFINANCIAL ASSETS

The investments the household makes can be separated into two major categories: finan- cial and nonfinancial assets. Financial assets are those whose ownership is represented and traded solely through pieces of paper. Financial assets often maintain or increase in value over time, particularly when the cash they generate is reinvested. Often financial as- sets are fully marketable. Fully marketable assets, also known as marketable securities, are those that can be sold currently in a public forum for fair value at low transaction costs.

200 Part Three Portfolio Management

Examples of fully marketable financial assets are stocks and bonds. They are what we typically put our savings into. We discuss them in the next chapter. Nonfinancial assets are all the other assets the household possesses. They can be seg- regated into real assets, human-related assets, and other assets. Real assets are items that we can see or touch that have market value. Included are a person’s home and the posses- sions in it such as the furniture, household appliances, and the car parked outside. Sometimes these real assets are called tangible assets, physical assets, or hard assets. Real assets are generally used in the household currently whereas financial assets may be reserved for future use The term durable goods is more specific. For our purposes, it applies to household possessions. We use that term frequently in this chapter. Real assets, a broader term, can be separated into real estate, commonly the home, and durable goods. Aside from their physical features, real assets differ from financial ones because real assets generally decline in value over time. That deterioration may be due to changes in physical, technological, or fashion appeal over extended periods. A partial exception is the home, which, if maintained properly, can appreciate, at least for a relatively long time. The second category of nonfinancial assets is human-related assets. They are items that derive their value from particular people. In personal finance, we are principally con- cerned with assets in this category that generate income. For example, strength and beauty can be considered assets, but they don’t qualify unless they produce cash flows. People most commonly generate income directly through their work efforts. We can call this in- come-earning ability a human asset. Closely allied are corporate pensions and government pensions such as Social Security, which are often based on work efforts.2 Anticipated gifts and bequests represent another area that we include because they are most often received through human relationships with either family or friends. Human-related assets are sometimes called intangible assets because many—such as a Social Security right, a projected inheritance, or human education—cannot be touched. Another reason that they are termed intangible is that they are often nonmarketable— they cannot be sold to others, and, in any event, placing a fixed value on them may

Factor Financial Real Estate Durable Goods Human† Human Related

Practical example

Stocks, bonds Home, residence Auto, furniture Job Pension

Marketability Fully marketable Fairly marketable Fairly marketable Nonmarketable Nonmarketable Valuation over time

Increases in value‡

Increases in value; cost for upkeep

Declines in value Generally declines in value

Increases and then declines in value§

Use For future use For current use For current use For current use Varies Associated costs Little or none Upkeep Upkeep Food, clothing,

shelter, etc. Varies

Example of capital expenditure

None directly Renovation and expansion

Is itself a capital expenditure

Education and training

Varies

Direct cash inflows

Dividends and interest

None None Salary Pension income, etc.

Indirect cash inflows

Appreciation Appreciation None Employee benefits

Varies

* Excludes other assets, including private revenue generating real estate, which are difficult to generalize. † Generally included under human-related assets in this book. ‡ Stable for bonds. § Increases as the date that payoff begins draws closer and then declines after payoff begins.

TABLE 8.1 Characteristics of Household Assets*

2 Pension assets then are those that provide streams of income over time. Pension plans such as 401(k)s that allow the withdrawal of monies in lump sums are considered financial assets.

Household Investments 201

significantly be subject to a measure of judgment. We discuss human assets here and deal with pension assets and gifts and bequests in the retirement and estate planning chapters, respectively. The third category, other assets, is a catchall. It comprises any other assets of worth. Some examples are jewelry, collectibles such as art or stamps, interest in a private business or other private investments, and prizes. A summary of characteristics for household assets is given in Table 8.1. Note that it uses a new category of marketability: fairly marketable. Items in this category can be sold but doing so involves one or more problems, which we can call inefficiencies. They can be transaction cost, time to find a buyer and close the sale, or time needed for the seller to substitute another asset for household use. External factors may impede marketability such as selling during an economic recession or having an unfashionable style or need for refur- bishment or repair by the buyer. Each of these inefficiencies can expose a person to higher cost or increased risk. Given this new category, the efficient marketable asset has been termed a fully marketable asset. In contrast to this more precise definition, in other uses throughout the book, the term marketable stands for fully marketable. A summary of household assets is given in Figure 8.1.

EXAMINING THE DECISION PROCESS

Decisions about which nonfinancial assets to select don’t come out of thin air. Instead, we form conclusions based on the values presented by investment alternatives. Our evaluation process for household investments begins by looking at the three ways household deci- sions are made and how total portfolio management relates to them. The process then describes capital expenditures and provides a step-by-step accounting for how decisions for many household assets should be determined. The final section describes the capital budgeting tools needed to measure the attractiveness of proposed investments.

Household Finance and Total Portfolio Management Household finance considers the household as one enterprise that resembles a business. Each of its operations can require investments. External work-related activities may require an investment in human assets such as an outlay for education; the house may re- quire a new roof or a new furnace; and future retirement needs may necessitate constant investments in financial assets.

Household Assets

Financial Nonfinancial

OtherStocks Bonds MutualFunds Exchange

Traded Funds

Real Estate

Durable Goods

Human Related

Private Investments

Commodities and Gold

Jewelry and Collectibles

Home

Appliances Auto Furniture InheritanceJob Pensions

Real Assets

FIGURE 8.1 Common Household Assets

202 Part Three Portfolio Management

Each of these investments can be evaluated from three perspectives:

1. Individual asset basis. Under the individual asset approach, decisions are made con- sidering the investment’s risk and return characteristics on a stand-alone basis. The question to answer is when looked at by itself, is this asset attractive?

2. Within activity basis. An investment can be proposed in any household activity. The question asked is how this proposed expenditure compares with current or future alter- natives within the same activity. For example, under human assets, considerations may be whether paying for education to improve skills in the current job or pursuing an MBA is more attractive. Sometimes the household thinks of investments in financial and nonfinancial assets as separate activities, comparing all alternatives within one of these two categories at the same time. For example, in financial investments, the ques- tion frequently asked is whether to sell selected bonds and buy additional stocks.

3. Fully integrated basis. Decisions are made not on a per asset or per activity basis but on an overall household basis. Each activity has assets that benefit the household. These assets can be grouped into financial and nonfinancial categories, as discussed. Together they form a portfolio of assets, the household portfolio. We can call the pro- cess of developing and maintaining an efficient combination of assets total portfolio management (TPM).

The nature of the household lends itself to centralized decision making. It generally has few adult members, thus permitting quick integrated decisions. The assets themselves are best assessed on a combined basis because resources are limited. Therefore, important goals are prioritized on an integrated household level. Moreover, tolerances for risk are set on an aggregate basis by household members. TPM looks at the household as a portfolio of assets.3 It presents solutions as to which assets should be placed in the household portfolio and how to weight them. The TPM ap- proach incorporates both risk and return. In more sophisticated versions, it incorporates correlations—that is, the degree to which individual assets are subject to the same risks. Generally, the lower the correlations, the lower the risk. By providing the appropriate blend of assets, TPM assists the household in operating efficiently. The household may engage in all three decision-making approaches. The purest ap- proach is evaluation through TPM. Even TPM, which is discussed in the next chapter, can be treated on a less comprehensive within activity basis because it typically considers fi- nancial assets alone.

Example 8.1 Sal and Diane, ages 31 and 30, are married and live in a rural town. The town was once a thriv- ing mining and manufacturing center but now has a disproportionate number of elderly. When children grew up, they moved elsewhere and few new people moved in. Consequently, the population declines modestly each year. Sal runs a lucrative minisupermarket that he inherited from his father. Diane is a clothing store manager in town who wants to become a lawyer. The couple are considering a number of investments. Each investment had passed an initial screening and was thought to be attractive on a stand-alone basis.

1. Purchasing a vacation home in the mountains nearby. 2. Adding a bedroom to their existing home for anticipated children to come. 3. Beginning to put away money in stocks and bonds for retirement. 4. Diane’s applying to a law school located one hour away. 5. Sal’s attending an expensive cooking school one weekend a month. The store could then

offer fresh-baked goods.

3 Liabilities are incorporated as negative assets here—terminology that has been used before. In other chapters, assets and liabilities are usually treated separately.

Household Investments 203

They did some preliminary calculations and decided that they didn’t have enough resources for all these investments. Borrowing money would only provide limited help because they be- lieved anything more than $150,000 in loans would exceed their household tolerance for risk. One of the five proposals would have to go. The couple grouped their investment proposals into categories: real assets, financial assets, and human-related assets. They decided that both real asset proposals were important. The addition to the home was needed because they expected to have children soon. The vacation home was required to offset the long hours at the store and could be purchased at a below- market price. The investment in financial assets for retirement had to begin. They were already behind where they wanted to be for an early retirement. That left the two investments in human-related assets. On a within activity basis, these two proposed assets were believed to have the lowest returns of all the alternatives. Between the two, Diane’s attending law school would be more attractive than Sal’s cooking school potential. It would provide a higher return on human assets. They had conducted their final evaluation on a TPM basis, looking at all proposals at the same time. They thought they had completed their deliberations. However, when looking at the results on an overall household portfolio basis, they recognized a weakness. Household risk, even with the limitation on debt, would exceed their overall risk tolerance. Virtually all their real human-related and other assets where the supermarket was located were subject to the risk attached to (correlated with) a community suffering a population decline. Sal’s business, Diane’s job, and their home would all be negatively affected by a further drop in the town’s population. If the decline accelerated, all their nonfinancial assets could be seriously affected. They decided to substitute an equally attractive vacation home located near a large growing community. They would have to drive two hours to reach it, but it would materially reduce their dependence on their current community and therefore on overall TPM risk. Decision mak- ing was finally completed.

The balance of the chapter provides the method of selecting common household investments—those having to do with real assets and human-related assets. It will enable you to decide if you should accept or reject proposed expenditures, whether they be for a house, a car, or a master’s degree. It will detail whether to buy or lease a house or a car and how to decide on the amount you can spend for a home.

Making Capital Expenditure Decisions Capital expenditures are outlays that provide benefits over an extended period of time. These outlays improve household operations as soon as they become available. Capital expenditure is the term used for an outlay for real or human-related assets but not for financial ones. The capi- tal outlays can be used for purchasing new assets or improving existing ones. For a discussion of the theory for making capital expenditures, called capital budgeting theory, see Appendix I. An understanding of capital improvements may require consideration of how the tax code views repairs versus capital improvements. If Will and Beth Allen have a leak in their home’s roof, they have little or no choice but to repair it. To the IRS, this is an ordinary expense and provides no tax benefit for the Allens. However, Will and Beth also can make a decision to spend money on replacing their roof, using higher-quality materials designed to last for decades, rather than spending money elsewhere. The IRS likely will consider this roof replacement a capital improvement, which may ultimately provide tax savings when the home is sold. The Allens can weigh several factors in deciding whether the roof should be repaired (involving lower repair costs and less hassle with roofing contractors) or replaced, which might have possible tax benefits. The benefits of capital expenditure may be higher revenues, lower cash cost, or less time to produce a desired result. Alternatively, the benefit may involve just an immediate increase in satisfaction. We often have a variety of capital expenditure alternatives. We must decide which to fund from household cash flows and household assets and which

204 Part Three Portfolio Management

merit borrowing money. We should do so by using the established business capital budget- ing techniques of calculating net present value (NPV) and internal rate of return (IRR).4 Before we describe these techniques, let’s go over the capital budgeting process.

The Capital Expenditure Process The ideal process of selecting capital expenditures is the one presented next as a series of steps. In reality, adherence to this schedule depends in part on the type and cost of capital outlays. When the returns are measurable and the cost is high, this recommended proce- dure is more likely to be followed. For example, in considering the purchase of a fuel-efficient furnace, the process and quantitative measurement of returns are more likely to be followed than in the purchase of a new HDTV set for which satisfaction levels are difficult to measure. But even when measurement is difficult, alternatives generally can be ranked in order of attractiveness. Here are the steps.

Review Goals Households have not only desires but also needs. We can loosely categorize them as dis- cretionary and nondiscretionary outlays. For example, whereas we can consider the option of retirement without assets, in reality we need to save sometime before retirement or we risk working forever or sustaining a sharp drop in our standard of living during retirement. Our goals of future priorities can result in our having limited resources for spending, even capital spending, today. Thus, it is important to place our household investments in the context of our overall goals.

Establish Required Rate of Return The household’s capital outlays must reach a required rate of return for all projects. Its members must decide on that return based on market figures for savings and investing in financial assets and on their priorities. For example, if market returns on stocks with com- parable risk to the household’s capital project have historically been 10 percent over the long term, members use that percentage as their required rate of return.

Identify Potential Projects Households generally don’t have to look for projects—they are usually apparent. They should just be considered at the time evaluation is to begin.

Evaluate Projects Normally, households view the costs and returns for each project. When feasible, its mem- bers calculate returns using IRR or NPV, to be discussed in a later section.

Rank All Projects Here the household ranks all projects using stand-alone calculations—first on a within activity basis, then within the category, and finally on a total portfolio basis. Their risk and blending (correlations) with other assets are considered, particularly on the total portfolio basis.

Establish Overall Capital Availability Perhaps more so than for businesses, capital is limited for the household. Debt financing is available to some degree, but, of course, it raises risk. Considering all factors, the amount of capital to be made available is established.

4 As Copeland and Weston say, “The decision criterion for investment decisions which is to maximize the present value of lifetime consumption can be applied to any sector of the economy.” See Thomas Copeland and J. Fred Weston, Financial Theory and Corporate Policy, 3rd ed. (Reading, MA: Addison-Wesley, 1992), p. 17.

Household Investments 205

Select and Invest in Final Projects Based on returns, capital availabilities, and risk and risk tolerance, the household decides on the assets it wants to fund. Some drop out forever; others are brought up at a future time when relative attractiveness and financial resources change.

Capital Budgeting Techniques The two most prominent capital budgeting techniques are NPV and IRR. Let’s discuss them separately.

Net Present Value (NPV) Chapter 2 introduced the time value of money concept. Both NPV and IRR are time value of money concepts applied to capital budgeting. The net present value (NPV) can be defined as the present value of all projected future cash inflows and outflows. It provides the amount of benefit from a capital expenditure as compared with investing the money in marketable investments. We receive the present value by discounting all cash flows back to the present at an appropriate discount rate.5 This discount rate is generally equal to the investment return—what could be earned on marketable securities with similar risk characteristics. We used the market rate because it is the minimum rate that must be earned on the capital expenditure. If we can’t earn that rate on capital expenditures, we probably should invest the money in marketable securities such as stocks and bonds. We can call this discount rate based on market factors the required rate of return.6 The NPV tells us whether we have earned the required rate of return. If NPV is zero or higher, we have earned it, and the capital expenditure is accepted. In other words, when NPV is positive, the capi- tal expenditure is preferable to a marketable investment. If NPV is negative, we have not earned the required return and reject the proposed expenditure. NPV is given by the following formula:

NPV = an t=1

CFt11 + k2t − CF0 where

CF = Cash flow generated CF0 = Amount invested (often a cash outflow) at time zero, the beginning of the

period k = Discount rate t = Time period involved n = Number of years

©nt=1 = Sum of the present values of cash flows from time 1 to time n In sum,

NPV = Sum of future cash inflows Discount rate

− Cash outflow in current period

= Present value of future cash inflows − Cash outflow in current period When the present value of future cash inflows exceeds the initial outflow, we consider accepting the capital expenditure. When the present value of future cash inflows is less than the initial cash outflow, we reject the capital expenditure.

5 Its definition, then, is the rate that we use to bring future cash flows to the present to establish their current value. 6 It can be defined as the return that must be earned to make an investment attractive. Market factors including the investment risk should be incorporated.

206 Part Three Portfolio Management

Example 8.2 A capital expenditure with a $1,000 initial cost and present value of inflows of $1,500 would have a $500 NPV and be accepted. If the initial cost was the same $1,000, but the inflows were only $900, the NPV would be negative $100, and the project would be rejected. In the negative $100 case, it is better to invest in marketable securities.

Example 8.3 June was thinking of purchasing a new air conditioner for her den. She had a home office there, and the air conditioner would be on 16 hours a day for 9 months of the year. The exist- ing air conditioner worked well but was not energy efficient. The new air conditioner would save about $15 a month in energy costs. It was of lower overall quality and, in fact, was expected to last only five years, about the useful life of the existing machine. June wondered whether the new machine’s energy efficiency would extend throughout its life span. Given the greater risk of this machine, June decided to assign a higher discount rate to it. This required rate of return would be 12 percent, about equal to marketable securities/common stocks with the same risk profile. The machine would cost $650. Using annual figures, calculate whether June should purchase the machine.

Initial cash payment = $650 Yearly cash inflows = $15 × 12 months

= $180 per year Number of years in inflows = 5

Required rate of return = 12%

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 650 CHS g CF0 650 +/− ENTER ↓ Enter cash inflows years 1−5 180 g CFj 180 ENTER ↓ Enter number of years 5 g Nj 5 ENTER ↓ Enter the discount rate 12 i NPV 12 ENTER ↓ Calculate the net present value f NPV CPT −1.14 −1.14

Calculator Solution

Step HP12C TI BA II Plus

Clear the register Press f FIN Press CF 2nd CLR Work

Enter initial outflow Enter cash flow in CF0 register as CHS g CF0

Enter cash flow in CF0 register as −/+ Enter ↓

Enter succeeding outflows or inflows

Enter cash flows in CFj register successively as g CFj

Enter cash flows in C register successively as Enter ↓

Enter number of years for repeating cash flows

Enter number of years in Nj register as g Nj

Enter number of years in F register as Enter ↓

Enter the discount rate Enter the discount rate in i register as i

Enter number by pressing NPV key in the number Enter ↓

Solution Press f NPV Press CPT

The NPV is negative. The proposed capital expenditure should be rejected. June could do better by investing the contemplated $650 purchase price in marketable securities.

Household Investments 207

If we had access to unlimited funds, we would accept all capital expenditures that would have a positive NPV. However, often our source of capital is limited. In that instance, we must select those investments that provide the highest returns.7 Unfortunately, NPV alone doesn’t provide that figure by comparing investments that differ in amounts invested. To rank investments in terms of attractiveness, we can use the profitability index (PI). It relates the amount of the NPV to the size of the original investment. The higher the value of the profitability index, the more attractive the investment is.

Profitability index = NPV Original cost

Any savings in the opportunity cost of time should be included in calculating the additional cost or benefits for household expenditures. That is so because this time used potentially could be employed in developing additional cash flows. As discussed in Chapter 4, we as- sign a cash flow figure to the cost of time based on the hourly wage rate that could be re- ceived if the time was spent working.

Example 8.4 Jason is considering purchase of a new vacuum cleaner. He is interested in two electric models. Both models would save him a quarter of an hour of time a week. The lower-quality vacuum would last three years and would cost $300; the higher-quality model would last eight years and cost $400. The purchase of either model would be funded from existing savings. Jason earns $15 an hour after tax in his job. His required rate of return based on what he could earn in the market is 6 percent after tax. Should he make the investment? If so, which one should he buy? Express all figures on an annual basis.

Lower-Quality Machine

Initial outflow = −$300 Weekly inflows = Savings in time × Hourly wage

= 1/4 hour × $15 = $3.75

Yearly inflows = $3.75 × 52 weeks = $195

7 Actually, the selection process under restricted borrowing would have to be made incorporating decision making over a multiyear basis. See Neil Seitz and Mitch Ellison, Capital Budgeting and Long-Term Financing Decisions, 3rd ed. (Fort Worth, TX: Dryden Press, 1999), pp. 722–725. See also Simon Gervais, “Behavioral Finance: Capital Budgeting and Other Investment Decisions,” in Behavioral Finance: Investors, Corporations, and Markets, ed H. Kent Baker and John R. Nofsinger (2010) for behavioral aspects of capital budgeting; faculty.fuqua.duke.edu/~sgervais/Research/Papers/BookChapter.OvCapitalBudgeting.pdf.

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 300 CHS g CFo 300 +/− ENTER ↓ Enter cash inflows years 1–3 195 g CFj 195 ENTER ↓

Enter number of years 3 g Nj 3 ENTER ↓

Enter the discount rate 6 i NPV 6 ENTER ↓ Calculate the net present value f NPV CPT 221.24 221.24

208 Part Three Portfolio Management

Higher-Quality Machine

Initial outflows = $400 Yearly inflows = $195, as above

Profitability Index

Lower-quality machine = 221.24 300

= 0.74

Higher-quality machine = 810.91 400

= 2.03 Both investments have positive NPVs, but the higher-quality machine has a higher profitability index and is, therefore, the more attractive investment.

Internal Rate of Return (IRR) The internal rate of return (IRR), which we discussed briefly in Chapter 2, provides a return on investment as a percentage. It can be defined as the rate of return that makes the present value of cash inflows equal to that of cash outflows. The IRR is, therefore, the discount rate that makes NPV equal to zero. The IRR approach is very similar to obtaining an NPV with cash inflows and cash outflows calculated. However, instead of inputting a market-based discount rate, we solve for the IRR. We compare the IRR with our required rate of return, the return we could get on marketable securities with the same risk. If the IRR is higher than the required rate of return, we accept it. If it isn’t, we reject the proposed capital outlay.

Calculator Solution

Step HP12C TI BA II Plus

Clear the register Press f FIN Press CF 2nd CLR Work Enter initial outflow Enter cash flow in CF0 register as CHS g CF0

Enter cash flow in CF0 register as −/+ Enter ↓

Enter succeeding outflows or inflows

Enter cash flows in CFj register successively as g CFj

Enter cash flows in C register successively as Enter ↓

Enter number of years for repeating cash flows

Enter number of years in Nj register as g Nj

Enter number of years in F register as Enter ↓

Solution Press f IRR Press IRR CPT

Example 8.5 Brandt is considering purchasing a new personal computer and related software that would cost $4,500. He has a part-time job editing books at home. He receives a flat fee per book that averages about $25 an hour after tax for 15 hours per week, 50 weeks a year. He expects to maintain this job for three years until his regular career pays enough money, at which point he

Calculator Solution General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CRL Work Enter initial cash outflow 400 CHS g CFo 400 +/− ENTER ↓ Enter cash inflows years 1–8 195 g CFj 195 ENTER ↓ Enter number of years 8 g Nj 8 ENTER ↓

Enter the discount rate 6 i NPV 6 ENTER ↓ Calculate the net present value f NPV CPT 810.91 810.91

Household Investments 209

would stop editing. He believes the new setup would increase his output by 10 percent. Assuming that his after-tax required rate of return is 11 percent, use annual savings calcula- tions to determine whether he should purchase the computer.

Initial payment = $4,500 Weekly inflows = Existing hourly wage × Hours per week

= $25 × 15 hours = $375

Yearly inflows existing = $375 × 50 = $18,750

Increase in yearly inflows = 10% Yearly inflows proposed = 18,750 × 1.10

= 20,625 Yearly benefit = 20,625 − 18,750

= 1,875 Years benefit applicable for = 3

Calculator Solution

General Calculator Approach HP12C TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 4,500 CHS g CFo 4,500 +/− ENTER ↓ Enter cash inflows years 1–3 1,875 g CFj 1,875 ENTER ↓

Enter number of years 3 g Nj 3 ENTER ↓

Calculate the internal rate of return f IRR IRR CPT 12% 12%

The IRR of 12 percent exceeds the required 11 percent. Therefore, the capital expenditure should be made.

Comparison of IRR and NPV Methods In evaluating these two approaches, NPV is the purer, more accurate method. However, because IRR is expressed in terms of percentage of return, it can be easier to understand. Moreover, an IRR can compare returns for expenditures of different amounts and time frames. A major difference in approach is that NPV assumes that cash flows from projects are invested at the required rate of return whereas IRR assumes that they are reinvested at the rate of return of that particular project. The weakness in the IRR approach is shown in Example 8.6. IRR also gives multiple answers under some circumstances.

Example 8.6 Suppose we were able to set up our first hamburger fast-food restaurant next to the sports center in our town with an inexpensive long-term lease. We planned to build other restaurants in the chain that would have an expected rate of return of 15 percent. We would probably have a very high IRR, say 90 percent a year, because of our location. Clearly, cash flows from that hamburger capital expenditure used to build other restaurants would probably not earn the same rate of return as our original investment. Thus, the NPV method, which employs the required rate of return of 15 percent for reinvestment, is more accurate than the IRR, whose ap- proach would assume a 90 percent return on the cash flows generated for the new restaurants.

There are ways to adjust for the reinvestment effect and other weaknesses of IRR. In most cases, both methods provide the same ranking of alternative expenditures.

210 Part Three Portfolio Management

ANALYZING MAJOR CAPITAL EXPENDITURES

We know that households engage in production activities just as businesses do. They pro- duce goods and services for internal household use and for external market-related activi- ties. Capital expenditures can make each individual good or service more productive. Consequently, the household makes many types of capital expenditures. Selected ones were presented as examples illustrating NPV and IRR techniques. In this section, we concentrate on decision making for what is often the three largest capital expenditures a household has: the car, the person, and in summary form the home. All three are thought of as investments in contrast to other outflows, which are expenses. That is so because they provide benefits that extend beyond the current period. We look at them separately beginning with durable goods and the car.

Durable Goods Purchases of consumer durable goods are capital expenditures that can benefit many types of household operations. Whether for a job, a nondiscretionary activity, or a discretionary activity, they provide returns to the household over an extended period of time. Among the reasons for purchasing a durable good are these:

1. To take advantage of a technological improvement with the potential to make house- hold maintenance more time efficient. For example, a new dishwasher can free time to be used to generate additional work-related income or to further leisure pursuits.

2. To replace an existing durable that has reached the end of its useful life because of physical wear and tear.

3. To reflect a change in circumstances; for example, a rise in the price of oil can sub- stantially change the cost and therefore the economics of a “gas-guzzling” automobile. The result may be the purchase of a fuel-efficient car.

4. To provide more pleasure—for example, purchasing a home theater system with sur- round-sound speakers.8

5. To attempt to raise returns on assets—for example, buying an investment software package with the hope of increasing investment performance.

The Automobile Because the car is generally the most expensive, pure consumer durable the household purchases, let’s use it as a practical example. Like most other durables, a car declines in value over time. This capital expenditure can assist in transportation to work, make household necessi- ties easier to obtain, and provide pleasure in itself or through its ability to take us to other pleasurable activities. Most multiperson households have at least one car. Depending on operating patterns, they may exchange cars as often as once a year or as infrequently as once in, say, 10 years when, for practical purposes, the car may no longer be considered useful. The car may be purchased for cash or debt, or it may be leased. A lease-versus- purchase example is given in Appendix IV. Some of the major factors in deciding to change automobiles, whether for a new or used car, are

8 To understand how capital expenditures on leisure products may be valued, see Appendix II, Assumed Rents.

Factor Explanation

State of current car The higher the repair bills, the lower the car’s attractiveness, and the more likely a trade-in will be contemplated.

Household Investments 211

Factor Explanation

Existing finances The greater the cash on hand, the more favorable the job and economic outlook, the more likely the trade-in.

Current car promotions At certain times in the economic cycle, the purchase of a new or used car may be particularly attractive. This means that prices, leases, and financing terms may cause households to exchange cars prior to their intended date.

Attractiveness of new car New cars may have style, safety, or mileage features that motivate peo- ple to buy them.

The factors that enter into a decision to purchase one car over another include its cost, its quality that would lead to lower repair bills, its fuel efficiency, safety features, its ride and cabin comfort, its projected trade-in value, and its style and image.

Example 8.7 Natasha has a suburban home within walking distance of the railroad. She commutes to work in the city at a cost of $180 a month. She also rents a car every weekend, which costs $600 a month including insurance and fuel. She is considering purchasing a new car for cash to replace commut- ing and rental costs. It would cost $25,000, get 28 miles per gallon, and have an estimated resale value of $10,000 after five years. After buying this car, Natasha would drive 15,000 miles per year and have maintenance and repairs of $2,000 per year, insurance of $1,500 per year, and fuel costs of $3 per gallon. Assume that all costs occur at the end of the year and that she sells the car at the end of the fifth year. If Natasha’s discount rate is 6 percent after tax, should she purchase the car?

Annual Operating Cost of Car

Yearly Maintenance Cost

Fuel consumption a15,000 miles 28 mpg

b = 535.7 gallons per year Fuel cost 1535 gallons × $32 = $1,607.14

Annual repairs and maintenance = $2,000 Annual insurance = $1,500

Total projected yearly cost = $5,107

Current Annual Cost Commute 1$180 × 122 = $2,160 Car rental 1$600 × 122 = $7,200

Total current annual cost = $9,360 Annual savings = 1$9,360 − $5,1072 = $4,253

Cost to purchase car = $25,000 Selling price year 5 = $10,000

Calculator Solution General Calculator Approach HP12C TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 25,000 CHS g CFo 25,000 +/− ENTER ↓ Enter cash inflows years 1–4 4,253 g CFj 4,253 ENTER ↓

Enter number of years 5 g Nj 5 ENTER ↓

Enter cash inflow year 5 14,253 g CFj 14,253 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 6.47% 6.47%

The return for this capital expenditure is 6.47% percent. It significantly exceeds the required 6 percent rate, so the car should be purchased.

212 Part Three Portfolio Management

Human Assets Our human assets are the human capital we have that we and others value: knowledge, skills, intellectual capacity, strength, beauty, compassion, ethical behavior, creativity, drive, health, and so on. From a financial standpoint, we often limit ourselves to factors that directly enter into our income-earning ability. Often, these factors are simplified to two basic traits: knowledge and skills with general health used as support for them. We can now define human assets as the resource that reflects the current value of all our future earnings. It is a nonmarketable asset; that is, it cannot be sold. Instead, it is often rented to an employer for a period of time at an hourly fee or a salary. Without knowledge and skills, human capital can be viewed as a basic commodity with the ability to earn only the minimum wage. Capital expenditures in this area include time and money spent on for- mal education and other ways to develop knowledge, many through practical experience. In effect, education, training, and proper health habits can provide us a higher return on our life cycle human assets. Empirical evidence points to often attractive returns of 14 to 16 percent on human assets9 although returns on human capital may vary among segments of society as well as between men and women.10

Capital expenditures to raise human assets are not restricted to job-related activities. They can be made in all relevant areas of the household. You may take a course to make

Consideration of household assets generally over-

balance sheet normally doesn’t contain a calculation of human assets. That is true despite the fact that human capital is often the household’s largest asset by far.

money spent for multiyear benefit is often restricted to durable goods. We can see or touch new durable goods. They are the household’s equivalent of busi-

on humans occurs because human beings can be

seen or touched. Nonetheless, most people would agree that education can add to long-term

income-earning capacity and therefore qualifies as a

wouldn’t be spending the money and time pursuing

on their income. Personal financial planners are aware of how

the balance sheet, they incorporate them in capital budgeting decisions and, of course, include them in projections of salaries in the cash flow statement.

on education and the capacity to earn additional -

well as durable goods.

Practical Comment The Importance of Human Assets

9 Gary Becker, Human Capital: A Theoretical and Empirical Analysis with Special Reference to Education, 3rd ed. (Chicago: University of Chicago Press, 1993). See also Adam Looney and Michael Greenstone, “Regardless of the Cost, College Still Matters,” The Hamilton Project, 2012, hamiltonproject.org/papers/ Regardless_of_the_Cost_College_Still_Matters/. Looney is Senior Fellow, The Brookings Institution, and Greenstone is 3M Professor of Environmental Economics, MIT. 10 See, for example, F. Blau, M. Ferber, and A. Winkler, The Economics of Women, Men and Work, 4th ed. (Upper Saddle River, NJ: Prentice Hall, 2001); also Mark M. Pitt, Mark R. Rosenzweig, and Nazmul Hassan, “Human Capital Investment and the Gender Division of Labor in a Brawn-Based Economy” (American Economic Association, 2010), aeaweb.org/aea/2011conference/program/retrieve. php?pdfid=112

Household Investments 213

you a better investor. You may read Consumer Reports each month to develop some ex- pertise in purchasing useful household appliances and obtain help in deciding which brand to buy. You may purchase a book on how to cook quickly but effectively. Finally, retired people may attend seminars on how to better enjoy retirement life.

Calculating Human Assets The value of our human assets varies over our life cycle. If we are skilled employees, our asset value may actually go up for a time.11 However, as we age, the decline in the number of our earning years generally results in a drop in our human assets over our life cycle. In effect, like many other assets, human assets depreciate over time. Capital expenditures on human assets are treated similarly to those for other assets with benefits compared with costs. Consider Example 8.8.

Example 8.8 Astrid, age 30, is a married architect with one child. Her salary has reached a plateau at $75,000 a year. She believes that if she pursues an MBA degree full-time, she would move into a mana- gerial position and her salary would rise by $45,000 a year. Astrid wants to maintain her current lifestyle, which already generates substantial yearly cash savings and accumulate the capital to leave to her son. Her MBA course would take two years to complete and cost $48,000 a year. Because she plans to pay for the MBA out of existing savings and would be spending the money to qualify for a new position, she would not be eligible for any tax benefits. Assume that Astrid pays one-third of her salary in taxes and her tax bracket will remain unchanged after the raise, that she can earn 6 percent after taxes on investments with a similar risk to her job, and that she plans to retire at age 65. Furthermore, assume that all salary and schooling payments are made in a lump sum at the beginning of each year. What is her rate of return on this investment? Should she pursue an MBA? If so, what will be the value of her hu- man capital, assuming a calculation that incorporates salary forgone and her extra salary from obtaining her MBA upon graduation. Her after-tax increase in salary per year is

After-tax gain = Pretax gain × 11 − t2 = $45,000 × 11 − 0.33332 = $30,000 per year

Numbers of years of gain = Retirement age − 1Current age + Full-time MBA study2 = 65 − 130 + 22 = 33 years

The cost of attending school is

Schooling cost = $48,000 a year for 2 years Opportunity cost of time = 2 years of salary forgone

= $75000 × 11 − t2 = $75000 × 11 − 0.332 = $50,000 a year for 2 years

Combined yearly cost = Schooling cost + Opportunity cost = $48,000 + $50,000 = $98,000 a year for 2 years

11 That is because of the higher present value of higher-earning years as we draw closer to them. For a time, higher earning years can more than offset the effect of fewer work years.

214 Part Three Portfolio Management

Internal rate of return = 14.1 percent

Because that rate exceeds Astrid’s rate of return on marketable investments of 6 percent, she should pursue the MBA. The value of her human capital would be

New salary = $75,000 + $45,000 = $120,000

After-tax income = $120,000 × 11 − 0.33332 = $80,000

Calculator Solution General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN 2nd CLR Work

Enter cash outflow year 1 98,000 CHS g CFo 98,000 +/− ENTER ↓ Enter cash outflow year 2 98,000 CHS g CFj 98,000 +/− ENTER ↓ ↓ Enter cash inflows 30,000 g CFj 30,000 ENTER ↓

Enter number of years 33 g Nj 33 ENTER ↓

Calculate the internal rate of return f IRR IRR CPT 14.1% 14.1%

Value of human capital = $883,527

The Home The home is the household’s most important tangible asset. It has many functions. By put- ting a “roof over your head” it is a durable good, which belongs in this chapter on house- hold assets. However, its ability to rise in value over time also makes it an investment asset along with other real estate. We have chosen to present it in the next chapter, Chapter 9 on real estate and other assets.

Behavioral Realities In general, the structure identified for capital budgeting decisions in this chapter represents an ideal framework. In reality, many such decisions are made using mental shortcuts. The portfolio approach to capital expenditures in a one-person household can be just the mental

Calculator Solution

Enter cash outflow year 1 98,000 CHS g CFo 98,000 +/− ENTER ↓ Enter cash outflow year 2 98,000 CHS g CFj 98,000 +/− ENTER ↓ ↓ Enter cash inflows 80,000 g CFj 80,000 ENTER ↓

Enter number of years 33 g Nj 33 ENTER ↓

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN 2nd CLR Work CF

Enter the discount rate 6 i 6

NPV

ENTER ↓

Calculate the net present value f NPV CPT 883,527 883,527

Household Investments 215

consideration of how this proposed asset affects cash flow, overall assets, and debt. In a two-person household with specialization of tasks, some less significant decisions are made on an individual asset, stand-alone basis. However, important decisions for all households are generally made or approved on an overall portfolio basis. And last, as mentioned in Chapter 5, household members and financial advisors alike sometimes forget to place significant capital expenditures into cash flow forecasts. Thus, they may omit such items as household remodeling and replacement of automobiles. In either case, average amounts should be placed in yearly or lump-sum amounts assumed over appropriate time periods, adjusted for inflation. Without anticipating such items, sav- ings needs can be materially understated.

EVALUATING THE LEASING ALTERNATIVE

Leasing often represents the alternative to making an investment in a nonfinancial asset. In many cases when the asset is essential such as with a car or home, we can perform a buy versus lease analysis to determine which approach to take. In this sec- tion, we examine the strengths and weaknesses of leasing and evaluate choice for a car or home. We provide an appraisal of the home as an investment using the lease as a benchmark.

An Introduction to Leasing As stated, the investment values for capital expenditures such as durable goods usually decline over time. We tend to purchase them for their benefits for household activities today and for periods in the immediate future. Consequently, our principal purpose is to reap the benefits from the items because owning them does not result in their appreciation as, say, owning stocks would. Therefore, we are often open to considering leasing assets. A lease is a way to acquire the use of an asset without purchasing it. The lease allows you to receive the asset’s operating benefits, generally for a stated period of time, in return for an obligation to make a series of payments over the term of the lease. The maintenance and overhead costs may be paid by the lessor, the company providing the equipment. For

The degree to which households use financial analy-

benefits can easily be measured, households often

new, more efficient furnace to save fuel costs may compare its cost with the projected annual fuel sav- ings. They also may consider the anticipated useful life of the new furnace and the remaining life of the

base the decision on information supplied by the furnace manufacturer or others.

made more intuitively. The household members an-

the process, the financial aspects of the transaction

and benefits should be identified. When the item is purchased for its increase in leisure satisfaction and

uses for the money can help identify its contribution to the household. In such cases, the effect of the outlay on the desired level of savings should be in-

Practical Comment Use of Capital Budgeting Techniques

216 Part Three Portfolio Management

example, in an auto lease most costs are borne by the person using the vehicle, called the lessee, in a transaction known as a net lease.12,13

Reasons for Leasing There are economic reasons for leasing. A person might want to lease an expensive computer if he or she thought a better one might be introduced soon. The lessor may absorb the risk of tech- nological or fashion obsolescence or large unforeseen expenditures on the asset. Moreover, the lessor is sometimes able to develop efficiencies in specializing in that asset. For example, the purchase price of the asset and its repairs may be less costly to the lessor who buys, say, com- puters in volume. Finally, the business owner may receive tax benefits that the lessor will not.14

Nonetheless, the cost of leasing generally is higher than the cost of purchasing, includ- ing the cost of borrowing money to do so. And perhaps, most important, it is higher because another cost structure is included: the lessor’s administrative cost including the need for profit. It can, however, be the most profitable way to obtain use of an asset when it is needed for only part of the period. For example, it may be less costly to lease a car or house for a month in the summer than it is to own and maintain it all year. Probably the most common reason for leasing an asset is that households are short of capital. Leases may be offered with no down payment. For example, we’ve mentioned that, for people in significant marginal tax brackets, buying a house carries substantial built-in tax benefits, but for people who don’t have sufficient funds to purchase their own house, long-term renting is an option. Finally, leasing is generally not presented as a liabil- ity on the household’s balance sheet as it often is on the business’s balance sheet. Therefore, when the household is short of funds and has limited ability to borrow, leasing may not be a negative factor in qualifying for a new loan.

Automobile Leasing Today one out of four cars is leased. Consumers are attracted to the ability to drive a desir- able car with little or no down payment. Moreover, the cost of leasing has become more competitive with purchase; automobile companies have placed more emphasis on it and sometimes offer disguised subsidies to lessees in order to sell more cars. Whether it is preferable to lease or purchase a car depends on such factors as these:

How long the car is to be held. Depreciation in prices of a car moderates after the first few years, which strongly favors its purchase if the purchaser plans to hold it for more than three or four years. The age of the car. New cars offer fewer problems and are covered by warranty. Leasing an older used car, when available, can subject the lessee to significant extra costs. The cost of time. Selling a car that is currently owned involves time and can expose the seller to price risk at the end of the designated ownership period. A lease that involves only dropping off the car at the end of its term can be drawn up quickly.

12 In theory, given a riskless environment with perfect capital markets, there should be no difference be- tween buying an asset and leasing it. The cost of the leasing payment would include a return to the lessor for purchasing it. The depreciation in its value over time and maintenance expenses, if there are any, would be borne by the lessor. The lessee’s cost would be equal to the lessor’s costs and would include the costs for maintaining the item over the term of the lease. A charge equal to the opportunity cost of capital also would be included because the capital not used to purchase the equipment could be invested elsewhere. 13 There are two basic types of leases: closed-end and open-end leases (see Chapter 7). In a closed-end lease (the most common for consumer vehicle leases), the lessee does not have an obligation to purchase the leased asset at the end of the agreement. On the other hand, with an open-end lease (rare for con- sumer leases, so care is warranted), also called a finance lease, the lessee has the obligation to pay the difference between a “residual value” and the “actual value,” if the latter is lower when the lease ends. 14 By providing flat lease payments, the lessor also takes the risk of higher interest rates. In contrast, the purchase of an asset financed in part through adjustable-rate debt exposes the buyer to higher interest costs should market rates rise.

Household Investments 217

Inspection standards. Lessees must comply with the lessor’s inspection standards in returning the car or face the consequences. What might be an almost unobservable scratch to the lessee or the person who purchases a car from her or him can sometimes require an expensive repair to bring the vehicle up to the lessor’s inspection standards. Mileage charges. Leases contain maximum mileage charges. Lessees who exceed the limit, can owe extra mileage charges. Lessees who are well under the limit, receive no benefit but are, in effect, being charged for mileage that they didn’t use. Lease obligation. A lease is made for a fixed period of time and may be difficult or expensive to break or find someone else to assume if the lessee experiences a change in circumstances. Assumption of the lease by a third party also could expose the lessee to liability in the event the sublessee defaults in payments. However, owners who can sell their cars may be affected by the cost of time factor. Ability to fund monthly payments. For those who have cash flow concerns, monthly payments for leasing will be lower than loan payments. On the other hand, once all loan payments have been made, those people own the car.

On balance, in the absence of manufacturer subsidies, leasing an automobile generally costs more than purchasing it outright. However, the extra cost for leasing may be accept- able to many, particularly those who hold new cars for around three years. The disparity in cost can be smaller in that period and more than offset by the absence of effort in changing cars and the benefit of having a risk-free sale of the relinquished car. Appendix III offers a description of the factors that enter into a lease. It also provides the computation of an actual lease payment. Table 8.2 provides a summary and description of the types of capital expenditures for the household.

TABLE 8.2 Analysis of Capital Expenditures

Type of Capital Expenditure Category

Summary of Capital Expenditures

Specific Cost or Activity

Examples of Activity or Durable Goods Specific

Capital Expenditure

Durable Goods Nondiscretionary Household overhead Mortgage interest, rent, fuel, electricity

Furnace, furniture

Nondiscretionary Household work Cooking, cleaning, child care, shopping

Dishwasher, oven

Nondiscretionary Biological Maintenance

Food, clothing, sleep

Bed

Discretionary Active Sports, traveling Ski, golf clubs Discretionary Passive Watching television Television, stereo Revenue related Human revenues Work Automobile as

transportation Revenue related Marketable assets Investing Computer

Human Assets: Education

Nondiscretionary All Any Books and seminars on improving productivity

Discretionary All Any Books and seminars on increasing pleasure

Revenue related Human revenues Work College, graduate school, conferences

Revenue related Marketable assets Investing Conferences Real Estate: Home

Nondiscretionary Household overhead See Durable Goods above

See Durable Goods above

Discretionary Active or passive Exercising, watching television

Construction of a den-exercise room

Revenue-related Real assets Investing Purchase of a home

218 Part Three Portfolio Management

College Age

a portfolio of nonfinancial assets to add to financial ones.

Twenties

Thirties

Forties

Fifties - gations there should almost be over.

living costs.

Sixties

Seventies and Beyond

Life Cycle Planning Household Investments

©Don Hammond/Design Pics, Inc.

Chapter Eight Household Investments 219

Back to Dan and Laura HOUSEHOLD INVESTMENTS—CAPITAL EXPENDITURES I had already briefed Dan and Laura on nonfinancial investments and how they can im- pact their lives. I had asked them to make a list of the future investments they felt were important. Both Dan and Laura had come with one big item on their list. Dan felt he had to have a “status car.” That car would cost him $30,000 net of the trade- in value of his old car that he drove to the station. His insurance would go up by $800 a year, his fuel by $750 per year, and his maintenance cost by about $1,000 per year. However, he would save train costs of $1,000 per year and would be able to use the car for seven years, at which time he believed it would have little value. Dan planned to buy the car at the end of the year in December. He wanted to know whether this was a worthwhile investment. Laura was concerned about her family and her career. Many of her friends had gone back to work almost immediately after giving birth. She liked her work and believed that, as an elementary school teacher, she had a significant positive impact on the lives of many children. Moreover, she couldn’t see herself being content by staying home all the time. On the other hand, she thought it might be best for the children if she raised them in their early formative years. She said she might enjoy that period herself. I sensed that she was conflicted and asked her if my thought was correct. She nodded yes. I also had the feeling that, all other things be- ing equal, she wanted to stay home and raise her children until they began school. When I asked her that question, she agreed but wanted to know the financial implications of doing so. Laura mentioned she had thought of pursuing a master’s degree in teaching methodology with a specialty in reading. She believed that all the course work would help improve her performance in the classroom. She would begin in about a year, take the courses gradually while raising her children and have it completed in about five years. The cost would be $80,000 in current dollars spread equally over the four-year period with education costs ris- ing by 6 percent a year. Upon completion of her degree, she would be entitled to an $18,000 annual increase in salary. She asked me if I thought doing that made sense financially. I thought to myself that the three areas we would have to work on were a new car, when to go back to work, and whether to enroll in a master’s curriculum.

Here’s the advice I presented to them: We’ve discussed whether to purchase a new car (durable goods assets), when to go back to work, and whether to enroll in a master’s program (human-related assets); all lend them- selves to financial analysis. Let’s go over the car first. The purchase of the car is simple. You would have a one-time cost of $30,000 net of trade-in plus extra yearly expenses of $1,550. The benefit at the $50-per-hour rate for your time as- sumed conservatively not to rise each year would be $50 per day, $250 per week, $12,500 per year before taxes and $8,906 after taxes. Unfortunately, this automobile expense is not tax de- ductible. Your net inflows, therefore, are $7,356 per year. The return on this investment is very high at 19 percent. You should buy the car and start working extra hours as soon as it is feasible.

New Car

Inputs

Cost of new car $30,000 Additional expenses $1,550 Additional work hours/week $5 Hourly rate $50 Marginal tax rate 28.8% After-tax hourly rate $35.63 Sale price $8,000

(continued)

220 Part Three Portfolio Management

Laura, you would be making $50,000 a year if you were working today. At an assumed marginal tax bracket of 28.8 percent when you work, plus Social Security payments of 7.65 percent, that would leave you with about $33,000 per year after tax. You mentioned that a full-time housekeeper would cost $25,000 a year and transportation, clothing, and eating out another $2,000 a year. The difference of $6,000 per year is not very meaningful, particularly given your wish to raise your children yourself. The master’s program provides the potential to earn an $18,000 raise its completion with $80,000 in costs over four years. Assuming that your marginal tax bracket is 28.8 percent, federal and state, when you return to work, your benefit is a raise of about $12,800 per year in today’s after-tax dollars for 16 years to your intended retirement at 55.

Master’s Program

Inputs Cost of program $80,000 Inflation (college) 6.0% Pay raise upon completion $18,000 Marginal tax rate 28.8% After-tax pay raise $12,825 Years of employment 16 General inflation 3.0%

Inflows Outflows Net Cash Flow

2015 0 0 0 2016 0 ($22,472) ($22,472) 2017 0 (23,820) (23,820) 2018 0 (25,250) (25,250) 2019 0 (26,765) (26,765) 2020 $15,314 0 15,314 2021 15,773 0 15,773 2022 16,246 0 16,246 2023 16,734 0 16,734 2024 17,236 0 17,236 2025 17,753 0 17,753 2026 18,285 0 18,285 2027 18,834 0 18,834 2028 19,399 0 19,399 2029 19,981 0 19,981 2030 20,580 0 20,580 2031 21,198 0 21,198 2032 21,834 0 21,934 2033 22,489 0 22,489 2034 23,163 0 23,163 IRR 13%

2015 2016 2017 2018 2019 2020 2021 2022

Cash Flow Inflows $8,906 $8,906 $8,906 $8,906 $8,906 $8,906 $16,906 Outflows ($30,000) $1,550 $1,550 $1,550 $1,550 $1,550 $1,550 ($1,550) Net cash flow ($30,000) $7,356 $7,356 $7,356 $7,356 $7,356 $7,356 $15,356 IRR 19%

As you can see, on your worksheet, the return on the graduate degree is high at 13 percent even without the additional pension benefits you would receive and the potential to receive

(concluded)

Chapter Eight Household Investments 221

an even higher return should you decide to retire later. Because it better fits your personal goals and provides an excellent return on investment, I believe obtaining the master’s de- gree to be a highly attractive investment. In sum, all of the proposed capital expenditures with the exception of going back to work immediately are considerably higher than those for investments in the marketplace with comparable risk, and therefore we recommend that you make them.

College Student Case Study and Review: Amy and John HOUSEHOLD INVESTMENTS Amy and her stepbrother John were both skeptical. They wanted to know what nonfinan- cial investments were and why these types of investments were important. I explained that the household has many types of assets besides financial ones such as stocks and bonds. The principle nonfinancial assets are real estate, other tangible assets—sometimes called durable goods—and human-related assets. Nonfinancial assets are important because they contribute to the functioning of the household, which can be called household production.15 They include pleasurable leisure as well as work-related activities. We study them because capital expenditures (outlays that provide long-term benefits) on nonfinancial assets can make the household more efficient, just as business capital expenditures can make business more productive. The intended outcome for businesses is higher profits whereas the outcome for households can be in- creased available cash flow, which raises household members’ standard of living. I thought Amy and John seemed a little puzzled, so I continued. Before we begin to describe household investments, it’s useful to know that the household enterprise* we just described evaluates such investments for purposes of making selections in three ways:

1. Individual asset basis. Looking at each option by itself. 2. Within activity basis. Making selections by comparing alternatives within type of assets.

An example is deciding whether to spend available cash or credit to get a washing ma- chine or a dishwasher.

3. Fully integrated basis. Comparing all alternatives available.

Total portfolio management (TPM) compares all assets as is done in the third type of selection on a fully integrated basis and with the goal of obtaining the most efficient com- bination for the household. As mentioned, capital expenditures provide benefits over an extended period of time. The process of deciding on capital expenditures to make for household investments is similar to that used by a business. We review goals, establish our required rate of return, identify potential prospects, rank all projects, and establish how much money we have available to spend. We then select the number of items that meet our criteria up to the amount we have budgeted based on a rank order of attractiveness. We may use either the net present value (NPV) or the internal rate of return (IRR) method. NPV is more accurate whereas IRR is easier to understand because it is expressed in a return figure. Generally, the methods give the same result for deciding among alternative expenditures. Consider durable goods such as air conditioners, cars, televisions, and so on. We buy new ones when the old ones wear out, or if technological developments make new ones more appealing. The car is often the most expensive durable good. It is important to note that most durables decline in value over time.

15 Both terms and parts of the overall discussion explained more fully in Chapter 4.

222 Part Three Portfolio Management

Human-related assets have a particular meaning within the household or business framework. Typically that includes the income-earning ability of the individual measured by discounting anticipated future cash flows to a present value. Humans incur capital ex- penditures by investing in themselves. For example, either or both of you may obtain a bachelor’s or a master’s degree that raises your income-earning ability. You may take a course or engage in job training or learn how to better invest. With such actions, the pres- ent value of human-related assets usually goes up. However, because people work for only a finite number of years, at some point human assets decline, and by the time they fully retire, have no financial value at all. Human-related assets also include pensions such as Social Security, future gifts, and inheritances. They are human-related because they come about because of our efforts and relationships and stop when we pass away. Other assets include collectibles, antiques, jewelry, business interests, and other items that provide income or have market value. We don’t have to buy all the assets we use. In some cases, leasing is an alternative. Leasing is defined as acquiring the use of an asset without acquiring ownership. An ex- ample of a lease is renting an apartment or leasing a car for a number of years. Whether we lease or buy can involve many factors, including such items as a relative cost comparison, the amount of cash available, and, in the case of a home, tax aspects. I informed Amy and John that we would talk about the home separately at a later time. The home is an example of a durable good, but unlike the others, it may actually appreciate in value over an extended period of time. I emphasized that in the real world, people don’t use fixed financial calculations to cal- culate the most efficient items to the penny. Instead people think about the relative costs and benefits and make decisions intuitively. However, in many cases, such as buying versus leasing a car, more sophisticated calculations could be especially important.

Summary The household can be separated into financial and household investments. Household investments are the real and human-related assets that contribute importantly to the house- hold portfolio. They are the ones covered in this chapter.

can be measured on an individual-asset basis, within a household activity, or on a TPM basis. In this chapter, an individual-asset basis was used principally.

case, returns on projected outlays are compared with similar market-based investment returns. NPV uses market returns to develop current values and accepts all investments that have a positive present value. IRR provides a return that is compared directly with the market-based return that is used to accept or reject a proposed outlay.

consist of job-related income discounted to the present plus those related to human work and other rights and relationships such as Social Security, corporate pension in- come, and anticipated gifts and bequests. Both use projected costs and benefits in deter- mining whether to make proposed outlays.

over renting because of its tax benefits.

purchase but is attractive for people who are short of capital or who desire more flexi- bility with their monies.

Household Investments 223

Key Terms capital expenditures, 203 discount rate, 205 durable goods, 200 financial assets, 199 fully marketable assets, 199

human assets, 212 human-related assets, 200 internal rate of return (IRR), 208 lease, 215

net present value (NPV), 205 nonfinancial assets, 200 profitability index (PI), 207 real assets, 200 required rate of return, 205

studyfinance.com/lessons/capbudget Capital Budgeting This link has several sections whose topics include capital budgeting, capital expen- ditures, cash flow analysis, and valuation techniques such as NPV and IRR.

leaseguide.com Lease vs. Buy Decisions This site provides extensive information including up-front fees, interest costs, maintenance fees, and so on in lease-versus-buy capital expenditure decisions. A kit that allows users to calculate the obligations in leasing or buying decisions is also featured.

realtor.com/home-finance/financial-calculators/?source=web National Association of Realtors Here you’ll find multiple calculators including those for evaluating buy-versus-rent decisions, home affordability, and loan comparisons.

freddiemac.com Freddie Mac Two programs—one designed to provide adults with comprehensive homebuyer educa- tion and the other focused on helping homeowners protect their investment—are offered.

fanniemae.com Fannie Mae This Website promotes home ownership and provides information on financial prod- ucts and services that help families buy homes of their own.

nahb.org National Association of Home Builders (NAHB) Instructive information about home building and new house pricing is contained here. It serves as a guide for people interested in building, buying, owning, or remod- eling a home.

Websites

Questions 1. Describe the three approaches to decision making for capital expenditures. 2. Briefly explain total portfolio management (TPM). 3. Compare capital expenditures with marketable securities as an investment. 4. Why should capital expenditures be treated separately on a cash flow statement? 5. What are the strengths and weaknesses of the net present value (NPV) and internal

rate of return (IRR) methods? 6. Why calculate a profitability index? 7. Why are durable goods considered to be capital expenditures? 8. Why is education a capital expenditure? 9. Contrast life cycle human-asset valuations for skilled and unskilled workers. 10. Compare capital budgeting practices as outlined in this chapter with those used on a

day-to-day basis.

224 Part Three Portfolio Management

If the appropriate discount rate is 8 percent, what are the NPV and the IRR for this outlay? Helen, a sociologist, is considering buying a new power lawn mower. It would save her 30 minutes of work a week, which she would use to see another client. Her fee is $16 per hour and she works 50 weeks a year. The lawn mower would cost $1,400. What would her IRR be if the mower was expected to last eight years? Express your figures on an annual basis and assume that her required rate of return is 9 percent. Marcia had a choice of two washing machines of equal performance. One cost $400 and had a present value (PV) of $230 in savings over having clothes done through an outside service. The second cost $600 and had a PV of $450. Which one should she select? Billy is considering enrolling in an MBA program. It would cost him $22,000 a year for two years. He believes it would raise his salary, which is now $50,000 a year, by the fol- lowing amounts:

8.2

8.3

8.4

11. What changes in day-to-day capital expenditure selections can you recommend? 12. Name three factors involved in the purchase of a car. 13. What factors should you consider when you aren’t sure whether to buy or lease a car? 14. What are the advantages of leasing over purchasing in general? 15. Why are more people leasing? 16. Is leasing less costly than purchasing? Explain. 17. Discuss the advantages and disadvantages of leasing a car.

Problems Laurence was presented with a capital expenditure for a furnace that would cost $12,000 today and would generate the following savings.

8.1

Year Amount

1 $2,000 2 $3,000 3 $2,000 4 $4,000 5 $5,000 6 $7,500 7 $5,000 8 $2,500

Year Amount

1–5 $15,000 6–10 20,000 11–15 25,000

Currently, Billy pays 28 percent of his salary in taxes; his tax bracket will change to 30 percent after the raise. Assuming that the required rate of return is 8 percent after taxes, should he make the investment? Use (a) the NPV method and (b) the IRR method to decide. John is considering buying a new car for $15,000 if purchased today. He also could wait to purchase the vehicle three years from now for $18,000. If John can invest in the capital mar- kets and earn a 10 percent return, should he purchase the vehicle today or three years from now? John himself is indifferent about whether he to buy the car today or in three years. As the owner of a business, you must make an investment decision. The investment will expand your company’s production plant at a cost of $1 million. The expansion will gener- ate income of $150,000 per year for 10 years; the required rate of return on the investment

8.5

8.6

Household Investments 225

A. The after-tax IRR of this investment is 1. 17.41 percent. 2. 19.20 percent. 3. 24.18 percent. 4. 28.00 percent. 5. 33.58 percent.

B. Which of the following is/are correct? 1. The IRR is the discount rate that equates the present value of an investment’s

expected costs with the present value of the expected cash inflows. 2. The IRR is 24.18 percent, and the present value of the investment’s expected cash

flow is $9,200.

is 9 percent. What is the net present value NPV of the investment, and should you proceed with the expansion? Item A has an NPV of $300 and an original cost of $500. Item B has an NPV of $350 and an original cost of $700. What is the profitability index (PI) of items A and B, and which is a more attractive investment? Joan has a choice of purchasing a car for $20,000 with 9.7 percent interest cost to borrow and a three-year repayment period for leasing the vehicle. Leasing the auto would cost $300 a month for a three-year term. The sales tax is 6 percent. The car is expected to have a value of $14,000 at the end of the leasing period. Joan can obtain 7 percent after tax on similar marketable investments. Should she lease or buy the car?

8.7

8.8

Investment A costs $10,000,000 and offers a single cash inflow of $13,000,000 after one year. Investment B costs $1,000,000 and will be worth $2,000,000 at the end of the year. The appropriate discount rate or required rate of return is 10 percent compounded annu- ally. Match the investment(s) listed below with the corresponding financial information in the items that follow.

A. Investment A. B. Investment B. C. Both A and B. D. Neither A nor B.

1. ___ The net present value (NPV) is $818,182 and the internal rate of return is 30 percent.

2. ___ The NPV is $818,182 and the internal rate of return is 100 percent. 3. ___ The NPV is $1,818,182 and the internal rate of return is 30 percent.

Smith invests in a limited partnership that requires an outlay of $9,200 today. At the end of years 1 through 5, he will receive the after-tax cash flows shown below. The partnership will be liquidated at the end of the fifth year. Smith is in the 28 percent tax bracket.

8.1

8.2

CFP® Certification Examination Questions and Problems

Years Cash Flows

0 ($9,200) CF0 1 $600 CF1 2 $2,300 CF2 3 $2,200 CF3 4 $6,800 CF4 5 $9,500 CF5

226 Part Three Portfolio Management

3. The IRR is 24.18 percent. For Smith to actually realize this rate of return, the invest- ment’s cash flows will have to be reinvested at the IRR.

4. If the cost of capital for this investment is 9 percent, the investment should be re- jected because its net present value will be negative. a. (2) and (4) only b. (2) and (3) only c. (1) only d. (1), (2) and (3) only e. (1) and (4) only

Chapter Eight Household Investments 227

Case Application NONFINANCIAL ASSETS—CAPITAL EXPENDITURES Unlike Richard, Monica remained very concerned about their financial future. Specifically she was fearful that the couple would not have enough money to retire comfortably as they had expected. She asked whether she should postpone or eliminate one improvement on her house. She estimated that a new furnace with a useful life of eight years would cost $20,000 and would save $4,000 a year in heating bills.

Case Application Questions 1. Do we know yet whether Monica’s fears about retirement are justified? Do you have

any preliminary opinion about this? 2. Do you think she should consider a new furnace now? 3. Complete the furnace problem and give your response.

Appendix I

Capital Budgeting Theory In this appendix, we discuss capital budgeting theory first using the marginal rate of time preference and then considering consumption and capital expenditure decisions.

MARGINAL RATE OF TIME PREFERENCE Under the theory of choice, to help us decide how much to invest and how much to allocate to current spending, we need to consider our personal rate of time preference. It is the rate of return that makes us indifferent (exactly neutral) about the choice between spending to- day on a good or saving that money and spending it in the future. That rate varies with the individual. If you have a high rate of time preference, you would consume more today and save less. Those who have low incomes and not enough money to cover their basic needs16 and others who “live for today” may have higher-than-average rates of time preference. In making spending decisions, we use marginal rates because the same person may have different rates of time preference at different levels of income and spending. For example, people with low incomes would usually have a higher rate of time preference in postpon- ing spending on the first and only leisure time activity they could afford than they would if they had a higher cash flow and were considering forgoing their fourth leisure activity. We focus on the marginal personal rate of time preference, which we’ll simply call the mar- ginal rate of time preference. The marginal rate of time preference is compared with rates of return on investments to help determine whether to save or to consume. If you had a marginal rate of time preference

16 Emily C. Lawrence, “Poverty and the Rate of Time Preference: Evidence from Panel Data,” Journal of Political Economy 99, no. 1 (February 1991): 54–77. See also James Andreoni and Charles Sprenger, “Time Preferences from Convex Budgets,” American Economic Review, 2012, econ.ucsd.edu/~jandreon/ Publications/AER12-AS-Estimation.pdf

228 Part Three Portfolio Management

of 3 percent in considering an investment and could receive a 5 percent return on that invest- ment, you would be likely to save the money. Savings decisions are also influenced by other factors such as the need to accumulate assets for spending in retirement and, in a world that includes risk, the need for precautionary savings to provide for future uncertainties. Often the personal rate of time preference is not stated but implied by our actions. We can compute the marginal rate of time preference by comparing cash outflows today with cash outflows in the future using the following formula.

FV = PV11 + s2n where

s = Marginal rate of time preference n = Number of years

Example 8.A1.1 Brittany was contemplating taking a vacation at a seaside resort, which would cost $800. She could not decide between taking the vacation today and taking a vacation and a weekend trip costing $882 two years from now. Assuming that her preferred lifestyle expenditures include these two alternatives, what is her marginal rate of time preference? Based on her indifference as to whether to take the vacation today or two trips two years from now, Brittany has a per- sonal rate of time preference of 5 percent. If a 7 percent return is possible by investing in the capital markets, what should she do?

882 = 800 11 + s22 Inputs: 2 882–800

Solution: 5

N I/Y PV PMT FV

Press i = 5%

Because the current market rate of return of 7 percent exceeds the 5 percent rate, she should save the money and use it to make two trips in two years. The 7 percent rate will actu- ally provide her with more than the cost of the trip in two years. She can use the extra money to purchase other goods and services.

CONSUMPTION AND CAPITAL EXPENDITURE DECISIONS We begin our capital expenditure discussions in a simple world that has perfect capital markets and no risk. In that world, outcomes are known with certainty; there are no infla- tion, taxes, or transaction costs; and all assets are fully marketable. And, very importantly, there is no difference between borrowing and investing rates. In theory, under perfect capital markets, consumption decisions are separate from capi- tal spending decisions. The consumption decision is determined by our personal rate of time preference. As mentioned, we save when market returns exceed the personal rate of time preference. We borrow when we have a desire for more consumption today and our borrowing rate is below our personal rate of time preference. Capital expenditure decisions in a world with perfect capital markets and no risk are based solely on market returns. We accept all capital expenditures whose returns equal or exceed the return on marketable investments. The reason is simple. We would have no incentive to make a capital expenditure if we could get a higher return by purchasing a marketable investment.

Calculator Solution

Household Investments 229

Keep in mind that in this world without risk there are no defaults, there is no limit on the amount we can borrow, and the cost to borrow monies and the returns on investments are assumed to be the same. When we run short of cash flow to place in capital expenditures, we borrow enough money to fund the capital projects whose returns exceed the borrowing/ investing rate. Because there is no distinction between the rates to borrow and to invest and an unlimited amount of capital is available to borrow for either consumption or capital ex- penditures, the two decisions on whether to consume or to invest can be treated separately. We assume that we have a positive cash flow available to fund our investments. Let’s trace how equilibrium for investment occurs in this ideal state. Capital projects—the rates of return on internal investments—are arrayed from highest to lowest returns. These proj- ects are displayed in stepwise fashion because each capital expenditure has a different cash amount that is needed for investment. For example, you cannot buy one-half of a new furnace. Either you pay the full purchase price or you forgo the outlay. The rates of return on marketable securities, on the other hand, are level and can be selected in any size needed. As mentioned, equilibrium for capital expenditures alone occurs where its rate of return meets that for marketable securities. Clearly, marketable securities only come into play when there is cash flow available for external investment. If, instead of having money to invest, additional cash flows are needed, they would be supplied by borrowing along the borrowing/investing line again where the marginal rate of time preference intersects the line. (See Figure 8.A1.1.)

Example 8.A1.2 Greg has a rising marginal rate of time preference as savings increase; it amounts to 8 percent where it meets the borrowing/investing line. At that point, cash flows from household operations amount to $6,000. His choices for savings include four capital expenditures, for (1) $2,000, (2) $500, (3) $2,500, and (4) $1,000 returning 12 percent, 11 percent, 10 percent, and 6 percent, respectively. Assuming an 8 percent rate for borrowing or investing in an equilibrium market environment, how should Greg invest?

Rate of Return, %

8 1,000 2,000 3,000 4,000 5,000 6,000

Borrowing/Investing ($) 6

Borrowing, % Savings, %

–3 –2 –1 0 1 2 3 4 5 6

CapEx 3 C ap

Ex 2 CapEx 1

CapEx 4

Capital Expenditure Line

C A

FIGURE 8.A1.1 Capital Expenditure Line

230 Part Three Portfolio Management

Greg will consider the following:

Amount Rate of Return

Capital expenditure 1 $2,000 12% Capital expenditure 2 $500 11% Capital expenditure 3 $2,500 10% Capital expenditure 4 $1,000 6% Total $6,000

Capital expenditures 1–3, totaling $5,000, exceed the market rate of return and are, therefore, funded. Because the fourth capital expenditure at its 6 percent rate is lower than the 8 percent market rate of return, it is not used. The remaining $1,000 of Greg’s cash flow is placed in marketable investments.

The equilibrium process is given in Figure 8.A1.1. Notice that point C in the figure delineates the point at which there is no borrowing or saving. Everything to the left of point C indicates borrowing; everything to the right, saving. The return on capital ex- penditures intersects the market line to the right, indicating that cash flow is available. Equilibrium for investing occurs at point A where it meets the borrowing/investing line. Point A indicates the amount of operating cash flow available for internal and external investing. Observe that the capital expenditure line starts directly above point A at the point of its maximum rate of return, point D, for capital expenditure project 1 (CapEx 1). The capital expenditure line then declines as succeeding capital projects—CapEx 2, then CapEx 3— offer lower and lower returns until the line meets the borrowing/investing line at point B, its equilibrium point. The horizontal distance between points A and B delineates the amount of capital expenditures used and between B and C the amount of marketable in- vestments used. Proposed capital expenditures below the return on marketable securities that are rejected are shown as a dotted line. If the borrowing/investing line were changed from the 8 percent return figure shown to 11 percent, capital expenditures would decline as external investments proved more attrac- tive relative to capital outlays. If the investment return on marketable securities were to be lowered instead of raised, the opposite effects would occur.

PRACTICAL ADJUSTMENTS Once we use more practical assumptions, the situation changes somewhat. Transaction costs for buying and selling securities and taxes on income are now part of the process. Moreover, in real life, risk is usually present in making decisions—we cannot be sure of any outcome. As a result, there is a difference in the borrowing and the investing rates as anyone who has both credit card debt and a position in a stock knows. We must accept fluctuations in performance whether that means the possibility of purchasing a car that is a “lemon” or investing in a stock that provides losses instead of gains. In this more realistic environment that includes risk, we cannot be sure how much money we will need to save for future consumption. We allocate extra money for precau- tionary savings to make more likely our ability to fund day-to-day and long-term retirement needs in the face of uncertainties. We are no longer able to borrow unlimited amounts of funds at the low risk-free rate. Instead, the borrowing will include an extra cost for risk, which will increase as the amount of money borrowed increases. Decisions on the amount to consume and the amount to invest will be made together. We discussed borrowing and its effect on consumption and investment in Chapter 7.

Household Investments 231

Assumed Rents Assumed rents are hypothetical costs for assets owned. They are hypothetical costs be- cause they are not paid to anyone. Because no cash is transacted, these rents are not nor- mally considered financial outlays and are not tax deductible. Nonetheless, that can be a useful tool in analyzing capital expenditures for items such as durable goods. Economists call these costs implicit costs. They are rents that would have to be paid to obtain the use of an asset if we had not purchased it outright. When we buy something, we can be consid- ered both owners of an asset, for which we would want to be compensated, and renters of the asset, but we rent the asset from ourselves. Looking at an asset in this way can aid in establishing costs and its fair market value. For example, if you bought a television, its implicit cost would be how much it would cost you to rent that set. The value of that television could be considered the NPV of all of its yearly implicit costs while in use. Analyzing implicit costs can shed some light on durable goods—for example, a house. When you buy a house to live in, you are both an owner who has invested in a home and the user of that home. If you divide the transaction into two parts, you can better under- stand the cost and the investment portion. The housing buy-versus-rent example in Appendix I of Chapter 9 Real Estate and Other Assets Appendix I includes the implicit rental cost in obtaining the investment return on owning it. Thus, your total cost of operat- ing a home could be considered not only the costs of electricity, heat, gardening, and so on, which are not generally covered in a rental, but also the implicit rental cost, which is equivalent to how much you would pay to rent a similar property.

III

Understanding the Lease Payment A lease payment has three parts. The first is the finance cost, the sum you pay to cover the borrowing cost and profit for the company that purchased the car and leased it to you. The second is the depreciation cost, the amount by which the market value of the car is ex- pected to decline over the lease’s life. The third is applicable taxes on purchase of the lease. Let’s take each separately in calculating the lease payment.

FINANCE COST The finance cost is expressed as a money factor. The money factor is the interest rate by custom divided by 2,400. The interest rate charged over the life of the lease is called the base interest rate.

Factor Explanation

Finance Factors Money factor The interest rate charged over the life of the lease, which is called the base

interest rate. By custom, this rate is expressed as a decimal obtained by dividing the base rate by 2,400.

(continued)

232 Part Three Portfolio Management

CALCULATING LEASE PAYMENTS

Monthly leasing price = Depreciation factor + Finance factor + Tax factor Monthly leasing price 1K2 = G + 1 + T

Depreciation factor 1G2 = A − 1B × D2 C

Finance factor 1I2 = 1A + 1B × D2 2 × E Tax factor 1T2 = 1G + I2 × F

where

A = Actual sales price B = Manufacturer’s suggested retail price (MSRP) C = Number of months D = Residual value as percent of MSRP E = Money factor (interest rate divided by 2,400) F = Actual tax rate G = Depreciation factor I = Finance factor T = Tax factor

Example 8.A3.1 Brad wanted to calculate the monthly payment for leasing a car. The negotiated price for the car for lease payment purposes was $30,647, down from the list price (MSRP) of $32,455. There was no down payment. The interest rate was 3 percent and the residual for a 39-month lease was 56 percent. What is the monthly payment assuming a 9 percent sales tax?

Money factor = 3% 2,400

= 0.00125

Monthly leasing price = Depreciation factor + Finance factor + Tax Factor

Factor Explanation

Selling price The actual cost of purchasing the car. Sometimes called the capitalized cost. MSRP The list price of the car. Depreciation Factors Residual value The assumed value of the car at the end of the lease period. It may be

expressed either as an amount or as a percentage of the list price. This value is the price you will pay should you want to purchase the car after expiration of the lease.

Calculation Depreciation expressed as an amount is divided by the number of months in the lease. Depreciation is the negotiated sale price less the residual value.

Tax Factors State and local taxes The taxes based on leasing the car. Often these taxes are lower than those

for purchase since lease payments are not made on the full value of the car. Calculation Total taxes divided by the number of months in the lease to obtain the

monthly tax.

(concluded)

Chapter Eight Household Investments 233

Depreciation factor 1G2 = A − 1B × D2 C

= 30,647 − 132,455 × 0.562

= 12,472 39

= 319.80 Finance factor 1I2 = 1A + 1B × D2 2 × E

= 130,647 + 132,455 × 0.562 2 × 0.00125 = 61.03

Tax factor 1T2 = 1G + I2 × F = 1319.80 + 61.032 × 0.09 = 34.27

Monthly leasing price = 319.80 + 61.03 + 34.27 = 415.10

Appendix IV

Buy versus Lease—Car In this example, we consider how to arrive at a financial decision about whether to buy or lease a car when lease payments are known.

Example 8.A4.1 Diane was interested in the Del Phillipo, an Italian sports car that came in one color—red. A car of that type was relatively inexpensive at $45,000. Diane was not sure whether she would keep the car for three years or six years. Consequently, she reviewed lease quotations for both periods. The dealership indicated that the cost for leasing for either period would be $650 a month claiming that although the car’s market value was higher after three years, it’s value would drop more precipitously after that time. On her own, Diane made estimates of a market value of $30,000 after three years and $15,000 after six years. The normal automobile warranty would cover special car problems such as engine troubles, air conditioning not working properly, or overall electrical problems. Diane would have to pay for normal wear and tear such as changing tires and brakes whether she leased or purchased the car. Therefore, she didn’t include such costs in her analysis. However, she did include a special $2,000 charge for a repair in the fifth year when she figured that her warranty, based on mileage, would run out. Assume no down payment, a 6 percent borrowing rate for a car loan on purchase to be repaid over six years, and a sales tax of 5 percent. Assume there are no considerations other than return and that Diane’s required rate of return is 6 percent. Use both a three-year and a six-year period. Calculate monthly payments, but use yearly figures for calculating IRR for both purchase and lease. Should she buy or lease?

234 Part Three Portfolio Management

Three-year return = 6.0% Six-year return = 10.7%

Ownership operating advantage = Buy cost − Lease cost In year 1 there is a $2,250 tax cost and in year 5, we add $2,000 extra repair cost to the annual loan payment. Balance debt for the three-year period equals the ownership operat- ing advantage for each year except for year 3, when the ownership operating advantage is subtracted from the market value of the car in year 3. The same approach is used in calcu- lation of the balance debt for the six-year period.

Car Buy versus Lease

Inputs Auto Loan Repayment (3-year period) Purchase price $45,000 Monthly payment $1,369 Market value in three years $30,000 Annual payment $16,428 Market value in six years $15,000 Repair cost in year 5 $2,000

Auto Loan Repayment (6-year period) Monthly lease payment $650 Monthly payment $746 Annual lease payment $7,800 Annual payment $8,949

Tax Cost on Purchase Annual interest rate 6% Tax cost (5% on purchase price) $2,250 Monthly interest rate 0.5% Sales tax 5% Required rate of return 7%

Year 1 2 3 4 5 6

Buy Yearly payment (3-year period) $16,428 $16,428 $16,428 Yearly payment (6-year period) $8,949 $8,949 $8,949 $8,949 $8,949 $8,949 Tax and extra repair costs $2,250 $2,000 Lease Yearly payment $7,800 $7,800 $7,800 $7,800 $7,800 $7,800 Ownership operating $10,878 $8,628 $8,628 advantage (3-year period) Ownership operating $3,399 $1,149 $1,149 $1,149 $3,149 $1,149 advantage (6-year period) Market value of the car $30,000 $15,000 Balance debt (3-year period) ($10,878) ($8,628) $21,372 Balance debt (6-year period) ($3,399) ($1,149) ($1,149) ($1,149) ($3,149) $13,851

Calculation Explanation

Auto Loan Repayment (six-year period)

72n (6 years × 12 months), 0.50i (6% ÷ 12 months), 45000 PV Press PMT = 746 Monthly loan payment Annual loan payment = 746 × 12 = 8,949 Yearly loan payment Auto Loan Repayment (three-year period)

36n (3 years × 12 months), 0.50i (6% ÷ 12 months), 45000 PV Press PMT = 1369 Monthly loan payment Annual loan payment = 1369 × 12 = 16428 Yearly loan payment Annual lease payment = 650 × 12 = 7800

Chapter Eight Household Investments 235

The return for purchasing for three years (6 percent) does not meet the 7 percent required rate. However, the six-year rate substantially exceeds it. Therefore, it pays to lease a car for three years but to buy for the six-year period. Over the longer period of time, the ability to own and sell an asset more than offsets the extra monthly cost for the purchase.

Appendix V

Excel Examples for NPV and IRR17 This appendix demonstrates how you can solve problems involving NPV and IRR methods by using Excel.

NET PRESENT VALUE Often we face investment decisions involving capital outflows and cash inflows in different periods. Few investments have even cash flows in each period. We cannot use Excel’s PV and FV functions for uneven cash flows because they assume equal payments or a lump sum. If we want to solve for the present value of uneven cash flows, we need to use the NPV. We use two methods for solving NPV problems: a time line and the Excel NPV function.

Example 8.A5.1 Capital expenditure requires a current investment of $5,000 and yields future expected cash flows of $1,200, $1,500, $1,800, $1,300, and $1,100 for the next five years. The required rate of return on the investment is 8 percent. What is the net present value of the investment, and should you undertake it (see Figure 8.A5.1)?

Three-Year Return

CF Clear the register f FIN 2nd CLR Work Enter cash outflow year 1 10,878 CHS g CFo 10,878 +/− ENTER ↓ Enter cash outflow year 2 8,628 CHS g CFj 8,628 +/− ENTER ↓ ↓ Enter cash inflow year 3 21,372 g CFj 21,372 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 6.0% 6.0%

General Calculator Approach HP12C TI BA II Plus

17 Troy A. Adair, Excel Applications for Corporate Finance (New York, NY: Burr Ridge: McGraw-Hill/Irwin, 2005), and Craig Holden, Excel Modeling in Investments, 4th ed. (Princeton, New Jersey: Prentice Hall, 2011).

Six-Year Return

CF Clear the register f FIN 2nd CLR Work Enter cash outflow year 1 3,399 CHS g CFo 3,399 +/− ENTER ↓ Enter cash outflow years 2–4 1,149 CHS g CFj 1,149 +/− ENTER ↓ Enter number of years 3 g Nj 3 ENTER ↓

Enter cash outflow year 5 3,149 CHS g CFj 3,149 +/− ENTER ↓ ↓ Enter cash inflow year 6 13,851 g CFj 13,851 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 10.7% 10.7%

General Calculator Approach HP12C TI BA II Plus

236 Part Three Portfolio Management

Building This Excel Model 1. Inputs. Enter the required rate of return as Discount Rate in cell B4. Build a table enter-

ing cash outflows (or current investment) in cell B6 and cash inflows (or future ex- pected cash flows) in cells C7:G7.

2. Net present value using a time line. We have a period 0 when current investment oc- curs and five consecutive future periods with the expected cash flows (see Figure 8. A5.2). Create a time line from period 0 to period 5 by entering 0, 1, . . . , 5 in the range B10:G10. Enter the corresponding cash flows in periods 0 through 5 in the range B11:G11. For your convenience, just copy the values from the Inputs table. Next calcu- late the present value of each cash flow using the formula for present value:

Present value = (Cash flow)/((1 + Discount rate)^Period)

Enter =C11/((1+$B$4)^C5) in cell C12 and copy it across to cell G12. The $ signs in $B$4 lock the column and row when copying. Put the same value in cell B12 as you do in cell B11 because this cash flow occurs in the current period, so you don’t need to discount it. Net present value is the sum of the present values of all cash flows. Enter SUM (B12:G12) in cell B13.

3. Net present value using the Excel NPV function. The NPV function calculates the net present value of a stream of cash flows. It has the following format:

NPV (rate, range of values)

The important thing that we should note here is that the NPV function discounts cash flows starting in period 1. Therefore, we must add the present value of the period 0 cash flow to the net present value of the cash flows for periods 1–5. Enter =B6+NPV(B4,C7:G7) in cell B16.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

A B C D E F G Net Present Value

Inputs Discount rate 8% Period 0 1 2 3 4 5 Cash outflows ($5,000) Cash inflows $1,200 $1,500 $1,800 $1,300 $1,100

Net Present Value Using the Time Line Period 0 1 2 3 4 5 Cash flows ($5,000) $1,200 $1,500 $1,800 $1,300 $1,100 Present value of cash flows ($5,000) $1,111 $1,286 $1,429 $956 $749 Net present value $530

Net Present Value Using the Excel NPV function Net present value $530

=B6+NPV(B4,C7:G7)

=C11/((1+$B$4)^C5)

FIGURE 8.A5.1 Excel Model for Net Present Value

($5,000) $1,200 $1,500 $1,800 $1,300 $1,100

0 1 2 3 4 5

FIGURE 8.A5.2 Finding PV of Future Cash Flows

Household Investments 237

The net present value of this investment is $530, which is a positive number. Therefore, you should accept the capital expenditure.

INTERNAL RATE OF RETURN Often we need to determine the yield of an investment given its cost and cash flows. The IRR approach helps us to solve for the yield of an investment. In the following example, we demonstrate the use of the Excel IRR function.

Example 8.A5.2 A project requires an initial investment of $10,000 and yields future expected cash flows of $1,800, $2,000, $2,200, $2,500, $1,900, and $1,700 in the next six years. If the required rate of return of the investment is 9 percent, what is the IRR, and should we undertake this project? (See Figure 8.A5.3.)

Building This Excel Model 1. Inputs. Enter the required rate of return in cell B4. You don’t need it in your calcula-

tions, but it is convenient to have it there when evaluating your project. Build a table entering cash outflows (or initial investment) in cell B6 and cash inflows (or future ex- pected cash flows) in cells C7:H7.

2. Internal Rate of Return Using the Excel IRR function. The IRR function calculates the internal rate of return of a stream of cash flows. It has the following format:

IRR (range of values, guess) Range of values is a range of cash flows including the investment cost, and guess is the

optional first guess at the correct rate of return. Generally, it can be omitted. Create a table with the periods from 0 to 6 and corresponding cash flows. Enter =IRR(B11:H11) in cell B13.

The project’s internal rate of return (6 percent) is less than the required rate of return (9 percent). Therefore, you should reject this project. Note that in the original example, there is only one sign change in the cash flow stream (from negative in period 0 to positive in period 1 and thereafter). Generally, there will be one IRR solution to the problem for each sign change. If there is more than one sign change, you should use the second parameter of the IRR function, guess, to find all the solutions to the problem. By adjusting the guess, you can identify all the IRRs.

1 2 3 4 5 6 7 8 9 10 11 12 13

A B C D E F G H Internal Rate of Return

Inputs Required rate of return 9% Period 0 1 2 3 4 5 6 Cash outflows ($10,000) Cash inflows $1,800 $2,000 $2,200 $2,500 $1,900 $1,700

Period 0 1 2 3 4 5 6 Cash flows ($10,000) $1,800 $2,000 $2,200 $2,500 $1,900 $1,700

Internal rate of return 6%

Internal Rate of Return Using the Excel IRR function

=IRR(B11:H11)

FIGURE 8.A5.3 Excel Model for Internal Rate of Return

238

Chapter Goals

This chapter will enable you to:

Laura said, ”Congratulate us; I am pregnant again.” I thought to myself that this might be only one additional child, but it was a whole new ballgame as far as near-term planning was concerned. The first area we would have to work on was the home.

Real-Life Planning Sebastian was a well-known film producer. He created motion pictures from one simple paragraph. His success came from delivering films that had wide appeal because of their similarity with life circumstances but with a little twist or reflection of very recent changes in human values. But Sebastian wasn’t happy just producing films. As a hard-driving person, he looked for a hobby, one that could provide a return on his time. He decided on real estate. He was friendly with the affluent creative set who had primary residences or vacation homes that reflected their money and desires for individual tastes. In one extreme example, he observed a home built as a medieval castle together with moats and marble floors and ceilings. It cost millions to build but sold for $15 million. Sebastian had long before decided to try real estate himself but on a small scale. He would renovate existing homes, making them appealing to people with taste for what he would offer. He started by looking for homes that were depressed in value. They would be cheaper because the overall market was temporarily depressed or because the property had some fundamental flaw, such as being a modern home in a community of colonial homes. Sebastian did very well in his new business and it allowed him to relax from the day-to- day pressures of making hit films. He was able to walk into a home for sale and instantly visualize how to make it appealing. He always paid attention to where the property was

Chapter Nine

Chapter Nine Real Estate and Other Assets 239

situated, purchasing a less costly home in an expensive neighborhood rather than a luxuri- ous one in a less desirable community. He was therefore following the old real estate adage that the three most important things in selecting a property are location, location, location. Because Sebastian’s hobby/business occurred during a period of strong gains in the real estate market, he questioned whether the strong market largely accounted for his profit- ability. When the real estate market crashed, he got his answer: He was left with a home he had previously purchased, and it was worth much less than he had paid for it. He never blinked. He went ahead renovating the home that was located next to a lake, an appealing aspect for his targeted buyer. The home lingered on the market. He then reintroduced the property at an open house and invited the press. He presented an appealing story of its in- dividualized charms. The resulting publicity resulted in multiple bids. Sebastian had taken some of the same techniques he had used for films—the visualiza- tion of what motivated people, the Hollywood set, and an ability to create publicity—to make his spare-time hobby into a large money earner. From a total portfolio management perspective, these household assets are considered nonfinancial. Real assets refer to real estate and the home whereas commodities and gold are included as other assets. Their functions in the household portfolio differ. The home is a basic heavily weighted asset in a majority of household portfolios. When used, com- modities and gold diversify a portfolio’s options with their risk management function.

OVERVIEW

In previous chapters, we discussed human and household assets as investments, and in the next one we will detail traditional financial investments such as stocks, bonds, and mutual funds. In this chapter, we discuss principal remaining areas, real estate and then touch on commodities including gold. Real estate is the most valuable asset that many people have. However, a good num- ber of homeowners don’t even regard it as a growth investment, preferring to think of it as a booster of their quality of life. It is, of course, both. Anyone who disregarded its investment characteristics or who mistakenly thought it always increased in value was in for a rude awakening as overinflated real estate values and the high level of debt connected to it caused the recession of 2008–2009. The process of adjustment and normalization is taking place over many years, following the deepest U.S. recession since the 1930s. In the chapter, we discuss the forms of ownership and types of real estate, including their strengths and weaknesses and how they are valued in the marketplace. Given its importance in household portfolios, we pay particular attention to homes and begin our discussion with it.

THE HOME

The home is a special investment because it serves many functions and has many features, and we explain how to appraise it as an investment. The home is a structure whose traditional function is to shelter its occupants. However, ownership of a home, whether it be a condominium, a townhouse, a duplex, or a stand-alone house, often carries significant symbolism. Some of the associations and feelings it can convey are achievement, stability, privacy, and comfort. Whether bought or rented, a townhouse or a house generally signifies a single financial structure for all its inhabitants. This unified structure allows us to utilize a household framework for financial planning purposes.

240 Portfolio Management

Housing Features The house has a number of features that distinguish it from most durable goods.

1. Unique physical characteristics. No two houses are exactly the same and when taking into account furniture, fixtures, and decoration most can readily be distinguished from others.

2. Long lives. Houses tend to have extended useful lives. Although the components of a house depreciate, its overall asset value often can be prevented from declining for many years by maintaining and renovating it.

3. Tax benefits. One government goal is affordable suitable housing for all Americans. The government provides tax benefits to owners, offers programs for mortgage financing, and subsidizes low-income housing.

4. Appreciation potential. Many properties that are well maintained tend to rise in value over time.

5. Fixed locations. Generally, houses remain in one place compared with durable goods, which can be moved around. As a result, a house’s location takes on significance in its market valuation.

6. Land. The house sits on land that, in most instances, is owned. Land may fluctuate in value, but over a long period of time, its value tends to rise when a house and the land it is on are considered a single asset. Unlike other durable goods, even over extended periods, these properties seldom lose their entire value.

Housing Uses Home ownership is normally an individual’s largest single cash expenditure. Multiperson occupancies, as, for example, in marriages, carry significant efficiencies because the costs of shelter can be shared. The home is also one of the clearest examples of multiple uses. Its first use is its classic role of providing shelter. In this role, it has ongoing cash maintenance costs for such items as utilities and repairs; work time must be expended for upkeep of the house. Moreover, the home requires periodic capital expenditures, such as putting on a new roof or buying a new furnace, to sustain it.1 The home’s second use is as a long-term investment. A well-maintained house can appreciate substantially over time. Its third use is in providing pleasure to its occupants. Among its benefits are relief from daily stresses and the ability of household members to express themselves in putting the entire house together according to their taste and then maintaining it as an attractive place to live. Because of the early 21st century housing boom and its subsequent bust, the rate of U.S. home ownership reached a peak in 2004 at 69.2 percent but has slipped since then (see in Table 9.1).

Mortgages Mortgages are an important part of the home as an investment process. They allow people with a continuing salary to finance a large portion, often 80 percent of the purchase price of the home, subject to limits as a percentage of their income. The method has placed the majority of Americans in homes with 15 or 30-year repayment schedules. Mortgages have allowed people to enjoy home ownership earlier than if they had to pay the entire price at purchase. Moreover, the use of debt can raise the return on investment for the home. Mortgages are one of the only forms of private borrowing whose interest payments the government allows to be tax deductible.

1 Most people refer to a house as real estate or property, not as a durable good. We distinguish it here from other types of household assets and treat it separately from durable goods throughout the book.

Chapter Nine Real Estate and Other Assets 241

See Chapter 7 for a more in-depth discussion of mortgages including the advantages and disadvantages of fixed rate versus variable rate.

Tax Benefits As mentioned, the government recognizes that owning a home is a primary goal of many people. Home ownership presents significant tax benefits because interest on a home mort- gage is tax deductible as are property taxes. The interest deduction is limited to the first $1 million borrowed on a home. In addition to its investment assets, appreciation in its value is not taxed until the home is sold. Upon sale, the first $250,000 of gain per individual taxpayer or $500,000 per married couple is tax free; amounts over that are taxed at capital gains rates. Capital expenditures on home improvements are added to the purchase price in calculating the owner’s basis in the property, which reduces the ultimate gain. This $250,000 or $500,000 benefit is allowed once every two years for those people who have had their home as their primary residence for any two of the past five years.

Example 9.1 Toby and Vicki Walker held their home for six years. During that time, they paid a total of $40,000 for capital improvements, including a bathroom renovation and installation of central air conditioning. This increased their basis in the home (their cost, for tax purposes) from $200,000 to $240,000. Then they sold the house for a net price of $320,000, which was an $80,000 gain: $320,000 net sale price minus their $240,000 basis. Married couples are al- lowed up to $500,000 of tax-free gains on sale of a principal residence, so the Walkers owe no income tax on their $80,000 housing profit.

Because tax benefits can be highly significant, individuals must take care to explicitly include them in decision making. They are incorporated in the market price of individual homes. A comparison of traditional durables with the home is shown in Table 9.2.

Total

1965 63.4% 1970 64.0% 1975 64.5% 1980 65.5% 1985 63.5% 1990 64.1% 1995 65.1% 2000 67.5% 2004 69.2% 2005 69.0% 2010 66.5% 2011 66.0% 2012 65.4% 2013 65.2% 2014 64.0%

TABLE 9.1 Home Ownership Rates

Source: Federal Reserve Economic Data, https:// research.stlouisfed.org/fred2/ series/RHORUSQ156N#

Factor for Comparison Traditional Consumer Durables House

Market value Depreciates Generally appreciates if well maintained Characteristics Uniform appearance Individually finished Life Limited Long Tax benefits Generally none Substantial

TABLE 9.2 Summary Table of Traditional Durables versus House Durable

242 Portfolio Management

One way to quantify the financial benefits of a home is to include the cost of renting it in the calculation of return. In effect, when purchasing a home, the buyer can be consid- ered to have rented the home to himself or herself (see Appendix II in Chapter 8 on assumed rents for more information). The outcome is that the buyer saves the cost of renting the home. Annual returns would then be:

Return on house for the period

= value during period Increase in house

+ Rent not paid − Cost of upkeep

Market value of house, beginning of period

Example 9.2 Sandy owned a home that was worth $100,000 at the beginning of the year and $114,000 at year’s end. The same house could be rented for $16,000 per year. Upkeep cost Sandy $2,000 for the year. What is his return for the year?

Return on house = 1114,000 − 100,0002 + 16,000 − 2,000

100,000

= 28,000 100,000

= 28% The value of an individual home is influenced by factors such as the status of the neigh- borhood, the style of the home, how well it is maintained, and its proximity to a business area. Because constructing a home is very labor intensive and factory mass production techniques are not generally used,2 few technological developments provide efficiencies in building new homes or remodeling older ones. Given its long useful life, purchasing a previously occupied home should not hold a stigma as there might be among purchasers of second-hand durables such as “used cars.” Therefore, new home prices strongly influence existing home prices. New home prices in turn reflect changes in wage rates for construc- tion workers and increases in raw material costs needed to build the home.3

Affordability Whether the purchase of a home is realistic and, if so, how much the buyer can afford to pay depends on several factors:

Current income. Obviously, the more a person earns, the more he or she should be able to afford. Tax bracket. Ironically, the higher a person’s tax bracket, the higher is the “govern- ment subsidy” for tax-deductible real estate taxes and interest expense, and the more expensive is the home that can be bought. Liquid assets and debt accumulated. With a down payment of 25 percent or more, a person can purchase a higher cost home and may still have lower ongoing demands on household cash flow. On the other hand, the higher the amount of nonmortgage debt outstanding, the lower are the allowable overhead costs for the home, and therefore the home price that is affordable is lower. Value system. The more important a home is to someone, the greater the sacrifice in other areas the person is willing to make; thus, she or he can afford a higher-priced home.

2 Lower-quality mobile homes are an exception. 3 In addition, increases in the discretionary income that people have can result in building more expensive homes. For example, homes built in recent decades are larger in size, reflecting changes in taste that probably result from increased amounts of disposable income.

Chapter Nine Real Estate and Other Assets 243

The local realities. Homes vary in price in different markets. A home in San Francisco can cost five times the same home in rural Ohio. The reality is that many people who live close to a major city in the Northeast or on the West Coast probably violate the affordability rule we explain later. Outlook. The more optimistic a person is about future income and the price apprecia- tion of real estate, the higher the outlay he or she willing to make. Risk tolerance. The higher a person’s risk tolerance, the higher is the mortgage payment he or she is willing to assume relative to available cash flow.

Clearly, there is no quick and easy answer to how much home a person can afford. The most common guide—the one used by banks in many situations—is to determine the amount of mortgage-related expenses, real estate taxes, insurance, and interest and princi- pal payments on a mortgage. The total figure for mortgage-related costs should not exceed 28 percent of a person’s total income. When other debt-related interest and principal pay- ments are added in, the total cost should be no more than 36 percent of total income. In expensive areas, that figure can be exceeded, however. During the peak of the housing boom, in the early years of this century, banks often became very lenient about minimum down payments. Subsequently, after many low down-payment loans went into default, most lenders resumed insisting on down payments of as much as 20 percent on a principal residence. Still, lenders may be more liberal about affordability issues if the buyer is will- ing to pay an extra fee that purchases insurance protecting the bank against default.

Example 9.3 Hanna was very interested in finding out whether she could afford the house she was consider- ing. The mortgage payments were $1,000 a month; the taxes and insurance on the home were $3,600 per year. Hanna earned $60,000 per year before taxes and had no other debt. Could she qualify for a bank loan and afford the home?

Hanna’s actual costs are below the allowable level. She qualifies for purchase of this home.

Calculations Explanation

Gross income before taxes $60,000 Allowable percent of income 28% Allowable housing costs 16,800 0.28 × 60,000 Actual annual mortgage costs $12,000 12 × 1,000 Taxes and insurance $3,600 Total yearly cost $15,600

Buy versus Lease—Home The buy-versus-lease decision for housing is somewhat sophisticated but can be handled without much difficulty. The details for leasing versus buying a home are in the purchase decision; the cost to rent is given with no opportunity to find an identical home at a lower lease price as can be done for a car. The weakness in taking a less sophisticated approach to decisions about housing is discussed here.4

See Appendix I for a buy-versus-lease example.

4 In a purely competitive market with no transaction costs, no difference between borrowing and lending costs, and no taxes, the costs of ownership including an appropriate return on owner’s capital invested in the property would equal the cost to rent. However, in reality, the fact that the government subsidizes housing costs and allows the sheltering of capital gains on sale will shift the balance toward home ownership. Other considerations also alter the buy versus lease choice.

244 Portfolio Management

accountants whether it is better to rent or own,

Practical Comment Analysis of Rent versus Own

Practical Comment When to Consider a Home an Investment

Overall Appraisal of the Home as an Investment As the buy-versus-lease example in Appendix I shows, the return on investment on the purchase of a home can be highly attractive. This should not be surprising because the government provides tax benefits for a home’s interest and property tax deductions. Another advantage of the purchase is that there may be no tax on the gain from a

Chapter Nine Real Estate and Other Assets 245

5 The criterion should be the marginal tax bracket. Marginal means the tax on the next dollar earned. Substantial might be a marginal bracket of 20 percent or more. See Chapter 14 for an explanation of marginal taxation.

Professional Advice Attractiveness of Home as a Portfolio Investment

home’s sale. Assuming reasonable maintenance costs, the two key factors in making the purchase of a home a generally attractive investment are (1) tax benefits, espe- cially when the buyer is in a substantial tax bracket5 and (2) the continued increase in the value of the house at near the inflation rate—in some cases, significantly beyond that rate. Thus, the house can provide a hedge against inflation and a return on the in- vestment. An unanticipated acceleration in inflation could raise the rate of return be- cause, as mentioned, the house would likely rise in value as would the higher cost of building new homes. Thus, the home deserves its reputation as a good hedge against inflation. Other factors that people who purchase homes instead of renting them find appealing are pride of ownership and their forced savings feature. Mandatory repay- ment of debt as stated in the mortgage contract is a savings and investment feature that many people overlook. Rental advantages include the flexibility of changing the dwelling site and the lack of a capital commitment. The disadvantages of home ownership include (1) its lack of short-term liquidity should an immediate sale become necessary, (2) the responsibility for maintaining the home and grounds, and (3) the cyclical nature of home prices. Such cycles and the lack of short-term liquidity can result in a loss when, for example, shortly after the purchaser of a home experiences an unexpected change in work location, requires the sale of the home. As many homeowners learned during the housing collapse of 2008 and in the following years, the combination of a reduced home value and sizable housing debt can have negative results, including the loss of the home through mort- gage foreclosure. A broad measure of home prices is given in Figure 9.1.

246 Part Three Portfolio Management

OTHER FORMS OF REAL ESTATE OWNERSHIP

Ownership of real estate may take many forms. They include home ownership, real estate investment trusts, publicly owned real estate companies, private partnerships, and direct ownership of income-generating forms of real estate.

Real Estate Investment Trusts Real estate investment trusts (REITs) are publicly owned investment companies that invest exclusively in real estate and mortgages that are mostly traded on stock exchanges. They are free from business taxation provided they comply with certain regulations. A small number of REITs are privately held. They represent the grouping of individual real estate assets managed by one company. The assets held may have mixed uses, but the companies often specialize in one area, for example office buildings, apartment houses, or shopping centers. What makes a REIT different is its tax benefit. Regular corporations are “double taxed,” once when they earn money and again when their stockholders receive dividends from those earnings. REIT owners bypass corporate taxation and are taxed personally only on dividend payouts from the company. The government allows real estate companies to use the REIT form if they distribute at least 90 percent of their earnings each year. Consequently, REITs are high-payout, high-dividend yielding companies. They have become a significant force in real estate investments in recent decades. As an example, the largest public REIT, as of this writing, is Health Care REIT, which trades on the New York Stock Exchange under the ticker symbol HCN. This REIT owns retirement communities, skilled nursing facilities, medical office buildings, hospitals, and so on.

Traditional Publicly Owned Real Estate Companies Many real estate entities select a more traditional structure like other publicly owned com- panies. They often prefer the ability to reinvest their monies to build asset values instead of having to use the REIT’s high payout of earnings method.

Private Partnerships Private partnerships and private corporations are often established to purchase certain types of properties. The most common form is private partnerships, which offer indi- viduals part ownership in an investment structure that is not traded continually on a public exchange; they may be syndicated, that is, mass marketed to qualified individuals or

FIGURE 9.1 S&P/Case-Shiller U.S. National Home Price Index

Source: S&P Dow Jones Indices LLC https://us. spindices.com/indices/real- estate/sp-case-shiller-us- national-home-price-index.

200

0 20 40 60 80

100 120 140 160 180

D ec

-1 98

7 D

ec -1

98 6

D ec

-1 98

5 D

ec -1

98 4

D ec

-1 98

3 D

ec -1

98 2

D ec

-1 98

1 D

ec -1

98 0

D ec

-1 97

9 D

ec -1

97 8

D ec

-1 97

7 D

ec -1

97 6

D ec

-1 97

D ec

-1 98

8 D

ec -1

98 9

D ec

-1 99

0 D

ec -1

99 1

D ec

-1 99

2 D

ec -1

99 3

D ec

-1 99

4 D

ec -1

99 5

D ec

-1 99

6 D

ec -1

99 7

D ec

-1 99

8 D

ec -1

99 9

D ec

-2 00

0 D

ec -2

00 1

D ec

-2 00

2 D

ec -2

00 3

D ec

-2 00

4 D

ec -2

00 5

D ec

-2 00

6 D

ec -2

00 7

D ec

-2 00

8 D

ec -2

00 9

D ec

-2 01

0 D

ec -2

01 1

D ec

-2 01

2 D

ec -2

01 3

D ec

-2 01

Chapter Nine Real Estate and Other Assets 247

formed by a small group of individuals. These partnerships may take the form of a general partnership in which one individual is in charge of operations and investors are limited partners, not part of day-to-day management, and have liability limited to the amount of their investment. Private partnerships have advantages and disadvantages. One disadvantage is its lack of liquidity. Often investors must wait until the property is sold to realize the cash proceeds from monies invested, and profits are typically returned many years later. One advantage for people prepared to wait is that private partnerships are thought to have higher projected returns than public ones to compensate for their liquidity risk. In addition, private partner- ships are not subject to daily fluctuations in price. The partnership may value its shares annually or not at all. For some people, the absence of short-term fluctuations forces them to focus on anticipated outcomes, which they find more reassuring than the volatility of prices in public markets.

Direct Ownership Direct real estate ownership is property belonging to a person or group without inter- mediaries operating and controlling it. Direct ownership is fairly common, particularly among individuals with high incomes. These individuals could be motivated by interest in any of a number of real estate types, which are described in the next section. One interest- ing combination is ownership of an entire small office or apartment building instead of renting space as a tenant; thus, the property is partially or fully occupied by a business or profession. For example, many dentists in individual practices own their own buildings, which often have proven to be an attractive investment over the longer term.

TYPES OF REAL ESTATE

Many types of real estate are appropriate for investment. Some leading ones are described next.

Single-Family homes. Home ownership is for many part of the American dream. About two-thirds of Americans own their own home. Therefore, single-family dwellings can be attractive purchases for rental, income, and capital appreciation purposes.

Multifamily homes and townhouses. These dwellings are neither a single-family home nor an apartment building. Given that the external building structures are built to be shared by two or more families, the purchase price per square foot may be lower than for a single-family home.

Office buildings. These are commonly sources of investment. Rental income is received from individual occupants, and any boost in building operating costs due to inflation or for other reasons may automatically be passed along to the tenants, resulting in a rise in their monthly expense.

Individual stores and shopping centers. Rents may be on a monthly basis and can involve passing along increases in operating costs to the renter. The rental arrangement for shopping centers may provide the center’s owner a percentage of revenues from the sales in the stores or other participation in store profitability. The more people who pass the store and the area around it, the more sought after the property, and the higher the rental rate that can be charged.

Other. Storage facilities charge on the basis of location and size of the facility, which provides extra space for residences and businesses. Hotels are businesses in which owners can be the operators or can sublease the space to others.

248 Portfolio Management

Land. Land is technically not real estate but the ground underneath it. The price of the land depends on its location and the success of the companies or people who occupy the property on it. Raw land is often valued on its future potential to be developed.

ADVANTAGES AND DISADVANTAGES OF BUSINESS REAL ESTATE OWNERSHIP

Real estate ownership has many attractive features and a few that are less attractive. Its advantages and disadvantages are described next.

Advantages Significant Income Quality real estate such as properties that are rented or are under long- term lease often provide strong cash flows that result in significant income distribution. Potential Growth Well-located and well-maintained real estate tends to appreciate over time. It is generally an integral part of both a successful business and a comfortable per- sonal lifestyle. As business and personal income increase so should the value of the space. Solid Total Returns When income and growth in asset values are combined, substantial total returns are possible. In aggregate, unleveraged real estate may be viewed as possibly presenting long-term returns that are higher than bonds and lower than stocks. Borrowing to purchase real estate adds to a venture’s risk and its potential returns. Lack of Correlation with Stocks The valuation of real estate typically is not correlated with stocks; therefore, real estate is an excellent diversification tool. However, publicly traded real estate companies such as REITs are influenced not only by real estate condi- tions but also by the movement in stocks overall. Easy to Borrow Against Many businesses, particularly those not well established or highly profitable, may find taking on debt difficult. Real estate lending is generally avail- able for companies with good credit histories based on the market value of their property. Inflation Hedge Real estate is often an excellent hedge against inflation. Office rentals of many types are principally made up of labor and materials, and higher outlays for them will be reflected in the prices of new construction. As with homes when prices rise for newer buildings, the value of existing properties tends to go up as well. Tax Advantages Ownership of real estate provides many tax benefits. Real estate offers the opportunity to take depreciation as a deductible expenditure. Real estate gains that are taxable on sale can sometimes be postponed through a swap with another investment prop- erty. The significant tax advantages upon the sale of homes discussed previously are not available for sales of commercial real estate.

Disadvantages Liquidity Real estate generally takes significant time to sell, particularly when prices are weak. Any attempt to speed the process can result in a liquidity cost in the form of a lower sales price. As mentioned earlier, private partnerships generally require waiting until the sale of properties to return capital, which can take many years. Involvement Direct real estate ownership is property belonging to a person or group without intermediaries operating and controlling it. Direct real estate investments are not like investing in publicly owned stocks but are more like operating a business. Without strong independent management, owners may be involved in the most basic operations. Significant Transaction Fees The sale of a building can result in a brokerage transaction cost of 6 percent, a substantial portion of a year’s growth. Legal and accounting fees add to the cost.

Chapter Nine Real Estate and Other Assets 249

Decline in Attractiveness Changes in favored styles, need to keep lobbies updated, and installing wiring for current technological developments can make costly outlays neces- sary or risk declines in a property’s appeal. Reduced Demand Due to Technology Technological developments are increasingly allowing people to work out of their homes. Video conferencing may result in a declining need for offices in which to conduct business with clients and co-workers, and online offerings can cause sales in brick-and-mortar stores to decrease. Reduced need for office buildings, hotels, stores, and shopping centers may result in reduced investment values.

REAL ESTATE VALUATION METHODS

Deciding on the value of a real estate property is often an inexact science. One reason for this is that, unlike mass-produced products, each piece of real estate is different and gener- ally isn’t movable. The three main methods for valuing real estate are comparable sales, replacement cost, and cash flow valuation. It is not uncommon for appraisers to use all three methods and take their average as the final valuation.

Comparable Sales Comparable sales involves examining the recent sales of similar properties to establish a specific property’s current value. Similar characteristics include location, size, exterior and interior quality, and style. This is used in most types of real estate and is the most popular method for valuing homes because earnings generally do not enter into consideration in owner-occupied homes.

Replacement Cost Replacement cost is the cost that would be incurred to rebuild a property that exists today. Estimating the cost to rebuild the property can be used to evaluate its current value. The valuation may be adjusted for the wear and tear on the existing structure.

Cash Flow Real estate cash flow is the actual cash generated from a real estate property’s operation. Cash flow is not its earnings, which are determined by accounting methods that make adjustments to cash flow. Accountants want a proper net income figure; real estate people want a pure cash figure so that they can value a building before items such as the amount of debt that is used to finance the building, which vary by owner, complicating the valua- tion process. Once they know the amount of pure cash flow, real estate people can make adjustments for different building items, such as total debt to determine what they would pay for the building.

ARRIVING AT CASH FLOW

Real estate companies or individuals are required to report their net income just like any other business operation. They have to make adjustments to reported earnings to arrive at cash flow. Together the cash flow is also known as earnings before interest, taxes, depre- ciation, and amortization (EBITDA). These companies or individuals do so by adding back selected items to the net income amount. An explanation of those items follows. In the next section, thereafter on the cap rate we use the cash flow generated that is called net operating income to learn how to value the building. Net operating income for real estate purposes can be defined as operating cash flow or earnings before interest, taxes, depreciation and amortization.

250 Part Three Portfolio Management

Exclusion of Interest and Tax In valuing a property, debt is often temporarily stripped from the calculation. Because the debt is treated separately, the interest on the debt is added back to net income for purposes of estimating the cash flow. Taxes on income for the building are affected by depreciation, interest, and other items. For this and other reasons, tax expense is also eliminated when valuing a property, thereby raising the cash flow.

Depreciation and Amortization Depreciation is a non cash charge that is supposed to reflect a decline in an asset’s value. However, well-maintained and well-located buildings do not lose allure and tend to move up in value over long periods of time. In other words, many buildings appreciate, not de- preciate. Despite that building owners are allowed to reduce their taxable earnings by a formulaic depreciation expense. Consequently depreciation can serve as a partial tax shel- ter against reported earnings. Therefore, depreciation is added back to net income to show an amount that is higher than net income. Amortization of building leaseholds, another noncash charge, is added back as well. Example 9.4 demonstrates how cash flow is gener- ated from net income figures.

Example 9.4 Ravi was examining the income statement of a public real estate company and as part of his analysis wanted to convert its earnings into cash flow. He had the following inputs: Net Income $123 Million, Interest $80 Million, Taxes $23 Million, Depreciation $65 Million, Amortization $10 Million

Cash Flow = EBITDA = 123 + 80 + 23 + 65 + 10 = $301 Million

VALUING REAL ESTATE CASH FLOW—THE CAP RATE

This section will show you how to actually value real estate using its cash flow. The capi- talization rate (cap rate) is perhaps the most popular measure by which cash flow is used to value a property. The cap rate is the appropriate rate of return on a real estate investment as measured by dividing its cash flow by the buildings value. As discussed in the previous section, EBITDA reflects the desire to strip away nonoperating costs to obtain a building’s operating cash flow. A second definition for net operating income is all business operat- ing revenues less only those costs necessary for operating the building on a continuing basis. The cap rate is the required rate of return on the building. In theory, the cap rate starts with the market returns on bonds and usually adds a return premium required for the per- ceived higher risk of real estate. Therefore, when market interest rates on bonds rise the cap rate goes up. The higher the cap rate the higher is an investor’s required rate of return and the lower is the building’s value. More practically, the cap rate can be obtained by comparing a building’s sale price with its expected cash flow. The cap rate may be based on the current cash flow for the building or the projected cash flow after some normalization process. This process may include incorporating changes in the building’s appearance, a new marketing approach, or a return to normal occupancy rates that are currently affected by a weak economy or oversupply of space in a particular area. The need for an acceptable rate of return on a building in a geographical area brings oversupply back into balance just as high returns on existing real estate bring about new construction and new supply. The upshot is that markets for real estate tend to migrate toward normal supply and normal rates of return.

Chapter Nine Real Estate and Other Assets 251

The formula for establishing a building’s value is:

Building value = Net operating income 1EBITDA2

Cap rate

The formula for solving for the cap rate by transposing terms is:

Cap rate = Net operating income 1EBITDA2

Building value

The cap rate can be thought of as the cash yield received based on the property’s purchase price. After the purchase, the cap may be based on the property’s current value. As mentioned its pure cash flow or EBITDA is generally called net operating income. The cap rate over time is shown in Figure 9.2.

Example 9.5 Henry was interested in purchasing an office building. It had annual net income of $35,000, depreciation of $100,000, interest expense of $68,000 and taxes of $7,000. The building’s current owner wanted $1.8 million for the building that had $1.7 million of debt attached to it and that would continue after the purchase. Henry found out that other buildings of similar quality in terms of construction and location were selling at a cap rate of 6 percent and thought that with some modest changes, he could attract technology companies to the building. The outcome could be higher rental rates and an increase in the rating of the building to A, which would reduce the cap rate to 5 percent, thereby raising the value of the building. But first Henry wanted to know whether the price on the building as is was correct. Henry knew he had to eliminate depreciation, taxes, and interest to arrive at an operating figure. Because he was given a net earnings amount that had already deducted these items, he added them back He made a mental note that the net asking price of $1.8 million also had deducted $1.7 million in debt for which he would be liable. By adding the debt back in, he would arrive at the real asking price for the building. Then, using established real estate proce- dures, he could determine whether the asking price was appropriate. The calculation follows.

Building value = Net operating income 1EBITDA2

Cap rate

FIGURE 9.2 Real Estate Cap Rates 1990–2014

Source: NCREIF Trends Report 2014. Cap rate values are based on current value cap rates, market weighted.

10.5

4.5

5.5

6.5

7.5

8.5

9.5

Q1 19

Q1 20

252 Portfolio Management

Net operating income = Net income + interest + taxes + depreciation = 35,000 + 2,800 + 7,000 + 100,000 = $210,000

Gross asking price of building = Net asking price + Value of debt on building = $1,800,000 + $1,700,000 = $3,500,000

Calculated value of building

V = $210,000 .06

= $3,500,000

Henry concluded that the asking price for the building agreed with what he believed its market value to be. It left room for him to make some modifications that would increase the building’s value and allow him to earn above average returns through higher yearly cash flows and realize a higher price when he sells the building.

OTHER ASSETS

Over the last several decades, the selection of assets for the average investor has grown. Hedgelike funds, including mergers and acquisition funds and long-short funds, have come into being through the mutual fund framework. The advent of exchange-traded funds (ETF), which are publicly traded groupings of stocks, bonds and other assets has broadened the use of indexes on all types of items including commodities, currencies, and alternative equity strategies, generally with the attempt to equal or exceed returns tradi- tionally available. The demand for new strategies meanwhile has increased as investors have become somewhat fearful of traditional investing as a result of the sharp decline in asset values in the 2008–2009 recession. Many investors are seeking alternatives, asking how they can protect themselves against a repeat of that portfolio plunge. It is not our purpose here to discuss the advantage and disadvantage of each investment alternative. Instead, we briefly discuss perhaps the two most popular alternatives: industrial and agricultural commodities and gold.

quality,

Professional Advice The Importance of Location

Chapter Nine Real Estate and Other Assets 253

Commodities A commodity is generally a basic good used in the business economy. Prices for com- modities (industrials such as oil and copper or agricultural products such as wheat, soy- beans, or livestock) reflect their own supply–demand schedules. The prices for industrial commodities often reflect the current stage in the economic cycle. Many commodities are traded on an international basis. They have been influenced by the increase in economic growth in less developed markets in Asia, Africa, and South America, which brings about higher commodity usage. The rise in commodity prices among the natural resource- producing countries in various parts of the world has created wealth used to purchase a higher standard of living. Populous countries, particularly China and India, whose economies have been growing at above average rates, may continue to influence commodity prices. The rise in commodity prices and labor costs are two principal creators of inflation. Many investors in commodities are seeking a hedge against inflation. Inflation signifi- cantly hurts most bonds and, for a time, stocks. This most popular way to invest in com- modities may be through mutual funds or exchange traded funds (ETF). They offer investments in commodity-influenced stocks or commodity indexes that directly benefit from commodity price rises.

Gold Gold, the best known precious metal,6 as a great deal of mystique that comes from the allure of precious metals and the fact that it was used by countries for many years to directly support paper currencies used in trade. That direct link has been terminated, but the appeal remains. Gold often does well when individual countries or the world is in turmoil. At that time, individuals may seek an alternative to paper currencies. For example, gold performed bet- ter than stocks in the periods leading up to and following the severe 2008–2009 recession. Gold can also appreciate in times of high inflation as investors seek something “stable” that can keep up with the rising cost of living. In aggregate, gold can be viewed as a hedge against traditional stock and bond invest- ments. It is one of a very few items that is negatively correlated with the performance of financial investments. Mutual funds offer investments in gold stocks, and some ETFs offer the ability to invest directly in the commodity itself. See Figure 9.3 for gold prices from 1970–2014.

6 Gold can be viewed as a commodity. However, our definition of commodity for this book’s purpose is a basic good used in business production. Gold is principally a store of value and therefore is best regarded as a precious metal.

FIGURE 9.3 Gold Prices, 1970–2014

Source: Based on World Gold Council, Interactive Gold Market Charting, LMBA, Datastream, BullionDesk/FastMarkets, http:// www.gold.org/

–500 USD

0 USD

500 USD

1,000 USD

1,500 USD

2,000 USD

1980 1990 2000 2010

254 Portfolio Management

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Real Estate and Other Assets

Chapter Nine Real Estate and Other Assets 255

Professional Advice Other Assets

Back to Dan and Laura REAL ESTATE AND OTHER ASSETS When Dan and Laura sat down, I knew something was up. Laura had a smile on her face and Dan had a frown. Laura said, “Congratulate us; I’m pregnant again.” After Dan and I managed a quick smile, he indicated his concern. Basically, he wondered if he could afford to have two children. He said that they would have to move almost immediately because their apartment was too small for two children. He wondered if they would be bet- ter off renting a home. They expected to live in a house for seven years and then sell it if they owned it or end the rental lease and move to a home closer to Laura’s job, which would also cost about what the original house had. Both agreed that the cost of a home would be about $250,000 to buy and $15,000 a year to rent. I thought to myself that this may be only one additional child, but it is a whole new ball- game as far as near-term planning is concerned. The main area we would have to work on was a home.

Here’s how I replied to their questions: Let’s go over the purchase of a home. There is no choice as to whether to move when a family situation dictates that a move must take place. Given Laura’s pregnancy, it must happen fairly soon. You’ve asked whether it would be better to buy or rent. Based on the figures supplied regarding $250,000 to buy or $15,000 to rent annually, I’ve calculated an after-tax rate of return. I’ve assumed that the house would increase in value by the pro- jected rate of inflation, 3 percent a year. I recommend the purchase of a home, not the rental. The tax benefits available through deductibility of interest and real estate taxes plus the ability to sell your home without pay- ing any tax (for a married couple the first $500,000 of gain is tax free) can make it a highly profitable investment. Our projected return is 19 percent after tax.

256 Portfolio Management

Buy versus Rent

Inputs

Rental expense $15,000 Cost of house $250,000 Down payment $12,500 Mortgage $237,500 Interest rate 7.25% Mortgage term (years) 30 Marginal federal tax rate 25.0% Marginal local tax rate* 3.8% Federal/state marginal tax rate 28.8% Inflation rate 3.0% Property taxes $2,500 Upkeep and insurance $3,000 Private mortgage insurance (PMI) $1,200

2016 2017 2018 2019 2020 2021 2022

Down payment $12,500 Beginning principal $237,500 $235,399 $232,943 $230,303 $227,465 $224,414 $221,134 Mortgage payment 19,442 19,442 19,442 19,442 19,442 19,442 19,442 Interest paid 17,143 16,971 16,786 16,587 16,373 16,143 15,895 Principal paid 2,299 2,471 2,656 2,855 3,069 3,299 3,547 Mortgage outstanding $235,399 $232,943 $230,303 $227,465 $224,414 $221,134 $217,609

Cash Flow

Outflows Down payment ($12,500) $0 $0 $0 $0 $0 $0 Mortgage payment (19,442) (19,442) (19,442) (19,442) (19,442) (19,442) (19,442) Interest payment (17,143) (16,971) (16,786) (16,587) (16,373) (16,143) (15,895) Principal payment (2,299) (2,471) (2,656) (2,855) (3,069) (3,299) (3,547) Property taxes (2,500) (2,575) (2,652) (2,732) (2,814) (2,898) (2,985) Upkeep and insurance (3,000) (3,090) (3,183) (3,278) (3,377) (3,478) (3,582) PMI 1,200 1,200 1,200 1,200 1,200 1,200 1,200 Balloon payment (217,609)

Total ($36,242) ($23,907) ($24,077) ($24,252) ($24,432) ($24,618) ($242,418)

Inflows Tax deductions $5,669 $5,625 $5,578 $5,528 $5,473 $5,415 $5,353 Proceeds from sale of home

$283,587

Total $5,669 $5,625 $5,578 $5,528 $5,473 $5,415 $288,940

Net Cash Flow ($30,573) ($18,282) ($18,499) ($18,724) ($18,959) ($19,203) $46,522 Rent not paid $15,000 $15,450 $15,914 $16,391 $16,883 $17,389 $17,911 Effective bottom line ($15,573) ($2,832) ($2,585) ($2,333) ($2,077) ($1,814) $64,433

IRR 19%

* Based on 5 percent state rate deductible on federal return.

Chapter Nine Real Estate and Other Assets 257

College Student Case Study and Review: Amy and John REAL ESTATE AND OTHER ASSETS The idea of buying a home captured the attention of Amy and John, but owning income- producing real estate and miscellaneous assets held little interest for Amy. I started by mentioning that real estate is the most valuable asset that many people have. The home is by far their most important piece of real estate. It has a number of features that distinguish it from most durable goods:

1. Unique physical characteristics. 2. Long lasting 3. Tax benefits. 4. Potential to rise in value. 5. Fixed location. 6. Situated on land.

Its uses include:

1. Providing shelter. 2. Being a long-term investment. 3. Giving pleasure to its occupants.

The ability to obtain a mortgage, if they are working and responsible, enables people to buy a home with only a 20 percent down payment rather than having to wait until they have saved the full price. Owning a home presents tax benefits including no tax on the first $250,000 of gains reached for an individual or $500,000 per couple. Also, interest on a home mortgage and property taxes are tax deductible.

The return on a home for a period

= Increase in home value + Rent not paid − Cost of upkeep

Market value of house, beginning of period

Factors in owning a home are:

Current income The higher the income, the higher is the amount to spend if desired.

Tax bracket The higher the tax bracket for income, the lower is the net cost of mortgage debt and real estate taxes.

Liquid assets and debt Liquid assets make it easier to access a down payment. Debt owed already can limit the amount of mortgage debt allowed.

Affordability As a general rule, pay less than 28 percent of your total income.

Price The further from business areas, the lower the cost of the home generally is.

The buy versus lease (rent) information regarding a home can be calculated. It is strongly influenced by the price of home versus the rental and the cost of debt. Therefore, the one that is cheaper can vary over time.

Advantages of home ownership Tax benefits, inflation hedge, good return on investment.

258 Portfolio Management

Disadvantages of home ownership Possible using up of liquid funds on purchase, responsibility for care of property to sell quickly if needed, vulnerability to short-term cyclical changes in home price.

Other Forms of Real Estate Characteristics REITs Public or private, required to pay out at least

90 percent of profits to avoid double taxation of gains; high payout with lower growth but above average dividend yield.

Private partnerships Not publically traded or liquid, possible higher return over the long term.

Direct ownership Investor responsible for supervision of property. Advantages of real estate ownership Significant income, potential growth of assets,

solid total returns, lack of correlation with stocks, easy to borrow against, inflation hedge, tax advantages.

Disadvantages of real estate ownership Ties up liquid funds, significant transaction fees, vulnerability to changes in location pref- erences, cost of upkeep

These are three ways that real estate is usually valued. Appraisers may blend all of the methods to arrive at their value.

Comparable sales The recent sales price of similar properties. Replacement cost The cost to rebuild the property. Cash flow valuation The property’s returns in cash: Depreciation treated as a noncash charge. Debt and interest often excluded in arriving at

valuation.

The most popular form of valuation is the CAP rate

Building Value

Cap rate = Net operating income 1EBITDA2

Building value

EBITDA = Earnings before interest, taxes, depreciation, and amorization

Other Assets Other assets as an alternative—or more usually as a supplement to stocks and bonds—have grown in popularity. Commodities such as those used in industry are being invested in more often. Gold has gained in popularity. It is used particularly in times of worldwide uncertainty and when inflation has increased sharply.

Summary Real estate and commodities make up an important section of an overall portfolio, provid- ing diversity of assets from stocks and bonds. Understanding the advantages and disadvan- tages of different types of real estate is critical in order to build an appropriate portfolio.

over renting because of its tax benefits.

Chapter Nine Real Estate and Other Assets 259

Key Terms 250 253

249 250

247

252 253

249 250 246

246 249

ncreif.org

gold.org

cmegroup.com

Websites

Questions

260 Portfolio Management

6. Compare and contrast the value in owning a home versus investing in real estate investment trusts (REITs).

7. In what cause would you to suggest direct ownership over private partnership? Why? 8. If you had to select one method of valuation for real estate, which would it be? Why? 9. What is involved in establishing the cap rate? 10. What is the cap rate’s significance in terms of real estate? 11. What do commodities protect against? What is the downside to commodity

investment? 12. Why is investing in gold appealing? 13. How should exchange traded funds (ETF) and other commodities be treated from an

investment standpoint? What is their main value? Explain.

Problems Jack purchases a house for $90,000 and spends $15,000 to renovate it. He holds the house for 35 years and then sells it in middle of a real estate bubble for $400,000. On how much of that amount does he have to pay taxes? Mary purchased a home for $200,000. By living in the home, she saved $18,000 annually because she did not have to pay rent. She had to pay $3000 annually for upkeep of the home. By the end of the first year, the home price had appreciated to $210,000. What was her return for the first year (considering assumed rents)? Josh earns $80,000 a year. He would like to purchase a home and applies for a mortgage from the bank. The bank requires that the debt not exceed 28 percent of his annual income. With the current down payment he is willing to pay, his monthly mortgage payment will be $1,600. In addition, he will have to pay $4,000 annually for tax and insurance. Will the bank approve his loan? Harry decides to purchase an apartment building as an investment. He pays $6,000,000 for the building. The building has a net income of $150,000, annual depreciation $150,000, annual taxes of $75,000, and annual interest payments of $105,000.

a. Calculate the building’s cap rate. b. One year later, the price of the building goes up to $7,000,000. Calculate the new

cap rate.

9.1

9.2

9.3

9.4

Chapter Nine Real Estate and Other Assets 261

Case Application REAL ESTATE AND OTHER ASSETS Monica continued to worry about the couple’s financial future. She began to question their investment in a home. She asked whether would be better to sell their home now and invest the proceeds. She estimated that the marketable securities would provide a return of 5 percent after taxes. She and Richard thought the current value of the house now would be $300,000 and would increase by 6 percent a year. A rental in a comparable apartment would cost $2,200 a month. Assume for purposes of this section only that Richard and Monica’s marginal tax bracket is 30 percent and other statistics including:

Annual maintenance $3,000 Property taxes $5,000 Insurance $1,500

Case Application Questions 1. Calculate the projected return on the house for the next year and give your recommendation. 2. Finish the nonfinancial investments section of this case, which includes the topics

described in the previous chapter and this one.

Buy versus Lease—Home The example of buying versus leasing that follows uses the “Analysis of Rent versus Own” Practical Comment in the chapter.

Example 9.A1.1 Frederick and Dorothy, who have two children, were interested in moving from an apartment to a house. They didn’t know whether to buy a house or rent it. They found a house they liked that would require a $200,000 expenditure including closing costs. There was a house for rent on the same block that was almost identical to the one they were considering and had a rental cost of $2,000 per month. The rental contract stated that the renter would pay all normal main- tenance costs inside and outside the house, but the owner would pay for repairs, maintenance, and improvements designed to maintain the value of the property in real terms, estimated to be worth $3,000 per year: property taxes totaling $4,000 per year and insurance on the house for $1,000 per year. Except for these items, Frederick and Dorothy assumed that the costs for rent- ing and buying would be the same and therefore need not be included in a comparison. To simplify this problem, assume that there is an interest-only loan; therefore, no payments of debt would be required until the mortgage falls due. Furthermore, assume that it would be a 10-year fixed-rate mortgage for 80 percent of the value of the property at a 7 percent interest rate. Assume that Frederick and Dorothy are in the 35 percent marginal tax bracket and have a 5 percent risk-adjusted after-tax rate of return on alternative investments. In addition, assume that the value of the house they are considering for purchase would increase at the projected inflation rate of 3 percent per year, that all costs other than interest would rise at 3 percent, and that costs with the exception of the down payment would be paid all at once at the end of each period. Finally, assume that if they buy the house, they will sell it themselves at its market value in seven years. Should they buy or rent?

262 Portfolio Management

Return on house = Proceeds from sale + Ownership operating advantage Mortgage = 80% of purchase price

= 0.8 × 200,000 = $160,000

Down payment = $200,000 − $160,000 = $40,000

Yearly rental cost = 12 × 2,000 = $24,000

Home Buy versus Lease

Inputs Explanation

Purchase price $200,000 80% of purchase price Mortgage $160,000 Purchase price − Down payment Down payment $40,000 Monthly rental cost $2,000 Yearly rental cost $24,000 2,000 × 12 months Mortgage interest rate 7% Required rate of return 5% Inflation rate 3% Marginal tax bracket 35% Holding period (in years) 7

Value of House in 7 Years

Selling price $245,975 Capital gain from the sale $45,975 Selling price − Purchase price

Ownership Costs

Yearly Costs Pretax

After Tax without Interest

After Tax with Interest Rental Costs

Ownership Operating Advantage Explanation

Interest $11,200 $7,280 Pretax = 160,000 × 7% After tax = Pretax (1-0.35)

Opportunity cost* $2,000 Opportunity cost = Down payment × Investment return = 40,000 × 0.05 After tax = 4,000 × (1-0.35)

Real estate taxes $4,000 $2,600 Insurance $1,000 $1,000 Repairs and maintenance

$3,000 $3,000

Total yearly costs

$19,200

$8,600

$15,880

Yearly after-tax costs = After-tax interest + Total after-tax costs

Year Down Payment

1 $40,000 $8,600 $15,880 $24,000 ($31,880)† Rental costs − Ownership costs (includes down payment cost)

2 $8,858 $16,138 $24,720 $8,582 3 $9,124 $16,404 $25,462 $9,058 4 $9,397 $16,677 $26,225 $9,958 After-tax costs excluding interest

grow 3% a year 5 $9,679 $16,959 $27,012 $10,053 6 $9,970 $17,250 $27,823 $10,573 7 $10,269 $17,549 $28,657 $57,083 Plus capital gain from the sale

* See Chapter 4 under the cost of time for a more detailed explanation of opportunity costs. In a related area, opportunity cost can be defined as the amount of money that can be made on an alternative use for an item. In this case, it is investing the down payment in financial assets. † This assumes for simplification purposes that all interest and rent payments occur at the same time as the down payment. The actual payment on average would be made at about the middle of the year, which would modestly reduce the internal rate of return (IRR).

Chapter Nine Real Estate and Other Assets 263

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN CF

2nd CLR Work Enter cash initial outflow 31,880 CHS g CFo 31,880 +/− ENTER ↓ Enter cash inflow Year 2 8,582 g CFj 8,582 ENTER ↓ ↓ Enter cash inflow Year 3 9,058 g CFj 9,058 ENTER ↓ ↓ Enter cash inflow Year 4 9,548 g CFj 9,548 ENTER ↓ ↓ Enter cash inflow Year 5 10,053 g CFj 10,053 ENTER ↓ ↓ Enter cash inflow Year 6 10,573 g CFj 10,573 ENTER ↓ ↓ Enter cash inflow Year 7 57,083 g CFj 57,083 ENTER ↓ ↓ Calculate the internal rate of return f IRR IRR CPT 33% 33%

Calculator Solution

Value of home in seven years: Inputs: 7 3 –200,000

Solution: 245,975

N I/Y PV PMT FV

Rate of return = 33%

At the end of year 7, close out the loan and resell the house.

Press FV = $245,975 Less purchase price of $200,000 yields pretax gain:

$245,975 − $200,000 = 45,975 According to current tax law, up to $500,000 of the couple’s gain could be excluded if they sold or exchanged their main home and they have owned it for more than two years. So there is no tax on the capital gain of $45,975. Determine the IRR of cash flows from ownership operating advantage in years 1 to 7 plus the gain on sale of the home in year 7 or (11,108 + 45,975) in year 7.

Because 33 percent substantially exceeds the comparable after-tax rate of return available for other investment alternatives (5 percent), the home should be purchased.

264

Chapter Goals

This chapter will enable you to:

Dan and Laura had a special interest in small companies, biotechnology, and investing in China. However, their investment tolerances for risk were far apart, with Laura more inter- ested in stocks and having a much higher tolerance for risk. Constructing an investment portfolio for them looked as though it was going to be difficult.

Real-Life Planning One of the themes underlying this chapter is the principle of risk and return. That is, risk and return are related and, generally, the higher the return people expect to receive on an invest- ment over time, the higher the risk they accept. People who may measure performance by only one of those variables—return—can overlook this principle. When people consider buying a risky investment, they should anticipate purchasing an asset with a larger projected gain to compensate for the possibility of loss. Many people say they don’t understand why so much time is spent on measuring risk. The following example may help you understand this. There was a mutual fund manager who developed a reputation for above-average per- formance purchasing U.S. government bonds. Bonds are considered more conservative and more stable than stocks. There are no bonds more “plain vanilla” than U.S. govern- ment issues because Treasury bonds are perceived as having no risk of nonpayment. Some people would say that the only way to invest in something that would outperform them is to be able to predict interest rates consistently. If there is anyone with that predictive abil- ity over extended periods of time, he or she hasn’t publicly demonstrated it. Thus, it was all the more surprising that this manager of mutual funds rather consistently invested in products that had high market returns. When asked whether he was taking risk in his active management approach, he said he wasn’t. His first priority was the safety of his investors’ principal and using primarily U.S. government bonds helped him achieve it. He had

Chapter Ten

Chapter Ten Financial Investments 265

developed a growing following among individual investors, financial planners, and investment managers who were all attracted to his high returns and his firm answers to their questions. Then one day Federal Reserve action raised interest rates sharply, which surprised vir- tually all investors in the bond market. The increase in rates had a major negative effect on bond managers who were using derivatives, a financial instrument sometimes employed to enhance returns. This manager’s funds declined by more than 25 percent, which, in the world of high-quality bond funds, happens less often than losing more than three-quarters of investors’ money in stock funds. A fundamental analysis of his style would have uncov- ered his heavy utilization of derivatives, which changed the bond price volatility and there- fore the profile of the fund. However, there was a much simpler way to identify the higher risk he had undertaken. His standard deviation, the measure of risk represented by fluctuations in his returns over time, was much higher than that for any other fund in this category. It suggested that under certain negative circumstances, he could have problems. This information was available in an easy-to-understand format accessible in many public libraries. In other words, analysis of risk and return could have prevented the loss that many investors of his clients experienced.

OVERVIEW

Why do people make investments? They typically don’t save money because they like investing as a leisure activity. Instead, investments are the result of a person’s decision to spend less today so that he or she will have enough for future spending needs. For exam- ple, one major reason for saving and investing is to have enough money to live comfort- ably in retirement when there is no longer active work-related income. How much people set aside for investments depends on their goals, which are strongly influenced by the pleasure they have from spending today versus their satisfaction from saving monies so that they can live the good life in the future. Chapter 8 explained that investments can be separated into financial and nonfinancial ones. Frequently, nonfinancial investments such as a person’s home and its possessions and his or her career and other human-related benefits are connected to household func- tions today. Many such investments fall under the umbrella of capital expenditures. On the other hand, financial investments such as stocks, bonds, and mutual funds tend to be reserved for future household use.1 Ownership of these assets is evidenced by pieces of paper instead of real assets that can be touched. In contrast to many nonfinancial assets, financial ones have little or no real cost of upkeep and often provide income and maintain or increase their value over time. For example, a financial asset such as a quality stock often provides dividend income and increase in price over time. In contrast, a nonfinancial real asset such as a washing machine or car has no cash income directly, requires upkeep, and tends to decline in value over time.2

Traditionally, investment theory and, to a large extent, investment practice tend to focus on financial assets, which are generally assumed to have readily available market prices. In this chapter, which concentrates on financial assets, we assume that all assets discussed are marketable and are called marketable securities. Analyses of these marketable investments are facilitated because their values are objectively determined, competitively established, and easily measured. It’s relatively simple to go online, for instance, and find the current price of a given stock or of a mutual fund holding many stocks.

1 However, during retirement, they are employed to fund current household functions and, in some cases, the investments or, more frequently, the income from those investments is used currently. 2 A house is a partial exception. If well maintained, it may rise in price for many years before it begins to decline.

266 Part Three Portfolio Management

Given the focus on financial assets, when we discuss risk, we concentrate on invest- ment risk. Investment risk is the risk principally associated with savings placed in fi- nancial assets—the chance of a decline in asset value, typically measured by its market price. Investment risk is in contrast to insurance risk, which is primarily associated with possible deterioration in usability or valuation of a household’s nonfinancial real or human assets. Insurance risk can be reduced or eliminated by transferring it to an insurance company. The analysis of household operations must, of course, incorporate both risks. In this chapter, we view investments and asset allocation from a financial planning per- spective. We describe the entire asset allocation process as an advisor would, beginning

FIGURE 10.1 The Planning System for Asset Allocation

Establish Goals

Consider Personal Factors

Include Capital Market Factors

Identify and Review Investment Alternatives

Employ Portfolio Management Principles

Formulate Asset Allocation Decisions

Evaluate Specific Investment Considerations

Select Individual Assets

Finalize and Implement Portfolio

Review and Update the Portfolio

Chapter Ten Financial Investments 267

with goals and ending with portfolio management implementation. With this knowledge, you should be able to establish an overall asset allocation, one that can improve your investment performance. Asset allocation for financial investments refers to the amount and type of securities that they place their money into. The financial instruments used are typically stocks and bonds or mutual funds. The exact breakdown by category and further separation into sub- category can vary depending on the person. For example, one person may have 100 percent of an investment portfolio in large company stocks whereas another may have 60 percent in stocks and 40 percent in bonds with holdings that include stocks of all sizes and invest- ment styles as well as many types of bonds. The planning system for asset allocation has eight components, which are given in Figure 10.1. We will examine each of them.

ESTABLISH GOALS

Goals are at the head of the financial planning process. They were discussed in detail in Chapter 3. Goals are, of course, determined by our needs and the things and activities that we enjoy. Common goals are becoming financially independent, saving for a major capital outlay such as a car, and putting away money for a child’s college education. A comfort- able lifestyle in retirement is often a key goal in personal financial planning. Once we have established our goals, we are in position to identify the role savings and investments play in the process. Investments can be viewed as a delivery mechanism: They help create sufficient assets to fund our goals. Our financial planning procedures can establish the amount of money needed for each goal. More narrowly, our investment focus is on the appropriate asset allocation to help meet our goals.

CONSIDER PERSONAL FACTORS

An asset allocation in practice is not a rigid representation of market factors alone. It is also influenced by personal characteristics. The factors discussed here are some of the personal considerations that enter into the asset allocation process.

Time Horizon for Investments We have many goals. They tend to vary in their horizon—that is, the time frame we have set to achieve our goals. Time frames are important because most investments fluctuate in value. It would be improper to place volatile stocks in an investment account due to be liquidated in three months; the risk of loss should the market decline would be too high. Similarly, for most people, it would be a mistake to place a person’s entire investment sum in a money market account when the monies will not be needed for 20 years; the after-tax returns could trail the cost of living and instead of an increase in investable sums, the amount accumulated could decline on an inflation-adjusted basis. We can group goals for investment purposes into five time horizons (see Table 10.1).

Liquidity Needs Liquidity in an investment framework is the need or desire to be able to convert assets into cash. The need can come from a planned expenditure to be made at a fixed future period. In that case, it is covered under the time horizon just discussed. Alternatively, liquidity can be needed for current income to fund living expenses. It also can be a function of risk preference, employed for emergency use to reduce risk in general because typically the more liquid the financial instrument, the lower the risk of investment loss. Investments

268 Part Three Portfolio Management

vary in their degree of liquidity. For example, well-known large-size issues such as U.S. government bonds are generally more liquid than small local hospital obligations, and publicly traded securities tend to be more liquid than private partnerships.

Current Available Resources The investments we select are influenced by the amount that we have accumulated in financial assets. In addition, other resources such as real estate and human assets affect our asset allocation. This thinking is, of course, part of total portfolio management (TPM). Simply put, under TPM, our asset allocation is affected by the amount and risk character- istics of all our assets.

Projected Future Cash Flows Projected future cash flows are obtained by subtracting anticipated outlays from revenue streams. We have called that difference net cash flow, the amount that we are free to employ in any way we wish. The higher our projected net cash flows and the lower their risk of a disappointing outcome for it, the more able we are to handle a risky investment. That is so because we have future monies to invest that will offset disappointing results from our current assets.

Taxes Our tax brackets vary. Investment decisions should be made based on our after-tax returns. Therefore, our asset allocations can vary depending on our marginal tax bracket. For example, those of us in low tax brackets use taxable bonds whereas those in high ones often own tax-free municipal bonds. When changes in portfolio assets are contem- plated, the impact of gains or losses on sale must be included in the calculation of return. For example, there is little purpose in selling a well-regarded stock to take advantage of a potential extra 10 percent price gain on another security purchased with the proceeds from sale of the well-regarded issue when the sale will result in a 20 percent federal and state tax payment from the gain on liquidation of the original stock bought at a very low price.

Restrictions Restrictions in formulating an asset allocation are limitations on freedom of choice for investment alternatives or investment practices. Many restrictions are included under the other items discussed—for example, not using municipal bonds for people in low tax brackets.

TABLE 10.1 Time Horizons

Time Frame Horizon (years) Examples of Goals Investment Policy

Immediate 0 Emergency fund and other Money market funds possible uses within days or weeks Short term 0–2 Vacation, new car U.S. government bonds, certificates of deposit, short-term bond funds Intermediate term 2–4 Down payment for home, Conservative stocks, renovation of home mutual funds, bonds Long term 4–10 Education for a child Normal long-term asset allocation Very long term More than 10 Retirement Normal long-term asset allocation

Chapter Ten Financial Investments 269

In addition, they may restrict the use of debt to finance purchase of investments or preclude the use of higher-risk options or commodities. Finally, individuals may have specific prefer- ences; for example, there are those who prefer funds promoted as being socially responsible by avoiding investments in tobacco companies.

Risk Tolerance Risk tolerance is the amount of risk a person is willing to accept. Some people think of it solely as a function of one’s personality. However, it can be influenced by many vari- ables in addition to personality including upbringing, current circumstances, family concerns, the amount and type of the household’s current assets, and expected future cash flows. A person’s risk tolerance can be determined in many different ways. People can be asked to describe themselves and their tolerance for risk. For example, the question may be framed as “In investment matters, do you consider yourself conservative, moderate, or aggressive?” Alternatively, their prior actions can be observed. For example, looking at a breakdown of their current portfolio can help determine the appropriate asset

SELF EVALUATION

Professional Advice Adjustments to Risk Tolerance

Professional Advice Past Experiences

270 Part Three Portfolio Management

allocation for them. Another approach is to give them a variety of oral or written ques- tions that can be scored to help determine their risk tolerance. One such questionnaire is given in Table 10.2.

INCLUDE CAPITAL MARKET FACTORS

We’ve established the goals and some distinguishing features of individuals. At the same time, we need to examine the characteristics of the overall financial markets and of the various types of securities likely to be considered for the asset allocation. We begin by discussing two of the most basic characteristics of finance: risk and return.

Risk and Return One of the most logical thoughts in investing is that risk and return should be related. If we select an investment that has a higher degree of risk, we expect to earn a higher

Answer the following questions using ratings from 1 (strongly agree) to 5 (strongly disagree).

1. Short-term fluctuations in the value of my assets do not bother me. 2. I tend to buy and sell securities at the right time. 3. Having high current investment income is not important to me. 4. If an investment could not be sold quickly without a substantial financial penalty, it would not disturb me, provided the

longer-term returns on the investment were favorable. 5. It would not bother me at all if I couldn’t sell my new investment for many years if there was the potential for unusually

good performance. 6. Investing in common stocks and common-stock mutual funds does not make me jittery. 7. I am willing to endure a significant decline in my principal over a few years if it will result in higher longer-term returns. 8. I am willing to take on higher risk so that I can obtain a hedge against inflation. 9. I don’t need a guaranteed return of my principal if forgoing that will greatly increase the potential longer-term growth rate

of my investments. 10. If the prevailing economic and investment sentiment seemed gloomy, I would not switch to safer securities.

Score

Risk taker Below 20 Middle of the road 20–40 Conservative 40 or higher

TABLE 10.2 Risk Profile Quiz

Source: Lewis Altfest and Karen Altfest, Lew Altfest Answers Almost All Your Questions about Money (New York: McGraw-Hill, 1992), p. 64.

Practical Comment Fluctuating Risk Tolerance

Chapter Ten Financial Investments 271

return. Why else would we expose ourselves to an above-average chance of loss? Generally, in finance, it is assumed that risk and return are proportionately related. It is a basic assumption of modern investment theory.3 For example, if we choose an invest- ment with a 20 percent higher risk, we should get a 20 percent higher return.4 Let’s look at the two factors, return and risk, separately.

Return Return is the total of income and the increase of monies invested over a period of time. We can establish the cumulative return using the following formula.

Holding period return 1HPR2 =

Sum of dividends or interest paid

+ Gain in principal invested

Original cost

We are often interested in calculating time-weighted returns. These returns affect how long we have owned a security and the timing of income payments during that period. The in- ternal rate of return (IRR) is often used to obtain this return, typically by providing a com- pound annual return.5 An example of holding period return (HPR) and IRR for a bond is provided in Example 10.1. The example details IRR for both a stock and a bond; the bond is expected to be held until it matures. In that case, the IRR is also known as the yield to maturity (YTM).

Example 10.1 Betsy bought a stock three years ago for $20 per share and placed it in a tax-sheltered pension plan. In years 1 to 3, she received cash dividends of $0.30, $0.60, and $1.00, respectively. She sold the stock for $28 per share the day she received the $1.00 dividend. She also purchased a bond in the pension plan for $960 on January 1. This bond would pay Betsy $50 of interest once a year until it was due to be redeemed at $1,000 after eight years. Calculate the actual HPR and IRR for her stock and the projected IRR/YTM for the bond.

Stock

Year 3: (28 + 1) = $29

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 20 CHS g CFo 20 +/− ENTER ↓ Enter cash inflow year 1 0.30 g CFj 0.30 ENTER ↓ ↓ Enter cash inflow year 2 0.60 g CFj 0.60 ENTER ↓ ↓ Enter cash inflow year 3 29 g CFj 29 ENTER ↓ ↓ Calculate the internal rate of return f IRR IRR CPT 14.6% 14.6%

3 Three prominent parts of this theory—modern portfolio theory, capital asset pricing model, and efficient market theory—are discussed in this chapter and in Web Appendix A: Modern Investment Theory. 4 After the risk-free rate, to be described, is considered. 5 We can calculate average annual returns when provided with annual or cumulative statistics. Average annual arithmetic mean returns are given as

Arithmetic mean returns = Sum of annual returns Number of periods

or 1 N

aN 1

rN and

Geometric mean returns = Number of Periods2Product of annual returns − 1 or NCqN1 11 + rN2 − 1.

Calculator Solution

272 Part Three Portfolio Management

Risks Explanation

Market The risk of a decline in the overall stock or bond market Liquidity The risk of receiving a lower-than-market price on sale of a holding Economic The risk of unfavorable business conditions caused by weakness in the overall

economy Inflation The risk of an unexpected rise in prices that reduces purchasing power Political The risk of a change in government or governmental policy adversely affecting

operations Regulatory The risk of a shift in regulatory policy impacting activities Currency The extra risk in international activities arising from currency fluctuations Technological The risk of obsolescence of a product line or inputs in producing it Preference The risk of a shift in consumer taste Other industry The risks that affect companies in an industry other than the preceding ones Financial The extra risk that arises from borrowing money

TABLE 10.3 Fundamental Risks for Financial Assets

Bond

Year 8: (1,000 + 50) = $1,050

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 960 CHS g CF0 960 +/− ENTER ↓ Enter cash inflows years 1–7 50 g CFj 50 ENTER ↓

Enter number of years 7 g Nj 7 ENTER ↓

Enter cash inflow year 8 1,050 g CFj 1,050 ENTER ↓ ↓ Calculate the internal rate of return f IRR IRR CPT 5.6% 5.6%

The stock had a 14.6 percent annual return and the bond has a projected yield to maturity of 5.6 percent.

Risk Risk, as most people view it, is the chance of loss on an investment. There are many types of risk for financial assets (see Table 10.3). According to modern investment theory, the total risk of a security—one that includes all the fundamental risks shown in Table 10.2—can be represented by one measurement: its price action. The wider the fluctuations around its average price, the higher is the stock’s risk. The most common measurement of price fluctuation is the standard deviation.6

The idea of standard deviation and risk is shown in Figure 10.2. Notice that company A and company B both have the same return (they start and end at the same price), but company B has higher total risk because its price has fluctuated more widely. Essentially, standard devia- tion measures price volatility, and higher volatility is equated with increased investment risk. Because the standard deviation measures price change, it includes fluctuations that result in gains as well as those that result in losses. Therefore, this method contrasts with investors’ measurement of loss only. The semivariance, a less-used methodology, measures fluctuations resulting in losses.7

6 The standard deviation is the square root of the sum of the squared deviations around the average return. 7 Harry Markowitz, “Foundations of Portfolio Theory,” Journal of Finance 46, no. 2 (June 1991): 469–77. For an update on how Nobel Laureate Markowitz views his theory, see Sicco Brakema, “Don’t put all your eggs in one basket: An interview with Harry Markowitz,” September 11, 2013, thiscomplexworld. com/put-eggs-basket-interview-harry-markowitz/

Calculator Solution

Chapter Ten Financial Investments 273

IDENTIFY AND REVIEW INVESTMENT ALTERNATIVES

We have discussed establishing goals and assessing risk tolerance and other factors. Before proceeding, we need to identify and review the investment alternatives that are appropriate for the asset allocation. We will review those most used by households—bonds, stocks, and mutual funds that are generally made up of bonds or stocks. In this way, you can be- come familiar with their investment characteristics such as their risk-return profiles and better understand how to employ them in the asset allocation process.

Bonds Bonds are contracts in which an investor lends money to a borrower. As compensation for receiving the money, the borrower agrees to pay interest, often twice a year and generally of a fixed amount. The borrower also agrees to repay a stated sum at the end of a fixed period. The date that the loan is to be repaid is called the maturity date.8

Bonds of high-quality companies are considered safer than most other types of invest- ments for the following reasons:

1. The annual income to be received is generally fixed in advance. 2. The contracted-for loan principal is likely to be repaid in full at the stated date.9 Even in the

event of financial difficulties, the borrower will have to comply with the terms of the contract. Interest and principal must be repaid on time or the company will face bankruptcy. Should bankruptcy occur, bondholders have priority in receiving the proceeds from liquidation of business assets and are therefore repaid before stockholders receive any material proceeds.

Common Stocks Common stocks are very different from bonds. A common stockholder is an owner, not a creditor, of a company. She or he is entitled to participate in the current profits and anticipated future growth of the enterprise. Of course, if there are no profits, the investment can end up hav- ing no value. Clearly, stocks typically have higher risks than bonds. In sum, stocks present po- tentially higher returns than bonds, but the shareholder must be prepared to take a greater risk. Individual common stocks, also called equities, can be placed in various categories. Professional investors often concentrate on one or more of these equity categories.

FIGURE 10.2 Companies with Same Mean Returns but Different Risks

St oc

k Pr

ic e

Company A

Company B

Time

8 Bond is the most popular term used for this type of investment, but a broader and perhaps more accu- rate term, fixed obligation, is sometimes employed. A fixed obligation is any investment whose terms, including the returns, are known at the beginning of the period or depend on clearly defined factors such as the inflation rate. Fixed obligations consist not only of bonds but also of other investments such as mortgages and bank certificates of deposits. Unless otherwise stated, we use the terms bonds and fixed obligations synonymously. Fixed obligations as they pertain to future household outflows described in Chapter 6, as opposed to future financial investment inflows as indicated here, have a different meaning 9 Unless repaid earlier, generally at the option of the corporation under terms stated in the contract.

274 Part Three Portfolio Management

Sometimes these professionals concentrate in this manner to ensure that they are never too far away from overall market performance or from the performance of the segment(s) of the stock market in which they operate. Some of the methods of categorizing stocks follow.

Relative Growth Rates Shares issued by companies that grow more rapidly in sales and earnings than the overall econ- omy and are less affected by cyclical business conditions are called growth stocks. Examples would be fast-growing technology leaders. Those that generally grow at average or below- average rates but are also less affected by business conditions are called defensive stocks. Companies in the consumer basics and utility sectors are examples of defensive companies. Firms whose growth rates are at or below those for the overall economy but whose operations are highly sensitive to aggregate business conditions issue shares called cyclical stocks.

Sector and Industry Sectors are the parts of the overall economy. The economic sectors that pertain to the stock market are sometimes divided into basic materials, capital goods, consumer cyclicals, consumer noncyclicals, energy, financial, health care, services, technology, transportation, and utilities. Each sector, in turn, is divided into a number of industries. For example, consumer cyclicals include, among others, autos, consumer appliances, and retail chains. Because sectors tend to share some similar characteristics, some active managers use these catego- ries and industries to decide which areas to over- or underemphasize.

Geographic Area Geographic area indicates which areas of the country or of the world we might concentrate in. For example, the northeast area of the United States is the most populated but slowest-grow- ing region. Some may be interested in investing in faster-growing sections of the United States or in parts of the world that present potentially more rapid growth rates than the United States.

Company Size Companies come in all sizes. As a generalization, larger companies are more secure often with entrenched positions in major markets. Smaller companies can be more flexible because they may have more entrepreneurial management. On the other hand, they also may have more risk if the outlook changes dramatically. Medium-size companies are a blend of the previous two.

Quality Quality in stocks is a measure of how confident we are that the anticipated prospects for a company are going to be fulfilled. Those companies of high quality are more likely to be large and have a strong position in their markets. Often they have good returns on investment and are less likely to have large noneconomic-related disappointments in earnings. Such companies are sometimes called blue chips and generally have risk that is below overall market averages. At the opposite end of the quality spectrum are companies whose operations are less predictable, their profitability more precarious with current or potential losses possible. Sometimes these companies have a large amount of debt in relation to the value of their equity. They can be highly risky and, if so, are called speculative investments.

Mutual Funds Mutual funds generally combine stock or bond assets10 for investors, who receive cen- tralized administration and investment management. In effect, people pay an investment company a yearly fee for handling their investment needs. Their investment is evidenced by shares of the mutual fund owned. Monies transferred to the investment company are

10 Other types of assets, such as asset-backed commercial paper held by money market funds, also are used.

Chapter Ten Financial Investments 275

pooled together with those of other shareholders for efficient management. This form of asset management has grown rapidly in recent decades, as shown in Table 10.4. The following are some selected mutual fund characteristics that have been separated into strengths and weaknesses.

Characteristics Explanation

Strengths

Expertise Fund companies are typically run professionally, and the portfolio managers in charge of investment activities are generally qualified.

Low cost Mutual fund activities are provided at relatively low cost. Diversification Diversification generally into 50 or more stocks is possible with a modest sum of money. Low minimum investment The minimum investment to purchase many funds is as low as $500 to $1,000. Professional recordkeeping Records are kept by the fund management, who can provide information about performance

or for tax purposes. General information Published information (in print and online) and telephone assistance from the fund

management companies are generally available to help investors select mutual funds and monitor them. The information is either obtained by the individual or from a broker or financial planner.

Safety Mutual funds are supervised by the Securities and Exchange Commission and the fund’s board of directors. Actual assets often are not directly under the manager’s supervision but are placed with a third party with the manager making only buy and sell decisions.

Daily pricing This fund’s price and performance statistics are available daily in some publications, through Internet sites, or from the fund companies directly.

Reinvestment and payout Mutual funds can provide automatic reinvestment of their distributions and can accommodate the need for withdrawals of a stated amount per period.

Weaknesses

Cost The overhead costs are higher than they would be if the investor were to manage the money him- or herself.

Performance The majority of mutual funds underperform their relevant markets. Tax Holders of mutual funds are subject to tax inefficiencies such as being taxed on realized capital

gains from individual stocks or bonds liquidated by the fund manager even though the fund itself hasn’t been sold by the investor.

Transparency Investors might not know exactly what’s in a mutual fund until it issues a quarterly report.

Industry Net Assets (billions of dollars)

Year Stock Funds Bond Funds Total11 Total Number of Funds

1970 45.1 2.5 47.6 361 1975 37.5 4.7 45.9 426 1980 44.4 14.0 134.8 564 1985 111.3 122.6 495.4 1,528 1990 239.5 291.4 1,065.2 3,079 1995 1,249.1 602.5 2,811.3 5,725 2000 3,934.5 824.0 6,964.6 8,155 2005 4,885.5 1,357.6 8,891.4 7,977 2010 5,596.6 2,591.0 11,833.0 7,554 2011 5,213.0 2,844.4 11,631.9 7,587 2012 5,938.8 3,390.7 13,052.2 7,588 2013 7,762.7 3,286.4 15,034.8 7,713 2014 8,314.3 3,460.9 15,852.3 7,923

TABLE 10.4 Total Industry Net Assets

Source: Investment Company Institute, https://www.ici.org/ pdf/2015_ factbook.pdf

Mutual Fund Classification System Mutual funds cover virtually all types of stocks and bonds. With more than 7,500 in number, there are more mutual funds than stocks on the New York Stock Exchange.

276 Part Three Portfolio Management

Historically, funds were categorized by risk. Thus, general stock funds ranged from most conservative, income only, to aggressive growth. More recently, they have generally been listed by size and investment style. Size Most mutual funds can be divided into small-company, medium-company, and large-company categories. The basis for this separation is the stock market’s valuation of the companies in which the mutual fund invests. Smaller capitalization companies provide higher potential returns because they may have the potential for faster growth and have more managerial flexibility than large firms. However, “small-caps” also have higher risk because they may not be as diversified as larger companies. Larger capitalization companies have more consistency of performance and lower company fundamental and stock market risk.12 Medium capitalization companies provide a blend of the other two categories. Investment Style The many styles of active investment are commonly separated into three categories: growth, value, and blend (or core).

Growth. A growth style of investing involves selecting companies that are expected to have rapid growth in revenues and earnings per share. These companies are more likely to be favorably thought of by investors and have higher-than-average valuations such as high price/earnings multiples. Value. An investor employing a value style places more emphasis on price in making pur- chase decisions. The manager looks for companies that are out of favor or otherwise mis- priced in relation to their outlook for earnings growth. The valuations of such ratios as their market price in relation to their earnings (price/earnings ratio) or market price in relation to their asset value as recorded on their books are likely to be below average. Their universe of stocks is broader, often with more emphasis on companies whose earnings growth or re- turn on investment is temporarily or permanently below that for the average stock. Blend. The blend category is essentially all else. It may include a fund run by a man- ager who moves from value to growth style or buys a mix of the two. A blend fund also may practice a style of investing that cannot be defined in value or growth terms as, for example, a fund with a manager who largely uses technical analysis.

Example 10.2 Helen had a choice of three styles of larger company mutual funds for her pension. The first, a growth style, picked the fastest-growing companies in industries with favorable outlooks such as those in the technology sector. The second, a value style, selected individual companies that had some blemishes in outlook but were soundly positioned and financed and were cheaply priced. The third, a blend style, was a mixture of the other two styles. She decided to select the value style fund, which suited her belief in making purchases for her household that were “bargains” and therefore represented value investments.

A sample grid employing these principles for stocks is shown in Figure 10.3.

12 Of course, many believers in risk-return theory and efficient markets regard the two as synonymous.

FIGURE 10.3 Morningstar Investment Style Box

Source: Morningstar, Inc.

Morningstar Style Box™

Large M

id Sm

all

Value Blend Growth ---------Style--------

--------Size----------

Chapter Ten Financial Investments 277

Exchange Traded Funds Exchange traded funds (ETFs) are in many ways like mutual funds. They differ from mutual funds in that a majority of ETFs are managed passively to track a specific market index. ETFs pool together investors’ monies for joint management. Their popularity has grown rapidly in recent years. Like passively managed mutual funds, ETFs typically have a lower cost structure. In comparison with mutual funds, ETFs can possess certain modest tax benefits. Because ETFs track market indexes, they offer investors a chance to match returns from the overall and individual segments of the stock and bond markets, com- modities markets, currencies, and so on; some ETFs have innovative methods for con- structing indexes via mathematical means. Unlike mutual funds, which can be purchased only once a day at the market value of their individual assets, ETFs are traded like stocks throughout the day, generally but not always at a price close to the market value of their individual holdings. For purposes of this chapter we treat ETFs as being very similar to mutual funds.

EVALUATE SPECIFIC INVESTMENT CONSIDERATIONS

Individual preferences create issues and choices in the way investments are managed. Two of them—active versus passive investing and use of individual securities versus mutual funds—are discussed next.

Active versus Passive Approach Risk-return and efficient market theory say that attempting to outperform the market will not be fruitful. People who manage to do so are just lucky, not skilled. This thinking leads to a passive approach to investing. With it, no attempt is made to receive higher- than- market returns. The theory’s proponents believe that efforts can better be used to diversify in order to reduce risk and keep costs low. Passive investors tend to purchase index mutual funds or ETFs of all types. An index fund attempts to duplicate market performance and

Professional Advice ETFs

278 Part Three Portfolio Management

keeps costs low by using computerized programs to purchase holdings and not employing high-priced investment managers and analysts.13

With the alternative, the active approach to investing, changes are made in holdings over time to take advantage of new opportunities. There are many different ways of per- forming active investing. However, they all have as their basis the belief that it is possible to outperform the market. Otherwise, it would be silly to make the effort. One prominent active approach is fundamental investing, which analyzes overall market, industry, and company data to identify opportunities. Often the basis of this approach is the belief in mean reversion. Mean reversion is the belief that security prices return to their true value over time from temporary overvaluation or undervaluation. For example according to mean rever- sion, investors who purchased shares in 2008 when they were undervalued and had declined more than 50% from the peak, were able to earn above average returns when stocks rebounded to more normal levels in subsequent years.

Individual Securities versus Mutual Funds Establishing an investment portfolio should involve making a decision about whether to use individual securities or mutual funds.14 Individual securities purchased by the household in- volve no fund-overhead expenses and offer more ability to buy and sell for tax planning pur- poses instead of dealing with annual taxable capital gains from mutual funds. With individual securities, there also can be the emotional “high” of watching a stock in the portfolio do well. Mutual funds offer professional advice at reasonable cost, the ability to delegate the investment management and recordkeeping function, and simple diversification with low investment minimums by specialists in a wide variety of types of securities, geographic areas, and styles of investing. Although there are notable exceptions, the majority of mutual funds underperform the market. Given the lack of expertise in many households, the lack of desire to monitor their investments, a sometimes emotional response to buy and sell decisions, and a desire for lower volatility, the majority of financial planners recommend implementing investment strategies through mutual funds.

13 It is generally included under the blend style of investing. Nonbelievers might say people at the time couldn’t be sure a major depression wouldn’t break out with even lower stock prices an outcome. 14 Actually, mutual funds represent just one of a number of investment alternatives including the use of separate accounts and the direct selection of investment managers, tax-deferred annuities, hedge funds, exchange-traded funds, unit investment trusts, and so on. However, in this introductory text, we have largely limited ourselves to this most popular alternative.

Practical Comment Why Mean Reversion May Work

Chapter Ten Financial Investments 279

EMPLOY PORTFOLIO MANAGEMENT PRINCIPLES

Portfolio management is the overall supervision of our investments program. It guides the decisions on asset allocation and individual investments. Each household does or should en- gage in portfolio management, which helps answer such questions as “Are my investments too concentrated in one area?” and “What returns am I likely to receive longer term.” In this section, we discuss the principles that help establish portfolio management policies. We have already described the characteristics of individual stocks and bonds and how both risk and household needs enter into decision making. Our approach was to look at each asset separately and decide whether it was attractive enough to purchase. There is a major weakness in using this approach.15 It assumes that a portfolio is just the sum of all its individual securities. Adding up all individual securities is roughly equivalent to saying that a house is only the sum of all the bricks and other materials that went into building it16 with no weight given to the safety and attractiveness of the building taken as a whole. Similarly, a portfo- lio is more than the sum of its parts because the individual assets are often related to each other. The interrelationships among the securities can create an attractive or unattractive portfolio just as the way the bricks are put together can create a beautiful or ugly house. A portfolio can be defined as a grouping of assets held by an individual or a business. A portfolio that holds a diversified grouping of assets can be said to be at- tractively balanced and not easily influenced by events other than those that affect overall markets. We also learned that individual securities are valued not only by the returns they offer but also by the risk they present in receiving their return. The two-parameter risk-return approach, here termed the mean-variance model,17 serves as the basis for portfolio theory and its approach to constructing a portfolio.18 Under portfolio theory, we strive to achieve the highest return we can given the risk we are willing to undertake. Let’s look at portfolio risk and return separately. Portfolio return is fairly simple. It is just the sum of the returns for each security multi- plied by the weighting it has in the portfolio. You might think, then, that portfolio risk is the weighted average sum of the risk for the individual securities. That isn’t the case. The reason has to do with the correlation coefficient. The correlation coefficient measures the degree to which an investment in a portfolio is related to other investments in that portfolio. As a practical matter, for financial invest- ments, it generally ranges from 0 to +1.19 Often in portfolio management, we measure

15 Of course, as we see later in this chapter, there is a second possible weakness. For people who believe in efficient markets, the effort to find attractive stocks will be fruitless. 16 Just as we look at a house overall and decide whether it is attractive or unattractive, we can look at a portfolio overall and decide whether by placing the right investments in the right proportion we have a grouping of assets that appropriately answers our risk-return needs. Just as one building material may look attractive by itself but not fit the overall house effect, individual securities relate to one another, and one that is attractive may not fit in with an individual’s point of view. 17 The variance measure of risk is just the standard deviation squared. 18 Harry Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91; “The Early History of Portfolio Theory: 1600–1960,” Financial Analysts Journal 55 (1999): 5. See also Bruce I. Jacobs and Kenneth N. Levy, “A Comparison of the Mean–Variance-Leverage Optimization Model and the Markowitz General Mean–Variance Portfolio Selection Model,” Journal of Portfolio Management (Fall 2013), iijournals.com/doi/full/10.3905/jpm.2013.40.1.001#sthash.Sn7Llo0F.BSTimMBg.dpbs 19 In theory, its range is wider, from +1 to –1. Investments can be negatively correlated, which means that when one rises, the other goes down. As a practical matter, negatively correlated investments are difficult to find.

280 Part Three Portfolio Management

correlation through movements in prices. That is so because price changes often largely determine performance, the reason for investing. Think of correlations as showing rela- tionships. We aren’t going to get much portfolio diversification benefit from investing in Coca-Cola, PepsiCo, and Dr Pepper Snapple Group. The movements of these stocks tend to be very similar and therefore have high correlations. Combining a beverage company with a smaller technology company and a low-valuation automobile company would reduce the correlations. By reducing correlations, we lessen price fluctuations and overall risk in the portfolio. Noncorrelation between asset classes also can reduce portfolio risk. In this century, for instance, long-term Treasury bonds have been negatively correlated with the broad stock market as represented by the Standard & Poor’s 500 Index. In 2008, large-cap domestic stock funds lost 38 percent on average whereas long-term government bond funds gained 28 percent. Thus, a portfolio split evenly between those two asset classes would have lost 5 percent for the year whereas portfolios tilted toward stocks lost 20 percent, 30 percent, or more. According to Markowitz, forecasts of return, risk, and correlation20 are combined to form what is called the mean-variance model. Its principles are key inputs into what is termed modern portfolio theory (MPT). The model computes the mix of portfolio assets that best meets the household’s return-risk profile. The Markowitz model and its simpli- fied off-shoot, the capital asset pricing model (CAPM), are provided in Web Appendix A, Modern Investment Theory. We can conclude by saying that the most important concern to the investor is the risk of the overall portfolio, not the risk of individual securities. The portfolio risk reflects the separate risks of each of its holdings and the degree to which the securities are correlated.

Total Portfolio Management (TPM) The Markowitz portfolio approach is, at heart, a theory of how overall capital markets work using individual securities. The CAPM has similar intentions. In contrast, total port- folio management (TPM), presented by the author of this book, is a more inclusive model of the individual household. It proposes that a household makes investment decisions based not only on marketable financial securities but also on all assets that it possesses. Although we have referred to portfolio analysis as employing securities, its approach can embrace all assets. In fact, Markowitz has made reference to doing so.21 The concepts we have explained thus far in the chapter apply to TPM as well. Under TPM, all household assets interact and their correlations are considered. Investment decisions that are made incorporate individual asset returns, risks, and the degree to which they are correlated. The traditional view is to treat financial assets such as stocks and bonds separately from other household assets. Although this solely finan- cial asset approach can be considered too narrowly focused, it is established thinking, and we have followed it in this chapter. The other components of TPM—real assets, hu- man and human-related assets, and liabilities—have been or will be discussed in other chapters. We deal with total portfolio management with its full integration of all assets in Chapter 17.

20 Actually, correlation is part of portfolio risk, and risk in this sentence refers to individual asset risk. It is segregated in this manner to differentiate it from the CAPM, which simplifies correlation to individ- ual assets relative to the overall market, thereby bypassing individual asset correlations with other port- folio assets. 21 Markowitz called them exogenous assets. For further details, see Harry Markowitz and Peter Todd, Mean-Variance Analysis in Portfolio Choice and Capital Markets (New Hope, PA: Frank J. Fabozzi, 2000).

Chapter Ten Financial Investments 281

FORMULATE ASSET ALLOCATION DECISIONS

We have now examined all the major factors that enter into the asset allocation process. The next part of the operation, taking portfolio management actions, can be viewed as the decision-making implementation arm of the asset allocation process. We assume that goals and evaluation of personal characteristics, including such factors as time horizon and risk tolerance, have been established. The remaining steps are listed next and then described separately.

1. Establish an active or passive management style. 2. Construct a strategic asset allocation. 3. Develop a tactical asset allocation.

Establish an Active or Passive Management Style At this point in the process because passive management may provide fewer investment choices and a simpler process, it is important to decide whether the portfolio is to be actively or passively managed. Underlying the active approach is the belief that changes can add to portfolio performance. With passive management, no attempt is made to antici- pate future events. Changes under passive management are made to maintain a constant asset allocation and risk profile, not to improve returns, and costs are kept very low. As mentioned, index-type assets such as index funds are often used in implementing a passive management approach.

Construct a Strategic Asset Allocation Asset allocation is the percentage makeup of the portfolio by asset type. Strategic asset allocation is the normal portfolio makeup over the longer term. The strategic allocation process begins by establishing allowable asset categories. This might include small, mid, and large cap stocks; international equities; and bonds or their mutual fund counterparts. Other categories may be eliminated, such as tax-free municipal bonds if the household’s marginal tax bracket is modest or private partnerships if the amount of assets or tolerance for risk is low. The strategic asset allocation stresses diversification.

Journal of Finance

Practical Comment Use of Modern Investment Approach

282 Part Three Portfolio Management

The strategic allocation should be strongly influenced by the household goals and risk profile. For example, if the goals can easily be achieved, a conservative asset allocation may be used even though the household can tolerate a more aggressive one. A shorter-term goal also will dictate a more conservative allocation. Financial advisors generally suggest that a strategic asset allocation be rebalanced periodically. Suppose that Arlene began 2008 with a simple asset allocation of 50 percent in a long-term government bond fund and 50 percent in a large cap domestic stock fund. At year-end 2008, strong performance by government bonds and weak performance by domestic stocks tilted her allocation to 65 percent in bonds and 35 percent in stocks, a much more conservative position than Arlene desired. To regain her target allocation, she sold an amount of her bond fund shares equal to 15 percent of her portfolio value and rein- vested the sales proceeds in stock fund shares. This brought Arlene back to her strategic 50–50 allocation. In reality, such rebalancing usually involves multiple asset classes rather than only two. Overall risk tolerance, as discussed, can incorporate many factors. As a rule, the younger we are, the more aggressive is the allocation. An example of strategic allocations by age and presumed tolerance for risk is given in Table 10.5.

TABLE 10.5 Strategic Asset Allocation

Asset Category Middle Aged/ Moderate Risk

Retired/ Lower Risk

Stocks

Small cap 15% 10% 5% Mid cap 10% 5% 2% Large cap 25% 30% 20% International 20% 15% 5% REIT 5% 5% 3% Total Stock 75% 65% 35%

Bonds

Short term 5% 5% 10% Intermediate 5% 10% 25% Long term 0% 5% 10% High yield 10% 5% 5% Total Bond 20% 25% 50%

Money market 5% 10% 15% Total 100% 100% 100%

Young/ Fairly Aggressive

Practical Comment Active versus Passive Investing

Chapter Ten Financial Investments 283

Develop a Tactical Asset Allocation A tactical asset allocation modifies the breakdown of a portfolio to attempt to profit from current circumstances. When constructing a tactical asset allocation for the current eco- nomic environment, the outlook for asset categories and prevailing asset valuations are included. Often, maximum allowable deviations of the tactical asset allocation from the strategic one will be set. The illustration involving Arlene showed that she had a 50–50 strategic allocation be- tween long-term government bonds and large cap U.S. stocks. She also has a tactical incli- nation that varies from time to time, depending on the outlook for interest rates, economic growth, and other factors. However, her investment policy puts a band of 5 percentage points, in either direction, on her ability to move for tactical reasons. Thus, Arlene can make a tactical allocation of up to 55 percent from 50 percent for either stocks or bonds. If she believes that the current outlook favors stocks over bonds, Arlene can sell enough bond fund shares and reinvest in stock fund shares to move her allocation to 55–45, stocks to bonds. Alternatively, she might put new money into stocks so that the 55–45 allocation results. As conditions change, allocations are altered. When a passive approach is taken, a tacti- cal asset allocation is not performed. Some people and advisors skip the tactical asset allocation as well, preferring a fixed strategic allocation at all times.

SELECT INDIVIDUAL ASSETS

Once the strategic and tactical asset allocations have been established, individual assets24 are selected for each category. Clearly, the goal is to select the assets that provide the high- est returns for the overall risk taken.

Individual Fund Analysis Asset allocation typically involves placing monies in a wide variety of areas. For the majority of individuals and financial planners, mutual funds are the appropriate and most

Professional Advice Pensions and Assets Allocation Strategy

24 As one entity, a mutual fund is also considered an individual asset.

284 Part Three Portfolio Management

popular form of managed account. Here we focus on how to select an individual mutual fund. This approach can be useful for other asset types as well. Individual fund ideas can come from media recommendations, advisors, friends, or our own examination of a mutual fund database. With passive management, the prime screen may be the availability of a diversified mixture of funds benchmarked25 to the categories stated in the asset allocation. The final choice for passive management might include exchange-traded funds as well as traditional mutual funds, selected on the basis of their correlation with the benchmark, with those having the lowest expense ratios and the high- est returns preferred. Active fund selection is more involved. With the exception of step 1, the information for which can be accessed independently such as receiving it from the management com- pany, broadly speaking the factors listed in the steps given below or similar steps can be found in a good statistical source such as Morningstar. Morningstar has excellent subscrip- tion services and offers free online access to selected information on virtually all mutual funds. You can see how to use the selected information at no charge by examining the Morningstar page provided in Figure 10.4. Note that beginning with step 2 each of the steps listed are keyed to the relevant information given in the Morningstar page. For example, step 2 calls for indentifying the fund’s size and style. Both are shown as step 2 on the Morningstar page. The steps listed below are enough to make informed decisions. Appendix III provides selected additional factors that are helpful. On the other hand, a simpler approach is given in the Professional Advice section following.

1. Try to obtain relevant descriptive information on the fund. Information written by the press, the management company, and industry sources can help.

2. Identify the fund size and style. The size of the companies it has in its portfolio and the style of investing are the appropriate beginning point for analysis.

3. Compare fund returns. Comparison should be with other funds with the same size and style. In theory, all markets move together. In reality, this isn’t always true. For example, large cap growth funds were up an average of 15.7 percent a year for the five-year period ending August 31, 2015 whereas small cap value was up 13.4 percent a year for the same period, a significant difference. Comparing apples with apples— for example, small cap growth with small cap growth indexes—will provide the most insight.

4. Look at the fund’s risk. Know the risk that being taken relative to the category and to the overall market. The beta coefficients and the standard deviations can provide the informa- tion. A beta coefficient of 1 indicates average risk relative to the index it is compared to. A beta above 1 indicates above-average risk; below 1, below-average risk. The higher the standard deviation, the higher is the risk of the security. The S&P 500 for the three-year period ending August 31, 2015, had a standard deviation of approximately 9.6 percent. Thus, a fund with a standard deviation higher than 9.6 percent has been more volatile than the broad market. The higher the fund’s Sharpe ratio, the better is its performance. Interpreting the alpha coefficient is even easier. A positive alpha coefficient indicates above-average risk adjusted performance; the higher the figure, the higher is the amount by which it exceeded the yearly market performance. Similarly, a negative alpha indicates negative risk adjusted performance. Obtain Sharpe ratios and alpha coefficients relative to

25 Benchmarked means taking an overall index that is closest in characteristics to the individual portfolio that has been established. Then overall performance can be compared with that benchmark. For example if we had a portfolio of larger companies, we could see how well we had done by comparing it with the S&P 500 as an index of the 500 largest companies in the United States.

Chapter Ten Financial Investments 285

other funds like it.26, 27 Unfortunately the risk measure given by Morningstar is only their assessment of risk of the individual fund relative to the category.

5. Look at consistency of performance. Performance should be measured over a minimum of three years and preferably five years or more. Fund performance that ranks in the top quartile for four out of five years may be preferable in anticipating future returns to an alternative that has higher cumulative returns but received all cumulative outperformance in only one out of five years. The Morningstar chart allows only cumulative ranking over 1, 3, 5, and 10 years and consistency must be imperfectly deduced from these statistics.

6. Look at the tenure of the current portfolio manager. With some exceptions, portfolio managers are the individuals most responsible for fund records. Once they leave, the records may be meaningless when attempting to forecast future performance.

7. Observe the fund’s size. Many equity portfolio managers admit that it is easier to man- age $50 million than $500 million, $500 million than $5 billion, and so on. Bond fund managers in broad-based high-quality funds may not have that difficulty.

8. Incorporate the fund’s expense ratio. For all share classes28 the average expense ratio for domestic stocks is 1.21 percent of net assets per year29 and for bonds is 0.86 percent.30 For no-load, no 12b-1 fee share classes the fund average expense ratio for domestic stocks is 0.90 percent and for bonds is 0.57 percent. Deviations well above or below that level can have an impact, particularly for bond funds. According to Morningstar, portfolio transaction fees, or brokerage costs, as well as initial or deferred sales charges aren’t included in the expense ratio. 31, 32

The factors listed in the steps given above can all be found in a good statistical source such as Morningstar. You can see how to do so by examining the Morningstar page

26 See Appendix III this chapter for additional measures for fund analysis. 27 See Appendix II this chapter for further information on these measures and Part III of Web Appendix A for additional elaboration on risk measures. 28 All share class funds include B and C fund shares which have higher operating expenses to compensate the broker selling the fund. 29 Domestic large, mid, and small cap stock funds, for both all funds and just no-load funds calculated from Morningstar data. 30 Domestic long-term, intermediate-term, and short-term bond funds excluding municipal bonds, for both all funds and just no-load funds calculated from Morningstar data. 31 Those stock and bond funds in the same categories identified by Morningstar as being no-load tend to have lower expense ratios than those for funds that impose loads, the industry term for sales charges. 32 Expense ratios include management fees, 12b-1 fees for marketing and administration, operating costs, and all other asset-based costs incurred by a fund.

Professional Advice Short Form Selection Process

286 Part Three Portfolio Management

FIGURE 10.4 Steps in Active Fund Selection

Source: Morningstar© Mutual Funds™, downloaded from http://quotes.morningstar.com/ in August 2015.

7 82

1 5

(continued)

Chapter Ten Financial Investments 287

FIGURE 10.4 (concluded)

provided in Figure 10.4, which is keyed to the step numbers above. For example, for step 3 Oakmark Select, a large blend fund, is compared with the S&P 500 Index, demonstrating the amount by which the fund generally outperformed this index. Finally, a significant number of financial planners use modern investment theory risk–return concepts such as overall portfolio analysis and examination of beta, alpha, standard deviation, and correlations. Although some planners use a passive approach including index funds, the majority use these figures to support rather than provide automatic approval for an investment in the decision-making process. In other words, modern investment theory statistics are one ingredient to help an advisor make a judgment as to when to make changes in a portfolio.

FINALIZE AND IMPLEMENT THE PORTFOLIO

At this point, the entire portfolio is checked overall. The following questions may be asked: Is the portfolio consistent with the overall tolerance for risk? Can risk be reduced with little sacrifice in return? Simply put, am I properly diversified and will my portfolio produce attractive returns? Further changes may be made to accomplish these objectives. When finished, the portfolio is implemented. An example of the diversification process by financial asset category is given below.

Example 10.3 Steve, who is 45, has set up his own strategic asset allocation based on his tolerance for risk. Because of current circumstances, Steve decides to vary his approach slightly and adopt a tacti- cal asset allocation instead. He believes that inflation will be higher than what investors expect and observes that small cap funds have valuations well below their historical level relative to mid and large company stocks. He further believes that large cap stock valuations are high relative to historical levels. Steve does

288 Part Three Portfolio Management

Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Stocks

Small cap 10% 20% Attractive relative valuation Mid cap 5% 5% Large cap 20% 10% Unattractive relative valuation International 15% 15% REIT 5% 5% Total Stock 55% 55%

Bonds

Short-term 5% 10% Not as affected by higher inflation Intermediate 15% 5% Higher-than-expected inflation is

anticipated to result in weak performance

Long-term 5% 0% Same as intermediate, only even weaker results

Inflation-indexed 0% 10% Benefits from higher inflation High-yield 10% 5% Can be negatively affected by higher

interest rates Total Bond 35% 30%

Money market 10% 15% Will easily reflect expected increases in current interest rates

Total 100% 100%

not think bond-fund managers can predict interest rates but believes they can take advantage of relative valuations among sectors of the bond market. He has two short-term bond funds he is looking at: one has had the highest absolute return, the other the highest risk-adjusted return. He also has two small cap stock funds that are almost identical in most respects. An exception is that one has a correlation with the S&P 500 of .90 and the other a .30 correlation. Steve’s strategic and tactical asset allocations are shown below along with an explanation of the difference.

Journal of Finance

Financial Analyst Journal

Journal of Finance

Review of Financial Studies

Journal Of Portfolio Management

Practical Comment Behavioral Principles

Chapter Ten Financial Investments 289

They can appreciate the - -

- -

Practical Comment Understanding the Portfolio Concept

Basketball A team with four high-scoring, high-ego players may benefit from adding a player who cannot shoot a ball himself but knows how to pass well and can keep the others happy and productive.

Dressing style Individual items of clothing may be attractive in themselves, but care must be taken that they don’t clash when putting together a daily “dressing portfolio”—for example, wearing a plaid shirt, tie, and jacket all at one time.

Salad Vinegar might be an unpleasant taste by itself but can produce a pleasing taste in a salad of fresh vegetables.

Journal of Finance

Even though it had a lower absolute return, Steve selected the short-term bond fund with the highest risk-adjusted performance knowing that there typically is no “free lunch” for returns as far as investment performance is concerned. He also selected the small cap fund with the lower correlation coefficient, which he figured would reduce his portfolio risk while adding to the asset category he preferred.

REVIEW AND UPDATE THE PORTFOLIO

As time moves on, the economic outlook and relative valuations change, as do household circumstances. Both passive and active investors must take into account current actual allocations relative to strategic ones and consider making changes. Active investors may want to purchase newly attractive securities and sell old ones that no longer fit perfor- mance requirements. A performance evaluation reviews past results. It should be done for an existing portfo- lio with the goal of answering the following questions: “How did I do?” “What were the reasons for the under- or overperformance?” “What can I do to improve future perfor- mance?” The evaluation also should be done when examining a potential future holding as,

290 Part Three Portfolio Management

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Financial Investments

Chapter Ten Financial Investments 291

for example, a mutual fund. The questions to be answered in both cases are somewhat similar: “How did the investment do?” “What were the reasons for the under- or overper- formance?” “What does it suggest for future performance?” “How does or will that fund and its performance fit into my portfolio?”

Back to Dan and Laura FINANCIAL INVESTMENTS Dan and Laura came prepared for our discussion on financial investments. They had thought about the investments they were attracted to and mentioned to me that they be- lieved that smaller companies were to their liking in general and that they considered them particularly attractive at that point in time. They also believed that biotechnology had great potential, as did China, and wanted my opinion about investing in all these areas. They were concerned that inflation was going to increase over time. Our discussion on tolerance for risk was a little more difficult. Dan was fairly conser- vative, saying they didn’t have enough money and couldn’t afford to lose it. He was concerned over the fluctuations in the current prices of stocks, preferring a mix of 40 percent in stocks and 60 percent in bonds. Laura, on the other hand, said that investing represented a terrific opportunity for those willing to take it. If they lost money, they had plenty of time to make it up. She wanted 80 percent in stocks and 20 percent in bonds. She said Dan was always concerned over the current price of a stock. He replied that she was always optimistic. After discussion among the three of us—I had the feeling that we all knew what the outcome would be at the beginning of the conversation—we decided on a 60 percent stock, 40 percent bond mix. They had their own economic scenario with normal economic growth but believed that higher inflation than generally expected would arrive fairly soon. They knew that I was a fi- nancial planner who provided ongoing investment management services and asked for some information on how I would manage their money. However, they wanted to maintain control of their assets until the financial plan was completed before deciding on investment manage- ment services. In the meantime, they would implement the recommendations I gave to them.

Here’s my response: We are up to the investments portion of the financial plan. I am going to incorporate in it most of the basics of an investment policy statement for both of you as part of the presenta- tion. The investment policy statement serves as a guide for the management of your port- folio. This statement, which I will present informally, includes many of the steps in my asset allocation process for you. It ensures that we are “on the same page” as to your per- sonal requirements and our investment approach for you going forward. Before we do that, however, I want to review some overall capital market variables. The first is that the outlook for stocks and bonds is strongly influenced by risk and return: In general, the higher the risk, the higher the return. For some, it indicates that most securities at any point in time are efficient; their current prices fairly reflect the outlook. For exam- ple, if it looks to you as though a bond had a very attractive yield and therefore high cash return, chances are it is because it has a higher risk attached to it. On the other hand, other people believe in mean reversion. Those people, many of whom have a value-oriented style of investing, buy out-of-favor stocks that are “bargains.” They have the conviction that a disciplined person can take advantage of the temporary mispricing of securities. Mean reversion implies that stocks that are temporarily selling for a lower price than they should will return to their fair value over time.

292 Part Three Portfolio Management

There are, of course, other styles of investing that attempt to take advantage of what are thought to be opportunities in individual securities or even the overall market at certain points in time. One, purchasing the fastest-growing companies available, is called the growth style of investing. There is a significant difference between efficient markets and mean reversion and between value and growth investing. Efficient market people believe you cannot consistently outperform the market; they prefer a passive approach to investing. They emphasize keeping expenses low and concentrating on proper diversification to reduce risk. Efficient market people generally use index funds to implement their investment strategy. People who employ mean reversion, one form of value investing, generally believe that strong research and control over emotional reactions can lead to better- than-average returns. This brings us to your asset allocation and my investment policy statement for you. You have several goals that we deal with in other parts of the plan, but your overriding goal for our purposes today is your desire to retire in 20 years. Thus, your time frame is longer term. Liquidity is not as large an issue for you, as we have stated, but not for the retirement monies already accumulated and to be invested in the future. We will be setting aside an emergency fund over time. In the interim, as you have indicated to me earlier, you can bor- row from Laura’s parents for any emergency. You seek above-average returns and your risk tolerance, while somewhat different for each of you, is nonetheless consistent with that objective. In other words, your risk–return objectives are in line. We will be thinking of tax consequences as part of our investment policy. For example, given their higher after-tax returns, tax-free municipal bonds of your state are likely to be used. Some people have restrictions on types of stocks, such as not allowing tobacco stocks, but you have not indicated any such requirement. For the time being, we will limit purchases to mutual funds. Mutual funds, in my opin- ion, provide the best balance of capable management and relatively low cost. They allow anyone to diversify widely in order to reduce risk and to take advantage of fund manager expertise in specific sectors of the bond and stock markets. We will employ an active approach to portfolio management. By portfolio management, we mean looking at your financial assets overall, making sure that they fit your return and risk requirements as represented by your asset allocation. Our approach of diversifying widely can handle the sometimes overlooked part of supervision—correlation. Correlation indicates the relationship between assets, the degree to which they react similarly to the same variables. All other things being equal, the lower the correlation, the lower the portfolio risks. For example, investments in Japanese stocks are going to be less correlated with U.S. ones than one large-sized economically sensitive U.S. industry is with another—say, retail stores and appliance stocks. I employ a diversified style of investing, but with a value tilt. I base the portfolio on a longer-term investment horizon. An asset allocation provides the average weighting of securities by category in the portfolio over time. The average percentage weightings over the longer term are called a strategic asset allocation. I do not try to time the market. I do attempt to take advantage of disparities in valuations at the present time. In other words, I try to moderately overweight those areas that appear to be attractive at the present time. For example, in the third column of the table I’m presenting to you I have overweighted international stocks because they seem to be fairly priced and provide attractive returns. On the other hand, I have underweighted REITs (that represent your real estate holdings), which, in my opinion, are overvalued at the moment. Unlike timing the market, which implies turnover for short-term profit, this approach expects that over the intermediate or longer term, our overemphasis of certain areas will lead to higher

Chapter Ten Financial Investments 293

returns. I call the portfolio breakdown that I have placed in the third column our tactical asset allocation. Based on those principles and an overall economic scenario, I have constructed your strategic and tactical asset allocations. They are shown in the accompanying table. Notice the wide diversity of asset classes in both stocks and bonds. In bonds they range in risk from short-term bonds, being the safest, to high-yield bonds, the most risky. Similarly, for stocks they extend from larger capitalization companies, which have the least risk and lowest expected return, to small capitalization companies, with the greatest risk and highest potential return. Notice also that I have included an allocation in interna- tional securities. Part of that allocation includes an investment in a China fund; I believe the securities in this fund to be reasonably priced currently relative to prospects. International securities have the potential to lower your portfolio’s overall volatility, even if they themselves are more volatile. Based on our discussions, I have provided a breakdown of a diversified portfolio of 60 percent stocks, and 40 percent bonds and money market funds. It stands in contrast to your current portfolio, which has 75 percent concentrated in large cap stocks and the rest in cash. The long-term bond area has not been given an allocation because, historically, inter- mediate-term bonds over longer periods have provided about the same returns but with lower risk. In view of your concern about inflation, I have placed more money in the short-term area and underweighted intermediate-term bonds in the tactical allocation. This allocation is more oriented to the current outlook. Shorter-term bonds will be affected less than inter- mediate ones in any rise in inflation. My recommendations will come in the form of mutual funds. I believe that funds offer an attractive alternative of expert management and ability to diversify widely. In sum, I have provided a diversified portfolio of investment that should assist you in achieving sufficient funds to meet your life cycle needs.

Asset Category Current

Allocation Strategic

Allocation Tactical

Allocation Standard Deviation

10 Year38

Stocks

Small cap – 10% 14% 19.6 Mid cap – 8% 10% 18.1 Large cap 75% 20% 18% 15.6 International – 17% 20% 19.6 Real estate funds39 – 5% 3% 23.5 Total Stock 75% 60% 65% 18.4

Bonds

Short term – 10% 15% 2.0 Intermediate – 15% 8% 3.5 Long term – 5% 0% 10.0 High yield – 5% 7% 9.5 Total Bond 0% 35% 30% 4.2

Money market 25% 5% 5% 0.5 Total 100% 100% 100% 13.3

38 10-year data from Morningstar® Office® for the period November 11, 2004, through November 11, 2014. © [2014] Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc., of any investment philosophy or strategy presented in this publication. 39 Includes traditional real estate funds and REIT funds.

294 Part Three Portfolio Management

College Student Case Study and Review: Amy and John FINANCIAL INVESTMENTS Amy and John arrived early for our meeting because Amy was anticipating this discussion. She knew very little about investments and had some money left to her by her grandfather. She said today’s topic, financial investments, was “news she could use today.” John joked that though his stepsister was extremely bright, she was so inexperienced in investments she thought common stock were cattle from a ranch in Texas. I interjected telling John to let Amy express herself. Amy proposed that we treat the topic as an investment plan for her $20,000 inheritance. Such a plan would summarize the components of financial investments and apply it step- by-step to her money. I explained to her that investments aren’t meant to be built up forever but to be accumu- lated for use for a specific purpose with the most common strategic use to help fund retirement. Asset allocation is how much is put in each category of assets, with stocks and bonds being the most typical category. As she requested, I presented the information step-by-step.

A. Establish Goals How you invest the money depends on what you want to do with it. Amy quickly said her grandfather had wanted the inheritance to be used as a down payment on a home, and that she would honor that request, probably within the next 10 years.

B. Consider Personal Factors Each individual has certain personal characteristics shaping his or her goals. For example:

1. The length of the investment period as determined by the time until the money will be spent. 2. Liquidity needs—the need or ability to convert the investment into cash. 3. Current available resources—what you have available. 4. Projected future resources—how much your resources are projected to grow based on

anticipated future cash flow, and savings and investment return on that cash flow. Both can help determine the amount of risk you should take.

5. Taxes—the percentage the government will take of future cash flows influences the type of investment.

6. Restrictions—practical or behavioral limitations on the type of investments. 7. Risk tolerance—an overall limitation on risk taken, based on factors such as personality

and resources.

Amy said, “I can answer those questions. I won’t buy a home until I get married. I don’t expect that to happen for 10 or more years. My parents are likely to give me money to support me in case of an emergency. I already have $20,000 in resources. One of my concerns is that if I keep the money in the bank I’ll spend it down over time on things I don’t really need. If I put it in a separate investment account and purchase stocks and bonds I am not likely to touch that money.” “I don’t expect to have further savings until I graduate and find a job but that shouldn’t be too long from now. I expect to start working in about 1½ years, after a two-month trip across Europe, which will be a promised graduation present from my mom and dad.” “My tax bracket should be low, the fashion industry trades off low salaries against glamor. I have no restrictions against investment asset classes. My risk tolerance is high. I expect to have a long life and successful career and if I lose it all at this age, I’ll just work harder.”

Chapter Ten Financial Investments 295

John and I looked at each other in amazement. It was clear that Amy had thought about and knew more than we had believed. I made a mental note that good things happen when people are interested in and motivated by a topic. Altogether, Amy’s responses indicated that she could hold a broad range of asset classes, with an allocation skewed toward vola- tile holdings such as equities. Accordingly, I proceeded with my presentation.

C. Include Capital Market Factors The most basic rule in investments, in theory and often in practice, is that prices for growth come from two variables, risk and return. Basically the higher the risk the higher the ex- pected return; if an investment has higher risk why would anyone buy it without the expec- tation of higher return? Generally, risk and return move proportionally higher together. The Capital Asset Pricing Model (CAPM) as an investment theory is based on risk and return. Risk is divided into systematic risk, the risk coming from the overall market and unsystematic risk, the chance for loss arising from the specific asset. In a large portfolio, unsystematic risk is diversified away (disappears) because worse than expected losses for some stocks are offset by other holdings with better than expected results. The remaining risk is identified by the beta coefficient, which is the movement in an individual holding or the entire portfolio as compared with an appropriate overall stock market index such as the S&P 500 or the Dow Jones Industrial Average. The overall index has a beta of one, lower-risk stocks have a beta below one, higher-risk ones above one. An alternative measure of risk is the standard deviation. It measures the amount of price fluctuation around the investment’s average price; therefore, unlike the beta, which is lim- ited to systematic risk, it measures the entire risk of the asset or portfolio. Both measures have the advantage of providing an objective measure of risk based solely on asset or port- folio price fluctuations instead of people’s opinions. Under CAPM the expected rate of return is equal to the risk-free rate, often the yield on a short-term Treasury bill, plus a risk premium. Each stock has its own risk premium and investors demand that the risk premium be higher for those securities that have higher risk, or as I mentioned they won’t buy it. The efficient market hypothesis (EMH)* is another part of modern investment theory. It says that all prices for investments already include all available information, and whether new information will be positive or negative news cannot be predicted in advance. This new information is rapidly built into the price of the shares. In other words, according to this theory don’t try to select stocks or mutual funds that outperform the market, you’re wasting your time and money. Buy mutual funds or exchange traded funds (ETFs) with razor thin costs that attempt to duplicate the market’s performance. John asked how EMH theory has done in practice. The answer is mixed: most investors have trouble outperforming the market, but tests show that it is possible, particularly for secu- rities about which people are extremely negative. An example would be those that are priced cheaply relative to their earnings. Another theory called mean reversion may be considered. It says that EMH works out over long periods of time; as stocks are stretched over the longer term, prices in the marketplace become what they should be. Mean reversion provides more hope that people can benefit from getting an edge in selecting cheap stocks by analyzing them carefully and thinking independently. Amy said thinking independently and buying when stocks were cheap was her type of approach. Then Amy glanced at John, who rewarded her with a smile of approval.

D. Identify and Review Investment Alternatives We discussed which investments would be suitable for Amy. I mentioned I thought they come down to individual stocks, bonds, and mutual funds. Bonds, I mentioned, were contracts

*See Appendix I for information on efficient markets and mean reversion.

296 Part Three Portfolio Management

between the lender and the borrower with the borrower agreeing to pay interest annually, generally at a fixed rate, and to repay the amount lent at the maturity date. With all elements generally in place contractually, bonds in many respects are safer than stocks. Common stocks, also called equities, are risker because they represent ownership, not lend- ing as in the case of bonds. When business operations work out well you can make a great deal of money; when they do not, you can lose part or all of your investment. Stocks vary by such factors as the sector of the economy and industry they operate in, their geographic area (domestic or international), the size and quality of the company, and their relative growth rates. Mutual funds are organizations that invest in stocks and/or bonds. They offer the expertise of professional managers and wide diversification of investments with professional record keeping and general information, all at relatively low cost. They can do so because of econ- omies of scale as all investors’ monies are integrated for common purchase, but maintaining separate share ownership in the fund with record keeping included at no extra charge. Mutual funds vary by many of the same characteristics as stocks and bonds. There are three size categories: small, mid, and large cap. For stocks they are generally separated by size and style. Size can be small cap as in your local steakhouse with five locations having a public offering so they can keep growing to, say, IBM, a large cap company with mid cap somewhere in between as measured by stock market value. The style of investing categories include growth, blend, and value. Growth managers buy the higher quality, faster growing companies. Value managers place more emphasis on price, purchasing companies that are cheap relative to fundamentals. Blend is in between or employs a different style altogether. John volunteered that he liked the value style because it reminded him of the way he purchased other products, which was to find quality goods at the cheapest prices available. I agreed with John that while growth and value vary in popu- larity and performance, over long periods of time value may exceed growth in results. Herd instincts and lack of patience for long-term vision attribute to the popularity of growth funds. Critical thinking investors can analyze and take advantage of relative degrees of over- or undervaluation over time by investing in value funds.

E. Evaluate Specific Investment Considerations I wanted Amy and John to evaluate two choices. The first choice was whether they were going to adhere to the efficient markets hypothesis and take a passive approach to investing or select an active approach and attempt to outperform the market. The second choice was whether to select individual securities or mutual funds. Amy once again said she wanted an active approach to investing, saying it fit her personality to try to get the best, not the almost guaranteed mediocre performance from a passive approach. She thought that mutual funds were right for her because she had neither the time nor the interest to select individual stocks. John generally agreed, although he said he would maintain the right to put a small portion of his portfolio in more specialized stocks that had the potential to “become another Apple.” We then discussed how to select mutual funds. An entire system has been developed including:

1. The goal of the funds and other descriptive information. 2. The investor’s preferred size and style. 3. The portfolio’s performance relative to other funds in the same category. 4. The portfolio’s risk. 5. How consistent past performance has been. 6. How long the portfolio manager has been there. 7. The fund’s size. 8. Its overhead costs called the expense ratio.

Chapter Ten Financial Investments 297

The alternative I would consider is looking at a Morningstar sheet for the fund. In basic form it is available free online. That company is the originator of the concept of classifying a stock fund by its investment style and the size of the companies it holds.

F. Employ Portfolio Management Principles Our discussions to date have been about individual holdings. Yet what we end up with is a portfolio of assets. The portfolio has its own characteristics including an overall growth rate and a measure of overall risk. But there is another factor that enters. Most everyone knows that people should diversify their investments. Many don’t know that their investments are likely correlated with each other, meaning that to some extent they move together when relevant events happen. The degree to which they move together is measured by the corre- lation coefficient with a low correlation, say 0.10, being generally more desirable than a high one of 0.95. A low correlation among assets at the time of a negative event can mean an anchor against a sharp decline in asset valuation for one segment of the portfolio. Assets with negative correlation to one another are even better, but are harder to find. While we are on this topic you should embrace some of the TPM® principles that we discussed in earlier meetings. Keep in mind that all assets and liabilities will enter into your household portfolio once you graduate and are working. It would include not only financial assets but human assets, human-related assets, and real estate assets. For example John, if you do become a financial planner, the firm you work for will generate part or all of its revenues from asset management fees on stocks and bonds. You should consider placing above-average emphasis on other assets such as real estate. Otherwise your career, a human asset, and financial assets may be too highly correlated with each other. For the moment, with each of you as undergraduate students living at home and not set on your ultimate careers, I believe we can make decisions based on financial assets alone.

G. Implement Portfolio Management Decisions I mentioned to John and Amy that it was time to review all of the key steps in establishing their financial portfolio:

Active versus passive investment style. You have decided on an active investment style that will require more asset review and some buys and sells over time. Construct a strategic asset allocation. A strategic allocation is your long-term break- down of assets in your portfolio. It is the allocation that you return to after particular circumstances, such as preparing for the possibility of a recession, have cleared up.

Both Amy and John mentioned that they were young and wanted to take above-average risk. They decided on a portfolio of 75% stocks and 25% bonds. Amy chose to put everth- ing in mutual funds and John put all but 5% in mutual funds with that modest amount placed in stocks with above-average risk.

H. Develop a Tactical Allocation A tactical allocation is one that deals with the realities at the present time. Two very impor- tant areas are the outlook for the economy and the stock market, and how components have been faring. I decided to provide them with some overall information from my perspective. I thought the economy would grow nicely over the next several years, and larger companies in the United States and abroad would do particularly well. I believed that interest rates, now down sharply from their norms, would rise gradually making existing holders of bonds subject to low returns relative to historical figures. Each decided to overweight in stocks, particularly large caps, and to underweight inter- mediate and longer-term bonds, which I said could be most hurt by a rise in interest rates.

298 Part Three Portfolio Management

I. Finalize and Implement the Portfolio The next step for Amy was to select and finalize the individual investments under each of the categories listed. John had little money to invest and I thought would go for high fliers, midway between risky legitimate stocks and Las Vegas gambles. I wanted to mention to Amy to not neglect correlation coefficient in her search for individual holdings. However, I decided she had investment information overload and passed on it for another time.

Summary Financial investments are generally the instruments for building assets for your future use. Without them, you would have difficulty funding those things you care about.

Stocks

Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Small cap 15% 12% Valuations too high Mid cap 7% 5% Outperformance will lead

to mean reversion Large cap 28% 31% The best domestic

outlook International 20% 22% Faster growth than U.S. REIT 5% 5%

Total Stocks 75% 75%

Bonds

Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Short term 4% 8% Hedge against rising rates Intermediate 8% 4% Adversely affected by

rising rates Long term 4% 1% Adversely affected by

rising rates Inflation indexed 3% 3% High yield 3% 4% Stronger economy results

in more confidence in low quality bonds

Total Bonds 22% 20%

Money Market

Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Money market 3% 5% Hedge against rising rates

Total 100% 100%

Chapter Ten Financial Investments 299

- able current resources, projected future resources, taxes, restrictions, and risk tolerance.

market will be unsuccessful.

and the Markowitz approach includes correlations among them. -

tions in its risk–return framework. -

cal one makes cyclical changes based on opportunities at the time.

Key Terms active approach to investing, 278 asset allocation, 267 blue chips, 274 bonds, 273 correlation coefficient, 279 cyclical stocks, 274 defensive stocks, 274 efficient market hypothesis (EMH), 295

growth stocks, 274 growth style of investing, 276 index fund, 277 insurance risk, 266 investment risk, 266 maturity date, 273 mean reversion, 278 mutual fund, 274 passive approach to investing, 277

portfolio, 279 risk premium, 295 risk tolerance, 269 speculative investments, 274 systematic risk, 295 unsystematic risk, 295 value style, 276

finance.yahoo.com Yahoo’s Finance Portal This site provides a wide array of financial information for students and beginning investors. It presents key statistics, financial statements, analyst opinions, news and charts for the majority of U.S. and world market stocks, mutual funds, ETF, indices, and options. It also contains links to a number of topics in investing and personal finance.

naip.com National Association of Investment Professionals This organization provides information geared to the interests and needs of individu- als working in the financial services industry. The site has links to resources of secu- rities laws, rules, and regulation information. It covers topical information for investment professionals.

investopedia.com Investing Glossary Information for students and beginners in the finance field. The site contains a rich dictionary with finance term definitions, explanatory tutorials, useful articles, finance exam information, and tools such as financial calculators and free trading kits.

Websites

300 Part Three Portfolio Management

investorguide.com Investor Information While the previous website is more educational, this site offers current market infor- mation, quotes and charts, news and comments, and research company information. It also has a glossary of finance terms.

Websites of U.S. and world stock exchanges include

nyse.com NYSE Euronext This is the website for the multiple exchanges, including the New York Stock Exchange, NYSE Euronext, NYSE Amex, and NYSE Arca.

nasdaq.com NASDAQ

tse.or.jp/english Tokyo Stock Exchange

londonstockexchange.com London Stock Exchange

1. Explain why under CAPM company risk can be diversified away. 2. Under the EMH, can you outperform the market? 3. Under the weak form of the EMH, if you are given the following recent day price

performance:

Questions

Day 2 Days Ago The Day before Yesterday Yesterday Today

Price 6 7 8 9

is the likely future performance higher than nine? Why? 4. Under the semistrong form of the EMH, should you read an annual report? Why? 5. Investing abroad has substantial individual asset risk. Why invest in it then? 6. Why can real estate be an attractive portfolio holding? 7. What are the strengths of mutual funds? 8. What are the weaknesses of mutual funds? 9. What types of investments are most appropriate for short-term needs? 10. What kinds of investments are best suited to saving for the down payment on a house

to be made in three years? 11. What types of investments are suited to retirement planning at age 67 assuming the

person is 55 and has an average risk tolerance? 12. What are the advantages of a passive approach to investing? 13. How has mutual fund performance compared with overall indexes? Why do you think

that is the case? 14. How are income taxes determined for mutual funds? 15. Stock A and stock B have no correlation. Does that mean we don’t have to include

correlation in calculating portfolio return? Explain. 16. Stocks C and D move in opposite directions. Does that mean they have no correlation?

Explain.

Chapter Ten Financial Investments 301

Problems Gennaro purchased a stock for $24 that paid $2.00 at the end of each year in dividends (dividends remained level over time). He sold it four years later for $28 at the time of the last dividend payment. What was his IRR? A stock has an expected rate of return of 9 percent and the risk-free rate is 3 percent. What is the risk premium?

10.1

10.2

“Stock prices adjust rapidly to the release of all new public information.” This statement is an expression of which one of the following ideas?

a. Random walk hypothesis. b. Arbitrage pricing theory c. Semistrong form of the EMH d. Technical analysis

If the client needs to accumulate wealth but is risk-averse, which of the following is the most crucial action the planner must take to have the client achieve the goal of wealth accumulation? Advise investing the client’s current assets

a. In the products that will bring the highest return to the client regardless of risk. b. In products that produce high income for the client because fixed-income products are

generally safe. c. In diversified mutual funds because of the protection that diversity provides. d. After determining the client’s risk tolerance. e. In 100 percent cash equivalents in the portfolio because most software programs recom-

mend this safe approach.

If the market risk premium were to increase, the value of common stock (everything else being equal) would

a. Not change because this does not affect stock values. b. Increase in order to compensate the investor for increased risk. c. Increase due to higher risk-free rates. d. Decrease in order to compensate the investor for increased risk. e. Decrease due to lower risk-free rates.

Which of the following are nondiversifiable risks?

1. Business risk. 2. Management risk. 3. Company or industry risk. 4. Market risk. 5. Interest rate risk. 6. Purchasing power risk.

a. 1 and 3 only b. 1 and 4 only. c. 2 and 4 only. d. 4 only. e. 1, 2, and 4 only.

10.1

10.2

10.3

10.4

CFP® Certification Examination Questions and Problems

302 Part Three Portfolio Management

Modern “asset allocation” is based upon the model developed by Harry Markowitz. Which of the following statements is/are correctly identified with this model?

1. The risk, return, and covariance of assets are important input variables in creating portfolios.

2. Negatively correlated assets are necessary to reduce the risk of portfolios. 3. In creating a portfolio, diversifying across asset type (e.g., stocks and bonds) is less ef-

fective than diversifying within an asset type. 4. The efficient frontier is relatively insensitive to the input variable.

a. 1 and 2 only. b. 1, 2, and 3 only. c. 1 only. d. 2 and 4 only. e. 1, 2, and 4 only.

A client has a $1,200,000 portfolio consisting of the following four stocks:

1. $300,000 ABC @ 1.1 beta. 2. $225,000 RTR @ 0.7 beta. 3. $405,000 XYZ @ 0.3 beta. 4. $270,000 PDQ @ 1.3 beta.

What is the beta of the portfolio as a whole?

a. 0.8. b. 0.85. c. 0.91. d. 1.0.

A young, single client approaches a CFP® professional with $5,000 stating that he would like to develop a financial plan and invest in the market. This is his first experience invest- ing and he like help choosing he appropriate account. What is the CFP® professional’s most appropriate course of action?

a. Open a brokerage account with margin. b. Open and fund a Roth IRA for the current year. c. Determine whether the client has any consumer debt. d. Determine whether the client has adequate life insurance.

10.5

10.6

10.7

Chapter Ten Financial Investments 303

Case Application FINANCIAL INVESTMENTS When it came to investments, Richard and Monica could agree on only one thing—that they would have a tough time reaching a decision on asset allocations and individual investments. Previously, Monica had deferred to Richard on investment matters. Given Richard’s large recent investment loss, however, Monica was much more forceful in expressing her feelings. She thought that a 40 percent stock, 60 percent bond allocation fit, particularly given the lower level of accumulated wealth they now had. Richard, on the other hand, wanted 100 percent of the funds placed in stocks. He asked if it wasn’t true that stocks always did better than bonds over the longer term. He said that to reach their goals, they needed some aggressive investments. Monica interrupted, saying it was just that “stocks-had-no-long-term-risk” mentality Richard had that led to their invest- ment losses. Richard then volunteered that there was an oil stock, “Energy Gulch,” a friend of his recommended that “couldn’t lose.” He wanted to place 20 percent of his money in it.

Case Application Questions 1. What do you think of the Richard and Monica argument? 2. Using the asset allocation alternatives listed in this chapter as a guide, what should their

asset allocation be? Why? 3. What do you think of the Energy Gulch idea? Why? 4. Select one mutual fund you find attractive and give the reasons why you chose it. 5. Complete the investments section of the financial plan.

Appendix I

Modern Portfolio Theory This appendix will distill many of the key points pertaining to modern portfolio theory, and the capital asset pricing model, the leading approach taught in financial courses. The capital asset pricing model (CAPM) is a specialized modern investment theory model that is based on risk-return principles. Its risk is received by measuring price change of a security relative to a benchmark’s price performance. The benchmark for large company stocks is usually the S&P 500, the Standard and Poor’s index of the 500 largest companies in the United States. The risk measurement is called the beta coefficient and the higher the price fluctuation of a security relative to the benchmark’s movements, the higher the security’s beta coefficient. The benchmark is automatically given a beta of 1 and stocks or mutual funds of stocks having a beta coefficient higher than 1.0 are deemed to have more risk than the market, while those having a beta less than 1.0 have below-average risk. Unlike the standard deviation, the beta coefficient doesn’t claim to measure total risk, just systematic risk. Systematic risk is the risk of overall market factors such as the econ- omy, inflation, interest rates, and the stock market. In contrast, unsystematic risk is risk related to an individual company such as a decline in market share, the loss of a key patent,

304 Part Three Portfolio Management

and so on. CAPM says individual company risk can be diversified away when you hold a large portfolio of securities. Therefore, CAPM says that all you need to know is systematic risk as measured by the beta coefficient. The standard deviation and the beta coefficient have a strong advantage. Unlike funda- mental measures of risk, they both can be measured objectively. For each measure, the higher the figure, the higher the risk. In most instances, beta coefficients and standard de- viations are developed by independent investment services such as Morningstar and Value Line, and their newsletters are available in many libraries. As a practical matter, all you need to remember is that a beta higher than 1.0 equals above-average risk; a beta below 1.0 equals below-average risk.40 Also keep in mind that both the beta and the standard deviation are best used when comparing securities that are similar to each other. For a more detailed explanation of beta coefficients, see Web Appendix A: Modern Investment Theory.

Example 10.A1.1 Dana was down to one of two choices of investments in her pension plan at work. She wanted growth of assets, was fairly aggressive in her investment tolerance for risk, and, therefore, chose from stock, not bond, mutual funds. She went to the library and found results for her pension plan’s two stock alternatives. The first fund, the Oaktimber Fund, had a beta coefficient of 0.75 and a standard deviation of 15.8. The second, the Advanced Horizon Fund, had a beta of 1.54 and a standard deviation of 31.2. Both mutual funds invested in large companies. She looked up an S&P 500 index fund that had statistics very close to those of the actual index and found its beta to be 1.0, as she thought. She knew that the S&P was the benchmark of large company performance and 1.0 meant average. She also found out that the S&P 500 had a standard deviation of 21.0 for the past period being measured. Dana instantly recognized that the beta coefficient of 1.54 for Advanced Horizon was well above the market, signifying higher-than-average risk. The standard deviation also was sub- stantially above the market’s 21.0. She also noticed that Advanced Horizon’s three-year return of 13 percent a year was well above Oaktimber’s 9 percent a year. She thought to herself, the higher the risk, the higher the return. She picked Advanced Horizon, which best fit her high risk tolerance.

EXPECTED RATE OF RETURN Under modern investment theory, the expected rate of return combines risk–return princi- ples to arrive at a projected future return. As the equation below indicates, the expected rate of return is equal to the risk-free rate plus a risk premium. Therefore, the risk premium is the extra return that compensates you for the additional amount of risk you are taking with a particular security over a completely safe one.

Risk-Free Rate and Risk Premium The risk-free rate, the completely safe one, is the rate of return you require even if there is no risk. The yield on 30-day U.S. government Treasury bills is generally used to gauge this rate.41

The risk premium depends on the degree of risk undertaken. For example, a nearly bankrupt airline will have a much higher risk premium than a leading high-quality food company.42

40 Relative to its benchmark. 41 Some would say 90-day or 10-year government issues are more appropriate depending on the time horizon for the investment. 42 The investor may use either the standard deviation, the beta coefficient, or more judgmental factors as inputs in establishing the risk premium.

Chapter Ten Financial Investments 305

The risk-return characteristics of various securities are demonstrated in Figure 10.A1.1. Notice that the risk-free rate appears right on the expected return line. That is because it is viewed as having no risk. The diagram shows that the more risky the security, the higher the risk premium and the higher the expected or required rate of return.43

Example 10.A1.2 Brad had two investments: one in government bonds, the other in a speculative stock fund. Over a five-year period, he received an average return of 5 percent a year in government bonds and 5.5 percent for the speculative fund. Brad thought to himself that he made more money in the stock than the bond. Yet he was dissatisfied with his stock performance. He felt he should have received higher return for the risk taken. In other words, his risk premium should have been more than 0.5 percent a year.

THE EFFICIENT MARKET HYPOTHESIS The efficient market hypothesis is one of the basic assumptions of a pure risk–return approach. When risk and return are exactly correlated, all investments sell at the prices they are expected to. As you can gather, the efficient market hypothesis (EMH) deals with investment information and valuation of individual securities. It says that the best valuation for an individual security is its current market price. This price reflects all information known about the security. It is the fair price for the asset. When new information is issued, it is quickly incorporated in the price of the shares. A major conclusion of the EMH is that it will not be profitable to attempt to outperform the market. Even if there were people who were not fully informed or capable of apprais- ing shares, and their actions could create particularly appealing prices, other investors would quickly step in to take advantage. By doing so, these investors would eliminate any above-average profit opportunities.

Example 10.A1.3 Suppose a market analyst disclosed that, according to his tests, the length of women’s skirts was an indicator of the future direction of the market. Actually, there reputedly was such a theory some 75 years ago. Suppose that buying stocks when skirt lengths rose and selling them when they dropped resulted in a doubling in investment returns. This information would

43 For our purposes, expected and required rates of return are synonymous.

Expected Return

Risk-free rate

Risk

Government bonds

High-quality stocks

Corporate bonds

Speculative stocks

Security market line

FIGURE 10.A1.1 Security Market Line

306 Part Three Portfolio Management

spread quickly. The next step would be market analysts, portfolio managers, and television commentators positioned at the fashion openings of prominent designers to observe leading- edge fashion lengths. As soon as the new skirt lengths were known, the investors would communicate orders via cell phone directly to the floor of the stock exchange and via television to all viewers. This information, now known by all who would try to act on it, would be instantaneously incorpo- rated in stock prices. Knowledge of skirt lengths would no longer have investment use. The price of all shares would be efficient in that it would reflect all available information including the length of women’s skirts.

There are three forms of the EMH: the weak form, the semistrong form, and the strong form.

The weak form. The weak form deals only with price and volume for a security. It says that looking at current and past information on stock price patterns and the number of shares traded will not be useful. The semistrong form. The semistrong form states that all publicly available information is incorporated in a stock’s price. Therefore, not only information on price and volume but also fundamental analysis such as analysis of annual reports, brokerage firm recom- mendations, discussions with industry and company representatives, and so on, will not lead to better-than-average performance. The strong form. The strong form states that the share prices fully reflect not only pub- lic but also private information. Therefore, knowledge of information on a company’s outlook that has not yet been released to the public or other insider information is not useful.

In effect, the weak form says that technical analysis has no use. That is because tech- nical analysts use just price changes and volume to make predictions about future per- formance. If the weak form of EMH is true, then technical analysts are wasting their time. Some tests of this hypothesis have turned up anomalies—exceptions to efficient market beliefs and opportunities to use technical analysis for extra profit.44 The strong form has not been tested as often,45 perhaps because intuitively it does not seem logical that knowledge of what is going on inside a company before others know it would not be profitable. Most tests of the EMH have focused on the semistrong form and public information. It not only includes the weak form’s technical analysis it also extends efficiency to include all public information. It isn’t as broad as the strong form because it doesn’t include private information. Contrary to efficient market theory, a relatively broad array of opportunities for profitable investing has been found including purchasing depressed stocks early in

44 David P. Brown and Robert H. Jennings, “On Technical Analysis,” Review of Financial Studies 2, no. 4 (October 1989); and Yufeng Han, University of Colorado at Denver, Ke Yang, Washington University in St. Louis, and Guofu Zhou, Washington University in St. Louis, “A New Anomaly: The Cross-Sectional Profitability of Technical Analysis,” 2010, apps.olin.wustl.edu/MEGConference/Files/ pdf/2010/49.pdf 45 See Jeffrey F. Jaffe, “Special Information and Insider Trading,” Journal of Business (July 1974): 410–28; Nejat H. Seyhun, “Insiders’ Profits, Costs of Trading and Market Efficiency,” Journal of Financial Economics 16 (1986): 189–212; Lisa K. Meulbroek, “An Empirical Analysis of Illegal Insider Trading,” Journal of Finance 47, no. 5 (December 1992): 1661–99; and Utpal Bhattacharya, Department of Finance, Kelley School of Business, Indiana University, “Insider Trading Controversies: A Literature Review,” 2013, papers.ssrn.com/sol3/papers.cfm?abstract_id=2340518.

Chapter Ten Financial Investments 307

January,46 small cap stocks,47 those with low price to book,48 and those with low P/E multiples;49 eliminating or shorting those with high P/E multiples;50 purchasing those that have been neglected;51 and so on.

Mean Reversion and Efficient Markets As mentioned in the chapter mean reversion,52 as it relates to groups of individual securi- ties or overall markets, says that returns for securities tend to move toward average perfor- mance when the returns are examined over longer time frames. Therefore, if securities underperform for a period, they may be more likely to outperform later on. When their results are highly favorable for a period of time, they can be vulnerable to poor returns in the period beyond. Thus, in contrast to efficient market beliefs, future stock price move- ments may be somewhat predictable.53

46 See Michael S. Rozeff and William R. Kinney Jr., “Capital Market Seasonality: The Case of Stock Returns,” Journal of Financial Economics 3, no. 4 (October 1976): 379–402; Marc R. Reinganum, “The Anatomy of a Stock Market Winner,” Financial Analysts Journal 44, no. 2 (March–April 1988): 272–84; and Kathryn E. Easterday, Miami University Farmer School of Business, Pradyot K. Sen, University of Washington Bothell, and Jens Stephan, University of Cincinnati—Department of Accounting, “The Persistence of the Small Firm/January Effect: Is it Consistent With Investors’ Learning and Arbitrage Efforts?,” 2008, http://papers.ssrn.com/sol3/papers.cfm?abstract_ id=1166149 47 Rolf Banz, “The Relationship between Return and Market Value of Common Stocks,” Journal of Financial Economics 9 (March 1981): 3–18; Marc R. Reinganum, “A Revival of the Small-Firm Effect,” Journal of Portfolio Management 18, no. 3 (Spring 1992): 55–62; and John B. McDermott, Ph.D., Fairfield University’s Dolan School of Business, and Dana D’Auria, Symmetry Partners LLC, “What Do We (Really) Know About U.S. Small-Cap Investing?,” ” Journal of Financial Planning,” January 2014, fpanet. org/journal/WhatDoWeReallyKnowAboutUSSmallCapInvesting/ 48 Barr Rosenberg, Kenneth Reid, and Ronald Lanstein, “Persuasive Evidence of Market Inefficiency,” Journal of Portfolio Management 11, no. 3 (Spring 1985): 9–17; Eugene F. Fama and Kenneth R. French, “The Cross Section of Expected Stock Returns,” Journal of Finance 47, no. 2 (June 1992): 427–65; and Stephen H. Penman, Columbia University—Department of Accounting, Scott A. Richardson, Wharton School, University of Pennsylvania, PA, and I

. rem Tuna, Wharton School, University of Pennsylvania, “The

Book-to-Price Effect in Stock Returns: Accounting for Leverage,” 2005, finance.wharton.upenn. edu/~rlwctr/papers/0505.pdf 49 Sanjoy Basu, “The Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis,” Journal of Finance 32, no. 3 (June 1977): 663–82 50 Ibid 51 Avner Arbel and Paul Strebel, “Pay Attention to Neglected Firms!” Journal of Portfolio Management 9, no. 2 (Winter 1983): 37–42; and Cem Demiroglu, Assistant Professor of Finance, Koc University, Istanbul, and Michael Ryngaert, Graham-Buffett Professor of Finance, University of Florida in Gainesville, “The First Analyst Coverage of Neglected Stocks,” Financial Management, Summer 2010, portal.ku.edu. tr/~cdemiroglu/initiation.pdf 52 See Werner DeBondt and Richard Thaler, “Does the Stock Market Overreact?” Journal of Finance 40 (1985): 793–805; James Poterba and Lawrence Summers, “Mean Reversion in Stock Prices: Evidence and Implications,” Journal of Financial Economics 22 (1988): 27–59; Eugene Fama and Kenneth French, “Business Conditions and Expected Returns on Stocks and Bonds,” Journal of Financial Economics 25 (November 1989): 23–49; and Daniel Mayost, Canadian Office of the Superintendent of Financial Institutions, “Evidence for Mean Reversion in Equity Prices,” 2012, osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/ pp-do/Pages/mnrv.aspx 53 Nicholas Barberis, “Investing for the Long Run When Returns Are Predictable,” Journal of Finance 55 (February 2000): 225–64; John Campbell and Robert Shiller, “Stock Prices, Earnings and Expected Dividends,” Journal of Finance 43 (July 1988): 661–76.

308 Part Three Portfolio Management

Example 10.A1.4 Phil was interested in stocks in two industries: beverage companies and manufacturers of branded foods. They had the same beta coefficients. Over the past year, beverage companies had performed extremely well, rising more than the overall market, while food companies had actually declined in price. There was no fundamental news to account for the discrepancy in performance. Each industry’s earnings were in line with expectations. Phil believed that stocks and industries “come back” in price over time (reversion to mean performance) and chose to invest in the consumer food sector. Over the following year, he was rewarded with strong gains when their shares moved back to normal valuations, while the beverage companies underperformed the market. Over the combined two-year period before and after Phil’s analysis, both industries had the same average performance of 11 percent per year. Mean reversion had brought both industries back into parity.

Measuring Performance Performance should be measured both in selecting a mutual fund or a stock or a bond as well as in measuring our existing holdings’ results. For our purposes we will concen- trate principally on mutual funds; for a majority of people who have neither the time nor the inclination to follow stocks and bonds closely, investing in mutual funds is the appropriate choice. Performance for an investment should be measured on a risk-adjusted basis. That means including not only return for a period of time but the risk you took to obtain that return. If you bought a five-year bond in a nearly bankrupt airline that eventually repaid the debt and returned 5.5 percent a year, did you really outperform a 5 percent a year return available in a U.S. government bond? The answer from a risk-adjusted standpoint is no. Ask yourself if you would invest in a new issue by the same airline for a 0.5 percent extra return. Both the standard deviation and the beta coefficient measure risk—the standard devia- tion, total risk and the beta, and market risk relative to a market index. The Sharpe ratio, which is the return less the risk-free rate divided by the standard deviation, measures return per unit of risk. The higher the Sharpe ratio, the better the performance. The alpha coefficient provides actual return minus expected return, given market per- formance and the individual security or mutual fund’s beta coefficient. A positive alpha coefficient signifies market outperformance—the larger the alpha, the better the perfor- mance. A negative alpha coefficient signifies underperformance. The formulas and examples using these two performance measures are given in Part III of Web Appendix A. Figures for alpha coefficients and Sharpe ratios for mutual funds are available through publicly available mutual fund services such as Morningstar. Another method of measuring performance is comparing results for a fund with others like it. For example, a small cap value fund’s results are compared with other small cap value funds or a benchmark of that size and style. Given the variation in performance by size and style, this approach is used instead of comparing results with one generally recognized benchmark of performance for the market such as the S&P 500 or the Dow Jones Industrial Average. Some advisors use this approach exclu- sively; they assume that risk is taken care of by grouping investments into the same size and style grid.

Chapter Ten Financial Investments 309

III

Individual Fund Analysis The following are additional measures investors can take in analyzing funds. This informa- tion can be found via further research or with a subscription service such as Morningstar.

Look at the fund’s correlation coefficient. All other things being equal from an overall portfolio standpoint, the lower the correlation (R-squared) with the overall market, the more attractive the fund is. Identical price movements of a fund and the overall market index would result in an R-squared of 100. Weigh the growth of assets in recent periods. Many times when a fund has outstanding performance, it receives media attention and a large inflow of cash. The higher cash can force it to purchase larger securities or less-attractive ones than those that produced the record. The result can be a regression toward mean performance and, in some cases, underperformance. Look at tax efficiency. Observe whether a fund manager is concerned with taxes.

310

Chapter Eleven

Risk Management Chapter Goals

This chapter will enable you to:

Dan and Laura indicated they were uncomfortable with their current overall risk profile. They felt they didn’t have enough insurance. They asked that all their assets be reviewed to make sure they weren’t exposed to potential losses. Dan said, “We want all of our assets protected against loss. Please examine our assets and tell us what changes need to be made.”

Real-Life Planning The topic of risk management as we know it today did not exist 50 years ago. At that time, people and businesses were more concerned primarily with limiting their risks through the use of insurance. As businesses grew larger, their owners recognized that they were subject to a wide array of risks. Businesses not only had the risk of fire or stolen property to concern them. In addition, there was risk that raw materials’ prices would skyrocket or that their product line would meet more competition. There was risk of a sharp drop in the stock market. If they didn’t treat their employees well, there was risk of a strike or that valuable employees would leave. The more that businesses looked at it, the more they saw that they had to assess their risk overall. In effect, they had a portfolio of risks. It called for a central focus on the problem. Many of the more dynamic companies hired a risk manager. Instead of focusing principally on negotiating contracts with insurance carriers, this person, or, in larger firms, this department, concentrated on risks in many aspects of the company’s businesses. Risk managers’ responsi- bilities included safety practices and educational procedures for employees, and sometimes they were even given a voice in operating matters like limiting investing in buildings in less- developed countries. Their goal was to bring down losses in the company at a tolerable cost. At about the same time, the field of finance began to broaden considerably. The advent of computers enabled companies to better measure their risk financially. New financial instruments like options and swaps and more futures market alternatives added to the choices companies had to limit their risk.

Risk Management 311

The field of risk management had come into its own. The professional society for risk managers changed its name from the American Society of Insurance Management to the Risk and Insurance Management Society, Inc., in 1975, and is now known as the Risk Management Society (RIMS). Occasionally, you may still hear people talk of risk management as the equivalent of insurance. However, an increasing number of people recognize that it is a far broader topic. Risk management can now be looked at overall as well as risk-by-risk. This risk management approach is also relevant to individuals and households. Obviously, it isn’t done in as sophisticated a way as it is in a large business, but the house- hold still needs to look at all types of risks and to use the tools that are available to deal with them. Our objective is to reduce the risk that negative events could result in the house- hold not meeting its goals.

OVERVIEW

The financial planning objective in risk management is to identify exposures that can create roadblocks to goal achievement or otherwise can be handled more effectively. People are often understandably nervous about the risks they encounter in daily life. Their concerns may mount as they age, if only because they have fewer opportunities to recover from what may be a major financial loss. Proper risk management practices should start at a young age. These desirable practices are described in this chapter. We begin with a discussion of risk management in theory as well as in practical terms. The balance of the risk manage- ment portion of the chapter is presented as a flow process. It shows you step-by-step how to establish and implement a risk management program. Information on overall types of insurance and their use is then provided. Finally, life insurance is discussed in some detail. After reading this portion of the chapter, you should be able to determine life insurance suitability and evaluate the alternatives. In Chapter 12 you will read about other kinds of insurance. We can conclude by saying that risk management is a very broad topic affecting most of the things that you do. To refer to it simply as insurance does not do justice to the topic.

RISK MANAGEMENT Risk Management Theory Risk management in theory can be viewed as the study of methods for controlling port- folio risk. As discussed in the last two chapters, the portfolio for individuals consists of all their household assets. A variety of risk management tools are available to modify house- hold risk. The ones you select will depend on such factors as the makeup of all of your household assets and your risk profile. The goal is to have the highest quality of life pos- sible, given your tolerance for risk. There is no grouping of assets or other techniques that can fully eliminate risk in your portfolio. Perhaps the biggest difficulty in doing so is the lack of a full hedge for the life- time work-related income streams we call human assets. We cannot fully diversify human assets.1 There are usually only one or two wage earners who make up human assets possi- ble per household. Products with negative correlation with human assets, such as unemployment insurance to cover the possibility of layoff and health insurance for sickness

1 For an explanation of the theory of hedging human asset risk, see Ney Brito, “Portfolio Selection in an Economy with Marketability and Short Sales Restrictions,” Journal of Finance 33, no. 2 (May 1978): 589– 601; and Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen, and Kevin X. Zhu, Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, (The Research Foundation of CFA Institute, 2007) proper- tyoz.com.au/vic/library/CFA%20Lifetime%20Financial%20Advice.pdf.

312 Part Three Portfolio Management

are available but do not control all the risks an individual worker is subject to. In addition, we cannot hedge away overall market risk; for example, the risk of a plague or an eco- nomic or stock market collapse. There is usually a significant cost to purchasing these negatively correlated assets. This cost tends to reduce your household income, which we can call returns on your household assets. You purchase these assets because they also reduce portfolio risk. For example, purchase of automobile insurance reduces the amount of money available for spending on those items that give you pleasure. On the other hand, it reduces the possibility of nonreim- bursement if your car is stolen or, worse yet, having to fund a personal injury lawsuit in connection with an auto accident. In sum, risk management techniques are methods of modifying a household’s portfolio risk. They take into account all the assets of the portfolio and the risks attached to them. Importantly, an overall portfolio risk is established. Household members compare current portfolio risk with their preferences for risk. They then select the most efficient risk man- agement technique to alter their portfolio and bring it in line with their own tolerance for risk. In revising their portfolio, they establish a risk–return strategy that attempts to opti- mize their portfolio income and brings about the highest standard of living possible for them. This approach, particularly when it is done in a structured way, is a part of the foun- dation for total portfolio management.

Risk Management in Practical Terms We have said that, in theory, risk is the probability of an outcome different from the one expected. Outcomes above and below expectations are considered risky. In practice, we have a different definition. In practice, we are only concerned with outcomes that are be- low expectations; these are the outcomes that produce losses. Therefore, we can view risk in practice as the probability of a loss or an outcome that is below expectations. People are exposed to risk in every aspect of their lives. Risk management in practical terms can be defined as the process by which we identify risks and control them so that we are able to achieve individual goals. Notice we use the word control. As we’ve said, we cannot hope to eliminate risk entirely; we can only attempt to keep risk within acceptable ranges of impact on our lives. As you know, financial planning develops a path for achieving household goals and risk creates obstacles in that path. When engaged in financial planning, you must first identify risks, knowing that losses in any one area can jeopardize overall household goals. Given significant risks in one area of the portfolio, household members may make adjustments elsewhere. For example, if one wage earner has a very lucrative but risky job, the house- hold may set aside extra money in household savings to compensate for the possibility of a layoff. Then the ways of dealing with the risks should be considered and the most effi- cient method selected. As you will see, sometimes it is best to just reduce or even assume the risk by doing nothing.

The Risk Management Process Risk management is an organized process that looks at practices in broad terms and works its way to the most specific details. A household’s members may be in charge of specific procedures such as obtaining needed insurance policies, but all people practice risk man- agement sometimes, even when they don’t realize it. The six steps of this process are outlined in Figure 11.1 and then discussed individually.

Develop Objectives Objectives determine the scope of the risk management process. Do you want to select one area or examine all household risks?

Risk Management 313

Establish Exposures Each area of household assets has its own risks. We can separate them into financial and nonfinancial assets. Nonfinancial assets may, in turn, be segregated into human-related assets and real assets. For risk management purposes, we can call human-related and real asset exposures personal and property risks, respectively. As we will discuss, our liabilities also contain risk. A risk that we are concerned about for planning purposes is one that can significantly affect assets or cash flows.2 The risk of your wallet or handbag being stolen is often present but, though frustrating if should it happen, is not of the consequence of your car being stolen.

Identify Available Risk Management Tools There are many techniques available to you in managing the overall risk of the household. Some of them have little or no cost. For example, being careful to lock the door to your apartment before going out involves no cash outlay and minuscule cost of time. If you lock the door, you may avoid loss and the cost of higher apartment owner’s insurance. Common risk management approaches are discussed below.3

FIGURE 11.1 Risk Management Process

Develop Objectives

Establish Exposures

Identify Available Risk Management Tools

Match Appropriate Risk Management Tools to Exposure

Implement

Review

2 The TPM approach generally capitalizes cash flows as assets. 3 These methods assume that the goal is to reduce risk. That approach is generally valid for assets designed for household usage but may not be so for investments intended for growth purposes; in other words, for real and human-related but not financial assets. For financial assets, risk–return principles hold, and we may actually want to increase risk. We can control financial risk by diversifying, as dis- cussed here, or by borrowing money or adding to the bond or money market portion or through more sophisticated financial instruments. We will proceed with the risk-reduction assumption for the balance of the chapter.

314 Part Three Portfolio Management

Avoid Risk Under the avoid risk method, you seek to eliminate exposure to risk. If there is risk that you will be injured if you cross the street on a red light, you may wait until the light is green.

Reduce Risk When you reduce risk, it is not eliminated; it is lessened. When you exer- cise and eat the right foods, you reduce the risk of becoming ill.

Reduce Potential Loss When you reduce potential loss, you lessen the damage should a loss occur. Wearing a seat belt serves this function in the event an accident takes place.

Retain Risk You retain risk when you reject the possibility of reducing or eliminating risk but instead decide to absorb the potential loss yourself. Of course, in some cases, you are forced to retain risk because it is uninsurable. For example, there is no direct insurance against a deteriorating neighborhood and its effect on the value of your house. You have to consider shifting homes. A desirable way to retain risk is to self-insure. Under self-insurance, you can actively set aside money to fund any losses should they occur.4 The money may be part of a pool of capital to fund losses that are both insurable and uninsurable, called precautionary savings. One instance of retaining risk might be saving extra monies to use in case physically you are temporarily unable to work, rather than buying short-term disability insurance.

Diversify With this method, assets are diversified so that the impact of an unfavorable outcome for any one asset is reduced. You diversify when you allocate your marketable assets to many different categories—domestic and international stocks including small, medium, and larger-sized companies. When you get married and both you and your spouse work, you are diversifying assets.

Transfer Risk When you take the possibility of loss and give it to someone else, you transfer risk. A typical example of transferring risk is when you purchase a homeowner’s policy that insures against the loss of your home being destroyed by a fire. You have trans- ferred your risk to the insurance company.

Sharing Risk When you share risk, the transfer of risk is not always a full one. Some risk may be retained, thereby limiting, though not eliminating, a risk. For example, when you coinsure medical policies, sometimes 20 percent of the risk is retained. When you transfer some risk and retain a part of it, we call that sharing risk. Sharing risk may have the advan- tage of making you more careful about your actions, thereby reducing the insurance com- pany’s exposure to loss. Therefore, the company is able to offer lower rates than it would without risk sharing.

Other Methods of Handling Risk There are a host of other methods to aid in altering risk. Many are utilized principally for marketable securities and in businesses. They in- clude options, futures, and swaps. These instruments can raise, lower, or eliminate risk. When you hedge risk, you transfer business risk to a third party. An example of hedging is a farmer who uses the futures market to sell a crop of corn today that won’t be brought to market for many months. In doing so he eliminates the risk of a drop in corn prices from the date of the futures sale until the date the corn is delivered.

Match Appropriate Risk Management Tools to Exposure Different exposures call for separate risk management tools. You would not literally buy insurance against the risk of job obsolescence. Instead, you might go for additional train- ing. Each major area of the household portfolio—human-related assets, real assets, and financial assets—has its own grouping of methods for managing them.

4 Often the term self-insurance is used more broadly to encompass all types of risk retention, not just instances in which money is physically set aside.

Risk Management 315

In determining the appropriate overall risk management tool, a number of factors should be taken into account. Among them are the cost of alternative risk management techniques, the amount and likelihood of loss, any convenience factors, and the risk tolerance of the person.

Example 11.1 Carol inherited an expensive diamond-studded necklace when her grandmother passed away. She indicated she had a moderate tolerance for risk.5 She received an estimate on an insurance policy to cover her against theft; the cost was very high. On the other hand, there had been a number of recent break-ins in her neighborhood. She considered the alternative, keeping the necklace in a safe deposit box. It wasn’t very convenient to go to the vault to take it out when needed. Then again, she wasn’t likely to wear the piece more than once every two years at a wedding or other formal occasion. She was willing to absorb the risk of having it taken from her at that function, which, if she was careful, she believed would be relatively low. She de- cided that saving the insurance cost was preferable for her. She placed the necklace in the safe deposit box.

Let’s look at the exposures by category and describe the risk management tools that apply. Human-Related Assets Human-related assets are generally the most significant portion of a household’s portfolio for a large portion of its life cycle. The portfolio incorporates human assets, pension assets including Social Security, and gifts and bequests. Your human asset alone is financially derived from the income you earn but more broadly in- cludes a variety of risks you are personally exposed to and can be listed separately. The risks include the following:

Longevity—premature death. Longevity is the number of years you will live. Obviously, people generally cannot forecast this figure accurately. The insurance industry and the U.S. government do publish tables on average mortality and life expectancy. One is given in Table 11.1. However, as we know, there is great variation around the averages.

Longevity risk is the possibility of living beyond normal expectations or dying prematurely. If a person dies prematurely, the other members of the household may undergo a decline in, or elimination of, income. Life insurance provides payments to surviving household members to compensate for this loss. Taking company pensions out over both spouses’ lives so that income continues at the death of the retired worker is another tool. Health measures discussed below can help as well. Longevity—extended life. The result of a good longevity program may be living an extra-long life. An extra-long life can result in a decline in your standard of living or running out of private funds. Establishing extra funds for the possibility of an extended

5 Many people indicate they have a moderate tolerance for risk. When someone says this, often more probing is needed. For this example, it is assumed that the self-description of “moderate” risk tolerance allowed the assumption of the risk that is described in this situation.

TABLE 11.1 Life Expectancy by Years

Source: Centers for Disease Control and Prevention, http:// www.cdc.gov/nchs/data/ hus/2014/016.pdf, Table 16

U.S. Average Life Expectancies at Birth (Years)

All Males Females

1950 68.2 65.6 71.1 1960 69.7 66.6 73.1 1970 70.8 67.1 74.7 1980 73.7 70.0 77.4 1990 75.4 71.8 78.8 2000 76.8 74.1 79.3 2010 78.7 76.2 81.0 2013 78.8 76.4 81.2

316 Part Three Portfolio Management

life, a form of precautionary savings, will help. Pension income provided by the U.S. government with Social Security benefits or by private businesses generates cash flow for the qualified worker throughout that person’s life. In addition to Social Security, Medicare provides reimbursement for medical costs, which generally rise as one ages.

Medigap insurance pays for the portion of medical expenses not covered by the govern- ment, and long-term care insurance reimburses for assistance at home and payments to a nursing home if needed. Privately purchased annuities also reduce risk since payments are based on average life span but provide continuing income for extra-long lives although they are generally not adjusted for inflation.

Health and disability. Health and disability are expenses for sickness and inability to perform at your job. This, of course, can reduce your income and therefore human- asset value. Diet, exercise, and stress management can help here, as can safety measures to prevent illness and becoming disabled. Medical insurance can reimburse you for doctor and hospital expenses. Government-supplied and privately purchased disability insurance can partially reimburse you for income you have missed, whether due to poor health or accident-related occurrences. Macro- and microeconomic risks. Macroeconomic risk is the risk inherent in the general economy and microeconomic risk is the risk associated with the individual industry or company. Each can cause you to suffer from inflation, thereby causing declines in your real income. General economic, industry, or company-related risks such as sluggish growth, overcapacity, technological obsolescence, or inefficient operations can result in layoffs or terminations.

Precautionary savings for such an event, government-supplied unemployment insur- ance, and diversification through an increase in the number of household members who work, all can reduce economic risks related to your job. In addition to your job income, there are human assets that are derived from your rights and relationships. Pensions both from governments and from the private sector are rights. Risks such as those from reduction in benefits or termination from a job can be reduced through diversification of savings, while inflation risk from flat business pension payments can be reduced through inflation-indexed bonds. Family relationships often result in gifts and bequests at the death of a loved one. While it may not be our focus, maintaining close relationships enhances the potential for ultimate sums. Real Assets Real assets are tangible assets that the household owns. The most impor- tant one for non-renters is the house they live in. Other items are automobiles, furnishings, and jewelry. Among other risks, the house is subject to fire, flood, termites, and accidents to people. The other household assets may be subject to accident and theft, while jewelry is subject to theft. Safety measures to prevent or reduce perils also help. Many houses carry homeowners’ insurance, which includes protection for general possessions such as furni- ture, and most states require auto insurance. Other valuable assets such as jewelry may be insured separately or are self-insured. Financial Assets Financial assets involve the ownership of assets that are typified by pieces of paper and are often marketable. Examples are stocks and bonds. Risk such as industry or company risk in investing can be covered by diversification strategies. Examples of risks that are difficult to diversify away are weakness in the economy or stock market and boosts in interest rates and inflation. Some examples of risk-reduction tech- niques for financial assets include the use of assets less affected by overall economic fac- tors such as food stocks, assets that are less correlated with the stock market such as real estate or gold, and others less influenced by inflation and interest rates such as inflation- indexed bonds or money market funds.

Risk Management 317

Liabilities Financial liabilities are monies owed to others, as, for example, debt. Having significant debt increases household risk. When negative events reduce cash flows—for example, when job income declines or the cost of borrowing increases because of higher interest rates—individuals can become vulnerable. Reducing debt, placing caps on rates borrowed when they are available, and accumulating precautionary savings can serve to reduce this risk. Intangible liabilities are less quantifiable current liabilities such as potential liabilities to third parties. For example, suppose someone slips on your sidewalk and sues you. A home- owner’s policy protects against that type of occurrence. Care of personal property, such as shoveling your sidewalk after a snowstorm, and safety precautions also can be employed. Umbrella insurance can cover myriad types of lawsuits,6 and professional liability insurance can help protect you in our increasingly litigious society. In addition, education about indi- vidual exposures to third-party risk and what to do to avoid them can reduce your risk. Although they don’t carry the legal responsibilities to pay debt, nondiscretionary ex- penses also can be thought of as obligations and intangible liabilities. Overhead costs of your entire household can be subject to serious difficulties if, for example, you cannot sup- port the cost of operating your house. Similarly, future goals that necessitate periodic fund- ing such as sending children to college can be viewed as intangible liabilities. Without funding these additional expenditures, such as those for retirement, you cannot fulfill your standard-of-living requirements. Long-term contracts and inflation-indexed bonds can help guard against inflation risk. You can buy insurance to protect tangible assets and establish precautionary savings to alleviate shortfalls from household operations.

Implement Implementation is taking the action step. Sometimes people have difficulty implementing a risk management strategy. They procrastinate in beginning new personal practices or purchasing an insurance policy. Setting an implementation plan with specific dates to accomplish tasks can help.

Review Risk management exposures can change. For example, a policy for household possessions may become insufficient over time because of inflation and new acquisitions. It is a good idea to review exposures at least once a year.

INSURANCE

We have discussed the role insurance plays and the various types of insurance as part of overall risk management. While we will maintain the risk management approaches, in this section we discuss insurance more extensively.

What It Is Insurance is a method of transferring risk. Risk is shifted from the person exposed to it to the insurance company that assumes the risk for a fee. The process by which an insurance company agrees to assume the risk in return for a projected profit is called insurance un- derwriting. The insurance company can spread the risk among many policyholders. By using scientific methods, the company can estimate its exposure to loss and charge enough to make a profit. Our government also provides insurance in certain areas in the public interest.

6 See Janet Bamford, “A New View,” Bloomberg Wealth Manager (April 2004): 72–82; and “Wealth at Risk: How High Net Worth Families Overpay to be Underinsured,” ACE Private Risk Services Insurance Intelligence White Paper, March 2013.

318 Part Three Portfolio Management

Insurance Theory and Practice Insurance is one of the principal tools used to modify portfolio risk.7 A good deal of aca- demic research in risk management has been devoted to the efficiencies of insurance prod- ucts. If insurance products were fully efficient, as they would be under theoretical assumptions—for example, assuming no transaction costs—the amount you paid for insur- ance would be exactly equal to the expected value of the loss. In other words, there would be no extra cost for the insurance company’s overhead including its profits. Under that assumption, every risk-avoiding person would select insurance. Why? Because the insur- ance would provide a hedge against risk at no extra cost. However, as we discussed in looking at portfolio theory, as a practical matter, insurance policies involve extra expendi- tures. They provide lower risk at a cost. Let’s look at some reasons why insurance products are not fully efficient in a financial sense.

Overhead Costs Insurance companies have overhead costs to maintain and grow their businesses, pay out claims, and earn a profit. These costs are built into the price of insurance policies.

Incomplete Information In a fully efficient market, all parties to a transaction share the same information. As a practical matter, insurance companies have incomplete information; in other words, they may have less knowledge about future claims than the applicant for an insurance policy. Specifically, less healthy applicants may pass insurance company screens. If the insurance company knew of their health problems, it would reject them. A healthy purchaser of an insurance policy will bear part of the operating cost of any less healthy people in their pool of policyholders. They are negatively affected by a moral hazard. Moral hazard is the increased chance of loss due to policyholder extra risk. The additional risk ranges from such things as a fully insured policyholder engaging in more dangerous activities, which could result in more frequent filing of claims, to faking injury after the policy is taken out.8 Moreover, the insurance pool may reflect adverse selection over time. Adverse selection refers to people who have greater chance of loss, purchas- ing more insurance than they would normally do because of knowledge of their health that the insurance company does not possess. For example, under adverse selection, people who are healthy are more likely to discontinue insurance than those who are not. As with a moral hazard, healthy people who remain with the insurer suffer higher ongoing cost for the insurance policy as they are part of a less healthy population pool.

Example 11.2 Mary, age 45, was in good health at the time she purchased a term life insurance policy and remained so throughout the 20-year period she held it. Jim (age 45) had a family history of heart disease, and both his brothers died at age 49. The insurance company approved Jim’s application for the same term policy without knowing about the vulnerability. He died at age 49 as well. Within the following 10 years, many other policyholders voluntarily dropped out, leaving a significant percentage of those remaining uninsurable due to ill health. Mary remained in good health. Her cost may be significantly higher than people having her good health might suggest. In Mary’s case, costs were higher because of the moral hazard arising from Jim’s nondisclosure of

7 For a study of insurance in a portfolio context, see David Mayers and Clifford Smith Jr., “The Interdependence of Individual Portfolio Decisions and the Demand for Insurance,” Journal of Political Economy 91, no. 2 (April 1983): 304–11; and Neil Doherty, “Portfolio Efficient Insurance Buying Strategies,” Journal of Risk and Insurance 51, no. 2 (June 1984): 205–24. 8 For a finer definition of moral hazard and its distinction from morale hazard, see Chapter 12.

Risk Management 319

his family history and subsequent premature death; Mary’s premiums were also higher because increasingly over time she was in a pool of policyholders with above-average mortality risk, an adverse selection problem.

Search Costs These are costs that the person desiring to be insured undertakes to find out which policy is best. Most of the costs involve hours spent in selecting and processing the policy. According to economic theory, this search cost would be billed at the cost of time. In finance, this is called an opportunity cost. Self-insuring eliminates this cost and could allow the person to select either higher income through additional work or extra leisure time as an alternative.

Behavioral Factors Some academic evidence suggests that humans may not always act efficiently in risk man- agement activities. For example, one study has shown that people are underinsured for flood risk despite large government subsidies for that insurance. There is evidence that people prefer to have low deductibles instead of taking high deductibles, even when they are given economic incentive to do so. They may prefer to insure against small losses that have high probabilities of occurring and not larger losses with low probabilities of occur- ring. They tend to overestimate low probability losses and underestimate high probability losses. The way the risks are presented to people seems to matter. These extra costs reduce somewhat the efficiency of insurance and result in some peo- ple substituting other risk management techniques such as self-insurance. However, as we know, people still find insurance attractive, particularly those who wish to protect them- selves against catastrophic losses to the household. Purchasing insurance is an example of the trade-off between risk and return. Even with these extra costs, insurance may be the preferable alternative to reduce portfolio risk. However, it also reduces household returns. The degree to which insurance is used will depend on the household’s tolerance for risk as it selects the risk–return mix that is preferable.

Types of Insurance Policies As we discussed, insurance is used to shift part or all of the risk for certain exposures. The three major types of policies are private personal, private property, and government insur- ance. Personal policies have to do principally with insuring people and families. Property policies primarily involve insuring real assets that the household owns. Government insur- ance can help both, but often that help only ensures a minimum standard of living for all Americans. The three types are shown in Table 11.2.

Insurance Providers There are three major types of providers of insurance to individuals: the government, private insurance companies through group policies offered institutionally, and private insurance companies through individual policies offered by independent agents. Government policies tend to concentrate in items with widespread exposures by cross sections or individual strata of society. The cost of these policies tends to be low or they are provided free of charge as social insurance that is part of the “safety net.” Social Security may be an exception to low cost because it has income redistribution motives. Group policies offered by private insurance companies to independent businesses for their employees, but also provided by insurance companies for fraternal or other organiza- tions, often present the cheapest form of nongovernment contracts. Independent busi- nesses can take advantage of low marketing costs, benefit from mass-volume efficiency, and may assist with screening and administrative costs, thereby further reducing premiums.

320 Part Three Portfolio Management

There may be tax advantages to group policies when a company offers a policy9 as well as company subsidization benefits.10

Individual policies bought directly from independent agents of insurance companies are often the most expensive but also the most flexible. Buyers can select the individual company and policy with the terms they prefer, which often will not be available in a group policy. Individual policies are portable, which allows the policyholder to maintain the policy at the same cost when leaving an employer. When a group policy is provided, the policy may end at employee separa- tion or the person may be offered continuing coverage at a high rate. Changes in a person’s health or in policy costs at that time may make new policies less attractive or even unavailable.

Analyzing an Insurance Company An important factor in selecting among insurance policies is the quality of the company that offers the policy. The criteria to consider are

Financial strength. How secure is the insurer’s financial condition? A.M. Best, Standard and Poor’s, Moody’s, and other agencies evaluate and rate an insurer’s finances. The ratings range from AAA to C with commensurate declines in your confidence in the insurance company’s promise to reimburse you for losses you may have in the future.

Good operating sense. Good operating sense contributes to financial strength. It measures how wise the company is in selecting risks it is willing to underwrite and how efficient it is in running its business and processing its claims. A more efficient company often has more competitive prices.

Service. Important questions to ask are “How good is the company’s service?” and “Does it pay out promptly and fairly on claims submitted?”

TABLE 11.2 Types of Insurance

Insurance Categories Coverage

Personal

Life Provides monies to others at the death of the insured. Disability Makes payments to replace income of the insured once the person

is incapacitated. Long-term care Payment provided generally to the elderly, which assists those

unable to care for themselves due to physical or mental conditions. Health Reimburses health-related expenditures.

Property

Property and casualty Pays for losses to home and possessions, and coverage for exposures to third-party losses.

Personal liability Extends coverage for liabilities of many types of a personal nature.

Government

Unemployment Supplies income for a specified period upon job termination. Social Security Provides income, disability, and medical reimbursement after

retirement. And, in the event of premature death, will provide payments to spouses, children, and parents being supported.

Other

Welfare, food stamps, Allows support for lower-income Americans and medical preretirement Long-term care and Issued principally for support for disabled Americans, generally with nursing home assistance few assets.

9 Through tax-advantaged cafeteria plans, and others. 10 In some instances, such as for disability insurance, when the company pays or subsidizes a policy, there may be a tax disadvantage at the time of payout for a claim.

Risk Management 321

Price. As in other forms of merchandise offered to the consumer, price often varies by company policy. Price should be compared with quality to obtain the best value. When using price as a criterion, pay particular attention to financial strength.11

Other considerations. Factors such as the size of the company, how long it has been in business, specialization, and so on, may enter into consideration. In addition, there is the question of location. Some states provide unofficial help for companies in financial difficulty in merging with stronger companies so that they don’t default on their policies.

Insurance as an Asset Insurance is commonly regarded as an expense, an appropriate designation. For certain uses, it can be viewed as an asset. This designation comes about because owning insurance can actually lead to higher net revenues. As we know, decisions are often made on an overall portfolio basis based on risk–return principles and household risk tolerance. If insurance reduces risk in one area, it can allow greater risk-taking in another area. For example, a business that is able to hedge currency risk at an acceptable cost may go forward in a highly profitable overseas investment whereas it wouldn’t do so otherwise.

11 For certain types of insurance policies such as whole life insurance, it can be difficult to compare policies based on price.

POLICIES SHOULD BE READ

substantial monies as long as he was unable to

CONSIDER THE COST OF REPORTING A CLAIM BEFORE DOING SO

Practical Comment Incorrect Insurance Coverage

322 Part Three Portfolio Management

Similarly, someone who is adventurous may be able to purchase life and disability in- surance and then undertake a somewhat risky but lucrative overseas job assignment, whereas without the ability to provide funds for the household in case of an accident, he or she would decline the opportunity. Viewing the job as part of an overall household portfo- lio, insurance added value by increasing net profits as compared with a domestic position and therefore was an asset that built household equity.

SUMMARY OF RISK MANAGEMENT AND INSURANCE

We have described how important insurance can be in controlling risk. However, before we move into a fuller treatment of life insurance, remember again that it is only one tool in the risk management arsenal. The wide scope of risk management activities, as they per- tain to individual exposures, is seen in Table 11.3.

TABLE 11.3 Summary of Selected Risk Management Activities

Asset Type Example Identify Risk Selected Risk Management Tools

Human Health Diet, exercise, stress management, safety measures

Illness or disability Medical insurance, public and private disability insurance

Longevity—early death Life insurance, diet, exercise, safety measures Longevity—extra-long life Precautionary savings, Social Security,

government Medicare and private Medigap insurance, long-term-care insurance, annuities

Lower income and layoff Precautionary savings, government unemployment insurance, additional household wage earners

Human-Related Integrity of pension assets1 Diversification of retirement savings, inflation-protected securities

Anticipated gifts Maintaining close relationship with asset owner

Real House2 Fire, flood, accident Safety measures, homeowners’ insurance Car Accident, theft Safety measures, auto insurance Other Jewelry, collectibles Theft Safety measures, self-insure, individual

possessions policy Financial Stocks, bonds Macroeconomic inflation Less cyclical equity assets, inflation-indexed

bonds Interest rate and market fluctuation Less correlated assets Industry Diversification Company Diversification Liability Financial Financial leverage Reduce debt Interest rate Caps on rates charged, fixed-rate debt,

precautionary savings Intangible Third-party lawsuit Umbrella insurance, professional liability

insurance, education, maintenance of property, safety measures

Maintenance Inflation-indexed bonds, longer-term contracts, precautionary savings, insurance as given under tangible assets

1 Fixed company pensions based on income and tenure, not 401(k) and other retirement after-tax savings established by individuals. Integrity expressed in inflation-adjusted terms. Social Security risk can include such factors as increased taxation for higher-income groups, outright emphasis on providing for those at the subsistence level, and increase in the age required for qualifying. 2 And its possessions.

Risk Management 323

LIFE INSURANCE Life Insurance Goals In the balance of this chapter, we will explain life insurance, one of the country’s most popular risk reduction techniques. You will learn about the various types of life insurance, how they work, the financial issues connected with them—including when they should be used—and how to determine the correct amount to have. Life insurance is traditionally used to provide money that compensates for the death of a household wage earner. It is part of the case employed by those academicians who be- lieve that the household is an economic and financial organization worth analyzing. Efforts focused exclusively on individual motivations, which indicate that people are concerned only about themselves, must explain why people carry life insurance. Its payments most frequently are made to other current or former members of the household after the death of the insured, who paid for the policy. If there are no other members of the household, there may be no need for life insurance.

Example 11.3 When Art finished his education and went to work full-time, he received a moderate amount of life insurance from his employer. Art decided he did not need more coverage; in the event of his sudden death, no one would miss his income, as he had no dependents. If Art were to die, the insurance would be enough for funeral and burial expenses. A few years later, Art married Barb, who also had a full-time job that provided a modest life insurance policy. Again, the young married couple decided against purchasing more life insur- ance. If either one of them died, the other would still have his or her earned income, which would be sufficient. When Art and Barb had a child, though, their situation changed. If either of them were to die, the lost income would seriously reduce the amount the survivor would be able to spend on their child’s upbringing. Even if one spouse were not earning income, at the time that spouse died, the survivor would need more cash flow for paid child care, housekeeping, and so on. Therefore, both Art and Barb acquired substantial life insurance policies, naming each other as beneficiary.

As we mentioned, human-asset risk cannot be eliminated. Life insurance is one of the financial instruments that is negatively correlated with human assets, specifically, with the risk of premature death.12 In terms of severity, mortality risk is one of the most serious risks a household may face. The current value of future job-related income from its princi- pal benefit is often the most important asset by far in the household portfolio.13

The total amount of life insurance in force is given in Table 11.4. In recent decades, life insurance has received more competition from other financial vehi- cles such as pension plans and mutual funds. Perhaps as a result, certain industry representa- tives have placed more emphasis on the investment aspects of whole life insurance. The monies you accumulate in a policy can be withdrawn or borrowed. Other sales representa- tives stress the pure risk management role of insurance as exemplified by a term policy. Life insurance, together with disability insurance, unemployment insurance, and other human-asset risk management techniques, helps to significantly reduce human-asset risk. We can conclude this discussion by simply saying that life insurance helps diversify the portfolio of a household with two or more members and helps align it with the household’s tolerance for risk.

12 Life insurance pays out when death brings future job-related income and, therefore, human assets to zero. 13 For a theoretical study of life insurance in a portfolio context, see Scott Richard, “Optimal Consumption, Portfolio and Life Insurance Rules for an Uncertain Lived Individual in a Continuous Time Model,” Journal of Financial Economics 2, no. 2 (June 1975): 187–203; and Roger G. Ibbotson, Chen, Moshe A. Milevsky, and Xingnong Zhu, “Human Capital, Asset Allocation, and Life Insurance,” Yale ICF Working Paper No. 05-11, May 2005, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=723167

324 Part Three Portfolio Management

Parts of an Insurance Policy Every life insurance policy is made up of several parts, which determine the price you pay for the policy. They include mortality charge, investment return, and overhead expense.

Mortality Charge Mortality risk can be defined as the probability of dying. In any given year across the United States, the probability of dying for any one individual is relatively low. Of course, as you age, the probability rises, more steeply at age 60 and above. Life insurance has proven to be an attractive product because it compensates indi- viduals for a generally unlikely event in any single year but one with potentially severe consequences. At the same time, the insurance company diversifies its risk of any one person or group dying through having great numbers of policyholders. Insurance companies calculate the probability of death for any group of insurance holders scientifically and include that as one cost in the policy. They also engage in a screening process for insurance applicants, generally with the goal of keeping their annual mortality costs for a given segment of soci- ety below industry averages.

Investment Return In the early years of a typical whole life policy, the annual premiums far exceed the mor- tality cost, providing the policy with extra cash to be invested. The return on this invest- ment helps pay the mortality costs in later years, when these costs can far surpass the annual premiums.

Overhead Expense These are the overhead costs that are added to the policy cost. They include such items as the costs to market the product and maintain the policy, and company profits. Low over- head cost per dollar of insurance revenues can be a measure of individual insurance com- pany efficiency. This expense item is generally not separately reported but included in investment return figures.

Total Life Insurance Purchases, by Year (Total)

Year Policies Face Amount

1940 18,157 $10,730 1950 22,834 $28,796 1960 24,755 $74,408 1970 23,769 $193,122 1980 29,007 $572,602 1990 28,791 $1,529,151 2000 33,357 $2,514,908 2010 28,621 $2,808,570 2011 27,177 $2,832,448 2012 27,063 $2,799,939

Individual Life Insurance Purchases

Policies Face Amount

Term Insurance Total 3,599 $1,088,606 Whole Life and Endowment 6,330 $560,127

TABLE 11.4 Amount of Life Insurance in Force by Type of Insurance (2012)

Source: Adapted from American Council of Life Insurers, Life Insurers Fact Book, 2013, Table 7.1, acli. com/Tools/Industry%20Facts/ Life%20Insurers%20Fact%20 Book/Documents/7_FB_2012_ Chapter7_web.pdf.

Risk Management 325

Amount of Insurance Life insurance is taken out to cover a need, the death of an income earner. It is a costly item because the possibility of loss of a sole or a principal income-earning asset through an untimely death can often place remaining household members in a serious financial bind.14

We can view the amount needed using three different approaches: income replacement, life insurance needs, and partial replacement.

Income Replacement If the amount of insurance is intended to cover the loss of income in full, it is called income replacement. The income replacement amount is equal to the present value of the lost in- come over a person’s remaining life expectancy on an after-tax basis, plus any funeral ex- penses. The proceeds of any current insurance plus any investment assets already accumulated are subtracted from those figures. With this approach, generally the older you are, the lower the insurance requirement as the amount of your future income declines over time.

Life Insurance Needs A second approach to how much insurance to purchase is to perform a life insurance needs analysis and calculate the requirements of the other members of the household in the event of the death of a wage earner. Adjustments to the needs analysis are made for

1. A decline in overall living costs caused by the reduction in household members. 2. Future education costs for children. 3. Repayment of the mortgage to reduce overhead costs and insurance needs resulting from (1).

The calculation of the appropriate amount of insurance under an insurance needs analy- sis projects income expense and shortfalls by period. It is done using present and future value principles. A life insurance needs analysis is provided in the appendix to Chapter 17.

Partial Replacement Insurance is costly, and funding can reduce cash flow availability for other purposes such as current cost of living. Therefore, a third approach may be employed that funds partially for needs or makes broader assumptions about future requirements. The household may only fund for a more modest lifestyle, or provide enough cash to educate a spouse so that he or she can generate higher wages, or just provide resources for a period of time until another marriage is assumed to have taken place.

Practical Comment Changes in Insurance Needs

14 Life insurance is used for other purposes as well, such as for estate planning.

326 Part Three Portfolio Management

Types and Uses of Life Insurance There are six major types of life insurance: term, whole life, universal life, variable life, variable universal life, and indexed universal life.15 Many or all can provide benefits to other household members—life insurance’s traditional role—or handle funding to com- pensate for the death of a divorced spouse or a business partner, and so forth. In addition, life insurance may be used to provide liquidity for estate taxes or to transfer assets upon death in a tax-efficient manner.

Term Insurance Term insurance is the simplest and cheapest form of life insurance. Its premiums are based principally on mortality cost and life insurance company overhead. Its costs are relatively inexpensive when people are young and mortality rates are lower, but rise steadily, becom- ing relatively high for people in their 60s. Therefore, term insurance can be defined as life insurance providing fixed coverage for a stated period of time with policyholder pre- miums that vary based on the possibility of death of the insured during that time frame. Term insurance has little asset value other than that for the probability of death at any given age multiplied by the amount of insurance for the period of coverage remaining. At the end of the year covered, if the insured is still alive, the payments made during the year are expensed. If the policy isn’t renewed, it expires and is worthless. In renewable term life, the ability to continue coverage could be considered an asset, as we will explain. During the term of the policy, the health of some insured people may have deteriorated. That risk could raise their rates or result in the insurance company choosing to cancel their policies, creating additional risk. To protect them against that risk, many term policies have a renewable feature. Renewable term guarantees that the policy will continue in force, regardless of the health of the insured, for a stated period of time (e.g., to age 65). The price for term insurance often increases each year as the possibility of death rises. Under level term, the price may be flat for 5, 10, or 20 years. In effect, like whole life, prices for term insurance in earlier years subsidize those in later years. Therefore, the term policy in the 17th year of a 20-year level-premium term will, in effect, have an asset value.16, 17

Another feature of some term policies is a conversion provision. Convertible term al- lows the insured to swap a term policy in the future for a whole life policy, generally of- fered by the same company. This change can occur regardless of the insured’s health at the time. This option can have some appeal for people who wish to switch when their finances permit substantially higher payments. Because term policies can be viewed by the insur- ance company simply as payout or no payout for annual payment, these policies are to some extent indistinguishable commodities and very price competitive. The ability to con- vert into a whole life policy can be viewed as attractive and may make a particular term policy more appealing to a prospective buyer.

15 Whole life insurance is commonly thought of as all life insurance other than term. In actuality, permanent insurance is a more accurate characterization, with whole and universal life, for example, as subgroups of permanent insurance. In this book we will refer to whole life insurance in the broader phraseology. 16 The cost for a year late in the 20-year term policy if separately priced would be greater than the cost actually paid, because the price paid for the policy incorporates average morbidity for the 20 years, while actual morbidity rises over time. The asset value will be the NPV of the difference between the current premium and the premium on an assumed one-year policy for years 17 through 20. Therefore, if the insured’s health has deteriorated and the person is no longer able to purchase new insurance, the asset value of a renewable noncancelable policy would rise significantly. 17 Most term policies have a current premium and a guaranteed maximum premium. This gives the insurance company some discretion to raise rates if expense assumptions have been too low. A boost in premiums can only be done by class of policies, not selectively by individual.

Risk Management 327

Another term insurance variation is reentry. Reentry is the requirement that you pass health tests at stated times to qualify for the annual rates given in the policy. Nonqualification can result in significantly higher rates, but not cancellation of the policy. Policies also vary in terms of how long current prices hold; for example, some typical time frames for rate increases are annually, every 5 years, or every 10 years. Finally, some policies pay dividends, as do certain whole life policies. They should be viewed as reductions in annual payments because payments are generally made at the beginning of the period, while dividends are often received at the end of the period. For time value of money purposes, they can be credited against the following year’s payments. Term policies pay out death claims much less often than most other forms of life insur- ance. The combination of term being used for limited periods of time over the life cycle and usually expiring by age 70 is the reason. A quotation for an ordinary term policy for a man age 22 is given in Table 11.5.

Whole Life Insurance Whole life is more complex than term. In contrast to term’s ever-increasing cost, pay- ments for whole life insurance are level over the life of the policy. Level payments are possible despite higher mortality costs over time because payments in early years are higher than policy needs. In other words, more money is paid into a policy in the early years than is needed to cover insurance company overhead and mortality pay- ments. Therefore, whole life can be defined as life insurance providing fixed cover- age for the life cycle of the insured. Level policyholder premiums are made possible by higher than pure mortality and insurance company overhead payments in the early years, which bring about a cash value savings component for the policy. The cost of a whole life policy for a man age 35 is represented in Table 11.6. Notice how much

Year Policy Premiums Year Policy Premiums

1 $173 25 $1,360 2 $235 26 $1,480 3 $343 27 $1,550 4 $453 28 $1,630 5 $570 29 $1,745 6 $575 30 $1,880 7 $580 31 $2,065 8 $585 32 $2,265 9 $590 33 $2,520 10 $590 34 $2,835 11 $590 35 $3,155 12 $605 36 $3,500 13 $615 37 $3,795 14 $630 38 $4,135 15 $660 39 $4,545 16 $685 40 $5,045 17 $730 41 $5,655 18 $770 42 $6,340 19 $815 43 $7,060 20 $875 44 $7,820 21 $950 45 $8,590 22 $1,035 46 $9,370 23 $1,135 47 $10,210 24 $1,250 48 $11,080

TABLE 11.5 Term Insurance— Man Age 22, $250,000 Policy

328 Part Three Portfolio Management

Year

Guaranteed Contract Premium

Guaranteed Death Benefit

Projected Dividend

Projected Cash Value1

1 $1,828 $250,000 0 0 2 $1,828 $250,000 0 0 3 $1,828 $250,000 0 $490 4 $1,828 $250,000 $105 $2,313 5 $1,828 $250,000 $151 $4,242 6 $1,828 $250,000 $201 $6,290 7 $1,828 $250,000 $415 $8,639 8 $1,828 $250,000 $462 $11,134 9 $1,828 $250,000 $515 $13,783

10 $1,828 $250,000 $572 $16,599 11 $1,828 $250,000 $632 $19,210 12 $1,828 $250,000 $701 $21,987 13 $1,828 $250,000 $775 $24,945 14 $1,828 $250,000 $853 $28,088 15 $1,828 $250,000 $941 $31,432 16 $1,828 $250,000 $1,033 $34,983 17 $1,828 $250,000 $1,139 $38,760 18 $1,828 $250,000 $1,249 $42,779 19 $1,828 $250,000 $1,367 $47,049 20 $1,828 $250,000 $1,498 $51,588 21 $1,828 $250,000 $1,637 $56,407 22 $1,828 $250,000 $1,788 $61,524 23 $1,828 $250,000 $1,954 $66,956 24 $1,828 $250,000 $2,131 $72,720 25 $1,828 $250,000 $2,309 $78,827 26 $1,828 $250,000 $2,497 $85,302 27 $1,828 $250,000 $2,681 $92,179 28 $1,828 $250,000 $2,881 $99,484 29 $1,828 $250,000 $3,101 $107,236 30 $1,828 $250,000 $3,344 $115,462 31 $1,828 $250,000 $3,622 $124,193 32 $1,828 $250,000 $3,917 $133,456 33 $1,828 $250,000 $4,245 $143,274 34 $1,828 $250,000 $4,608 $155,668 35 $1,828 $250,000 $4,992 $164,686 36 $1,828 $250,000 $5,403 $175,357 37 $1,828 $250,000 $5,802 $188,729 38 $1,828 $250,000 $6,237 $201,838 39 $1,828 $250,000 $6,715 $215,721 40 $1,828 $250,000 $7,248 $230,415 41 $1,828 $250,000 $7,847 $245,956 42 $1,828 $250,000 $8,458 $262,350 43 $1,828 $250,000 $9,088 $279,632 44 $1,828 $250,000 $9,707 $297,810 45 $1,828 $250,000 $10,394 $316,986 46 $1,828 $250,000 $11,073 $337,190 47 $1,828 $250,000 $11,790 $358,482 48 $1,828 $250,000 $12,498 $380,887

1 Includes accumulated dividends.

TABLE 11.6 Whole Life Policy— Man Age 35, $100,000 Policy (in dollars)

greater the cost in early years is for whole life as compared with term; more than seven times as much. However, in later years, the cost comparison reverses. The relative costs over a full adult life cycle are provided in Figure 11.2.

Chapter Eleven Risk Management 329

Annual payments in excess of mortality and overhead costs are placed in a cash value account. The cash value can be withdrawn less some redemption charge or borrowed against. You receive a return based on the insurance company’s investment performance and com- petitive factors. As the cash value account amount increases, it provides higher income. In later years, assuming coverage remains level, premium payments are able to remain level despite the sharply higher mortality costs because of this return on the cash value account. In Figure 11.3, the cash flow process for life insurance is given. Limited pay policies, sometimes illustrated as vanishing premium policies, are a varia- tion on ordinary life insurance that has level payment throughout the insured’s life. With this approach, yearly payments are even higher than with level pay.18 This creates an even higher cash value with greater yearly income. After a period of time, say 10 years, or at age 65, payments are scheduled to stop. At the time policies are fully paid up, the income and principal paydown on the cash value account is intended to cover the death benefit, with no further payments. Similarly, a single-premium policy is priced so that one large premium will build a self-sustaining cash value reserve and if the assumptions built into the quote are correct, no additional contributions will be necessary.

Universal Life Insurance Universal life is more flexible than whole life insurance. It often has a significant cash value account, but yearly payments by the policyholder may vary. In essence, it combines term and whole life since it has both term-like charges and a side fund that receives an in- vestment return intended to pay term insurance premiums. If payments and existing cash

22 27 32 37 42 47 52 57 62 67 Age

Pr ic

e pe

r t ho

us an

Term Whole Life

FIGURE 11.2 The Cost of Term versus Whole Life Insurance

18 Limited pay policies also have level payment, but, as mentioned, they have a greater annual outlay.

FIGURE 11.3 Whole Life Insurance—The Cash Flow Process

Excess premium payment

Mortality cost Other insurance expense

Premium payment

Beginning-year cash surrender value

Income on beginning- year cash surrender

value

Cash surrender value year-end

+ =

330 Part Three Portfolio Management

value are not sufficient to meet current insurance company needs, insurance coverage can be reduced. In contrast to whole or term life, insufficient payment does not automatically result in cancellation of the policy. Universal life policies can be cheaper than whole life policies, but, if policy projections are not met, the extra cost may be shifted to the policy- holder through additional insurance payments; in contrast, whole life provides a guaran- teed payout for a fixed stated annual premium.

Variable Life Insurance Variable life is similar to whole life except that it transfers the investment function from the insurance firm to the individual. Individuals may select the proportion of stocks or bonds they would like and the types of funds within each category. The choices can be limited to monies managed by each insurance company or may include an outside money manager. There exists the potential for greater return than what an insurance company would offer in a whole life policy. Variable life might result in lower future premium pay- ments or higher cash values, but there is also greater risk. If the funds have poor perfor- mance, greater premium payments may be needed or coverage could be jeopardized.

Variable Universal Life Insurance Variable universal life combines the payment flexibility of universal life with the investment flexibility of variable life. It offers the choice of both time and amount of premium payments, as well as the opportunity to select bond or stock funds, frequently with a choice within cate- gory. On the other hand, it can be difficult to determine what an adequate level of funding is.

Indexed Universal Life Insurance Indexed universal life offers a cash value account tied to one or more market benchmarks, such as the Standard & Poor’s 500 Index. This means your cash value growth is based on how well the stock market performs. Policy holders are allowed to decide the percentage of funds that they wish to allocate to fixed and indexed portions. Typically, this account will lose little or no value in any year, even if stocks crash. On the other hand, policy gains may be capped at, say, 12% or 15% in a given year, even if the index moves much higher. Overhead costs for this type of policy are higher and stock index returns passed along generally don’t contain dividend in- come. Policy terms can be complex and often can be altered after the policy has been issued so it pays to study the policy closely before making any commitments.

Term as Compared with Whole Life Policies As we have seen, there are basically two types of insurance: term and whole life. Term is pure protection against premature death. Whole life adds an investment component. The individual characteristics among whole life–type policies may differ: whole life provides level payment, universal allows more flexibility in premium payment, variable gives more flexibility in investment options, and indexed policies have upside potential with downside protection at a significant fee, but they all offer an investment feature. Consider this comparison of the two principal types of life insurance:

Term Strengths 1. Pure insurance—risk management is the prime intent. 2. Unlimited flexibility in investment options is associated with buying term and investing

the difference in costs between term and whole life. 3. There is highly competitive pricing. 4. It is relatively easy to compare policies against one another. 5. There is flexibility in reducing or eliminating coverage efficiently over time.

Risk Management 331

Weaknesses 1. Rates rise over time until they are prohibitively expensive. 2. There is the potential for underinsurance if individuals do not invest the savings in out-

lays between term and whole life, spending the money instead. 3. Some policyholders are uncomfortable with what can be significant payments without

continuing values. 4. The policy may be more susceptible to moral hazard and adverse selection than other

types of insurance, particularly if there is no reentry provision.

Whole Life Strengths 1. The premiums remain level over time and thus aren’t unaffordable in later years. 2. Higher payments than needed to cover mortality risk are an effective “forced savings”

component for those who need it. 3. The amount in the cash value account that is built over time is tax-sheltered. No taxes

are paid unless the policy is surrendered.19

4. Cash values accumulated can be borrowed against to help finance retirement. 5. Monies spent in premiums can provide a tangible cash benefit over time, not a pure

expense as in term. 6. The policy is designed to commonly pay a cash benefit to the beneficiary in contrast to

term’s less frequent payout as temporary insurance.

Weaknesses 1. The costs for full coverage for young people on limited incomes can be very high. 2. The investment element of whole life, the cash value accumulated, is only available

while the person is alive. The amount paid out at death is just the insurance amount, not the insurance amount plus the cash value.

3. Policies are difficult for the average person to compare. 4. Non-tax-deductible interest20 is charged on amounts borrowed on cash value. 5. Termination of the policy in early years generally provides little or no cash value,

making it an inefficient investment for many years. (Approximately 20 percent of the policies are canceled in the first 2 years.)

On balance, given the same coverage for both types of policies, decisions should be made based on

1. How long the policy is to be held. Term, which has no cash value, may be most com- petitive for periods of 10 years or less; whole life should be held for at least 10 years.

2. Whether in fact the “difference” is saved, not spent, when buying term and investing the difference.

3. The buyer’s risk tolerance for investments. Those with low risk tolerance are more likely to find whole life returns attractive than are those with a high tolerance for risk.

4. The actual difference in return between a whole life policy and the investment alterna- tives available to the policyholder.

19 When it is surrendered, taxes are only paid on the difference between cash value and total premiums paid, even though premiums covered the possibility of premature death since the policy was taken out. 20 Unless the sum is used to finance a tax-recognized project such as an investment in a business venture.

332 Part Three Portfolio Management

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Risk Management

©Don Hammond/Design Pics, Inc.

Chapter Eleven Risk Management 333

Example 11.4 Henry and Helen, two friends who had separate households, decided to investigate insurance policies together. They are both disciplined savers who could afford either term or whole life premiums. They each thought they would need the insurance for 20 years. Based on the cur- rent returns, they calculated that the return on a whole life policy was 6 percent. In other words, the return on a whole life policy after taking into account its higher payments in early years as compared with term was 6 percent on a time-weighted basis. Henry, who had a low tolerance for risk, calculated that he would put any money saved by buying term into money market funds yielding 2 percent; he took the whole life policy. Helen, who had a higher risk profile, felt that she could invest the money at a rate of return in excess of 6 percent. She purchased the term policy.

If you seek insight on past returns, Best’s Review (Life-Health Edition) could be used to compare past actual versus projected dividends. Also, where the life insurance company is willing to supply the information, Joseph Belth’s method of calculating actual rates of re- turn for policies already in existence for the current and past two years could be used as a representation of recent returns.22 The Belth formula is provided in Appendix II. The most common quantitative comparisons of policies are given in Appendix I.

Back to Dan and Laura RISK MANAGEMENT AND LIFE INSURANCE Our meeting was set for late afternoon. Dan was able to get off from work early, and Brian was sleeping quietly in the carriage. Judging by previous discussions, I decided that Dan and Laura were too focused on insurance to the exclusion of other risk management techniques.

22 Joseph M. Belth, Life Insurance: A Consumer’s Handbook, 2nd ed. (Bloomington, IN: Indiana University Press, 1985). Joseph M. Belth, editor, The Insurance Forum, monthly newsletter, theinsuranceforum.com/ index.html

People often don’t understand how to differentiate properly between whole life insurance offerings.21

They have greater success with term insurance where, once a few basic differences are explained, they select properly. Whole life insurance is much more complex with significant differences by company in mortality costs, overhead costs, and investment returns. Moreover, even if a company had above-average in- vestment returns in the past, there is no assurance

Practical Comment Comparing Life Insurance Policies

21 This is corroborated in Albert Auxier, “A Test of the Usefulness of Policy Information in Ranking Life Insurance Alternatives,” Journal of Risk and Insurance 43, no. 1 (March 1976): 87–98. For corroboration of the premise that life insurance can confuse and intimidate people, along with tips for picking the right policy, see “Life insurance: Who needs it?” by Chris Kissell, Bankrate.com, 2/27,2013, bankrate.com/ finance/insurance/life-insurance-who-needs-it.aspx

that this was not due to chance or to a portfolio man- ager who had left, and consequently past returns may not be a reliable indicator of future performance. One alternative approach in comparing life insur- ance companies is to eliminate investment returns as a consideration and concentrate principally on mor- tality and overhead costs. With this approach, all companies providing policy illustrations would be asked to employ the same rate of return, say 6 percent. Then we could calculate their return on life insurance for all policies of the same type using the return method shown in this chapter. The policy with the highest return among those companies with well-established, high-quality operations would be selected. Interestingly, companies can come out with materially different relative rankings of return at different policyholder ages.

334 Part Three Portfolio Management

I thought it would be helpful to provide some initial education. I mentioned that they needed to take an overall risk management approach. I indicated that risk management involves all of their assets and their personal practices. I told them that they should think of their assets, both marketable and nonmarketable, as part of a portfolio to supervise for overall return and risk maintenance. Dan understood the approach right away and Laura picked it up after a brief example. Dan said, “I suppose I should tell you that I am a hot-rod racer. I have been ever since I was 16 and my uncle, who was a mechanic, taught me how much fun it was to enter and compete at a race track.” A quick glance over at Laura indicated she didn’t share his joy. She said, “Dan didn’t tell you about the time he broke his collarbone in an accident and the other time they pulled him out of a burning car.” Their other personal practices seemed okay. They paid attention to their diet and exer- cised; Laura now jogged with her baby carriage in front and their dog following. Despite disagreements, Dan and Laura seemed to have a good relationship, with each deferring to the other’s wishes. They did yoga exercises together to eliminate the day’s stresses. Neither had any serious illnesses. Dan and Laura had different points of view concerning the type of life insurance they should have. She was the more aggressive investor and preferred term insurance. She believed that gains of 20 percent a year were possible in stocks, providing you were in the “right investments.” She wanted to have the maximum amount of cash available to invest. Dan was not sure that he wanted to place all household money in investments under their control. I had the feeling that Dan preferred whole life insurance and was attracted to the steady returns of a cash value insurance policy. They both indicated they preferred the structure of a fixed-payment whole life policy to a more flexible universal life policy. Neither one was attracted to variable life insurance. Both were confident that their recent inability to save money would end and be replaced by substantial yearly net cash inflows. As the meeting wound down, they gave me insurance proposals with actual quotes on two whole life insurance and two term insurance policies. They asked me to review them and make some preliminary recommendations. They understood that I would not be able to tell them how much insurance they should have until later in the process. However, they wanted my preliminary opinion as to whether it should be whole life or term. We decided to end the conversation there. I told them I would send them a preliminary draft of overall risk management procedures and the life insurance section for their comments. At a future meeting, we would go over the other types of insurance.

Here’s the advice I presented to them: Risk management is the method by which we control the risks for each household. It is much broader than just gauging insurance needs. It involves examining household assets overall and one by one. You have asked me to look over all your exposures. To facilitate this process, assets are separated into three principal categories. The first category is human-related assets, which include human assets. Human assets are derived from your salaries. Your exposures hence involve your personal health, safety practices, and insurance needs. They also include pen- sions and gifts derived from your work and relationships. Exposures involve inflation and relationship risk, respectively. The second category is financial assets, which involve your investment and financing practices. As you are aware, financial assets have a chance for loss particularly if they are not selected properly. The third category is the real assets com- prising your house, furniture, car, and so on. Fire, theft, and depreciation in value are three exposures here. In addition, we will consider your intangible assets including household goodwill and liability exposure to others.

Risk Management 335

As we discussed, these assets should be thought of as being part of a special portfolio. It is special because it is yours. It comprises not only marketable assets but nonfinancial ones such as your careers. Our goal is to control individual assets and your overall portfo- lio risk to enable you to have confidence that you will reach your goals. From a personal perspective we are pleased to affirm that you have good personal safety practices. You both are practicing good eating habits including balanced meals. Laura is to be commended for her quick loss of the 35 pounds she gained during her pregnancy with Brian. Both of you exercise regularly. Based on our discussions, you seem safety-conscious in your activities. At the present time, each of you is in good health. Your efforts to reduce stress through daily yoga exercises are a plus. However, Laura’s side of the family’s seem- ing genetic exposure to early mortality due to heart ailments bears watching. It could suggest the advisability of more savings today and perhaps more insurance coverage, as the household would be materially affected financially by any loss of her income and an inability later to qualify for insurance. The only change of practice I could see would be to review Dan’s participation in drag car racing. Dan, I recognize that you have enjoyed racing your 1953 hot rod Chevrolet for many years. I question, however, whether this hobby is appropriate given your responsi- bilities to Laura and Brian. Any personal injury could have a material effect on them. Moreover, it seems inconsistent with your generally conservative nature. Perhaps you could explore an alternative hobby that you might find satisfying. I am pleased that you will have two sources of income once Laura goes back to work. Given her tenure as a schoolteacher, her position balances the higher levels of risk and higher returns that Dan has in his career. You have both indicated that your personal relationship is excellent and that having a child had not resulted in any friction between you. Your exposures in property, health, disability, and miscellaneous areas will be handled later. Moreover, investments and debt risk, both of which are meaningful to you, have been covered in separate sessions. I will limit myself to life insurance at the present time. Life insurance is a method of protecting family assets so that many goals can be reached in the event of the untimely death of an income earner. Thinking of life insurance is impor- tant to the household because both incomes will be needed long term to meet retirement goals. Your material current debt and your desire to fund a private college education for two children make it particularly relevant. The absence of a replacement source of income could place an inordinately large burden on the surviving spouse. As mentioned before, I do not have enough data yet to recommend a specific amount of insurance. However, I will make a preliminary statement of the adequacy of your current coverage. You have separately indicated that in the event of the loss of one of you, the other should be funded comfortably for life. After careful thought, you have defined that as a 10 percent decline from current living costs now and in retirement; that figure reflects the absence of one household member and a modest reduction in leisure time expenditures. Based on that assumption, it is clear that both of you are currently underinsured. You asked whether you should have term or whole life insurance. Actually, I am going to recommend a combination of both. Here is a brief description of both types and the rea- sons why I am making that recommendation. Term life represents pure insurance today. Its advantage is low current cost and full freedom to place your savings from the lower cost of your policy in investments that you select. Based on our discussions, it is clear that Laura would like as much yearly cash flow as possible to invest herself. Furthermore, it is likely that much more expensive whole life could put a crimp in your current living style if it is used to fund your entire insurance need. Perhaps most important, based on a savings pattern that I will propose, you are likely to be financially independent at some point. At that time, you won’t need any life insurance.

336 Part Three Portfolio Management

As the need is temporary and the return on alternative investments is likely to exceed life insurance rates, I will be recommending some term insurance. On the other hand, I am recommending some whole life insurance as well. I am con- cerned about your ability to save. Your future goals of saving a material sum are reasonable, but, at the present time, judging by your current debt outstanding, you have not yet shown the discipline to save. The excess cash value that you accumulate can be made available to you at the time you cash in your policy. This could be done at the point you reach financial independence. In addition, I believe that Laura’s projection of 20 percent a year growth in investments is too optimistic. This life insurance can be considered a conservative invest- ment in your portfolio to help diversify and balance your aggressive aspirations. As for the comparison between the two term policies (see Appendix I) it is clear that policy A is cheaper in the early years. On the other hand, policy B becomes less expensive after year 8 and the disparity grows in subsequent years. Both insurance companies are of high quality. The policies are guaranteed renewable and convertible into whole life. If I thought your need was only for eight years, I would recommend A. You could always purchase A and in eight years attempt to go through the process again. I say “attempt” be- cause there is no assurance that you would qualify if some unforeseen decline in health occurred. I believe you will need life insurance for an extended time and I would prefer not running the risk of your becoming uninsurable. Plan B’s 20-year net present value is mate- rially below plan A’s. Consequently, I prefer B. As I mentioned, these preliminary recommendations are intended to move our conver- sations forward. They are subject to insurance amounts that I will give in a later section of your plan and an overall integration of your goals and resources.

College Student Case Study and Review: Amy and John RISK MANAGEMENT Risk management is a very important part of household planning. In fact, both Amy and John were very eager to learn more. I was a little baffled because many people their age tend to be optimistic about their future and blow off cautious behavior. So I asked them why they were so interested. John pointed to his wallet and said the “great recession” had changed both his and Amy’s lives. They wanted to know how to learn from their parents’ mistakes to avoid taking a decline in their standard of living when they were on their own. I explained to them that risk management was a very broad topic. It encompassed protecting every important asset they had in their household. I recommended we put the household assets together and look at them as the household portfolio. Risk creates obstacles to goal achieve- ment. We don’t necessarily need to eliminate risk; just control it so that it doesn’t materially disrupt our planning. Risk management techniques help us modify a household’s portfolio. The risk management process consists of developing objectives, establishing risks (called exposure), identifying the tools that can alter risk, matching tools to exposure, im- plementing, and reviewing. The tools that we have include:

Avoid Risk Eliminate your exposure. Example: Don’t drive when intoxicated.

Reduce risk Eating well and exercising reduces risk of becoming sick.

Reduce potential loss Accidents happen; seat belts reduce possibility of significant injury.

Risk Management 337

Retain risk Risk protection is too costly; absorb some financial loss through self-insurance. Example: Assuming the cost of a break in is a limited amount of damage to the home and no loss of possessions.

Diversify By broadening assets you protect against an unfavor- able event.

Transfer risk Shift risk to others such as an insurance company. Sharing risk Share risk with an insurance company.

The types of risks are broken out by type of asset.

Human-related assets Human assets, Social Security pension assets, gifts and bequests.

Longevity risk Premature death or living an extra-long life. Protection premature death Life insurance, health measures. Protection extra-long life Greater savings, start Social Security at a later date. Health and disability risk Medical insurance, disability insurance. Economic risk Macro (overall economic risk)/Micro (industry or

individual company risk). Protection Precautionary savings, two wage earner incomes. Real assets Tangible assets household owns. Protection Insurance for each significant asset and precautionary

practices like locking doors.

Financial assets Protection Diversify among financial assets as affected by the

economy. Consider real estate and gold; less correlated with movements in stocks.

Financial liabilities Protection Reduce debt, buy mortgages with caps on interest

rate, precautionary savings. Intangible liabilities Less quantifiable liability exposures, Example:

Being sued if someone falls in front of your house. Protection Umbrella policy, taking care of your property.

Insurance Insurance is a method of transferring risk. The insurance company assumes the risk, called insurance underwriting, in return for a fee that builds in a profit for the company. Moral hazard is the extra credit coming from such factors as undisclosed illness or faking injury. Adverse selection is the greater chance of loss, relative to that for the average per- son. It is based on knowledge the individual has about health that the insurance company does not have. Insurance companies can be differentiated by:

Financial strength Ratings from the highest, AAA, to C. Good operating sense Selecting proper risks and keeping overhead down. Service Responsive to client wishes and pays out promptly

and fairly.

338 Part Three Portfolio Management

Price Providing value. Other Size of the company, the larger the lower

risk of failure; specialization and years in business.

Life Insurance Life Insurance is generally payment on death. Life insurance diversifies the portfolio of the household assets for two or more members and helps adjust it to the household’s tolerance of risk. The three portions of a life insurance policy are mortality charge, investment return, and overhead expense. Mortality charge is the amount of expense based on the proba- bility of dying during the time period selected. If the insurance is for a full life, it is the expectation of the age when the person will die calculated with probabilities around that age. Investment return is the return on the extra monies deposited by the policy- holder in early years, which exceed the mortality charge and the overhead costs. Overhead costs are the other expenses of the insurance company and the expected profits built in by the insurance company. The amount of insurance taken out depends on your goal. A specific goal may be to fully or partially replace an income earner’s wages to fund education costs for children in the event of death. Term insurance is pure mortality insurance for a fixed period of time. If you don’t pass away during the period of the policy, the entire cost is written off. As you grow older, the probability of death rises and therefore so does the insurance cost. Whole life insurance is more complex. The policyholder pays a level fee over time. The outcome is an excess payment in early years with the excess earning interest, allowing the cash value to grow. This cash value finances the higher mortality costs later in life, when the probability of death rises. The four variations on whole life are universal life, which is more flexible as to the payment terms and amount covered may vary over time; variable life, which allows the policyholder to select the investment vehicle, generally stocks and bonds, and the excess is invested instead of the insurance compa- nies assigned; investment return of variable universal, which combines the other two alternatives; and indexed universal life insurance, which offers a cash value account tied to one or more stock market benchmarks, such as the Standard & Poor’s 500 Index. In looking at term versus whole life, term has highly competitive pricing, easy com- parability of policies, no investment/all expense element, and flexibility in amount of coverage over time. However, rates rise over time until they become prohibitively expensive. Whole life payments are level, the excess payments in early years are a form of forced savings, interest on excess cash value payments aren’t taxed, amounts in cash value can be borrowed against, and people have the feeling of accumulating value with their rising cash value over time. On the other hand the annual cost for young people is very high relative to term, the cash value accumulated is not returned at death—just like the face value of the policy—unless the cash payments are used to buy a higher face value. Policies are difficult to compare against each other if you die in the early years of the policy you get relatively little cash value back. On balance a key element is how long you expect to keep the policy. For shorter periods and tempo- rary exposures, term may be the best. The lower the risk tolerance, the greater the need for forced savings, the longer the period of need the greater the attraction of whole life. Simplistically, we generally may buy term for holdings under 10 years and whole life for periods over 10 years.

Chapter Eleven Risk Management 339

Summary Risk management is an underappreciated part of PFP. It too often is equated with insur- ance alone.

macro- and microeconomic risks. -

folio risk.

Key Terms 318 326

316 317

325 317

insurance 317

317 326

323 315

315 316 316

318 324

316 327

326

risk management in 312

risk management 311

326 329

330

330 327

acli.com

rmahq.org Risk Management Association

risk management problems are presented.

Websites

340 Part Three Portfolio Management

irmi.com International Risk Management Institute The site offers practical strategies and tactics to help understand insurance and risk management information.

Questions 1. Define risk management. 2. How does portfolio management enter into the risk management process? 3. Why is diversification important in risk management? 4. What are the functions of a risk manager? 5. Contrast business and personal risk and separate the household’s risk exposure into

one or the other. 6. Which type of insurance might be more susceptible to moral hazard: term or whole

life? Why? 7. A person who trades in his 15-year-old automobile and purchases a new car with disk

brakes is practicing which method of managing risk? 8. How would you decide whether to transfer risk or share risk? 9. Indicate what type of life insurance you would recommend for someone who is sched-

uled to be financially independent in eight years. Why? 10. How can insurance modify portfolio risk? 11. What are the significant factors in selecting an insurance company? 12. List the types of risks to human assets and briefly explain how to reduce them. 13. How is whole life insurance able to maintain a flat payment? 14. Describe the insurance needs approach. 15. Assuming continuing payments, will the cash value of whole life always go up over a

life cycle? Why? 16. Why can term insurance be deducted from whole life to determine the return on the

whole life policy? 17. Contrast variable and universal life insurance. 18. Julian was considering whole life and term insurance for his 20-year need. Which one

should he select? 19. Name three strengths and weaknesses of whole life and term insurance. 20. What is indexed universal life insurance and how is it different from the other whole

life policies? 21. Identify the three parts of an insurance policy? 22. What is longevity risk and explain the two different scenarios that exist?

Problems These problems are based on information provided in Appendix I. Randy had two term policies to compare, with costs as shown below. Calculate the NPV at a 6 percent after-tax discount rate and the IRR. Which one should she select and why?

11.1

Years A B

1 $225 $300 2 $275 $310 3 $350 $320 4 $400 $330 5 $500 $340

Chapter Eleven Risk Management 341

Find the return on the whole life insurance policy when the cost of term is included. Which would you select if you can invest the difference between the term and whole life policies’ premiums at a 9 percent rate? Explain your reasoning.

Given the following information:11.2

Guaranteed Contract Premium

Guaranteed Death Benefit

Projected Dividend

Projected Cash Value

Term Premium

$2,300 $200,000 0 0 $325 $2,300 0 0 $330 $2,300 0 0 $335 $2,300 0 $3,500 $340 $2,300 $250 $6,000 $355 $2,300 $400 $9,000 $370 $2,300 $600 $12,000 $390 $2,300 $750 $15,000 $400 $2,300 $900 $18,000 $410 $2,300 $1,000 $24,000 $430

Regarding the characteristics of insurance, which of the following is/are fundamental?

1. Probability (possibility and predictability of a loss). 2. Law of large numbers. 3. Transfer of risk from individual to group. 4. Insurance is a form of speculation.

a. (1) and (2) only. b. (1), (2), and (4) only. c. (2) and (4) only. d. (4) only. e. (1), (2), (3), and (4).

What is the main responsibility of the underwriting department of a life insurance company?

a. To guard against adverse selection. b. To set a limit on the amount of insurance issued. c. To set adequate insurance rates. d. To avoid exposures that could result in loss.

Veronica recently purchased a car for $1,500 for her 16-year-old child. Which of the fol- lowing risk management techniques would be most appropriate for handling the collision exposure of this automobile?

a. Subrogation. b. Insurance. c. Retention. d. Avoidance.

11.1

11.2

11.3

CFP® Certification Examination Questions and Problems

342 Part Three Portfolio Management

Which of the following best describes the difference between a variable life policy and a universal life policy?

a. Variable life has a variable death benefit and universal life has a fixed death benefit. b. Variable life subaccounts do not guarantee market returns, while universal life contracts

contain a guaranteed rate. c. Universal life has guaranteed mortality charges, while variable life has nonguaranteed

mortality charges. d. Variable life contracts do not guarantee market returns, while the market interest rates in

universal life contracts are guaranteed.

11.4

Risk Management 343

Case Application RISK MANAGEMENT AND LIFE INSURANCE In our meeting, it became apparent that Richard’s investment loss was not a solitary act. Richard was very indulgent and paid little attention to his health. He went out on shopping sprees that he and Monica couldn’t afford. He was overweight. He used alcohol exces- sively and smoked. His doctor had warned him of his unhealthy habits including a high cholesterol level, which placed him at risk of a major illness. His work output was excel- lent, but he often got into verbal arguments with superiors. The result was a reputation as a brilliant but unsteady worker who shifted from job to job often. Monica, on the other hand, was as steady as Richard was fickle. She was a vegetarian who exercised regularly. Her doctor told her she had the physical condition of a woman 10 years younger. Given Richard’s erratic behavior, one would think Monica would be under great stress. When I posed that question to her, she said that she had learned to cope with Richard’s behavior. The couple had no life insurance except for a policy providing one times Richard’s sal- ary at work. Monica had often asked Richard to get some additional insurance. His reply was that they did not have enough money. Monica specifically requested that I look at term and whole life insurance and tell her the type and amount of insurance that was appropriate. As we completed the topic, Richard said he was sorry for his behavior and would “turn over a new leaf.” Monica replied that she was not sure Richard could do it.

Case Application Questions 1. What do you think of this couple’s overall risk profile? 2. What recommendations would you make to improve it? 3. Do you believe these recommendations will be followed? 4. Assuming there is some uncertainty that the advice will be followed, what other recom-

mendation might you make? 5. Do you believe they should have more insurance? 6. Which type would you recommend: whole life or term insurance? 7. Prepare the overall risk management and life insurance parts of the financial plan.

Quantitative Comparison of Policies Insurance policies can be compared within each category; for example, one term policy with another. In addition, one category’s policies can be compared with those from another area; for example, term versus whole life. The return on investment method, an interest- adjusted method, and the net payment cost index are two common insurance industry methods. They appear on many policy quotations and are used to compare like kinds of investments. The lower the figures presented, the more attractive the policy. However, the purchase decision for insurance policies can be looked at as just another household capital budgeting problem. The cash outflows and inflows can be developed and compared both within each category and across categories using normal NPV and IRR methods.

344 Part Three Portfolio Management

Collectively, we can call these approaches the return on investment methods to differentiate them from common insurance industry methods. The NPV method just employs a discount rate to solve for the term policy with the lowest current cost. The IRR method can be used to compare alternative types of policies; say, a whole life with a term policy. It does so by taking the difference in costs between the two types of policies to see if the higher outlay for whole life in early years is justified on a return basis. It is sometimes called buy term and invest the difference. Term is preferable when the person will actually save and invest the sums at a rate that exceeds the return built into the whole life policy. The NPV method also can provide a solution under this method. The IRR calculation, which we can call the return on investment method, is further described later in the appendix.

Example 11.A1.1 Lisa wanted term insurance coverage for 10 years and had two finalists. One policy, policy A, was advertised as remarkably cheaper in the first year than the other. Which should she select, assuming the discount rate is 7 percent after taxes? (See Table 11.A1.1.)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

A B C D E Year Policy A

Premium Policy B Premium

1 2 3 4 5 6 7 8 9 10

($105) ($140) ($180) ($190)

($200) ($210) ($220) ($225) ($235) ($240)

($156) ($160) ($164) ($169) ($174) ($181) ($188) ($196)

($205) ($215)

Discount Rate 7%

Net Present Value

Policy A ($1,404.49)

Policy B ($1,332.11)

= B2+NPV(B14, B3:B11)

= C2+NPV(B14, C3:C11)

Excel Solution

TABLE 11.A1.1 Year Policy A Premium Policy B Premium

1 $105 $156 2 140 160 3 180 164 4 190 169 5 200 174 6 210 181 7 220 188 8 225 196 9 235 205 10 240 215

Risk Management 345

Practical Comment Use of Cost as a Selection Criterion

Calculator Solution

Policy A

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter cash outflow Year 1 105 CHS g CF0 105 +/− ENTER ↓ Enter cash outflow Year 2 140 CHS g CFj 140 +/− ENTER ↓ ↓ Enter cash outflow Year 3 180 CHS g CFj 180 +/− ENTER ↓ ↓ Enter cash outflow Year 4 190 CHS g CFj 190 +/− ENTER ↓ ↓ Enter cash outflow Year 5 200 CHS g CFj 200 +/− ENTER ↓ ↓ Enter cash outflow Year 6 210 CHS g CFj 210 +/− ENTER ↓ ↓ Enter cash outflow Year 7 220 CHS g CFj 220 +/− ENTER ↓ ↓ Enter cash outflow Year 8 225 CHS g CFj 225 +/− ENTER ↓ ↓ Enter cash outflow Year 9 235 CHS g CFj 235 +/− ENTER ↓ ↓ Enter cash outflow Year 10 240 CHS g CFj 240 +/− ENTER ↓ ↓ Enter the discount rate NPV 7 i 7 ENTER ↓ Calculate the net present value f NPV CPT −1,404.49 −1,404.49

Net present value = $1,404.49 Policy B

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter cash outflow Year 1 156 CHS g CF0 156 +/− ENTER ↓ Enter cash outflow Year 2 160 CHS g CFj 160 +/− ENTER ↓ ↓ Enter cash outflow Year 3 164 CHS g CFj 164 +/− ENTER ↓ ↓ Enter cash outflow Year 4 169 CHS g CFj 169 +/− ENTER ↓ ↓ Enter cash outflow Year 5 174 CHS g CFj 174 +/− ENTER ↓ ↓ Enter cash outflow Year 6 181 CHS g CFj 181 +/− ENTER ↓ ↓ Enter cash outflow Year 7 188 CHS g CFj 188 +/− ENTER ↓ ↓ Enter cash outflow Year 8 196 CHS g CFj 196 +/− ENTER ↓ ↓ Enter cash outflow Year 9 205 CHS g CFj 205 +/− ENTER ↓ ↓ Enter cash outflow Year 10 215 CHS g CFj 215 +/− ENTER ↓ ↓ Enter the discount rate NPV 7 i 7 ENTER ↓ Calculate the net present value f NPV CPT −1,332.11 −1,332.11

Net present value = $1,332.11

346 Part Three Portfolio Management

Although policy A is much cheaper in the first year, it more than makes up for it with rapidly increasing premiums in subsequent years. Its net present value is higher than policy B’s, which means it costs more to buy on a time-weighted basis.23 Thus, the answer is that Lisa should select policy B. Once the decision is made to purchase life insurance, the question is which policy. The two insurance methods discussed below, the interest-adjusted method and the return on investment method, can help the purchaser make that decision. These approaches are the established insurance company alternative to the return on investment method we have discussed in this chapter.

INTEREST-ADJUSTED METHOD The interest-adjusted method is used to compare like kinds of investments. Using this ap- proach, all cash outflows for insurance premium payments and all cash inflows from pol- icy dividends are brought forward to a specified future date, often 20 years. The discount rate used to adjust for the timing of cash flows is the investor’s assumed after-tax return on alternative use of the money in the market. In the following calculations, a 5 percent after- tax return was assumed. The future value of the net cash flows (outflows less inflows) is divided by the cash surrender value of the policy. With the cash surrender value approach, the lower the ratio of the future value of cash outflows to cash surrender value, the more attractive the policy.

Inflation-adjusted surrender policy cost

index

Future value of dividends received

over period

Future value of premiums paid

over period

End-of-period cash value

Future value of $1 deposited annually

over period $1,000

Amount of coverage

The net payment cost index is similar, except that the cash surrender value is excluded in the calculation. Table 11.A1.2 compares two term policies using a net payment cost index. Neither has dividends. Because term policies have no accumulated cash value, the cash surrender in- dex and the net payment index produce the same result. Note that policy A produces a better 10-year cost and policy B a more advantageous 20-year figure. The reason is evident when we compare the differences in cost by year, as shown in the last column.

RETURN ON INVESTMENT METHOD The second method, which is called the return on investment method, allows compari- son between whole life contracts and term as well as among whole life contracts that are being considered. It estimates the rate of return on the cash value of whole life con- tracts. Our construct below can be viewed as a modified insurance industry approach.24

In it the premium from a competitive independent term policy is used as a proxy for the

23 Note that in contrast to capital expenditures the calculation provides a negative sum. That is because it represents an expense, not an inflow (asset). Consequently, the alternative selected is the one that provides the lowest amount possible. 24 Called the Linton yield approach.

Risk Management 347

mortality and overhead costs of the life insurance policy being considered. This amount is subtracted from the whole life payment, as is the projected dividend. The result is a “pure” extra payment by the holder for which an investment return is expected. The an- nual extra payment for investment is the sum that could alternatively be used each year for investment. The extra payments are compared with the inflow from the cash surrender value, as- suming the policy is cashed at a given point in time. An NPV at an assumed discount rate based on the rate of return for alternative investment or a time-weighted return on the cash value (IRR) is calculated. Taxes are taken out of the cash surrender value at the policy- holder’s marginal tax rate and should be compared with the after-tax returns available on alternative investments. The outcome can indicate whether it is more favorable to purchase whole life or to buy term insurance and invest the difference in alternative investments. With the return on investment method, the rates of return between two whole life insurance policies can also be compared.

Example 11.A1.2 Michael didn’t know whether to purchase a whole life or a term policy. He narrowed his search to two policies—one life, one term. He wasn’t sure he needed the insurance for more than 20 years and wanted the comparison to be done purely on both a 10-year and a 20-year financial basis. He had no concern that he wouldn’t save the difference between the term and whole life policies and believed that if he bought the term policies, he could invest the monies on a 10 percent pretax basis. Assume that Michael was not subject to taxes. Which policy should he select? (See Table 11.A1.3).

TABLE 11.A1.2 Comparison of Two Term Policies—Man Age 35, $100,000 Policy

Year Policy A Premium Policy B Premium Difference (A – B)

1 $110 $156 ($46) 2 $110 $160 ($50) 3 $110 $164 ($54) 4 $110 $169 ($59) 5 $110 $174 ($64) 6 $174 $181 ($7) 7 $191 $188 $3 8 $207 $196 $11 9 $224 $205 $19 10 $240 $215 $25 11 $374 $227 $147 12 $398 $241 $157 13 $424 $256 $168 14 $452 $272 $180 15 $484 $291 $193 16 $517 $312 $205 17 $557 $337 $220 18 $602 $365 $237 19 $654 $394 $260 20 $713 $424 $289

Current Cost Index

10 Years 1.52 1.78 20 Years 2.85 2.26

Net Payment Index

10 Years 1.52 1.78 20 Years 2.85 2.26

348 Part Three Portfolio Management

PROJECTED INTERNAL RATE OF RETURN ON WHOLE LIFE POLICY

TABLE 11.A1.3 Whole Life versus Term Policy—Man Age 35, $100,000 Policy Year

Guaranteed Contract Premium

Guaranteed Death Benefit

Projected Dividend

Projected Cash Value

Term Premium

Life Premium Minus Term

Premium and Dividend

1 $1,189 $100,000 $0 $0 156 $1,033 2 1,189 100,000 5 105 160 1,024 3 1,189 100,000 6 711 164 1,019 4 1,189 100,000 46 1,858 169 974 5 1,189 100,000 122 3,182 174 893 6 1,189 100,000 202 4,490 181 806 7 1,189 100,000 283 5,986 188 718 8 1,189 100,000 371 7,678 196 622 9 1,189 100,000 415 9,328 205 569 10 1,189 100,000 462 11,238 215 512 11 1,189 100,000 512 13,114 227 450 12 1,189 100,000 563 15,158 241 385 13 1,189 100,000 617 17,275 256 316 14 1,189 100,000 674 19,570 272 243 15 1,189 100,000 736 21,949 291 162 16 1,189 100,000 798 24,515 312 79 17 1,189 100,000 905 27,215 337 (53) 18 1,189 100,000 1,019 30,058 365 (195) 19 1,189 100,000 1,143 33,058 394 (348) 20 1,189 100,000 1,277 36,327 424 (512)

In year 10, subtract $512 from $11,238 (projected cash value for year 10) to get the net inflow of $10,726.

Internal rate of return = 6.11%

Calculator Solution

10 Year

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter cash outflow Year 1 1,033 CHS g CF0 1,033 +/− ENTER ↓ Enter cash outflow Year 2 1,024 CHS g CFj 1,024 +/− ENTER ↓ ↓ Enter cash outflow Year 3 1,019 CHS g CFj 1,019 +/− ENTER ↓ ↓ Enter cash outflow Year 4 974 CHS g CFj 974 +/− ENTER ↓ ↓ Enter cash outflow Year 5 893 CHS g CFj 893 +/− ENTER ↓ ↓ Enter cash outflow Year 6 806 CHS g CFj 806 +/− ENTER ↓ ↓ Enter cash outflow Year 7 718 CHS g CFj 718 +/− ENTER ↓ ↓ Enter cash outflow Year 8 622 CHS g CFj 622 +/− ENTER ↓ ↓ Enter cash outflow Year 9 569 CHS g CFj 569 +/− ENTER ↓ ↓ Enter cash inflow Year 10 10,726 g CFj 10,726 ENTER ↓ ↓ Calculate the internal rate of f IRR IRR CPT return 10-year 6.11% 6.11%

Risk Management 349

In year 20, add $36,327 (projected cash value for year 20) to $512 to get net inflow of $36,839.

Internal rate of return = 9.70% Michael selected the term policy. Because the whole life insurance policy provided a return of 6.11 percent pretax for 10 years and 9.70 percent for 20 years, he believed he would do better by buying term and investing the difference at his 10 percent rate than by purchasing whole life insurance. If his rate of return on investments had been 5 percent, he would have come to the opposite conclusion.

ANALYSIS OF EVALUATION METHODS Each of the two methods of comparing policies has advantages. The interest-adjusted method places emphasis on costs for life insurance policies. Individual policies are com- pared with one another to find the lowest cost. Normally, capital budgeting problems of this type in finance solve for present value using the net present value technique, as was shown in this chapter, but the custom in insurance is to calculate the value of cash value to life insurance outlays at a future point in time. Because the reason for purchasing life in- surance is most often to protect, and protection involves expenses, a cost-based system of analysis has the advantage of being consistent with that intent. The second method is a return-based system. It takes into account the investment com- ponent of life insurance policies and calculates the net return on the investment. The lower

20 Year

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter cash outflow Year 1 1,033 CHS g CF0 1,033 + − ENTER ↓ Enter cash outflow Year 2 1,024 CHS g CFj 1,024 + − ENTER ↓ ↓ Enter cash outflow Year 3 1,019 CHS g CFj 1,019 + − ENTER ↓ ↓ Enter cash outflow Year 4 974 CHS g CFj 974 + − ENTER ↓ ↓ Enter cash outflow Year 5 893 CHS g CFj 893 + − ENTER ↓ ↓ Enter cash outflow Year 6 806 CHS g CFj 806 + − ENTER ↓ ↓ Enter cash outflow Year 7 718 CHS g CFj 718 + − ENTER ↓ ↓ Enter cash outflow Year 8 622 CHS g CFj 622 + − ENTER ↓ ↓ Enter cash outflow Year 9 569 CHS g CFj 569 + − ENTER ↓ ↓ Enter cash outflow Year 10 512 CHS g CFj 512 + − ENTER ↓ ↓ Enter cash outflow Year 11 450 CHS g CFj 450 + − ENTER ↓ ↓ Enter cash outflow Year 12 385 CHS g CFj 385 + − ENTER ↓ ↓ Enter cash outflow Year 13 316 CHS g CFj 316 + − ENTER ↓ ↓ Enter cash outflow Year 14 243 CHS g CFj 243 + − ENTER ↓ ↓ Enter cash outflow Year 15 162 CHS g CFj 162 + − ENTER ↓ ↓ Enter cash outflow Year 16 79 CHS g CFj 79 + − ENTER ↓ ↓ Enter cash inflow Year 17 53 g CFj 53 ENTER ↓ ↓ Enter cash inflow Year 18 195 g CFj 195 ENTER ↓ ↓ Enter cash inflow Year 19 348 g CFj 348 ENTER ↓ ↓ Enter cash inflow Year 20 36,839 g CFj 36,839 ENTER ↓ ↓ Calculate the internal rate f IRR IRR CPT 9.70% 9.70%

350 Part Three Portfolio Management

the cost of the term policy used in the example, the lower the return on the investment will be. One advantage of the return-based system is that the average buyer can relate better to a given return. That number can easily be compared with estimates for alternative invest- ment uses for the money as well as with individual whole life policies.

Belth Method Joseph Belth has presented a method for calculating the yearly rate of return on the savings component of a life insurance policy. It is given in the following formula:

R = 1CV + D2 + 1YPT2 × 1DB − CV2 × 1.00121P + CVP2 − 1

Excel Solution Whole Life versus Term Policy

1 2

3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

A B C D E F G H I

Year

Guaranteed Contract Premium

Guaranteed Death Benefit

Projected Dividend

Projected Cash Value

Term Premium

Life Premium Minus Term

Premium and Dividend

10-Year Cash Flows

20-Year Cash Flows

($1,033) ($1,024) ($1,019) ($974) ($893) ($806) ($718) ($622) ($569)

$10,726

1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19

$1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189 $1,189

$100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000

0 $5 $6 $46

$122 $202 $283 $371 $415 $462 $512 $563 $617 $674 $736 $798 $905

$1,019 $1,143 $1,277

0 $105 $711

$1,858 $3,182 $4,490 $5,986 $7,678 $9,328

$11,238 $13,114 $15,158 $17,275 $19,570 $21,949 $24,515 $27,215 $30,058 $33,058 $36,327

$156 $160 $164 $169 $174 $181 $188 $196 $205 $215 $227 $241 $256 $272 $291 $312 $337 $365 $394 $424

$1,033 $1,024 $1,019

$974 $893 $806 $718 $622 $569 $512 $450 $385 $316 $243 $162 $79

($53) ($195) ($348) ($512)

($1,033) ($1,024) ($1,019) ($974) ($893) ($806) ($718) ($622) ($569) ($512) ($450) ($385) ($316) ($243) ($162) ($79) $53

$195 $348

$36,839

IRR

10-year 6.11%

20-year 9.70%

= IRR(H4:H13)

= IRR(I4:I23)

Risk Management 351

where

R = Yearly rate of return on savings component of policy, expressed as a decimal CV = Current cash value at end of year D = Annual dividend YPT = Yearly price per $1,000 of protection DB = Death benefit P = Annual premium CVP = Cash value at end of preceding year

Part Four

Specialized Planning 12. Other Insurance 13. Retirement Planning

Specialized planning involves areas of PFP that require particular knowledge and frequently uses focused analytical tools. Insurance has a broad scope. In the previous risk management chapter, we discussed insurance overall and life insurance in particular. In Chapter 12, which deals with other insurance, we explain additional insurance essentials and present the other major types of insurance such as disability, homeowners, and automobile insurance. Chapter 13 discusses retirement planning, often the most compelling reason for saving money—particularly for people who are middle-aged or older. Fortunately, there is a method for establishing the amount needed; it is outlined here and described in the final section of the book.

354

Chapter Goals

This chapter will enable you to:

Our meeting was brief. Dan and Laura dropped a satchel full of individual insurance policies on my desk and said, “Please examine them.”

Real-Life Planning Our country has come a long way over the past half century. An average family then might have had a life insurance policy, a modest amount of bank savings, and a union or com- pany pension to carry them through retirement. Life insurance was particularly important because there was typically only one wage earner in a family and if something happened to that person, usually the husband, the family could be in dire straits. Over the 50 years since, things have changed significantly: two-wage-earner households have become com- mon, life expectancies have risen, and disposable incomes have increased. The insurance industry has had to compete more intensely with other financial institutions and products offering returns for the consumer dollar. For example, believe it or not, 60 years ago many considered stocks too risky to be placed in company pension funds or the average house- hold’s portfolio, nor were mutual funds widely used. Insurance companies responded to the heightened competition with equity-related prod- ucts such as variable life and variable annuities. Many insurers grew larger by offering products in several different areas of the insurance industry. Moreover, the lines of distinction between an insurance company, a bank, a stock-brokerage firm, and an investment company began to blur, with some companies taking on several of these functions. Consequently, insurance companies developed a significant position in return-related products. Meanwhile, from a risk standpoint, the increase in the average household’s wealth allowed people to focus on additional risk management tools. Disability policies for working-age people and long-term care, which, in essence, is a disability policy after retirement, grew in popularity. So did cost-of-living adjustments in policies to protect against the impact of inflation. The government’s role in risk management increased. Programs such as workers’ compensation for disabilities developed on the job, Social Security, Medicare for medical attention for the elderly, and Medicaid for the poor were either developed or expanded.

Chapter Twelve

Other Insurance 355

In some cases costs for existing insurance coverage grew as well. The desire for high- quality medical attention and the increased expense for sophisticated medical devices and drugs made medical coverage perhaps the single most expensive type of insurance. Accident and settlement claims cost in automobile, medical, and other areas rose sharply in an increasingly litigious society. The safety net around individuals and families as established by government and private insurance has grown significantly, and this has created an environment conducive to increased spending as well as periods of aggressive investing in assets such as technology stocks, residential real estate and gold. As future incomes and technological capabilities increase the range of risk management, offerings for households are likely to continue to expand.

OVERVIEW

In the previous chapter, you learned about the important role that risk management has in household planning. Often people’s attention is focused on investments and improving financial and nonfinancial asset returns. However, by balancing risk and return and helping protect valuable assets, risk management in general and insurance in particular contribute significantly to achieving household efficiency and well-being. In this chapter, we will continue the analysis of insurance begun in the previous one with life insurance. You will learn about specific risk management tools provided by insur- ance companies and the government, for each of the major household assets. We will start by explaining when insurance is suitable and discuss common risk man- agement terms. We will then elaborate on difficulties that insurance companies have in determining risks and the ways they have developed to reduce their expenses. It is helpful to understand why insurance companies institute the procedures they do.1 Following that, we will describe the private policies that protect household tangible and human assets. Finally, we will discuss governmental policies that provide coverage.

WHEN IS INSURANCE SUITABLE?

From a practical standpoint, insurance should be used when you want to alter your exposure to risk and can do this efficiently. Insurance can be attractive when infrequent but severe losses that can cause hardship to you are possible. The insurance company can diversify away its risk. Hardship means the losses can have a material impact on the household’s overall financial condition or current cash resources. Insurance agents call this hardship severity. Insuring against all losses is extremely costly and therefore inefficient. Although it may seem surprising to some, when losses are material and there is a strong likelihood that they will occur, insurance may not be the appropriate choice. When losses happen very often, referred to as high frequency, insurance companies end up adding on their overhead costs to the losses; you end up paying more with insurance than without it. Try to develop a rough idea of the cost of the loss and its probability and compare it with the cost of coverage, known as insurance premiums. If the costs are too high, and the impact is manageable, consider self-insuring. For example, many years ago when disabil- ity insurance first was offered, many insurance brokers said the cost was too high relative

1 It can foster a more positive attitude toward their goals, which, with the possible exception of personal claims, may not be that dissimilar from policyholder objectives. It also can result in a more efficient search for low-cost policies. For example, given the knowledge that life payouts are based on policyholder life spans, it may be useful to be aware that certain professionals live longer than average, thereby making policies for professionals potentially more cost-effective.

356 Part Four Specialized Planning

to the benefit. Once the insurance companies had more claims experience and competition increased, disability coverage became a more efficient risk-reduction mechanism. Table 12.1 summarizes an appropriate insurance strategy for pure risks. Notice that it only calls for purchasing insurance under high-severity, low-frequency circumstances. In other cases, retaining risk by self-insurance (“retention”) is the appropriate strategy. Retaining risk highlights the need to practice other risk management approaches such as risk avoidance and diversification. Insurance often also can be made more cost-efficient by considering high deductibles in coverage. Processing a claim can be relatively expensive for an insurance company. Often you can receive a higher potential return on your insurance payment by selecting a copay- ment up to a high but still manageable amount.

Example 12.1 John, young and in good health, bought a medical insurance policy with a $2,000 annual deductible that cost him $1,000 less per year than the normal $200 deductible. John’s medical payments had not exceeded $200 annually over the past several years. Therefore, since in the past John had not had a high frequency or severity, he decided to assume some initial risk by self-insuring by selecting a large deductible, and saving on the costs of a higher premium.

RISK MANAGEMENT AND INSURANCE TERMS

There are a variety of terms commonly used in connection with risk management overall and insurance in particular. In many cases, there are two terms in each category that can be contrasted with one another. Occasionally they are used incorrectly—for example, peril and hazard are sometimes confused, as are risk and uncertainty. We have listed some terms below. There are two types of risk we should differentiate, business risk and pure risk:

A business risk is a risk taken for potential reward. An example of business risk might be expanding your business into a new area. If you succeed, say your overall annual profits might increase 20 percent; if you don’t succeed, your entire investment becomes an unrecovered cash outflow or, in other words, a loss. Pure risk is a risk that carries no financial reward. An example might be skydiving. This is a hobby that might cause an insurance company not to issue a life insurance policy to you. Most exposures are pure risks as the loss of income or assets carries no reward.2 This leads to efforts to reduce pure risk.

We should be able to distinguish risk from uncertainty. Uncertainty involves no knowl- edge of outcomes. With risk, the exact outcome is not known, but the probabilities for alter- native outcomes are. For example, if someone asked you what the weather was going to be tomorrow and you hadn’t listened to the weather report, you would say you were uncertain. If you had heard the forecast, you might have said there was an 80 percent probability of rain and could add that the person would be taking a risk by not carrying an umbrella. In common parlance, the two terms are often used interchangeably. We also should understand the following commonly used terms in connection with risk:

Perils are exposures to the risk of loss. Examples are floods or fires.

TABLE 12.1 Loss Frequency and Severity

High Severity Low Severity

High Frequency Retention Retention Low Frequency Purchase insurance Retention

2 Taking a high-paying job that carries a health risk is an exception.

Other Insurance 357

Hazards increase the probability of a peril. For example, having a home near a river that overflows every 10 years or so increases the likelihood of a flood. There are three types of hazards:

A physical hazard is a deficiency in physical property that increases the possibility of loss. Leaving your car door unlocked when leaving it on a busy city street would be one example. A moral hazard arises from actions taken by the insured person that increase the possibility of loss. A dishonest person purchasing a disability insurance policy from a company with the intention of aggravating a nagging back injury because he or she plans to collect on the policy is an example of a moral hazard. Another is taking out a life insurance policy because you know something the insurance company doesn’t— that heart disease at an early age is common in your family background. In a morale hazard, the risk comes not from dishonesty but from a person behaving negligently because he or she has insurance coverage. An example would be getting into an accident because a person was driving while intoxicated, knowing that any damage to the car would be paid by the insurance company.

If insurance companies had perfect information, they could place clients in risk classes based on probabilities of losses at the beginning of the business relationship and provide less expensive policies for the average client. But as you know, there is asymmetric infor- mation in connection with insurance. That means insurance applicants know more about themselves and their probability of future actions than the insurance company does. Under adverse selection, the customer base drawn to an insurance product may differ and be less attractive than that of the population as a whole. For example, people with fam- ily histories of Alzheimer’s disease may purchase long-term care insurance and the greater payments to that group of individuals could drive up the cost of buying long-term insur- ance for people who have a normal chance of an insurance policy payout. The industry’s competitive drive to identify these problems and minimize them to lower costs has resulted in the following practices:

Insurable interest simply says you generally can only insure against loss of items that you yourself would suffer a loss on, should they be damaged or eliminated entirely. For example, if you took out an insurance policy on a building you were scheduled to buy in three days, but the building was destroyed the next day, you would not be able to collect. You did not suffer a loss. By restricting most insurance to those adversely affected by the loss, insurance companies hope to limit the use of policies to earn a profit instead of to hedge potential losses. Under indemnity, your maximum reimbursement in the event of loss of an asset you own is the value of the item. As with insurable interest, there is an economic reason for indemnity. If you could gain personally by triggering a loss, you might be tempted to do so. Not only would rates rise for other people insured, but the economy would operate less efficiently. For example, if you were earning $100,000 a year but had insurance coverage when disabled for $200,000, more people might attempt disability leave, thereby reducing the productivity of the overall economy. Indemnity therefore reduces potential moral and morale hazards of dishonest and careless behaviors that lead to greater insurance claims.

The industry has further reacted by several means.3

3 See David Mayers and Clifford W. Smith Jr., “Contractual Provisions, Organizational Structure, and Conflict Control in Insurance Markets,” Journal of Business 54, no. 3 (July 1981): 407–34; and Omri Ben-Shahar, University of Chicago Law School, and Kyle D. Logue, University of Michigan Law School, “Outsourcing Regulation: How Insurance Reduces Moral Hazard,” 2012, papers.ssrn.com/sol3/papers. cfm?abstract_id=2038105.

358 Part Four Specialized Planning

Screening and Segregation of Applicants Screening and segregation of insurance applicants (often known as underwriting) involves separating people based on their risk categories. Two examples are rejecting people with serious illnesses from life insurance coverage and placing smokers in a higher-risk, higher- premium class. Similarly, disability insurance companies have charged higher premiums to physicians in some specialties where there has been a history of frequent claims for benefits.

Institution of Deductibles Under deductibles, the insurance company reimburses individuals’ claims only for the amount above an established minimum. The process of coinsuring can reduce moral and morale hazards as well as processing costs.

Use of Coinsurance With coinsurance, the policyholder pays a certain percentage of the outlay along with the insurance company; often this is subject to an overall cap on payments by the holder. Coinsurance makes the insured more careful in practice and also reduces the need for insur- ance companies to monitor payments on claims. Coinsurance can take the following forms:

1. Instituting exclusions and waiting periods. Exclusions involve eliminating certain con- ditions from insurance company payout when a new contract is drawn up. For example, the contract may exclude coverage of disability from a health condition that recently required treatment on a new disability policy, often for the first year of coverage. It serves to screen against adverse selection. Having periods before reimbursements are allowed can serve the same function, as can reducing moral and morale hazards.

2. Prespecified limits. Prespecified limits establish the amount the insurance company is willing to pay contractually. They can limit the amount of litigation and absolute expo- sure for the company. Examples would be $1 million for medical expenses in total or four visits per year to a psychologist.

3. Experience-based alteration in policy costs. Charging rates to policyholders based on their loss experience after they have become clients reduces the problems of moral and morale hazards and makes insurance more competitive and attractive for those people with low claims experience. People who repeatedly file homeowners insurance claims, for example, may see their premiums increase and might even have their policies canceled.

4. Use of group policies. Group policies can offer a number of advantages over individual policies for both the company and the policyholder. If the groups are not established for insurance purposes alone, and the insurance covers all the participants such as all cor- porate employees, insurance companies are not subject to adverse selection. Monitoring costs for moral and morale hazards are covered, at least in part, by the business itself. For example, the corporation may itself investigate the validity of an illness for an em- ployee who is not working and is receiving disability payments.

In some cases, employees may be more straightforward about their actions in group insurance claims because they know that not doing so might inhibit their progress within the company. Finally, taking out a group policy can reduce processing and marketing costs. Consequently, group policies may cost significantly less for coverage, although in some cases they also may provide less flexibility in tailoring terms to individual needs.

Coinsurance is most commonly associated with major medical insurance where the insurer and the insured share costs up to a certain point, say 80 percent for insurer and 20 percent for the insured, up to a certain amount per year. Beyond that amount, the insurer pays all. It is also commonly used for property insurance when, as will be explained later in the chapter, replacement cost comes into play.

Other Insurance 359

Mutual Companies versus Stockholder-Owned Companies There are two major forms of legal structures for private insurers: mutual and stockholder- owned companies. Mutual companies in insurance are those that are owned by the policyholders. Stockholder-owned insurance companies are run for the benefit of the stockholders. Stockholder-owned company actions in attempting to maximize profits for their owners may conflict with the interests of policyholders. In recent times, several large insurance companies have switched from mutual to stockholder status.

NEEDS ANALYSIS

The question of how much insurance is needed arises in all areas of insurance coverage. The calculation of need can simply be the net present value of potential losses in income or assets. The methodology for doing so will be presented in Chapter 17, Appendix I. However, deciding on the amount and types of insurance to pay for varies by household. One household may seek protection against all losses, another partially insure, and still another not insure at all. Here we discuss some of the many factors that enter into house- hold decision making.

General Characteristics In this instance, the term need has to do with whether the household believes purchasing the insurance is essential. Households may be more apt to purchase insurance against a loss that is more likely to occur or one that would have more impact on their lifestyle. They are attracted to policies whose costs they consider affordable.

Tolerance for Risk The expected value of payments for losses will be lower than the amount policyholders contribute to purchase the policy. Therefore, insurance is a cost that can limit a household’s current and prospective future funds available for leisure expenditures. Consequently, households will clearly differ on the amount and type of insurance purchased based on their willingness to assume risks, thereby trading off income for safety. In short, households with low tolerances for risk will be more attracted to insurance.

Personal Likelihood of Occurrence Insurance will be a “better buy” the less it costs relative to the probability of risk. When a person believes he or she is at more risk for a negative occurrence than the population at

Practical Comment Claims Practices

360 Part Four Specialized Planning

large, and the insurance cost has not been raised for that increased occurrence, he or she is more likely to take out insurance. It is this greater willingness that ensures adverse selec- tion difficulties for insurance companies and other holders.

TYPES OF INSURANCE COVERAGE

Insurance coverage can be separated into three areas. The first, property and liability, gener- ally is concerned with coverage arising from losses in real property and in connection with legal liability. It includes homeowners insurance, automotive insurance, umbrella insurance, and liability to others. The second is personal insurance, which is concerned with losses in human assets. Personal insurance includes life insurance, which we discussed in Chapter 11, as well as disability insurance, long-term care, and health insurance. The third type of cover- age, the many forms of insurance provided by the federal and state governments, can be called social insurance. It includes Social Security, unemployment insurance, Medicare and Medicaid, and workers’ compensation. The types of coverage are given in Figure 12.1.

PROPERTY AND LIABILITY INSURANCE

Property and liability insurance is concerned with protection of the assets used in household production and any personal liabilities that arise because of them. The major areas we will discuss are property insurance for the home, automobile, liability, and umbrella insurance.

Property Insurance Homeowners insurance is concerned with losses from fire, theft, flood, termite damage, hur- ricanes, and so on. Both real property and personal property related to the home are covered. Real property includes dwellings and other structures that are affixed to land. Land itself is not covered by insurance, perhaps because it generally cannot be destroyed. Personal property comprises assets that are not affixed to the land and therefore are usually portable. Originally, the individual risks involved with the home were separately insured; now they are usually combined in a single policy. The risks covered may be listed separately.

FIGURE 12.1 Major Types of Insurance

Property and Liability

Home UmbrellaAuto Liability

Personal

Life Long-Term Care

Disability Health

Government

Unemployment MedicareWorkers'Compensation Medicaid Social Security

Other Insurance 361

Often, 16 separately stated risks are used. These may be similarly stated among policies or may include all relevant risks except the ones separately stated.

Types of Policies There are various types of homeowners policies, as listed in Table 12.2.

Contract Terms Property insurance contracts generally have structured terms. We will use HO-3 as an example. It specifies which assets are covered and for what types of losses. Perils that are excluded are stated. It also lists the conditions under which the policy will pay out benefits. The assets that are included are separated in Table 12.3. Liability to others as covered under coverages E and F have different standards depend- ing on whether the person injured was a trespasser or was invited into the house. The dwelling and personal property exclusions often differ somewhat. Major overall exclu- sions include war, earthquake, flood, intentional loss, neglect, nuclear hazard, defects in title for property bought, and so on.

Amount of Coverage Assets are valued for loss purposes either on an actual cash value at the time of the loss or on a replacement cost basis. The actual cash value approach uses replacement cost but takes into account depreciation, the physical wear and tear on the asset. For example, your roofing may have cost $6,000 and lasted for eight years. Its replacement cost could be $10,000 due to rapid inflation. Assuming a complete loss after four years, under actual cash value your

TABLE 12.2 Types of Homeowners Policies

Name Type of Dwelling Type of Coverage Comments

HO-1

HO-2 HO-3

HO-4

HO-5

HO-6

HO-8

Homeowner

Homeowner Homeowner

Tenant

Homeowner

Condominium and cooperative Homeowner

Basic coverage

Broad coverage Special coverage

Contents broad form

Comprehensive coverage

Unit owner’s form

Modified coverage

Less comprehensive, less popular, and not always available. It has separately stated risk coverages. It covers more risks than HO-1 and HO-2 and is the most popular policy of the three. Since house or apartment is not owned by a tenant, the policy principally covers risks to personal property. The standard HO-5 policy offers broader coverage than an HO-3 policy. While the HO-3 policy provides named-perils coverage, the standard HO-5 provides open-perils or all-risks coverage on personal property. For people who share ownership in a building such as an apartment or a townhouse. For houses that have replacement cost greater than their fair market value. For example, a historic or period house.

TABLE 12.3 Types of Property Coverages

Coverage Type Explanation

A The dwelling and other property attached to it such as a garage. B Structures not attached to the dwelling. C Personal property. D Outlays for expenses when damage does not allow occupation. E Personal liability, which includes the cost of litigation and the proceeds of the suit. F Medical payments to injured parties.

362 Part Four Specialized Planning

maximum reimbursement subject to policy limits would be 50 percent of $10,000, or $5,000. That is because you had use of the asset for half of its useful life, four of its eight years. With the replacement cost method, depreciation is not deducted. You would receive the full $10,000 in the example above. Your actual reimbursement with either method would depend on deductibles and coinsurance clauses. Deductibles limit small claims, which are costly to the insurer and would reduce major losses by a relatively modest amount. Company insurance in which you coinsure part of the cost in the event of loss is more involved. The policy states what percentage of replacement cost you are required to maintain to receive full payment from the insurer. Often it is 80 percent or 90 percent of the needed outlay. If you are below that figure, you will absorb part of the loss according to the following formula:

Insurance reimbursement = Amount of insurance in force Amount of insurance required

× Amount of loss

where

Amount of insurance required = Coinsurance percentage × Replacement cost

Example 12.2 Martin had a fire resulting in a $110,000 loss on his home. The cost to replace the home was $300,000. Martin had a policy requiring that, for full payment, he maintain insurance coverage of 90 percent of replacement cost. At the time of the loss, he had $250,000 of insurance out- standing with no deductibles. How much will he collect?

Insurance reimbursement = $250,000 90% × $300,000 × $110,000

= $250,000 $270,000

× $110,000

= $101,852

Martin would receive $101,852 from the insurance company and would, in effect, coinsure for the remainder of the loss, which is $8,148.

Note that in the event of full loss unless insurance coverage taken out equaled 100 percent of the loss, the amount reimbursed would be less than the full value of your loss. To prevent this from happening, in addition to the policy, an inflation guard that would increase coverage each year can be put into effect. Alternatively, you can take out guaranteed replacement cost coverage, which will ensure your receiving full replacement cost for loss even if it exceeds the face value of your policy. The replacement cost method is often viewed as an exception to indemnity because you can be better off after a loss than before.4 For example, you could have paid $200,000 for a house, but, if it is completely demolished in a fire, you may receive $350,000, the current replacement cost for the home. Because of that, insurers may require that you rebuild to collect on a replacement cost policy. If you choose not to rebuild, you may receive only an amount equal to the actual cash outlay. There are exceptions to coverage. Earthquake insurance may be available through a rider to the policy. Flood insurance is supervised and underwritten by the Federal Emergency Management Agency (FEMA). There are requirements to qualify for the insurance. Title insurance reimburses you for loss in the event the title you received is defective in whole or

4 Another point of view is that to indemnify means to make secure against loss and that is what replacement cost coverage provides. However, by providing you with the funds to purchase a brand new property, you are generally in a more advantageous position than with a partially worn one.

Other Insurance 363

in part. It is available through a separate policy that requires a single payment at inception. Thus, it is not part of a homeowners policy. Each time you refinance your mortgage, gener- ally a new title insurance policy is written.5

Personal property is always included under a homeowners policy but with significant limits on coverage available.6 Personal articles not covered by the basic policy can be handled through a floater. A floater covers the named items wherever they may be located. Examples of items that a floater might cover are jewelry, fine art, and silver above the limits in the policy for these items.

Taxation Payments as reimbursement for property losses are not taxable. Property losses them- selves, whether the result of theft, an act of nature, an accident, or some other cause, are tax-deductible to the extent they exceed $100 per occurrence and 10 percent of your adjusted gross income for the year.7

Automobile Insurance Automobile insurance is the most widely used form of property and liability insurance. Most households own a car and accidents do occur. Further efforts are being made to build safer cars, have less injury-prone highways, and require that seatbelts be used on a regular basis. The emphasis for automobile insurance has been broadened over the past 50 years from protecting yourself and your property to paying for suits from third parties. In fact, having personal auto insurance in prestated amounts, which are mandatory in some states, is done in part to protect third parties. In addition to injury to others, coverage includes you and your family members and other persons using your car. The automobile policy is separated into six sections:8 bodily injury liability, medical pay- ments, property damage, collision, uninsured motorist coverage, and the comprehensive

Practical Comment Property Coverage

5 Actually there are two policies: lender’s title policy that indemnifies the lender up to the amount of the mortgage and owner’s title policy that indemnifies the borrower (owner) for the full value of the house. 6 Usually a percentage of the insurance value of the homeowners policy. 7 You may not deduct casualty and theft losses covered by insurance unless you file a timely claim for reimbursement, and you reduce the loss by the amount of any reimbursement or expected reimbursement. 8 See “Auto Insurance Information” section on the website of the Insurance Information Institute, at iii. org/articles/what-is-covered-by-a-basic-auto-policy.html.

364 Part Four Specialized Planning

section. Each part is separately priced. Bodily injury liability covers injury to others caused by you and injury to you and members of your family when driving someone else’s automobile. Medical payments reimburse you for injuries to the driver and passengers within your car. Property damage covers damage you or a designated driver in your car makes to some- one else’s property. Most frequently it involves your damage to another’s automobile, but it also covers damage to other property such as buildings or lamp posts. Collision covers damage to your car whether through impacting another automobile or by the vehicle turn- ing over. If the accident wasn’t your fault, your insurance company will seek to recover from the other driver’s insurance company. Uninsured motorist coverage reimburses you for uninsured, underinsured, and hit-and-run drivers who cause losses to you. Comprehensive insurance covers auto-related losses that arise from theft or damage to your property, but not those that come from another automobile. The price of automobile coverage depends on such factors as the type of the car, the age of drivers, and their previous accident and driving violations record. Your rate can be changed to reflect your incidence of accidents during the time you are covered by the company. Many states have instituted modified no-fault automobile insurance claims. No-fault does not seek to assign blame for an accident. With no-fault automobile insurance, each person is paid for damages by his or her own insurance carrier. Unlike the traditional system, there is no need for an injured party to sue in order to collect damages. Damages under no-fault may exclude pain and suffering. Modified no-fault may use no-fault for cases that are not as involved and revert to the traditional tort system for serious injuries or death. (A tort is an act of wrongdoing and serves as the basis for the lawsuit to be compensated for the loss.) The no-fault approach is intended to reduce litigation expenses and help protect third parties.

Liability Insurance Liability insurance protects you personally against having to pay for a variety of potential losses to others. Consequently, it is called third-party coverage. Third-party liabilities occur through personal injuries and property damage to others caused by you. Such liabili- ties extend to your home and you and other family members and to personal operations as they pertain to exposures to others. Third-party coverage stands in contrast to losses to you or to your property directly, and this is sometimes called first-party coverage. An individual’s exposure to others has expanded considerably since the early 1970s.9

Historically, in order to collect money from others, you had to prove negligence, which involved establishing that the party who caused the injury had been careless. Establishing negligence and the amount of loss was left up to the jury to decide. In the 1970s, according to Priest, judges began to award much larger sums as damages when the judges found defendants at fault. They were influenced by what they thought would be a deterrent to accidents in the future.10 In addition, there was a shift from the doctrine of strictly causing a loss to contributory negligence by each party to a loss, and greater sums were provided for poor victims. In the 1980s and 1990s, there was some shift back, with caps set on damages and limits on reimbursement for pain and suffering.11

9 See George L. Priest, “The Modern Expansion of Tort Liability: Its Sources, Its Effects, and Its Reform,” Journal of Economic Perspectives 5, no. 3 (Summer 1991): 31–50; and Theodore Eisenberg, Cornell University - Law School, “The Empirical Effects of Tort Reform,” 2012, papers.ssrn.com/sol3/papers. cfm?abstract_id=2032740 10 Ibid. 11 Patricia H. Born and W. Kip Viscusi, “The Distribution of the Insurance Market Effects of Tort Liability Returns,” Brookings Papers on Economic Activity (1998): 55–100; and Andrew Chow, J.D., “How Much Pain and Suffering is Enough to Sue?,” June 8, 2012, blogs.findlaw.com/injured/2012/06/how-much- pain-and-suffering-is-enough-to-sue.html

Other Insurance 365

The issue continues to be a contentious one, in the twenty-first century. All in all, individu- als have become more vulnerable to significant damages in third-party suits. Basically, a personal automobile policy covers auto-related bodily injury and property damage to others. An umbrella policy, discussed below, may be purchased to augment coverage.

Umbrella Insurance Umbrella insurance is a broadly diversified grouping of property and liability coverages in addition to liability coverage under existing homeowners and automobile insurance policies. It is also known as excess liability insurance. This means that, generally, it does not pay until the limits of coverage in the primary insurance policy are reached. In today’s litigious society with large awards being made, umbrella insurance can reduce your expo- sure to catastrophic losses. Umbrella insurance generally has a minimum coverage of $1 million and rises in incre- ments of $1 million. Because the prospect of insurance company payout is relatively low, coverage is often inexpensive. Contract provisions are nonstandard, which means you must read each policy carefully to see what is or is not covered. The scope of umbrella coverage is often greater than that of comprehensive personal liability insurance. For example, it may include personal liabilities other than bodily injury such as slander and defamation of character. Property that you own or rent is often excluded, as are your business activities. Umbrella insurance may be offered by your auto insurer or your homeowner insurer, giving you broader coverage and higher limits than in the normal automobile policy or homeowner policy. Normally, an umbrella policy requires certain basic coverage to qualify for its usage.

PERSONAL INSURANCE

Whether they are expressed in strict economic money terms or in broader lifestyle terms, human assets usually represent our most important holding over our lifetime. Personal in- surance protects our human assets against losses for our own and other household mem- bers’ benefit. Life insurance, which protects our heirs against the wage earner’s untimely death, was discussed in Chapter 11. In this chapter, we consider Social Security benefits to spouse and other dependents after the wage earner dies. In addition, we will discuss many other types of insurance, whether they are funded by the people covered, the corporation that employs them, or the federal or state gov- ernment. Health insurance provides funds to defray the costs of sickness through indi- vidual and group health insurance policies and government Medicare and Medicaid plans. Disability insurance provides cash flows to partially or fully replace your salary, as does workers’ compensation when your injuries are job-related. Long-term care through personal and government policies defrays the cost of being disabled after you retire. Unemployment insurance protects against loss of income due to termination of your job.

Health Insurance Background Health insurance provides direct payment or reimburses you for medical expenses in connection with illness or accident. Health care is one of the country’s most expensive costs, and, as shown in Table 12.4, this cost has risen over the past 50 years.

366 Part Four Specialized Planning

The majority of individuals and their families receive their medical coverage through the workplace or the government. A breakdown of sources of coverage is shown in Table 12.5. Group policies through business are an efficient method of receiving coverage. As men- tioned earlier, businesses assume a portion of the administrative costs, and, particularly when they pay for the cost of the policy for all workers, they protect against adverse selection. The economies of scale in group policies are indicated by the fact that the majority of the non- elderly population in the U.S. gets private insurance through an employer while only a small percentage purchases insurance individually.12

The structure of the health care industry has changed significantly in recent decades. As a major funder of medical costs, large corporations and others sought ways of reducing their expenses as their cost of coverage rose. The outcome was a change from the individ- ual doctor to the group practice, the rise of health maintenance organizations (HMOs) and other health care management systems, and more emphasis on decision making by the in- surance company. A consumer’s goal is to identify the health need and then to find the type of provider that best meets that need. For example, if you are a healthy individual earning a modest income, you might select an HMO, while an older person, having some physical problems might use a point of service (POS) or preferred provider organization (PPO). (See defini- tions below.) Of course, some employers do not offer alternatives. Clearly, cost and the choice of doctors are key determinants.

12 See Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care,” American Economic Review 53, no. 5 (December 1963): 941–73; and Kavita K. Patel, Mallory L. West, Lyla M. Hernandez, Victor Y. Wu, Winston F. Wong, and Ruth M. Parker, “Helping Consumers Understand and Use Health Insurance in 2014,” Institute of Medicine of the National Academies, iom.edu/~/media/Files/ Perspectives-Files/2013/Discussion-Papers/BPH-Helping-Consumers-Understand.pdf

National Health Care Expenditures

Year Amount

(in billions) Percentage of

GDP Per Capita Amount

(in dollars)

1960 $27 5.0% $147 1970 75 7.0 356 1980 256 8.9 1,110 1990 724 12.1 2,855 2000 1378 13.4 4,881 2010 2,604 17.4 8,428 2013 2,919 17.4 9,255

TABLE 12.4 Health Care Costs

Source: U.S. Department of Health and Human Services, Centers for Medicare and Medicaid Services, “National Health Expenditures Data 1960–2013,” https://www.cms. gov/Research-Statistics-Data- and-Systems/Statistics- Trends-and-Reports/ NationalHealthExpendData/ Downloads/NHEGDP13.zip

Coverage as a Percentage of the Population

Type of Health Insurance 2011 2012

Private insurance 63.9% 63.9% Employment-based 55.1 54.9 Direct purchase 9.8 9.8 Government insurance 32.2 32.6 Medicare 15.2 15.7 Medicaid 16.5 16.4 Military health care 4.4 4.3

Insured 84.3% 84.6% Uninsured 15.7 15.4

TABLE 12.5 Health Insurance Coverage

Source: U.S. Census Bureau, “Coverage Rates by Type of Health Insurance: 2011 and 2012.”

Other Insurance 367

Types of Providers Blue Cross–Blue Shield The Blue Cross and Blue Shield Association is a national federation of 37 independent, community-based and locally-operated Blue Cross and Blue Shield companies that collectively provide health care coverage for 100 million members in all 50 states, the District of Columbia, and Puerto Rico. Some of the “Blues” are publicly traded while others are privately held. Health Maintenance Organizations Health maintenance organizations, or HMOs, pro- vide a full range of medical services for a flat fee. Often there is a physician as primary care provider who may control the level of specialized medical services. The HMO may support regularly scheduled checkups and healthful practices. The doctors can work for the insurer, as an independent group, or as individual practitioners, in which case they may be paid based on the volume and complexity of services rendered. Such an approach is called a fee-for-service basis. Alternatively, doctors may be paid a total amount per patient under management, regardless of the amount of service rendered. This approach is called being compensated on a capitation basis. Point of Service Systems With point of service (POS) systems, patients can choose either POS doctors (those listed in a directory provided to participants) or non-POS providers of health care. The patient receives a greater choice of doctors but must finance a significant coinsurance payment for each visit. Costs are lower if the patient uses an in-network health care provider because the insurance companies have contracted with these providers. If the patient uses an out of network provider, the provider can charge any amount for the service, but the insurance plan will only pay what is deemed to be usual and customary (UCR) for the service, requiring that the patient pay the rest. Preferred Provider Organizations Preferred provider organizations (PPOs) are fairly similar to point of service providers. One difference is that while PPOs use primary care physicians, they are not used as gatekeepers whose approval is needed in order to be reim- bursed for additional services. The providers are often independent individual or group practices that offer a discount for a volume of patients.13

Individual Contracts Individual contracts may separately cover hospitalization, surgery, and ongoing medical expenditure or cover all in the form of a major medical policy. The policies may be noncancelable, in which case your coverage cannot be dropped in the event of illness, and renewable so that your annual fee is not raised unless all members of your group are given a similar price increase. To discourage frequent use, many policies have deductibles and a copayment. In sum, most types of medical coverage include a basic medical expense policy for doc- tors; nonsurgical costs whether in or out of the hospital; a basic hospital policy for hospital costs such as room, board, and ancillary services (testing costs, etc.); and a basic surgical policy to pay for the surgeon’s costs, whether in or out of the hospital. Major medical policies can provide broad coverage and are used for expensive care. They usually have deductible and participation requirements.

Policy Differentiation The majority of people are given policies at their workplace. Their choice may be limited to HMOs versus a broader variety of doctors at a higher cost. For those who select indi- vidual policies or who are given a choice, some features in which policies differ include

1. Deductible copayment and coinsurance clauses. 2. Ease with which you can be approved for services you desire or wish to have.

13 Some POS providers are now offering direct access to specialists as well, thereby diminishing the differences between them.

368 Part Four Specialized Planning

3. Benchmarks for reimbursement levels, which can result in your not being reimbursed fully for the insurer’s share of the coinsurance payment. There may be less than full reimbursement because of internal dollar limits on any one procedural cost, hospital room cost, or nursing cost, often based on reasonable and customary averages for the procedure in your geographical area.

4. Ability to interact with a skilled employee representative and receive an appropriate response to questions about coverage and disputed reimbursement allowances.

Under the Consolidated Omnibus Budget Reconciliation Act of 1985, or COBRA, the federal government requires that people who leave positions be allowed to maintain their medical coverage for a maximum of 18 months regardless of their medical condition at the time.14 The former employee must pay for the full cost of the policy. The law requires that employers who have more than 20 employees and maintain a group medical plan follow COBRA’s continuation provisions.15

Affordable Care Act In 2010, federal legislation was passed that dramatically changed the rules for health insur- ance in the United States. This legislation has become known as the Affordable Care Act (ACA), although the ACA is sometimes called Obamacare because it was passed during the administration of President Obama. The ACA is far-reaching. Its provisions include a requirement that most Americans have health insurance. Major employers are required to offer adequate and affordable coverage to employees. People without employer- or government-provided health insurance are gener- ally required to purchase their own coverage; online state-specific exchanges facilitate shopping for insurance policies. Failure to purchase health insurance may result in a fine, payable via a tax return. Federal subsidies in the form of a cap on policy costs are available to some purchasers, depending on income. Meanwhile, health insurance policies were made subject to many new require- ments, such as what benefits they must offer and which applicants must be accepted. Despite all of these changes, the basics of health insurance remain in place. Most cover- age comes in the form of employer group plans, the acceptance of provider networks can reduce consumer costs, and it is necessary to compare policies closely in order to obtain suitable coverage at a competitive price.

Disability Insurance Disability insurance provides cash flows to compensate you if you are unable to work due to an accident or illness. Long-term disability is a very costly problem. Suppose, for example, that corporate executive Alan Brown suffers a stroke at age 33 and no longer can work at all. Alan will not have any more earned income to help support his family, which includes two young children. In fact, his family may incur significant out-of-pocket costs. In effect, you can be compelled to retire temporarily or permanently with insufficient income to support yourself and members of your family. If Alan had a long-term disability income policy, the insurer might pay Alan a substantial amount every month for decades, easing his family’s financial strain. Yet disability insurance is not nearly as popular as life insurance. Reportedly, about 70 percent of Americans have life insurance while about 40 percent have dis- ability insurance.16 This disparity exists even though it costs a family more to sustain itself when the disabled family member is living than when that person dies and the cost is eliminated.

14 May be extended to 36 months under some circumstances. 15 In some cases, widows and students may have longer than 18 months. Also, many states have continu- ation coverage copying the federal law. 16 “Do you need disability insurance?,” Consumer Reports, August 2010, consumerreports.org/cro/ money/insurance/do-you-need-disability-insurance/overview/index.htm

Chapter Twelve Other Insurance 369

There are many types of disability insurance including those from Social Security, state workers’ compensation, and corporate and personal policies. First, we will discuss private plans, which encompass those offered through business, often either partially or fully sub- sidized as an employee benefit, or directly through employee purchases.

Private Disability Insurance Private disability insurance can be divided into two parts, short-term and long-term dis- ability in one policy or separate policies. Short-term disability policies provide income for illnesses for up to a few years while long-term disability covers longer periods, most com- monly ranging from 10 years and usually up to ages 65 or 70. Employers often offer short- term disability coverage, also known as sick leave. Those plans can cover just a few days of pay to as much as a year. In addition, employers might offer a long-term disability plan, which will take effect when short-term coverage ends. Typically these group plans will pay about 60 percent of a worker’s salary. Individuals can also buy a supplemental plan or individual plan that will cover up to 70 percent or 80 percent of their earnings.17

Here we look at some of the important features that differentiate private long-term dis- ability policies. Definition of Disability The definition of disability describes the terms under which the insurance company will pay money out. The strongest definition of disability is own occupation. Under this definition, payments are made when you are unable to work in your existing occupation. A broader definition would have payment begin when you are unable to work at any occupation that you are qualified for based on your education experi- ence and training. The more restrictive the definition the better because it can allow pay- ments to begin even though you can work in another occupation.

Example 12.3 John was a gynecologist. He developed an inner ear problem and was unable to deliver babies anymore. He took a position as business manager for a medical practice. Only one of his two disability policies had an own occupation definition in it. It paid the face amount of monthly income despite the fact that he earned a comfortable salary in a related field. The other policy did not provide any support.

Elimination Period The elimination period, which is the time before disability payments begin, is often three to six months after the onset of disability. Residual Benefit Residual benefit is a partial payment when you have returned to your job but with a shorter work week and reduced income. In effect, at that point, you are partially disabled. Payments are based on the difference between your former and current salaries. Preexisting Condition A preexisting condition clause in a policy may state that it will not pay out benefits for illnesses or injury that occurred within a period of time before the policy was taken out, or the policy may state that such conditions are permanently excluded from reimbursement. Rehabilitation Benefit Some policies will reimburse you for outlays that help to rehabili- tate you and may serve to bring you back into the workforce more quickly. Insurance carriers generally offer these programs that assist in going back to work so as to reduce the amount of payments to the insured that would have been necessary with a slower return to work. Cost-of-Living Rider The cost-of-living rider can adjust the amount of the initial pay- ment and/or the ongoing payments for the effects of inflation. The increase may be based on the consumer price index or rise by a stated amount per year, and it can be subject to an overall cap.

17 When paid with pretax dollars—for example, when part of a tax-deductible cafeteria plan—the insurance payment would be taxable to the policyholder.

370 Part Four Specialized Planning

Due to insurance company concerns about potential worker incentives to profit from illnesses, most benefits from disability policies are limited to 60 to 70 percent of predisability earned income. Disability income insurance benefits are taxable if the policy was paid for by the company and is tax-free if the policy was paid for by the policyholder with after-tax money.18

Social Security Disability The Social Security system pays disability income to people who, because of illness or accident, are unable to work for at least two years, or whose illness will result in death. There are eligibility requirements including a time frame for previous contributions to the Social Security system, a history of working prior to disability, and a period of six months before payments begin. Eligibility has become more stringently enforced and is defined as the inability to be gainfully employed in any position in the workforce. Amounts paid are comparable to what you would have received if you were retired. As of 2014, you gener- ally are able to earn up to $1,070 a month without losing disability payments.19

Long-Term Care Insurance Long-term care insurance reimburses you for expenses incurred when you are unable to perform certain activities of daily living on your own. It often pays a fixed benefit accord- ing to a level of purchased coverage. Long-term care covers expenses when in a nursing home and often covers home health care expenses as well. The importance and value of

18 When paid with pretax dollars – for example, when part of a tax deductible cafeteria plan – the insurance payment would be taxable to the policy holder. 19 If total income exceeds base amounts, up to 80 percent of the benefits may be taxable.

Practical Comment Difficulty in Understanding Policies

Disability policies are often very difficult for the aver- age person to understand. The language of policies is not standard, and seemingly subtle differences in wording can have important effects on payout. In contrast to the usual circumstance in this part of the process, the insurance company often has more knowledge of potential payout than the individual.20

LOW COVERAGE The low incidence of long-term disability coverage relative to life insurance coverage is somewhat puzzling. As Cox, Gustavson, and Stam point out,

the incidence of disability at any age is considerably greater than that of death.21 As mentioned, the cost to replace the income of a disabled wage earner is also greater for households than the death of that wage earner. Then why do so few families have personal disability policies while so many have life insurance? Possible answers might include (1) the lack of an “investment component” or cumulative cash value in disability policies in contrast to many life insurance policies; (2) finding long-term disability policies too expensive and overemphasizing the more prevalent short-term disability policies; (3) difficulty in understanding and finding an efficient policy; (4) reliance on Social Security disability or on other immediate or extended family members; (5) from a behavioral standpoint, death may be more “salient”—easier to visualize happening—than a long-term disability; and (6) lack of disability offerings for the full population—many disability insurance companies only market to certain people such as business owners, executives, and professionals.

20 Larry A. Cox and Sandra G. Gustavson, “The Market Pricing of Disability Income Insurance for Individuals,” Financial Services Review 4, no. 2 (1995): 109–22, support this observation: “Finally, our findings provide a preliminary indication that disability definitions, preexisting conditions clauses, and insurer solvency may not be fully impounded in DII (disability) prices.” 21 Larry A. Cox, Sandra Gustavson, and Antonie Stam, “Disability and Life Insurance in the Individual Insurance Portfolio,” Journal of Risk and Insurance 58, no. 1 (March 1991): 128–37.

Other Insurance 371

long-term care coverage will increase as our population continues to age. The U.S. popula- tion age 65 and older has increased from 35 million in 2000 to 40 million in 2010 and is projected to increase to 55 million in 2020 while the 85+ population is projected to increase from 5.5 million in 2010 to 6.6 million in 2020. The long-term care approach is similar to disability insurance with a principal differ- ence being an ability to independently take care of yourself as opposed to the disabled person’s inability to work as a trigger for receiving benefits. Approximately one in three people over age 65 will spend some time in a nursing home facility, with an average stay of three years. Among seniors entering a nursing home, there is a 20 percent chance of staying there for at least five years.22 The length of stay is important because the cost of a nursing home can be very expensive, ranging from $30,000 to well over $100,000 a year in high-cost locations. With people living longer and a growing percentage of the popula- tion in the elderly bracket, long-term care expenditures may be a growing concern for the entire country, not just the elderly. You qualify for long-term care insurance payments when you are unable to perform a number of the activities of daily living (or ADLs) such as eating, dressing, showering, transferring from bed, and toileting. An alternative way of qualifying is through cognitive impairment such as Alzheimer’s or other severe cognitive diseases. The policies cover costs ranging from skilled nursing to custodial care and also may include medical and therapeutic expenditures. As with disability coverage, the length of the policy period, cost- of-living rider, the elimination period, and preexisting conditions are all relevant factors.

22 Russ Banham, “Facing The Future,” The Wall Street Journal, 2010, online.wsj.com/ad/article/ longtermcare-future

- -

Practical Comment Whom Policies Are Best Suited For

372 Part Four Specialized Planning

Policies generally have caps on the total amount that will be paid in any period as well as overall limits. The policies may offer a flat daily amount when you meet the definition of disability or may reimburse you for actual expenditures made. Unlike many disability policies, the yearly cost may be raised after the contract is in effect, but the policy is nor- mally guaranteed renewable. Common policy coverage periods can range from three to six years to a lifetime. In a growing number of states, there are special partnership policies that integrate private and governmental aid. You pay for the first three years of coverage and then the government pays the excess of care cost over the income you generate. Your assets are protected for your spouse or your heirs, but not your income. A portion of the premium paid for long-term care insurance may be tax-deductible. However, it is subject to the standard 10 percent23 of adjusted gross income floor on medical outlays before tax deductibility is allowed. The insurance company payments for care are tax-free to the extent of reimbursement for actual expenses. Payment beyond expenses may be taxable. Additional factors related to long-term care policies are discussed in Table 12.6.

GOVERNMENT INSURANCE

Social insurance is insurance provided by governments. It can be distinguished from pub- lic assistance because employers and employees fund social insurance payments directly, generally through mandatory payroll withholding. The justification for these programs in- cludes absence of adverse selection, and income redistribution, which helps establish a minimum quality of life for all citizens. The principal government insurance programs are Social Security, workers’ compensa- tion, disability payments, and unemployment insurance. These will be discussed here except for Social Security “old age” pension payments, which we look at in Chapter 13.

Workers’ Compensation Workers’ compensation provides income to people who are disabled because of work- related activities and payments to their families in the event of death. The system is

Factor Explanation

Age The younger the age, the lower the yearly cost, but generally the longer the period of pay in until potential reimbursement begins.

Maximum benefit Generally depends on reimbursement amount, with sum needed contingent in part on insured location.

Average usage Forty percent of seniors receive long-term care usage and use it for about 2.5 years.1

Years covered Often 3, 5, 6, or lifetime. Inflation adjustment Costly; can be CPI or as much as 5 percent a year. Inflation

in long-term care is expected to exceed CPI. Premium price Not capped as it is in disability policy. Likely to increase, as,

say, needed costs have risen, although not necessarily at same pace.

Waiting period Benefits may not start for say 0, 30, or 100 days. Cost and client financial position are decision factors.

Underwriting Client health a factor in quotation. Reimbursement and selection policy Ability to select caregiver can save middleman agency costs.

1 Based on long-term care data in nursing homes.

TABLE 12.6 Long-Term Care— Other Variable Factors

23 Until the end of 2016, a senior above the age of 65 can still apply the previous 7.5% floor.

Chapter Twelve Other Insurance 373

regulated by individual states, which impose their own requirements. The majority of the policies are offered by private companies, with the states and company self-insurance providing the rest. Individual businesses are required to participate. Medical care and rehabilitation costs also are covered. Workers’ compensation is no-fault; you don’t have to prove negligence and sue the company to collect. Payments can be made for the life of the disability; therefore, depending on the circumstance, it will be either short or long term. Amounts payable relative to predisability earnings may be lower for long-term as opposed to short-term disability.

Medicare Medicare coverage is provided for all people and their family members age 65 or over who are covered by Social Security. Medicare is divided into Parts A, B, C, and D. Part A is given to most seniors and includes hospital care for the first 60 days for a deductible of $1,216.24 There is a maximum coinsurance charge of $304 a day for days 61–90 and $608 a day for days 91–150. Home health care services are paid in full subject to the recommen- dation of a doctor for such things as part-time nursing, physiotherapy, social worker services, and medical supplies. The first 20 days of an approved stay in a facility providing qualified nursing is free, with a copayment of $152 thereafter.25

Part B is a supplement that covers doctor’s charges and related expenses. To qualify for the benefit, a monthly premium is charged. Only certain expenses are covered and some- times in limited fashion. Consequently, Medigap insurance is available to cover those items not fully covered by Medicare. The scope of coverage under Medigap is coded by letters from A through D, F, G, and K through N, with each letter representing a plan with standardized benefits. Plans E, H, I, and J are no longer sold, but existing policies can remain in force. Medicare Part D offers prescription drug coverage. Those who select this option pay a monthly premium to one of the private insurers offering a Part D plan; patients also owe copayments or cost-sharing amounts for various medications. Once annual prescription costs reach $2,850 (in 2014), a patient’s share of the ongoing cost will increase.

Many consumers are reluctant to buy long-term in- surance because they’re reluctant to pay for cover- age they might not need. When Eva Matthews turned 60, for example, she was concerned about her possible need for care and the costs that might entail. However, the insurance policy she wanted had an annual cost of over $1,500. Eva was reluctant to spend that much each year for perhaps 20 or 30 years, with no assurance she would ever collect any insurance benefits. Consumers such as Eva can turn to so-called com- bination products with long-term care riders. If Eva decides she needs life insurance, she can buy a policy

with such a rider (an added feature, acquired at a cost). Eva knows the premiums she pays eventually will provide a death benefit to a beneficiary she names. Meanwhile, if Eva needs care while she is alive this policy will pay her cash to help pay the bills. Either way, Eva feels she hasn’t “wasted” the premium dollars. Similarly, if Eva doesn’t have a need for life insurance she can buy a deferred annuity with a long-term care rider. The annuity can provide her with cash flow in retirement and, if she does need care, the optional rider will deliver additional funds to Eva.

Practical Comment Packaged Products

24 All the figures provided are as of 2014. 25 Medicare payments for skilled nursing care in nursing homes stops after 100 days.

374 Part Four Specialized Planning

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Other Insurance

©Don Hammond/Design Pics, Inc.

Other Insurance 375

Medicare enrollees generally can choose a Medicare Advantage plan, known as Part C. These plans, offered by private companies, provide the services covered in Parts A, B, and usually D. Consumers in Medicare Advantage plans generally have lower costs because they needn’t pay the standard Medicare cost-sharing amounts and they don’t need to buy a Medigap policy or (usually) a Part D plan. In return for lower expenses, Part C enrollees typically must stay within a provider network or pay more for out-of-network medical care.

Medicaid Medicaid is run by individual states and is supported by a combination of federal and indi- vidual state funds. It is intended to cover those people who cannot afford health insurance coverage themselves. Even with Medicaid, approximately 15 percent of Americans have no health insurance at all, as you can see in Table 12.5. (A primary goal expressed by sup- porters of the ACA is to reduce the percentage of the uninsured.) Medicaid covers not only those traditionally thought of as disadvantaged but also many younger people or those who otherwise don’t qualify for Medicare. Some people, especially seniors, spend down virtu- ally all of their assets and subsequently have Medicaid pay their nursing home costs.

Unemployment Insurance Unemployment insurance provides payments when you have been terminated from your previous job. It is a benefit organized by the federal government but largely run by the indi- vidual states. It is funded by individual businesses. The benefits amount varies by state and may be a fixed sum or a percentage of your income up to a sum. It generally lasts for 26 weeks but may be extended in times of high unemployment. (Following the 2008 recession, federal extensions temporarily pushed payouts to as long as 99 weeks.) Thus, unemployment insur- ance provides short-term benefits giving people time to find another position. You must have had a history of working prior to the application, be interested in obtain- ing a new job, and not turn down a position that is appropriate for you. You will not qualify if you were fired for misconduct or left because of a labor dispute.

Social Security Survivors Benefits Survivors benefits are benefits given to family members when a qualified wage earner dies. The children can each receive 75 percent of a wage earner’s basic Social Security benefit. Payments to children end at age 18.26 Elderly parents (over 62) who were supported by the wage earner also each receive the 75 percent payment. If there is only one surviving depen- dent parent, he or she receives 82.5 percent. The widow’s or widower’s benefit is up to 100 percent of the decedent’s basic benefit; a surviving spouse can receive benefits as early as age 60 but would receive only 71.5 percent of the decedent’s basic benefit.

Back to Dan and Laura OTHER INSURANCE The meeting for all insurance other than life took place at the same time as the overall risk management session. Dan and Laura’s discussion was very brief. They dropped a satchel full of insurance policies on my desk and said, “Please examine them.”

I reviewed all of your insurance excluding life insurance, which has already been dis- cussed. My impression is that you generally have done a good job of protecting yourself.

26 Age 19 if the child is still in high school.

376 Part Four Specialized Planning

My specific recommendations follow: In your auto insurance policy, you currently have $100,000 for bodily injury and property damage and $300,000 per accident, which is the state minimum. I recommend that you increase that coverage to $250,000 and $500,000, respectively. Coverage in today’s liti- gious society, in which costs for claims have climbed steeply, suggests that this is a more appropriate figure. The cost increase isn’t that great. You should save money on my next recommendation, which is to eliminate collision coverage on Laura’s car. The car is 10 years old and the current cost you are paying for collision is too high relative to the benefit. You should self-insure for that risk. Your rental coverage on your apartment is adequate for now. As you accumulate more expensive furniture, appliances, and other items, you will need higher amounts. I believe we will be revisiting this question should you purchase your home. Although we can discuss homeowners insurance in more detail at the appropriate time, I believe a broad form HO-5 policy is best and prefer one that has guaranteed replacement cost so that you are fully protected as the market value of your home increases. You should review your apartment or homeowners coverage every two years or so to make sure that the coverage reflects the then-current value of your possessions. The entire family is currently covered under a comprehensive medical plan. In recent years, you have not had any medical expenditures other than for delivery and follow-up for your son. You mentioned that your experience with the HMO doctor was only fair. I recommend that you consider a point of service policy that your company offers and that you would have to contribute to. This policy is partially subsidized by the employer and will allow you to select a physician of your choice. Be prepared to pay coinsurance for many medical occurrences. I believe the cost-to-benefit ratio is worth it, if only for your ability to select a doctor of your choice in the unlikely event of a major illness. Dan has a disability policy at work that is paid for by his employer and pays 60 percent of his total compensation in the event of a disability. Unfortunately, the coverage is limited to one year for any type of disability. Thereafter, the policy will pay only if he is unable to perform a position he is suitable for. I would prefer an own occupation definition that would pay if he could no longer perform in the career he has now. Moreover, the policy isn’t portable. If Dan were to have some mishap that rendered him uninsurable and then for any reason he left his job, he would be vulnerable. Because there is a viable policy in force, the question is whether you want to fund a more desirable policy. If you do, please let me know within the next week so that I can include its cost in our projection. (They subsequently declined.) Long-term care insurance is, in my opinion, a worthwhile product to consider. It can provide funds for extraordinarily high-cost nursing home care that might otherwise impov- erish the still healthy spouse and provide more assurance of leaving funds for your children. Its home health payments to aides also can actually allow people who might otherwise have to move to a facility to remain in their own home. However, I believe it is too early to consider this type of policy. The costs would be relatively inexpensive, but they are not locked in and can be increased based on insurance company experience. Interim investing may provide a better rate of return. At a later date, say, in your 50s when you hope to retire, your financial circumstances may be better known. Of course, you would have to assume the risk of an illness in the meantime that rendered you uninsurable. Finally, I recommend a $1 million umbrella insurance policy. As the term indicates, an umbrella covers you for a variety of losses. It will support you against a very large automobile- related lawsuit (the cost to obtain it is reduced by the extra auto coverage I am recommending on your existing policy). It also will provide coverage for miscellaneous losses such as slander and defamation of character.

Other Insurance 377

College Student Case Study and Review: Amy and John OTHER INSURANCE If risk management and life insurance were a bit of a drag for Amy and John, I expected it to be even more difficult to get them to engage with the rest of insurance. Nonetheless, since it was an important topic I attempted to go on. John surprisingly started off by asking when insurance is suitable. I mentioned that the appropriate time to buy insurance raises some surprises. The two key factors in deciding when to purchase insurance are severity and frequency. Severity tells you the impact on your household in case of a loss: the greater the impact, the greater the severity. Frequency is the number of periods in which loss may occur. Periods with surprisingly high severity and high frequency may not be appropriate for insurance because the insurance company may charge you a greater amount than self-insurance in order to cover their overhead, administrative costs, and profit needs. It is only when losses are infrequent and severe that insurance can have value. At that time the insurance company can spread the large cost over the premiums paid by other policyholders, the majority of whom didn’t have losses. A business risk is one taken for a possible reward. A pure risk is one that has no finan- cial reward. Perils are exposures to risk of loss. Hazards increase the probability of a peril. Three types of hazards are

1. A physical hazard. A deficiency in the physical property, say leaving a car door unlocked. 2. A moral hazard. The action that increases the probability of a loss. An example is buy-

ing a disability policy dishonestly knowing that you will be claiming a back injury and getting a payout.

3. Morale hazard. Behaving negligently because you have coverage; for example, not shoveling snow from your sidewalk knowing that if someone slips and falls and sues, you are covered.

The above problems and others cause the insurance company to react. Three approaches are

1. Insurable interest. You can only insure against loss of items that you yourself would suffer a loss on.

2. Indemnity. The maximum amount of reimbursement in the event of loss is the value of the item. Otherwise you could be tempted to create a profit by overinsuring on a property.

3. Coinsurance. The policyholder shares in the loss by a prespecified percentage or amount.

The types of insurance are property and liability, personal, and government. More specifically

1. Property and liability. Home, auto, umbrella, liability. 2. Personal. Life, disability, long-term care, health. 3. Government. Unemployment, workman’s comp, Medicare, Medicaid, Social Security.

PROPERTY AND LIABILITY INSURANCE Homeowner Property and liability is concerned with losses in real and personal property generally used in household production. Real property is the dwelling and other structures affixed to the land. Personal property includes those items not affixed to the land that are therefore portable. Now real and personal insurance are often consolidated into one homeowner

378 Part Four Specialized Planning

policy. The types of homeowner policies vary by how comprehensive they are and whether they are homeowner, tenant, or condominium-coop policies. They are broken out into coverage types: the dwelling and other attached property, structures not attached to the dwelling, personal property, costs for temporarily vacating the property, personal liability, and medical payments to insured parties. Payments on losses are not taxable and property losses themselves if AU they exceed $100 and are above 10% of your adjusted gross income are tax deductible.

Automobile Insurance Coverage for auto losses is the most widely used property and casualty area. It covers you and your property and also protects you from suits brought by others. Many states have modified no-fault policies, which means they do not seek to assign blame for an accident. Each person is paid for damages by their own insurance company. No-fault is intended to reduce litigation expenses and protect third parties. Most drivers are required to carry automobile insurance. The choice is only among what, how much, and from which company.

Liability Insurance Liability coverage protects you personally against having to pay for a variety of potential losses to others. It is therefore called “third-party coverage.” Your own losses or losses on your property are called first-party coverage.

Umbrella Insurance Umbrella insurance protects you from very large losses, just like a normal umbrella protects you from severe weather. It is known as excess liability insurance because it only pays out after your regular (usually home and auto) insurance reaches its liability disbursement limit. It covers specified areas in property and liability including broader coverage such as protec- tion against slander and defamation of character. Its minimum coverage is $1 million and rises by $1 million at a time. Because it is excess coverage, its cost can be surprisingly low.

Personal Insurance This insurance protects the household by protecting the insured and others in the house- hold. We have already talked about life insurance, so now we will go over the others.

Health Insurance Health insurance provides direct payment or reimburses you for medical expenses in con- nection with illness or accident. Most people get their coverage in the workplace or the government group policies, which tend to be cheaper than those for single purchases. The types of providers vary, including

Health maintenance organizations (HMOs), which provide a full range of medical services for a flat fee Point of service (POS) plans, which allow you to choose from an array of doctors while the plan may pay a part of the fee when you see out-of-network doctors. Preferred provider organizations (PPOs), which are similar to POS plans but have certain differences. For example, many POS plans require having a doctor act as a gatekeeper, approving patient visits to a specialist. PPOs generally do not have that requirement.

The types of plans listed above may be offered by licensees of Blue CrossBlue Shield, which is a traditional health insurance provider that may be given special status, varying by individual states. For all health insurers, most types of health insurance coverage include a basic medical expense policy for visits to doctors, nonsurgical costs in or out of the hospital, and a basic hospital policy for hospital costs such as room, board, and related costs. Policies

Other Insurance 379

differ by amount of copayment and coinsurance, whether drugs are covered and in what manner, exclusions, ease of approval for requested additional services, and stated lifetime limits. In recent years, provisions of the Affordable Care Act (“Obamacare”) have taken effect, imposing new health insurance rules. Major employers must offer coverage to employees and health insurers must provide access to policies with certain benefits. Americans gener- ally are required to have insurance or else pay a fine, but financial help to pay premiums may be provided to low- and middle-income consumers by the federal government. Online exchanges (“marketplaces”) can facilitate shopping for appropriate coverage.

Disability Insurance Disability insurance provides cash flow to compensate you when you are unable to work due to an accident or illness. Long-term disability may compel you to retire or to have more limited work at a lower fee. The features of a policy include

Definition of disability – The best possible policy qualification for payout can be inability to work in your own occupation. More restrictive requirements include inability to work in any occupation you are qualified for. Cost of living rise – This provision adjusts payouts for changes in the cost of living.

Social Security pays disability under certain circumstances such as being unable to work for at least two years or where illness will result in death.

Long-Term Care Insurance Long-term care (LTC) policies can reimburse you for expenses incurred when you are un- able to perform certain activities of daily living on your own. They often cover home health care expenses, subject to policy limits, and nursing home payments. To qualify for LTC benefits you must be unable to perform a number of activities of daily living (ADL) such as eating, dressing, showering, transferring from bed, and toileting. Policy coverage ranges form three to six years or for life. Special partnership policies set up by individual states that vary in provisions can, after the first three years are paid by the policyholder, have the government pay the excess of care cost over the income you generate. Your assets are protected for your spouse or your heirs, but not your income.

GOVERNMENT INSURANCE The principal government insurance programs are

Workers’ compensation Income to people who are disabled because of work-related activities.

Medicare Offered to all over the age of 65 who are covered by Social Security for a fee. Coverage, which is fairly broad, can be broadened through private supplemental insurance policies.

Medicaid Supported by the federal government and indi- vidual states. Generally covers people with low income and few assets.

Unemployment insurance Payments made when someone has been terminated by a previous employer. It is run by individual states and funded by businesses.

Social Security Survivor Benefits Benefits given to family members, spouses, and in some cases children, when a qualified earner dies.

380 Part Four Specialized Planning

Summary This chapter largely provides the facts on individual types of insurance based on the risk management and insurance principles established in Chapter 11. That chapter also detailed life insurance.

social insurance. -

erty while liability protects you against losses to others.

insurance.

- ployment, and Social Security.

Key Terms business risk, 356 coinsurance, 358 disability insurance, 368 floater, 363 frequency, 355 hazard, 357 health insurance, 365 indemnity, 357 insurable interest, 357 liability insurance (first- party coverage), 364

liability insurance (third- party coverage), 364 long-term care insurance, 370 moral hazard, 357 morale hazard, 357 own occupation (definition of disability), 369 peril, 356 personal property, 360 physical hazard, 357

pure risk, 356 real property, 360 severity, 355 social insurance, 372 umbrella insurance, 365

iii.org Insurance Information Institute An online guide for all types of insurance and insurance industry facts and statistics. It also has a search tool for finding insurance companies in your state.

healthinsurance.org Health Insurance Resource Center This website provides free information and links to additional information about health care and health insurance, including FAQs on the Affordable Care Act. The site also has a small glossary of health insurance terms.

naic.org National Association of Insurance Commissioners (NAIC) The NAIC’s home page gives insights into the insurance industry regulations.

The links below provide information about Medicare and Medicaid services:

medicare.gov The official U.S. government website for Medicare Services

cms.hhs.gov Centers for Medicare and Medicaid Services

Websites

Chapter Twelve Other Insurance 381

1. Define adverse selection and give an example of it. 2. Why are insurable interest and indemnity basic insurance beliefs? 3. Gerald wanted to purchase a medical policy with 100 percent coverage. The best he

could get was $200 deductible and 80 percent coinsurance. Why wouldn’t companies provide fuller coverage?

4. Why are group policies often cheaper than individual ones? 5. Distinguish between an HO-3 and an HO-4 property policy. 6. Marisa has a policy with replacement cost coverage and has a loss of $100,000 on a

house. Total policy coverage is $300,000 and replacement cost is $400,000. Because the loss is less than the coverage, she expects to get the full amount of the claim paid by the insurance company. Is she correct? Why?

7. Erin purchases disability insurance from her employer. Will any payments she receives be taxable?

8. Contrast the traditional tort system and no-fault auto insurance. 9. Why should a family have umbrella insurance? 10. Contrast an HMO and a PPO. 11. John was young and Lisa elderly. Discuss potential provider preferences. 12. Why is an own occupation definition for disability so valuable? 13. Explain why life insurance is so much more popular than disability insurance. 14. For what type of retired individuals is long-term care insurance particularly appropriate? 15. Identify and briefly explain the principal types of social insurance.

Questions

Jeremy lost a wing of his house in a storm, which resulted in an outlay of $250,000 to replace it. The replacement cost on the house was $900,000, and he had $500,000 of insur- ance. His policy had an 80 percent coinsurance clause. How much will the insurance company reimburse him for? Paulette, a trial attorney for a corporation, was forced to leave the field due to an injury to her vocal cords. She switched careers and became a lower-paying author. Fortunately, she had three disability policies. Policy A had an own occupation definition that was paid for by her employer and was for $20,000 per year. Policy B, which she paid for, had an own occupation definition and was for $30,000 of coverage per year. Policy C, which also was purchased by her, had no own occupation definition and was for $60,000 in coverage per year. Paulette’s marginal tax rate was 33 percent. How many after-tax dollars did she receive per year?

12.1

12.2

Problems

Bob, age 47, has worked for XYZ Company the past 12 years. XYZ Company has lost a major contract and must begin downsizing immediately. Bob was laid off yesterday. What should Bob do first?

a. File for unemployment benefits. b. Roll over his company 401(k) plan. c. Convert disability coverage under COBRA provisions. d. Notify the bank holding the mortgage on his house.

Conditions that increase either the frequency or severity of loss are called

a. subrogation b. risks c. hazards d. perils e. extenuating circumstances

12.1

12.2

CFP® Certification Examination Questions and Problems

382 Part Four Specialized Planning

A client recently purchased a new home from a builder for $150,000, including the lot valued at $40,000. How much insurance would you recommend that your client purchase to cover full replacement of the house in the event of a loss?

a. $88,000 b. $110,000 c. $120,000 d. $150,000

A successful architect wants to purchase disability income insurance. She is concerned about becoming totally disabled, but also about a reduction in income if she is obliged to reduce her workload because of a less-than-total disability. To satisfy these concerns, which of the following should be included in her disability income coverage?

a. Residual disability benefits b. A change-of-occupation provision c. Dismemberment benefits d. A relation of earnings-to-insurance provision

Terry Underwood purchased a 15-year-old compact car with 10,000 miles for his teenage son who recently received his license. Which of the following auto insurance coverages should be included in the policy for this auto?

1. Part A—liability coverage 2. Part B—medical payments coverage 3. Part C—uninsured motorist coverage 4. Part D—damage to insured’s auto

a. (1), (2), and (3) only b. (1), (2), and (4) only c. (1), (3), and (4) only d. (2), (3), and (4) only

Typically, when group long-term disability income insurance premiums are paid by a C corporation, all disability benefit amounts received by an employee are

a. not includable in the income of the employee for federal tax purposes without regard to any other sources of income.

b. includable in the income of the employee for federal tax purposes without regard to any other sources of income.

c. not includable in the income of the employee for federal tax purposes if any portion of the benefit is reduced/offset by other income.

d. includable in the income of the employee for federal tax purposes if any portion of the benefit is reduced/offset by other income.

e. includable in the income of the employee for federal tax purposes unless he or she is over age 65.

Under the Consolidated Omnibus Budget Reconciliation Act (COBRA) of 1985, an em- ployer is required to extend medical plan coverage to eligible members of the employee’s family if the employee

1. dies. 2. retires.

12.3

12.4

12.5

12.6

12.7

Chapter Twelve Other Insurance 383

3. divorces. 4. terminates employment (prior to retirement).

a. (1), (2), and (3) only b. (1) and (3) only c. (2) and (4) only d. (4) only e. (1), (2), (3), and (4)

Ginny is a sole proprietor. She wants to provide 60 percent of salary disability coverage to Joanna, her employee who is in a 35 percent combined tax bracket. Joanna’s W-2 wages are $40,000 and Ginny’s annual contribution to her qualified profit-sharing account on Joanna’s behalf is $4,000.

1. Ignoring cost-of-living adjustments or any possible Social Security benefits, calculate Joanna’s net-of-tax monthly disability payment if Ginny pays the disability premium and Joanna’s tax bracket during disability remains at 35 percent.

a. $1,300 b. $1,430 c. $2,000 d. $2,200

2. Ignoring cost-of-living adjustments or any possible Social Security benefits, calculate Joanna’s net-of-tax monthly disability benefit if Joanna pays the disability premium and Joanna’s tax bracket during disability remains at 35 percent.

a. $1,300 b. $1,430 c. $2,000 d. $2,200

An HO-3 policy (Special form—“All risks of physical loss” except those specifically excluded) with no endorsements excludes which one of the following perils?

a. flood b. fire c. collapse d. weight of ice e. volcanic eruption

12.8

12.9

384 Part Four Specialized Planning

Case Application OTHER INSURANCE When I examined Richard and Monica’s insurance policies, I found the following: a. Medical coverage was adequate. b. Auto insurance was at the minimum level for the state of $50,000 to $100,000 per ac-

cident. c. Homeowners insurance was at a level of 50 percent of replacement cost for the house.

They had a 90 percent coinsurance clause. d. Richard had no disability coverage. e. A note saying that Richard didn’t want long-term care insurance, but Monica was inter-

ested in looking at it.

Case Application Questions 1. What is your recommendation for auto insurance? 2. What is your homeowners insurance recommendation? 3. Give the advantages for Richard obtaining disability insurance. 4. Do you believe Richard and/or Monica should have long-term care insurance? Why? 5. Complete the other insurance part of the financial plan.

Monetary Windfalls A monetary windfall is generally the creation of new liquid assets currently or over time due to the resolution of an event, dispute, family occurrence, or other matter. It is a wind- fall because it is not recurring and it takes place outside the normal cash flow generation of the household. Examples are insurance proceeds, lottery winnings, legal settlements in- cluding structured ones, and inheritances. Aside from tax and timing of payment consider- ations, they all have many similarities. Essentially, people receive cash currently or distributions over time. Monetary windfalls are in this chapter because insurance is often related to the payment or the investment vehicle, which, for settlement purposes, may have a special tax-advantaged feature. The range of people receiving significant assets is often broader than just middle- or upper-income people. Moreover, the impact on a household’s standard of living can be greater for lower-income people. Many people are unprepared for the sudden inflow of assets. They often lack financial knowledge. Their spending pattern may appear short-term oriented, taking the form of a splurge in outlays. Purveyors of investments both from ques- tionable external sources and sometimes from friends and relatives can create risk of loss. What is often needed is a financial plan. The plan should be highly specific in detailing spending plans and simple and direct in presenting the operating parts of the document. Just as important, it should be monitored closely because failing to maintain structure and not adhering to the plan are common shortcomings. When there is an inability to convert the lump-sum payments to a lifetime income stream, using an insurance company’s annuity can be appealing.

Other Insurance 385

TAXABILITY Disability insurance payments received are not taxable if the person paid the premiums di- rectly but are taxable if an employer paid. If the employee paid through a cafeteria or other plan that made such payments for the policy tax-deductible, then payments from the policy upon disability are taxable.27 Compensation for physical injury or illness other than through disability policies is not taxable. Therefore, payments received from suits or settlements for these types of illnesses are not taxed. Payments received from an accident and health policy for permanent loss of a bodily function or permanent disfigurement are also not taxable. That is true whether you or your employer paid for the policy. Disability income from Social Security is not taxable for lower-income people, but it is for people who have significant other income. On the other hand, punitive damages awarded from suits for physical injury or physical illness are taxable. Emotional distress is not considered a physical illness. Therefore, pay- ments received for emotional distress are taxable. An exception is made for payments for medical care for emotional distress, which are nontaxable. Payments received from lottery winnings or other monetary windfalls are generally tax- able. Life insurance payments are not subject to income taxes if they are paid upon death or in a viatical settlement, meaning advance payments for those with a terminal illness. Distributions from life insurance based on cash surrender value are taxable to the extent they exceed prior payments into the policy.

STRUCTURED SETTLEMENTS Structured settlements are payments made of a fixed nature, in lump sum or over time, or a com- bination of the two, to resolve claims generally related to personal injuries. Typically, at least part of the claim is in annuity form. When such settlements are for physical injury or physical illness, the payments are not taxable. The income, received from the payments after lump-sum payments are received, is taxable. Therefore, lump-sum payments will generate greater taxable income than equivalent periodic payments. Consequently, from a tax standpoint, it can be ben- eficial to take annuity payments for living costs for part or all of the settlement. Annuity pay- ments also ensure that the person receives a material sum annually, often over his or her life span, although inflation generally reduces the purchasing power of that annual sum over time. On the other hand, the annuity payment is highly inflexible. As with other annuities, once agreed to, it typically cannot be altered because the recipient needs cash or wishes to invest the proceeds personally. Often a combination of a lump-sum amount and annuity payments is selected by the recipient. Suppose that Ed Peterson, age 52, is severely injured in an industrial accident. Ed had burns over most of his body. His attorney and his financial advisor negotiated a settlement in which Ed would receive $200,000 in cash. In addition, Ed received a retirement annuity, to start at age 65, of $1,500 per month. This would continue as long as Ed lived. However, in the event that Ed were to die before age 90, the $1,500 monthly payments would continue to that point, going to a beneficiary Ed named. Thus, the payments were guaranteed for at least 25 years. The amounts and terms of a structured settlement can be very involved. At least to some extent, there is often an adversarial relationship between the parties to the settlement. Financial advisors are needed by the payer to establish costs and can be helpful in finding efficient prod- ucts to fund the costs of a settlement. A separate financial advisor can be used by the recipient to assist in calculating the true amount of benefits and the terms to fit the need. Therefore, the benefits of a lump sum versus a series of payments, competitive policies, and approaches, in- cluding whether payments should incorporate inflation adjustments, all must be calculated.

27 Disability benefits under a no-fault car insurance policy, whether you paid for the policy or not, are not taxable.

386

Chapter Thirteen

Retirement Planning Chapter Goals

This chapter will enable you to:

Dan and Laura were surprisingly detailed about their retirement goals. Both wanted to retire when Dan became 55 so that they could share a life of almost total leisure, with vir- tually the only work being to split the household chores. They added that they would like to travel more both in the United States and in Asia.

Real-Life Planning Many financial planners observe that the desire and ability to save money varies by person and by stage in life. Some people want to save money, expect to do so, but end the year without anything in their savings account. Others, particularly at earlier stages in their adult life, prefer living for today. Tomorrow, they say, will take care of itself. So, the advisor was somewhat surprised by the actions of the 29-year-old man, Tom, who came to see him. Tom was married and said that his wife was one of those who felt no need to plan for tomorrow. He, on the other hand, had a very structured list of things to accom- plish. As an industrial psychologist with a reputation in a desirable specialty, he said he could work as hard as necessary in his consulting practice to earn the money to achieve his goals. Tom wanted a gradually increasing standard of living including a more expensive car. He said that he preferred that his older child, his son, become a doctor and his daughter be a lawyer. He would pay for their entire education through medical school and law school, respectively. His retirement planning goals were particularly important to him. He wanted to retire at age 55, take frequent trips, and have a second home in the country near a golf course. He said his father never had a chance to enjoy life, having had to work until he died. The advisor thought to himself that these were lofty goals and that Tom was pretty young to be thinking of retirement. He was heartened by the fact that Tom was very disci- plined about strong savings. He wasn’t living high on the hog. Tom told the advisor to state exactly how much money would have to be put aside conservatively each year for each

Chapter Thirteen Retirement Planning 387

goal and it would be done. The advisor looked into Tom’s eyes and saw a sincerity and fierceness that said that Tom would deliver on his promise. The advisor designed a financial plan for Tom with particular emphasis on retirement planning. He took into account Tom’s growing consulting revenues and an expense struc- ture that would climb over the years. He provided for an additional home at retirement and living costs that would increase, although from a fairly modest base. He took into account existing investments and found out what additional savings were needed annually. The savings figure was not that much larger than what Tom had been saving to date. Tom thanked him and made plans for a yearly update. Some 20 years and updates later, Tom is around 50 and heading into the home stretch. He is actually ahead of schedule and is likely to be able to retire at around 55. The advisor thought about the reasons for Tom’s success. The first was an ability to anticipate future developments. His investment portfolio benefited from some high-risk medical technology and drug stocks that he bought at their infancy. But the positions were too modest to ac- count for his progress by themselves. The principal reasons for his retirement asset growth were that Tom started to save ear- lier in his adult life and his machinelike method continued it each year. The advisor wondered whether there was a way to bottle that ability to plan so carefully. He decided it ran contrary to most people’s nature. He chuckled when he remembered finding out that their planning together including setting aside money for Tom’s two chil- dren, which had occurred before those youngsters were born. And as a further sign of his uncanny predictive ability, Tom did have a boy and a girl. Now his son was old enough to think about a career and he wanted to become a doctor.

OVERVIEW

Retirement planning is the single biggest long-term issue for many households. For younger people, this planning is frequently expressed positively, as an opportunity to achieve financial independence. Many think of financial independence as the ability to move on to other active pursuits without the further need to consider money issues. For many people who are middle-aged or older, retirement generates a different thought. They are concerned that they will not be able to retire when they want to or be able to maintain their current standard of living in retirement. Alternatively, they fear that they could run out of retirement funds, particularly if they live to a ripe old age.

FIGURE 13.1 Income Sources at Retirement

Social Security 35.3%

Earnings 33.9%

Pensions 17.1%

Asset Income 10.5%

Other 3.0%

388 Part Four Specialized Planning

The answer for both groups is to have an organized approach to the topic, to plan with an objective in mind. Planning for retirement has as its objective providing sufficient assets to enable you to live comfortably in retirement. Too little accumulated carries a risk of prema- turely running out of money while saving too much means that you could be enjoying a higher standard of living. PFP helps identify the goals, ascertain their cost, and calculate the savings needed to accomplish them by using the most attractive savings structures available. In this chapter, we will look at retirement planning as a process. Once that process has been implemented correctly, all groups can be optimistic about achieving retirement goals. The principal sources of retirement income are presented in Figure 13.1. The nine steps in the retirement planning process are given in Figure 13.2.

FAMILIARIZE YOURSELF WITH RETIREMENT ISSUES

It is useful in planning to familiarize yourself with some overall background retirement facts and issues. The concerns of retired people are assigned a relatively high priority by the working population and the government. Per capita spending by the government on the elderly substantially exceeds that for the rest of the population. In recent years, people have been retiring later in life, reversing an earlier trend. From 1962 to 1990, the average retirement age for men fell from 65 to 62. By 2009, however, that average retirement age had risen to 64.1 Several factors have contributed to this reversal, in- cluding changes to Social Security and a decline in employer-based retiree health insurance.

FIGURE 13.2 Retirement Planning Process

Source: Income of the Aged Chartbook (2012) http://www. ssa.gov/

Familiarize Yourself with Retirement Issues

Develop Goals

Become Knowledgeable about Retirement Structures

Assess Types of Retirement Assets and Alternative Structures

Analyze Retirement Risks

Decide on Retirement Investment Policy

Calculate Retirement Needs

Finalize Plan and Implement

Review and Update

1 Alicia H. Munnell, “What is the Average Retirement Age,” Society of Actuaries, February 2012, soa.org/ News-and-Publications/Newsletters/Pension-Section-News/2012/february/What-Is-The-Average- Retirement-Age-.aspx

Chapter Thirteen Retirement Planning 389

The average retirement age for women was 62 in 2009.2 Determining a trend is more difficult because the role of women in the labor force changed dramatically during the twentieth century. The outlook for the elderly creates some important issues. In the past 50 years, the qual- ity of life of the elderly has risen absolutely and probably relative to the average worker. Now the percentage of the elderly population in the United States is expected to rise from 13.0 percent in 2010 to 20.4 percent in 2040.3 This greater concentration of retired people is projected to create a shortfall in Social Security pension resources. In addition, medical costs are rising at a faster pace than overall inflation, which adversely affects the elderly on fixed-cost pensions and government funding to assist in medical cost reimbursement. The outcome may be challenging circumstances for the elderly. Social Security may be cut back by, for example, further extending the age of eligibility for full benefits. The average age of retirement may move higher. Planning for retirement may require more effort and savings than what our retired parents or grandparents experienced. With this background in mind, we can turn our attention to goals.

DEVELOP GOALS

Retirement planning is just life cycle planning for the period when the paychecks stop. You must prepare for that period or risk having an uncomfortable outcome. That means you should have an assessment of your assets, projected cash flows and costs, and savings patterns as well as the retirement structures to be used and the individual investment assets to be placed in them.

2 Ibid. There is some indication that labor participation rates, including those of ages 55 and older, have declined in the period subsequent to the recession of 2008-09. It is not clear whether these people have left the labor force temporarily due to a relative lack of job opportunities or have permanently retired. 3 Linda A Jacobsen, Mary Kent, Marlene Lee, and Mark Mather, “America’s Aging Population,” Population Reference Bureau, Vol. 66, No. 1, February 2011, prb.org/pdf11/aging-in-america.pdf

FIGURE 13.3 Workforce Participation Rates of Men Ages 55–64 and 65 and over, 1975–2013

Year

All

Women Men

19 75 19

77 19

80 19 83

19 84

19 85

19 86

19 89

19 90 19

93 19

96 19 97

20 00

20 03

20 05

20 08

20 09

20 10

20 11

20 12

20 13

20%

25%

30%

35%

40%

45%

50% 49.4%

34.7%

23.1%

22.9% 22.4% 22.0%

22.2% 22.1% 22.9%

23.0% 22.8% 23.9%

24.6%

26.1%

30.0%

31.4%

33.9%

34.7%

35.1%

35.1% 35.1%

35.1%

22.8%

33.6% 32.8%

31.4%

30.7%

30.3% 30.3% 30.3% 30.9%

32.4%

35.7%

37.2% 39.4%

40.0% 40.2% 40.5%

40.3%40.2%

30.1% 30.1% 29.4%

47.4%

45.6%

43.0% 41.8%

41.0% 40.4%

39.6% 39.4%

37.7% 38.3%

38.9%

40.1%

42.6%

44.2%

46.0% 46.3%

46.4%

46.3%

46.8%

46.5%

Annual Civilian Labor-Force Participation Rate for Americans Ages 55 and Older, by Gender, 1975–2013

390 Part Four Specialized Planning

At the head of this planning process are your goals. What do you want retirement to look like? Will your overall living costs go up or down? For example, will your retirement involve more high-cost travel or perhaps more leisure activities in a less expensive part of the country? When do you want it to happen? For the majority of Americans, the sooner the better. However, a significant number view retirement differently, as something you do when you are unable to continue working. Clearly, the retirement sum you need to accu- mulate if you delay your retirement date will be lower. An increasing number of people may choose a combination of the two: retiring and working part-time for financial, per- sonal interest, or mental health reasons. In planning, many people select an early retirement or financial independence date.4

That can provide them with the option of retirement at that time and also better accommo- date a forced retirement due to health or company layoffs. In any event, many financial planners discourage the use of a figure beyond age 70, even if clients indicate that they never want to retire. Beyond this age, health reasons or a change in interests or job circum- stances raise risks considerably.

BECOME KNOWLEDGEABLE ABOUT RETIREMENT STRUCTURES

Retirement structures are financial frameworks such as pensions, annuities, and Social Security that are established specifically for retirement. Many can make it easier to save money for retirement and to provide tax benefits by doing so. In other words, where you put your money can influence how much money you end up with. Each structure is described below.

Pensions Introduction Pensions are the savings structures into which money is deposited to generate income for retirees. In private pensions, they may be funded by the retiree, by the employer, or through a combination of the two. Virtually all those who work help fund the U.S. government’s public Social Security system, and if they spend at least 10 years working, they receive pension income from it at retirement. The monies deposited in private pensions grow through investment returns, which are often tax-advantaged and are generally paid out over a person’s retired lifetime. Some private pensions start at a certain designated age, such as 65, while the public Social Security system’s payout at full rates depends on your year of birth. Private pensions used to be largely limited to fixed monthly retirement sums set by companies.5 They were sometimes heavily weighted toward highly compensated workers and those who had worked for a company for many years. It was not uncommon for eligi- bility for private pensions to begin after 15 years of service. Therefore, vesting, the point at which an employee is entitled to a stated amount of nonrevocable benefits from an em- ployer, escaped most workers who moved from job to job. In recent decades, the U.S. government, concerned that the average worker was being slighted, has mandated that plans be nondiscriminatory by being open to all workers. Maximum periods before full vesting were reduced sharply and generally are no more than

4 For financial purposes, the two are equal. However, financial independence suggests an earlier retire- ment date, say, prior to 60, and a more active period thereafter including the possibility of a full-time occupation without worry about compensation. 5 Or, in some cases, set by unions with amounts directly or indirectly funded by the retiree.

Chapter Thirteen Retirement Planning 391

six years. The government passed the Employee Retirement Income Security Act (ERISA), which required that employers act as fiduciaries managing investment assets in the employee’s best interests. The government later established the Pension Benefit Guarantee Corporation (PBGC), which was funded by corporate pension plans and guarantees pen- sion assets or income when companies go bankrupt.6

Qualified Plans Pension plans provide significant tax benefits. Qualified plans are those pension struc- tures that comply with established government regulations. They allow you to place pretax (untaxed) dollars into the plan. Having pretax dollar deposits means that you can place a greater sum in the plan, which results in higher earnings. All dividends and capital gains generated while in the pension plan are tax-deferred as well. Under tax deferral it is not until monies deposited are withdrawn that taxation begins. Because your deposits have not been taxed previously, all amounts you withdraw are treated as taxable income and are taxed at ordinary income rates. Regular withdrawals from pensions can start at age 59½ and must start at age 70½. Withdrawals that you make before 59½ are generally penalized with an extra 10 percent tax. At death, the entire sum left in a qualified plan may be subject to income taxes at ordi- nary income rates.7 Contributions to qualified plans are usually limited to a maximum of $52,000 annually.8 The qualified pension’s combination of pretax dollars deposited and tax-free compounding is what makes it such an appealing way of saving. Its benefits are shown in Example 13.1.

Example 13.1 Alex and Stewart, both age 25, had identical salaries and each saved $12,000 annually over their working lives. Alex saved his money in personal accounts; Stewart placed his savings in a pension account. Both worked until age 65 and died at age 85. Assume that investment returns in each case were 7.5 percent pretax and that both were in the 33 percent marginal tax bracket throughout their lives. Assume that Alex turned over his portfolio every year and the combination of ordinary income on dividends and interest and capital gains on sale of stock came to a 25 percent tax rate on investment returns. What is the difference in amounts saved, assuming that Stewart withdrew the entire amount from his pen- sion at age 65?

6 The guarantee is subject to a maximum amount. 7 One method for avoiding this is to implement a tax-free rollover of the lump sum to an IRA account. 8 As of 2014, and this figure increases with inflation. In 2014, participants age 50 or are able to make additional “catch-up” contributions up to $5,500.

Alex Stewart

Pretax dollars saved $12,000 $12,000 Tax at 33% rate (3,960) — After-tax dollars saved $8,040 $12,000

Investment Return

Pretax return 7.5% 7.5% Tax at 25% rate −1.9% − After-tax return 5.6% 7.5%

Number of years 40 40 Gross assets at age 65 $1,125,905 $2,727,078 Tax on withdrawals at 33% − ($899,936) Net assets at age 65 $1,125,905 $1,827,142

392 Part Four Specialized Planning

Although Alex and Stewart took the same amount from their salaries for savings and earned the same pretax return, Stewart actually saved about $700,000 more, or almost 40 percent more money. The differential would not be as dramatic if Alex had chosen to hold his stocks for a longer period of time before selling them. On the other hand, if Stewart had cho- sen to keep the money in the pension longer, making withdrawals only when needed, the differential would be even greater.

There are two principal types of qualified plans: defined contribution and defined benefit. Defined contribution plans place an amount of money in the pension regularly. The amount available in retirement depends on the sum contributed and the returns on that money. Defined contribution plans are often portable when you change jobs or retire. Examples are company profit-sharing plans, 401(k) plans, 403(b) plans, and IRAs. Among qualified plans, 401(k)s have become extremely common in the private sector. Besides tax deferral, they offer the possibility of matching contributions, at the employer’s discretion. Suppose that Amy Brown accepts a job at ABC Corp., which has a 401(k) plan. ABC offers a 100% match on up to 6% of a participant’s salary. Amy’s initial salary is $40,000, so 6% would be $2,400. That year, Amy should contribute at least $2,400 to her 401(k) account. That $2,400 will be reduced from her taxable salary and allowed to grow, untaxed until a withdrawal is made. In addition, Amy will receive a $2,400 contribution to her 401(k) account from her employer ABC, untaxed. If Amy invests $2,400 the additional contribution by ABC can be considered a 100% initial return on investment, with no investment risk. Each subsequent year, Amy should contribute at least 6% of her salary to her 401(k) account, to get the full employer match. If Amy wishes, she also can make unmatched contributions to her 401(k), up to the annual limit. Such contributions also can grow, untaxed until withdrawal. For a further explanation of defined contribution plans including Roth 401(k)s see Appendix I. Defined benefit plans provide a stated stream of income, often a level amount, throughout retirement. The amount of income received generally depends on the time you spent with the corporation or other organization and on your salary in the period around retirement. Defined benefit plans may just be thought of by an employee as annual income for retirement. The normal pension by a company or a union offering yearly income is a defined benefit plan. Social Security can be considered one as well. It is the emphasis on end-of-working-period time and/or salary for calculating bene- fits in contrast to beginning-of-working-period contributions that distinguishes defined benefit from defined contribution plans. Defined benefit plans are described more fully in Appendix I.

Inputs: 40 7.5 –12,000

Solution: 2,727,078

N I/Y PV PMT FV

Calculator Solution Inputs: 40 5.6 –8,040

Solution: 1,125,905

N I/Y PV PMT FV

Alex

Stewart

Chapter Thirteen Retirement Planning 393

Nonqualified Plans Nonqualified plans are those that may be used for retirement, but whose deposits are generally not eligible to receive a tax deduction. Therefore, less desirable after-tax dollars are placed into the plan. While deposits are in the plan, investment income and capital gains are not taxed. Withdrawals are taxed only on appreciation in asset values. The origi- nal amounts placed in the plan are not assessed by governmental authorities because they were taxed prior to their deposit. The taxable portion of withdrawals is subject to ordinary income rates. Two common examples of nonqualified plans are tax-deferred compensation and tax-deferred annuities. Tax-Deferred Compensation Tax-deferred compensation refers to monies that employees have earned that is not paid out by their employers until some future time. Selected employers offer this option as a company benefit. In the interim, the sums grow tax- deferred. The amounts may be paid out at a stated date, at retirement, or over a period of years. Since tax-deferred compensation is an exception to the nonqualified pensions’ after-tax rule (perhaps because the money has not yet been physically received by the employee), a requirement of these plans is that the employee be sub- ject to risk; if the employer goes bankrupt, the employee becomes a general creditor of the company. Tax-Deferred Annuities9 Tax-deferred annuities are investments offered by insurance companies and other financial firms. Consumers invest after-tax dollars, which can grow tax-free until the monies are withdrawn.10 As after-tax dollars are placed into accounts,

Professional Advice Pension Savings and Early 401(k) Contributions

9 Excludes 403(b) plan annuities for nonprofit organizations. 10 Employees of nonprofit organizations can place pretax dollars in 403(b) plan annuities.

394 Part Four Specialized Planning

withdrawals are taxable only to the extent of any untaxed income and gains on original deposits. You are not required to make withdrawals from this type of annuity. If not withdrawn by the time of your death, all gains over original cost are subject to tax at ordi- nary income rates. Tax-deferred annuities can be separated into fixed and variable types.11 Fixed annuities provide an interest rate that is established by the issuer and changes periodically. Frequently, there is a guaranteed minimum rate that the issuer must provide. Rates for fixed annuities paid by the issuer are influenced by market interest rates, the investment performance of the issuer, and competitive factors among annuity companies. Their returns are often compared with bank certificates of deposit, investment-quality taxable bond funds, and municipal bonds. Variable annuities offer a range of investment choices to be selected by the purchaser, often in funds that mirror stock and bond mutual funds. Thus, the returns on invested capital depend on market results. Variable annuities can be likened to a tax-deferred portfolio of mutual funds. In fact, some individual mutual funds available to the general public are also included in variable annuity investment choices, called subaccounts, or similar formats. Most annuities also have a redemption charge for liquidation or transfer prior to a fixed period of 5 to 10 years with a declining rate as the period the annuity is held increases. There might be a 7 percent redemption fee in year 1, a 6 percent fee in year 2, and so on. Withdrawals of a fixed percentage annually, sometimes 10 percent, are not subject to this redemption charge. Because early liquidations of tax-deferred annuities are subject to ordinary income taxation, possible tax penalties, and redemption charges, they often are viewed as more restrictive than individual securities and funds. Tax-deferred annuities can, however, be exchanged for another tax-deferred annuity without generating taxable income. An important feature of tax-deferred annuities is the ability of holders to annuitize if they wish. Annuitization refers to converting a lump-sum asset accumulated into the payment of a fixed flow of income per year based on life expectancy. There are other features such as guaranteed minimum annual returns, but they generally come at a significant increase in an- nual cost and must be read carefully as to what the guarantee does and does not cover. Such annuities have significant advantages and disadvantages over competing financial instruments. For example, these annuities have the benefit of tax deferral. On the other hand, their returns are taxed at ordinary income rates in contrast to favorable tax rates on long-term capital gains and most stocks dividends as well as tax exemption for municipal bond interest. A comparison of fixed and variable annuities with selected alternative investment structures is given in Table 13.1.

Social Security Introduction Social Security principally provides monies to retirees and their spouses to live on. It also extends benefits to surviving spouses and the family’s minor children when a wage earner dies before retirement. It also gives benefits to those who are permanently disabled. The stream of income that the U.S. government provides to retirees resembles a private com- pany’s defined benefit plan. When the Social Security system was passed in 1935, it was a more modest system in which life spans were lower and many didn’t survive until the age 65 payout. Over the suc- ceeding period, benefits were broadened. These include benefits to survivors and

11 There are also variations on these two types of annuities that combine a fixed payout with a variable one. The holder combines a lower upfront payout with a market-based extra return. One such product is called an equity-indexed annuity.

Chapter Thirteen Retirement Planning 395

dependents, making more people eligible to receive benefits; the addition of disability and Medicare coverage; and adjusted payments for inflation. The Social Security system is a blend of two goals. The first is to provide retirement payments to individuals based on their contributions. The second is to redistribute income so that all workers may retire at a minimum standard of living. Those who favor the cur- rent system say that it provides a foundation of income on which workers can build to plan for their retirement12 while providing life insurance and disability insurance protection as well. Others say that the Social Security trust fund is in crisis, likely to be exhausted by 2036.13 Since the system was established, poverty has declined and the poverty rate may now be lower for retirees than for the population as a whole.

How It Operates Social Security is a mandatory system that is funded by a payroll tax on both employers and employees. Each paid a tax of 6.2 percent on earnings up to a maximum of $117,000 in 2014 and a Medicare tax of 1.45 percent with no maximum. In order to be eligible to receive full retirement benefits, you must have completed 40 quarters, equivalent to 10 years of work. The retirement age for full benefits, once age 65, rises in steps to age 67 for

Competing Instrument

Advantages of Annuity

Advantages of Competing Instrument

Explanation or Additional Information

Fixed Annuity versus

CD Tax deferral Safety of U.S. government agency guarantee Flexibility in shifting

Comparison of returns varies

Taxable bond Tax deferral Annuity has redemption charge for a number of years

Comparison of returns varies

Lack of fluctuation in principal

Municipal bond Higher pretax return

Tax-free return1 Highest return often depends on length of holding period; very long periods often favor annuities

Variable Annuity versus

Mutual funds Tax deferral Guaranteed death benefit

Favorable capital gains rates on equity fund, appreciation, and dividends Higher total expense ratios and a redemption charge for annuities Limitation on investment choice for annuities

Death benefit is guarantee of return of original principal or, in some cases, a higher interim amount Most variable annuities have total charges of 0.75 to 2.0 percent

1 If you buy a municipal bond issued in your home state.

TABLE 13.1 Comparison of Annuity with Competing Instruments

12 Center on Budget and Policy Priorities, “Policy Basics: Top Ten Facts about Social Security,” Updated November 6, 2012, cbpp.org/cms/?fa5view&id53261. 13 Veronique de Rugy, “The Facts About Social Security,” Reason.com, May 20, 2011, reason.com/ archives/2011/05/20/the-facts-about-social-security/1

396 Part Four Specialized Planning

those born after 1959 and is maintained at 67 thereafter. Early payments can begin at age 62 at a reduced level, with those retiring after their eligibility for full benefits receiving a greater sum. Benefits are linked to the amount of contributions.14 Spouses can receive the greater of their own work-based benefit or 50 percent of that of the sole or other wage earner. If the higher-earning spouses passes away first, the surviving spouse payout is raised to 100 per- cent of the decedent’s benefit. Your date of birth determines the percentage you receive for early retirement at age 62. It ranges from 70 percent to 80 percent, depending on the date you were born. That per- centage rises proportionately the longer you wait until retiring. If you wait until after your normal retirement age to start taking payments, they will rise by 8 percent a year until you are age 70. There is no incentive to delay payments beyond age 70. Your normal retire- ment date based on your date of birth is shown in Table 13.2. Finally, those who choose to work beyond their full entitlement date (age 66, for those born from 1943 to 1954) are entitled to their full Social Security benefits regard- less of the amounts they earn. Those who were eligible for payments but were younger than age 66 were allowed to earn $15,480 in 2014 with a phaseout of benefits of $1 for every $2 earned above this amount. (Special rules apply in the year of reaching full retirement age.) Social Security payments for people earning more than certain thresh- old levels of income are subject to taxation on up to 50 percent or up to 85 percent of the cash received. The analytical questions asked concerning Social Security benefits are often: “When should I start taking Social Security benefits?” “Should I begin at a permanently lower payout at age 62, or full payout at my normal retirement age?” Of course, the longer you wait to retire, the greater your ability to fund your retirement lifestyle. From a financial standpoint, the answer to whether you should take reduced early Social Security payments, assuming your payment date is independent of your actual retirement date, will depend in part on the factors listed in Table 13.3.

14 The average person will receive a benefit of about 40 percent of preretirement earnings, and those contributing the maximum will receive benefits that replace about 25 percent of prior earnings. The maximum monthly amount paid in 2014 depended on when benefits started: if you retired at full retirement age (66), your maximum benefit would have been $2,642 a month, compared with a maximum of $1,992 a month, starting at age 62, and $3,425 a month, starting at age 70.

Birth Year Year Worker Attains Age 62 Normal Retirement Age

1938 2000 65 + 2 months 1939 2001 65 + 4 months 1940 2002 65 + 6 months 1941 2003 65 + 8 months 1942 2004 65 + 10 months 1943–1954 2005–2016 66 1955 2017 66 + 2 months 1956 2018 66 + 4 months 1957 2019 66 + 6 months 1958 2020 66 + 8 months 1959 2021 66 + 10 months 1960 2022 67 1961 and thereafter 2023 and thereafter 67

TABLE 13.2 Normal Retirement Age Based on Date of Birth

Source: ssa.gov

Chapter Thirteen Retirement Planning 397

Example 13.2 Elyssa is about to turn age 62. She retired at age 60 and has sufficient funds to support her retirement. She wants to know whether it would be best to take Social Security at age 62 or wait until age 66. She will receive $21,000 in current after-tax dollars at full retirement age and would receive 75% percent of that amount if she decides to take Social Security currently. Assuming that she will earn a 4 percent return after taxes on the money received, has a life expectancy of 87 (that is, she will live 25 more years), and will have a constant marginal tax bracket over time, what should her decision be? Express all amounts in current dollars.

TABLE 13.3 Factors in Decision on Social Security Payout Age

Factor Reasoning

Risk tolerance—investments The lower the person’s risk tolerance, the lower the investment return on the money taken at an earlier age. A low investment return favors a full payout date.

Longevity People in good health from families with longevity may want a full date while others with weak health and life span factors might favor early Social Security. Payouts are not differentiated by sex. Women statistically live longer than men. Therefore, all other things being equal, women should be more likely to take a later payout than men.

Desire for current funds Those retirees having a preference for spending as much as possible today will favor an early retirement payout. Those with modest assets and a desire to retire early also will favor early payout.

Tax bracket People currently in high marginal tax brackets, which are likely to decline over time, favor later Social Security payouts.

Step Statistic Explanation

Benefit starts today at age 62 $15,750 $21,000 x 75% Period for benefits 25 years

Calculator Solution

Inputs: 25 4 15,750

Solution: 246,048

N I/Y PV PMT FV

Step Statistic Explanation

Benefit starts at age 66 $21,000 Period for benefits 21 years Benefits start four years from now and end at age 87

Calculator Solution

Inputs: 21 4 21,000

Solution: 294,612

N I/Y PV PMT FV

This is the present value at age 66. We now have to bring that amount back to age 62 so that it can be compared with the benefit that starts at that age.

398 Part Four Specialized Planning

This is the present value at age 62, today. Because it is higher than the benefit that starts at age 62, it is the preferred alternative. You can ignore the negative sign obtained in the results. Taking retirement payments at full retirement age has a higher PV at age 62 and therefore is the preferred choice.

ASSESS TYPES OF RETIREMENT ASSETS AND ALTERNATIVE STRUCTURES

The assets that are important for retirement use are diverse. Each can provide cash flows to fund retirement living. We can separate the principal resources into financial assets, human-related assets, and real assets (principally, the home).15

Financial Assets Financial assets are often considered the backbone of retirement planning. They can be divided into pension and personal assets. Savings through qualified pension structures— principally, defined contribution plans—offer the benefit of pretax contributions and tax deferral. Savings in personal accounts are more liquid in case of need. When withdrawn through asset sales, personal account savings are generally taxed at favorable capital gains and dividend income rates as opposed to ordinary income rates on pension withdrawals. Annuities, which can be used as nonqualified pensions, offer tax deferral and annuitization features and, like qualified plans, have withdrawals at ordinary income rates. Annuities that are converted into fixed annual payments most resemble company pensions. We will discuss company pensions under human-related assets.

Inputs: 4 4 294,612

Solution: 251,836

N I/Y PV PMT FV

Professional Advice Social Security and Risk Management

15 Retirement assets are sometimes categorized by the cash flows they generate. The cash flows often have been portrayed as coming from a “three-legged stool.” The stool consists of Social Security, personal savings, and company pensions. With the shift to employee-funded pensions and the frequently offered choice of lump-sum payouts at retirement instead of streams of income, this model gets more complex. We have chosen an alternative approach that, of course, produces the same total cash flows.

Chapter Thirteen Retirement Planning 399

Human-Related Assets Human-related assets can be defined as assets whose worth is typically derived from streams of income related to a person’s life span. Social Security and company pension payments from defined benefit plans are two such assets related to retirement. You have less control over these human-related assets. In the case of Social Security, your contributions as an employee are automatically taken from your paychecks. For com- pany pensions, money need not be taken from you, but the company may have an obliga- tion to pay you a fixed sum based on your salary and years employed. You are paid in yearly income streams that you cannot sell, nor can you otherwise control the payout. These income streams are discounted back to the present using an appropriate market- established discount rate. An important feature of human-related retirement assets is that they are typically nonmarketable; they cannot be sold to others. The human-asset portion, your salary, is generally worth more than that for Social Security or pension assets for working people not close to retirement. That is easy to figure out as salaries typically exceed these other income streams, and they go on for a longer period of time. However, as you approach retirement, your human-asset values decline sharply; and because Social Security and pension payments draw nearer, their discounted values become larger. Social Security and pensions, of course, start to decline in their dis- counted asset values once retirement payments begin. It is important to take into account human-related asset values for retirement planning purposes. Presently, their values are not placed on balance sheets, yet few would argue that these are not significant assets. For example, people who receive a large yearly pension from their companies when they retire have an important asset, a big advantage over those who have no private pensions. Financial planners take into account these flows in their recommendations and the total portfolio management approach uses the asset values and their relationship to other assets in helping make investment decisions. Company pension and Social Security retirement income streams have significant benefits over income generated from financial investments. Company pensions generally provide a pre- dictable level annual payment not subject to market fluctuations.16 Social Security’s payout is even more attractive because it is adjusted for inflation and is at least partially tax-exempt, with full exemption for those in lower income brackets. The disadvantages of company pensions and Social Security payments are the absence of an option to draw down the money earlier than the scheduled date of payment and the inability to transfer this asset to others at death.17

A simple calculation of the value of these pension streams is provided in Example 13.3.

Example 13.3 Tony was about to retire and wanted to establish the current value of two of his three assets. He already had the value for his 401(k) pension plan, which was worth $102,000. The first was a corporate pension paying $30,000 and the second was Social Security, which would offer $19,000 a year. Regular U.S. government bonds were currently yielding 4.5 percent while U.S. government inflation-indexed bonds provided a current return of 4.0 percent. If his remaining life span is 18 years, what are his pensions worth?

16 For a discussion of pension payments as a bond, see William Reichenstein, “Rethinking the Family’s Asset Allocation,” Journal of Financial Planning 14, no. 5 (May 2001): 102–09. 17 Company pensions often can be set up to continue partial or full payments to the spouse after the death of a worker, and Social Security provides surviving spouses with the full payment made to workers after their death.

Inputs: 18 4.5 30,000

Solution: 364,800

N I/Y PV PMT FV

Calculator Solution— Company Pension

400 Part Four Specialized Planning

You can ignore the negative sign obtained in the results.

Combined Worth of Tony’s Assets

401(k) Pension Plan $102,000

Company Pension 364,800

Social Security 240,527

PV of Tony’s Assets $707,327

By placing the present value of these two pension flows into asset form, we obtain a value of $364,800 for the company pension and $240,527 for Social Security, which together with the 401(k)’s $102,000 provides a combined worth of $707,327. As you can see, there are significant differences in retirement savings structures. A detailed comparison of the advantages and disadvantages of saving through alternative retirement structures is given in Appendix II in Table 13.1A. It is followed by a comparison of the treat- ment of payout for alternative retirement structures in Table 13.2A in Appendix II.

The Home Unlike most other retirement assets, the home serves many functions. It is a maintenance expense that provides shelter, it is a leisure refuge, and it can be a sound retirement invest- ment. For those who own a home, thinking of it as a retirement savings structure, an in- vestment for retirement, is complicated. We know it has certain cost advantages including a tax deduction for mortgage interest and property taxes, and no taxation at sale on the first $250,000 of gains per person or $500,000 per couple, with any remainder taxed at favor- able capital gains rates. In addition, homes historically have been a good inflation hedge and can be financed largely through debt. However, while it doesn’t happen often home prices can fall sharply, as they did in the aftermath of the 2008 financial crisis temporarily, and homeowners who borrow heavily to make a purchase may see their home value tem- porarily fall below their outstanding mortgage debt. Therefore, treating the home as an investment should involve an understanding of shorter- term risks as well as longer-term profit potential. In order for something to be considered an investment, cash flow should be received or there should be an expectation of selling it at a profit at some future time. The home doesn’t provide cash flow unless part or all of it is

Calculator Solution— Social Security

Inputs: 18 4.0 19,000

Solution: 240,527

N I/Y PV PMT FV

Sometimes, in calculating resources needed for retire- ment, financial planners exclude the value of a home, unless directed not to do so by their clients. House liq- uidation can be viewed as a safety alternative to be used if a financial shortfall occurs. When valuing the home for retirement need purposes, the home should not be assessed at its fair market price alone; the net

present value of future rental payments should be de- ducted from the price (as well as any applicable taxes). Note that this net value will differ depending on the age of the retirees and the rental costs of the dwelling they are moving into. The older the retirees and the lower the rental costs, the greater the asset value that represents the proceeds if the house is sold.

Practical Comment Calculation of Resources on Sale of Home

Chapter Thirteen Retirement Planning 401

rented out.18 A principal residence often can be sold as long as an alternative dwelling can be found. But many retired people prefer living in the same home for the rest of their lives. That is true despite the fact that housing for an individual or a couple may be economically ineffi- cient; the residence can be too big or otherwise inappropriate from an economic standpoint. The household could borrow money based on the house’s asset value even when there is no visible means of paying it back. The vehicle is called a reverse mortgage.19 A reverse mortgage provides borrowed funds based on the market value of the house and the age of the borrower. There is often no need to pay back the money. Instead, the amount of debt grows due to interest charged on the amount outstanding. The debt is repaid from the proceeds of the home upon voluntary sale or upon the death of the borrower. This money from the reverse mortgage can generate cash flow for living needs from the house as an investment. Yet the reverse mortgage has not proven to be popular. Because the home is not intended to be sold, aside from any planned benefit for heirs, should it be considered an asset? Even when the intention is to remain in it forever, the home generally contains what is called an embedded option—meaning the alternative of selling, provided there is some prepa- ration for moving. The option may be exercised under certain conditions—for example, when you live an extra-long life and need additional capital; when you become ill and prefer more help—the kind you would receive in an assisted-living facility or nursing home; or simply when you change your mind about living in your home. Obviously, the greater the home’s value, the greater the option’s value. For a more extensive treatment of a home including why, on balance, it is considered an excellent long-term investment, see Chapter 9.

ANALYZE RETIREMENT RISKS

Risk management as it concerns retirement covers many risk factors. Its objective is to control risks so that retirees can fund the standard of living they plan for. It can be divided into investment risk, inflation risk, longevity risk, and health risk.

Investment Risk Investment risk for retirement purposes can be thought of as the potential for below-average returns. While large-company stocks have returned nearly 10 percent per year, on average, since 1926, they have declined more than one-fourth of the time. In the early years of this century, large-company stocks as well as other corporate shares have suffered enormous declines in both 2000–2002 and 2007–2009. In 2007–2009, for example, the benchmark Standard & Poor’s 500 Index declined 56% from peak to trough.20 Declines are of particu- lar relevance to retirees because of withdrawal risk; as explained below, withdrawal risk is heightened when a severe decline occurs early in retirement. Consequently, many financial advisors urge retirees to trim investment risk, by diversifying into other assets besides stocks, and thus reduce withdrawal risk. Withdrawal risk, also called sequence of returns risk21 is the uncertainty created by taking monies out to fund retirement when asset prices are depressed. Withdrawals made at that time have a great effect on accumulated savings, as generally the same amount is withdrawn whether the market is up or down. In other words, a fixed amount taken out when the market is down will result in an extra percentage of the portfolio being with- drawn. When the market is down, the extra percentage taken is lost forever: There can be

18 Of course, the absence of rental expense could be considered as cash flow. 19 A person generally has to be advanced in age to be eligible for this alternative. 20 “Ibbotson SBBI, 2013 Classic Yearbook,” Morningstar, Inc. 21 For discussion see Wade D. Pfau, “The Lifetime Sequence of Returns: A Retirement Planning Conundrum,” Social Science Research Network (September 1, 2013). http://ssrn.com/abstract=2544637

402 Part Four Specialized Planning

no price recovery on that extra percentage of withdrawal because that money has already been spent. Consequently, there is less money left to generate investment income. When declines in assets happen at the beginning of retirement, they have a much greater effect than they might at the end of the retirement period. Withdrawal risk for retirees contrasts with the experience of working people. For those who are still working, the timing of negative investment returns makes little difference. Unless assets are withdrawn, the average compounded return over a period of years is the only item that matters. Consider the difference in impact of market declines occurring at the beginning and end of retirement in Example 13.4.

Example 13.4 Let’s look at the effect of a decline in the stock market at the beginning of the investment period versus one at the end of the period. We will do so by taking two people whose begin- ning assets and withdrawal rates were identical. By doing so we can make clear the important impact of these alternatives on ending dollars. Michael and Helen each started with $80,000. They retired, and both took out $12,000 of their money at the end of each year and spent it. Michael had a 40 percent decline in his assets in year 1 whereas Helen’s occurred in year 4. They both had a 10 percent increase per year in their assets in the remaining years. Assuming no tax impact, what sums did each have at the end of the period?

Year Michael Explanation1 Helen Explanation1

Year 1 Price Decline Balance

Year 4 Price Decline Balance

0 $80,000 $80,000 1 36,000 80,000 × (1 − 0.4) − 12,000 76,000 80,000 × (1 + 0.1) − 12,000 2 27,600 36,000 × (1 + 0.1) − 12,000 71,600 76,000 × (1 + 0.1) − 12,000 3 18,360 27,600 × (1 + 0.1) − 12,000 66,760 71,600 × (1 + 0.1) − 12,000 4 8,196 18,360 × (1 + 0.1) − 12,000 28,056 66,760 × (1 − 0.4) − 12,000 1 Annual withdrawals = $12,000.

Notice that Helen has more than three times as much money left at the end of year 4 as Michael even though they differed only in the timing of their one-year 40 percent decline. That is because the permanent drop in Michael’s asset value left less for investing earlier than for Helen. In sum, we see that the timing of price declines, whether they come in year 1 or year 4, matters, with greater impact for the one occurring earlier.

Withdrawal risk can be reduced by taking money from the bond portion of port folios, which tend to be less volatile. You could keep, say, two years’ worth of income in money market funds, to be used instead of liquidating stocks when there are sharp declines in the stock market.22 Adjustment for overall investment uncertainties can come in part through diversification, a higher bond allocation, and more conservative projections of future re- turns, or through the risk-adjusted projections discussed in Chapter 10.

Inflation Risk Inflation risk is a particular problem for retired people. That is because salaries are often adjusted to take into account inflation, but the retired don’t have that job-related revenue buffer to offset increases in living costs. Instead, many retirees have flat-payout company

Chapter Thirteen Retirement Planning 403

pensions and own fixed-payout bonds, which result in difficulties when their living costs rise sharply. In addition, extra withdrawals due to higher costs leave fewer dollars to gen- erate investment income. This situation can lead to a downward spiral in savings with little opportunity for retired people to make it up. Inflation rates vary considerably over time. In the post–World War II period, the con- sumer price index peaked at 13.3 percent in 1979 and was as low as 0.1 percent in 2008.23 The change in the consumer price index over time is shown in Figure 13.4. In plain terms, it means that your standard of living goes down because your income fails to keep pace with the spiraling cost of supporting yourself. For example, suppose that Fred Grant retires at age 66 with $500,000 in his account at a brokerage firm. Fred fears a collapse in the stock market, so he puts all of his money into 30-year Treasury bonds. Such bonds have virtually no risk of default; they have actually appreciated in value during recent stock market slumps. Fred buys these bonds when they yield 3.2%. Therefore, he anticipates receiving $16,000 a year (3.2% of $500,000) every year for the next 30 years, assuming he lives that long. However, that $16,000 of income will lose its value as prices rise. Over his retirement, Fred’s $16,000 will buy less of the goods and services he desires. If inflation increases 4% a year its purchase power will decline by half in 18 years and will buy only $8,000 worth of goods when he is 84. Recourses for retired people include inflation-indexed bonds, whose principal value is in- dexed for inflation and should not decline when inflation moves up, and significant equity posi- tions that can adjust for inflation after a lag. If the stocks in a portfolio are issued by well-managed companies, those companies may be able to increase profitability (perhaps by

FIGURE 13.4 Annual Inflation 1913–2013

19 13

–1 91

19 20

–1 92

19 30

–1 93

19 40

–1 94

19 50

–1 95

19 60

–1 96

19 70

–1 97

19 80

–1 98

19 90

–1 99

20 00

–2 00

20 10

–2 01

3 –4%

–2%

10% 9.80%

5.52%

2.04% 2.32%

7.06%

5.51%

3.00% 2.56%

2.29%

3.22%

–0.09%

–2.08%

12%

Long term Ave.

1913– 2013

23 “Ibbotson SBBI, 2013 Classic Yearbook,” Morningstar, Inc.

404 Part Four Specialized Planning

growth in units and raising prices), which night lead to future share price increases. Consideration should be given to indexing insurance policies such as those for housing through replacement-cost coverage and long-term care through a cost-of-living rider. Making inflation assumptions that are at the high end of the range, having substantive concentrations in stocks, and owning a home that one is willing to liquidate also can help.

Longevity Risk Longevity risk26 is the possibility of death occurring well before or after it is expected. Dying considerably before anticipated can pose a risk for other household members when they are counting on the deceased’s labor income. In retirement, the financial risk is of living longer than the average person your age does. If you are healthy, doing so can provide you with many more years of pleasure in retirement. At the same time, living longer requires greater retirement resources. Since you usually cannot know when you will die, most people provide resources for a longer-than-usual life. By age 65, U.S. males in average health have a 40% chance of living to age 85 and females have a 53% chance of living to age 85. If the couple is married, there’s a 72% chance that at least one of them will live until age 85 and a 19% chance of one making it to 95. Those who are in better-than-average health have even longer life expectancies.27 Social Security extends until death as company defined benefit pension plans typically do.

Annuities and Longevity Risk28

Earlier in this chapter, we described tax-sheltered annuities as retirement savings vehicles. Here we concentrate on annuity payouts through annuitization. Annuitization provides level payments or, less typically, payments indexed for inflation that may last as long as you are alive. An annuity is often set up by exchanging a fixed amount of cash, sometimes called a lump sum, for a stream of income payments. Social Security and private yearly

26 A dictionary definition of longevity indicates that it refers exclusively to a human life of long duration. The definition here for longevity risk expands this definition to include premature death. 27 Ashlea Ebeling, “Americans Clueless About Life Expectancy, Bungling Retirement Planning,” forbes.com/ sites/ashleaebeling/2012/08/10/americans-clueless-about-life-expectancy-bungling-retirement-planning/ 28 Mark Miller, “Insure Against Longevity Risk with Immediate Annuities,” WealthManagement.com, June 13, 2011, wealthmanagement.com/retirement-planning/insure-against-longevity-risk-immediate- annuities, and Moshe Arye Milevsky, “Optimal Asset Allocation towards the End of the Life Cycle: To Annuitize or Not to Annuitize?” Journal of Risk and Insurance 65, no. 3 (1998): 401–26.

Annuitizing has generally not been a popular alter- native for most people, although consumer interest has grown somewhat in the twenty-first century. Many cite the lack of substantially higher returns relative to purchasing long-term bonds. In addition, annuities generally lack flexibility and inflation pro- tection; resources to heirs are cut off; and insurance company overhead limits payouts. Nonetheless, in theory, annuities retain significant appeal in a portfolio setting as they substantially reduce both longevity and market risk. What may be needed is a way to provide both higher returns and an inflation-protection option.24 More recently, the

spread of online comparison sites has made it easier to find low-cost annuities.25 A broadened appeal it- self would help by creating economies of scale, more competition, and, under some circumstances, a more representative population. In any event, the payouts for annuities vary considerably and thus individual policies should be shopped.

24 There are inflation-protected annuities, but payouts are reduced. 25 Steve Vernon, “Why Immediate Annuities Deserve A Second Look for Your Retirement,” CBS Moneywatch, July 18, 2011, cbsnews.com/8301-505146_162-39944515/why-immediate- annuities- deserve-a-second-look-for-your-retirement/

Practical Comment The Popularity of Annuities

Chapter Thirteen Retirement Planning 405

income from company pension flows are, in effect, annuities but with their cash contribu- tions coming over an extended period of time. Traditional annuities are typically offered by insurance companies or other companies that usually contract with insurance firms to provide these policies to the public. Here are their strengths and weaknesses:

Strengths

1. Annuities offer cash flow uncorrelated with equities or bonds. They can assist in meet- ing retirement expenses as can equities or bonds but are more appealing for those peo- ple with low risk tolerances.

2. Most investments offer only dividends, interest, or capital gains, but an annuity has a fourth component: mortality return. Many people approach retirement without enough money, so annuities offer an option for not running out as the payments are continued until death.

3. Annuities can provide piece of mind as no further investment decisions need be made given its corporate guarantee of unlimited level payments.

Weaknesses

1. Lack of flexibility and liquidity. Once a consumer purchases an annuity, the money may be gone, so there will be no way to access funds in an emergency. To avoid this, you must pay extra (take a lower payout) for a guarantee or a refund option.

2. Annuity payments are usually not inflation adjusted. The flat payments tend to decline in purchasing power over time.

3. Payouts may be lower than for an average mix of Americans because the people attracted to annuities may be expected to live longer lives and insurance companies reduce their cash payments for that fact.

4. Safety concerns. Picking an annuity provider means picking a partner for life, so it’s vital to buy from a company that is financially sound.

5. There is no sum to liquidate at death and leave for your heirs as payments generally stop upon your death.

6. During periods of low interest rates, those rates depress what insurance companies can earn, cutting permanently into annuity payouts.

Health Risk Health risk as it pertains to financial matters is the possibility of large unreimbursable costs. All people are subject to health risk. However, as one ages, health risk increases materially. A great number of elderly people find that their medical costs more than double in retirement, even without a catastrophic illness. Many medically related costs for the elderly are paid for under Medicare. If the elderly are required to take expensive medications not approved for pay- ment or they need human assistance during illness not covered by the government, these costs may force them to live at a lower standard of living. Medigap insurance, which can pay for certain supplemental medical costs, is a way of meeting this risk. Another form of insurance, known as Medicare Part D, can cover some of the costs of prescription drugs Another cost, which can be very high, is long-term care. As retired people age, particularly into their 80s, their ability to take care of themselves may diminish. Because more women reach this age than men, they are at greater risk. The elderly may need partial or full assistance from another person either in a facility or in their own home at costs that can be sizable. Government assistance in this area tends to be limited in what is covered and the time period for coverage. Those daunting costs sometimes compel people to enter a nursing home. For most, nursing homes are not perceived as a desirable personal option. In addition, the cost of a

406 Part Four Specialized Planning

nursing home, which in certain parts of the country amounts to well over $100,000 per year, can cut into or eliminate the funds available for a spouse. Home health care designed to allow you to stay in your home when you have difficulty operating independently also can be very costly, particularly when care is needed 24 hours a day. Long-term care insurance, discussed in Chapter 12, can meet part or all of this cost. Inflation riders on the policy can further reduce the risk in this area. Another way of meet- ing these costs is by having significant cash reserves. This precautionary savings is one reason that people have cash remaining at death.

DECIDE ON RETIREMENT INVESTMENT POLICY

The retirement investment policy comprises types of assets and, in many cases, which in- vestment structures they go into. We have already reviewed types of relevant assets— typically, stocks, bonds, and mutual funds—in Chapter 10 on financial investments and houses in Chapter 8 on household investments. Retirement investing is just investing for these assets with a longer-term outlook. Therefore, in many cases, the allocation for these assets will be similar to the overall longer-term asset allocation. To sum up, typically the most attractive place to save for retirement is a qualified pension. The principal exception can be the purchase of a home. A home not only provides tax deferral for any increases in its worth and partial or no taxation on gains upon sale of the home but also financial and nonfinancial benefits in living in one. However, in order to realize the financial benefits of homeownership for retirement planning, the home must be sold or borrowed against. Once the investment policy has been established, we can project the returns on invest- ments and begin our retirement needs analysis.

CALCULATE RETIREMENT NEEDS

Capital needs analysis is a way of establishing how much money we have to save to meet our goals. Under the household approach, then, internal funds generated, specifically savings and often higher future income (in effect, money retained in the household busi- ness), are used as the principal approach to support future capital needs. Although we

Calculating retirement needs is a complex process that can involve among other things projections of future returns, inflation rates, and the retirement period, all of which are subject to judgement. Looking at past figures over long periods of time is useful but obviously not definitive. Being conservative in projections can help. After a number of years at the beginning of retirement, with- out poor investment or above average costs, you may be able to raise your annual withdrawal beyond the adjustment for inflation. Beyond that time if you have higher than expected assets, further increases may be possible. Unless you have particular differences with the average person in health, risk tolerance, and other

material factors, a 4% beginning rate can be a helpful first approximation of allowable spending patterns. The 4% rate is the amount taken for living needs expressed as a percentage of investment assets available. The allowable withdrawal grows by the level of inflation each year. The 4% rate is not however a hard and fast rule. Your short-and long-term preparation for retirement is one of the most important decisions that need to be made. It often requires further analysis by you as Chapter 17 shows, and a consultation with a finan- cial planning practitioner would be helpful. The withdrawal rate method as well as the more precise CFP®-type approach are given in that chapter.

Professional Advice Calculate Retirement Needs

Chapter Thirteen Retirement Planning 407

make important decisions on an overall organizational basis, as a business does, we fund each objective separately, using a capital needs approach. We often restrict our use of a formal capital needs analysis to items of great significance to our goals. Four of them are the purchase of a house, life insurance needs, disability needs, and retirement needs. The actual method of calculating a capital needs analysis and the final two steps in the retire- ment process are covered in Chapter 17.

RETIRED HOUSEHOLDS

Retirement planning can be viewed as not ending at retirement. Instead, planning goes on for the remainder of retirement. After retirement, though, distribution planning becomes part of personal financial planning. How much should you take from your investment port- folio each year? Should your withdrawals come from your IRA or from your taxable brokerage account? Should you raise money by selling stocks or by selling bonds? Suppose Nick Owens retires at age 66 with $1 million worth of investments. Nick decides that a 4% initial withdrawal is practical, based on the analysis beginning on page 544 (refer to Safe Withdrawal box). Thus, he takes $40,000 from his portfolio in year 1 of his retirement. If inflation is 5% in that year, Nick will increase his withdrawal by 5%, to $42,000, the following year. And so on, year after year. Nick is confident this method will allow him to maintain his standard of living for the next 30 years. Nick begins by taking the money from his taxable account so that his IRA will have more time for tax-deferred growth. Even when he reaches age 70½ and must take mini- mum IRA distributions, Nick takes as little as required from his IRA, drawing down his taxable account before drawing down his tax-advantaged IRA. As part of Nick’s drawdown plan, he always keeps an ample amount of money in cash, in his IRA and in his taxable account. He arranges for automatic deposits into his regular checking account each month, effectively replacing the paychecks he no longer receives. As a result, Nick has spending money for his retirement. When his cash reserves run low, Nick liquidates some of his bonds to replenish those reserves. He maintains a constant asset allocation adjusting it only for age related declines in risk.

Going for the Goals Retirement planning must be reviewed periodically for goals as well as current and pro- jected assets changes. The outcome can be an alteration in savings, cost-of-living, or other retirement strategies. One of the greatest changes may occur in the postretirement period. We will deal with it in some detail. Postretirement planning is in many ways similar to preretirement analysis. In fact, they would likely be the same if all the factors that we thought would come to fruition did. As we know, however, this generally is not the case. That is why financial planning incorpo- rates risk into its analysis. Some common risk factors are:

and at an advanced age you cannot find a replacement job.

needed at home or at a facility.

done at all. (This is true of many Americans.)

408 Part Four Specialized Planning

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Retirement Planning

Chapter Thirteen Retirement Planning 409

A major difference between pre- and postplanning is that choices are more limited in retirement. Basically, the opportunity to enhance cash inflows is limited or nonexistent. A full-time job at a large salary is typically a thing of the past. Therefore, the changes in household operations are likely to be largely focused on costs. Common alternatives are

1. Cutting back in cost of living. Cutbacks can include any number of things such as eating out, gifts, and vacations; unless active, retirement as one ages may help reduce expenses without the need for sacrifice should medical costs not rise too much.

2. Moving to a lower-cost region. For those in a higher-cost metropolitan region, moving to a lower-cost area can reduce expenses by as much as 25 percent.

3. Receiving help from others. Typically, financial aid can come from children. When pos- sible, the amounts advanced may be paid back from the proceeds of the estate at death.

4. Taking a part-time job. This is an exception to the cost-only emphasis. When available, a part-time job can bring in additional monies and also may be looked at as a pursuit that keeps you physically and mentally healthy.

Not all planning surprises result in cutbacks. A large number of the retired generate funds that are in excess of their needs, even given conservative assumptions for investment returns, long lives, and high reserves for extraordinary expenses. As these people age, it becomes clear to them that they have choices. When there is free cash flow generated net of potentially higher medical expenses, they can spend and raise their standard of living. Many times comfort with their estab- lished way of doing things can limit these expenditures. Another alternative may be to gift children and grandchildren and receive pleasure from the effects it has on their quality of life. In any event, as people age, more time is spent on estate planning for other household members, elder care matters in case of physical or mental impairment (see Chapter C on the Website), and gifting and bequests. Strategies not only may be legal or insurance- related but also can include moving closer to children.

Back to Dan and Laura RETIREMENT PLANNING Dan and Laura were surprisingly detailed about their retirement goals. Often people their age in their circumstances are more concerned about moving their careers forward and raising their children. Both wanted to retire at age 55. They particularly wanted to retire at the same time so that they could share a life of almost total leisure, with virtually the only work being to split the household chores. Laura mentioned that many elementary school teachers tended to retire early and that with generous retirement packages, some teachers felt there was little incentive to stay on past their mid-50s. She indicated that if she retired at 55, she would receive a pension worth $40,000 per year in today’s dollars, beginning at age 65. If she were to work until age 60, it would be worth $45,000 and at age 65, $50,000. Unfortunately, Laura had no voluntary pension savings vehicle such as a 403(b) plan available to her. I asked them how important the age 55 goal was, and they replied that they would like to retire then but would be satisfied if they could retire at age 60. Both wanted to move in retirement to an area about 150 miles away that had three attributes. First, it had a large university within it, and they liked the cultural activities and ability to interact with younger people when they were older. Second, there was a long-established

410 Part Four Specialized Planning

retired population there. Finally, the costs were about 15 percent cheaper than where they lived. I asked them about other costs that might change in retirement. They said they would like to travel more both in the United States and in Asia and estimated that would add $10,000 per year to living costs. Medical costs would not be a problem. Laura’s gener- ous school retirement package would cover them both. They couldn’t think of any other major changes except taxes. They said they simply wanted to maintain their current standard of living into retirement, which they thought could be done at lower cost in the retirement community. Dan mentioned his concern that he was not saving enough money for retirement. He didn’t believe he would be receiving a pension from his present company or from any other company he might work for in the future. His private pension would have to come from the 401(k) plan entirely funded by him. He asked whether I thought he should continue contributing to the 401(k) in light of his planned capital expenditures and debt problems. I asked them if there were any inheritances in their future. Dan laughed and said far from it. His parents, currently age 60, had enough savings to last until age 80. He and his brothers would have to contribute part of their living cost thereafter. Laura said her parents, age 66 and 65, were expecting to leave some money to her and her siblings. I asked her to provide conservative projections of the amount. She thought that she might receive $100,000 in today’s dollars but insisted strongly that it not be included in retirement planning. Dan believed that his compensation would grow 10 percent a year for the next 10 years and then level off, with raises growing at the rate of inflation. Laura indicated her compen- sation would increase at the rate of inflation after the step-up due to her projected comple- tion of a master’s degree. Both thought their standard of living after purchase of the house was what they would like to maintain throughout their lives. They wanted to fund their children’s undergraduate education at a good state university in their area, which would cost approximately $20,000 per year per child. In addition, Dan asked me what I thought of long-term care insurance for them at this time. Finally, I mentioned that our plans generally provide for funding to ages 95 for fe- males and 91 for males based on about a 10 percent probability of their exceeding that age. They looked at each other and laughed and said they wanted funding for both to age 95.

I gave them the following advice: Retirement planning is considered by many to be the focal point of financial planning. For those people being able to enjoy a comfortable retirement is their uppermost concern and goal. To be able to do so with confidence, it is important that long-term planning for retire- ment start at an early date. Your insightful comments on what retirement might look like have made it easier for me to calculate the financial steps that should be taken to ensure that you can reach your retirement objectives. The process of establishing your current situation includes ascertaining your re- quired savings as compared with your current savings. It reflects your retirement goals and all resources to be established before and after retirement. First, I will answer the questions you have asked for they bear on the questions of resources generated. Then I will state the assumptions made in calculating retirement needs. I will then calculate your retirement needs. Using the retirement needs and the educational funding you intend to provide, I will calculate your life insurance needs. Placing your entire life cycle inflows and outflows together with your resources, I will indicate whether your current savings pattern appears adequate to meet your goals.

Chapter Thirteen Retirement Planning 411

Dan asked whether he should continue funding his 401(k) plan in view of spending pressures on the two of you. The 401(k) plan is not an ordinary savings vehicle. It is one that includes special tax benefits. Pretax dollars are placed into it, which means that the deposits are not taxed at that time. For tax purposes, then, it is as if you didn’t earn that money despite the fact that it will be a strong source of investment and retirement dollars. Income and capital gains are also not taxed currently. It is only when you start withdrawals that the money is taxed. By then you should have generated a substantial nest egg. I refer to qualified plans such as the 401(k) as a “government gift” to make my clients aware of the benefit in participating in it and the concurrent loss if they choose not to fund the payments. I believe that thinking applies to you as well. You should make the pay- ments once Laura returns to work and even earlier if possible. Finally, I will comment that your goals and resources appear to be out of balance. Specifically, your resources are likely to fall short of your goals. This is not unusual, par- ticularly for people your age. I will leave the discussion until after the capital needs analy- sis is completed (Chapter 17). At that time, we will have a better handle on what is doable.

College Student Case Study and Review: Amy and John RETIREMENT PLANNING Amy started the meeting with a statement. She knew that retirement planning was impor- tant. Her parents talked about money and planning for retirement all the time. However, she found the subject too distant from her life today. Could I indicate whether she needed to pay attention to it now and if so provide the essentials to what she needed to know?

Why Retirement Planning Interest Now I indicated to Amy that I sympathized with her feeling currently unrelated to the topic. I joked that many people her age thought that retirement was so far into the future it was almost as if they would live forever before having to consider it. On the other hand, dealing with it as soon as she began working would place her well ahead of many young adults. That is because money saved and invested beginning today, through compounding, can with little sacrifice result in sufficient funds to retire comfortably. If savings are delayed two, three, or four times as much money or more would be needed if savings began later. I mentioned that there was a possibility that taxes could rise from here and that the govern- ment’s safety net for retired people through Social Security and medical support could be more limited, particularly for those who aspired to a high standard of living. Why be burdened with the uncertainty when a little more action earlier could eliminate it? I mentioned that of all the financial decisions people worry about and seek help for, retirement planning, when cou- pled with investment analysis to get them there, is the most popular financial planning topic. You should know that there are pension plans that are targeted for retirement use. The most potent of these are qualified pensions that allow you to deposit pretax (untaxed until later) dollars with income from interest, dividends, and growth in investment prices remain- ing untaxed until distributions are taken at retirement. Defined contribution plans are quali- fied plans that limit the amount of pretax dollars that could go in but doesn’t limit the amount that can be accumulated. The most common is a 401(k) plan, which is offered by many em- ployers. An IRA is another defined contribution plan that is open to all people that work. The defined benefit plan is an alternative qualified plan whose contributions may be more flexible, but whose distributions at retirement are more restrictive. These may be set up by employers, unions, partially/fully owned small business, or self-employed persons.

412 Part Four Specialized Planning

The final type of qualified plan is a Roth IRA or Roth 401(k). In these plans, after-tax dollars go in initially or when qualified plan transferred dollars are taxed and then depos- ited in a rollover plan. Annuities are a common form of a nonqualified plan with after-tax dollars deposited, and no taxation until withdrawals are made. John spoke up for the first time. “Which type plan is best?” he asked. I said each plan has its strengths and weaknesses. However, many corporations in the country have shifted from a defined benefit plan, which often gave a level stream of income at retirement for life, to a defined contribution plan. Clearly employees favor the defined benefit because it was funded by the corporation with the amount paid out annually dependent on the corpo- ration’s selected percentage of work income provided in retirement, the actual salary received generally in the years before retirement, and the number of years the employee worked for the corporation. Some employers found these pensions too costly in competing with international corpo- rations. Many have gradually shifted to a principally employee funded 401(k), defined contribution system. The employer may select the investment alternatives allowed and often makes a limited contribution. The employee’s final sum available at retirement depends on how much each person contributes over their time with the corporation and how well the investments they selected to use out of the choices presented turn out. These 401(k)s are “portable”—transferable (rollover) to IRAs or to new employers—while defined benefit plans are not, although the amounts accrued to time of shift in company are generally paid out at retirement. Your account will not be taxed if it is rolled over to an appropriate retirement account. Roth 401(k)s and Roth rollover IRAs are a significant alternative to the traditional defined contribution plan. Roth’s advantage is in giving the government taxes on monies that you earn, depositing the remaining sum into a pension, and then “paying no more income taxes forever.” It is powerful. It has particular benefit when a person is likely to be subject to a higher tax rate in the future and when the individual is able to afford to leave a large sum for their children. In the case of rollover IRAs, the contributor can pay the tax due out of nonpen- sion accumulated assets. However, the pay-no-further-tax benefit is limited by its constrained life, due to the need to withdraw the sums over the child’s or other beneficiaries’ life spans. The most appropriate plan depends on individual circumstances. However, the defined benefit plan would probably be voted most popular by the employee because of “no pain of having to contribute personally, all gain.”

Social Security Social Security is the government pension plan that many qualified persons save for and receive. It may be the most sought after government benefit as it allows many to afford retirement. It is so popular that it may one day become the third word out of a baby’s mouth after mommy and daddy. At the present time (2014) people receive full benefits at age 66–67, depending on their year of birth. Permanently lower benefits can generally begin at age 62 payouts and higher ones for life if payouts are delayed until age 70. John cut in again. “Well what age is the preferred one to begin taking payouts?” I told him there was no magic answer. Such factors as poor health, absence of need for funds, and aggres- sive projected investment returns on investing oneself could argue in favor of an early payout. On the other hand, good health and longevity in your family, a conservative investment policy, and projected lower tax rates in retirement are advantages for an age 70 payout. On balance, people have an important risk management tool in taking an age 70 payout because they will receive more funds when they probably would need the money, in the event they live an extra- long life. That having been said, many people prefer getting their money as soon as possible and use it as a key to be able to retire. These people then are drawn to age 62 retirement.

Chapter Thirteen Retirement Planning 413

Retirement Assets and Structures There are more types of retirement assets than most people think. Of course there are financial assets like stocks and bonds. Then there are human-related assets. This category includes pension payouts like Social Security and corporate defined benefit pensions. They are priced based on the current value of future income. Then there is the home, which can be used as a source of funds if needed by taking out a reverse mortgage loan that when col- lateralized by the home need not be paid back. Alternatively someone can sell the home and rent thereafter. We have already talked about retirement structures like qualified plans, Social Security, and so on. The final one is personal savings, which don’t have much tax saving relative to the other structures. Its advantage is ease of accessing, but that doesn’t eliminate the advantages of qualified plans. You should be aware of retirement risk that can derail you on your way to a comfort- able retirement. There are five principal ones. Investment risk comes about because of lower than expected returns. Inflation risk is having a higher cost of living because of rising operating costs such as those for food or health care. Longevity risk is the possi- bility of living a longer life than anticipated, which leaves you short of the cash needed to finance it. The fourth one is health risk, which is the cost of financing a medical mishap or long-term services to support your lifestyle due to deteriorating health. The final one is withdrawal risk. It says the exact timing of declines in the market can have substantial effects on the success rate for funding for retirement; if a sharp decline in the market occurs early in retirement it has much greater risk than if it occurs late in retire- ment. That is true because a sharp drop in the market early in retirement forces a person to withdraw a greater percentage of a market depressed pension sum or savings to support the same amount being withdrawn. Because the withdrawal is consumed in expenditures needed, it isn’t available to bounce back as the overall market generally does. This amount is forever lost and can severely injure the prospects for a successful outcome that wouldn’t be the case if the weak market happened late in a person’s retire- ment life cycle.

Investments and Payout Policies It generally pays to select the proper asset allocation for yourself. Pay attention to invest- ment policy, which was discussed in the financial and nonfinancial investment chapters. Being overly aggressive or conservative can create roadblocks to a successful retirement. Higher than prudent withdrawal rates can undermine a person during retirement. If the past is any indicator of the future, a 4 percent withdrawal rate per year is generally a good benchmark of “safe” withdrawals from your savings.

Upon Considering Early Retirement I know this is of little relevance to you personally now. However, try to think of it as a body of knowledge to impart if your parents ever needed a helping hand. They could be forced to retire early because of such things as poor health, loss of a job, poor investment results, high unreimbursed medical costs, or poor planning for retirement. In such case they could postpone retirement or take a part-time job in retirement, or reduce retirement living costs.

Calculate Retirement Needs Retirement needs called capital needs analysis, tells you whether you are on track for a comfortable retirement; that is, whether you will have the funds necessary to retire at the cost of living and time you desire. If you aren’t you need to make some changes in your income or more likely expense structure to accumulate greater savings.

414 Part Four Specialized Planning

I could discuss more detailed and more accurate approaches. However, for now I will mention a very quick method called the highly abbreviated capital needs method. It takes your initial withdrawal from your assets to live on in retirement and divides it by your projected total retirement assets. If it is 4% or less you appear to be in good shape. If you or, in this case your parents, are coming close to retirement you should hone in more closely using a more sophisticated approach (given in Chapter 17). As they both literally ran out of the room I caught a look in Amy’s eyes that said our discussion today was useful and relatively painless.

Summary Having sufficient capital to retire comfortably is the number one financial concern for many people. As such, it has particular importance in PFP.

plans allow for a tax deduction for plan deposits.

contributed.

time in the future. Even without that statement, a home may be sold in a financial emergency.

risk, withdrawal risk, longevity risk, and health risk.

fluctuations.

capital appears possible for 30-year retirement periods.

Key Terms annuitization, 394 defined benefit plans, 392 defined contribution plans, 392 fixed annuities, 394

health risk, 405 longevity risk, 404 nonqualified plans, 393 pension, 390 qualified plans, 391 reverse mortgage, 401

withdrawal risk, 401 tax-deferred annuities, 393 tax-deferred compensation, 393 variable annuities, 394 vesting, 390

ssa.gov Social Security Administration (SSA) This is the home page of the Social Security Administration. It offers complete infor- mation about regulations on Social Security benefits, statistical data, and helpful top- ics discussing the most important issues regarding Social Security.

pbgc.gov Pension Benefit Guarantee Corporation (PBGC) Comprehensive information about defined benefit pension plans and how PBGC guarantees timely and uninterrupted payments of pension benefits is featured.

Websites

Chapter Thirteen Retirement Planning 415

dol.gov/ebsa Employee Benefits Security Administration (EBSA) Assistance and educational information on pension, health, and other employee ben- efit plans for both employers and employees are presented.

dol.gov/dol/topic/health-plans/erisa.htm ERISA This link provides complete information about the Employee Retirement Income Security Act (ERISA), which deals with voluntarily established pension and health plans.

irs.gov/Retirement-Plans Internal Revenue Service (IRS) This link offers useful tax information for retirement plans.

irionline.org Insured Retirement Institute (IRI) This trade association for annuities provides comprehensive learning material, statis- tical data, and publications on both fixed and variable annuities.

psca.org Plan Sponsor Council of America (PSCA). PSCA offers valuable information about 401(k) retirement plans, tax legislation re- garding these plans, and answers to frequent questions about these plans.

401kcalculator.org 401kCalcukator.org On this site, a 401(k) calculator is provided to help you determine how much you need to save for retirement.

aarp.org American Association of Retired People The home page of American Association of Retired People provides people age 50 and over with useful information in various areas they are concerned about. The top- ics include health and wellness, community service, learning and technology, travel and leisure, and so on.

tiaa-cref.com TIAA-CREF This is the home page of TIAA-CREF, a group of companies that includes Teachers Insurance and Annuity Association and College Retirement Equities Fund and is the nation’s largest pension fund manager with over $300 billion in assets under management. The site features various retirement plans, individual investing, insurance planning, practical tips in the savings and retirement area, and calculators and planning tools.

Questions 1. Why is retirement perceived as so important to people? 2. List the principal concerns of people in planning retirement. 3. Explain the relationship of life cycle theory to retirement planning. 4. Explain the difference between a defined benefit and a defined contribution plan. 5. Which plan is more likely to be attractive to a younger person, a defined benefit or a

defined contribution plan? 6. Why do people save through qualified pension plans?

416 Part Four Specialized Planning

7. What is the principal benefit of nonqualified plans over other forms of savings? 8. When would a mutual fund be more attractive than an annuity? 9. What does capital needs analysis provide? 10. What is longevity risk? 11. What are the similarities and differences between retirement needs and insurance? 12. How does investing for retirement differ from investing after retirement? Why? 13. Why is it advisable to have a significant amount of a retirement portfolio invested in

equity? 14. Explain withdrawal risk. 15. Name three strengths and weaknesses of annuities. 16. Identify the factors that will help make the decision as to whether to take Social

Security early.

Problems Marisa and Jennifer both attempted to put away $10,000 a year toward savings. Marisa used a 401(k) pension plan while Jennifer tried to do the same but was forced to pay taxes on that $10,000 in savings each year. Assuming that the process was the same each year for 40 years, how much will Marisa and Jennifer have at the end of the period, assuming identical investments providing pretax returns of 10 percent annually? The marginal tax brackets for both are 35 percent overall and for Jennifer’s investments 27 percent due to blending income with favorable capital gains rates. (Note: Be sure to use after-tax figures for Jennifer’s deposits and investment returns.) Dawn and Mildred had the same starting sum of $120,000. Each made withdrawals of $24,000 a year. In years 2, 3, and 4, each had returns of 9 percent a year. Dawn had a 50 percent drop in year 1 and a 50 percent gain in year 5, while Mildred had a 50 percent gain in year 1 and a 50 percent drop in year 5.

a. Calculate the remaining sum for each woman at the end of year 5. b. Explain why there is such a big difference in the remaining amounts.

Kenneth was considering whether to place $10,000 in a tax-deferred annuity or a tax-free municipal bond. Assume the municipal bond returned 5 percent a year and the tax-deferred annuity 6 percent. Calculate approximately how long he would have to hold the annuity so that, if he withdrew the money and paid taxes on it, he would come out ahead. His mar- ginal tax rate is 35 percent. Elizabeth, age 62, wanted to consider the benefits of age 62 Social Security at a reduced 75 percent payout versus full payments at age 66. She could invest the monies at 5.5 percent after tax and expects to live until age 88. She will receive $15,000 a year after tax at age 66. Which alternative should she select? Show all calculations.

13.1

13.2

13.3

13.4

The investment portfolio for a defined benefit retirement plan has declined in value during a year in which most financial market investments have incurred losses. Which one of the following entities would be impacted most by this decline in portfolio value?

a. Individual participants in the plan. b. Company sponsoring the plan. c. Investment banker handling the plan. d. Plan underwriters.

13.1CFP® Certification Examination Questions and Problems

Chapter Thirteen Retirement Planning 417

Which one of the following statements is not true for a defined benefit plan? a. Favors older participants. b. Arbitrary annual contribution. c. Requires an actuary. d. Maximum retirement benefit of the lesser of $90,000 (indexed) or 100 percent of pay

per year. e. Requires Pension Benefit Guarantee Corporation (PBGC) premiums.

Your client, the chief financial officer of a new company, wishes to install a retirement plan in the company in which the pension benefits to employees are guaranteed by the Pension Benefit Guarantee Corporation (PBGC). Identify the plan(s) below that must meet this requirement.

1. Profit-sharing plan. 2. Money purchase plan. 3. Target benefit plan. 4. Defined benefit plan.

a. (1) and (2) only. b. (2) and (3) only. c. (1) only. d. (3) and (4) only. e. (4) only.

Which of the following is/are true concerning nonqualified deferred-compensation plans?

1. They can provide for deferral of taxation until the benefit is received. 2. They can provide for fully secured benefit promises. 3. They can give an employer an immediate tax deduction and an employee a deferral of tax.

a. (1) only. b. (2) only. c. (3) only. d. (1) and (3) only. e. (2) and (3) only.

Which of the following are common actuarial assumptions used in determining the plan contributions needed to fund the benefits of a defined benefit plan?

1. Investment performance. 2. Employee turnover rate. 3. Salary scale. 4. Ratio of single to married participants.

a. (1), (2), and (3) only. b. (1) and (3) only. c. (2) and (4) only. d. (4) only. e. (1), (2), (3), and (4).

13.2

13.3

13.4

13.5

418 Part Four Specialized Planning

Marcus has a salary of $150,000. He contributes the maximum to his 401(k) and wishes to make the highest possible level of additional tax-deferred savings for retirement. Which of the following are feasible options for Marcus?

1. Invest in a flexible premium, deferred annuity. 2. Make annual contributions to an IRA on a pretax basis. 3. Make annual contributions to an IRA on an after-tax basis.

a. (1) only. b. (3) only. c. (1) and (2) only. d. (1) and (3) only.

A client, Tom, informs a CFP® professional that his daughter, Susie, graduated from col- lege last month and landed her first job. Tom wants to establish a Roth IRA for Susie. Tom wants to make a $5,000 contribution for Susie and explains that she does not know about investing and probably would not have money to contribute. How could the CFP profes- sional best accomplish Tom’s objective?

1. Open the account in Susie’s name and then gift the assets to Susie. 2. Explain to Tom that he can contribute to an IRA for Susie. 3. Request Tom set up a joint meeting with Susie to complete the planning process with her. 4. Explain to Tom that Susie must complete a risk questionnaire before Tom can open the

account.

Ron and his wife Susan, both 61 years of age, ask a CFP® professional to provide a recom- mendation on whether or not Susan should start to draw Social Security benefits when she first becomes eligible at age 62. Which of the following would be least important to obtain in order to provide a recommendation?

1. Family longevity and health history. 2. Social Security earning statement for each. 3. Other retirement assets or financial needs. 4. Long-term disability coverage.

13.6

13.7

13.8

Chapter Thirteen Retirement Planning 419

Case Application RETIREMENT PLANNING

Part 1 At the retirement planning meeting held recently, Richard and Monica were in agreement that they were well short of the money they needed for retirement at Richard’s age 65. Monica said she was thinking of handling investments herself. Richard said he wanted to do it and thought that savings outside the pension given current lower tax rates for capital gains and dividends made sense.

Case Application Questions 1. What do you think of Monica’s idea of taking control of retirement investing? 2. What is your opinion of Richard’s contention that saving outside the pension was best? 3. What are their alternatives in covering the shortfall in annual retirement savings? 4. What are you recommendations? 5. Construct the retirement planning portion of the financial plan.

Part 2 Brad and Barbara also attended the meeting. They said they were too young to start saving for retirement. Retirement seemed “hundreds of years” away and they wanted to have fun today. They would have plenty of time to save for retirement when they were in their 50s.

Case Application Questions 1. How do you feel about their beliefs? 2. Describe the disadvantages of their approach. 3. Suppose they wanted to have $1 million accumulated in 40 years. Indicate how much

money would have to be saved each year if they started now. Assume that the money would be accumulated in personal accounts and earn 6 percent a year after taxes.

Pension Plans This appendix provides additional information on pension plans. Unless otherwise indi- cated, the statistics on income eligibility and maximum contributions are as of 2014.

DEFINED CONTRIBUTION PLANS Defined contribution plans are pensions that specify the amount of money that can be placed into them. They limit the amount or percentage of salary that may be deposited. They make no restrictions on the amount accumulated or yearly income that can be withdrawn from the pension other than the 59½ age limitation before payout. Defined contribution plans take many forms. As compared with defined benefit plans, they have grown in favor over recent decades in part because of a trend toward employee-funded pensions. Some types of these plans are discussed below.

420 Part Four Specialized Planning

IRA Plans IRAs are open to all people who earned taxable income. If you are not eligible for any other pension plan, you can place pretax dollars into an IRA if your modified adjusted gross income is below $70,000 and you are single or $116,000 if you are married and filing jointly. Otherwise, after-tax dollars will be used. Contribution limits are $5,500 for an individual and $11,000 for a married couple.29

Rollover IRAs Rollover IRAs are structures for which qualified pension plans of all types may be trans- ferred without triggering a current tax. Generally, the transfers occur when you retire or move to another job. You may combine amounts in other qualified plans in one rollover, although it is generally considered advisable to segregate sums in a separate rollover in which after-tax pension dollars were originally deposited. That segregation is advisable because no income is assessed on withdrawals of after-tax deposits, only on the income they generated.

Roth IRAs Roth IRAs are pensions into which after-tax dollars are placed, and no further income tax is paid on the sums accumulated. Roth IRAs can receive rollovers from other IRAs, providing that current taxes are paid on the rollover sums. Taxation is made on the amount rolled over, which is included in ordinary income in the year transferred. It can place you in a higher marginal tax bracket for that year. General contributions are limited to those who have earned income and have a modified adjusted gross income of $129,000 or less per individual or $191,000 or less jointly. Maximum ordinary Roth IRA contributions are $5,500 per year.30

Profit-Sharing Plans Profit-sharing plans are qualified pensions whose funding varies based on the profits of the firm. The maximum contribution allowed is the lesser of $52,000 (in 2014) or 25 percent of each employee’s salary.

Target Benefit Plans Target benefit plans are qualified pensions in which a fixed percentage of profits is con- tributed to an employee’s pension each year. The maximum contribution allowed is the lesser of $51,000 (in 2013) or 25 percent of each employee’s salary.

SEP IRAs A Simplified Employee Pension (SEP) is a qualified pension plan that is simpler to set up and to run. It is normally limited to small businesses. The maximum that can be contrib- uted is the lesser of $52,000 (in 2014) or 25 percent of each employee’s salary.

Keogh Plans Keoghs are another form of simplified defined contribution plan or a defined benefit plan that is used by people who are self-employed or in a partnership.

401(k) Plans The 401(k) is the most popular defined contribution plan in the United States today. These plans are generally funded largely by employees, although employers may contribute as well. Because of government requirements to make the plans broad-based among employees, employers have an incentive beyond concern for their workers to make voluntary contribu- tions if the employees also contribute so that they attract more employee participation. The

29 Plus $1,000 extra per year for a person over 50. All of these IRA numbers are for 2014, and will be increased for inflation. 30 $6,500 if you are 50 or older by the end of applicable year. All of these Roth IRA numbers are for 2014, and will be increased with inflation.

Chapter Thirteen Retirement Planning 421

contributions by employees and employers are generally based on a percentage of salary, with employee contributions in 2014 limited to $17,500 per year;31 the limits increase with inflation. Contributions vest immediately, and departing employees generally transfer these plans to their new employers or to rollover IRAs. Typically, employees are given a number of investment choices in their 401(k). They are required to provide at least three choices, which may include a money market fund, a bond fund, and a stock fund. However, the trend is for employers to present a widening array of selections, particularly in the equity area. The choices may extend beyond mutual funds to individual asset managers and less often to other types of structures such as hedge funds. The employer is required to monitor the performance of those choices on behalf of the employees and provide up-to-date figures on overall performance for the alternatives and results for each employee’s account. The 401(k) plan perhaps best symbolizes the growing shift from fixed pension sums to those that are funded and run by employers. Today the most popular pension is one largely employee-financed, with investment risk and employer choices self-selected and entirely portable upon leaving. In addition, businesses have the ability to offer their workers a Roth 401(k) plan. Unlike a traditional 401(k), under the Roth option employees place after-tax dollars into the plan. Employees can deposit the same amount as allowable for traditional 401(k)s. As we have men- tioned in the chapter, the traditional 401(k)’s pretax dollar contribution is an important benefit. However, assuming they hold the money in the Roth 401(k) plan for at least five years and they do not withdraw it before age 59½, they pay no income taxes on all withdrawals. Among people who may find the Roth 401(k) particularly appealing are any of the following: those who (1) are younger and have many years of tax-free compounding ahead of them, (2) are affluent and don’t need to make withdrawals to live on, (3) want to leave money to their children—as the children will not pay income taxes on future withdrawals either, (4) can afford to pay for the income taxes due up front and still put the maximum allowable cash contribution into the plan, or (5) expect to be in a higher tax bracket in retirement. For those in a higher tax bracket when retired, Roth 401(k) plans can provide an especially important advantage over traditional 401(k) plans.

Example 13.1A At many companies, 401(k)s now come in two versions: traditional and Roth. Traditional 401(k)s offer tax deferral, but withdrawals are subject to income tax. Roth 401(k)s offer no initial tax benefits, so contributions are made with dollars that already have been subject to income tax. After a Roth 401(k) account has been established for five years and the employee has reached age 59½, all withdrawals avoid income tax. Choosing between the two versions is often a mat- ter of age and income. Suppose Helen Jones works for XYZ Corporation as a senior executive. Helen, age 58, earns a substantial salary, so she is in a high tax bracket. She expects to retire in a few years and move to a low-tax state. Helen chooses to contribute to the traditional 401(k), to avoid the high tax on some of her current income. Her future 401(k) withdrawals may be taxed at a lower rate, after she stops working and has moved to a state with low income taxes. Helen’s nephew, Ivan King, age 22, has just finished his education and has begun to work for XYZ, so he has to make the same choice between retirement plans. With his entry-level salary, Ivan is in a low tax bracket, so he will save little money by deferring taxable income with a traditional 401(k) contribution. Thus, Ivan contributes to the Roth 401(k). He doesn’t plan to withdraw funds before age 59½; by then, he’ll be able to take tax-free withdrawals, no matter how much income he has or how high income tax rates might be in the future.

403(b) Plans The 403(b) plan was established for nonprofit institutions. It is in many respects like a 401(k) plan. The limitations on contributions are $17,500 in 2014, with the amounts raised periodically. Moreover, 403(b)s may be annuitized, which means that, generally, fixed payments may be received over the life of the retiree or a husband and wife.

31 Plus $5,500 for people over 50.

422 Part Four Specialized Planning

DEFINED BENEFIT PLANS Defined benefit plans are the second major type of qualified pension plan. They fund for a pre- determined amount or percentage of salary, generally to be paid out upon retirement. Thus, unlike a defined contribution plan, the contribution at the beginning of each period is not set, but the payout at the end of the period—the beginning of retirement—is established. The defined benefit plan used to be the most common plan in the United States. Typically, a person receives a pension sum based on years of service and ending salary for the year or years immediately preceding retirement. When the employer wants to encourage early retirement, the company will often offer incentives in the form of reducing the years of service or make additional annual contributions to make an early retirement package more attractive. The defined benefit plan is also used by smaller businesses, which may employ a Keogh format. In the case where the principal or principals are close to retirement, relatively large sums can be contributed to fund large retirement payouts. Defined benefits can be an exception to the $52,000-per-year maximum on pension contribution, with yearly amounts deposited potentially exceeding $100,000 per year for people in their late 50s or early 60s. Retirement payouts are based in part on business income and can be as high as $210,000 per year, adjusted for inflation. In comparison with the defined contribution plan, the defined benefit plan has distinct ad- vantages for mature individuals who may have more money placed into a plan by their corpora- tion or, in the case of ownership in a small business, as a tax shelter for themselves. Where the principals are older and the other employees are younger, the principals can receive a dispro- portionate share of the overall contributions. In recent years, employers have moved away from defined benefit plans. Only 11 Fortune 100 companies offered a traditional defined benefit plan to new salaried employees in 2012, down from nearly 90 percent of such companies in 1985.32

The defined contribution may be more favorable to younger employees. Their monies contributed can grow to large sums over their working years. For smaller businesses, the plans are simpler to supervise as they don’t require actuarial computations of allowable contributions as defined benefit plans do. For businesses, defined contribution plans financed by business are easier to control as they can be partially or fully funded based on profitability; therefore, they can be cut back when profits decline. Employee-funded plans like the 401(k) can reduce or eliminate employer cost. Defined contribution plans also pass market risk to the employee. Disappointing results lead to a lower sum available to employees at retirement. Any reduction in the market value of investments set aside for future pensions would have to be absorbed by the corporation under a defined benefit plan as its obligation to provide a fixed pension at employee retirement would remain the same regardless of the return on investment.

32 Jerry Geisel, “Fewer Employers Offering Defined Benefit Pension Plans to New Salaried Employees,” Workforce, :October 3, 2012, workforce.com/article/20121003/NEWS01/121009976/fewer-employers- offering-defined-benefit-pension-plans-to-new-salaried-employees#

Appendix II

Retirement Structure Summary The two tables below present summary information on retirement structures. Table 13.1A provides the advantages and disadvantages of alternative ways of saving. In Table 13.2A, impact of distribution from alternative retirement structures are compared.

Chapter Thirteen Retirement Planning 423

✓ Money generally cannot be withdrawn without penalty until age 591/2

✓ Withdrawals taxed at ordinary rates

✓ Overall limits on annual contribution

✓ Mandatory withdrawals must start at age 701/2

✓ Withdrawals taxed at ordinary rates

✓ Material overhead charges ✓ After-tax dollar contributions

✓ No overall tax shelter ✓ After-tax dollar contributions

Advantages Disadvantages

Qualified pension plans

Annuities

Personal savings using mutual funds

✓ Pretax dollar contributions ✓ Tax deferral ✓ Modest administrative charges or none ✓ Often the most attractive retirement

savings vehicle

✓ Tax deferral ✓ No price fluctuation and guaranteed rate for fixed

annuities ✓ The option to annuitize ✓ No limits on annual contributions ✓ No mandatory withdrawals ✓ Capital gains and dividends taxed at favorable rates1 ✓ Broad flexibility in shifting investment positions ✓ Ability to select from the universe of choices ✓ No limits on annual contributions ✓ No mandatory withdrawals

TABLE 13.1A Comparison of Saving through Alternative Retirement Structures

1 Mutual funds offer a form of tax deferral because gains are not taxed until shares are sold either by the fund manager (net of losses or other holdings sold) or by the fund holder. When accounts are individually managed instead of managed in mutual fund format, holdings can be deferred indefinitely as it is the holder who decides exactly when to sell each asset.

Pretax dollars Pretax dollars After-tax dollars After-tax dollars N/A

Yes Yes Yes No N/A

Yes Yes No No N/A2

Yes Yes Yes N/A N/A

Ordinary income Ordinary income Ordinary income Capital gains3 N/A

No Yes No No Yes

No No No No Yes

No5 No6 No6 Yes No Financial Human-related Financial Financial Human-related

Factor Defined

Contribution Defined Benefit Annuity1

Personal Savings Social Security

TABLE 13.2A Comparison of Retirement Payouts by Type of Retirement Structure

Tax treatment of initial deposit Tax deferral on income and capital gains Taxation of pension payout of original deposit Taxation of pension payout of gains on original investment Type of taxation on gains Government-backed guarantee Typically indexed for inflation Is sum liquid?4

Total portfolio asset category

1 That is annuitized. 2 Taxation, if any, based on overall household income. 3 For sales at a profit. Dividends taxed at favorable capital gains rates and interest at ordinary income rates. 4 Assuming person currently works for a company. 5 In some cases, money can be borrowed for a limited time. 6 Yes, if not annuitized.

Part Five

Tax and Estate Planning 14. Tax Planning 15. Estate Planning

Tax planning and estate planning are two essential elements of a financial plan. They share a heavy orientation toward minimizing taxes and present a legal basis for much of the analysis. For financial planning majors, perhaps because of the detailed nature of the material presented, part or all of one or both of these topics is sometimes postponed to advanced courses. Taxes, the subject of Chapter 14, enter into most parts of a financial plan. It is easy to grasp the importance of this topic. A dollar saved in taxes is another dollar of cash flow generated for household use. We will go over income tax planning strategies to schedule and reduce the tax burden. Estate planning has a tax-planning element as well but extends beyond that to the welfare of others. Chapter 15 presents the major estate planning tools and strategies that can be used to take advantage of them. Appendixes in both chapters present the theories that underlie their disciplines.

426

Chapter Goals

This chapter will enable you to:

Dan had decided to do his own tax returns. Dan and Laura’s current return was being done by Laura’s father. As Dan viewed it, “We are grown up and can take care of our own activities.” It turned out that, like some of my other clients, he had become almost obsessed with the idea of finding another tax deduction. Laura said she didn’t expect to see him from April 1 to April 15 when the tax return was to be mailed.

Real-Life Planning The elderly woman who came in had an air of elegance and entitlement. She was well dressed, lived in the expensive part of town, and spoke as if she had been sent to finishing school. She wasn’t very friendly and wanted the advisor to restrict the analysis to tax matters only. In fact, the only time she showed any change from her smooth manner was when she said the word taxes. It was uttered with complete disgust. The advisor explained that he didn’t do tax returns but would be happy to see if there were ways to reduce her outlays through proper tax planning. They agreed on an hourly fee and the work began. The advisor attempted to put together some background information. She mentioned that her husband had taken care of financial matters but recently had died. The advisor looked at her current tax return and noticed that she had paid substantial taxes on the distribution of her husband’s IRA monies. The woman was very cost-conscious and had chosen not to hire any professional help. It was clear that a simple election to transfer (roll over) the funds to her would have increased her wealth. One of the most basic tax-planning techniques was to defer taxes as long as possible. The advisor recalled the words that Marlon Brando spoke in the movie The Godfather and thought about giving her a synopsized version, “If you would have come to me before, I could have helped you,” but decided there was no sense in upsetting her over something that could no longer be changed. He developed her current and projected income and deductible expenses and exemptions. It became clear that she was in the very lowest tax bracket. There were few tax-planning strategies open to her. He told her that her donations of clothing to charity were deductible. He mentioned to her that he would not be recommending tax-free municipal bonds. Based

Fourteen

Tax Planning 427

on her tax bracket, taxable bonds provided a higher after-tax return. She quickly interrupted, saying, “Young man (the advisor was in his 50s), I want to pay the lowest tax I can.” He elaborated simply on the calculation that showed that municipal bonds would provide her with less money to spend. She again responded angrily, saying, “You don’t understand. I don’t want to give the government one cent more than I have to.” She signed a letter indi- cating that she knew taxable bonds were better for her but that she wanted tax-free bonds. The driving force for her was the goal that fewer of her dollars go to the government. The advisor gave her some recommendations on municipal bond funds and she thanked him for being sensitive to her needs. The advisor thought to himself that the woman’s feelings, while extreme in execution, were fairly common. To many, a dollar saved in tax matters is somehow worth more than one saved in, say, shopping more carefully. It was true despite the fact that more time may be expended on generating tax deductions than on careful shopping. The reasons varied. For some it was the belief that they were paying more than their fair share of the tax burden. For others it was the challenge of reducing their taxes to the minimum possible.

OVERVIEW

Taxes are another expense for our household enterprise. However, for many of us, tax takes on greater significance. It is often a large outlay, and we receive no pleasure in pay- ing it. Often our objective is to minimize the payment and we employ planning techniques to help us do so. There are many types of taxes. Some are income-based, like federal income taxes; some are consumption-based, like the sales tax; others are event- and asset-based, like the estate tax, which is triggered by the death of the estate owner. In this chapter, we will concentrate on income taxation and leave the discussion of estate taxes to Chapter 15 on estate planning. We will begin with some background information on taxes and the tax return. The tax return can be viewed as a type of income statement with qualifying expenses reducing the income for tax purposes. Following that, tax-planning strategies are presented using both stand- alone techniques and tax-advantaged investment vehicles. Tax theory is provided in Appendix I. Finally, a case study for completing an income tax return is provided in Appendix II along with step-by-step illustrations of the return. It should help anyone who needs to fill out a tax return.

INCOME TAXATION

Income taxes are a nondiscretionary cost in household operations, with the outlay dependent on both revenues and expenses. Decision making in most household activities is influenced by taxes. A brief example of the tax impact in each area of a financial plan is given below.

Category Explanation

Cash flow planning Taxes influence the timing of transactions and preparation for payment of sums due.

Investments The calculation of returns is often done on an after-tax basis. Financing The calculation of the cost of borrowing is done on an after-tax basis. Risk management There is often a clear preference for tax-deductible employee health and life

insurance. Retirement planning There is a substantial benefit when saving through qualified retirement-

pension vehicles. Estate planning Tax minimization comprises a large part of estate planning activities.

428 Tax and Estate Planning

INCOME TAX FORMAT

Income taxation is generally based on transactions typically involving cash inflows and outflows. Income earners are taxed on an individual basis except for married couples, whose income is generally combined for income tax purposes. The income tax return resembles a household cash flow statement in form. All cash receipts are recorded, adjust- ments are made for certain expenses, and the net is the adjusted income figure called adjusted gross income (AGI). Deductions follow based on fairness,1 popularity, and society’s goals, and exemptions are allowed based on the number of people in the household and other factors. The result is the amount available to be taxed, called taxable income. The tax rate is established based on progressive rates, meaning that rates increase as taxable income increases. To give a simplified example, a taxpayer might owe 15 percent on all taxable income between $25,000 and $50,000 while owing 20 percent in tax on income between $50,000 and $100,000. And so on, with higher rates prevailing for even higher income ranges. The total tax calculated in this manner, less any available tax credits, is due. The amount due for the year less payments already made is the sum to be enclosed with the return. For example, Bill calculates his income tax obligation at $22,000 while $20,500 has been with- held from his paychecks for federal income tax. Bill must pay the $1,500 balance with his tax return. We summarize the individual income tax return, IRS Form 1040, in Table 14.1. A summary breakdown of the components of the tax return is given in Example 14.1. A more detailed breakdown of the components including tax-deductible items is given in Appendix II. An extensive tax-planning statement is provided in the Dan and Laura case study.

Section Explanation

Income Sources of revenues Wages Dividends Capital gains Other income Adjustments Special deductions from revenues 401(k), IRA contributions Student loan interest Deposits to other qualified plans Adjusted gross income Adjusted revenues Deductions Allowable reductions based primarily on operating costs Standard or itemized deduction Exemptions Allowable reductions based primarily on number of

household members Taxable income Income subject to tax Tax The gross amount to be paid Credits Dollar-for-dollar reductions in gross tax Other taxes Dollar-for-dollar additions to amount due Total tax due The amount to be paid Total payments made Amount owed

* Schedule A will be discussed in Appendix II.

TABLE 14.1 Principal Components of Tax Return*

1 For example, someone would say it is fairer to recognize as deductions large casualty losses—which can be looked at as losses of important assets—after having taxed the income that led to these assets.

Chapter Fourteen Tax Planning 429

Example 14.1 Beverly had taxable revenues of $60,000 last year and expects $68,000 in the current year. Her adjustments to revenues were $2,000 last year and are projected to be $3,000 this year. Her deductions and exemptions last year were $18,000; this year they are projected at $23,000. There is no state income tax where Beverly resides. Compute her federal tax under an assumed 20 percent average tax bracket for both years.

Abbreviated Tax Planning Worksheet

Last Year This Year

Revenues $60,000 $68,000 Adjustments 2,000 3,000 Adjusted gross income 58,000 65,000 Deductions and exemptions 18,000 23,000 Taxable income $40,000 $42,000 Tax $8,000 $8,400

TAX PLANNING: A GENERAL ANALYSIS

Tax planning is the analysis and implementation of strategies to reduce tax expenditures. It also involves the scheduling of tax payments and the programming of tax-related cash outlays. Your overall goal is generally to minimize taxes, provided that doing so is consis- tent with efficient household operations. If you were sick and postponed going to the doctor for three months until the new year so that you qualified for a tax deduction, you would not necessarily be operating efficiently. Another way to define your goal for tax-planning purposes would be to maximize your after-tax returns on investments includ- ing your investment in human assets. A tax-planning statement provides a projection of future tax expenses by year. Often the most recent year’s actual tax return figures are used as a basis for them. Such a tax- planning worksheet is shown in Table 14.2.

Marginal Analysis In making tax-planning decisions, you often must weigh the benefits of alternative approaches. For example, which should you purchase: a higher-yielding taxable bond or a lower-yielding municipal bond? The answer often depends on your marginal tax bracket. The marginal tax bracket is the sum you pay on the next dollar of income. It is expressed as

Marginal tax bracket = Tax on next dollar earned ÷ Next dollar earned It is to be distinguished from the average tax bracket, which is total tax dollars expended as compared with total earnings.

Average tax bracket = Total income tax outlays ÷ Taxable income

Example 14.2 Edward and Mary had $90,000 of combined adjusted gross income. They had paid $30,000 in federal, state, and local taxes and $40 on the last $100 of income. What are their marginal and average tax brackets?

Marginal tax bracket = $40 ÷ $100 = 40%

Average tax bracket = $30,000 ÷ $90,000 = 33%

430 Tax and Estate Planning

We often use the marginal, not the average, tax bracket because many decisions need to be made based on the next dollar earned, not the average dollar.2

Example 14.3 Esther found an additional tax deduction of $6,000. She was in the 33 percent average tax bracket and the 40 percent marginal one. If she stays in the same tax brackets, how much will her tax bill be lowered?

Lower tax = 1Amount of deduction2 × 1Marginal tax bracket2 = $6,000 × 40% = $2,400

The correct figure is $2,400. If she used the average tax bracket, she would have misestimated her benefit as $1,980 from the new deduction.

To obtain a total marginal tax bracket, you add your federal state and local taxes and subtract the tax benefit arising from the ability to deduct state and local taxes on the federal return.3

2015 2016 2017 2018 2019

Income Wages Dividends and interest Capital gains Other income Total income 401(k), IRA contributions Student loan interest Deposits to qualified plans Total Adjusted gross income Personal exemptions Standard deduction Deductible medical and dental expenses Deductible taxes Deductible interest Deductible gifts to charity Allowable miscellaneous expenses Total itemized deductions Total deductions Total taxable income Tax Total credits Total other taxes Total federal tax Total state tax Total federal and state tax Social Security (FICA) Medicare tax Total tax Average tax rate Marginal tax rate

TABLE 14.2 Tax Planning Statement

2 The calculation assumes that the person remains in the same marginal tax bracket after deduction or extra income is reflected. It also assumes that the person is able to deduct state and local income tax. Where these assumptions are not correct, a more elaborate calculation is required. 3 From 2004 through 2013, taxpayers were able to take either state and local income taxes or sales tax as a deduction on their federal tax returns. At the time this book was published, it had not been established whether this deduction will continue for future years.

Tax Planning 431

The formula is

Marginal federal bracket

Marginal state

bracket

Marginal state

bracket

Marginal local

bracket

Marginal tax

bracket = + + – ×

Marginal state

bracket

Marginal local

bracket +

Example 14.4 Albee was in the following marginal brackets: 33 percent federal, 7 percent state, and 2 percent local. What is his total marginal bracket on income earned?

Marginal tax bracket = 33% + 7% + 2% – 33% × 17% + 2% 2 = 42% – 3% = 39%

You can use the marginal tax bracket to compare alternative investments on an “apples to apples” basis. Doing so is necessary because market forces adjust prices for investments with tax benefits and reduce their pretax returns to investors. Two approaches can be used to compare investment alternatives: after-tax returns and pretax equivalents.

After-Tax Returns This approach simply reduces returns on alternative investments to after-tax figures in or- der to compare their benefits. It is given by the following formula:

After-tax return = Pretax return × 11 − t2 where

t = Marginal tax bracket, expressed as a decimal

Pretax Equivalent Returns Pretax equivalent returns compute tax-advantaged returns on a before-tax basis. In effect, this approach takes the investments with tax benefits and grosses them up to the equivalent return on investments without tax benefits. If an investment has no tax benefits, no calcula- tion for it is necessary.

Pretax equivalent return = After-tax return 1 − t

Example 14.5 Karen was offered two investments. One, a corporate bond, provided a 7 percent return with no tax benefits. The other was a tax-free municipal bond with a 5 percent return. Karen is in the 40 percent marginal tax bracket. Calculate comparable after-tax and pretax equivalent re- turns and indicate which is more favorable.

After-Tax Returns

Corporate bond = 7% × 11 − 0.42 = 4.2%

Municipal bond = 5% × 11 − 02 = 5%

Pretax Equivalent Returns

Corporate bond = 7% 1as stated2 Municipal bond = 5%

1 − 0.4 = 8.3%

The muni bond provides a higher tax-adjusted return.

432 Tax and Estate Planning

Both approaches should provide the same conclusion about which investment to select. The after-tax return method is more common whereas the pretax equivalent is often used by investment professionals; it more favorably highlights the benefits of a particular tax- advantaged investment because of its higher-yield figure.

TAX-PLANNING STRATEGIES

We can use a number of techniques to reduce our taxes. Many of these techniques involve planning well before the actual tax return needs to be filed. They include increasing de- ductible expenses, deferrals, conversions, transfers, eliminations, timing of income and expenses, and tax planning for investments.

Increasing Deductible Expenses and Credits Tax law is involved, and with each new “tax simplification” act, it seems to get more com- plex. By carefully going through IRS publications or a good tax-planning manual,4 you may be able to develop new deductions or credits. For example, you may not have been aware that a tax credit of up to $7,500 is available for those who purchase an electric car. Clustering can be a productive tax-planning tool. Under current tax law, medical expenditures exceeding 10 percent of your AGI are deductible; the same is true for miscellaneous deductions over 2 percent of your AGI. If you have medical or miscellaneous expenditures that fall below the 10 percent or 2 percent limitations, respectively, you may be able to pay and group two years’ outlays together in one year to bring your deductible expenditures above their respective floors. This strategy is aided by the ability of individuals to deduct expenses on a when-paid rather than an accrual basis.

Example 14.6 John made $40,000 a year and had investment costs of $200 per year and fees to a tax pre- parer of $500 per year. Each year John’s total deductions of $700 fell short of the miscella- neous expenditures floor of $800—2 percent of his AGI. He decided to cluster two years of his tax-planning expenditures by visiting his tax preparer in March for the past year and December for the current year. His deductible expense for each for the two years is now $200 (for the first year, with no tax planning) and $1,200 (for the second year, thanks to clustered tax plan- ning) instead of $700 and $700. John has developed a way to generate a new $400 deduction (the amount over the $800 threshold) every two years.

Miscellaneous expenditures floor = $40,000 × 2% = $800

New deduction = Miscellaneous expense − Expenditures floor = $1,200 − $800 = $400

Tax Deferral Tax deferral refers to postponing taxes to be paid today to some time in the future, so they can provide sizable benefits due to your ability to use that money in the interim. The defer- ral may be for one year or for a considerably longer period.

Example 14.7 Susanna, a businesswoman, asked her client to bill her in early January instead of December. Therefore, her taxes were due one year later. Her billing was for $10,000. Susanna was in the

4 See, for example, The Ernst & Young Tax Guide for the latest year.

Tax Planning 433

40 percent marginal tax bracket and was able to earn 7 percent a year after tax on the money deferred, which was also the discount rate. She repeated this process each year for the 25 years she was an individual proprietor. Compute her yearly tax deferral, yearly tax benefit, and cumulative tax benefit at the end of 25 years.

Yearly tax deferral = Yearly bonus × Marginal tax bracket = $10,000 × 40% = $4,000

Yearly tax benefit = Yearly tax deferral × After-tax return on investment = $4,000 × 7% = $280 per year

For as long as she performed this service, Susanna had a continuing tax benefit of $280 a year when a December payout was compared with a January one. You can find the cumulative benefit as follows:

Inputs: 25 7 280

Solution: 17,710

N I/Y PV PMT FV

Cumulative tax benefit $17,710

Tax deferral is the key to the benefits of a pension or deductible IRA. Taxes are deferred on the portion of salary placed in the pension or IRA as well as on the interest, dividends, and capital gains earned while it is in this tax shelter. Taxes are paid on withdrawals and, in many cases, for the remainder upon death. The older the person making the contribution, the less the benefit of tax-free compounding until withdrawals at retirement. However, in many instances where withdrawals will be spread over normal life expectancies, even people nearing retire- ment will find it beneficial to continue to make deposits into pensions or deductible IRAs. Moreover, people nearing retirement may be at or near their peak earning years and thus in a high tax bracket. They will benefit if they can defer income until retirement if their marginal tax rate is expected to be lower then. Jill, a successful executive in her 50s, is in the 40 percent marginal tax bracket. She contributes fully to her company’s 401(k) plan, avoiding a $400 tax payment on every $1,000 she puts in the plan. Jill expects to be in a 30 percent marginal tax bracket after she retires because she will have scant earned income. Thus, she can withdraw those contributed dollars, as well all the untaxed earnings inside the 401(k), and pay only $300 in tax on every $1,000 she takes out of the plan for her re- tirement spending. Jill will have the same tax benefit if she rolls over her 401(k) money to an IRA, which would maintain the tax deferral.

Conversion Conversion involves the change from one amount of tax due to a lower one. There are two ways that this can happen. The first involves shifting income; the second, transforming income.

Shifting Income Shifting income involves transferring income from a person in a higher bracket to some- one in a lower bracket. This might be done by gifting money to a child or to an elderly parent with low income.

Calculator Solution5

5 Ignore the negative sign obtained in the result in this and succeeding problems in the chapter.

434 Tax and Estate Planning

Example 14.8 Paul and Marisa were in the 40 percent marginal tax bracket and decided to gift $20,000 a year to their daughter Melanie for her college education. They did so on her tenth birthday. Melanie was in the 10 percent marginal income tax bracket at this time. Assume that the money would be placed in fully taxable investments earning 10 percent whether it were kept in the parents’ or child’s name. How much did they save per year?

Taxable income per year = Amount invested × Pretax return = $20,000 × 10% = $2,000

Tax due if in parents’ name = Taxable income × Tax rate = $2,000 × 40% = $800

Tax due if in child’s name = First $1,000 is tax-free. The next $1,000 is taxable at child’s rate. Therefore, $1000 × 10% = $100

Tax benefit of income shifting = $800 − $100 = $700

Transforming Income Transforming income means changing it from a high-tax to a lower-tax status. Typically, it involves changing from being taxed at ordinary income rates to being taxed at more favorable capital gains rates.

Example 14.9 Frances decided to purchase an apartment for $100,000 and then rent it to a third party. Her thought was that even if she wouldn’t make money on the apartment rental, she would take advantage of losses6 at ordinary tax rates and a sale at a capital gains rate. She depreciated the property on a straight-line basis (equal depreciation each year over 27.5 years). Things actually turned out that way with a breakeven yearly on an operating cash flow basis and a sale 10 years later at the $100,000 she paid for it. How much, if anything, did she earn? Assume Frances was in the 35 percent marginal tax bracket for ordinary income and 15 percent for capital gains income and earned 6 percent after tax on the cash flow generated.

Yearly deductible depreciation = $100,000 ÷ 27.5 years = $3,636

Yearly tax benefit = $3,636 × 35% = $1,273

Cumulative Tax Benefit

Inputs: 10 6 1,273

Solution: 16,779

N I/Y PV PMT FV

Calculator Solution

6 Available up to $25,000 a year to people actively managing property who have less than $100,000 of income a year and are not subject to the alternative minimum tax.

Chapter Fourteen Tax Planning 435

Tax Paid on Sale

Cost of property = $100,000 Cumulative depreciation = $36,360 $3,636 per year × 10 years Adjusted cost = $63,640 Sale price = $100,000 Gain on sale = Sales price – Adjusted cost = $100,000 – $63,640 = $36,360 Tax on gain = $36,360 × 15% = $5,454 Cash inflow from yearly tax benefits = $16,779 Cash outflow from sales = $5,454 Net cash earned = $16,779 − $5,454 = $11,325

Note that this business transaction turned out to have no economic merit. There were no earnings from renting out the apartment, and there was no gain on the sale of it. The only benefit came from the difference between taking a deduction at the 35 percent marginal tax bracket for ordinary income and investing the proceeds over the years and eventually paying a tax on sale at the 15 percent capital gains rate. In other words, these benefits came from the use of the tax-deductible money in the interim until sale (deferring) and the lower tax rate on capital gains (transforming).7

Elimination of Taxes Tax elimination involves not paying taxes at all on a specific type of income being generated. Permanent elimination of taxes can be a particularly powerful tool. Some methods of eliminat- ing taxation include gifts to charities, transfers to children, establishment of Roth IRAs, and structuring of employee benefits. Other methods, including purchase of tax-exempt securities and continual investment in residential real estate, will be discussed under tax shelters.

Gifts to Charities A broad cross-section of taxpayers make tax-deductible gifts to charities. Many charitable donations are in the form of cash, check, or property. Those donations made in property form are based on fair market value, not cost, if you have held the property longer than one year. If you sell property that has appreciated since you purchased it, the property will be subject to taxation at capital gains rates. If, on the other hand, you donate an investment to a charity, the capital gains tax on any increase in the value of the investment, which, under normal circumstances, would have had to be paid by you when it was sold, is eliminated. Therefore, charitable gifts have two tax benefits: a tax deduction for the contribution and the elimination of any capital gains tax.

Example 14.10 John gave $12,000 to his church in cash each year. This year he had a $10,000 gain on a stock, now worth $12,000. John is in the 33 percent marginal tax bracket on ordinary income and 15 percent on capital gains income. (1) How should John handle the transaction?

7 The example above made tax advantages the sole source of return on investment. In some cases, income-producing property provides positive pretax cash flow as well. The combination of pretax cash flows plus tax benefits can make income-producing real estate an attractive form of investment.

436 Part Five Tax and Estate Planning

(2) How much of a cash benefit will John have from the contribution? (3) How much of a cash saving will he have from any tax strategy proposed? John should donate the appreciated shares of stock to the charity instead of selling them. His sales of the shares would result in a $1,500 tax bill (15% rate x $10,000). His donation of those shares therefore saves $1,500. In addition, John receives a tax deduction for a charitable contribution worth $3,960 (33% rate x $12,000), whether his donations were in the form of cash or stock. In sum, the use of appreciated stock instead of cash in making the charitable donation saved John $1,500, for a total benefit of $5,460 as it eliminated the capital gains tax that would have resulted had he donated cash and sold the stock separately.

Transfers to Children Under the so-called kiddie tax, the first $1,000 of investment income earned by certain youngsters is not subject to tax, in 2014. This tax applies to:

their support (excluding scholarships).

Establishment of Roth IRAs Roth IRAs are IRAs that are never subject to income taxation once sums are placed into

after-tax dollars In contrast, traditional IRAs under some circumstances can reduce taxable income. This is commonly referred to as deposits coming from pretax dollars—dollars of income on

deposit in your Roth IRAs, currently $5,500 per person per year ($6,500 for those 50 or -

tional to a Roth IRA, after paying a tax on the money transferred.

529 Plans A detailed description of 529 Plans is discussed on page 440.

Structuring of Employee Benefits -

Example 14.11 Samantha was negotiating with a small firm about coming to work for them. They offered her $33,000 per year with no medical benefits. These benefits cost Samantha $3,000 per year. Samantha said she would take the job if the company would give her $30,000 per year and pay for her medical policy. Samantha would save income and Social Security taxes on $3,000 of income, while her new employer would save the employer’s portion of Social Security taxes on $3,000 of Samantha’s salary.

Tax Planning 437

Timing of Income and Expenses The timing of income and expenses involves optional selection of the year in which to report transactions. The simplest use of timing methods is to maximize tax-deductible pay- ments in the current year. By doing so, you can lower taxes in the current year and have use of that cash for an extra 12 months instead of waiting until the following year to take the deduction. Your marginal tax bracket may vary from year to year because of such factors as fluctuations in income earned, unusually high or low deductible expenses, or just a change in the country’s taxation methods or tax brackets. In a year in which your marginal tax bracket is high, you may wish to postpone income to the next year but accel- erate the reporting of deductible expenses to the current year. You would take exactly the opposite approach if your current marginal tax bracket was low. Cash-basis accounting for tax purposes makes it easier to shift income and expenses.

Example 14.12 Because she had a large gain on the sale of stock, Adriana did some tax planning. She calcu- lated that she would be in the 44 percent marginal tax bracket in the current year as compared with her normal 28 percent. She decided to make her charitable contribution of $3,000 in December instead of her normal practice of doing it in February of the following year. She also shifted her overtime by one week, so she would be paid her $2,000 in January instead of December. How much money would she save?

Adriana’s After-Tax Return on Investments

Without Tax Planning With Tax Planning

Current Year Following Year Current Year Following Year

Income from overtime $2,000 − − $2,000 Charitable contribution − ($3,000) ($3,000) − Total income $2,000 ($3,000) ($3,000) $2,000 × × × × Marginal tax bracket 44% 28% 44% 28% = = = = Tax payments $880 ($840) ($1,320) $560

Two-year balance $40 ($760)

Saving in taxes ($760) − $40 = ($800)

Her saving in taxes is $800. Moreover, the timing of the payments (with a $1,320 current-year tax deduction versus an $880 current-year tax payment without tax planning) would add to the benefit.

Tax Planning for Investments Tax planning for investments is generally weighted more heavily toward the timing of revenue transactions. The principal tax-planning tools for household operating activities, on the other hand, are often heavily weighted toward the timing of expenditures by year. The reason is that the receipt of income from job-related activities is often beyond the control of the taxpayer, whereas an investor often has a choice as to when to sell an invest- ment and declare the gain. There are four types of income from financial investment activities: ordinary income, dividend income, short-term capital gains and losses, and long-term capital gains and losses.8

8 In addition to financial investments, there are such things as passive and active investments in real estate and oil and gas and other natural resources that may have separate tax treatment and differentiation between passive and active participation in the activity.

438 Tax and Estate Planning

Ordinary Income Ordinary income is income taxed at normal rates based on your taxable income. It is appropriate for interest or other operating income from investments. It is taxed at the same rate as income from job-related activities.

Dividend Income Dividends are received on payouts from corporations. Qualified dividends are eligible for special taxation. Under current law, the standard tax rate is 15 percent. Certain high- income taxpayers owe 20 percent while lower-income taxpayers owe zero percent on qual- ified divided income. To receive the tax benefit, common stock dividends must have been taxed on a corporate level. Although most common stock dividends will qualify, only a fraction of preferred stocks will. To receive the benefit, the shares must be held for more than 60 days during the period surrounding the declaration of the dividend; the dividend cannot be paid to a tax-deferred account such as a pension. Those dividends that don’t qualify, such as the ones from a real estate investment trust (REIT), will be taxed at ordinary income rates.

Short-Term Capital Gains and Losses Short-term transactions arise from gains and losses when sales prices for investments are compared with their costs. The tax code defines short term as sales that are made in one year or less from the date of purchase. In the absence of long-term transactions, short-term gains are taxable at ordinary income rates. Deductions for net short-term losses are limited to $3,000 per year, but amounts in excess of $3,000 can be carried forward to future years indefinitely until the entire amount is utilized.

Long-Term Capital Gains and Losses Long-term transactions for financial securities are those that are held for more than one year. Long-term capital gains on these securities are tax-favored, having the same zero percent, 15 percent, and 20 percent tax rates that apply to qualified dividends.9 Long- and short-term investment transactions are netted against one another.10 The following are some tax-planning strategies.

Take Capital Losses This strategy proposes that you take advantage of losses on current holdings by selling the shares. If they are sold within the current year, you realize the tax benefit from the loss earlier than if you postpone the sale. The benefit of this strategy is, of course, limited to $3,000 of capital losses net of capital gains for the year. In addition, the tax benefit from the losses must be measured against the potential investment gains in continuing to hold the shares. For example, there is some indication that stocks that have performed poorly during the year are subject to unusual declines at year-end due to people taking advantage of this strategy (called tax-loss selling), and that shares rebound sharply in January.11 It can sometimes be beneficial to wait and sell in January as the gains in price can more than compensate for the deferral of the tax-loss-selling benefit by one year.

9 The long-term capital gains rates for some real estate profits are 25 percent and the maximum tax on long-term collectibles gains is 28 percent. 10 Long-term capital losses after netting out capital gains, combined with any net short-term capital losses, can only be deducted for the first $3,000 each year. The balance is carried forward until the losses are offset against gains or applied against ordinary income at the rate of $3,000 annually. 11 Jay Ritter, “The Buying and Selling Behavior of Individual Investors at the Turn of the Year,” Journal of Finance 43, no. 3 (July 1988): 701–17.

Tax Planning 439

Take Capital Losses to Offset Capital Gains This strategy is very close to the one above. However, its trigger is the desire to reduce or eliminate taxes on gains on already-sold securities. It is done by selling shares with losses to the extent of gains or for $3,000 more of losses than gains. Say that Mark tallies his stock market trades for the year in December and finds that he has net gains (all long term) of $25,000. If Mark is in a 15 percent tax bracket for long- term capital gains, he will owe $3,750 in tax (15 percent of $25,000). So Mark goes over the stocks held in his taxable account and decides to sell some losers. He takes $35,000 of losses by year-end, so he has a net loss of $10,000 for year. Thus, Mark saves $3,750 by not reporting any capital gains on his tax return for that year. He also deducts a $3,000 net capital loss, the maximum allowed. If Mark is in a 25 percent ordinary tax bracket, he will save another $750: 25 percent of his $3,000 net loss. That brings Mark’s total tax saving for the year to $4,500, from this strategy. In addition, Mark will have $7,000 of unused capital losses to carry forward for future tax benefits. For this strategy to work, Mark cannot immediately buy back the stocks he sold for a loss. He can wait at least 31 days for a repurchase or immediately buy different securities.

Postpone Capital Gains to the New Year This strategy defers taxes by postponing gains until the next calendar year. It is subject to the same provision that it must be measured against the risk of changes in stock prices—in this case, share declines in the interim while waiting to sell.

Postpone Sales until Investments Are Held More than One Year As mentioned, investments that you have held for more than one year are subject to favor- able long-term capital gains tax rates. Therefore, if you have a material gain, you may benefit from waiting until the investment has been held more than one year before selling. A summary of the tax-planning strategies discussed is shown in Table 14.3.

TABLE 14.3 Summary of Tax-Planning Strategies

Strategy

Increase deductible expenses and credits Tax deferral Conversion

Timing of income and expenses

Elimination of taxes

Take capital losses

Postpone capital gains to new year Postpone capital gains until held more than one year

Explanation

Finding new deductions and clustering existing ones Postponing taxes and investing the money Bringing about a lower tax rate by: a. shifting income from a higher- to a

lower-income person b. transforming income from one taxed at an

ordinary income tax rate to taxation at a more favorable rate, normally a capital gains rate

Selecting the year to declare a gain or loss to take tax advantage of a more favorable marginal tax bracket Pay no further income taxes on a sum after taking a certain action Selling investments with losses to reduce current taxes Delay selling an investment that has risen in value until the new year Delay selling an investment that has appreciated in value until it qualifies for favorable long-term capital gains treatment

Example

Bunching two years of medical visits and payments into one year to get over floor deductible Placing money into a 401(k) pension plan

Gifting to child

Holding an investment asset that has appreciated for 12 months to receive long-term capital gains treatment

Postponing the subscription to a deductible business magazine until the new year when you will be in a higher marginal tax bracket Purchase of municipal bonds of the state you reside in Sell stock with $3,000 loss before the end of December Waiting until January to sell a profitable investment you intended to liquidate in December Retaining a profitable investment until owning it for at least 12 months

440 Tax and Estate Planning

TAX-ADVANTAGED INVESTMENTS

There are a variety of investments providing tax benefits that can be used in tax planning. They can be separated into investment structures and individual investments.

Tax-Advantaged Investment Structures Tax-advantaged investment structures are entities that provide an umbrella of tax benefits for investments made within the entity. Some of the leading ones are discussed below.

Pension Plans and Traditional IRAs Qualified pension plans along with certain IRAs are among the few entities that allow pretax dollars to be invested. As you have learned, placing pretax dollars into a pension means that no taxes are paid on the deposits currently. Taxation is deferred on initial deposits and on subsequent dividends, interest, and capital gains on deposits until monies are withdrawn. Pension plans come in many formats including 401(k) plans, profit-sharing plans, and so on. Their tax deferrals, including one for contributions with pretax dollars, make pensions a particularly attractive tax-advantaged investment.

Roth IRAs and Roth 401(k)s Roth IRAs require that after-tax dollars be placed into them. In contrast to traditional IRAs and pensions, which provide tax deferral, Roth IRAs are not subject to any further taxation after five years and after age 59½. There is a current limit of $5,500 ($6,500 for those 50 or older) annually that can be placed in a Roth IRA and some overall limits, based on income, as to who can take advantage of a Roth. However, there is no income limit on taxable con- versions of traditional IRAs to Roth IRAs. A Roth IRA is particularly beneficial for younger people who have opportunities for many years of tax-free compounding without an ultimate income tax. Roth 401(k) plans offered by some employers have the same general characteristics as Roth IRAs but can allow larger yearly contributions. For a description of them, see Chapter 13, Appendix I.

529 Plans Section 529 plans (qualified tuition plans) accumulate funds for future educational expenditures. After tax saving placed in these vehicles grow tax free and are not taxed upon withdrawal provided they are used for tuition fees and education support material such as books. Eligible students include those in the immediate family, grandchildren, and cousins. The monies must be placed in separate accounts operated by state designated investment managers. For more information see Web Chapter A–Educational Planning.

Employer Nonqualified Plans Certain employer plans offer both pretax-dollar deposits and tax deferral for nonqualified plans. We will be discussing them in the next section of this chapter.

Tax-Deferred Annuities Tax-deferred annuities are investments in which after-tax dollars are placed into entities. The tax on all earnings on deposits is deferred until withdrawals are made. There are two types of annuities: fixed and variable. As we discussed in Chapter 13, fixed annuities have stable principal and earn a rate of return determined by the market, contract terms, and the discretionary factors of individual annuity companies. Variable annuities offer an invest- ment alternative in which returns are generally determined by market factors. Both choices

Tax Planning 441

offer the option of paying out money accumulated, generally in level sums for the life of the holders, based on projected life expectancy.

Life Insurance Sums deposited and accumulated in certain life insurance policies beyond policy costs, called cash value, earn income. That income grows tax-deferred in the same way annuities do. There are fixed and variable life insurance policies as well. The cash value can be withdrawn, which may generate income tax, or it can be borrowed without a taxable-income event occurring.12 If the cash value is left in the policy without purchasing more insurance, it will not increase the payout at death, with the payout generally limited to the stated amount of the policy.13

Individual Tax-Advantaged Investments Tax-advantaged individual investments are those in which the specific investment, not the overall investment structure, provides the tax benefit. Some of them are discussed below.

Home Investment in an apartment or house you live in provides many tax advantages. Interest to finance the home is tax-deductible, as are real estate taxes. The first $250,000 of gain on sale of a home ($500,000 per couple) that is your primary residence is excluded from taxa- tion. You must have lived in and owned a home for at least two of the previous five years14

before being eligible for this exclusion of gain on sale. Taxation on gains beyond this exclusion is based on favorable long-term capital gains rates.

Real Estate Investment Real estate that you don’t reside in full time but is intended as an investment allows tax deductibility of interest, taxes, and other operating costs. It also allows you to take depre- ciation on the investment. This depreciation expense can be employed as a tax deduction despite the fact that well-located and well-maintained properties generally appreciate in price. Depreciation is allowed to the extent of taxable profits on the property and other similar assets plus an additional maximum of $25,000 per year, subject to overall taxpayer adjusted gross income limitations. Finally, business real estate that you own can be exchanged for other “like kind” property without triggering taxation on gains.

Municipal Bonds Most municipal bond interest is free from federal taxation. When you purchase qualified municipal bonds of the state you live in, your interest is not subject to state and local taxes either.

Series EE Bonds Series EE bonds are U.S. government bonds. New bonds purchased will earn a fixed rate of interest. For bonds purchased between May 1995 and April 2005, the interest rate floats with five-year U.S. government Treasury securities and pays 85 percent or 90 percent of that rate depending on the issue date of the bond. Interest is not paid out but deferred until

12 Only when cumulative withdrawals begin to exceed cumulative payments do the withdrawals become taxable. 13 Except for certain universal life contracts that, in effect, add cash values to the face amount at death and for dividend-paying life insurance policies that use the dividends to purchase paid-up additional insurance, which increases the death benefit. 14 With some exceptions.

442 Tax and Estate Planning

the bonds are cashed in. Cashing in the bonds isn’t required for many years, and until they are cashed, taxes on the bonds’ income can be deferred.

U.S. Government Bonds Although subject to federal taxation, U.S. government bonds are free of state and local taxes. This tax benefit is only useful, of course, in states that assess income taxes.

Tax-Sheltered Investments There are a variety of investments on which the federal government has elected to bestow tax benefits. Some of them include oil and gas, low-income housing, rehabilitation of older buildings, tax credits on certain investments, and so on.15

Example 14.13 Adam and Corina were in the 40 percent tax bracket and decided to compare investments in various tax-advantaged alternatives starting with $80,000 in each. Assume that all amounts were to be withdrawn and used in 20 years and had the pretax return listed below.16 What are the after-tax sums available at that time?

Practical Comment Taxes and Investment Merit

15 See Andrew A. Samwick, “Tax Shelters and Passive Losses after the Tax Reform Act of 1986” (National Bureau of Economic Research working paper no. 5171), in Empirical Foundations of Household Taxation, ed. Martin M. Feldstein and James M. Poterba, pp. 192–233 (Chicago: University of Chicago Press, 1996); and Del Wright Jr., Valparaiso University Law School and Arizona State Law Journal, Forthcoming, “Financial Alchemy: How Tax Shelter Promoters Use Financial Products to Bedevil the IRS,” 2013, ssrn. com/abstract=2212588 16 These figures are not intended to fully represent the relative attractions of these assets. Relative returns can differ between assets at a point in time and when compounded over time. They also differ depend- ing on the household’s marginal tax bracket and the specific investment used within the tax-advantaged structure. For example, a variable annuity may provide a higher rate of return than a fixed annuity.

Qualified Pension

Nonqualified Pension

Tax-Deferred Fixed Annuity

Municipal Bond Roth IRA Equities House

Pretax dollars 80,000 80,000 80,000 80,000 80,000 80,000 80,000 After-tax dollars 80,000 48,000 48,000 48,000 48,000 48,000 48,000 Pretax return 10% 10% 6% 5% 10% 10% 4% After-tax return 10% 10% 6% 5% 10% 9.4%1 4% Accumulated amount—20 years 538,200 322,920 153,943 127,358 322,920 289,459 105,174 Tax rate 40% 40% 40% 0% 0% 20% 0% Tax on accumulated 215,280 109,968 42,377 0 0 48,292 0 amount Amount remaining $322,920 $212,952 $111,566 $127,358 $322,920 $241,167 $105,1742

1 Assume 3 percent dividends and 7 percent deferred appreciation. 2 Excludes other nontax benefits, including inputted rent.

Tax Planning 443

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Tax Planning

©Don Hammond/Design Pics, Inc.

444 Tax and Estate Planning

Back to Dan and Laura TAX PLANNING Dan came alone to the tax meeting as Laura said she was tied up on Brian matters. Dan now felt very strongly about taxes. He said, “Every dollar I save in taxes is one more dollar that I can spend on things that we enjoy.” I reminded him that I was not a tax accountant or tax preparer but would point out the tax strategies that were available and how he and Laura related to them. He also asked about tax shelters. He said that one of his neighbors claimed to have a tax shelter that eliminated all the taxes he had to pay for the year. And he wanted to know how much money he should place in his company’s flexible spending plan. His medical expenses above insurance-reimbursable amounts would be either $1,500 or $2,500, with $2,500 highly likely. He was concerned that under the flexible spending rules, he would either use or lose the last $1,000 if he committed to $2,500 and his actual expen- ditures came to $1,500. Laura later called and informed me that Dan was going to do their tax return. She said it turned out that Dan really liked learning how to do it. He had mentioned to me previ- ously that he was researching the idea of deducting the cost of his gym membership with the thought that it was needed to improve a two-year-old knee injury that had required arthroscopic surgery. He had gained access to tax court rulings throughout the country and had set up an appointment with the manager of the gym. I thought of mentioning to Dan that his time might be more productively spent on his career pursuits. However, income tax work for him seemed to have a leisure component. He got pleasure from the challenge of finding allowable deductions. I raised the issue in speak- ing to Laura when she dropped off some information. She smiled and said jokingly that she didn’t expect to see Dan from April 1 to April 15 when their tax return was to be mailed.

Here’s how I explained tax planning to them: Tax planning is taking advantage of all established methods of reducing your outlays to the government. There are five established ways of doing so plus a separate category for investments, and I will explain them all and indicate whether there is any potential for you to use each method.

1. Increasing deductible expenses. Increasing deductible expenses means finding expenses that you did not know were deductible. In addition, you can develop them by grouping expenses of more than a year into one year or by some other method. You indicated that you and Laura contribute your used clothing to charity. You can deduct your contribu- tion at the market value of those clothes.

2. Deferrals. By deferring taxes, you postpone them, which allows investing the amount deferred in the interim. You are doing this now by investing in a Keogh plan, which accepts pretax dollars that aren’t taxed until you start withdrawals.

3. Conversion. Conversion involves shifting income to reduce the tax rate. It can be done by gifting money directly to your child, who is in a lower tax bracket. I don’t recom- mend this. As you will see in point 4, there is a better solution. The second method is to transform ordinary income into capital gains income. I will discuss this soon.

4. Eliminations. With this method, taxes are eliminated entirely. I have two recommenda- tions. The first is to shift from taxable bonds to municipal bonds in your taxable accounts. Municipals from the state you live in provide tax-free income. The second is to consider saving education money in Section 529 plans. After-tax monies are placed in these plans; they compound tax-free and are not taxable when withdrawn and used for defined educa- tional expenses.

Tax Planning 445

5. Timing of income and expenses. Where appropriate, income and expenses can be timed to take advantage of changes in marginal tax rates. I don’t believe there is any opportu- nity here for you.

6. Tax planning for investments. Tax planning for investments uses short- and long-term gains and losses from investments in strategies designed to reduce taxation. You men- tioned to me that you had a significant loss on investment in Hypotronics stock, which you intended to sell within the next few months. I noticed you have a gain on Clioxin stock already sold. Unless there is some investment reason not to do so, you should consider selling the Hypotronics before the end of the year to partially offset the gain on Clioxin.

As you are probably aware, flexible spending accounts provide a tax deduction but operate under a “use it (by finding a qualified expense) or lose it” approach. I would take the $2,500 amount. I recognize that you may lose $1,000, but after deduction at your marginal tax rate of 29 percent, it would only come to $710. Your indication of a high likelihood of reaching $2,500 makes that the better opportunity. However, if the possibility of an over- payment is disturbing to you, you can skip the last $1,000. Your tax-planning worksheet with the above recommendations included follows.17 Notice that after this year, your com- bined marginal tax rate of 29 percent stays constant throughout the next three years, but your average tax rate declines. This is due to the favorable tax effects of owning a home. Finally, I am pleased that you are taking over preparation of your tax return. The draft work you have shown me up to now suggests that you are handling it in a competent way. It is likely to make you more knowledgeable in financial matters, which won’t hurt person- ally or in business activities. If your tax work results in further organization of your records and thinking, it is likely to save me time and therefore you money in future follow-up work. Why not take a part of any tax savings and spend it together with Laura on a restau- rant or a weekend away, depending on your success in chipping away the tax bill?

Tax-Planning Statement

2015 2016 2017 2018 2019 2020 2021

Before Plan After Plan

Income Wages $100,000 $100,000 $110,000 $121,000 $133,100 $146,410 $239,882 $258,352 Dividend & Interest $2,500 $2,500 $2,500 $2,500 $2,500 $2,500 $2,500 $2,500 Capital Gains $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 Retirement Account Distributions $0 $0 $0 $0 $0 $0 $0 $0 Other Income $0 $0 $0 $0 $0 $0 $0 $0

Total income $104,000 $104,000 $114,000 $125,000 $137,100 $150,410 $243,882 $262,352 401(k), IRA Contributions $0 $0 $0 $0 $0 $0 $18,000 $18,000 Student Loan Interest $2,500 $2,500 $2,452 $2,226 $1,985 $1,729 $1,458 $1,170 Total $2,500 $2,500 $2,452 $2,226 $1,985 $1,729 $19,458 $19,170 Adjusted Gross Income $101,500 $101,500 $111,548 $122,774 $135,115 $148,681 $224,424 $243,182 Personal Exemptions $11,850 $11,850 $12,206 $12,572 $12,949 $13,337 $13,737 $14,150 Standard Deductions $12,400 $12,400 $12,772 $13,155 $13,550 $13,956 $14,375 $14,806

Medical and dental expenses $1,350 $1,350 $1,648 $1,697 $1,748 $1,801 $1,855 $1,910 AGI times 10% $10,150 $10,150 $11,155 $12,277 $13,512 $14,868 $22,442 $24,318

Deductible medical & $0 $0 $0 $0 $0 $0 $0 $0 dental expenses State and local income taxes $9,385 $9,385 $10,400 $11,534 $12,780 $14,150 $21,798 $23,692 Real estate taxes $0 $0 $2,500 $2,575 $2,652 $2,732 $2,814 $2,898

17 The 1040 schedule is presented in Appendix II. We use 2014 income tax returns, the latest available on the IRS website at the time of publication.

(continued)

446 Tax and Estate Planning

Personal Property taxes $0 $0 $0 $0 $0 $0 $0 $0 Other taxes $0 $0 $0 $0 $0 $0 $0 $0 Deductible taxes $9,385 $9,385 $12,900 $14,109 $15,432 $16,882 $24,612 $26,590 Home mortgage interest $0 $0 $17,219 $17,066 $16,902 $16,727 $16,538 $16,336 and points Investment Interest $0 $0 $0 $0 $0 $0 $0 $0 Deductible Interest $0 $0 $17,219 $17,066 $16,902 $16,727 $16,538 $16,336 Deductible gifts to charity $500 $500 $500 $500 $500 $500 $500 $500 Unreimbursed employee expenses $0 $500 $515 $546 $597 $672 $779 $930 Tax preparation fees $0 $0 $0 $0 $0 $0 $0 $0 Other Miscellaneous expenses $0 $2,000 $515 $530 $546 $563 $580 $597 Total Miscellaneous expenses $0 $2,500 $1,030 $1,076 $1,143 $1,235 $1,359 $1,527 AGI times 2% $2,030 $2,030 $2,231 $2,455 $2,702 $2,974 $4,488 $4,864 Allowable miscellaneous expenses $0 $470 $0 $0 $0 $0 $0 $0 Total Itemized deductions $9,885 $10,355 $30,619 $31,675 $32,834 $34,109 $41,650 $43,426 Total Deductions $12,400 $12,400 $30,619 $31,675 $32,834 $34,109 $41,650 $43,426 Total Taxable Income $77,250 $77,250 $68,724 $78,528 $89,332 $101,235 $169,036 $185,606 Tax $11,025 $11,025 $9,979 $12,419 $15,231 $17,021 $34,577 $39,217 Total credits $0 $0 $0 $0 $0 $0 $0 $0 Total other taxes $0 $0 $0 $0 $0 $0 $0 $0 Total federal tax $11,025 $11,025 $9,979 $12,419 $15,231 $17,021 $34,577 $39,217 Total state tax $9,385 $9,385 $10,400 $11,534 $12,780 $14,150 $21,798 $23,692 Total federal and state tax $20,410 $20,410 $20,379 $23,953 $28,011 $31,171 $56,375 $62,909 Social security tax (6.20%) $6,200 $6,200 $6,820 $7,347 $7,347 $7,347 $7,347 $7,347 Medicare tax $1,450 $1,450 $1,595 $1,755 $1,930 $2,123 $3,478 $3,746 FICA Tax $7,650 $7,650 $8,415 $9,102 $9,277 $9,470 $10,825 $11,093 Total tax $28,060 $28,060 $28,794 $33,054 $37,288 $40,641 $67,201 $74,002

(concluded)

College Student Case Study and Review: Amy and John TAX PLANNING I knew tax planning was mixed in terms of its interest for Amy and John. On the one hand they weren’t paying taxes now and the details of income and deductions were not particularly interesting. On the other hand, learning how to save money in taxes is a challenging “game” with a future real cash payout. I decided to skip many technicalities to keep things relevant. I began by saying that taxation is an essential part of most areas of financial planning. Tax planning can be thought of as the analysis and implementation of strategies to reduce tax expenditures. It can be useful to recognize that there are two main ways of approaching the tax brackets. The first is establishing your average tax bracket, which is merely

Average Tax Bracket = Total Taxes Paid Taxable Income

The second is the amount you would pay on the next dollar you earned (marginal tax bracket).

Marginal Tax Bracket = Tax on next dollar earned Next dollar earned

As long as we are on calculations, in the case of purchasing municipal bonds we do not have to pay federal taxes, on the interest income or even state taxes if the municipal bond bought is in the state we reside in.

Tax Planning 447

There are two ways to calculate returns:

1. After tax return = Pretax return x11 − t2 t = the marginal tax bracket

2. Pretax equivalent return is the rate you would pay if municipals weren’t tax advantaged.

Pretax equivalent return = After the return

1 − t There are a number of techniques to reduce taxes:

Method Explanation

Increase deductible expenses and credits One method of doing so is to group expenses by years, where possible, to reach amounts needed for tax deductions.

Tax deferral Postponing taxes allows earning money on amounts until the taxes absolutely have to be paid; for example, contributing to qualified pension plans.

Conversion Shifting income to people in lower tax brackets such as your children or transfer- ring income from one tax rate to another, such as from a short-term capital gain to a long-term gain.

Elimination of taxes Avoiding taxes by putting money in municipal bonds, for example, or giving taxable assets to charities instead of selling them when you would normally give cash to the charity.

Timing of income and expenses Selecting the year to recognize income for deductible expense to take advantage of changes in your tax bracket.

Tax planning for investments involves knowing the difference in taxation between reporting gains on sales of investment assets held for more than one year versus reporting gains on shorter-term holdings. As a general rule you should take capital losses in the current year and postpone capital gains to the next year. Tax advantaged investment structures include:

Type Explanation

Pension plans and traditional IRAs Defer taxes on earnings normally subject to taxation by depositing them in qualified plans (creating “pretax contributions”).

Roth IRAs and 401(k)s Eliminate further taxes after paying taxes upfront on deposited sums.

Tax-deferred annuities Postpone taxes on earnings on amounts deposited after paying taxes upfront on deposited sums.

Home Eliminate $250,000 per person, $500,000 per couple worth of gains of sale on a home, obtaining a tax deduction on mort- gage interest and real estate property taxes.

448 Tax and Estate Planning

Key Terms adjusted gross income (AGI), 428 after-tax dollars, 436 average tax bracket, 429 clustering, 432

conversion, 433 marginal tax bracket, 429 ordinary income, 438 pretax dollars, 436 shifting income, 433

tax deferral, 432 tax elimination, 435 tax planning, 429 taxable income, 428 transforming income, 434

irs.gov Internal Revenue Service (IRS) This is the Internal Revenue Service’s home page, which provides thorough informa- tion on taxation in all areas of economic life. The site lets the user download forms, instructions, and publications by the IRS. It also features a fill-in form service where users can directly fill in tax forms and print them out.

taxprophet.com Taxation Issues An extensive list of tax topics from taxation of employee stock options to estate taxa- tion, information for foreign taxpayers, real estate taxation, and a column featuring published tax articles are provided.

taxsites.com/rates.html TAXSites.com Links to different tax and accounting topics are given. There is a link that could be of particular interest for taxpayers, providing information on tax rates and tables rang- ing from alternative minimum tax rates, automobile rates, depreciation, and Section 179 rates to IRA, per diem rates, state taxes, and withholding tables.

Websites

Summary Tax planning is a crucial factor in PFP because of the size of the outlay and the possibility of reduction with proper procedures.

credits, deferring taxes, making a conversion, shifting income, transforming income, eliminating taxes, and timing income and expenses.

IRAs, Roth IRAs, nonqualified plans, tax-deferred annuities, and life insurance.

bonds, series EE bonds, U.S. government bonds, and other tax-sheltered investments.

Real estate Buy assets other than your dwelling and hold for investment, which allows appropriate deductions on outlays against income. You can deduct depreciation even though well-kept over time.

Municipal bond You pay interest that is generally feder- ally tax free, and state and local tax free as well if the bonds are from the state you reside in.

Chapter Fourteen Tax Planning 449

cchgroup.com CCH Incorporated This is the home page of CCH Inc., which is a leading provider of tax and business law information and software.

1. State how taxes are relevant in five major financial planning areas. 2. Why perform tax planning? 3. Contrast marginal and average tax brackets. 4. Which is the most appropriate tax bracket to use in making investment decisions:

marginal or average tax bracket? Why? 5. A person’s marginal tax bracket includes the sum of the relevant federal, state, and

local income taxes. True or false? Explain. 6. John discovered a $400 tax deduction. In order to calculate its cash benefit, should he

use his marginal or average tax bracket? Why? 7. What is the difference between shifting income and transforming income? 8. What is clustering of expenses? Give an example of it. 9. Why can tax deferral be so advantageous? 10. What is the difference between conversion and shifting income? 11. Give three examples of tax elimination. 12. Sarah had unrealized long-term capital gains and Marcy had unrealized long-term

capital losses at year-end. When should each sell her shares: the current year or the next year?

13. Assuming that you didn’t regard a stock that declined since you bought it particularly highly, why wouldn’t you want to take a loss in the current year?

14. Why is a qualified pension plan such an attractive tax shelter? 15. Using the table in Example 14.13 on page 442 providing a comparison of tax-

advantaged structures, explain why the qualified pension plan and the Roth IRA seem to be particularly attractive investments.

16. Compare a municipal bond with a tax-deferred annuity. When would one be more attractive than the other?

Questions

Melinda earned $50,000 and paid taxes of $12,500. She would have paid $35 on the next $100 she made. Compute her average and marginal tax brackets. Murray was in the following marginal tax brackets: federal, 35 percent; state, 7 percent; local, 4 percent. What is his total marginal tax bracket? Sally was able to negotiate a deferral in her $8,000 bonus from December to the beginning of January. Compute the benefit of receiving the bonus in January, assuming that she is in a 30 percent marginal tax bracket and could earn 6 percent after tax per year and that the bonus would remain for 30 years until retirement. What is the annual benefit of parents gifting $300 each year to their child if the parents are in the 35 percent bracket and the child is in the 15 percent bracket? Laurence bought a classic car for $40,000 as a business investment opportunity. He was allowed to depreciate it over 10 years and take the amount as a business tax deduction on his return. At the end of 10 years, the car was sold for $40,000. If Laurence was in the 38 percent marginal tax bracket and could earn 8 percent after tax on the cash flow gener- ated, what was his cumulative cash benefit after sale on this transaction?

14.1

14.2

14.3

14.4

14.5

Problems

450 Tax and Estate Planning

Frances donated $20,000 to a charity each year. This year she thought that, instead of cash, she would donate $25,000 of a stock that cost her $8,000. She was going to sell the shares anyway. If the combined federal and state capital gains tax for Frances is 20 percent, how much would she save in taxes by donating stock instead of selling the shares and then donating the proceeds? Compare a pretax $10,000 sum placed in bonds yielding 6 percent in a qualified pension with an investment in a municipal bond yielding 5 percent. The municipal bond sum deposited was made with after-tax dollars on the same pretax $10,000. The marginal tax rate was 32 percent. Assume that the sums were accumulated for 25 years and the pension was liquidated at that time.

14.6

14.7

Your client’s federal marginal tax rate is 36 percent, and the state marginal rate is 7 percent. The client does not itemize deductions on his federal return and is considering investing in a municipal bond issued in his state of residence that yields 5 percent. What is the adjusted taxable equivalent yield?

a. 3.2% b. 4.65%. c. 5.38%. d. 7.81%. e. 8.40%.

The tax bracket and holdings of your client are as follows:

Federal tax bracket = 33%

Investment* Annual Income June 30, Last Year Purchase Price June 30, This Year Market Price

Money fund $6,500 $100,000 $100,000 11% T bonds $11,000 $100,000 $140,000 S&P index fund $6,000 $100,000 $160,000 Computer stock fund $3,000 $100,000 $85,000

* There have been no capital gains distributions.

During the 12 months from June 30 last year through June 30 this year, the portfolio earned, in annual yield and before-tax appreciation, respectively

a. 5.5% and 17.5% b. 5.5% and 21.3% c. 6.6% and 17.5% d. 6.6% and 21.3%

A client purchased a mutual fund with a $10,000 lump-sum amount four years ago. During the four years, $4,000 of dividends were reinvested. Today the shares are valued at $20,000 (including any shares purchased with dividends). If the client sells shares equal to $13,000, which statement(s) is/are correct?

1. The taxable gain can be based on an average cost per share. 2. The client can choose which shares to sell, thereby controlling the taxable gain.

14.1

14.2

14.3

CFP® Certification Examination Questions and Problems

Tax Planning 451

3. To minimize the taxable gain today, the client would sell shares with the higher cost basis.

4. The client will not have a gain as long as he/she sells less than what he/she invested. a. (1), (2), and (3) only. b. (1) and (3) only. c. (2) and (4) only. d. (4) only. e. (1), (2), (3), and (4).

Jorge is single and owns $30,000 of stock he originally purchased four years ago for $7,000. His adjusted gross income (AGI) is $40,000. If Jorge donates the stock to his church, which of the following is the maximum amount he can deduct as a charitable con- tribution for this gift on his federal income tax return this year? a. $12,000. b. $15,000. c. $20,000. d. $30,000.

14.4

452 Tax and Estate Planning

Case Application TAX PLANNING Richard and Monica estimated they would have adjusted gross income of $108,000 in the current year and would have exemptions of $7,900 and deductions of $25,000. Their aver- age combined federal and state tax bracket was 33 percent.

Case Application Questions 1. Compute their projected taxes for the year. 2. Richard wanted to know if he should take a $10,000 tax deduction this year or wait

until next year to do so. He was inclined to do so now even though his average tax bracket would likely be 28 percent next year. What do you think he should do?

3. Monica wanted to know if they should place their savings into a qualified pension or save it personally. She said that Richard often had modest losses, not gains, each year. What is your recommendation?

4. Monica asked what tax-planning strategies you would recommend for them? Do so while completing the tax-planning section of the plan.

Appendix I

Tax Theory Let’s look at a theory of taxation from society’s and your point of view. Taxation is, of course, the method by which governments raise the funds to carry out the activities for the people they serve. There are a variety of methods of developing the required government revenues and the question can arise concerning how much each of society’s income groups should pay. The alternatives are as follows:

Proportional payment. Individuals pay in the same ratio that they receive government services. Progressive payment. Individuals fund the services on the basis of their ability to pay, with higher-income people paying more. Regressive payment. Individuals in lower income groups pay a greater percentage.

A problem with proportional payments is the difficulty in assigning the amount of benefit to such services as clean air, external defense, and internal security. One theoretical approach to determine how much each group should pay employs util- ity principles. Paying taxes provides negative utility. With this approach, payouts would be assessed so that all people’s disutilities from the tax payments are the same.18 This theory would likely be consistent with a progressive approach. People with greater incomes gen- erally are better able to afford taxes. They therefore may have a higher threshold of “tax pain,” which would allow them to take on above-average tax burdens. In taking an applied approach with the overall society’s well being in mind, we would have to include the impact of higher taxes on an individual’s incentive to work. If an increase in taxes resulted in lower tax revenue to the government, the system would be counterproductive. There are two main methods of taxation: consumption based and income based. 18 Joseph Stiglitz, Economics of the Public Sector, 3rd ed. (New York: Norton, 2000), p. 476. Stiglitz takes issue with this approach, explaining its weaknesses.

Tax Planning 453

THE CONSUMPTION-BASED METHOD Under this method, people are taxed on the amount that they consume and the amount that they save. Importantly, savings are defined not as the sum you deposit in savings accounts but as the amount your total assets rise during the period.19 Its proponents say it is fairer because, among other reasons, taxes are paid on amounts consumed that give the individ- ual pleasure and withdraw needed resources from society.20 An income tax, on the other hand, is uneven. For example, it discriminates against workaholics who benefit society by providing above-average labor productivity and by utilizing little of society’s leisure resources. In addition, the consumption tax is nondiscriminatory; it takes gains on all types of wealth. A weakness is the difficulty in objectively assessing the amount that a certain asset has appreciated. Because a sales tax is dependent on purchases, it is an example of a tax based on the consumption method.

THE INCOME-BASED METHOD This approach taxes your total income less certain allowable deductions. It uses a broad cash flow framework. In general, if money is received, it is taxed. Under the income method, the interest and dividend income, and the gain from sale of an investment, called a realized gain, would be included. The gain on assets not sold, on the other hand, called unrealized appreciation, would not be included as no transaction occurred. Its advantage is the ability of the government to determine gains objectively and to monitor compliance because transactions are often verifiable through third-party records. An example of an income approach is the federal income tax. Some economists believe that a consumption approach is preferable because it is fairer.21 There would be fewer loopholes or inconsistencies such as the income approach’s taxation of gains on a stock sold but no taxation of the same stock purchased at the same time but not liquidated. In deciding on which tax to assess and on whom, there are a number of factors that are considered.

Fairness. Any system must take into account how fair it is for different strata of society. Fairness should mean that people with similar incomes and in similar situations in life pay the same amount in taxes. This is called horizontal integration. Society also may want people to be assessed based on their ability to pay, which is called vertical integration. Administrative efficiency. The costs to run the system should be low, with tax evaders kept to a minimum. Transparency. The system should be easy to understand by all individuals. In this manner, all can determine if it is fair to them and can lobby for change if a different system is thought better. Minimum impact on economic choice. Taxes are generally meant to raise revenues, not affect the normal operations of the economy. Therefore, the goal in most cases should be to minimize the impact on society’s operations. A tax that is onerous enough to materially reduce the incentive to work or to channel resources into inefficient areas can lead to a less productive economy.

19 Called the “Haig-Simons” accretion income. See David Wildasin, “R. M. Haig: Pioneer Advocate of Expenditure Taxation?” Journal of Economic Literature 28, no. 2 (June 1990): 649–60. 20 David F Bradford, Taxation, Wealth, and Saving (Cambridge, MA: MIT Press, 2000). 21 For arguments in favor, see Stiglitz, Economics of the Public Sector, pp. 579–82; and Bradford, Taxation, Wealth, and Saving, pp. 3–40.

454 Tax and Estate Planning

Societal benefits. Governments use progressive taxation in part to redistribute wealth and benefits to individual groups thought to be deserving of aid, while other taxation policies may be meant to direct funds into activities deemed to be in society’s best interests.

There are a number of taxes that governments use, including personal income taxes, corporate income taxes, import taxes, excise taxes, value-added taxes, Social Security taxes, and sales taxes. Our federal and state governments use a balance of consumption and income taxes. Relative to most other developed countries, we utilize income taxes more and consumption taxes less. On balance, our system is progressive with higher incomes assessed at a greater rate. Whether the system is fair depends in part on individual beliefs and economic and political considerations. From an economic and finance standpoint, our focus should be on effi- ciency. Efficiency from the standpoint of an individual household involves minimization of taxes paid. Therefore, it targets income and estate taxation as efforts in both areas may have the most impact on the total amount of outlays for taxes*.

Appendix II

Detailed Segments of an Income Tax Return This appendix provides a detailed breakdown of the income tax return. Each income tax category occupies a separate section of a tax return. We will explain each category and then show the corresponding segment of a tax return after it has been filled out. We will then show the complete tax return at the end of the appendix. Let’s start at the top of the numbers portion of the tax statement with income. We will use Dan and Laura’s case, although the education figures will differ from the final ones, due in part to timing. Some additional information on Dan and Laura follows. (Not all the examples in the case will be those of Dan and Laura.)

INCOME AND ADJUSTMENTS Dan called to say he was in the neighborhood; he wanted to know if he could stop by for a few minutes. He provided some further details on his thinking. He asked if I could help him become more knowledgeable about taxes. He had decided to do his own tax returns. Their current returns were being done by Laura’s father. Her father had no special back- ground in taxes but didn’t mind doing them for his children. Dan didn’t know how well he was doing, and, though grateful, he was uncomfortable with the idea of his father-in-law preparing their return. Besides, the do-it-yourself project seemed interesting to him. As I did when he came in with Laura, I again mentioned to Dan that I was not a tax preparer myself but that tax planning was part of the financial work we were doing for him. I had to gather and input the relevant current tax information to generate the planning projections. I had developed some sheets explaining how to fill out a tax return and would fill them out using the projected figures for the year that would soon end. All he had to do was e-mail the projected amounts on income, expenses, and growth rates over the next two years using a sheet I had given him. Shortly after that, I received the information, which is listed below. The sheets follow- ing represent the information and explanations that were sent back to Dan.

*We have excluded asset based taxes as it is beyond the scope of this chapter. For example, property tax, a major budget item, is not considered.

Tax Planning 455

Tax Figures

Amount Growth Rate

Income

Wages—before 401(k) $100,0001 10% Dividends and interest 2,500 0 Capital gains 1,500 0 Other — Total $104,000 Adjustments

Student loan interest $2,500 Standard deduction 12,400 Personal exemptions 11,850 Total taxable income $77,250 Total tax $11,025 Tax withheld 12,500 Tax due –1,475

1 Figures for wages and salaries are entered on the tax return after 401(k) and other qualified pension contributions by employees have been deducted. Therefore, they do not appear on the tax return.

Income Included in income are all qualifying cash payments less cost figures or, in some instances, a basis other than cost.

Category Explanation

Salaries, wages, tips Based on cash received Interest Taxable interest on bonds, CDs, and so forth Tax-exempt interest Listed on return in memo column but not included in income Dividends Received from stocks, and so on Alimony Received from former spouse Business income Shown net of expenses with the details provided on a separate

tax schedule Capital gains Profits on sale of assets based on sales price less purchase price;

other basis of taxation shown on a separate schedule IRA and pension distributions Taxable portion included Unemployment compensation A form of government salary that may be included Social Security A portion taxable to certain higher-income households Other Taxable refunds, other gains and losses, rental real estate

income, royalties, farm income, and so forth Total income The sum

Fo rm 1040 Department of the Treasury—Internal Revenue Service (99)U.S. Individual Income Tax Return 2014 OMB No. 1545-0074 IRS Use Only—Do not write or staple in this space.

For the year Jan. 1–Dec. 31, 2014, or other tax year beginning , 2014, ending , 20 See separate instructions. Your first name and initial Last name Your social security number

If a joint return, spouse’s first name and initial Last name Spouse’s social security number

Make sure the SSN(s) above and on line 6c are correct.

Home address (number and street). If you have a P.O. box, see instructions. Apt. no.

City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions).

Foreign country name Foreign province/state/county Foreign postal code

Presidential Election Campaign

Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking a box below will not change your tax or refund. You Spouse

Filing Status

Check only one box.

1 Single 2 Married filing jointly (even if only one had income) 3 Married filing separately. Enter spouse’s SSN above

and full name here.

4 Head of household (with qualifying person). (See instructions.) If the qualifying person is a child but not your dependent, enter this

child’s name here.

5 Qualifying widow(er) with dependent child

Exemptions 6a Yourself. If someone can claim you as a dependent, do not check box 6a . . . . . b Spouse . . . . . . . . . . . . . . . . . . . . . . . . } c Dependents:

(1) First name Last name

(2) Dependent’s social security number

(3) Dependent’s relationship to you

(4) if child under age 17 qualifying for child tax credit

(see instructions)

If more than four dependents, see instructions and check here

d Total number of exemptions claimed . . . . . . . . . . . . . . . . .

Boxes checked on 6a and 6b No. of children on 6c who: • lived with you • did not live with you due to divorce or separation (see instructions)

Dependents on 6c not entered above

Add numbers on lines above

Income

Attach Form(s) W-2 here. Also attach Forms W-2G and 1099-R if tax was withheld.

If you did not get a W-2, see instructions.

7 Wages, salaries, tips, etc. Attach Form(s) W-2 . . . . . . . . . . . . 7 8a Taxable interest. Attach Schedule B if required . . . . . . . . . . . . 8a b Tax-exempt interest. Do not include on line 8a . . . 8b

9 a Ordinary dividends. Attach Schedule B if required . . . . . . . . . . . 9a b Qualified dividends . . . . . . . . . . . 9b

10 Taxable refunds, credits, or offsets of state and local income taxes . . . . . . 10 11 Alimony received . . . . . . . . . . . . . . . . . . . . . 11 12 Business income or (loss). Attach Schedule C or C-EZ . . . . . . . . . . 12 13 Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 14 Other gains or (losses). Attach Form 4797 . . . . . . . . . . . . . . 14 15 a IRA distributions . 15a b Taxable amount . . . 15b 16 a Pensions and annuities 16a b Taxable amount . . . 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E 17 18 Farm income or (loss). Attach Schedule F . . . . . . . . . . . . . . 18 19 Unemployment compensation . . . . . . . . . . . . . . . . . 19 20 a Social security benefits 20a b Taxable amount . . . 20b 21 Other income. List type and amount 21 22 Combine the amounts in the far right column for lines 7 through 21. This is your total income 22

Adjusted Gross Income

23 Educator expenses . . . . . . . . . . . 23 24 Certain business expenses of reservists, performing artists, and

fee-basis government officials. Attach Form 2106 or 2106-EZ 24 25 Health savings account deduction. Attach Form 8889 . 25 26 Moving expenses. Attach Form 3903 . . . . . . 26 27 Deductible part of self-employment tax. Attach Schedule SE . 27 28 Self-employed SEP, SIMPLE, and qualified plans . . 28 29 Self-employed health insurance deduction . . . . 29 30 Penalty on early withdrawal of savings . . . . . . 30 31 a Alimony paid b Recipient’s SSN 31a 32 IRA deduction . . . . . . . . . . . . . 32 33 Student loan interest deduction . . . . . . . . 33 34 Tuition and fees. Attach Form 8917 . . . . . . . 34 35 Domestic production activities deduction. Attach Form 8903 35 36 Add lines 23 through 35 . . . . . . . . . . . . . . . . . . . 36 37 Subtract line 36 from line 22. This is your adjusted gross income . . . . . 37

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11320B Form 1040 (2014)

Daniel C Jones 0 4 2 3 1 5 3 1 2

Laura S Jones 0 3 9 2 9 4 6 1 4

123 Park Ave 7B

New York, NY. 10001

✔ ✔

✔

Brian Jones 0 3 8 3 5 5 2 1 3 Child

100,000 500

2,000

1,500

104,000

2,500

2,500 101,500

456 Tax and Estate Planning

Adjustments Adjustments, which reduce gross income, come from a variety of areas.

Category Explanation

IRAs Payments as qualifying deposits into these pension-type accounts for a maximum of $5,500 in 2013–2014.1

Student loan interest Qualified loan interest deductible up to $2,500 per year Higher-education expenses Deductible for as much as $4,000, subject to income limitations

NOT EXTENDED SO FAR, FOR 2015 Health savings accounts Contributions to account for qualified medical expenditures. Moving expenses To a new job using standard mileage rate of 23.5 cents a mile2 plus

other allowable costs Pension plans Payments into qualified retirement accounts Alimony Paid to former spouse Other One half of self-employment tax, self-employed health insurance,

self-employed pension plans, penalty paid on early withdrawal of savings

Total adjustments The sum Adjusted gross income Total income minus total adjustments

1 For people 50 or older, $1,000 extra. 2 For miles driven in 2014.

Fo rm 1040 Department of the Treasury—Internal Revenue Service (99)U.S. Individual Income Tax Return 2014 OMB No. 1545-0074 IRS Use Only—Do not write or staple in this space.

For the year Jan. 1–Dec. 31, 2014, or other tax year beginning , 2014, ending , 20 See separate instructions. Your first name and initial Last name Your social security number

If a joint return, spouse’s first name and initial Last name Spouse’s social security number

Make sure the SSN(s) above and on line 6c are correct.

Home address (number and street). If you have a P.O. box, see instructions. Apt. no.

City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions).

Foreign country name Foreign province/state/county Foreign postal code

Presidential Election Campaign Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking a box below will not change your tax or refund. You Spouse

Filing Status

Check only one box.

1 Single 2 Married filing jointly (even if only one had income) 3 Married filing separately. Enter spouse’s SSN above

and full name here.

4 Head of household (with qualifying person). (See instructions.) If the qualifying person is a child but not your dependent, enter this

child’s name here.

5 Qualifying widow(er) with dependent child

Exemptions 6a Yourself. If someone can claim you as a dependent, do not check box 6a . . . . . b Spouse . . . . . . . . . . . . . . . . . . . . . . . . } c Dependents:

(1) First name Last name

(2) Dependent’s social security number

(3) Dependent’s relationship to you

(4) if child under age 17 qualifying for child tax credit

(see instructions)

If more than four dependents, see instructions and check here

d Total number of exemptions claimed . . . . . . . . . . . . . . . . .

Boxes checked on 6a and 6b No. of children on 6c who: • lived with you • did not live with you due to divorce or separation (see instructions)

Dependents on 6c not entered above

Add numbers on lines above

Income

Attach Form(s) W-2 here. Also attach Forms W-2G and 1099-R if tax was withheld.

If you did not get a W-2, see instructions.

9 a Ordinary dividends. Attach Schedule B if required . . . . . . . . . . . 9a b Qualified dividends . . . . . . . . . . . 9b

Adjusted Gross Income

23 Educator expenses . . . . . . . . . . . 23 24 Certain business expenses of reservists, performing artists, and

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11320B Form 1040 (2014)

Daniel C Jones 0 4 2 3 1 5 3 1 2

Laura S Jones 0 3 9 2 9 4 6 1 4

123 Park Ave 7B

New York, NY. 10001

✔ ✔

✔

Brian Jones 0 3 8 3 5 5 2 1 3 Child

100,000 500

2,000

1,500

104,000

2,500

2,500 101,500

DEDUCTIONS You may select a standard deduction whose amount varies depending on such factors as filing status—single, married joint return, and so forth—or itemize your deductions based on actual transactions. When itemized, deductions are placed on a separate tax schedule called Schedule A. Certain categories of expenditures are deductible to the extent they exceed a minimum amount called the floor. The floor is usually based on adjusted gross income (AGI). The formula is

Deductible amount = Actual payments − AGI × Floor percentage

Example 14.A2.1 Harold had $100,000 of gross income and medical expenditures of $11,300 for the year. Because medical outlays are deductible to the extent they exceed 10 percent of adjusted gross income, Harold would be allowed to deduct $1,300. (For taxpayers 65 and older, the threshold is 7.5 percent of AGI, through 2016.)

Deductible amount = $11,300 − $100,000 × 10% = $11,300 − $10,000 = $1,300

Tax Planning 457

On the other hand, certain deductions are phased out based on income. The phaseout for 2014 is AGI of over $305,050 on joint tax returns ($254,200 for single filers). The ex- penses that qualify for this phaseout are taxes, charitable contributions, home mortgage interest, and miscellaneous itemized deductions. The total of your itemized deductions falling in these categories is reduced by the smaller of 3 percent of the amounts of AGI over the applicable threshold or 80 percent of the itemized deductions subject to this limit. The AGI figures are adjusted annually for inflation. The major categories of deductions follow:

Category Explanation

Medical and dental Qualifying expenses subject to 10 percent floor Taxes State and local income taxes,1 real estate and personal property taxes,

excise taxes, and certain other taxes Interest paid Qualifying home mortgage interest and qualifying points, investment

interest limited to total interest and dividends and other forms of income less noninterest investment expenses and the option of including income from capital gains received during the year

Charitable gifts Gifts to qualified charities subject to maximum yearly deductions generally of 50 percent of AGI, but in some cases 20 or 30 percent

Casualty and theft losses Subject to floor of 10 percent of AGI after deduction of $100 per occurrence

Miscellaneous Subject to floor of 2 percent of AGI for total miscellaneous expenditures. Miscellaneous expenses include unreimbursed business expenses such as business-related travel and entertainment at 50 percent of amount paid, union dues, education to improve your performance in an existing position, and so on; in addition, tax preparation fees, safe deposit fees, and investment-related expenditures (excluding interest deducted in the interest section), such as newsletters, books, payments to advisors, and so on

Other miscellaneous Other items to be deducted Standard deduction You can take a standard deduction if you do not care to itemize as above

or if your deductions total less than the allowable standard deduction; the standard deduction is increased for people over 65 or those who are partially or completely blind

1 Taxpayers could take either state and local income taxes or sales tax as a deduction, through 2014. At the time of publication, the opportunity to deduct sales tax for periods beyond 2014 has not been established.

Possible economic reasons to justify a deduction for certain expenditures include

Medical and dental. To protect and repair human capital, which can be viewed as an investment asset. Expenses supporting investment assets, including investments in businesses, are generally deductible.

Other income taxes. Federal method of evening out variations in estate and local income taxes by area.

Interest paid. Interest is deductible when made for investment purposes, with a resi- dence also treated as an investment.

Charitable gifts. To support nonprofit charitable operations, which are viewed as in society’s interest.

Casualty and theft. To reflect a decline in investment assets with capital items treated as an investment.

Other business expenses. A necessary expense supporting business assets.

458 Tax and Estate Planning

A&B Schedule A—Itemized Deductions SCHEDULE A (Form 1040)

Department of the Treasury Internal Revenue Service (99)

Itemized Deductions Information about Schedule A and its separate instructions is at www.irs.gov/schedulea.

Attach to Form 1040.

OMB No. 1545-0074

2014 Attachment Sequence No. 07

Name(s) shown on Form 1040 Your social security number

Medical and Dental Expenses

Caution. Do not include expenses reimbursed or paid by others. 1 Medical and dental expenses (see instructions) . . . . . 1 2 Enter amount from Form 1040, line 38 2 3 Multiply line 2 by 10% (.10). But if either you or your spouse was

born before January 2, 1950, multiply line 2 by 7.5% (.075) instead 3 4 Subtract line 3 from line 1. If line 3 is more than line 1, enter -0- . . . . . . . . 4

Taxes You Paid

5 State and local (check only one box): a Income taxes, or b General sales taxes } . . . . . . . . . . . 5

6 Real estate taxes (see instructions) . . . . . . . . . 6 7 Personal property taxes . . . . . . . . . . . . . 7 8 Other taxes. List type and amount

8 9 Add lines 5 through 8 . . . . . . . . . . . . . . . . . . . . . . 9

Interest You Paid

Note. Your mortgage interest deduction may be limited (see instructions).

10 Home mortgage interest and points reported to you on Form 1098 10 11

Home mortgage interest not reported to you on Form 1098. If paid to the person from whom you bought the home, see instructions and show that person’s name, identifying no., and address

11 12

Points not reported to you on Form 1098. See instructions for special rules . . . . . . . . . . . . . . . . . 12

13 Mortgage insurance premiums (see instructions) . . . . . 13 14 Investment interest. Attach Form 4952 if required. (See instructions.) 14 15 Add lines 10 through 14 . . . . . . . . . . . . . . . . . . . . . 15

Gifts to Charity If you made a gift and got a benefit for it, see instructions.

Gifts by cash or check. If you made any gift of $250 or more, see instructions . . . . . . . . . . . . . . . . 16

Other than by cash or check. If any gift of $250 or more, see instructions. You must attach Form 8283 if over $500 . . . 17

18 Carryover from prior year . . . . . . . . . . . . 18 19 Add lines 16 through 18 . . . . . . . . . . . . . . . . . . . . . 19

Casualty and Theft Losses 20 Casualty or theft loss(es). Attach Form 4684. (See instructions.) . . . . . . . . 20 Job Expenses and Certain Miscellaneous Deductions

Unreimbursed employee expenses—job travel, union dues, job education, etc. Attach Form 2106 or 2106-EZ if required. (See instructions.) 21

22 Tax preparation fees . . . . . . . . . . . . . 22 23

Other expenses—investment, safe deposit box, etc. List type and amount

23 24 Add lines 21 through 23 . . . . . . . . . . . . 24 25 Enter amount from Form 1040, line 38 25 26 Multiply line 25 by 2% (.02) . . . . . . . . . . . 26 27 Subtract line 26 from line 24. If line 26 is more than line 24, enter -0- . . . . . . 27

Other Miscellaneous Deductions

28 Other—from list in instructions. List type and amount

28 Total Itemized Deductions

Is Form 1040, line 38, over $152,525?

29 No. Your deduction is not limited. Add the amounts in the far right column for lines 4 through 28. Also, enter this amount on Form 1040, line 40. } . .Yes. Your deduction may be limited. See the Itemized Deductions Worksheet in the instructions to figure the amount to enter.

If you elect to itemize deductions even though they are less than your standard deduction, check here . . . . . . . . . . . . . . . . . . .

For Paperwork Reduction Act Notice, see Form 1040 instructions. Cat. No. 17145C Schedule A (Form 1040) 2014

Tax Planning 459

EXEMPTIONS Exemptions are based on the number of people who are supported by the household. People who qualify for that status, which provides a fixed reduction in taxable gross in- come per person, are called dependents. In order to qualify as a dependent, you must be a household member or a relative. To qualify for the exemption, the household must provide over 50 percent of the living costs for that person, who earns less than a stated amount of income unless it is one of your children who is under age 19 or a full-time student under age 24. Children have no income limitation. As of 2014, your exemptions phased out be- ginning at AGI of $152,525–$305,050, depending on filing status—single, head of house- hold, married filing separately, or married filing jointly. Taxpayers over those AGI levels lose the personal exemption tax benefit by 2 percent for each $2,500 ($1,250 for married filing separately) that AGI exceeds their threshold amount.

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Standard Deduction for— • People who check any box on line 39a or 39b or who can be claimed as a dependent, see instructions. • All others: Single or Married filing separately, $6,200 Married filing jointly or Qualifying widow(er), $12,400 Head of household, $9,100

40 Itemized deductions (from Schedule A) or your standard deduction (see left margin) . . 40 41 Subtract line 40 from line 38 . . . . . . . . . . . . . . . . . . . 41 42 Exemptions. If line 38 is $152,525 or less, multiply $3,950 by the number on line 6d. Otherwise, see instructions 42 43 Taxable income. Subtract line 42 from line 41. If line 42 is more than line 41, enter -0- . . 43 44 Tax (see instructions). Check if any from: a Form(s) 8814 b Form 4972 c 44 45 Alternative minimum tax (see instructions). Attach Form 6251 . . . . . . . . . 45 46 Excess advance premium tax credit repayment. Attach Form 8962 . . . . . . . . 46 47 Add lines 44, 45, and 46 . . . . . . . . . . . . . . . . . . . 47 48 Foreign tax credit. Attach Form 1116 if required . . . . 48 49 Credit for child and dependent care expenses. Attach Form 2441 49 50 Education credits from Form 8863, line 19 . . . . . 50 51 Retirement savings contributions credit. Attach Form 8880 51 52 Child tax credit. Attach Schedule 8812, if required . . . 52 53 Residential energy credits. Attach Form 5695 . . . . 53 54 Other credits from Form: a 3800 b 8801 c 54 55 Add lines 48 through 54. These are your total credits . . . . . . . . . . . . 55 56 Subtract line 55 from line 47. If line 55 is more than line 47, enter -0- . . . . . . 56

Other Taxes

57 Self-employment tax. Attach Schedule SE . . . . . . . . . . . . . . . 57 58 Unreported social security and Medicare tax from Form: a 4137 b 8919 . . 58 59 Additional tax on IRAs, other qualified retirement plans, etc. Attach Form 5329 if required . . 59 60 a Household employment taxes from Schedule H . . . . . . . . . . . . . . 60a

b First-time homebuyer credit repayment. Attach Form 5405 if required . . . . . . . . 60b 61 Health care: individual responsibility (see instructions) Full-year coverage . . . . . 61 62 Taxes from: a Form 8959 b Form 8960 c Instructions; enter code(s) 62 63 Add lines 56 through 62. This is your total tax . . . . . . . . . . . . . 63

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

67 Additional child tax credit. Attach Schedule 8812 . . . . . 67 68 American opportunity credit from Form 8863, line 8 . . . 68 69 Net premium tax credit. Attach Form 8962 . . . . . . 69 70 Amount paid with request for extension to file . . . . . 70 71 Excess social security and tier 1 RRTA tax withheld . . . . 71 72 Credit for federal tax on fuels. Attach Form 4136 . . . . 72 73 Credits from Form: a 2439 b Reserved c Reserved d 73 74 Add lines 64, 65, 66a, and 67 through 73. These are your total payments . . . . . 74

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge. Your signature Date Your occupation Daytime phone number

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

Fo rm 1040 Department of the Treasury—Internal Revenue Service (99)U.S. Individual Income Tax Return 2014 OMB No. 1545-0074 IRS Use Only—Do not write or staple in this space.

For the year Jan. 1–Dec. 31, 2014, or other tax year beginning , 2014, ending , 20 See separate instructions. Your first name and initial Last name Your social security number

If a joint return, spouse’s first name and initial Last name Spouse’s social security number

Make sure the SSN(s) above and on line 6c are correct.

Home address (number and street). If you have a P.O. box, see instructions. Apt. no.

City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions).

Foreign country name Foreign province/state/county Foreign postal code

Presidential Election Campaign Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking a box below will not change your tax or refund. You Spouse

Filing Status

Check only one box.

1 Single 2 Married filing jointly (even if only one had income) 3 Married filing separately. Enter spouse’s SSN above

and full name here.

4 Head of household (with qualifying person). (See instructions.) If the qualifying person is a child but not your dependent, enter this

child’s name here.

5 Qualifying widow(er) with dependent child

Exemptions 6a Yourself. If someone can claim you as a dependent, do not check box 6a . . . . . b Spouse . . . . . . . . . . . . . . . . . . . . . . . . } c Dependents:

(1) First name Last name

(2) Dependent’s social security number

(3) Dependent’s relationship to you

(4) if child under age 17 qualifying for child tax credit

(see instructions)

If more than four dependents, see instructions and check here

d Total number of exemptions claimed . . . . . . . . . . . . . . . . .

Boxes checked on 6a and 6b No. of children on 6c who: • lived with you • did not live with you due to divorce or separation (see instructions)

Dependents on 6c not entered above

Add numbers on lines above

Income

Attach Form(s) W-2 here. Also attach Forms W-2G and 1099-R if tax was withheld.

If you did not get a W-2, see instructions.

9 a Ordinary dividends. Attach Schedule B if required . . . . . . . . . . . 9a b Qualified dividends . . . . . . . . . . . 9b

Adjusted Gross Income

23 Educator expenses . . . . . . . . . . . 23 24 Certain business expenses of reservists, performing artists, and

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11320B Form 1040 (2014)

Daniel C Jones 0 4 2 3 1 5 3 1 2

Laura S Jones 0 3 9 2 9 4 6 1 4

123 Park Ave 7B

New York, NY. 10001

✔ ✔

✔

Brian Jones 0 3 8 3 5 5 2 1 3 Child

100,000 500

2,000

1,500

104,000

2,500

2,500 101,500

TAXABLE INCOME Taxable income is the amount from which your tax liability is calculated. The federal rates progress from 10 percent to 39.6 percent depending on income.

TAX This is the amount computed as due before other items below.

Example 14.A2.2 Mary and Henry are married and are filing a joint return. They have no children. Their taxable income was $87,000 in 2014. They elected the standard deduction. Compute their tax. Answer per Tax Table.

Tax = $10,162.50 + 25% × 1$87,000 − $73,8002 = $13,462.50

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

ALTERNATIVE MINIMUM TAX This is an alternative income tax that must be paid if it exceeds the regular tax. It adjusts for certain special categories such as installment sales, accelerated depreciation, and incen- tive stock options. It was intended to promote a fairer tax, particularly for those who paid

460 Tax and Estate Planning

little in tax. However, because it hasn’t been indexed for inflation, more and more people are paying an extra amount of tax. The alternative minimum tax (AMT) can result in a material shift in approach. For ex- ample, real estate and state and local income taxes are not deductible for AMT purposes. When a choice is possible, it can benefit those who are under AMT to locate in a state with little or no state income tax.

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

CREDITS Credits are amounts that reduce taxes owed. They are more valuable than deductions or exemp- tions because they reduce taxes dollar for dollar. Deductions or exemptions reduce taxes by an amount equal to the marginal tax bracket you are in, multiplied by the amount to be deducted.

Example 14.A2.3 What is the difference in benefit between a tax credit and a tax deduction, assuming the amount is $3,000 and the person is in the 40 percent marginal tax bracket? The amount of taxes owed before giving effect to this benefit was $14,000. The tax credit is a $3,000 cash benefit, which would result in a net amount owed of $11,000. The tax deduction is only a fraction of that $3,000 amount because the person is in the 40 percent bracket. In this instance, the cash benefit is $1,200 and the net amount owed would be $12,800.

Cash benefit = Deduction × t = $3,000 × 1.402 = $1,200

Some common tax credits follow:

Category Explanation

Child and dependent Expenses outlaid for dependents to allow you to work; subject to care expense limitations including a maximum amount of $6,000 for two or more

qualifying children Child credit Subject to income limits, cuts tax bill by $1,000 for each child under

age 17 Care of elderly or disabled For low-income people with low Social Security benefits; this credit can

reduce or even eliminate income taxes owed Adoption Maximum of $13,190 for outlays to adopt a child as of 2014, subject

to income limitations Foreign Taxes paid on income to a foreign country are credited against U.S.

taxes, subject to limitation to the extent that the same income is taxed by the United States

Education Lifetime learning credits of $2,000 per year each year of college or higher, with maximum of one per tax return, or (through 2017) American Opportunity credit of up to $2,500 per year per student for four years with phaseout based on income

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

Tax Planning 461

OTHER TAXES These are additions to taxes due for items such as the following:

Category Explanation

Self-employment tax Social Security and Medicare tax to be paid for people who have their own business

Alternative minimum tax This additional tax is designed to make a greater percentage of people pay equitable income taxes; certain items are subject to it, including incentive stock options, installment sales, certain property transactions, and others

Domestic employee Social Security and Medicare taxes (and federal and state unemployment taxes) must be paid on employees, including domestic workers

TOTAL TAX The total tax is your calculated tax plus any “other taxes” due.

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

PAYMENTS Payments are amounts already paid against taxes owed. They normally include amounts withheld by employers and estimated payments made by individuals filing the return. Also included in this portion of the tax return is an earned income tax credit for certain individu- als having low income, including some who may not have to pay taxes but nonetheless may be eligible to receive some cash from the government.

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

NET AMOUNT The net amount is your total tax less your payments to date. It may require an additional payment or you may be entitled to a refund from the federal government.

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

462 Tax and Estate Planning

Fo rm 1040 Department of the Treasury—Internal Revenue Service (99)U.S. Individual Income Tax Return 2014 OMB No. 1545-0074 IRS Use Only—Do not write or staple in this space.

For the year Jan. 1–Dec. 31, 2014, or other tax year beginning , 2014, ending , 20 See separate instructions. Your first name and initial Last name Your social security number

If a joint return, spouse’s first name and initial Last name Spouse’s social security number

Make sure the SSN(s) above and on line 6c are correct.

Home address (number and street). If you have a P.O. box, see instructions. Apt. no.

City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions).

Foreign country name Foreign province/state/county Foreign postal code

Presidential Election Campaign Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking a box below will not change your tax or refund. You Spouse

Filing Status

Check only one box.

1 Single 2 Married filing jointly (even if only one had income) 3 Married filing separately. Enter spouse’s SSN above

and full name here.

4 Head of household (with qualifying person). (See instructions.) If the qualifying person is a child but not your dependent, enter this

child’s name here.

5 Qualifying widow(er) with dependent child

Exemptions 6a Yourself. If someone can claim you as a dependent, do not check box 6a . . . . . b Spouse . . . . . . . . . . . . . . . . . . . . . . . . } c Dependents:

(1) First name Last name

(2) Dependent’s social security number

(3) Dependent’s relationship to you

(4) if child under age 17 qualifying for child tax credit

(see instructions)

If more than four dependents, see instructions and check here

d Total number of exemptions claimed . . . . . . . . . . . . . . . . .

Boxes checked on 6a and 6b No. of children on 6c who: • lived with you • did not live with you due to divorce or separation (see instructions)

Dependents on 6c not entered above

Add numbers on lines above

Income

Attach Form(s) W-2 here. Also attach Forms W-2G and 1099-R if tax was withheld.

If you did not get a W-2, see instructions.

9 a Ordinary dividends. Attach Schedule B if required . . . . . . . . . . . 9a b Qualified dividends . . . . . . . . . . . 9b

Adjusted Gross Income

23 Educator expenses . . . . . . . . . . . 23 24 Certain business expenses of reservists, performing artists, and

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11320B Form 1040 (2014)

Daniel C Jones 0 4 2 3 1 5 3 1 2

Laura S Jones 0 3 9 2 9 4 6 1 4

123 Park Ave 7B

New York, NY. 10001

✔ ✔

✔

Brian Jones 0 3 8 3 5 5 2 1 3 Child

100,000 500

2,000

1,500

104,000

2,500

2,500 101,500

Tax Planning 463

Form 1040 (2014) Page 2

Tax and Credits

38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check

if: { You were born before January 2, 1950, Blind.

Spouse was born before January 2, 1950, Blind. } Total boxes

checked 39a b If your spouse itemizes on a separate return or you were a dual-status alien, check here 39b

Other Taxes

Payments 64 Federal income tax withheld from Forms W-2 and 1099 . . 64 65 2014 estimated tax payments and amount applied from 2013 return 65

If you have a qualifying child, attach Schedule EIC.

66a Earned income credit (EIC) . . . . . . . . . . 66a b Nontaxable combat pay election 66b

Refund

Direct deposit? See instructions.

75 If line 74 is more than line 63, subtract line 63 from line 74. This is the amount you overpaid 75 76a Amount of line 75 you want refunded to you. If Form 8888 is attached, check here . 76a

b Routing number c Type: Checking Savings d Account number

77 Amount of line 75 you want applied to your 2015 estimated tax 77 Amount You Owe

78 Amount you owe. Subtract line 74 from line 63. For details on how to pay, see instructions 78 79 Estimated tax penalty (see instructions) . . . . . . . 79

Third Party Designee

Do you want to allow another person to discuss this return with the IRS (see instructions)? Yes. Complete below. No Designee’s name

Phone no.

Personal identification number (PIN)

Sign Here Joint return? See instructions. Keep a copy for your records.

Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation If the IRS sent you an Identity Protection PIN, enter it here (see inst.)

Paid Preparer Use Only

Print/Type preparer’s name Preparer’s signature Date Check if self-employed

PTIN

Firm’s name

Firm’s address

Firm's EIN

Phone no.

www.irs.gov/form1040 Form 1040 (2014)

101,500

12,400 89,100 11,850 77,250 11,025

11,025

- 11,025

11,025 12,500

12,500 1,475 1,475

Engineer (361) 422-0899

Housewife

464

Chapter Goals

This chapter will enable you to:

Dan and Laura did not have wills. They couldn’t agree on who would be the guardian of their children or the executor should they die in a joint accident. As Dan said, “We have time to get a will. We don’t plan to leave anytime soon.”

Real-Life Planning The advisor was familiar with the practices of many people concerning wills. Although most agreed that having a will was important, many didn’t execute one. Often when he mentioned the absence of a will, the reply was, “I have to get around to doing it.” It almost did not matter how old the person was. In the advisor’s experience, even many estate at- torneys who could draw up a comprehensive will for themselves in no time, for no money, did not have wills. Consider the very different life situations contained in the following two cases.

Ted and Louise Ted and his girlfriend Louise lived together for nine years. For most of that time, they saw no reason to get married even though they were committed to each other. They said that their bond, though it was not legal, was much stronger. But their plans to have chil- dren changed that. In fact, they were going to be married in early October of 2001. But a tragedy, 9/11, intervened. Louise was killed when the second tower at the World Trade Center collapsed. Consistent with their beliefs about legal documents, neither Ted nor Louise had a will. When Ted was asked, he said that both he and Louise were common people, had next to nothing in assets, and besides, “Who expects to die in their 20s?” While no one could bring Louise back, an executed will or marriage a few weeks earlier would have changed things financially. Louise’s parents were the statutory designated beneficiaries, not Ted. The av- erage payout for 9/11 victims was over $2 million.

Fifteen

Estate Planning 465

Hillary In contrast to Louise, Hillary was one of the heirs to a retailing fortune. She was brought up in style and never had to worry about money. Actually, she lived fairly modestly, but she maintained her parents’ values of caring financially for her children and donating money to charity. Hillary was a rebellious child who balked at her parents’ supervision, which carried through to her present age, which was 60. She had no financial knowledge and no financial advisors, a potentially lethal combination. In fact, she had little more than a will. She was freely gifting money to her children and to charities, a few thousand dollars at a time. She said why not do so, given her eight-figure fortune. One child in particular seemed particularly needy. Hillary’s reason for the visit with the advisor was to program an efficient way of stepping up her gifting. The advisor evaluated her situation, projecting her income, expenses, assets, and gifting policy. He found that if her present program continued, she would be broke in less than 15 years. When he explained her vulnerability, she was shocked and asked that the figures be rechecked, and the checking was done. The advisor recommended several changes, including a revised strategy for gifts to her daughter and to members of her daughter’s family. In addition, the advisor suggested donating stocks with built-in gains to charities instead of cash. These changes were made to take advantage of tax benefits. The advisor also recommended setting up trusts. And perhaps most important, he persuaded Hillary to cut back on gifting during her lifetime in favor of leaving money at her death, a safer approach. The advisor chuckled when he thought about Hillary’s situation. While no one needed to cry over her circumstances, it was interesting that even very affluent people needed to have controls—estate planning limits to protect them from an untimely negative outcome.

OVERVIEW

Estate planning is what we do principally to protect and benefit others we care about after we die. According to pure economic and financial theory, we are supposed to be interested solely in our own well being. Any consideration of others comes out of a contractual rela- tionship to provide mutual services in our own interests. In practice, however, we are often concerned about household members and other people, and this often gives rise to the focus on estate planning. For more on this issue, see Appendix I. From a household enterprise standpoint, we are planning for a period when the wage earner is incapacitated or has died. The goal is to keep the household functioning efficiently. In some ways, it resembles the succession planning by key executives of a business for the period beyond their active management. The household is maintained until the last member reaches adulthood, remarries, or dies. The responsibility is there whether you believe the obligation arises from a businesslike contract or true concern. We have several financial planning objectives. The first is to pay as little in taxes as possible. In that way we can distribute the maximum amount of wealth to our heirs. The second is to match the amount and type of assets to be distributed to our circumstances and our wishes. The next is to leave our heirs with little or no conflict wherever possible. A final objective is to protect ourselves while we are still alive. This chapter will deal with the estate planning decision-making process as a series of steps that should be executed. Sometimes, particularly when planning is complex, the approach will be established with the assistance of an attorney who will draw up the final documents. However, the financial aspects, particularly the financial calculations such as projected resource availabilities, are generally beyond a lawyer’s scope. The end result can be termed an estate plan. The steps of such planning are given in Figure 15.1.

466 Tax and Estate Planning

UNDERSTAND WHAT ESTATE PLANNING IS

Estate planning is analyzing and deciding how your assets are to be managed and appor- tioned to others in the event of your death or disability. The goal is to establish an estate structure that will maximize assets left to your beneficiaries and achieve your other wishes in an efficient way. That structure may just be a simple will. On the other hand, if needed, it could include an elaborate system of trusts and other mechanisms intended to minimize taxes and strengthen your ability to accomplish your objectives. The estate planning process can extend from accumulating the assets to be left along with retirement planning sums to managing those assets properly, and ultimately to distrib- uting them as intended. The process, while varying in the amount of supervision needed, can be the same whether it is for a large estate or just to ensure that some family heirlooms are protected and go to the appropriate party. As you can see, estate planning is not reserved just for the wealthy; it concerns virtually everyone.

IDENTIFY OBJECTIVES

Estate planning uses financial and legal inputs, among others, to accomplish personal objec- tives. Clearly, the objectives, which vary widely from person to person, need to be known at the beginning. The key question, then, is, What am I trying to accomplish? Am I trying to set aside monies for the people with the greatest need? Alternatively, do I want to provide for people I care most about? Do I want to gift at least in part now or wait until my death? When we speak of maximization of assets as an objective, we have to decide on the priority that we give to others as compared with ourselves. To pick extremes, for some, estate planning is giving to others only what is left over after you die. On the other end, estate planning might mean assigning a higher priority to lifetime gifting and bequest pro- cedure by specifically providing a stated sum for beneficiaries; for example, saying that your three children will receive $100,000 each means that $300,000 will not be available for your own use.

ESTATE PLANNING

1) Understand what estate planning is 2) Identify objectives 3) Identify assets 4) Establish a will 5) Consider other estate planning tools to meet objectives 6) Evaluate obstacles and ways to overcome them 7) Become familiar with all types of relevant taxes 8) Determine available financial planning strategies 9) Incorporate estate risks 10) Consider separately estate planning for minors 11) Assess anticipated resources 12) Finalize the estate plan 13) Implement the plan 14) Review periodically

FIGURE 15.1 Estate Planning Steps

Estate Planning 467

IDENTIFY ASSETS

All household assets currently available should be identified and their owner specified. Information should include whether assets are jointly or separately owned, the original cost, and current fair market value. The total amount, cost, and way that assets are titled are relevant to the outcome strategies that you will select.

ESTABLISH A WILL

A will is often the most important document in estate planning. A will is a legal instrument that specifies who is to receive a person’s assets upon death1 and that expresses other wishes. Everyone has a will whether he or she knows it or not. If you don’t execute one, the state in effect provides one for you—but uses its standards and wishes, not yours. To be legally recognized, a will must conform to certain requirements. For example, generally it must be in writing and be witnessed.2 The will generally follows a structured format, including clauses for who gets what assets and for the powers of the executor, who is in charge of administering the estate,3 complying with legal requirements, and liquidating its assets. There is also a clause designating a guardian, where appropriate, who is in charge of people unable to care for themselves; for example, any minors.

General Evaluation A will, even if legally recognized, should be evaluated for a number of factors, including the following:

1. Does the will reflect your wishes? Most people have their wills written by a lawyer. Lawyers can inform you about requirements and alternatives and make sure you comply with legal requirements. However, they cannot always reflect your wishes within one draft. You should examine the draft and, where necessary, have it modified to express your wishes.

2. Are your wishes unambiguously stated in the will? Make sure who gets what is clearly stated and that the terminology in the will is easy to understand.

3. Once written, is the will completely up to date? Personal circumstances change, and so does tax law. Your current will should be examined periodically to ensure that it complies with your needs at the time. Wills often can be modified by a simple “codicil.”

4. Are there overlooked assets? Are there assets that you have strong feelings about? If so, they should be individually described and who they are meant for should be separately stated.

5. Can the will cause conflict? If the beneficiaries are likely to have negative feelings because of its contents, consider modifying the will to reduce or eliminate the problem.

6. Is the will stored in a safe place?4 If the will can’t be found, it is as if you don’t have one.

1 Except for assets that have designated beneficiaries or certain types of jointly held property, which are discussed later in the chapter. 2 Some states recognize an oral will when there is an immediate possibility of death, and some states allow handwritten wills without witnesses. 3 When a person dies without a will, the person in charge of supervising the estate is called an administrator, not an executor. 4 Common places can be in a locked drawer with valuables in the home where it can be found by heirs and in a bank’s safe deposit box. The lawyer who drew it up usually has a copy as well. Many people keep their will in a bank’s safe deposit box but state laws vary as to how accessible that box will be after the death of a sole owner. In any case, the executor should know the location of the will and have easy access to it.

468 Tax and Estate Planning

7. Does the will comply with state law? State laws differ in many requirements. One is the number of witnesses needed at the time of signing. This item can be particularly impor- tant when you don’t use a lawyer to draw up a will or when you move to another state.

8. If there are assets in other states, make sure that the will complies with their laws as well.

Intestate Many people do not have a will. Possible reasons include not recognizing its importance, believing you don’t have assets worth giving away, feeling when young that you have time to set one up, having difficulty determining whom to name as heirs or as executors or guardians, and finding the subject too uncomfortable to think about. Intestate means dying without a will. The division of assets after someone dies intestate depends on the applicable state and sometimes on the size of your assets as well as how they are titled. Table 15.1 provides one possible breakdown. Keep in mind that moving to a neighboring state can result in a completely different division of assets. As you can see, dying without a will can have significant consequences.

Selected Reasons for Having a Will Some selected reasons for having a will are listed below.

1. You may want your spouse to receive all your assets. If you die without a will, he or she may often receive only a fraction of them.

2. States may mandate that assets be given to elderly parents who may not need the money.5 Giving your assets to them could cause an estate tax many years earlier as com- pared with leaving that money to someone younger who has a longer expected life span.

3. In the event that there is no surviving spouse, the guardian of any children would be selected by the court, which might assign a person other than the one you would prefer.

Personal Situation Spouse Parents Sisters and Brothers

Nieces, Nephews, and Other Closest RelativesChildren

Married with 1 child 50% 50% Married with 2 or more 33% 67%E children Married—children dead 33% 67% among grandchildren Married—no children, 50% 50% parents alive Married—no children, 50% 50%E parents dead Married—no children, no 100% parents, no brothers or sisters, nieces or nephews Unmarried with children 100%E Unmarried—no children, 100%E no parents Unmarried—no children, 100%E no parents, no brothers or sisters No relatives found 100% to state

Note: E = equally divided.

TABLE 15.1 One Possible Division of Assets

5 The state statute.

Chapter Fifteen Estate Planning 469

4. Your particular wishes as to who gets items of sentimental worth would not be accommodated.

5. When your intentions are not stated, conflict over the distribution of assets becomes more likely.

6. The assets would pass to the children at age 18 or 21 when they might not be mature enough to handle this responsibility.

7. Important friends are entitled to nothing. As discussed, if you were engaged to be married, that person would probably not receive anything.

8. As discussed, many items vary by state. For example, in some states, when the second marriage has no children and there is no will, money is given to estranged children of the first marriage even when the second spouse is in desperate need of funds.

9. The will can provide for tax-advantaged trusts.

The argument that you do not have material assets may be erroneous. For example, in the event of your death from an accident, your estate could receive the proceeds of a wrongful death lawsuit brought by your executor. In sum, virtually anyone can benefit from having a will. Having a lawyer draw up a will is generally not that costly and will significantly reduce the risk of nonqualification or in- correct meaning or vague terms in do-it-yourself wills sold in stationery stores.

CONSIDER OTHER ESTATE PLANNING TOOLS TO MEET OBJECTIVES

We have already discussed a will, a basic document that all people should have. There are a variety of other instruments that can help in overall estate planning. They include trusts, gifts, titling, insurance, powers of attorney, and letters of instruction.

Trusts Trusts are separate legal entities in which a third party manages property for the benefit of another person.6 The person who manages the trust assets is called the trustee. The trustee is considered a fiduciary, meaning he or she must act in the best interests of the person the trust is established for. The person to whom the property is given or for whom the property

It is noteworthy how many people ignore the need for estate planning. For a majority of people the principal item they need is a simple will. However, in the advisor’s experience, even a significant number of lawyers who draw up wills don’t have them for themselves. There must be other factors at work here. For some it is the feeling that there is plenty of time before they have to do so. For others it is the pain of confronting an unpleasant topic sometimes with aggravating choices that have to be made. A smaller number actually consciously or unconsciously think that dealing with it can bring death closer.

The outcome can have important ramifications. While for younger people the probability is low, no one can possibly know when their “time is up.” Passing away without having a will nonetheless provides one; it is the one the state has drawn up for all people, and this may or may not be the one you wanted. Everyone should have a will. One could be drawn up legally with some simple instructions and some basic papers available at a stationery store or online. A better idea is to consult with a lawyer who can provide valuable information and draw up the docu- ment according to your specific wishes.

Professional Advice Ignoring the Need

6 In some states, trust creators (“grantors”) can be their own sole trustees.

470 Tax and Estate Planning

is being managed is called the beneficiary. The person setting up the trust to comply with his or her own specifications is called the grantor or trustor. A trust is created by a writ- ten document. It can be highly flexible, accommodating many wishes of the grantor. It can be established during the grantor’s lifetime or by a will to take effect on death. Some common reasons for setting up a trust are:

To obtain professional management. The person setting up the trust may believe that the beneficiary is unable, because of age, education, or personality, to handle his or her affairs. The trustee is charged with fiduciary responsibility to make decisions in the beneficiary’s best interests. The duties can include transferring assets, managing those assets including obtaining an investment subadvisor where necessary, and distributing assets. For example, a trust may be set up for a minor and extend well into adulthood. In the meantime, the trustee may not only manage the assets but, if given the power in the trust document, decide whether interim payments of principal, such as one for starting a business or going to college, are worthwhile to fund. For tax purposes. Certain trusts can provide significant tax benefits. For example, bypass trusts, which will be discussed later, can save money in taxes. For control purposes. An outright gift is not reversible. A revocable trust can put the ultimate beneficiary in place to receive the gift or inheritance but maintain the grant- or’s influence over the beneficiary as the trust can be changed or abolished. To bypass probate. Probate is the procedure after a person’s death where the will is validated and the period during which the court supervises the administration of estate assets. It is viewed by some as bothersome and costly and exposes their assets to public scrutiny. Placing assets in trust bypasses the probate process for those assets and may allow a person’s affairs to remain private. To strengthen protection from creditors and dissatisfied relatives. Because a trust is a separate legal entity, placing assets into it often can protect them from creditors and people who believe they did not get their rightful share of assets. To consolidate management. Trusts can provide consolidated management of property where there are several beneficiaries and centralized decision making is needed. The heirs may dispute items or be otherwise incapable of managing the property themselves or assigning someone to handle the task. To provide for different people over time. A trust can provide for one person during his or her lifetime and then give the remaining principal to another.

The disadvantages of setting up a trust are

Cost. It can be expensive to set up a trust. Moreover, as a separate entity, the trust has to file a tax return each year, which can involve an ongoing fee to a professional. Deviation from the grantor’s wishes. Trustees are charged with the duty to act in the beneficiary’s interest according to the terms of the trust. However, there is often consid- erable leeway in interpreting that mandate and trustees may perform in a way inconsistent with the wishes of the grantor. They also may clash with the beneficiaries in interpreting the trust or just do not get along well with them due to conflicts in personality. Effort required to set up. Certain trusts can require effort to set up—for example, changing the title to all trust assets. Resentment. The beneficiaries may resent the fact that the grantor did not leave the assets to them outright.

Clearly, the selection of the trustee is very important. As with an executor, the trustee can be someone you know, a bank, or a professional advisor. The advantages of a spouse,

Estate Planning 471

relative, or friend are familiarity with your circumstances, close individual attention, and, in many cases, lower cost. The advantage of a bank or advisor is experience in handling similar situations, an ability to closely interpret the mandate of the trust without fear of affecting personal relationships, and, in the case of a bank, perpetual existence of the trustee. Where the grantor believes it is best, two or three trustees may be named to act in concert. Figure 15.2 summarizes the advantages and disadvantages of setting up a trust. Trusts can be separated by various characteristics. These include whether they are living or testamentary trusts and whether they are revocable or irrevocable. (You can read about many types of trusts in Appendix III.)

Living Trust A living trust is one set up during a grantor’s life. Living trusts have become popular in certain regions as a method for the elderly to organize their assets and place them in posi- tion for professional management by an independent trustee in the event of disability or for disposition of assets at death. Until then the grantor can be the trustee. A living trust can be revocable or irrevocable (see below), but the term usually refers to revocable trusts. Suppose Alice creates a revocable living trust and transfers the title to her bank accounts, investment accounts, home, investment property, and shares in her closely held company to the trust. She names herself the trustee and the sole beneficiary. Even after these transfers, Alice continues to live in her home, manage the trust assets, collect invest- ment income, and so on. She can annul the trust if she wishes, and bring the assets back to her outright ownership. Why have these trusts become popular? For one reason, if Alice becomes incapacitated, a successor trustee she has named (her attorney, for example) will take over management of the trust assets with a responsibility to act for Alice’s well being. Also, at Alice’s death, the trust assets will bypass probate and go directly to parties named in the trust.

Testamentary Trust A testamentary trust is provided for in the will and comes about after death. Proponents of testamentary trusts believe that living trusts are sometimes unnecessary. To some observers, the net present value of the cost of setting up a living trust is high because the outlay for expenses is accelerated and bypassing probate in many states does not save much money. These critics recognize, however, that a living trust can be advanta- geous in other circumstances.

FIGURE 15.2 The Advantages and Disadvantages of Setting Up a Trust

TRUST

Disadvantages: Cost Potential trustee deviation from grantor’s wishes Effort required to set up Possible resentment by beneficiaries

Advantages: To obtain professional management For tax purposes For control purposes To bypass probate To strengthen protection from creditors and dissatisfied relatives To consolidate management To provide for different people over time

472 Tax and Estate Planning

Revocable Trust A revocable trust is one that can be revoked or changed by the grantor whenever desired. It allows the grantor to view the trust’s workings and make alterations whenever circum- stances change or even to terminate the trust with the assets returned. A revocable trust is established by a living grantor and generally becomes irrevocable at the grantor’s death. It usually has no impact on gift or estate taxes.

Irrevocable Trust An irrevocable trust is one that cannot be altered. Its main advantage over other trusts is the ability to qualify for favorable estate tax treatment. Brad creates an irrevocable trust to hold a $1 million insurance policy on his life. At Brad’s death, the policy pays $1 million in death benefits to the trust, which owns the policy. Assuming all the formalities have been carefully observed, that $1 million will not be subject to estate tax. (Life insurance proceeds at death generally avoid income tax.) In order to qualify for tax benefits, all incidents (characteristics) of ownership by the grantor must be given up. Its disadvantage is, of course, the finality of the decision. As with a gift, care must be taken that the grantor has enough capital to provide for the house- hold and will not regret the trust decision later due to a shortage of funds. Irrevocable trusts usually have gift tax and/or estate tax consequences.

Gifts Gifts, a major estate planning tool, are irrevocable transfers of property to others. They are called inter vivos transfers because they happen while the giver is alive. Gifts can be made for any number of reasons. From a theoretical standpoint, they are like bequests, which take place by will after the donor’s death. Both often have concern for others as a reason for giving the sum. Gifts, as opposed to bequests, can provide funds when needed, thereby raising the enjoyment of the recipient and providing donors with the satisfaction of observ- ing their gifts providing pleasure. Common reasons for gifting include giving funds for college education or for down payments on a home, items for newborns, and jewelry that others will use and enjoy and for reducing ultimate estate taxes. In order for an item to be considered a gift, it must be given without any characteristics of control left with the giver. That means the giver cannot normally influence the gift after it has been given, as, for example, by taking it back. Nor can the item be exchanged for an agreement to provide a contra gift or service. It would then be a contract, and any gift por- tion would be represented by the excess of the value of the gift over the value of the ser- vices to be received.

Example 15.1 Ernesto told his son he was giving him $10,000, which his son could keep if he graduated from college. Is that a gift? The answer is no because his son would have to give the money back if he didn’t graduate. Ernesto retained a characteristic of control.

Gifts are combined with estate assets to establish the exemption from estate taxes. That means that the fair market value of any gift will be deducted from each person’s lifetime exemption. The first $5.34 million of lifetime gifts will not be subject to federal taxes.7 In other words, in the vast majority of cases in which, say, $5.34 million isn’t gifted, in con- trast to what some people believe, there is no current tax to be paid on gifts by either the giver or the recipient. In smaller estates, no federal estate or gift tax will be due at all.

7 In 2014. The gift tax exemption and the estate tax exemption amount are identical; they increase to match inflation.

Chapter Fifteen Estate Planning 473

An exception is a gift of property. For appreciated property, the recipient takes the cost basis of the person providing the gift. When the property is sold, the recipient will pay an income tax at capital gains rates on the difference between the proceeds received and the cost basis.

Example 15.2 Flynn received a gift of his parents’ home when they moved into a retirement community. The house had cost them $25,000 and was worth $240,000 at the time of the gift. Flynn never lived in it and sold it five years later for $425,000. His basis for cost purposes was $25,000. He had to pay taxes on a gain of $400,000.

There are many types of gifts that don’t count as a deduction from the lifetime exemp- tion amount, an additional tax benefit. Here we discuss three.

Gifts between Married People An unlimited number of gifts are allowed between husband and wife, regardless of their amount.8

Gifts of Under $14,000 per Year Each person is allowed to make a gift of up to $14,000 of assets (in 2014) per year per recipient without affecting the $5.34 million lifetime gift tax exemption or the amount of the combined gift-estate tax exemption. (See page 479 for an example of the interaction between the gift and estate tax exemptions.) Spouses can combine their deduction to gift $28,000 per year to each person. If they wished to, for their child’s family of four they could gift $112,000 per year by gifting $28,000 to each member. There is nothing to stop anyone who had the desire and the funds to do so from gifting $14,000 to an unlimited number of people without triggering a gift tax. Clearly, gifting where appropriate can reduce estate taxes. Gifts over the $14,000 level per person per year will reduce the lifetime tax exemption by the amount the gift exceeds $14,000.

Example 15.3 Helena gave her daughter jewelry worth $50,000. Will she pay a gift tax that year? By how much will her $5.34 million lifetime exemption be reduced? As discussed, she will not pay a gift tax. Her lifetime gift tax exemption would be reduced from $5,340,000 to $5,304,000. The first $14,000 of the $50,000 gift is excluded, and the remaining $36,000 is deducted from the $5.34 million exemption.

Charitable Gifts Charitable gifts are also not subject to lifetime exemption. Although there are some limitations for allowable deductions for income tax purposes, an unlimited amount of money may be do- nated to charitable institutions for estate tax purposes. A charitable contribution may be income tax–deductible based on its fair market value at the time of the gift. Gifts to charities may be made outright or with some benefits to be received through trusts set up for that purpose.

Gifts are sometimes used as a method of helping particular children in need without having to deal with the conflict-producing approach of unequal be- quests. The funds could be said to be available for any one of the offspring in need at that moment. In

some cases, the other beneficiaries may never have to be made aware of it. Where the need is only short term, however, the gift could be deducted from that person’s ultimate bequest share.

Practical Comment Gifts and Unequal Bequests

8 There are special rules for noncitizens.

474 Tax and Estate Planning

Two principal types of charitable trusts for gifting purposes are charitable remainder trusts and charitable lead trusts. Under a charitable remainder trust, the donor receives a stream of annual income for a fixed period or for life, and the remainder is given to the charity. The net present value (NPV) of the remainder portion is deductible for income tax purposes. Under the charitable lead trust, the charity receives the stream of income for a desig- nated term, and the balance thereafter goes back to the donor or to an heir. The income tax deduction in this case comes from the NPV of the charity’s income received. Either trust’s benefits increase when the gift is in the form of property that would have high taxable profits on sale that is donated instead of being sold on the open market. In that case, there is no income or estate taxation on the sale of an appreciated property. On the other hand, the government will not allow tax benefits for any charitable transaction that lacks sufficient charitable intent.

Titling and Transferring of Assets Many people believe that a will is the final determinant of who will have legal ownership of a deceased’s property. In reality, this is often not true.9 It is very important to determine the way an asset is titled, not only for inheritance but for tax purposes as well. In this sec- tion, we look at property that is owned by two people.

Joint Property Property owned jointly with someone else can be titled in one of three ways: joint tenancy with right of survivorship, tenancy by the entirety, and tenancy in common.

Joint tenancy with right of survivorship (JTWROS) allows a person to automati- cally inherit the property upon the death of the other owner. The surviving co-owner’s right to the property takes precedence over the provisions stated in a will and, as men- tioned, bypasses probate. A common joint tenancy is a bank account. The account should clearly state that it is a joint tenancy and should recognize the right of the other to inherit the property upon the death of the co-owner.

Marie was an elderly widow with no children but several nieces and nephews. She changed the title of her bank account to JTWROS with her niece Phyllis, who lived nearby and would be able to write checks to pay Marie’s bills. At Marie’s death, all of the money in the bank account went to Phyllis, the co-owner, even though Marie’s will called for equal distribution of her assets among her nieces and nephews.

Tenancy by the entirety, the second form of joint ownership, is only allowed in some states. In many respects, it is like JTWROS. In the event of death, the surviving co-owner receives full ownership. However, it is only available to married persons and, unlike JTWROS, can only be undone by consent of both parties.

In tenancies in common each co-owner owns a specified percentage of a property. That percentage may be different from the amount invested. There can be any number of co-owners. The sale of an interest is permitted and, in the event of death, the inter- est will pass to the individual’s heirs, not the co-owners unless so specified. When there is no indication of type of tenancy, it will be assumed to be a tenancy in com- mon. When one owner in a JTWROS sells his or her share of assets, the ownership form becomes tenancy in common.10

9 A will is often superseded. For example, beneficiaries of a life insurance policy or a payable-on-death bank account will inherit the money even if the will stipulates that the same beneficiary will have no share of the decedent’s assets. Also, a spouse generally can inherit a certain percentage of the assets whether provided for in the will or not. A possible exception is where there is a prenuptial agreement. 10 Unless a state statute provides otherwise.

Estate Planning 475

Trust Ownership of Property Property owned by a trust is usually treated the same way as property owned by an inde- pendent entity. It is subject to similar tax treatment based on income generated and any tax-related benefits. The trustee is responsible for preserving trust assets and attempting to enhance their value over time.

Marital versus Separate Property Marital property refers to rights in property gained through marriage. It may be in your spouse’s property or in property deemed to have mutual marital rights. Separate property is an asset owned entirely by a person. Generally, assets owned before marriage and gifts and inheritances made specifically to one spouse are considered separate property—but only if they are kept in separate accounts. Why do we care about distinguishing between marital and separate property? Because it can determine who is entitled to receive the assets at death or divorce. For example, if pre- and post-marriage gifts and property inherited are jointly titled, they may be deemed to be a tenancy by the entirety. In such cases, premarital property that if separately titled would have gone to the decedent’s heirs but is intermingled could now be given to the surviving spouse, along with the right to designate who receives it upon his or her death. Surviving spouses have certain rights to property by law whether the decedent provided for them or not. Their rights will differ by state and may include ownership of a share of the decedent’s assets, often one-third to one-half or a life estate. A life estate refers to rights to property while the spouse is alive but with no right to pass the rights on to heirs. There are eight community property states in which the rules differ: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington. Community property states make a clear distinction between marital and separate property and believe marriage forms a kind of business partnership in which assets accumulated during marriage are the equal property of both spouses, regardless of who earned the money. Equal rights to these assets in community property states stand in contrast to some of the other states in which who earned the money can help determine who is entitled to it.

Life Insurance Life insurance has a number of potential roles in estate planning. These include liquidity, relative assurance of payment, and tax savings.

Liquidity For people with considerable resources, estate taxation can be sizable. There also may be other expenses such as funeral, burial, and business interruption. Decisions such as the sale of estate property could be compelled under less-than-optimal conditions. Buyers some- times regard the term estate sale as a potential license to get a bargain. Life insurance can provide a ready source of cash flow, which can fund estate taxes and enable postponement of the sale of property and other business decisions to an optimal time.

Relative Assurance of Payment Monies supposed to be set aside for beneficiaries may never be deposited, or they may be spent by the estate owner subsequent to their accumulation. Alternatively, the sums invested may involve considerable investment risk. The insurance policy can provide the structure that enables a stated sum to be left to beneficiaries at death. If John, a divorced father of two, purchases a $500,000 policy on his life, payable to his children, John will know that each of his children will receive at least $250,000 at his death, regardless of how he spends his other funds.

476 Tax and Estate Planning

Escape from Probate and Spousal Election Life insurance payable to others, whether from an ordinary policy or from a life insurance trust, escapes probate because it is not payable to the deceased or the estate. In addition, in some states, life insurance may not be subject to a requirement that husband or wife receive a certain minimum amount at death of their spouse.

Tax Savings As a general rule, the proceeds from insurance arising from the death of a person are not subject to income taxation but are subject to estate taxation. Say that Fred buys a $250,000 policy on his life that requires premium payments of $500 a year. He makes three pay- ments that total $1,500 and then dies in an auto accident. His daughter Gina, the policy beneficiary, typically will collect $250,000 and owe no income tax on what might be considered a $248,500 gain. The $250,000 probably will be included in Fred’s estate and might be subject to estate tax, depending on Fred’s other assets as well as his home state’s tax law. There are generally a maximum of three parties to an insurance policy: the owner of the policy, the insured, and the beneficiary. When the owner is also the insured, the amount will be taxable for estate purposes. However, in most cases where the proceeds are payable to another beneficiary and all incidents of ownership are eliminated by the insured, no estate taxes will be assessed on the estate of the insured. Therefore, life insurance can be a viable way of reducing estate taxes. Ownership of a policy can be transferred to another person, say a child,11 or a new policy established. The ongoing contributions to pay for the policy would come from the parent. Amounts contrib- uted in excess of $14,000 per person or $28,000 per couple would be considered a gift. Sometimes the cash value of a policy is borrowed before a transfer as its value at that time is also considered a gift.

Life Insurance Trust As with other types of trusts, the life insurance trust must be irrevocable to qualify for estate tax savings. Sometimes this trust is “funded,” which means there are enough other assets placed in the trust to cover the annual premium payment. Certain procedures must be followed in how gifts are made for insurance payment purposes so that they are not included as part of the deceased person’s estate. A life insurance trust may be used when an outright gift of the policy to the beneficiary is not desired. That could happen if the grantor was afraid the new owner would cash in the proceeds or change the beneficiary. Life insurance and the life insurance trust can be viewed as an alternative to a gifting plan. Both insurance payments and cash gifts reduce the size of estates and can add to the assets of the beneficiary. The gift can be more efficient economically and more flexible, while the life insurance trust can better control the timing of payments and will be more productive in the event of a premature death.

Power of Attorney A power of attorney is a legal document that lets someone act on your behalf. Powers of attorney will be discussed under incapacity.

Letter of Instruction The final estate planning tool we will discuss is a letter of instruction. This letter, which usually is not a legal document, is a supplement to a will that helps people understand your thinking and provides direction for matters to be accomplished. It can indicate where the will and other important papers are located as well as the telephone numbers of advisors and

11 An exception is a policy transferred within three years of death, as discussed under tax savings.

Estate Planning 477

perhaps an evaluation of them. It can discuss sensitive family matters that an executor may find helpful such as conflicts, untrustworthy individuals, and so on. It can include burial wishes and provide a justification for certain life actions including those provided in the will.

EVALUATE OBSTACLES AND WAYS TO OVERCOME THEM

Obstacles are impediments to the estate planning process. They may be legal obstacles such as probate, but many stem from human variables such as lack of knowledge or discomfort in decision making. Finally, the obstacles can involve protecting minors as beneficiaries. Here we will discuss each of them separately.

Probate Probate, as mentioned, is the process after a person’s death when the court supervises the review procedures to facilitate fair assignment of estate assets. After all estate obligations have been taken care of, the court will approve termination of probate and the assets may be distributed. Probate is sometimes viewed as a ponderous process, an obstacle particularly in certain states. This is because the procedures that must be followed result in expenditures and delay in distributing estate assets. In addition, probate opens up your private affairs to public scrutiny. Probate has some significant advantages as well. The process places court-approved finality on the estate. Creditors are given an opportunity to present their claims in court, and, after probate is terminated, no further liabilities need be paid. Disputes between inter- ested parties such as the heirs can be resolved by the court. Thus, after probate is over, beneficiaries know they have the assets free and clear of disputes. Although there are costs in connection with probate in certain states, they may not be that significant, particularly after attorney’s fees are deducted, and this may, for the most part, be needed with or without probate. Therefore, establishing trusts that separately title assets to bypass probate in many situations may not be necessary. Nevertheless, some lawyers recommend procedures to avoid probate, such as setting up a living trust and transferring assets into it. Some assets bypass probate, so they needn’t be transferred to a trust. They include (a) those that are titled jointly with right of survivorship, (b) qualified pension plans such as IRA and 401(k) and nonqualified deferred compensation plans, and (c) proceeds from life insurance on the decedent’s life payable to a named benefi- ciary other than the decedent or the estate of the decedent. Typically, accounts with a desig- nated beneficiary will go directly to that beneficiary, without going through probate.

Conflict Conflict in estate planning matters can come about because of differences in opinion be- tween spouses about who should be appointed for various estate administrative and super- visory tasks, concern over the receptivity of other interested parties to decisions made, or just internal conflict in making decisions when alternatives have several strengths and weaknesses. Selected common conflicts are given below. Because of the personal nature of the decisions, overcoming these conflicts can be difficult. However, consultations with people who have made similar decisions, or with close friends, relatives, and, of course, spouses, can help. Often lawyers specializing in these issues also can provide insights.

Division of Assets Perhaps the most difficult issue for many is how assets are to be divided, particularly for children. Should they be apportioned equally or based on another factor such as need or closeness of relationship? Equal apportionment has the advantage of objectivity. Need can be more subjective. Should need be related to the amount your beneficiaries make or to the

478 Tax and Estate Planning

amount of assets they have accumulated or should it be related to how happy they are in their current occupation, regardless of their income and assets? The closeness of relationship may be characterized in many ways; for example, who visits most often and who performs the most services when you are elderly. On the other hand, should children be penalized because their jobs take them away from the area? In practice, the vast majority of people allocate equally among their children.12

Executors and Guardians As mentioned, executors are assigned the task of administering the estate and carrying out the deceased individual’s wishes. A good deal of the work is usually done by a lawyer, so many people select a person they are close to as executor. When the assets are not that substantial, the individual executor, who may not be paid, can be the most popular choice. The person selected should have the time, the concern, and a sense of fairness and practi- cality in going about the task of dividing up the estate. When assets are sizable, sometimes professionals—particularly lawyers and bankers—are selected as executors. Determining the guardian for your children in the event that both parents—you and your spouse—die can be a perplexing issue. Should it be the person who is concerned most about the child? Or is it more important to select someone who has done a good job of raising his or her own offspring? How important is it that the person share your values? How much weight should be given to his or her financial means? Sometimes the decision is clear, and at other times, it can lead to uncertainty and conflict between husband and wife. Whoever is chosen should be informed and should assent to the selection. For a divorced couple, the guardianship may go to your former spouse no matter what your wishes may be.

The Age of Inheritance Money left to minors will not be given to them until they become adults, which, depending on the state, will be defined as between 18 and 21 years of age. In the interim, it will be managed by a guardian you name, who need not be the same one who supervises your children. The question can be whether the child is mature enough to handle the money at the age he or she receives it. If not, at what age? Commonly, that age is thought to range

12 See Mark O. Wilhelm, “Bequest Behavior and the Effect of Heirs’ Earnings: Testing the Altruistic Model of Bequests,” American Economic Review 86, no. 4 (September 1996): 874–92. Research indicates that over two-thirds (68.6 percent) allocate evenly. In addition, see Roger Faith, Brian Goff and Robert D. Tollison, “Bequests, Sibling Rivalry, and Rent Seeking,” Public Choice, 2008, vol. 136, issue 3: 397–409, econpapers.repec.org/article/kappubcho/v_3a136_3ay_3a2008_3ai_3a3_3ap_3a397-409.htm. This paper examines the “equal division puzzle.”

- - -

Professional Advice Separation of Estate

Chapter Fifteen Estate Planning 479

from 18 to 35. In the absence of a trust, the monies will have to be distributed when the children reach adulthood. If a trust is set up, the trustee can be given discretion about in- terim amounts for education or for other significant costs and a series of payments at what- ever ages are specified.

BECOME FAMILIAR WITH ALL TYPES OF RELEVANT TAXES

Taxes are one of the most important factors in estate planning. There are three types of assessments in connection with planning in this area: estate, gift, and income taxation. Our discussion will focus on federal taxation and exclude state taxes, which in the case of estate and gift taxes vary by state and are sometimes combined with federal taxes and in other cases added to them.

Estate Taxes Estate taxes that are due after the death of the owner are based on assets owned at death. Only certain assets qualify. For example, those assets gifted or left to a spouse who is a U.S. citizen are not taxed until the surviving spouse’s death. Estate taxes can be substantial as the current rate is 40 percent. Estate taxes should not be confused with income taxes, which also can add to the tax burden at death. Estate tax law provides an exemption from taxation for initial asset accumulation. The exemption is in the form of a credit against taxes called a unified credit because it is coordinated (“unified”) with the gift tax. Suppose Maude dies in a year with a $5.8 million exemption. If Maude has made $1 million of reported lifetime gifts, her exemption will be reduced to $4.8 million. In 2011, the federal estate tax exemption was set at the first $5 million of assets owned per person.13 Since then, the exempt amount has increased each year to track inflation. The unified credit is the tax on the sum that is eliminated by the exemption. Say Jack died in 2014 with $6 million in total net assets, which all were left to his daughter. Jack’s taxable assets were $660,000 (his $6 million estate minus the $5.34 million exemption) and his estate owed $264,000 (40 percent of $660,000) in federal estate tax.

Gift Taxes As explained, lifetime transfers are combined with estate assets to calculate the total ex- emption (see Table 15.2). In other words, there is what is termed a unified gift and estate tax process in effect. As we’ve seen, certain gifts are not subject to taxation. Even though gift and estate taxes are combined for calculating any tax due, the exemption for lifetime gifts alone is now set to match the estate tax exemption, so gifts up to $5.34 million were not taxed, in 2014, while excess gifts were taxed at 40 percent.

Income Tax Income taxes are assessments based on job-related and investment earnings. More relevant for estate matters, income taxes on gains on sale of assets are based on selling price minus

TABLE 15.2 Federal Estate Taxation

Year Estate Tax Exemption Maximum Federal Estate Tax

2011 $5,000,000 35% 2012 $5,120,000 35% 2013 $5,250,000 40% 2014 $5,340,000 40%

13 Those who are not U.S. citizens have separate requirements for estate and gift tax purposes.

480 Tax and Estate Planning

original cost. In recognition of the sizable estate and income taxes, Congress passed into law a bill providing that assets at death be given a fair-market-value basis for income tax purposes instead of the original cost. Basis can be viewed as the amount of an asset’s value that isn’t taxed. This new valuation for taxation purposes is called a step-up in basis. You have the option of selecting either the fair market value at the date of death or six months later for basis purposes if the later date will reduce your estate tax, but your choice must be taken for the entire estate and not done separately by asset.14

The effect of the step-up in basis is to eliminate income taxation on unrealized capital gains at death for stocks, houses, and other assets that have appreciated during the period since pur- chase. There is no benefit for unsold assets that have declined since original purchase. Their basis becomes the market value at death. Finally, assets in tax-sheltered accounts such as IRAs do not benefit from tax-favorable step-up in basis.15

Table 15.2 presents estate tax law as of the raising of the unified credit in 2011. These changes are “permanent,” meaning they are not scheduled to change. However, passage of a new federal estate tax law is always possible. There are state estate taxes as well. They vary widely and may have greater impact on modest estates than on larger ones.

DETERMINE AVAILABLE FINANCIAL PLANNING STRATEGIES

A variety of financial planning strategies are available for estate consideration. Most of them, at least in part, have a numbers orientation, frequently with a potential for saving tax dollars. Those that are ultimately selected will depend, of course, on individual circum- stances. Virtually any strategy considered for all but the very affluent will have to include the life cycle needs of the grantor. That means estate planning must incorporate retirement needs. Here are some basic strategies.

Use Portability As mentioned, bequests to a spouse usually escape estate tax, no matter how large an amount is involved. Current law includes a concept known as “portability,” which allows a surviving spouse to inherit any unused exemption amount, if the proper procedures are followed. To illustrate, suppose Ed dies in a year when the estate tax exemption is $6 million. Ed has an $8 million net worth and has not made any taxable gifts; he leaves $1 million to his children and the other $7 million to his wife Eve. The bequest to Eve is excluded from the calculation so Ed actually has a $1 million taxable estate, which is covered by the $6 million exemption that year, so Ed’s estate does not owe federal estate tax. Ed’s attorney, the executor of his estate, files an estate tax return to elect portability of his unused exemption. The exemption for the year was $6 million but Ed’s estate used $1 million to cover the bequests to his children. Thus, $5 million was unused, and can pass to Eve. If Eve later dies in a year with a $6.5 million exemption, without making any taxable gifts, her estate will have an $11.5 million exemption, including $5 million from Ed. The bottom line is that portability allows a married couple to pass well over $10 million to heirs, including their children, without owing federal estate tax and without having to establish trusts for that purpose.

Consider a Bypass Trust Even though portability makes estate tax planning simpler for married couples, some pro- fessionals prefer traditional trust techniques. In the above example, Eve might leave money

14 Fair market value may be established by published market prices, as in the case of stocks; by an appraiser, as in the case of a home or a business; or through some other method. 15 If you receive a gift, as opposed to being an estate beneficiary, your basis in the gift is the owner’s original cost or the market value at date of gift, whichever is lower.

Estate Planning 481

to her own children, rather than to Ed’s children, if both had offspring from previous mar- riages. Or Eve might remarry and leave assets to her new husband. Or the tax law could change. Trust tactics can address such risks. The most common form of trust for married couples planning for estate tax is called a bypass trust. A bypass trust—also known as a nonmarital, exemption-equivalent, type B, or credit shelter trust —is a document that is set up while the grantor is alive or is provided for in the will. As mentioned, it must be irrevocable to qualify for tax savings. Under a bypass trust, funds are provided for two beneficiaries: the income beneficiary and the remainder person. The income beneficiary, normally the spouse, receives the income from the trust. The remainder person becomes the primary beneficiary after the death of the income beneficiary. Where the grantor doesn’t exclude it, the surviving spouse may take not only income but withdrawals of 5 percent of the principal each year or $5,000, whichever is larger. In fact, many lawyers permit the trustee other than the spouse to withdraw any amount neces- sary to cover spousal illness or just to maintain the spouse’s ordinary and customary stan- dard of living. For many surviving spouses, that may allow all the funding they require. Many lawyers also allow the surviving spouse to be a trustee (although not the sole trustee), in order to have some influence over how the trust is operated. Assuming the bypass trust has been drafted properly, its funding will use the unified credit of the first spouse to die to avoid estate tax at the first death. The trust assets will not be included in the estate of the second spouse to die, so those assets will “bypass” estate tax altogether. Potentially, this can save hundreds of thousands of dollars in estate taxes. The amount placed in a bypass trust depends on the needs of the surviving spouse for principal. Clearly, only money in excess of projected living costs would be put there. The maximum that would make sense from a tax standpoint would be equal to the exclusion amount. The balance of the money could be left outright to the spouse or to a marital trust16, assuming he or she is the primary beneficiary. Because of the unlimited marital deduction, the money left outright to the spouse or to a well-drafted marital trust would not be subject to estate taxation at that time.17

The primary disadvantage of a bypass trust is the inability of the beneficiary to have all the household funds available to spend. In addition to the bypass trust, two other types of trusts are commonly used in estate planning for married couples. They are the power of appointment trust and the QTIP trust, both discussed in Appendix II.

16 A marital trust is a trust that is eligible for the marital deduction. There are different types of marital trusts with different terms. Two kinds of marital trusts are discussed in Appendix II—Power of Appointment and QTIP Trust. 17 Here again, the regulations are different for those who are not U.S. citizens.

- -

Practical Comment Irrevocable Trusts and Control

482 Tax and Estate Planning

Gifting versus Bequests Giving money while you are still alive versus waiting until your death is often an active issue. As we saw, gifting provides resources when needed—say, for the down payment on a home—and allows you to observe the benefits of your gift. If the gifting is under the $14,000-per-person-per-year limit, it is a highly efficient tax-free transfer for those with significant assets that will be subject to estate tax. Bequests, on the other hand, can be safer, allowing the grantor to maintain all assets for household use. They also can postpone providing assets to younger people when there is concern about negative influences of money on career choices and drive. Some people choose a combination of gifts and bequests.

Follow an Investment Policy for Estate Planning Investment policy is generally the same for estate planning as it is for any long-term plan- ning function such as retirement planning. Where the money has been set out exclusively for beneficiaries, however, the investment policy can take on the risk tolerance of the ben- eficiaries instead of the grantor.

Example 15.4 Mary Ann was perplexed. She wanted to provide as much money as possible to her heirs, her three children. On the other hand, she herself was very conservative and was afraid of losing her money. She asked the advisor for help. The advisor performed a retirement plan analysis and found that, based on her lifestyle and investment in very-low-risk securities, she would need about half her current savings in retire- ment. He split her money 50 percent into U.S. government bonds for her use and 50 percent in a much more aggressive portfolio consistent with her children’s risk preference. Mary Ann felt that the recommended asset allocation accommodated both her wishes.

Where liquidity or estate taxation is an issue, life insurance can be considered as an investment asset in the asset allocation. For example, when the estate consists of a busi- ness that will be retained or is difficult to sell, insurance on the life of the grantor can provide the cash to pay off estate taxes.18 Placing the insurance in a life insurance trust payable to the beneficiaries can take the proceeds out of the estate and bypass both estate and income taxes.

Consider Placing Monies in Joint Name in Smaller Estates Where assets at death are not likely to reach federal unified credit limits and material state taxation levels, estate taxes may not be an issue. In that circumstance, placing money in joint accounts can ensure that the intended person receives the money quickly and free of probate expenditures. On the other hand, be aware that you are providing another person with ownership rights in your estate while you’re alive, and this, under some circumstances, could result in significant financial losses. For example, either party may be allowed to withdraw the entire sum deposited. A dual signature required on withdrawals can help but may restrict your movement. Limiting joint accounts to people you absolutely trust or to monies that are needed for your support should be considered. Where assets are or will be over the maximum estate exemption, you should work with professional advisors to develop an estate plan that addresses all of your goals, including tax reduction.

18 Such insurance also might be especially useful to cover the estate tax on inherited IRAs and Roth IRAs. This will enable the beneficiary to utilize the tax deferral from the regular IRA and tax-free accumulation for the Roth IRA throughout much of his or her lifetime.

Estate Planning 483

Integrate Estate and Income Tax Considerations in Planning There are many occasions when possible actions involve a choice between an income tax and an estate tax. Often the alternative triggering an income tax comes first and the estate tax later at death. Before arriving at a decision, your goal should be to consider both by using a time value of money technique such as obtaining the NPV of both alternatives and selecting the one with the greatest sum made available net of taxes.

Gift Fast-Growing Assets Assets that are expected to increase rapidly in value are often preferred gifting vehicles. They remove assets that can increase the estate’s valuation and therefore estate taxes.

Pay Compensation to Executor on Large Estates Large estates often have higher estate tax rates than income tax rates for beneficiaries. Consequently, paying an executor who is a beneficiary for his or her services can be advantageous.

Think about Designating Younger People as Heirs Estate taxation repeats at each death of the owner. Therefore, the net present value of estate taxes is likely to be lower for each generation below yours that you provide for. Clearly, the least efficient way is to select another elderly person, say a father or mother, as a ben- eficiary. A second death that occurs after 10 years or more will result in a second full estate tax levied.19 Generation-skipping trusts, provided the trust is drafted to minimize the gen- eration-skipping transfer (GST) tax, can be attractive.20 Of course, consideration of the needs of the person who is your primary beneficiary and who may resent gifting to grand- children can take precedence.21

Give Consideration to the Step-Up in Basis The step-up in basis can be a powerful antitax tool. The elimination of income taxes on assets with a low cost basis by retaining instead of selling them should be considered by people who are elderly or seriously ill. When a spouse is seriously ill but expected to live for at least one year, the required minimum for this type of transaction to be effective, a gift of assets with low basis to that spouse may be an attractive alternative.

Example 15.5 Rod had a close relationship with his grandmother, now 93, and was one of her beneficiaries. She had a modest country home on the water in Cape Cod, Massachusetts. The home was bought for $15,000 when she was first married. Now it was worth $1 million. She was too old to use the house anymore and wanted to sell it. Rod explained to her that selling it would involve paying taxes of over $200,000. If they waited until her death, the estate would receive a step-up in basis and would not have to pay any income tax at all on a subsequent sale for $1 million. They decided to wait and rent the house out in the meantime.

Pay Particular Attention to IRAs and Other Qualified Plans Upon death, both estate and income taxes are due on qualified pension plans. Spouses who are beneficiaries have the option of electing a spousal rollover, which can defer current

19 Estate taxes for a second death that occurs within 10 years are benefited by a credit that declines with time. 20 Bequests that go from, say, a grandparent to a grandchild and thus avoid a layer of estate tax may be subject to the 40% GST tax but there is an exemption to the GST tax, equal to the current gift and estate tax exemption amount. 21 A disadvantage is that the tax can be punitive if the GST tax exemption limit is exceeded.

484 Tax and Estate Planning

taxation. In a process somewhat similar to a rollover, nonmarital beneficiaries of an IRA can defer income taxation upon death and take mandatory withdrawals based on their life expec- tancy. In order for this option to be available for the beneficiaries of the IRA, they must ensure the title of the account retains the name of the decedent. It should then state “for the benefit of the beneficiary.” If Nick inherits an IRA from his uncle Pete and wants to stretch out required minimum distributions over his own life expectancy, he can retitle the account from “Peter Jones IRA” to “Peter Jones, deceased, IRA for the benefit of (fbo) Nick Jones.”

INCORPORATE ESTATE RISKS

There are many risks to which estate plans are subject. The primary ones have been cov- ered in risk management chapters. The two principal risks that are particularly relevant for estate planning are longevity and incapacity.

Longevity The age at which death occurs has a significant effect on estate planning. Dying prema- turely can alter all plans, including those of household members. Where there is a desire for a fixed or minimum amount to be given, whether to household members or others, it can be ensured using insurance on the estate owner’s life, payable to the intended beneficiaries. Ironically, dying in the period close to the retirement date can place greater resources in the hands of beneficiaries. That is because the retiree often has accumulated substantial sums for retirement. Unusually long lives (or large age-related medical or care benefits) can place retirement and therefore estate sums in jeopardy. An active gifting policy can increase the exposure. A policy practiced by many people and proposed by some financial planners is to plan conservatively for retirement needs incorporating the possibility of living well past age 90, although it is likely that death will occur before that time. The remaining assets, possibly including a home, would then be made available to beneficiaries.

Incapacity Incapacity, the inability to function on your own behalf because of sickness or some other reason, obviously can disrupt the normal functioning of the household. There are a number of legal documents that can help, including trusts, powers of attorney, and medical powers of attorney, which will now be discussed.

Health-Related Trusts Trusts can be set up for almost any reason. In this case, a revocable living trust can provide the funding to administer a person’s care under the supervision of a trustee when the per- son can no longer handle his or her own affairs. For example, for a person suffering from Alzheimer’s and no longer considered mentally competent, an independent trustee could hire people to administer home care or to ensure that the person is well taken care of in a nursing home.

Durable Power of Attorney A power of attorney is a legal document that lets someone act on your behalf. Andy might create a document that empowers his son Ben to act as Andy’s agent in financial matters. You might want to give someone a power of attorney when expertise is required and you are not equipped to handle the matter yourself, when you are out of the country and a busi- ness matter may come up, when you are ill, or in a host of other circumstances. Ben could act as Andy’s agent at a house closing, for instance, if Andy is away on a business trip.

Estate Planning 485

The power may be temporary or potentially permanent, specified to stay in effect until revoked. It may be limited to specific areas or it may be a general power. The form itself is intended to affirm that person’s ability to act, which, in a durable general power, is not af- fected by any subsequent incapacity of the person giving it. Among various types of powers of attorney, a durable power of attorney remains in effect over time with the amount of power and the circumstances under which it can be used stated in the document. A durable power of attorney survives incompetency. If a person becomes senile, a durable power generally eliminates the need for the court to appoint a guard- ian or a conservator. The durable power of attorney is less costly than a living trust. If the power of attorney is not worded as a durable one, it will terminate on the disability of the person, as it becomes legally invalid. The durable power terminates upon the death of the person. Another variation, a springing power of attorney does not take effect until a specific event stated in the document occurs, such as incompetency. For example, it could come into effect when the person is mentally or physically disabled. Its weakness is a potential problem in determining whether that event has occurred. This can make it difficult for the person possessing the power to be recognized by third parties as legally able to act. However, a springing power might deal with this issue by requiring, say, that two physi- cians familiar with the power’s creator affirm the onset of incompetency.

Medical Power of Attorney A medical power of attorney, also called a health care power of attorney,22 allows someone else to make medical decisions when you are not capable of doing so yourself. It is used because a general durable power of attorney is not recognized in medical matters. This format is stronger than a living will, which also can indicate definitive beliefs about your right to refuse artificial treatment to prolong your life.

CONSIDER SEPARATE ESTATE PLANNING FOR MINORS

Children are treated separately because they are deemed incapable of handling their own affairs. Gifts to them have a tax advantage. As we saw in Chapter 14, for certain young people the first $1,000 of income on investments owned is not taxable and the next $1,000 is taxed at the child’s low tax rate (as of 2014). The rest of their investment income will be taxed at the parent’s marginal rate. On the other hand, children or even young adults may be viewed as not capable of handling monies. For example, there may be concern that they would spend the money without thinking about the long-term effects.

22 Or a health care proxy.

Practical Comment Powers of Attorney

486 Tax and Estate Planning

Under the Uniform Gifts to Minors Act,23 a donor can make a gift to a minor and have a guardian supervise that gift in a way similar to that of a guardian acting as a trustee. This right may be limited to financial assets; and if the donor acts as custodian and dies, the money will remain in the donor’s estate for estate tax purposes. Moreover, the custodial arrangement must be terminated when the minor reaches adulthood, which, depending on the state, is between the ages of 18 and 21. At that point, the youngster will have absolute access to the relevant assets. A trust for minors called a 2503(c) trust can be set up. It provides more flexibility. Many kinds of assets, including property, can be placed into it. Any outlays of income from the trust must be spent on behalf of the child and the money distributed when the child becomes 21. Income spent is taxed to the recipient and that reinvested income is taxed at the trust’s rate. If the grantor is not the trustee, it will not be includable in the grantor’s estate.24

If you want to provide for extension of control beyond age 21 and the sums are consid- erable, a trust may be the best solution. It can allow the trustee the flexibility to vary the terms of payout, if you wish. Bank accounts set up with the words “in trust for” or “trustee for” are not gifts nor are they, technically, a trust. The donor can withdraw the monies at any time. The income on the sum will be taxable to the donor, not the child, and the sum accumulated will be part of the donor’s estate. At the donor’s death, the sum will be transferred to the child and will not go through probate. When the child or children have disabilities, special actions may be called for. A special needs trust may be set up that can be instituted when the beneficiary is a child or during adulthood. It can provide financial support or be considerably broader, providing for su- pervision of operating functions. When the disability is covered by government support, care must be taken to ensure that the trust does not disqualify that aid. See Chapter C on the website for more information on the special needs trust.

ASSESS ANTICIPATED RESOURCES

The amount of current assets accumulated was established earlier in the PFP process. Here we are projecting what resources will be available for estate planning. Because the date of death is not known, the figure will be an estimate. Where amounts are specifically set aside for estate planning and not used for retirement planning purposes as well, the figure will be easier to ascertain. The total amount projected as available will help determine the tools and strategies used. For example, if $400,000 is likely to be a peak sum, holding assets in joint names may be the strategy used, whereas a $4,000,000 ultimate sum could result in an extremely different approach.

FINALIZE THE ESTATE PLAN

This step integrates the original objectives, which are typically both financial and personal. In other words, it combines estate planning tools and strategies with personal wishes about who gets what. The strategies and tools will attempt to maximize assets; selecting those that achieve the purpose depends on circumstance. Table 15.3 is a summary of estate planning tools available and the advantages and dis- advantages of using them.

23 Called in some states Uniform Transfers to Minors Act. 24 If the child is given the option of taking the money out at age 21 and refuses, the trust terms can provide for extension beyond that age. The grantor may suggest to the beneficiary separately that if the money is withdrawn, additional sums that are potentially in excess of those in the trust will not be forthcoming.

Chapter Fifteen Estate Planning 487

IMPLEMENT THE PLAN

Implementation involves drawing up the legal documents by the estate attorney and the actions that the grantor must take. For example, if a living trust is set up, the assets that are going to be part of it must be transferred in. If, on the other hand, the estate plan calls for more equal separation of spousal assets, then transfers from one spouse to the other must take place.

REVIEW PERIODICALLY

Estate planning is one of those financial areas that should be reviewed fairly frequently. Economic circumstances change and people’s opinions on what they want to do with their monies and their other wishes can shift over time. Besides, tax and other estate planning laws are altered by the government and new tax strategies arise.

1 Where the will provides for tax-advantaged trusts. 2 Except for making tax-exempt deathbed gifts. 3 However, for certain assets where there is a conflict as to the beneficiary, other documents may take priority over the will.

Provides for division of untitled assets upon death Transfers assets when alive

Separate entity with trustee managing property

Allows someone to act for you Allows someone to act for you in medical affairs when you are incapacitated Share in control

TABLE 15.3 Summary of Estate Planning Tools

Will

Gift

Trust

Durable power of attorney Medical power of attorney

Joint account

Possibly1

Yes

Possibly

No2

Legally recognized document of wishes Flexible Giver can observe benefit Reduces size of estate Expertise Protects against disputes Bypasses probate Flexibility Inexpensive Flexible Specific power to take or approve medical actions

Bypasses probate Quick liquidity Targeted beneficiary

None3

Loss of control over asset

Costs Potential risk of inappropriate actions by trustee Effort to set it up Risk of financial loss through delegation of control Risk attached to having inappropriate actions taken

Risk of financial loss through delegation of control

Document Characteristic Material Tax Advantage

Principal Advantages

Principal Disadvantages

Although the implementation part of the process may appear pro forma, particularly after the time and expense of engaging in estate planning, a surprisingly large number of people don’t do it. Whether because of lingering uncertainty about decisions made, the effort needed to complete the procedures, ignorance, or some other reason, too many legal documents stand as empty shells.

An understanding of the behavior patterns of people, including the need for prodding by the financial planner or lawyer, can be helpful. For example, financial planners almost always recom- mend a will. When they do, if they also schedule an appointment with the lawyer while the client is present, the odds of successful completion increase considerably.

Practical Comment Implementation

488 Tax and Estate Planning

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Estate Planning

Estate Planning 489

Back to Dan and Laura ESTATE PLANNING The meeting with Dan and Laura on estate planning did not take very long. They agreed that the executor of the will should be Dan’s older brother. They couldn’t agree on who would be the guardians of their children should there be a joint accident. Dan wanted his older brother; he was well established and could provide the monies to have the children live comfortably, and he shared the same values the couple had. Laura wanted her sister to take care of them. She said that although her sister’s lifestyle was more “countercul- ture” and she and her husband lived modestly, she really cared for their children and had already formed a relationship with Brian. In the event one of them died, Dan and Laura agreed that they wanted 100 percent of their money to go to the surviving spouse. As for subsequent bequests, Laura wanted each child to be guaranteed a substantial sum as her parents planned to do for her. She planned to leave each child $100,000. Dan said that their investment in their children in the form of college aid was enough. Besides, he said, both children were likely to receive a significant sum because the probability was that Dan and Laura wouldn’t live until age 95 as funded for in the retirement planning section. Dan’s opin- ion carried the day, but I had the feeling Laura would bring it up again later in their lives.

At the end of our meeting, I summarized my thoughts on the value of estate planning this way: Estate planning is the method of providing for your heirs according to your wishes in a tax-efficient manner. You are at a relatively young age in your marital lives with limited assets now. I have assumed that there will be two children, as is your wish, as you are well on the way to fulfilling that intention. My principal objective here is to get you to obtain a will. There are many people who say they should have a will but, for whatever reason, never actually do it. If you die intestate (with- out a will), the state will determine the division of your assets. For example, if Dan were to pass away in this state, the children would receive half of the assets. I know, Dan, that you want Laura to receive all of your assets. And you are correct, Dan, that the likelihood is you will both live long lives, but the will provides important protection in the event of a premature outcome. The issue of who should be guardian is a contentious one and beyond the scope of the financial plan. I am confident that you will select the person who is best suited to raising your children. Even including potential insurance proceeds, should either of you pass away while be- ing covered by life insurance, you are both well under the federal estate and gift tax mini- mums. Therefore, I am not going to focus on the tax savings and disadvantages inherent in relying upon exemption portability or setting up bypass trusts. I believe that you should both establish durable and medical powers of attorney and living wills. The durable powers will allow each of you to act on behalf of the other at times of inca- pacity, in general situations for the durable power and in times of serious illness for the medi- cal power. The living will can indicate your desires in connection with terminal illness. You also should have a document that details your personal wishes as well as the location of assets and personal papers along with the name, address, and telephone number of your advisors. Keep in mind that estate planning should be reviewed periodically as your assets grow and the needs for your children change. Finally, I want to underline my desire for you to obtain a will as soon as possible. If you like, I will supply some recommendations of attorneys to consider.

490 Tax and Estate Planning

College Student Case Study and Review: Amy and John ESTATE PLANNING When I told Amy and John that the next session would be on estate planning, I heard an “ugh” from both. Amy said that was an “icky” topic and a friend of hers who was into unusual reli- gions said just even thinking about it could jinx you. John just said, while smiling, that many people his age thought they didn’t need estate planning because they would live forever. Nonetheless both agreed that knowledge of the topic was important not only for them, but also for their parents who had ignored it. I assured them that many others, including estate planning lawyers who could draw up documents at no charge, had also neglected the topic. I began by informing them that estate planning is what we do principally to protect and benefit others we care about after we die. It involves analyzing and deciding on how your assets are to be managed and apportioned in the event of your death or disability. The first step in an estate plan is to identify all assets. The second step is establishing a will. It is often the most important document in the estate plan. A will combines instructions for who gets what assets with expressions of the person’s wishes. It also indicates the powers of the executor who administers the estate and dispenses its assets. If necessary, a will can designate a guardian for the young, elderly, and others who cannot care for themselves. Some key points in analyzing a will include:

Does it reflect your true wishes clearly? Is it up to date? Will it cause conflict? Is it stored in a safe place? Does it comply with state law?

If you die intestate, meaning without a will, the state in which you reside will determine the division of assets. Your own wishes may diverge significantly from that division. A will can always be changed until the creator is deceased. So you likely don’t need to have all of the answers now. Trusts are separate legal entities in which a third party manages a property for the ben- efit of another person. The trustee is the person who manages the trust assets. The benefi- ciary is the person who receives the property or otherwise for whom the property is being managed. The grantor or trustor is the person setting up the trust. The possible advantages of a trust are:

The potential disadvantages are:

Estate Planning 491

The types of trusts are:

Living trust—Set up during grantor’s life. Testamentary trust—Provided for in will and established after death. Revocable—Can be changed after being drawn up. Irrevocable—Cannot be changed after being drawn up. Lack of ability to alter is re- quired to obtain tax benefits.

Trusts may be funded during the grantor’s life or at death, but gifts are always made by living persons. Gifts are irrevocable transfers of property. There are generally no taxes paid on gifts of cash by either the giver or the recipient. In gifts of appreciated property the recipient takes the cost basis of the giver and will pay capital gains taxes on the gain upon sale. Gifts between mar- ried people are unlimited. As of 2014 the first $14,000 of annual gifts to any person do not generate gift tax; such gifts also will not reduce the giver’s combined federal gift and estate tax exemption, now set at $5.34 million per person or $10.68 million per married couple. The state exemption for estate tax varies from state to state but is generally lower than the federal amount. Gifts over $14,000 per recipient reduce both the lifetime gift tax and federal estate tax exemp- tion. A person can make an exempt $14,000 annual gift to an unlimited number of people. Charitable gifts are not subject to lifetime exemptions. Rather, an unlimited amount of money may be donated to charitable institutions. Under a charitable remainder trust the donor receives a stream of annual income for a fixed period of time or for life and the re- mainder is given to charity. Under a charitable lead trust the charity receives the stream of income for a designated term and the balance goes to the grantor or to an heir. Joint property is owned with someone else. There are three variations:

Joint tenancy with right of survivorship (JTWROS) – Allows a person to automatically inherit the property upon the death of the owner. Tenancy by the entirety— In the event of death, the surviving owner receives full

ownership. Only available in certain states and only to married couples

when both agree to this designation. Tenancy in common—Each co-owner owns a specific percentage of the property.

Marital property includes property considered to be owned by both spouses while separate property includes assets owned entirely by one person. Life insurance has many attributes in estate planning:

Liquidity Provides money for the estate tax on death Available Provides a high degree of confidence of

being on hand Tax Savings Can bypass estate and income taxes

A letter of instruction is a supplement to a will that helps people understand your think- ing and provides directions for matters to be accomplished. It is not a legal document. Probate is the court-supervised process of reviewing the assignment of estate assets to facilitate fairness. After estate obligations are paid off, probate is terminated and the assets may be distributed. Know the types of taxes:

Type Explanation Estate tax Taxes on a decedent’s estate, based on amount

of assets. The unified credit exempts the first $5 million of assets adjusted for inflation; as of

492 Tax and Estate Planning

2014 the exempt amount is $5.34 million per person and twice that per couple.

Gift tax Taxes on amounts given when alive, in excess of an annual exclusion and a lifetime exemp- tion. The gift tax is unified with estate taxes for federal taxation, but states may have various separate exemptions.

Income tax Taxes based on job-related and investment earn- ings. At a person’s death the basis for income taxation shifts from the decedent’s cost to fair market value at the date of death or alternatively, six months later. The choice must reduce tax due at death and must cover all estate assets.

Planning strategies include:

Type Explanation Gifting vs. Bequests Gifting each year of $14,000 amounts for

children, their spouses, and grandchildren can reduce estate taxes. However, the federal estate tax exemptions (over $5 million per individual and $10 million per couple) are so high that beneficial planning frequently involves lowering state estate tax.

Consider placing monies in joint If estate tax amounts are not going to be reached, names in smaller estate placing assets in joint names creates more

flexibility. Integrate estate and income taxes Look at both taxes to see how to deal with tax-

able items where there is a choice. Consider younger people as heirs The government can get less over time if you

do so. Think about step-up in basis It helps decide whether to sell assets before or

after death.

Two estate risks are longevity—dying too early or living a long time—and incapacity. Health-related trusts and durable powers of attorney, which allow someone else to act on your behalf when you become ill, are two approaches to incapacity. A medical power of attorney (also called a health care power of attorney) is a required separate document if you want someone else to make medical decisions when you are not capable of doing so.

Summary Estate planning is a PFP activity that increases in importance in later years in the human life cycle.

- portioned to others in the event of your death or disability.

ones we care for with as little conflict as possible.

estate planning.

Estate Planning 493

what’s in a will, so periodic review is vital.

benefit of another person. -

ership rights, they are not gifts.

payment, and tax saving.

administers certain estate assets.

Key Terms administrator, 467 beneficiary, 470 bequest, 472 bypass trust (nonmarital, exemption-equivalent, type B, or credit shelter trust), 481 charitable lead trust, 474 charitable remainder trust, 474 durable power of attorney, 485 estate planning, 466 executor, 467 gifts, 472

grantor (trustor), 470 guardian, 467 intestate, 468 irrevocable trust, 472 joint tenancy with right of survivorship (JTWROS), 474 letter of instruction, 476 life estate, 475 living trust, 471 marital property, 475 medical power of attorney (health care power of attorney or health care proxy), 485

power of attorney, 476 probate, 477 remainder person, 481 revocable trust, 472 separate property, 475 springing power of attorney, 485 step-up in basis, 480 tenancy by the entirety, 474 tenancy in common, 474 testamentary trust, 471 trust, 469 trustee, 469 unified credit, 479 will, 467

naepc.org National Association of Estate Planners & Councils The NAEPC’s site contains a monthly estate planning newsletter

estateplancenter.com Estate Plan Center At estateplancenter.com/5week/brochure_download.html, you can download a living trust brochure.

nolo.com Nolo This is the home page of Nolo, a leading provider of legal solutions for consumers and small businesses. The site offers articles and information about wills, living trusts, powers of attorney, and estate taxes.

gift-estate.com Estate Planning and Gifting This site offers a large number of links that stress the importance of gifting in estate planning. There is extensive coverage of charitable trusts.

Websites

494 Tax and Estate Planning

niepe.org National Institute for Excellence in Professional Education This is the home page of the organization that administers the Certified Specialist in Estate Planning® (CSEP) designation. Relevant information regarding the designation is provided.

alllaw.com/articles/wills_and_trusts/article2.asp AllLaw.com This link provides an article on why you need a will.

Questions 1. Identify five reasons for having a will. 2. Explain the difference between an executor and a guardian. 3. What is a letter of instruction and why have it? 4. Detail the advantages and disadvantages of probate. 5. Identify the alternative ways of titling and transferring assets and indicate how they

differ. 6. Shelly had just inherited money from her parents that she was considering placing in

a joint account with her husband. She also was contemplating a legal separation from her husband. What advice would you give her? Why?

7. Howard said he wouldn’t have to pay taxes on the money he inherited from his de- ceased father because it was under the $5.34 million threshold. He promptly withdrew the $900,000 that was in his father’s traditional IRA. Was his belief correct? Explain.

8. Why are basis and a step-up in basis important? 9. Sally gave $200,000 to her daughter and said, “It’s yours as long as you agree to sup-

port me when I am older, if I should run out of my funds.” Is that a gift? Explain. 10. Samantha was affluent and gave $6,000 to each of 1,000 needy individuals. Someone

told her that under the uniform estate and gift tax, she would have to pay a tax. Were they correct?

11. Why is it preferable to donate appreciated property to a charity rather than sell it and contribute the cash?

12. Detail the advantages and disadvantages of setting up a trust. 13. Why set up an irrevocable trust when you can establish a revocable one that provides

you with more flexibility? 14. Shane didn’t want to establish a bypass trust with her son as remainder beneficiary

even though it would reduce the tax on her estate. She said her husband might need some of the money. Is that wise? Explain.

15. Morris didn’t understand why he should set up a bypass trust. He said that without a trust, upon his death the $6,000,000 in assets in his name could go to his wife free of estate tax. Why should he put restrictions on his wife by transferring the money to the trust with his wife as income beneficiary and his son as remainder person? (His wife also had $6,000,000 in assets in her name) Did he have a full perspective? Explain.

16. Carl and his wife had a total estate of $400,000. What estate planning tool would you recommend? Why?

17. Why is life insurance potentially useful in estate planning matters? 18. What are the strengths and weaknesses of a durable power of attorney? 19. Name the three major ways of receiving non–work-related funds from acquaintances

and indicate how they should be valued.

Estate Planning 495

Problems John inherited $1 million in an IRA, which comprised the entire estate from his father, who had recently died. He promptly withdrew the funds. The appropriate marginal tax rate was 39.6 percent. Was there any tax due? If so, how much? Assume it was $1 million in stocks held in a personal account. Would your answer be the same? Explain. Sophia inherited 1,000 shares of IBM that her father’s parents bought for her when she was a child. The father’s cost was $2 per share at the time of purchase and $84 per share at the time of his death. Sophia sold them at $86 per share. Calculate the total amount of her capital gain. Henry will be giving $50,000 to each of his five children. Indicate how much of his as- sumed $5.34 million gift tax exemption will remain. Hilda wanted to know how much her children would be saving if she set up a bypass trust for $300,000 rather than giving it directly to her husband. She had an illness that made it likely that she would be the first to die. Assume she and her husband each had over $6 million in assets and no change in the amount over time, as well as an estate tax rate of 40 percent. What would her savings be? Maurice gave $20,000 to charity each year. He had $20,000 in stock that cost him $14,000 to buy. Assuming he is in the 23 percent marginal tax bracket for capital gains, how much will he save by donating the stock directly to charity?

15.1

15.2

15.3

15.4

15.5

Before her death, LaDonna Kiniston, age 74, gave her three grandchildren some money for their private school education. She paid $12,000 to the school for Jake’s tuition and gave a like amount to Sarah and Nicole. What would be the adjusted taxable gifts calculated in her estate taxes?

a. $0. b. $2,000. c. $6,000. d. $16,000. e. $36,000.

What is an appropriate standard estate planning strategy for married couples to minimize taxes over two deaths?

a. Bequeath the entire estate to a trust, giving the surviving spouse a general power of ap- pointment.

b. Bequeath the applicable exclusion amount to a qualified terminable interest property (QTIP) trust and the balance to the surviving spouse.

c. Bequeath the application exclusion amount to a bypass trust to take advantage of the unified credit at the first death.

d. Bequeath the applicable exclusion amount to the surviving spouse and the balance to the children.

Five years ago, Tom Mohy bought 10,000 shares of stock at $10 per share in a pharmaceu- tical company. Today, the stock is worth $200,000 and is paying a dividend of $8,000 per year. Tom feels that the stock will continue to appreciate at a rate of 12 percent per year, including the dividend. Tom wants to establish a college education fund for his two daugh- ters, ages 15 and 9. Which of the following is/are true?

1. If Tom gives 2,500 shares of stock to his 15-year-old daughter, all dividends from the 2,500 shares will be taxed at her income tax bracket.

15.1

15.2

15.3

CFP® Certification Examination Questions and Problems

496 Tax and Estate Planning

2. If Tom gives 2,500 shares of stock to his nine-year-old daughter, all dividends from the 2,500 shares will be taxed at her marginal rate.

3. Two years from now, if Tom’s older daughter sells her 2,500 shares of stock at $30 per share, Tom will need to report the gain as a long-term capital gain on his personal in- come tax return.

4. All dividend income earned by his nine-year-old daughter that exceeds $1,400 in 1998 will be taxed at Tom’s marginal tax rate.

a. (2) only. b. (1) and (2) only. c. (1) and (3) only. d. (1) and (4) only. e. (3) and (4) only.

If a client’s primary goal in making lifetime gifts to his children is to lower his estate taxes, he should make gifts of property that

a. are expected to depreciate significantly in the future. b. are expected to appreciate significantly in the future. c. have already depreciated significantly. d. have already appreciated significantly.

Doris Jenkins is a 71-year-old widow with a son and daughter ages 43 and 45, respectively, and six grandchildren. Doris has an estate currently worth $572,000, which includes her home valued at $250,000 and a life insurance policy on her life with a face value of $160,000. Her children are named as primary beneficiaries. Doris recently suffered a se- vere stroke that left her paralyzed on her right side. She is home from the hospital, but her health will continue to decline and she will need to go into a nursing home within one year. The only estate planning she has done to date is to write a will in 1989 that left all her as- sets to her children equally. Of the following estate planning considerations, which is/are appropriate for Doris at this time?

1. Transfer ownership of her home to her children, so it will not be counted as a resource should she have to go into a nursing home and apply for Medicaid.

2. Execute a durable general power of attorney and a durable power of attorney for health care.

3. Place all assets in an irrevocable family trust with her children as beneficiaries. 4. Start a gifting program transferring assets up to the annual exclusion amount to each of

her children and grandchildren.

a. (1), (2), (3), and (4). b. (2) and (3) only. c. (1) and (4) only. d. (4) only. e. (2) only.

Bruce, age 55, is the beneficiary of his mother’s $200,000 life insurance policy. The in- surer has requested that he select a settlement option for payment of the proceeds. What factors should he consider before making the election?

1. His current income needs. 2. His asset management ability. 3. His net worth.

15.4

15.5

15.6

Estate Planning 497

4. His estate planning goals. 5. His tax liability on the $200,000.

a. (1), (2), (3), and (5) only. b. (2) and (4) only. c. (1) only. d. (3), (4), and (5) only. e. (1), (2), (3), and (4) only.

Mr. and Mrs. Jones own 640 acres of farmland deeded as “joint tenants, not as tenants in common.” Currently, the land is appraised at $3,000 per acre and continues to escalate annually in value. In addition, Mr. Jones holds a $250,000 CD in his name only, and Mrs. Jones holds a $250,000 CD in her name only. Mr. and Mrs. Jones have no debts. Mrs. Jones’s last will and testament provides that “all of my assets at my death shall be divided in three equal portions among my children and my husband.”

1. Mrs. Jones dies unexpectedly, leaving her husband and two children as her sole heirs. Which of the following statements is true?

a. The children will inherit two-thirds of Mrs. Jones’s interest in the CD and her 50 percent interest in the farm.

b. The children will inherit two-thirds of Mrs. Jones’s interest in the CD and no interest in the farm.

c. The children will inherit two-thirds of Mrs. Jones’s interest in the CD and two-thirds of her 50 percent interest in the farm.

d. The children will inherit a statutory interest in the CD and the farm. e. The children’s share of Mrs. Jones’s CD and her 50 percent interest in the farm are

subject to probate.

2. Two weeks after Mrs. Jones’s death, Mr. Jones dies, and his will provides that, “I hereby give all my real property to my brother James, and I give all my personal property to my children, share and share alike.” Which one of the following statements is true?

a. The children will inherit Mr. Jones’s CDs and his interest in the farm. b. The children will inherit Mr. Jones’s CDs and none of his interest in the farm. c. The children will inherit no interest in either Mr. Jones’s CDs or the farm. d. Mr. Jones’s CDs are subject to probate, but Mr. Jones’s farm interest is not subject

to probate. e. Neither the CDs nor Mr. Jones’s interest in the farm are subject to probate.

Which of the following circumstances would definitely cause the date-of-death value of the gifted property to be included in the donor’s gross estate?

1. Donor retains a life estate in the gift property. 2. Donor retains the power to revoke or amend the gift. 3. Donor gives more than $10,000 to one donee in one year. 4. Donor dies within three years of the date of the gift.

a. (1), (2), and (3) only. b. (1) and (2) only. c. (2) and (4) only. d. (3) and (4) only. e. (1), (2), (3), and (4).

15.7

15.8

498 Tax and Estate Planning

While deciding whether to equalize the estates at the death of the first spouse or to defer estate taxes until the death of the surviving spouse, it is important to consider

1. the age and health of the surviving spouse. 2. whether the combined estates exceed two unified credit equivalents. 3. whether the surviving spouse wants to make gifts to the children. 4. whether the estates have substantial appreciation potential.

a. (1), (2), and (3) only. b. (3) only. c. (2) and (4) only. d. (1), (2), and (4) only. e. (1), (2), (3), and (4).

An individual received a bequest of 100 shares of XYZ stock from a relative who died on March 1 of this year. The relative bought the stock at a total cost of $5,500. The value of the 100 shares of XYZ stock was $5,750 on March 1. Its value rose to $6,250 on July 1 of this year, on which day the individual sold it for $6,250, incurring expenses for the sale of $250. The taxable gain on the sale would be a

a. $250 long-term capital gain. b. $250 short-term capital gain. c. $500 long-term capital gain. d. $500 short-term capital gain.

15.9

15.10

Estate Planning 499

Case Application ESTATE PLANNING Richard and Monica maintained their contrasting views when it came to estate planning. Even though their assets were well under the threshold for exposure to federal estate tax, he wanted to set up a bypass trust. Monica wanted the personal assets, now mostly in Richard’s name, placed in their joint names. I had the feeling that she would prefer to have as many of the assets in her name as possible as a control on Richard’s investment policy. She wanted their daughter, who might be divorced fairly soon, to receive the majority of their estate. Richard said that fact did not persuade him and that their son (who had an av- erage career potential) should not be penalized due to their daughter’s situation. Somehow it did not surprise me that they didn’t have wills currently.

Case Application Questions 1. Why should Richard and Monica have wills drawn up? 2. Discuss your opinion about equal versus unequal division of estate assets. 3. Do you believe they should establish bypass trusts? 4. What do you think of the advantage Monica would gain having all personal assets

including Richard’s placed in her name? Does she deserve this? 5. What other estate planning recommendations do you have? 6. Complete the estate planning section of the financial plan.

Altruism and Bequest Theory Do we always act in our own interests or are we capable of feeling and acting unselfishly so that others benefit?25 Two economists, Robert Barro and Gary Becker, popularized the term altruism for family relationships.26 Altruism can be defined as unselfish concern for others. As it pertains to estate planning, it means providing some of our money to others when we are alive or after we pass away instead of spending it all on ourselves. These economists and many others maintain that altruism, while not present in everyone and certainly not practiced at all times, is fairly common. An example cited for altruism is charitable giving. There are economists who argue that altruism doesn’t exist or is overemphasized. They say that many of the things people do that appear altruistic are really exchanges of ser- vices. For example, you may help your elderly widowed mother get along in return for an unwritten understanding that you will receive a sizable estate payment after her death. If altruistic intent is not present and the estate tax exemption is decreased, thereby reducing the potential financial reward, you may cut back on services to your mother. Alternatively,

25 Gary S. Becker, “Altruism in the Family and Selfishness in the Market Place,” Economica, New Series 48, no. 189 (February 1981): 1–15. 26 Gary S. Becker and Robert J. Barro, “A Reformulation of the Economic Theory of Fertility,” Quarterly Journal of Economics 103, no. 1 (February 1988): 1–25; and Robert J. Barro and Gary S. Becker, “Fertility Choice in a Model of Economic Growth,” Econometrica 57, no. 2 (March 1989): 481–501.

500 Tax and Estate Planning

your mother may try to maintain the same ultimate payment to you by paring living expenses. Knowing how people think and act about estate planning matters can help us improve our own financial and other personal activities as children, parents, grandparents, spouses, and advisors. The strict form of life cycle theory implies that people think only of their household with the goal of having no money left after the death of the last member-owner. Any money remaining is purely incidental, caused by the inability to determine when we will die. Of course, that would mean that estate planning is not important; it has no priority in people’s financial actions. Many people leave material bequests when they pass away. Bequests are gifts of assets intended to be transferred to others subsequent to the owner’s death. There are a number of theories about why households have assets remaining at the time the last member-owner dies. Identifying the appropriate motivating factor is important because it can influence the choice of an estate planning strategy. Some of the predominant approaches are given below.

ACCIDENTAL BEQUESTS Accidental bequests occur when assets are left to others as an incidental outcome of other planning. Most commonly, with this approach you are likely to have an estate at death because you cannot be sure how long you will live. You may want to provide for a bequest that has a reasonable possibility of occurring even though it isn’t the most likely estimate. For example, you may establish funding through age 95 when the average mortality age is 80 because you could live longer than average. You also may want to provide a sum in case of catastrophic illness. In either case, the resultant bequest is unintentional and thus is what is left over from normal life cycle planning. The capital needs analysis for retirement planning discussed in Chapter 17 would, therefore, not factor in any amount for bequests. Proponents of this ap- proach point to research showing relatively little bequest behavior beyond that for the af- fluent.27 For example, one study of bequest intent showed no difference in the degree to which people reduced their assets when retired between those who had children and those who did not.28

BEQUESTS AS COMPENSATION Bequests can be used as a reward to garner attention by children or other relatives and friends. For example, there may be an understanding that care given by a child when a par- ent is elderly will result in a large bequest to that child upon the parent’s death. This agree- ment may be explicitly stated or may just be understood. In this case, the bequest can be viewed as a kind of liability, even though generally not a legal one. The liability can be established as a minimum amount in real terms that would be paid out to the beneficiary at death. In this approach, the capital needs analysis is run with that minimum fixed payout incorporated as a deduction in amounts available for con- sumption over the remaining life span.

27 Franco Modigliani, “The Role of Intergenerational Transfers and Life Cycle Saving in the Accumulation of Wealth,” Journal of Economic Perspectives 2, no. 2 (Spring 1988): 15–40. 28 Michael D. Hurd, “Savings of the Elderly and Desired Bequests,” American Economic Review 77, no. 3 (June 1987): 298–312.

Estate Planning 501

Advocates of bequests as compensation point to the absence of both widespread annuitization and gifting as support for their position.29 Annuitization would leave nothing for heirs, and gifting could be interpreted as more of an altruistic measure as the amount gifted ceases to be a potential future reward. They also point out that people who have more money to reward service providers receive more attention from their children than do lower-income people. Critics say analysis of estates shows that the majority of people divide their estates equally among their children. Therefore, this businesslike strategy of implied contracts to favor children providing more attention to needs cannot be too widespread.

ALTRUISTIC BEQUESTS In financial terms, altruism is the sacrifice of your resources for the benefit of others. Bequests given without requiring offsetting services qualify because they reduce the amount you can spend over your life span. The altruistic bequest variable in a capital needs analysis could be handled in several different ways, depending on the wishes of the asset holder. One approach would, in effect, result in risk sharing. An intended sum would be pro- vided, assuming a normal life span and no abnormal medical expenses. The sum would be reduced to a minimum level or eliminated entirely if there were extended life cycles or major extraordinary expenses. If, on the other hand, life spans in retirement were short- ened, payouts would be greater than expected.30

Proponents of this approach can point to the large amount of assets left at death, which may be well beyond the sums set aside for longevity risk and reasonable catastrophic illness risk. Like people who believe in bequests as compensation, proponents of risk sharing interpret the absence of annuitization as interest in bequests. Critics ask: If altru- ism exists, why don’t more people leave money to heirs based on need instead of leaving them equal shares? Other researchers believe that altruism may exist but that it is not very common.31

OTHER APPROACHES Any of the reasons for bequests given above can generally be incorporated under a broad- ened form of the life cycle hypothesis and personal financial planning. Each approach can be integrated into capital needs analysis. There are other motivations that are not necessar- ily consistent with a life cycle framework. One would be a desire to accumulate money to provide utility to the holder for status or other reasons. Another is related to satiation.32

Here it is argued that people have enough money to spend additional amounts but choose not to because they have all they want, and additional spending will not provide any further pleasure.

29 B. Douglas Bernheim, Andrei Shleifer, and Lawrence H. Summers, “The Strategic Bequest Motive,” Journal of Political Economy 93, no. 6 (December 1985): 1045–76. 30 Laurence J. Kotlikoff and Avia Spivak, “The Family as an Incomplete Annuities Market,” Journal of Political Economy 89, no. 2 (April 1981): 372–91. 31 Mark O. Wilhelm, “Bequest Behavior and the Effect of Heirs’ Earnings: Testing the Altruistic Model of Bequests,” American Economic Review 86, no. 4 (September 1996): 874–92. 32 Laurence J. Kotlikoff, “Intergenerational Transfers and Savings,” Journal of Economic Perspectives 2, no. 2 (Spring 1988): 41–58.

502 Tax and Estate Planning

- -

GIFTING AND BEQUESTS

ABSENCE OF BEQUEST MOTIVE

- -

Practical Comment Handling Bequests Overall

Journal of Economic Theory

American Economic Review

Power of Appointment and QTIP Trusts There are two other types of trusts that provide estate tax benefits: power of appointment and QTIP.

Estate Planning 503

POWER OF APPOINTMENT Power of appointment trusts36 are set up either when the grantor is alive or at the grant- or’s death. They allow the recipient of this power, called the donee, to decide who is to receive property or in what share he or she will receive it. It may be either a special or a general power. The special power limits the donee’s decision to an established group of individuals; the general power allows the donee to choose anyone. The power of ap- pointment trust qualifies for a marital exemption if the spouse receives all the trust income at least annually and possesses a general power to select the ultimate benefi- ciary. The assets in a power of appointment trust will be included in the estate of the surviving spouse at death. As with the previous approach, money is left to the bypass trust up to the estate tax exemption amount in order to take advantage of the grantor’s unified credit, with the power of appointment trust taking the balance of the property. The power of appoint- ment trust can be used when the decedent wants further observation of the children or other heirs by the donee before a decision is made on the division of the property. The power of appointment is no longer required to qualify for the marital deduction for es- tate tax purposes.

QTIP The qualified terminal interest property (QTIP) trust requires that all trust income be given to the surviving spouse at least annually and that the trust assets will be included in the surviving spouse’s estate. However, unlike the power of appointment trust, the QTIP al- lows the first decedent to name the ultimate or remainder beneficiary of the assets in the trust after the death of the surviving spouse. A QTIP trust also can be used in conjunction with the bypass trust to take advantage of the unified credit. The assets placed into the QTIP trust must be income-producing. The QTIP’s principal attraction is the aforementioned ability for the decedent to control the disposition of the money; for example, when there is concern that the surviving spouse may remarry and not leave the money to their children or leave some of the money to his or her children from a prior marriage. Thus, Tim can bequeath assets to a QTIP trust for his second wife Wendy, who will receive lifetime assets, while Tim also pro- vides that his children from his first marriage will become the remainder beneficiaries after Wendy’s death.

36 Actually power of appointment is a clause in a trust or will rather than a separate trust in itself.

III

Summary of Characteristics of Types of Trusts For a summation of the characteristics of general and specific types of trusts, see Table 15.A3.1.

504 Tax and Estate Planning

TABLE 15.A3.1 Types of Trusts

Document Characteristic Who For Tax

Advantage Principal

Advantages Principal

Disadvantages

General Living Established when alive Anyone Yes, when

irrevocable Bypasses probate Expertise

Cost to set up and operate

Trustee in place in event of incapacity

Testamentary Takes effect by will after death

Anyone Possibly Similar to living trust but can have lower NPV cost and may not bypass probate1

Cost to operate may not bypass probate1

Revocable Grantor can reverse Anyone None Flexibility Cost to set up and operate

Irrevocable Grantor cannot alter Anyone Yes Tax advantage Cost to set up and operate

Specific Bypass Two beneficiaries:

income person and remainder person

Principally for married couples

Yes Use of decedent’s unified credit

Some loss of control for surviving spouse

Power of appointment2

Allows another person to make decision on division of assets

Anyone Possibly Qualifies for marital deduction Tax benefits if used with bypass trust

Possible loss of control by grantor

QTIP Allows grantor to retain control over who receives estate principal

Married couples

Possibly Qualifies for marital deduction

Assets placed in trust must be income- producing

Life insurance Set up to accommodate life insurance

Anyone Yes, when irrevocable

Can save estate taxes Can provide lower return than gifting

Charitable remainder

For charitable intent Anyone Yes Used when grantor is to receive income with remainder to third party

None

Charitable lead For charitable intent Anyone Yes Used when charity is to receive income with remainder to third party

None

Generation skipping

Monies left to someone at least two generations younger than grantor

Anyone Yes Saves one generation’s estate taxation

May not go to true intended beneficiary

Trust for minors Established for people not yet adults

Minor children

Yes Flexibility in payout Cost

1 Probate may either be an advantage or a disadvantage depending on the state a person resides in and other individual factors. 2 A clause in a trust or will; not a separate trust.

Part Six

Planning Essentials 16. Stocks, Bonds, and Mutual Funds

Planning essentials are basic topics that are helpful to know as preparation for the financial planning process. The one chapter appearing in this section, Stocks, Bonds, and Mutual Funds is useful for studying financial investments provided in Chapter 10. In Chapter 16 on stocks, bonds, and mutual funds, which follows we elaborate on material presented in conceptual form in the financial investments chapter. Each of these three subtopics is described and methods of evaluating them are presented. Other basic material is covered in a chapter on background topics in Part 8 available on the web. That chapter, Chapter B, covers economics, law, and organizational structures with its roots in law and taxation.

506

Chapter Sixteen

Stocks, Bonds, and Mutual Funds Chapter Goals

This chapter will enable you to:

I was surprised to find that Dan and Laura had not followed my advice completely. They had a sheepish look on their faces as they entered. The two confessed that when the market started to move up, they had changed my recommended asset allocation and placed more monies into the best-performing areas.

Real-Life Planning The advisor had two clients who managed their own monies and they could not have been more different. When thinking about them, he was reminded of the contrast in their person- alities. The first, a management consultant, was very bright, but he used his emotions rather than his intellect in making decisions. He could cite logical reasons at any time why he wanted to be in or out of the market. But the truth was that he was an impulsive momen- tum investor. Whenever stocks went up, he wanted to get in, and when they declined, he wanted to get out. One day he phoned in the morning to get into the market because of the last few weeks’ positive performance. When the market declined by 100 basis points, or around 1 percent, during the day, he changed his mind, which resulted in both purchases and sales in the same day. The advisor tried to counsel him to take a longer-term approach but met with only lim- ited success. Needless to say, his account substantially underperformed the market. The second investor was a fairly young woman. She had originally intended to become an actress and had begun the necessary training after attending undergraduate school. Then an unfortunate accident with a malfunctioning car left her critically injured. In fact, she was thought dead and had a near-death experience of her soul floating from her body. But thanks to some excellent medical care, she made a complete recovery.

Chapter Sixteen Stocks, Bonds, and Mutual Funds 507

The experience persuaded her to become a doctor so that she could help others. She chose as her specialty emergency room care. She said that when things were highly emo- tional in the emergency room, she became most relaxed in making life and death decisions. She attributed this ability to her having faced her own death. Her investments were made with the same cool detachment. She could see beyond the tem- porary emergency that panicked other people to the fundamental merits of an individual secu- rity or sector of the market. She enjoyed investing and spent considerable time doing it. Her performance was extremely good as she picked securities that were temporarily out of favor and over an extended period of time returned to their historical valuation and performance. The advisor asked himself how he could capture her logical unemotional take on alter- native investment choices and use it for other clients. He decided that for most people, given their personality and lack of devotion to the task, it was impossible. He took what he believed was the next best alternative. His approach was to stress upper and lower limits in weightings for mutual funds in different major asset sectors determined by their relative values and emphasize that individual selections within those sectors should be made based on their longer-term performances.1

When that selection process could not be made properly, either alone or with the help of a financial planner or other investment advisor, the advisor took a passive approach. He recommended index funds—a diversified mix of mutual funds intended to reduce overhead expenses and duplicate market performance. There were alternative styles of investing that other people used successfully, but the advisor felt comfortable with the two above. The details of these two as well as other methods of investing are discussed in this chapter.

OVERVIEW

Our discussion of financial investments in Chapter 10 focused primarily on general prin- ciples such as risk–return and ways of establishing an overall financial allocation. In this chapter, we get to the details of stocks, bonds, and mutual funds and summarize other types of managed accounts. We will stress critical factors and ways of measuring returns and attractiveness for each type of financial asset and will place somewhat greater empha- sis on mutual funds, which are often the desired implementation tool for individuals and financial planners. We look first at bonds, then stocks, followed by mutual funds and other managed accounts. An easy “one-stop” way of selecting mutual funds, using the material presented in Chapter 10 and this chapter, also is provided. Finally, Web Appendix A presents a de- tailed analysis of modern investment theory. In this chapter, our financial objective is to familiarize you with all the investment alter- natives and allow you to begin to make logical rather than emotional investment choices. Such an approach is a key to success in financial investing.

BONDS

Bonds can be considered loans. An investment in a corporate bond is either a loan to that company or the purchase of a loan from another investor who had made that loan. The same is true for investments in bonds issued by a city or by the federal government. As a lender (or a substitute lender), investors generally are entitled to receive periodic interest payments over the life of the bond. At the end of the predetermined loan term, the

1 Performance is viewed relative to other funds like it, as discussed in the chapter. The capability and investment style of the fund manager also are taken into account.

508 Part Six Planning Essentials

investors are scheduled to receive the face value of the bond. In between a bond’s issue and its redemption, bonds typically trade at higher or lower prices, set by supply and de- mand for bonds with certain characteristics. The many types of bonds can be broadly classified by two of those characteristics: ma- turity and quality. Maturity refers to the number of years until the amount borrowed is to be repaid. The longer the period until maturity, the greater the risk the bond has, and the greater the likelihood prices will fluctuate. That is because the longer the period, the greater the potential for a change in the ability of an issuer to repay its debt. Also, a broad- based change in interest rates will have a greater effect on long-term bonds. Both factors are included in the term maturity risk. Consider Example 16.1.

Example 16.1 Sean bought two bonds: the first had a 2-year maturity, the second a 20-year maturity. Both bonds had provided 5 percent yields when purchased. The very next day, an announcement that inflation was unexpectedly high drove market interest rates up to 6 percent. Sean had learned about the relationship between bonds and interest rates. He knew his bonds would decline in price because of the interest rate hike. Both of his bonds would decline by an amount that would offer 6 percent returns to new buyers. Sean knew that would happen be- cause his 5 percent contracted-for rate couldn’t compete with new 6 percent market rates unless the price of his bonds dropped to a level that allowed them to offer an identical 6 per- cent return in the marketplace. The price of the 2-year bond dropped 2 percent, from $1,000 to $980, while that of the 20-year bond declined 11.5 percent, from $1,000 to $885. Initially, Sean was surprised by the difference in market performance, but after thinking about the greater number of years a holder of the 20-year bond would receive the now-lower interest rate, it began to make sense. He calculated the yields to maturity now available to buyers, based on the new market prices for the bonds, and found that they were both 6 percent. Sean noted that when market interest rates rose, bond prices dropped, and when market interest rates declined bond prices increased. He would tell this to his friends, some of whom believed a rise in interest rates was good for bondholders. From then on, he always remem- bered that the longer the time until being repaid, the greater the interest-rate risk.

Bonds are generally given their classification and risk profile by maturity date, as seen in Table 16.1. Quality, the second classification of bonds, refers to the likelihood that the bond will fulfill its obligation to pay interest and repay the amount owed at maturity. There are bond rating agencies such as Standard & Poor’s and Moody’s that assign ratings indicating the relative quality of a bond. They range from AAA, the highest, to C, the lowest. BBB rep- resents the lowest possible “investment grade,” or high- to medium-quality rating for which the rating agency believes the bond will fulfill all its obligations. Anything below BBB is regarded as a high-yield bond or a junk bond with a chance of default (nonpayment), which typically results from the issuer’s bankruptcy. We can call this risk default risk. Naturally, the lower the rating, the greater the default risk. Of course, given our knowledge of risk-return principles, we would expect bonds with higher default risk to provide higher anticipated returns and they do.

TABLE 16.1 Bond Classification Category

Maturity Date (in years)

Risk for Given Change in Interest Rates

Money market 0–1 Extremely Low Short term 1–3 Low Intermediate term 3–10 Medium Long term 10–30 High

Chapter Sixteen Stocks, Bonds, and Mutual Funds 509

Bonds can be classified into the categories given in Table 16.2. When we want to calculate expected returns for a bond, we have to add one more factor to maturity and default risk: liquidity risk.

Liquidity Risk Liquidity is the ability to convert an asset into cash quickly and at a relatively low transac- tion cost. Liquidity risk is the possibility that you will not be able to find a buyer at the cur- rent market price for an asset. Assets vary in terms of liquidity. For example, a U.S. Treasury bond is more liquid than a municipal bond from a small city. Even if the small city were to have the same assurance of payment of interest and repayment of principal at maturity, U.S. Treasury bonds are traded daily in large quantity. If you were to purchase the small-city bond, you would have to spend costly time investigating it. You would worry that, in selling it, you might have to accept a lower price than you would if you bought a comparable U.S. government issue. The outcome is that the small-city bond will have to offer an inducement in the form of a higher yield to attract investors, just because of its higher liquidity risk.2

We can express the expected return for bonds as

Expected bond return = Risk-free rate + Risk premium where

Risk premium = Liquidity risk + Maturity risk + Default risk

Example 16.2 Anna noticed that a 10-year U.S. government bond was offering only a 5 percent yield while the newly issued bond of a small startup airline company, also due in 10 years, offered a 14 percent return. At the time, the anticipated inflation rate was 2.5 percent and U.S. Treasury bills were yielding 4 percent. She thought the airline’s return of 14 percent a year for 10 years looked attractive and decided to investigate further. Her examination indicated that the airline had a speculative outlook. After looking at bonds offered in the marketplace, she was able to separate the U.S. government and airline bonds into the following components at the time: After her investigation, she concluded that both bonds were fairly priced—that is, their required rates of return were consistent with the risks they represented.

TABLE 16.2 Characteristics of Bond Ratings

Quality Rating Risk of Default Expected Relative Yield

High AAA, AA Very low Low Medium A, BBB Low A little higher than high-quality bonds Low1 Below BBB Considerably higher, with

those rated C having a distinct possibility

Significantly higher to account for the possibility of bankruptcy

1 Called high-yield or junk bonds.

U.S. Government Airline

Pure rate of return1 1.5% 1.5% Inflation premium 2.5 2.5 Total risk-free rate 4.0% 4.0% Liquidity risk — 1.0% Maturity risk 1.0% 1.0 Default risk — 8.0 Total risk premium 1.0% 10.0% Expected bond yield 5.0% 14.0%

1 The risk-free rate minus the inflation rate. This is the real return after adjustment for inflation and other risks. In theory, the rate is supposed to be level at all times but as a practical matter it fluctuates.

2 There is another risk called reinvestment risk, the possibility that cash received through payments of interest and principal will not be reinvested at the original rate on the bond. The reinvestment rate can be more difficult to factor into the required interest rate for bonds.

510 Part Six Planning Essentials

Bond Characteristics Interest payments on bonds are called coupon payments. (Bonds historically were issued with coupons attached; bondholders periodically would “clip” the coupons from the bond and present them to receive the interest.) The amount provided is stated in the bond instru- ment. It is important to note that bond coupons are fixed contractual payments that are not affected by changes in market rates over time. Principal is the payment due at maturity. The amount due at maturity is called the par value, face value, or maturity value. The majority of bonds have a par value of $1,000; that is, one bond costs $1,000. However, the market price of a bond is quoted one decimal point lower. Therefore, a bond quoted at 100 has a market value of $1,000. Returns on bonds are called yields. There are a number of yields on bonds that are cal- culated. Three yields that will be discussed below are coupon yield, current yield, and yield to maturity. The coupon yield is the return that is calculated based on the annual coupon and the face value of the bond. By knowing the coupon yield, you can calculate how much you will receive in cash payments per year.

Coupon yield = Annual coupon

Face value of bond

The current yield is the annual coupon divided by the market value of the bond. The cur- rent yield provides you with the current return on a bond should you purchase it at that time.

Current yield = Annual coupon

Market value of bond

The yield to maturity indicates the return you would receive if you purchased the bond today and held it until it was repaid. The return can be separated into two parts: the coupon yield and the appreciation or depreciation in the price of the bond. The yield to maturity is the appropriate benchmark to use in calculating financial return on investment. It can be approximated by the following formula:

Yield to maturity = Annual coupon +

Face value − Market price Number of years to maturity

Face value + Market price 2

A more accurate calculation for yield to maturity would be where

PV = CF1

1 + y + CF211 + y22 + p + CFn11 + y2n

PV = Current price of the bond CFn = Cash flow in year n

n = Maturity date y = Yield to maturity

To find the yield to maturity, we solve the above equation for y.

Example 16.3 Elizabeth was offered a bond selling at $700 with annual coupon payments of $60. Calculate her coupon yield, current yield, and yield to maturity under the approximate and correct meth- ods. Assume the bond is due in eight years and has a par value of $1,000.

Coupon yield = 60 1,000

= 6.0%

Chapter Sixteen Stocks, Bonds, and Mutual Funds 511

Current yield = 60 700

= 8.6%

Approximate yield to maturity = 60 + 1,000 − 700

8 1,000 + 700

2 = 11.5%

Press I/Y = 12.0%

When a bond sells for more than its par value, generally $1,000, it is said to sell at a premium and is known as a premium bond. When the coupon yield is lower than the current market yield, the bond will sell at less than $1,000 and be called a discount bond. A discount bond will have a greater fluctuation in price than a premium bond when market interest rates change.

Example 16.4 Suppose that the town of Plainview issues a 20-year municipal bond with a 5 percent interest rate. John buys $10,000 of those bonds. Every 6 months, John will receive $250 in interest, or $500 a year, as his 5 percent coupon yield. (For simplicity purposes we will assume one annual payment of $500 per year) Three years go by and John wants to sell those bonds. By then, interest rates have dropped so that comparable new issues yield only 4 percent, or $400 a year on a $10,000 investment. Buyers will prize the higher 5 percent yield on John’s bond, so they will pay a premium. Calculate the amount that Rachel, a new buyer, will pay on each of these bonds.

PMT = $1,000 × 5% = 50

PV = a17 t=1 a 50

1 + .04tb + 10001 + .0417 = 1,121.66

Calculator Solution— Yield to Maturity

Inputs: 8 60–700

Solution: 12

N I/Y PV PMT FV

1,000

Calculator Solution

Inputs: 17 4 50

Solution: 1,121.66

N I PV PMT FV

1000

Rachel will pay $1,121.66, which will yield the current market rate of 4 percent until the scheduled maturity of those bonds. The $50 Rachel receives each year on each bond will com- pensate her for paying more than par. Now suppose that 10 years pass and Rachel wants to sell the bonds. By now, interest rates have soared so that new investors are receiving 6 percent yields on comparable bonds. Hal, the new buyer, is not impressed by $500 in annual interest if he can get $600 a year from new 6 percent bonds. Thus, Hal will buy Rachel’s bonds at a discount from par value. Calculate the amount that Hal will pay for each bond

PV = a7 t=1 a 50

1 + .06tb + 10001 + .067 = 944.18

512 Part Six Planning Essentials

Hal will bid only $944.18 per bond, at which point the $50 in yearly cash flow on each bond will generate a yield to maturity equal to the market rate of 6 percent.

Calculating the Value of a Bond A bond’s current price is equal to the present value of its future cash flows discounted to the present by the market interest rate. The market interest rate is equal to the investor’s required rate of return for the bond reflecting its risk characteristics. The value of a bond can be separated into its two components: the present value of its interest payments and the present value of the principal at maturity. We can express it as

Value of bond = Present value of interest payments + Present value of principal payment The mathematical formula for a bond price is

PV = an t=1

PMTt11 + i2 t + FV11 + i2 n where

PMT = Annual coupon payment i = Market interest rate

FV = Face value of the bond n = Numbers of years to maturity

Market interest rates fluctuate over time depending on such factors as changes in the expected rate of inflation, economic activity, Federal Reserve actions, prospects for the company issuing the bonds, and cyclical investor interest in bonds. This change in market rates will alter the market price of the bond.

Example 16.5 Yesterday Matthew bought a bond due in 12 years at $1,000 yielding 6 percent. Demonstrate that the combined present values of the principal and interest payments equal the market value of $1,000. Then, assuming rates rose to 7 percent today, calculate the new present value of the bond and compute the loss in bond value due to the rise in rates.

Annual Interest Payments

PMT = $1,000 × 6% = $60

PV = a12 t=1

6011 + .062t + 1,00011 + .06212 = $1,000 Present Value of Interest Payments

Inputs: 12 60

Solution: 503.03

N I/Y PV PMT FV

Press PV = $503.03

Calculator Solution

Calculator Solution—Rise in Rate to 6%

Inputs: 7 6 50

Solution: 944.18

N I PV PMT FV

1000

Chapter Sixteen Stocks, Bonds, and Mutual Funds 513

Present Value of Principal Payment

Inputs: 12 0

Solution: 496.97

N I/Y PV PMT FV

10006

Press PV = $496.97

Present Value of Interest and Principal Payments

Value of bond = Present value of interest payments + Present value of principal payment = $503.03 + $496.97 = $1,000

Inputs: 12 60

Solution: 920.57

N I/Y PV PMT FV

10007

Press PV = $920.57

Percentage change in price = New price

Former price − 1

= 920.57 1,000

− 1

= –7.9% The loss is 7.9 percent.

Types of Fixed Obligations The types of bonds and other fixed obligations3 are given below.

Cash Equivalents Cash equivalents include money market accounts, bank savings accounts, and U.S. Treasury bills. They can be liquidated at little or no charge because they are considered low-risk securities.

Certificates of Deposit Certificates of deposit (CDs) are a form of bank debt with maturity dates often clustered from three months to five years. The repayment of interest and principal is guaranteed by a federal agency for amounts up to $250,000 per depositor per bank. Thus, Sam could have $250,000 in Northern Bank, $250,000 in Southern Bank, and $250,000 in Western Bank; all $750,000 would be federally insured in case of bank failure.

U.S. Treasury Securities U.S. Treasury securities are high-quality securities that usually have been rated AAA. They are separated by maturity date: Treasury bills (0–1 year), Treasury notes (2–10 years), and Treasury bonds (10 years or more). Many Treasury securities are not

Calculator Solution—Rise in Rate to 7%

3 Fixed obligations is a broader and more accurate title than bonds. Some financial instruments that we consider bonds are not—for example, a mortgage or a certificate of deposit. However, they are often categorized as bonds and, for the sake of simplicity, we will do so as well.

514 Part Six Planning Essentials

callable,4 which guarantees the buyer that the rate contracted for will be paid until ma- turity. U.S. government bond interest is subject to federal but not state income taxes.

Corporate Bonds Corporate bonds are issued by businesses. Their returns vary with the quality of the bonds as reflected by the issuer’s bond rating. Standard & Poor’s ratings of AAA to BBB are considered to be of investment quality. Most corporate bonds are callable, which means that the bond and its interest rate may be retired if interest rates rise sharply.5

High-Yield Bonds High-yield bonds, often called junk bonds, are bonds rated below BBB, usually BB to C. These bonds are more speculative, and, in the past, a significant portion of them have gone bankrupt before maturity. The yields, which are materially higher than those for invest- ment-quality bonds, usually incorporate an assumed potential for bankruptcy.

Inflation-Indexed Bonds Inflation-indexed bonds are securities most often issued in the United States by the U.S. government. The interest rate paid for these bonds varies with the inflation rate. If inflation increases, investors will receive higher yields.

Series EE Bonds Series EE bonds are U.S. government bonds that pay both interest and principal when the bonds are redeemed. As we discussed in Chapter 14, new EE bonds now earn a fixed rate of return. The maturity date varies with the rate of interest, but the bonds can be held well beyond that date. The buyer has the option of deferring taxes on interest earned until the date the bonds are cashed in.

- - -

Practical Comment

4 This means that the issuer of the bonds will not be able to retire them before the indicated date at which they are due to be repaid. Generally, an issuer will not do so unless it will be rewarding to call a bond in when the current market interest rate is below the bond’s contracted-for rate. By retiring the old bond and bringing out a new issue, the company can reduce its interest cost. 5 Many bonds have a stated period from time of issuance in which they cannot be called.

Chapter Sixteen Stocks, Bonds, and Mutual Funds 515

Zero Coupon Bonds Like Series EE bonds, zero coupons are bonds whose interest is paid at maturity. Because no cash payments are made until maturity, the bonds are more volatile than normal bonds, which pay interest semiannually. Despite the fact that no cash is received, the bonds are subject to income taxes on a current basis, which can make them most suitable for tax- deferred accounts.

Mortgage Bonds Also known as mortgage-backed securities, these bonds are fixed-income securities that are backed by pooled mortgages on real estate. Technically speaking, they are synthetic securities; however, in common parlance, they are considered bonds. The best known are securities guaranteed by the Government National Mortgage Association (GNMA), an in- stitution backed by the federal government. Mortgages taken out by Americans to pur- chase their homes are pooled by mortgage originators such as banks and sold in the marketplace. Investors, including individuals and mutual funds, receive on a current basis not only interest but principal repayments as well. A portion of the mortgages in the pool are repaid as people move or refinance their mortgage. Some mortgage-backed securities from issuers other than GNMA lost value when the housing market weakened in 2007 and subsequent years, thus playing a role in the 2008–09 financial crisis.

Municipal Bonds Municipal bonds are tax-advantaged. They are issued by state and local municipalities and others with nonprofit or other public benefits in mind. The interest generally is not subject to federal taxes and is free of state taxes if you purchase bonds issued in the state you re- side in. Reflecting their tax advantage, the bonds’ yield is usually lower than that of tax- able bonds, with yields influenced by the ratings of the state or local issuer.

International Bonds International bonds are bonds of foreign governments and private organizations. Their rates will depend on local country economic conditions and their credit ratings. The inter- national bonds have an additional amount of volatility due to currency fluctuations but also can provide diversification benefits because the amount paid is partially independent of U.S. market factors.

PREFERRED STOCKS

While preferred stocks sound like they are like common stocks, in many ways they resem- ble bonds. For example, holders of preferred stocks are not owners of a business but pro- vide common stockholders with a source of capital in return for a fixed annual payment. Preferred stocks have a lower priority on assets than bonds in the event of bankruptcy and lack the assurance of a bond’s contracted-for return of principal. Consequently, pre- ferred shares are generally considered more risky and typically have higher yields than bonds, and their prices can be more sensitive to a change in market interest rates. Preferred stocks can be valued using the following formula:

P = D0 ke

Where:

P = Price of preferred shares D0 = Current dividend ke = Required rate of return

516 Part Six Planning Essentials

The required rate of return is based on current market rates of interest for preferred shares having the same risk this company possesses.

Example 16.6 Alan wanted to know the price sensitivity of preferred shares to a 2 percentage-point increase in market interest rates. At the time, the required rate of return on preferred shares of a com- pany he looked at was 7 percent and the dividend was $3.00. What did the share sell at origi- nally, and how much would it decline if rates were to rise to 9 percent?

Price of the Preferred Stock before Increase in Market Interest Rates

P = 3.00 0.07

= $42.86 Price of the Preferred Stock after Increase in Market Interest Rates

P = 3.00 0.09

= $33.33

Percentage change in price = 33.33 42.86

−1 = −22.2%

STOCKS

Most stock trading involves common stocks. The key to common stocks, as it is for most investments, is valuation. Under efficient market theory, the price of a stock at any time fairly presents its true value. Therefore, it is not possible to find undervalued stocks and to outperform the market. Anyone who has done so has merely been lucky and is as likely to underperform as to outperform in the future. Efficient market theory suggests that you should confine yourself to reducing risk by diversifying and save your money and effort rather than become involved in fruitless attempts to receive above-average results. Two other approaches to be discussed here are fundamental and technical analysis. Proponents of each believe it is possible to outperform the market. Fundamental analysis is the principal alternative because it, too, is based on logical thinking.

Fundamental Analysis Fundamental analysis involves looking at economic, industry, and company data to help determine the fair value for a company’s stock. For example, a fundamental analyst would ask such questions as

1. What is the outlook for the economy, and how does it affect the company being looked at? 2. What stage of development is the industry in, and will it grow at a faster or slower rate

than the overall economy? 3. Is the company growing faster or slower than the industry and how does its return on

investment compare with that of other companies in the industry?

Fundamental analysis may involve looking at annual reports, testing the products of- fered, calculating ratios, and using overall valuation models.

Technical Analysis In contrast to fundamental analysis, technical analysis focuses exclusively on price and vol- ume. In effect, it says that everything you need to know is in the stock’s past price action and the number of shares traded. There are many approaches to the interpretation of price action.

Chapter Sixteen Stocks, Bonds, and Mutual Funds 517

One popular one is relative strength, sometimes called momentum investing. With this ap- proach, stocks that have had large price movements relative to the market are purchased.6 To the extent that it works, it may be due to people’s behavior patterns in purchasing stocks that have performed well. Technical analysis contrasts with fundamental analysis, which says that the higher a stock rises without new positive developments, the less attractive it is. Of course, efficient market analysis, which maintains that the fair price for a security is the current one, would disagree with both technical and fundamental analysis. Example 16.7 illustrates the differences among the three alternatives.

Example 16.7 Marie, a security analyst for a Wall Street brokerage firm, researched the retail company L Mart. A fundamental analyst, she believed that the stock was undervalued at its current price of $10 per share. She thought the stock had a fundamental worth of $16 and recommended it to her clients. Here is her report as well as the reactions of technical analysts and efficient market proponents as the stock rose.

Price Fundamental Analysis Technical Analysis Efficient Market Hypothesis

$10 Buy—Stock is undervalued. Don’t buy—Stock has no momentum. Stock is fairly priced. $12 Buy—Stock is still undervalued. Buy—Stock has relative strength. Stock is fairly priced. $16 Hold—Stock is fairly priced. Buy—Stock has relative strength. Stock is fairly priced. $20 Sell—Stock is overpriced. Buy—Stock has relative strength. Stock is fairly priced.

Fundamental analysis forms the basis for the valuation models discussed in the next sections.

Valuation Methods There are many methods of valuing securities. These include dividend models, earnings models, and other models that use the current market price in relation to individual factors in the company’s financial statements such as cash flows. We will discuss two methods: the dividend discount model and an earnings model.

Dividend Discount Model The dividend discount model assumes that a stock is equal to the sum of all its future dividends discounted to the present. It is given by the formula

P0 = D1

ke − g where

P0 = Current value of the security D1 = Annual dividend payable next year g = Projected growth rate in dividends ke = Company’s required rate of return on its equity

Thus,

D0 = Current annual dividend The company’s required rate of return is the return that an investor would require, given the company’s growth prospects and risk profile. We can solve for it using a variety of

6 Charles M. C. Lee and Bhaskaran Swaminathan, “Price Momentum and Trading Volume,” Journal of Finance 55, no. 5 (October 2000): 2017–69; and Tobias J. Moskowitz, Yao Hua Ooi, and Lasse Heje Pedersen, “Time Series Momentum,” Journal of Financial Economics 104 (2012): 228–50, http: //openarchive.cbs.dk/bitstream/handle/10398/8862/time_series_momentum_lasse_heje.pdf?sequence=1

518 Part Six Planning Essentials

methods. One is to estimate the risk premium using another company in the marketplace that is like it and add the risk-free rate to it. Another method is to use the formula above but transposing its terms. Note that in this form, the g represents the market’s expectation of the growth rate as reflected in its current price.

ke = D1 P0

+ g

Example 16.8 John thought the Hickary Food Manufacturing Company might be undervalued and decided to use the dividend discount model to find out if that was so. The company paid a $2.00 divi- dend, and he believed the dividends would grow 5 percent a year. Hickary was then selling at $20 per share, and companies with its return-risk profile had a required rate of return of 12 percent. Should he purchase the stock?

P0 = D1

ke − g =

2.00 × 11 + 0.052 0.12 − 0.05

= 2.10 0.07

= $30.00

The projected price of $30.00 is well above the current market price of $20.00. Consequently, John should purchase the shares.

Price-Earnings (P/E) Multiple The price-earnings (P/E) multiple method is based on earnings. It is literally the num- ber of years of current earnings it takes for you to “pay off ” (reach) the cost of purchasing the shares at the current price. If ABC Corp. earns $2 per share and trades at $20, its P/E ratio is 20/2 = 10; XYZ Corp. with $2 per share of earnings and a $30 trading price has a P/E ratio of 30/2 = 15. The P/E ratio is given by the following formula:

P/E multiple = P E

where

P = Prices E = Earnings

Generally, for stocks, the above figures are expressed on a per-share basis. The price expressed is usually the current price per share. Most commonly, the earnings per share (EPS) figure can be either the

1. Latest 12-month actual EPS. 2. Projected EPS for the current year. 3. Projected EPS for a future year.

This future-year figure, called the normalized P/E, is often used when the current EPS is not representative either because the company is growing quickly or because profitability is depressed and a return to a more normal earnings figure is anticipated. When earnings are not subject to unusual or cyclical factors, the higher the P/E ratio, the more highly regarded the company. Therefore, a fast-growing technology company would get a higher P/E than a slow-growing steel company. The P/E multiple for the typical large company has fluctuated widely over the past 50 years but has averaged 15 to 20 times

Solution

Chapter Sixteen Stocks, Bonds, and Mutual Funds 519

earnings, as you see in Table 16.3, which tracks the P/E ratio of the S&P 500 Index, a popular benchmark for large-company stocks.

Example 16.9 Lucinda was interested in becoming the owner of a local drugstore that was for sale. The net profit for the store was $200,000 per year and was expected to remain at that level for the foreseeable future. She agreed to buy it for $800,000 thinking that she would recover her in- vestment back fairly quickly and afterward would continue to receive $200,000 of profits per year. Calculate her P/E multiple to purchase the business.

P/E multiple = 800,000 200,000

= 4

Example 16.10 Frank thought that United Motors, a major truck manufacturer, might be an interesting in- vestment. At the time, the country was in recession, the company’s earnings were off sharply, and the share price had dropped from $50 to $30. The last 12-month EPS was $0.50, and estimated current earnings per share for the year were $2.00. Frank figured that in two years, the company could return to its previous peak earnings per share of $5.00. The mar- ket’s P/E multiple was 18 times for the latest 12-month earnings, and 17 times the expected earnings for the year. Calculate the three P/E multiples and indicate which one is most appropriate to use.

Latest 12 Months

P/E = 30/0.50 = 60

Solution

Year P/E Ratio* Year P/E Ratio*

1965 17.5 1990 15.3 1966 14.8 1991 26.4 1967 17.7 1992 24.5 1968 18.1 1993 22.2 1969 15.1 1994 15.5 1970 16.7 1995 17.9 1971 18.3 1996 19.0 1972 19.1 1997 22.3 1973 12.3 1998 28.3 1974 7.3 1999 29.3 1975 11.7 2000 24.1 1976 11.0 2001 26.8 1977 8.8 2002 19.1 1978 8.3 2003 20.5 1979 7.4 2004 18.5 1980 9.1 2005 16.9 1981 8.1 2006 16.6 1982 10.2 2007 17.4 1983 12.4 2008 16.5 1984 9.9 2009 19.1 1985 13.5 2010 15.4 1986 16.3 2011 13.4 1987 15.6 2012 14.4 1988 12.2 2013 17.5 1989 14.7 2014 18.3

* This P/E ratio uses the closing price at year-end and the trailing 12 month EPS. The trailing 12 month EPS is a diluted EPS from continuing operations and excludes the effects of all one-time and extraordinary gains and losses.

TABLE 16.3 Historic P/E Multiples for the S&P 500

Source: Bloomberg Terminal

520 Part Six Planning Essentials

Expected Earnings for the Current Year

P/E = 30/$2.00 = 15

Normalized Earnings in Two Years

P/E = 30/$5.00 = 6

The normalized P/E appears most appropriate. As the other P/Es are based on depressed earn- ings, they make the shares appear expensively priced, while the projected normalized figure of six times earnings indicates the shares are very reasonably valued compared to the market’s P/E and may be attractive.

The dividend discount approach to valuation is theoretically purer, and changes in divi- dends tend to be more reliable than those for earnings. The P/E approach is simple to employ and is used more often by financial planning and investment practitioners as well as by the public.7

MUTUAL FUNDS

Mutual funds typically hold dozens or even hundreds of securities, mainly stocks and bonds. They are often the choice of people with little time or inclination to manage individual mon- ies themselves. Given the public’s potential for inefficient selections and frequent unproduc- tive changes in holdings, many financial planners would like to see even greater use of mutual funds. The general mutual funds are typically extensions of the size and styles for stocks and maturities and qualities for bonds already discussed in this chapter and in Chapter 10. Aside from these general funds, there are special-purpose stock funds, those with spe- cific mandates. The categories below offer specialized funds that concentrate in publicly traded securities.

Type Examples

Sector funds Utility, technology, energy Industry funds Drug and REIT Commodity Gold, precious metals, oil and gas Regional Midwestern United States International Pacific Rim, European Balanced Blend of stock and bond “Hedge” Mergers and acquisition, market neutral Other High dividend yield, asset allocation

Bond Funds Bond funds have their own categorizations. One criterion is maturity; the other is degree of risk. Maturity can be divided into short, intermediate, and long term while risk can be separated by gradations of quality: high, medium, low. A fund holding short-term govern- ment bonds, therefore, would be considered much less risky than a fund holding low-rated

7 The price-earnings to growth ratio (PEG) relates the P/E multiple to the growth rate. It is given in the

following formula: PEG Ratio = P/E Ratio Annual EPS Growth

. Under this approach, the lower the ratio, the more

attractive the company is because you are paying a lesser amount for future earnings progress.

Chapter Sixteen Stocks, Bonds, and Mutual Funds 521

(high-yield) corporate bonds with an average maturity longer than 20 years. Aside from general categories, more specialized funds include the following:

Type of Bond Fund Explanation

Government securities U.S. government bond funds invest in U.S. government bonds and also in mortgage-backed securities handled by a U.S. government agency called GNMA. The latter are often called GNMA funds.

Corporate Generally searches for higher-than-government yields in investment-quality bonds.

High yield Below investment quality, more risky. Generally invest in high-yield or so-called junk bonds.

Municipal Bonds issued by local municipalities, regulatory authorities, and others that are tax-favored.

International Investment-quality government and other bonds from abroad. Emerging market More speculative bonds from more speculative countries. Floating rate Adjusts to market rates, often through purchase of adjustable-rate

mortgages or corporate debt. Inflation indexed Often U.S. government bonds whose rates and principal values vary with

inflation. Other Zero-coupon bond funds, convertible securities funds, multisector boned

funds, etc.

Open-End versus Closed-End Funds Mutual funds can be further separated into open-end and closed-end funds.

Open-End Mutual Funds An open-end mutual fund is generally open to new deposits by existing or new inves- tors,8 and redemptions by current holders. The price established for the purchase or sale transaction is net asset value (NAV) per share, less commissions or redemption costs where applicable. The NAV per share is obtained by adding up the market values of all of the stocks in the portfolio and dividing by the total number of fund investor shares out- standing. The NAV is calculated at the end of each day for purposes of determining the price of purchases and sales of shares for that day. The transactions are effected through the management company operating the mutual fund, although a brokerage firm may be an intermediary.

8 Unless it is closed temporarily or, less frequently, permanently, often due to larger inflows than the fund wishes to manage.

Example 16.11 Assume a new mutual fund held only three stocks. It had 500 shares of General Motors selling at $50, 1,000 shares of IBM selling at $100, and 800 shares of Microsoft offered at $60. Further assume that there were just four shareholders, each owning 10,000 shares. What is the mutual fund’s NAV per share?

Amount Explanation

General Motors $25,000 500 × $50 IBM 100,000 1,000 × 100 Microsoft 48,000 800 × $60 Total portfolio value $173,000 Total shares outstanding 40,000 10,000 × 4 NAV $4.33 173,000 ÷ 40,000

522 Part Six Planning Essentials

Closed-End Mutual Funds The management company for a closed-end mutual fund does not engage in any regular purchase or sales transactions after the initial offering. Instead, the shares are typically traded through a stock exchange, often the New York Stock Exchange. Purchases or sales prices are not necessarily made at NAV but are established by supply and demand for the fund. Therefore, the shares may be offered on the exchange at a premium—a price higher than NAV when the fund has great appeal to investors—or at a discount, a price below NAV when it doesn’t.

Load versus No-Load Funds Mutual funds also can be segregated into load and no-load funds. A load fund is one that provides a sales commission to the individual or brokerage firm that markets the fund with the new fund holder paying the charge.10 A no-load fund is one that does not offer sales commissions to the marketers of the funds. Load funds are offered by full-service broker- age funds and financial planners who are compensated by commissions. In effect, the com- missions are a charge for the advice and convenience of having the transaction done for investors. No-load funds are offered directly by fund management companies and by discount brokerage firms representing them. Loads on funds can be divided into front-end and back-end loads. A front-end load is one that is charged when the shares are initially purchased. It is done by adding a commission to the trans- actions, often 4 percent for a bond fund and 5 percent for an equity fund. For example, a new investor in an equity fund with a $10.00 NAV that has a load attached might be charged $10.50. A back-end loaded fund places the entire investor deposit in a fund and then charges an annual sales commission. Often that amount is 1 percent per year for stock funds and 0.75 percent a year for bond funds. The ongoing sales charge may go on for a fixed period or forever.11 Type B funds may have a charge for redemptions prior to a stated number of years, often six to eight. The amount of the redemption charge generally declines as the number of years the fund is held increases. There is no charge if a transfer in assets is made within the same management company, called a fund family. Sometimes the sales charges are covered under marketing fees for the funds, which are called 12b-1 fees.12 Some mutual

10 A few management companies also charge a load that they retain. 11 Forever for type C shares and for a fixed period for type B shares. 12 No-load funds also may have 12b-1 fees; these tend to be more modest. They are generally 0.25 percent or under of the fund’s average annual net assets. The SEC allows certain funds that provide commissions to brokers and financial planners that have no redemption charges but have higher 12b-1 fees, many known as type C funds, to be called no-load.

Journal of Finance and Martin Cherkes, Jacob Sagi, and Richard Stanton,

The Review of Financial Studies

Practical Comment Closed-End Fund Discount

Chapter Sixteen Stocks, Bonds, and Mutual Funds 523

funds offer multiple share classes for different types of investors for example institutional versus retail ones or for alternative types of loads as shown in Table 16.4. A no-load fund is one that charges no sales commission to buy the fund. The investor generally executes transactions directly through the management company. As mentioned, no-load funds are often also available through discount brokerage firms. If purchased through a discount brokerage firm, the individual will be charged a transaction cost or the mutual fund will absorb the transaction cost and typically incorporate it in the 12b-1 fee passed along to all the shareholders. These transaction charges are generally less than 1 percent when bought in amounts over $5,000. Because the ongoing fee is often spread over all fund assets, not just those assets transacted by discount brokers, an overall charge can amount to less than 0.20 percent per year for no-load funds and is generally under 1 percent for load funds. A summary of the relevant characteristics of various load and no-load funds is given in Table 16.4.

Mutual Fund Performance The majority of all actively managed mutual funds underperform the benchmark averages for their asset class. This record, which supports CAPM and the efficient market theorists, has led to the growth in popularity of index funds that seek to match the benchmark index. Possible reasons for this underperformance are

1. Significant expenses to support analysts, portfolio managers, and other overhead costs as well as trading costs to shift investment holdings. These expenses, including trading costs, often reduce portfolio returns by 1 to 2 percentage points per year.

2. Mutual funds frequently keep 5 percent or more in cash for such reasons as meeting unusually large redemptions. That money is invested at rates substantially lower than long-term equity returns. The fact that cash positions also reduce portfolio risk is often overlooked. Therefore, risk-adjusted performance can be a better comparison of indi- vidual fund versus index fund results than one based solely on returns.

3. The relative performance between categories—for example, large versus small capital- ization funds—may differ substantially over extended periods of time. Many managers in one category may have holdings in another. For example, large capitalization fund managers may have holdings in mid and small capitalization funds. When mid and small capitalizations underperform, as they did, for example, for a large part of the 1990s, large capitalization managers underperform their indexes.

4. Fund overhead expenses, including direct management fees, can provide benefits other than performance. These include the cost in time saved in selecting and monitoring indi- vidual stocks and in recordkeeping as well as in assuming a task that many lack interest in or are unable to perform effectively. Consequently, the amount of underperformance may be reduced by the value of these other services.

Type Load Front-End Charge Annual Sales Charge Redemption Charge 12b1 fee

A Yes 4–6 percent No No Possibly 0.25 percent

B No Yes 0.75–1.0 percent Yes Generally 1.0 percent

C No Yes 0.75–1.0 percent No1 Generally 1.0 percent

No-load No No Sometimes2 Possibly 0.25 percent or less

1 There is a 1 percent charge if the shares are sold within the first year. 2 The redemption charge when imposed varies in time frame and amount. A common range for inclusion of the charge is a time frame 5 to 365 days and a fee 1 to 2 percent.

TABLE 16.4 Characteristics of Load and No-Load Funds

524 Part Six Planning Essentials

Studies of whether individual funds are able to consistently outperform their peers or the market overall on a risk-adjusted basis have been mixed, with some indicating there is some evidence and others not.13 To the extent that running larger sums of money reduces performance, having a favorable record that attracts many new investors may inhibit con- tinuation of those results.

Taxation Investment companies such as mutual funds are not taxed as an entity provided they pay out all dividends and capital gains income to investors yearly. Mutual fund stock dividends and long-term capital gains distributions generally are subject to favorable tax rates. Capital gains taxes are paid by shareholders on net gains on fund sales of securities in their portfolio for the year based on fund costs to purchase those securities. Therefore, capital gains taxes may be paid yearly even though the shareholder has not sold any fund shares. Taxes are due on fund gains regardless of whether you reinvested distributions even if you personally had a loss in the shares you owned

Example 16.12 Hedda purchased shares in a volatile emerging-markets fund on December 8 at $15.00 per share. The shares dropped sharply in the next two weeks and by December 22 were down to $12.00 per share. The fund made considerable changes in its portfolio during the year, selling at a large profit shares that it had purchased three years ago. At year-end, the fund declared a capital gains dividend of $2.00 per share. Hedda has to pay tax on $2.00 per share in capital gains taxes for the year. This is true despite the fact that she had an unrealized loss of $3.00 ($12 current price – $15 cost) and that the taxable gains in the portfolio occurred in the months before she owned the fund.

OTHER INVESTMENT MANAGEMENT STRUCTURES

There are many investment management structures aside from mutual funds that are rele- vant to households. Among them are separately managed accounts, exchange-traded funds, unit investment trusts, variable annuities, and pension plans.

The often-yearly tax on mutual fund distributions is a significant disadvantage when compared with ownership of individual securities in a buy-and- hold strategy. However if you assume the individ- ual securities will eventually be sold, it is not an extra tax but an earlier payment. Whether it is best for the shareholder depends on relative investment performance of a buy-and-hold versus a

more active strategy and the extent to which the portfolio manager takes into account planning to minimize taxes in the portfolio changes. A growing number of mutual fund managers try to offset gains on shares sold because they no longer appear attractive by liquidating securities that they have losses in, thereby reducing the shareholders’ tax burden for the year.

Practical Comment Mutual Fund Taxation

13 See, for example, Russ Wermers, “Mutual Fund Performance: An Empirical Decomposition into Stock- Picking Talent, Style, Transaction Costs, and Expenses,” Journal of Finance 55, no. 4 (August 2000): 1655–95; and Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal, July/August 2013, Vol. 69, No. 4, http://cfainstitute.org/learning/products/publications/faj/Pages/faj.v69. n4.7.aspx?WPID=AlsoViewedProducts

Chapter Sixteen Stocks, Bonds, and Mutual Funds 525

Separately Managed Accounts Separately managed accounts, also called separate accounts, are segregated assets that are managed personally for each individual. They are managed much like mutual funds. However, while a mutual fund pools all investor funds in one account and each investor owns shares of that fund, in separate accounts investors own stocks and bonds that are placed in their name in a segregated account. In some instances, managers of mutual funds provide separate account management to other investors as well. Separate accounts have been growing rapidly in recent years. Suppose that Russ invests $1 million with a financial planner who determines that 40 percent of this portfolio ($400,000) should be invested in large-company domestic stocks. The planner might put this $400,000 into one or more appropriate mutual funds. Alternatively, the advisor might place this $400,000 in a separate account with a money manager who focuses on such stocks. This separately managed account may be tailored to the risk tolerance, time horizon, and other features that Russ has specified. One of the advantages of separate accounts is improved tax management. You may have more flexibility as to when to realize capital gains, and you don’t have the problem of paying capital gains taxes on fund sales made prior to your date of entry, as you do with mutual funds.14 Another advantage is your ability to exclude certain assets. Reasons for exclusion can range from too close a correlation with other household assets to your own negative opinion of certain securities. Brokerage firms offering a client a portfolio of sepa- rate accounts often include transaction costs to buy and sell securities and all management fees in one charge, called a wrap account, for a price that is often 1 to 3 percent of the ac- count size annually, depending on the amount of assets managed for the investor. Disadvantages include more difficulty in diversifying properly as account minimums often range from $100,000 to $500,000 and can occupy a large percentage of total house- hold assets. In addition, there are problems in switching managers quickly and without objections, as you can with mutual funds. The cost of a separate account ranges widely and can be considerably higher or moderately lower than that of an individual mutual fund. Larger-sized separate accounts may provide greater service to clients, while service for minimum-sized accounts run by a computer can be lower than that for a mutual fund and subject to similar yearly tax treatment.

Exchange-Traded Funds Exchange-traded funds (ETFs) are portfolios of stocks and bonds that are traded on the major exchanges. They typically differ little from a mutual fund that is constructed as an index fund for the overall market or specific industries or sectors. For example, the largest ETF is SPDR S&P 500, which trades on the New York Stock Exchange under the ticker symbol SPY. As of this writing, SPY has over $150 billion in net assets. Its holdings are the stocks in the S&P 500 Index, such as Apple, ExxonMobil, and Microsoft, and the ETF’s performance virtually mirrors the performance of that benchmark. With such ETFs, there is no portfolio manager or strategy to outperform the market through individual stock selection. While majority of ETF’s are like index mutual funds, one difference is that investing in an ETF allows you to purchase and sell assets at a current mar- ket price throughout the day, whereas with mutual funds your transactions can be made only once a day, and the purchase price is established after you have purchased the shares. The price you receive for an ETF may not be NAV, and you normally pay a transaction cost to purchase or sell the shares, which often can be avoided with mutual funds. There is no load with ETFs, just a trade commission. ETFs have some tax advantages over index mutual funds.

14 Many separate account managers discourage highly customized portfolios for tax and other reasons.

526 Part Six Planning Essentials

ETFs and similar products, which were introduced in the 1990s, have enjoyed enor- mous popularity in this century. In 2014, total assets topped $1.75 trillion in the U.S. and neared $2.5 trillion globally.15 Their advantages include trading flexibility, liquidity, rela- tively low management costs, and tax efficiency. The unexpected tax bills that mutual funds can deliver are often lower than that for ETFs, although it is useful to recognize that the difference in taxes are in effect equalized when the ETF is sold. There’s more transparency too, so investors know what’s in the ETF they’re buying and holding. ETFs have expanded into active management which further blurs the distinction with mutual funds.

Unit Investment Trusts Unit investment trusts are portfolios that are set up at a point in time, as are mutual funds but are generally unmanaged. They are sometimes employed in the bond area to provide clusters of securities, with the fund being liquidated at the maturity date of the bonds. They have no ongoing overhead costs and are sometimes difficult to sell at their NAV.

Variable Annuities Variable annuities wrap investment accounts that resemble mutual funds in a tax-sheltered framework for an extra ongoing charge. They are discussed in Chapter 10.

Pension Plans Pension plans are run by a corporation or provide a range of investment vehicles for the employee to select from. Where the employees select the investments, the alternatives may be in the form of mutual funds or pooled pension account managers. Where the corpora- tion invests the money, individual employees’ assets typically are pooled together within it. This type of organization is discussed in Chapter 13.

15 http://etfdailynews.com/ “Assets of ETFs and ETPs Listed In The U.S. Reach A Record $1.76 Trillion” May 8, 2014.

Back to Dan and Laura STOCKS, BONDS, AND MUTUAL FUNDS It was now some time since I made my original investment recommendations for Dan and Laura. In the meantime, the stock market had some change in price with small and mid cap funds performing extremely well, large cap up less sharply, and international securities actually declining. During this period, the performance of bond funds was about normal. However, the threat of inflation seemed to have receded. I was surprised to find that Dan and Laura had not followed my advice completely. That had become apparent when they asked for a meeting. They had a sheepish look on their faces as they entered. The two mentioned that they had implemented their asset allocation as agreed upon. However, when the market started to move up, they had taken some money out of bonds and international and large cap stocks and placed it into the best-performing areas, small and mid cap stocks. They had come in to see if they should place even more money into these areas. Finally, they had one large capitalization fund with a value style of investing they were very interested in. They wanted an in-depth report of that fund’s performance and my opinion of it.

Here’s what I suggested: First, let me congratulate you on your call on overweighting the small cap area. That call plus higher valuations for stocks overall should make our job a little simpler for achieving your shorter-term goals. However, I am concerned about your shifts in asset allocation.

Chapter Sixteen Stocks, Bonds, and Mutual Funds 527

They suggest a style of investing called relative strength or momentum investing. In es- sence, people who practice this approach believe that whatever has moved up strongly will continue to do so. This approach is one of many proponents of technical analysis use. I believe that financial investments should be looked at as being similar to any other purchase. The higher the price without a supporting reason, the less attractive the item to be purchased is. This type of thinking is more in line with an approach known as funda- mental investing in which decisions are made based on logical thought. Small cap and mid cap have moved; they are currently less attractive from a fundamental standpoint. You are considering having me manage your investments and will decide, in part, based on your satisfaction with the quality of the financial plan and your comfort with our rela- tionship. However, there is no absolute need for you to have me perform this service. You can do it yourself. You can follow the instructions on the handout I had given you earlier about how to select mutual funds. As far as the asset allocation is concerned, I have supplied it in the following table. Notice that I have recommended a return to the original asset allocation. Given your attrac- tion to making short-term movements based on market performance, I have decided that you are better off maintaining a consistent asset allocation. When there are movements between securities, this system will be purchasing those that are more reasonably valued. The approach is demonstrated in the accompanying table.

Asset Category Recent Annual Performance

Strategic Asset Allocation

Current Asset Allocation Alterations

Proposed Asset Allocation

Stocks

Small cap 22% 10% 25% –15% 10% Mid cap 18% 8% 20% –12% 8% Large cap 7% 20% 15% +5% 20% International –2% 17% 15% +2% 17% REIT 10% 5% 5% 0% 5% Total Stock 60% 80% –20% 60%

Bonds

Short term 3% 10% 4% +6% 10% Intermediate 5% 15% 3% +12% 15% Long term 6% 5% 0% +5% 5% High yield 7% 5% 8% –3% 5% Total Bond 35% 15% +20% 35% Money Market 3% 5% 5% 0% 5%

Total 100% 100% 100%

There are three mutual funds that I will provide opinions on. The first is at your request, the next two are recommendations. I have examined your Highrise mutual fund. Highrise has had a strong performance relative to other large cap value funds over the past 5- and 10-year periods. The portfolio manager is known for his style of purchasing value-oriented companies in industries that are out of favor. The fund has performed particularly well in periods of sharp market de- cline. It has a beta coefficient that is 25 percent below that for the average company, which provides the funds with a significant positive alpha coefficient. It has a consistent record of placing in the top half of all funds. While it currently has $5 billion under management, the manager has demonstrated he knows how to supervise large sums. I believe Highrise is an attractive fund that should be maintained. In view of diversification needs, however, you should reduce your holding from 75 percent to 5 to 10 percent of your total assets.

528 Part Six Planning Essentials

I am recommending that we add Surveyor International Small Cap Fund. While moder- ately volatile, the fund has had an excellent longer-term record. During all but one year, it has been in the top half of all international small cap growth funds. Its manager has a knack for selecting smaller companies that have proprietary products and good manage- ment teams and are on their way to becoming larger companies. While the beta coefficient is 1.35, the standard deviation is 26 percent, and the risk-adjusted performance, the alpha, is a positive 2 percent a year. I particularly like the fact that the fund has slipped under the radar because it has never had a “top ten” performance and hasn’t had an inrush of money. Should that happen, we might have to sell the fund. Straight Arrow Bond Fund has had a consistent record of favorable performance. It has usually been in the top quartile of all intermediate-term bond funds and has a leading Sharpe ratio for its category. The fund has two distinct advantages. The first is a relatively low expense ratio, which I believe is more important for bond than stock funds. The sec- ond is an ability to select sectors of the bond market that are undervalued. It shows no ability to predict interest rates, but I have not found any fund that is able to do this. Although the fund has a large amount of money under management for a diversified bond fund, this is not as important as it can be for stock funds. The monies in the categories to be reduced can be taken from each holding proportion- ately. To sum up, I have provided a diversified portfolio of investment that should assist you in achieving sufficient funds to meet your life cycle needs.

Summary This chapter provided the practical facts and financial tools to implement the principles established in Chapter 10.

premium consists of liquidity risk, maturity risk, and default risk.

fair value for a company that may be at variance with its current price.

company. One approach uses dividends, the other earnings, to arrive at decisions.

risk-adjusted performance relative to other funds in the same category.

Key Terms bond quality, 508 closed-end mutual fund, 522 common stock, 516 coupon payments, 510 coupon yield, 510 current yield, 510 default risk, 508 discount bond, 511 dividend discount model, 517 exchange-traded funds

525 fundamental analysis, 516

liquidity, 509 liquidity risk, 509 load mutual fund, 522 maturity, 508 maturity risk, 508 momentum investing, 517

per share, 521 no-load mutual fund, 522 open-end mutual fund, 521 preferred stock, 515 premium bond, 511

multiple method, 518 principal (par, maturity, or

510 reinvestment risk, 509 separately managed accounts, 525 technical analysis, 516 unit investment trusts, 526 yield to maturity, 510

Chapter Sixteen Stocks, Bonds, and Mutual Funds 529

finance.yahoo.com/bonds Bond Center The bond center on Yahoo’s finance portal provides bond rates; commentary and analysis about the bond market; search tools for corporate, municipal, zero coupon, and Treasury bonds; bond calculators; education sections; and a glossary.

finance.yahoo.com/etf Exchange-Traded Fund (ETF) Center This section on Yahoo’s finance portal contains extensive information about exchange-traded funds. The site features an ETF overview and coverage, a search tool, education material, annual reports, news, and a small glossary.

aaii.com American Association of Individual Investors This website is generally geared toward providing investment education to individual investors. There is also a research section that contains quotes, risk grades, S&P reports, commentaries, and analyses.

ici.org Investment Company Institute (ICI) The ICI’s home page is an excellent source for the latest developments in the securities industry, investor education, mutual fund statistics, and retirement research materials. The site offers guides for mutual funds, ETFs, closed-end funds, and unit investment trusts. The ICI publishes annually the Mutual Fund Fact Book, which is a valuable source for information and statistics.

mfea.com Mutual Funds Investor’s Center™ This site serves as a resource for investors who want to use mutual funds to reach their financial goals. The website offers a large collection of mutual fund companies, website links, fund listings, and exclusive planning, tracking, and monitoring tools available on the Internet.

schwab.com Charles Schwab The home page of Charles Schwab, discount brokerage firm, offers information and access to online brokerage services.

nyssa.org New York Society of Security Analysts (NYSSA) Awareness and understanding of securities analysis, investing, and the operation of the securities markets is the NYSSA’s objective. The site presents information of particular interest to investment professionals including conferences, seminars, professional courses, and the taking of the CFA exam. There are also job search tools and career development programs.

cfainstitute.org CFA Institute The website of the CFA Institute, the administrator of the Chartered Financial Analyst (CFA) exam, features preliminary information, brochures, online registration services, and readings for the CFA exam. CFA candidates have the option to order online the books needed for the exam.

Websites

530 Part Six Planning Essentials

valueline.com ValueLine ValueLine’s home page is a comprehensive source of information and advice on approximately 1,700 stocks, mutual funds, special situations, options, and convert- ibles. The site also offers information on investor education.

morningstar.com Morningstar This is the home page of Morningstar, a leading authority on information on stocks, mutual funds, variable annuities, closed-end funds, exchange-traded funds, separate accounts, and 529 college savings plans.

metastock.com Stock Analysis Innovative Market Analysis, the parent company, develops, markets, and supports the MetaStock software line, which provides charting and technical analysis for the self-directed securities trader.

fool.com Motley Fool This site features stock and portfolio analysis. There is available information for ETFs, index funds, and mutual funds.

bloomberg.com Bloomberg Bloomberg is one of the leading websites for financial news and stock performance information.

people.stern.nyu.edu/adamodar/ Aswath Damodaran The website of the well-known NYU professor Aswath Damodaran offers rich content from his books on corporate finance, investments, and valuation. It also contains downloadable data sets and various Excel models.

Below are the websites of the world’s leading companies in credit ratings, stock and bond research, and risk analysis:

standardandpoors.com Standard & Poor’s site moodys.com Moody’s site Here are the Websites of newspapers providing financial information:

online.wsj.com The Wall Street Journal

online.barrons.com Barron’s newspaper

ft.com Financial Times

Questions 1. List the maturity dates for classification purposes for bonds. 2. Why are bond maturity dates important? 3. What is the significance of bond ratings? 4. List and give examples of the three types of bond risks.

Chapter Sixteen Stocks, Bonds, and Mutual Funds 531

5. Distinguish between a bond’s coupon yield and a current yield. 6. Compare preferred shares with common shares and with debt. 7. Distinguish between technical analysis and fundamental analysis. 8. Distinguish between a dividend discount model and a price-earnings model. 9. How do an open-end and a closed-end mutual fund differ? 10. What is the difference between a load and a no-load fund? 11. Explain the separate characteristics of three prominent types of load funds. 12. How does a separate account differ from a mutual fund? 13. What is an exchange-traded fund? 14. What are the Sharpe ratio and the alpha coefficient used for? Contrast them. 15. Fred compared smaller-company fund returns against the Dow Jones Industrial

Average. Is that advisable? Explain. 16. List and explain four key steps in selecting a mutual fund.

Problems Tricontinental’s bond had a liquidity risk of 1 percent, a maturity risk of 2 percent, a pure rate of return of 1.5 percent, and an inflation premium of 4.0 percent. If the expected bond yield was 17 percent, what was the default risk? What does your answer indicate about this bond? Multicolor Corp. had an annual coupon of $60.00, a face value of $1,000, and a market value of $840. Calculate the coupon yield and the current yield. Beth bought a bond at $800 with annual coupon payments of $40. If the bond is due in nine years and has a par value of $1,000, what is her yield to maturity under both the approxi- mate method and the more exact method. If a bond has annual interest payments of $50 and a par value of $1,000, with six years to ma- turity, what is its current market value if bonds like it are currently offering a 7 percent yield? Pamela bought a bond for $926 with a face value of $1,000 and an annual coupon of $50. If the bond matures in 18 years, what is her yield to maturity? If a preferred stock has annual payments of $6.00 and a required rate of return of 8 percent, what is its current price? Y Co. has a projected dividend of $2.00, has a required rate of return of 8 percent, and is expected to grow 6 percent a year. Solve for its anticipated stock price. X Co. has the latest 12 months’ earnings per share (EPS) of $2.50, expected EPS in the current year of $3.00, and normalized EPS of $4.00. If its current stock price is $20, solve for its three P/E multiples based on the separate time frames given.

16.1

16.2

16.3

16.4

16.5

16.6

16.7

16.8

Which combination of the following statements about investment risk is correct?

1. Beta is a measure of systematic, nondiversifiable risk. 2. Rational investors will form portfolios and eliminate systematic risk. 3. Rational investors will form portfolios and eliminate unsystematic risk. 4. Systematic risk is the relevant risk for a well-diversified portfolio. 5. Beta captures all the risk inherent in an individual security.

a. 1, 2, and 5 only. b. 1, 3, and 4 only. c. 2 and 5 only. d. 2, 3, and 4 only. e. 2 and 5 only.

(See Web Appendix A)

16.1CFP® Certification Examination Questions and Problems

532 Part Six Planning Essentials

a. Fund B because the annual return is highest. b. Fund A because the standard deviation is lowest. c. Fund C because the Sharpe ratio is lowest. d. Fund D because the Treynor ratio is highest. e. Fund A because the Treynor ratio is lowest.

(See Web Appendix A)

The standard deviation of the returns of a portfolio of securities will be__________________ the weighted average of the standard deviation of returns of the individual component securities.

a. equal to. b. less than. c. greater than. d. less than or equal to (depending upon the correlation between securities). e. less than, equal to, or greater than (depending upon the correlation between securities).

(See Web Appendix A)

Match the investment characteristics listed below with the appropriate type of investment company in the items that follow.

A. Passive management of the portfolios. B. Shares of the fund are normally traded in major secondary markets. C. Both A and B. D. Neither A nor B.

1. ____ closed-end investment companies. 2. ____ open-end investment company. 3. ____ unit investment trust.

The Performance Fund had returns of 19 percent over the evaluation period and the bench- mark portfolio yielded a return of 17 percent over the same period. Over the evaluation period, the standard deviation of returns from the fund was 23 percent and the standard deviation of returns from the benchmark portfolio was 21 percent. Assuming a risk-free rate of return of 8 percent, which one of the following is the calculation of the Sharpe in- dex for the fund over the evaluation period?

a. .3913 b. .4286 c. .4783 d. .5238 e. .5870

(See Web Appendix A)

16.3

16.4

16.5

Given the following diversified mutual fund performance data, which fund had the best risk-adjusted performance if the risk-free rate of return is 5.7 percent?

16.2

Fund Average Annual Return Standard Deviation of Annual Return Beta

A .0782 .0760 0.950 B .1287 .1575 1.250 C .1034 .1874 0.857 D .0750 .0810 0.300

Chapter Sixteen Stocks, Bonds, and Mutual Funds 533

Company ABC is currently trading at $35 and pays a dividend of $2.30. Analysts project a dividend growth rate of 4 percent. Your client, Tom, requires a rate of 9 percent to meet his stated goal. Tom wants to know if he should purchase stock in Company ABC.

a. Yes, the stock is undervalued. b. No, the stock is overvalued. c. No, the required rate is higher than the projected growth rate. d. Yes, the required rate is higher than the expected rate. e. No, the required rate is lower than the expected rate.

The current annual dividend of ABC Corporation is $2.00 per share. Five years ago, the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compound annual rate as they grew during the past five years. The required rate of return on the firm’s common stock is 12 percent. The expected return on the market portfolio is 14 percent. What is the value of a share of common stock of ABC Corporation using the constant dividend growth model?

a. $11. b. $17. c. $25. d. $36. e. $54.

According to fundamental analysis, which phrase best defines the intrinsic value of a share of common stock?

a. the par of the common stock. b. the book value of the common stock. c. the liquidating value of the firm on a per-share basis. d. the stock’s current price in an inefficient market. e. the discounted value of all future dividends

Which of the following is/are characteristics of a municipal bond unit investment trust?

1. Additional securities are not added to the trust. 2. Shares may be sold at a premium or discount to net asset value. 3. Shares are normally traded on the open market (exchanges). 4. The portfolio is self-liquidating.

a. (1) only. b. (1) and (4) only. c. (2) and (3) only. d. (2) and (4) only. e. (1), (2), (3), and (4).

A $1,000 bond originally issued at par maturing in exactly 10 years bears a coupon rate of 8 percent compounded annually and a market price of $1,147.20. The indenture agreement provides that the bond may be called after five years at $1,050. Which of the following statements is/are true?

1. The yield to maturity is 6 percent. 2. The yield to call is 5.45 percent. 3. The bond is currently selling at a premium, indicating that market interest rates have

fallen since the issue date.

16.6

16.7

16.8

16.9

16.10

534 Part Six Planning Essentials

4. The yield to maturity is less than the yield to call.

a. (1), (2), and (3) only. b. (1) and (3) only. c. (2) and (3) only. d. (4) only. e. (1), (3), and (4) only.

The Zeta Corporation’s current dividend is $3.85. If future dividends are expected to grow at 4 percent forever, which of the following amounts should Zeta stock sell for if the required rate of return on the stock is 14 percent?

a. $28.57. b. $38.50. c. $40.04. d. $41.60.

16.11

Part One

The Theory of International Trade 1. Introduction to Personal Financial Planning 2. The Time Value of Money 3. Beginning the Planning Process

Part Seven

Integrated Decision Making 17. Capital Needs Analysis 18. Behavioral Financial Planning 19. Completing the Process

Integration is one of the most important actions in personal financial planning. It takes decision making for all parts of the household and weighs potential moves in one area against those in another. Whenever you take the time to determine how a current decision fits within your household portfolio of resources and obligations, you are likely to have a better outcome. Integration is often a key ingredient in distinguishing PFP from recommendations given by other professionals. They may give specific financial advice but, in their evaluations, seldom look systematically at the person as a whole. In performing comprehensive financial planning with its integration component, PFP accomplishes that task. In this section, integration is divided into its financial, human, and proce- dural components. The integrated solution is expressed in financial terms in Chapter 17. In its most basic form, it is given as a simple capital needs analysis. The withdrawal rate method is an ab- breviated form of this method. The regular form of this method incorporates all life cycle income and spending requirements and is most often used for determining retirement needs or life insurance requirements. A more sophisticated version of capital needs that explicitly includes risk is provided through Monte Carlo simulation. Chapter 17 also presents total portfolio management (TPM), a more advanced method of integrated decision making. It includes all household assets and liabilities, risk, and correlations in decisions. Importantly, instead of handling investments sep- arately, it integrates asset selection directly into the PFP decision-making process. Chapter 18, on behavioral financial planning, shifts the focus from quantitative analysis to human variables. It is unwise to complete a planning project without considering human responses and behavior patterns and incorporating nonfinancial goals. In this chapter, practical ways to improve your financial performance and, in some cases, modify traditional financial goals are explored. The final chapter, Chapter 19, describes the procedures you should follow in making integrated decisions and completing the planning process. These include reviewing preliminary decisions and procedures and using planning tools to create a successful plan.

536

Chapter Goals

This chapter will enable you to:

As the financial plan was drawing closer to its end, Dan and Laura would come in to drop off necessary and not so necessary documents. I had the feeling they were trying to influ- ence its results, to make them rosier. At a recent meeting, Dan asked how financial plan- ners went about reaching conclusions.

Real-Life Planning

The Johnsons For middle-aged people, retirement matters often become their number one financial con- cern. As people reach their 40s and 50s, many want to implement a savings plan that can provide a secure retirement. One couple that the advisor worked with did not follow the normal path. Frank and Sarah Johnson were both in their late 40s. He was a distinguished architect in a high- paying specialty and was associated with a prominent firm. She was a lively, well-dressed woman who worked part-time. No one would suspect that these prominent people had only $35,000 in accumulated savings, all of it attributable to a recent inheritance. When he first saw the couple, who had come from a different part of the country to consult him, they were despondent. They felt that at their stage in life, no one could help them. In fact, they had $60,000 worth of repairs and renovations that needed to be made on their home. The advisor assured them that while he couldn’t produce an attractive retire- ment at age 65, one later on could be feasible. The advisor went through the process of looking at assets, compiling their cost of liv- ing, incorporating returns on assets and projected inflation rates. It was clear that they would have to find a way to save more money. The wife’s goals precluded a full-time job.

Chapter Seventeen

Capital Needs Analysis 537

Therefore, they would have to cut back on expenses. Two items stood out. One was tens of thousands of dollars spent on clothing each year, mostly hers. The second was education expenses for their son, who was in graduate school. The advisor thought about how he could best present what would be a sharp cutback in expenses and enrolled other members of his staff in the process. A carrot-and-stick approach was decided on. At the next meeting, the couple was assured that if they followed the plan, an age 67 retirement at somewhat close to their current standard of living would result. Sarah would have to cut back on her clothing expenditures. The advisor said, “All your clothes that I’ve seen are very attractive—so much so that they can be used for at least two years instead of one.” Their son was to finance graduate school through borrowing. Their home renovation would wait and would be instituted after a fixed level of household savings was developed. The advisor sensed they weren’t fully buying into his recommendations. He decided to become more graphic. They were told that any inaction would be like playing Russian roulette, with the risk of adverse job or health circumstances placing them in a precarious situation. Savings would have to start immediately. Two years later the couple came back, this time with only modest savings. They had implemented the expense cutbacks. However, they said there had been negative circum- stances that forced them to liquidate most of the inheritance. Because little of the savings plan had been implemented, a harder line was taken. They were told that the stakes in Russian roulette had been raised and now “all the gun’s chambers were loaded.” They assured the advisor of their ability to comply. The advisor wanted more frequent contact but settled on a meeting in one year. At the end of the year there were further modest additional pension savings, and the entire inheritance was spent. Once again they had failed to save. The advisor was perplexed. Why were these people coming to see him and paying money if they wouldn’t follow his advice? He wondered, how could two seemingly normal middle-class, well-respected people place themselves in such a vulnerable position? Other people had made the necessary adjustments fairly quickly. The advisor decided it was time to be even more blunt and graphic. He told them that if they didn’t begin material savings, their new lifestyle, which was to start when the husband retired, voluntarily or involuntarily, would be close to poverty. Without savings, if they were careful they could treat themselves once a week to a full meal at a McDonald’s. Moreover, if they didn’t follow the savings program, the advisor said he would resign. The couple’s request for a box of tissues and subsequent discussions indicated that the advisor had finally reached them. For the first time, Sarah said she did not believe in sav- ing since “no one knows when it is their turn to go.” However, the stark portrayal of a highly unattractive lifestyle in retirement had forced her to look at another picture—one in which the rest of her life was extremely disappointing. In fact, the Johnsons’ delay had already significantly increased that risk. In practical terms, they were now on their way to reducing the risk of an unsatisfying quality of life. They started a true savings program. From the advisor’s standpoint, retire- ment planning had at last begun. We will use the Johnsons’ story as background for the case study later in the chapter.

OVERVIEW

Financial integration means using all assets and liabilities, all cash flows, all household activities, all future plans to arrive at decisions. Put simply, it means including all current and future resources and information in decision making. It is the opposite of making one decision at a time based strictly on the merits of that item.

538 Integrated Decision Making

Earlier in this book, you learned that the household operates as an enterprise. Let’s briefly review its characteristics. The household has current and projected revenues and expenses and generates money to fund future goals. Your goals determine what future financial resources you need. These goals are expressed in a life cycle framework, gener- ally with at least a desire for some consistency in your standard of living over time. There are three principal ways of making integrated financial decisions: simple capital needs analysis, capital needs analysis incorporating risk, and full integration—total portfo- lio management. You will learn the strengths and weaknesses of each method as well as how to do a capital needs analysis yourself. Integration will take place through a retirement needs set- ting that is fairly common in practice. The final part of the chapter is devoted to it. A life and disability insurance needs analysis is demonstrated in Appendix I. Both will use infor- mation on the Johnsons, whose case we have just discussed.1

SIMPLE CAPITAL NEEDS ANALYSIS

Capital needs analysis qualifies as a PFP integration approach because it takes into account all current and projected income, expenses, assets, and liabilities over our life cycle. It is frequently used to determine the sum needed at retirement to fund our retirement needs. There are two methods presented for simple capital needs analysis. The first, called the withdrawal rate method makes use of a single figure (4%) as the limit for the amount to be taken from savings as a percentage of total financial assets. The 4% rate comes from his- torical tests of withdrawal rates over long periods of time to determine what is considered the maximum safe rate for people to use. Its ease of use is one of its key advantages. The second approach is more exacting. We can call it simple needs analysis regular form. It estimates retirement living expenses and compares them with revenues available through Social Security and other revenue sources that we can be reasonably sure will be available. The differ- ence, which can be called the shortfall, is typically made up through additional savings. We compute the lump sum needed at retirement to provide cash thereafter that will meet living needs. This retirement lump sum is funded through implementation of a yearly savings figure. We need to employ a full life cycle approach in connection with the yearly savings figure to determine whether, given the costs of our current cost of living and goals, we will be able to generate that yearly savings. If the savings are not sufficient, we then determine what adjustments have to be made. Life insurance analysis is another major use of capital needs analysis. The approach is very similar to retirement needs except life insurance is broader. The major life cycle period needs, including the retirement period, are discounted to today. The insurance needed is just the sum total of all the period’s shortfalls. Life insurance is often intended to replace the cash flow from a deceased wage earner. It is discussed in Appendix I. The two simple retirement needs calculations are illustrated separately in later sections of this chapter.

CAPITAL NEEDS ANALYSIS—RISK-ADJUSTED

Simple capital needs analysis provides a single estimate of an outcome. For example, it attempts to tell us the amount we have to save to retire comfortably. However, virtually all projections are subject to risk. Some common risks are disappointing investment returns, longer-than-average life cycles, and higher-than-projected inflation rates.

1 Given the complexity of the Dan and Laura case study, the simpler Johnson case was used to demon- strate the steps mathematically. Integration for the Dan and Laura case is discussed in Chapter 19.

Chapter Seventeen Capital Needs Analysis 539

These risks can result in your savings pattern being insufficient to meet your need, say, for retirement. Notice that our objective has now shifted from funding the single estimate2 to one that incorporates risk. For example, the best estimate for male life span may be around age 80, but, if we funded until age 80, 50 percent of the time we would not have enough money for an extended retirement. We meet that possibility by funding to an age that extends well beyond the 50 percent probability, with the exact age selected being dependent on our risk tolerance. There are two overall methods that are commonly used to adjust for that possible occurrence. The first method is to be more conservative in our simple capital needs projections. For retirement, we may lower our assumed investment return, raise the inflation rate, and, as discussed above, provide for living well into our 90s.3

The advantage of this method of including risk is that it is easy to understand and to execute. The disadvantage is that you really have no benchmark to determine how much to alter each calculation. For example, to be conservative, should you take the return figure down 1, 3, or 5 percent or more? After you select a reduction in investment return, should you also raise the inflation rate and assume living to a ripe old age? You could end up being too conservative and, as a result, save too much money and forfeit a better lifestyle. Alternatively, you could not be conservative enough, thus exposing yourself to a potential negative planning outcome. The second method used is Monte Carlo simulation. Under Monte Carlo analysis, selected key factors are run randomly, based on their mean figures and potential outcomes around their means. Each individual run, called a trial, provides a different combination of factor outcomes. Think of it as resembling a slot machine with many choices. Each time you press the handle, you get a different combination. Each individual combination pro- duces a different result in money terms, telling you whether your money lasted long enough. If many of these trials are run, you receive a frequency distribution of potential outcomes. Then the probability of a favorable or unfavorable result can be estimated. As the accompanying Figure 17.1 for Monte Carlo simulation shows, the probability of having enough money to fund retirement declines as the client’s age increases. In this set of simulations, the probability declines from 100 percent at age 75 to 75 percent at age 90. Note that Monte Carlo is run by a computer program and what is more important is an understanding of its strengths and weaknesses.

2 This estimate can be overly optimistic. See, for example, withdrawal risk in Chapter 13. 3 Given the withdrawal risk for many people, an investment return reduction to compensate for a poor outcome can amount to 3 percent or more.

FIGURE 17.1 Monte Carlo Simulation— Probability of Having Sufficient Assets to Fund to Extended Retirement Age

60 65 70 75 80 85 90 95 100

20%

40%

60%

80%

100%

P ro

b ab

ili ty

Age

540 Integrated Decision Making

Monte Carlo allows you to combine many factors at the same time, often using their mean and standard deviations to determine the frequency of each factor’s outcome. For example, running the previously mentioned investment return, age, and inflation risk together, you can get a better reading on the probability of outliving your diminishing sav- ings. Assume the calculation indicates that there is a 75 percent chance of having sufficient funds. You can then raise the savings rate to bring that figure up to, say, 90 percent if that is the probability that you find acceptable. The advantage of Monte Carlo is a more precise calculation than the “guesstimated” risk-adjusted approach. The disadvantage is that people prefer one clear figure to probabil- ities. Moreover, the basic Monte Carlo approach assumes that the key factors are not cor- related with each other, although they may be. On balance, Monte Carlo provides additional insight as compared with a simple capital needs analysis. Monte Carlo analysis is being used, at least in part, by a growing number of financial planners.

TOTAL PORTFOLIO MANAGEMENT

The Practical Comment above serves as an introduction to the topic. The total portfolio management system explained below can be considered an answer to his question. Total portfolio management (TPM) is a fully integrated approach to personal financial planning. As you will see, it can provide a purer form of capital needs analysis. It does so by using all household resources in making its planning and investment decisions. The other forms of capital needs analysis we have discussed input a separately arrived-at investment return, which doesn’t fully reflect individual circumstances. Let’s review what you have already learned about TPM. Unlike other models, it includes all assets and liabilities, not just financial assets alone. Assets can be separated into financial investments such as stocks, bonds, and mutual funds as well as nonfinancial investments such as real assets, human-related assets, and other assets.4 Liabilities are made up of financial liabilities and overhead costs.5

Assets and liabilities include not only items that are currently marketable but those that are estimated from cash inflows and outflows using market-based discount rates.

Stanley was a liberal arts professor who had great

learned the essence of the capital asset pricing -

Practical Comment Introductory Comment

4 Sometimes we leave out “other assets” because this category often is not as meaningful as the two other nonfinancial asset categories. 5 In practice, some may wish to omit overhead costs and perhaps modest miscellaneous financial debt such as credit card obligations. This leaves only assets and debt attached to financing them to be pro- cessed; for example, mortgages paid to finance a house. If TPM is being used principally for investment allocation matters, a less exact but still beneficial approach is to drop all liabilities and concentrate on an asset-only allocation.

Capital Needs Analysis 541

For example, a person with a U.S. government–guaranteed job for $50,000 a year indexed for inflation for 40 years, who we assume has no risk of not getting paid or being unable to work, would have a human-asset value of $2 million ($50,000 × 40). Few would argue that the cash flow from this job isn’t an asset even though you cannot point to a daily traded asset figure in the newspaper because human assets are not marketable. These assets and liabilities form a portfolio, the household portfolio. It is assumed that important decisions for the household are made on an integrated portfolio basis. That means decisions are made including all relevant information and activities. We call this process total portfolio management.

Example 17.1 Selena had to decide whether to go to graduate school for an MBA. She had taken a course in PFP as an undergraduate and understood that she has a proposed capital expenditure— an investment in a human asset, her own. She considered its effect on her cash balance and her need to borrow money to finance it. Importantly for her, it would cut into her leisure time and force her to postpone the purchase of both a car and a home. On the other hand, it would result in a significant increase in her income over her remaining work years. She decided to enroll in graduate school but to postpone its date for 24 months. That would allow her to purchase the car now. She would postpone buying the home until she graduated. At the same time, she would be able to add to her financial investments. She smiled to herself when she thought about her decision, which took into account all her rele- vant factors, including all her assets and liabilities. She remembered the professor calling it “total portfolio management” and saying that it was easier for her to accomplish the process than for a large organization whose owners and many workers may not always agree on actions.

The TPM method incorporates all household risks as well. Each asset and liability carries risks, as you learned in Chapter 11. The TPM approach reflects what comprehen- sive personal financial planning and capital analysis needs do. In fact, TPM can be thought of as a further modification of simple capital needs analysis. It uses the same basic infor- mation as inputs but employs them differently. TPM does not depend on the validity or lack of workability of any one formula for mak- ing decisions. However, the origins of its financial solution are the Markowitz approach to modern portfolio theory (MPT). MPT is discussed in Chapter 10 and Web Appendix A, Modern Investment Theory. It uses risk-return principles to find the optimum mix of assets. That optimum mix provides the highest return for a given level of risk.6 When you input all assets and liabilities using the Markowitz approach, the outcome presents the net income or leisure outlays you can afford to make.7

Use of All Assets TPM’s use of all assets and obligations against them creates a broader and deeper analysis of a person’s future requirements. It is the logical outgrowth of PFP theory discussed in Chapter 4 and more closely approximates the way financial planning practitioners think in making their recommendations to clients.

6 Or, less often in PFP circumstances, the lowest risk for a given level of return. A given maximum risk may approximate human behavior more closely. 7 There are a few limitations in practice called constraints. The first is the assumption of flat real leisure expenditures over time as used in Modigliani’s life cycle theory. The second is a budget constraint. You can only spend in early adult years as much cash flow as generated. Therefore, flat real expenditures be- come more appropriate over time. Finally, certain variables, including human assets and real assets such as the home, are considered separately determined and TPM may focus on the financial asset mix. These limitations are often consistent with real-life financial planning assumptions by practitioners. Where the assumption of flat real expenditures over time is not appropriate, the analysis can be modified.

542 Integrated Decision Making

Example 17.2 There are two retirees, age 67, who have the same living costs and the same cash inflow stream including identical Social Security payments. Jack, a corporate employee without a fixed company pension, has saved in stocks and bonds currently worth $600,000 and is largely being supported by income from them and by slow withdrawals of principal. Jason, a public school teacher, receives the majority of income from a fixed government pension that has a net present value of $600,000. They have the same overall risk tolerance. Each has received a $300,000 inheritance recently. Should their allocation for that inheritance be the same? Although in practice some advisors might provide them with the same stock/bond mix, the answer is probably no. Jason’s pension is bondlike in its payment of fixed annual sums8 and, as a government obligation, is extremely safe. Both should view Social Security payments as bon- dlike as well. As it currently stands, Jason’s household portfolio incorporating all assets—in this case, including human-related assets as represented by a teacher’s pension—is safer than Jack’s. Therefore, Jason should be provided with a greater percentage of stocks than Jack to bring their overall portfolio risks in line.

One sample breakdown of TPM assets over a life cycle is seen in Table 17.1.

Use of Correlations The household is more than the sum of its separate assets less its liabilities. It is an operat- ing enterprise in which the individual activities influence each other. Under TPM, the influence is partially reflected in the correlations among the assets and liabilities. The total portfolio risk is a more accurate measure of risk and makes better investment decisions. Example 17.3 illustrates the impact of including TPM.

Example 17.3 Walter was a bond buyer for a major bond firm. His strength was marketing, and he claimed no particular knack for selecting better-than-average bonds. He had his personal account man- aged by an independent investment advisor. Walter received the recommendations of the in- vestment advisor from a friend, a tenured professor who was using that same person. When the two friends were talking one day, they found they had the same asset allocation, about 50 percent invested in stocks and 50 percent in bonds. They asked the advisor why they had the same financial asset allocation. He told them each had filled out the questionnaire that provided an overall tolerance for risk in a similar way. Walter went to a financial planner who practiced TPM. Walter was told that his human as- set, his job as a bond buyer, was highly correlated with his financial assets. This correlation raised the risk of an unfavorable outcome should inflation increase sharply causing interest rates to rise materially, thereby bringing bond prices down. A sustained decline in the bond market would adversely affect both his investment portfolio and his commission income, which dropped precipitously when bond markets were weak. The planner recommended that Walter reduce his position in traditional bonds substantially and place the monies in inflation-indexed bonds and private real estate. He said that the risk of his household portfolio would decline significantly as a result.

8 Of course, it is more precisely an annuity, which, unlike bonds, has no repayment of principal at death.

TABLE 17.1 Sample Breakdown of Total Portfolio Management of Assets over the Life Cycle

Individual Asset Categories as a Percentage of Total Assets

Age Human Assets Financial Assets House Pension Assets Social Security Total

25 93% 0% 0% 2% 5% 100% 35 83 01 9 2 6 100 45 74 3 13 3 7 100 55 57 12 19 3 9 100 65 18 35 29 5 13 100 75 0 45 43 3 9 100 85 0 35 65 0 0 100

1 Financial assets at age 35 are less than 1 percent; lack of savings due to assumption of life cycle theory of level leisure expenditures throughout life span.

Capital Needs Analysis 543

Integration of Investments and PFP Investments, including asset selection and investment policy, represent one part of PFP, but often investment policy is established by itself and the return inputted into planning operations. For example, capital needs analysis runs on an assumed investment growth rate separately decided upon. In contrast, the return on TPM is an integral part of the overall planning procedures. The asset selection and return can be combined in the planning pro- cess. Its disadvantages are that it hasn’t been tested extensively and that it is somewhat more intricate to solve. Although TPM can be used exclusively to determine asset selection alone, it is truly the end result of an overall personal financial planning process. It merits that designation because it is the implementation arm of PFP theory and approximates the goal of financial planning and practitioners. A summary of the characteristics of alternative approaches to capital needs analysis is shown in Table 17.2. Although TPM and Monte Carlo simulation have distinct advantages, the most popular form of analysis is the simple capital needs approach, sometimes modified to include deliberately conservative inputs to incorporate risk. It is the calculation that people taking the CFP® exam are required to be able to perform.9 In the balance of this chapter; we will go over this method. First, we will describe the method using a retirement needs example and then we will compute its result using the Johnson case study.

Example 17.4 Ann and Seth Parker, a married couple in their late 20s, recently welcomed Emily, their first child. Now the Parkers, who had been enjoying life in their comfortable downtown apartment, with two incomes to spend, must make some financial decisions. Should Ann keep working? If so, child care will become an added expense; if not, the Parkers will lose Ann’s steady paychecks. Perhaps Ann can stay home and see if she can free- lance—she had been a public relations account manager—to bring in some money. Where will they live? Their apartment may become too small for a family of three. Buying a house will require a down payment and enough reliable income to qualify for a mortgage. Should they start a college fund? Ann and Seth are both interested in setting up a 529 college savings plan, which offers tax advantages. But which state plan should they choose, and how much should they contribute? What about retirement? Both Ann and Seth contribute regularly to their 401(k) plans at work, deferring substantial portions of their salary and deferring the income tax as well. Will they be able to keep doing so, with all the new expenses Emily’s arrival has generated: food, clothing, life insurance, and so on?

TABLE 17.2 Summary of Capital Needs Characteristics

Simple Capital Needs Analysis

Adjusted for Risk Monte Carlo Simulation TPM

Solves for life cycle needs Yes Yes Yes Yes Integrates financial planning process Yes Yes Yes Yes Tells you how much to save Yes Yes Yes Yes Uses market-based returns as inputs Yes Yes Yes Yes Provides a one-number savings figure Yes Yes Yes Yes Adjusts for risk No Yes Yes Yes Presents probability of success No No Yes Yes Includes all assets and liabilities in investment decisions No No No Yes Incorporates correlations of factor inputs No No No Yes Provides full integration of planning and investing No No No Yes

9 Exam takers should be familiar with the basics of the Monte Carlo method for retirement analysis as well.

544 Integrated Decision Making

There are no right or wrong answers to these questions, but they need to be asked and considered carefully. Capital needs analysis can help by setting goals for life insurance, home purchasing, college funding, and retirement savings. This in turn would involve projection of cash flow needs and the mapping out of the timing of each based on the avail- ability of funds and the anticipated cash flows for each. Total Portfolio Management provides a method for handling them over the household’s life cycle. In the absence of people experienced in TPM, working with a knowledgeable financial advisor, the Parkers set up a plan, as explained below, as they work toward all these worthwhile goals.

SIMPLE CAPITAL NEEDS ANALYSIS—WITHDRAWAL RATE METHOD

This method is the simplest approach that can be taken. Essentially the capital needs analy- sis takes your income and expenses after retirement and deducts them from the amount saved at the beginning of retirement. For most people the amount of savings declines over retirement years. The question is will you have enough money to maintain your standard of living in retirement and not run out of savings prematurely. The withdrawal rate method attempts to answer that question. Simply put, what is the maximum amount that can be withdrawn from an investment sum to cover an annual retirement shortfall? Researchers have come up with different statistics based in part on different methods and varying time periods. However, many agree that under a 30-year retirement period a 4% withdrawal rate is the appropriate figure. For example, a study by Michael Kitces, employing a 60% stock and 40% bond portfolio, found that using a 4% figure resulted in a 90% probability of not running out of money.10

That 4% figure assumes that the initial year’s withdrawal amount grows with inflation annually. The actual asset allocation between stocks and bonds is not as significant a factor as some would think as long as at least 50% of the total is placed in stocks. The formula for the withdrawal rate is given as:

Annual Withdrawal Rate = Initial annual withdrawal need Investment assets at beginning of retirement

Example 17.5 Boyan saved $2 million for his current retirement. He projected his expenses including taxes at $75,000 per year. Is that an acceptable figure?

Annual Withdrawal Rate = Annual withdrawal need Investment assets

= 75,000 $2,000,000

= 3.75% The 3.75% is lower than the maximum rate of 4%. Therefore, it is an acceptable rate.

Projecting how much money is needed at retirement to ensure a comfortable lifestyle incorporates many factors. Developing that figure properly takes a great deal of prepara- tion and knowledge that may be beyond the capability of many people. Canned programs offered often vary in their recommendations. Therefore, establishing the appropriate method may be difficult for many; even professionals differ in their approaches.

10 Kitces, Michael. Financial Planning online http://www.financial-planning.com/news/retirement_planning/ kitces-smart-fix-for-the-4-percent-rule-2693665-1.html?bcpg=3

Chapter Seventeen Capital Needs Analysis 545

The withdrawal rate method makes it fairly simple to ascertain the amount of retirement money needed. It is abbreviated in both preparation and calculation. The steps that lead to the appropriate withdrawal rate are:

Establish the Assumptions and Facts The assumptions needed are the number of retirement years to be funded, and these include

Retirement Years outcome.

Asset Allocation

Projected Growth Rates Projected returns on stocks and bonds should be compared

estimated conservatively. The inflation rate, which is often

Projected Savings retirement realistically.

Calculate the Amount of Financial Assets at Retirement

multiplied by the projected investment return, to arrive at investable assets available at retirement.

11 Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, “Portfolio Success Rates: Where to Draw the Line,” Journal of Financial Planning 24, no. 4 (2011).

546 Integrated Decision Making

Determine the Annual Cost of Living Beginning in Retirement The cost of living in retirement is likely to be different from today’s living cost figure as the absence of transportation and other work-related expenses, lower income taxes and potentially higher leisure time and medical expenses alter the calculation. The computation should begin with living expenses including income taxes currently and reflect retirement adjustments as if retirement began today. That current figure is then brought up to the retirement date by the projected inflation rate.

Ascertain the Amount of Annual Income Available for Retirement The annual income available in retirement includes Social Security, corporate or union pensions, and any other type of income to be received. It does not, however, include income from financial investments such as dividends, capital gains, and interest income. If the figure for annual income used assumes that retirement begins currently, it should be brought up to the retirement date by employing the appropriate growth rate. In many cases the inflation rate can be used as the growth rate.

Develop the Initial Annual Withdrawal Amount Needed The initial withdrawal need is the full-year amount that will be taken from the investment assets at the beginning of retirement to fund living costs. It is equal to retirement income less retirement living costs including income taxes.

Compute the Annual Withdrawal Rate The annual withdrawal rate is the initial withdrawal need divided by the investment assets available at retirement.

If Necessary Review and Reconsider Key Figures When changes in the 4% withdrawal rate are called for, particularly when there is a higher than 4% rate, there are a number of alternatives that can have the effect of reducing the projected amount of retirement money required and therefore the required annual amount to be withdrawn. They are provided below.

Change the Risk Tolerance: Before or After Retirement Changing the risk tolerance can encompass: (1) being less conservative about the projec- tion for investment return or inflation, (2) actually stepping up the asset allocation to incorporate a greater percentage in more volatile but higher returning stocks, (3) funding for a reduced number of retirement years, or (4) not making any changes in assumptions or actions and accepting a higher risk tolerance overall.

Reduce Expenditures or Raise Income Expenditures can be reduced prior to or after retirement. Alternatively, obtaining higher income—for example, working overtime or getting an additional job—can accomplish the same goal.

Postpone Retirement Retiring at a later date or working part-time in retirement can both create additional savings for retirement and reduce the lump sum amount that is required to retire comfortably.

Capital Needs Analysis 547

Example 17.6 Justin’s actual withdrawal rate was higher than the required 4% for his risk tolerance. His al- ternatives to bring it down and his ultimate choice follows:

1(a). He considered changing the risk tolerance by assuming a 7% growth rate instead of 6% for investments prior to retirement, which would increase the projected investment sum available after retirement. The higher the investment sum available prior to retirement, the lower the projected withdrawal rate.

1(b). He had a more conservative portfolio planned for after retirement, which he had pro- jected would grow 5% a year that he changed to 6%, which would allow a higher with- drawal rate after retirement.

1(c). He could lower the assumed inflation rate from 3% to 2% and therefore reduce the spending pattern prior to retirement, which could allow a higher savings rate and there- fore a higher accumulated sum at retirement.

1(d). He could lower the assumed inflation after retirement from, say, 3% to 2%. The lower spending pattern after retirement would reduce the sum needed at retirement.

2. He could raise the amount in stocks prior to or after retirement by, say, 10 percentage points, which would increase the investment return and therefore the savings available for retirement withdrawals. This alternative could actually increase the investment sums where the others just make changes in the assumptions not actions.

3. He could fund for a reduced number of retirement years, assuming his own demise at age 90 instead of 95.

4. He could make no changes in assumptions or actions but just take more risk by allowing a greater actual withdrawal, say 5% instead of the desired 4%.

5. He could reduce expenditures prior to or after retirement, or both.

Jason thought about his alternatives carefully. Most of the choices involved changes in assumptions which would raise his risk of a shortfall instead of actions that would reduce risk. He chose saving more prior to retirement, which would be implemented through a cutback in expenditures. Since Justin was young, the cutback would accumulate over many years and be sufficient to meet his need.

Finalize the Savings and Withdrawal Pattern After experimenting with methods that reduce the withdrawal rate where necessary, house- hold mandated levels of the savings and spending pattern can be finalized.

Review and Update There are many “moving parts” that can change over time. Investment returns, expenses, retire- ment dates, and other factors can shift. It is important to not react too strongly to cyclical fluctua- tions in those amounts but at the same time to be prepared to make changes when fundamental shifts in assets, income, or expense levels occur. Having realistic plans to reduce expenses if necessary can permit a modestly higher withdrawal rate and add to the probability of success.

Example 17.7 Stanley & Elizabeth are 50 years old. They expect to retire at age 67, like to feel safe, and there- fore decide to fund for 30 years of retirement. They believe a 65–35 stock-bond allocation is appropriate for investment today and a 50–50 allocation is their preference for investing in retire- ment. They assume a 6.5% annual rate of return on investments today and a yearly inflation rate of 3%. Their cost of living including income taxes of $22,000 is $90,000 currently, which allows them to save $20,000 annually on their combined income of $110,000. They expect retirement income to include Social Security of $37,000 per year in today’s dollars. Their current cost of liv- ing, excluding taxes, of $68,000 ($90,000 – $22,000) will increase $5,000 for higher vacation costs and medical costs of $6,000 while declining by $7,000 due to reduced business transporta- tion and clothing. Their taxes will decline by $8,000. They have $500,000 accumulated in finan- cial assets today. They want to know if they are on-track for a comfortable retirement. Given the assumptions and facts as stated above we can go on to the next steps. Calculate the projected amount of financial assets at retirement.

548 Integrated Decision Making

17 6.5 500,000 20,000

2,048,384

N PV PMT FVI/Y

Number of years until retirement = 17 (67–50) Investment return = 6.5% Yearly savings = $20,000 Current assets accumulated = $500,000 Solve for future value of assets = $2,048,384

Determine the Annual Cost of Living Beginning in Retirement.

Retirement cost of living in today’s dollars = Current cost of living & retirement adjustments = 68,000 + 5,000 + 6,000 – 7,000 + (22,000 – 8,000) = $86,000

17 3 86,000

142,145

N I/Y PV PMT FV

Number of years until retirement = 17 (67–50) Inflation rate = 3.0 % Retirement cost of living = $86,000 Solve for future cost of living in retirement = $142,145

Ascertain the Amount of Annual Income Available for Retirement

17 3 37,000

61,155

N I/Y PV PMT FV

Number of years until retirement = 17 (67–50) Inflation rate = 3% Retirement income available = 37,000 Solve for future retirement income = $61,155

Establish the Initial Annual Withdrawal Needed.

Annual withdrawal needed = Retirement living costs – Retirement income = 142,145 – 61,155 = $80,990

Calculate the Annual Withdrawal Rate

Annual withdrawal rate = Withdrawal need investment assets = $80,990 = $2,048,384 Calculated required withdrawal rate = 3.95%

Evaluate and Finalize the Withdrawal Rate Theoretical margin of safety = Maximum allowable – Calculated required withdrawal rate withdrawal rate = 4.0% – 3.95%

The calculated withdrawal rate is slightly below the maximum allowable withdrawal rate and therefore is acceptable. Stanley and Elizabeth appear to be on a path to a comfortable retirement.

Chapter Seventeen Capital Needs Analysis 549

SIMPLE RETIREMENT NEEDS ANALYSIS REGULAR FORM

Retirement needs analysis is broadly based on the life cycle theory of spending and saving. It is a way of mapping future cash inflows and outflows to establish resource requirements during retirement. Its objective is to ensure that enough resources are avail- able prior to retirement to cover retirement needs. Often the retiree’s goal is to maintain the standard of living in retirement that was established while working.13

Retirement needs analysis involves the following planning steps:

1. Review goals. 2. Establish risks and tolerance for them. 3. Determine rates and ages to be used for calculations. 4. Develop retirement income, expenses, and required capital withdrawals. 5. Calculate lump sum needed at retirement. 6. Identify current assets available at retirement. 7. Compute yearly savings needed. 8. Project income, expense, and savings during remaining working years.

The 4% withdrawal rate as an answer to how much you can safely take out annually has proven to be highly popular, perhaps too popular. One weakness is a “one withdrawal rate fits all” mentality. There are people, for example, who may desire taking more risk and withdraw, say, 5% and provide for only a 20-year retirement. Others may retire earlier or later than their mid-60s and should use a different rate. As this book is being written there are some who believe that past results may not be indicative of the future and say a 3% rate is more fitting. On the other hand the withdrawal rate is relatively easy to calculate and to understand and implement. The method’s simplicity itself may allow more people to focus and act on their retirement needs. Clearly this method falls short of a professional’s full-scale analysis, which can incorporate more detailed personal information about the household and use of more sophisticated techniques described in this chapter. One approach is to use the 4% withdrawal rate as a broad check on the course of savings toward a lump asset goal at retirement and determine if that is enough for your annual living expenses. Be sure to bring up all calculations to the retirement date. All the assumptions need to be realistic; there is a common problem of realism for a certain group of

people who, always have savings that turn out lower than predicted. Of course this approach assumes that you have average household factors such as date of retirement, absence of a very conservative investment policy, and health. Even selected planning professionals may use a variation of the withdrawal rate for interim checks on their clients. They often combine a withdrawal rate analysis with constant updates based on posi- tive or negative actual events that occur. Be flexible. For example, if you come up short after retirement due to such factors as sharp declines in the market early in retirement,12 or higher than expected costs, adjust the withdrawal rate down. If results are better than expected you can raise the withdrawal rate. This flexibility can provide more confidence in a 4% rate. A more sophisticated approach is preferable. A potentially much more accurate alternative is needed in preparation for retirement given its high importance. Get familiar with more sophisticated systems such as the CFP® desired approach explained in detail in this chapter. Then, by yourself, or better yet by consulting a planning professional, keep track of your progress both before and after retirement. 12 For its importance see Chapter 13—Retirement Planning under the topic “withdrawal risk”.

Professional Advice The 4% Withdrawal Rate

13 Often the same standard-of-living costs are less in retirement because of lower living costs.

550 Part Seven Integrated Decision Making

9. Reconcile needs and resources. 10. Finalize plan and implement. 11. Review and update.

As you can see, retirement needs analysis is highly structured, a necessary condition to obtain the right results. We will consider each step separately.

1. Review Goals At this point in the process, overall retirement goals already should have been established. Our role is to review them to make sure they reflect our best thinking. Key goals are the age at which retirement is to take place and the standard of living desired at that time. Are there goals to leave money to children, other individuals, or charities? If so, for what amount and are they subject to maintaining a stated minimum standard of living for house- hold members or is a fixed amount to be provided for heirs? The answers to these questions help frame the calculations.

2. Establish Risks and Tolerance for Them Significant risks are those occurrences that can alter retirement goals. There are many risks while working. Essentially, they were covered in previous chapters. As mentioned, retire- ment risks can be divided into a few major categories: longevity risk, extraordinary expenses, often health-related investment risk, and inflation risk. Our tolerance for risk helps us to determine our responses to those risks. For example, if we were to provide funds only to an average mortality date of around age 80, we would be a high-risk taker because in 50 percent of the cases we would live longer and have insufficient funds to cover the extra time. Providing funds until the early 90s would give us less than a 10 percent chance of outliving our assets, a much more conservative stance.

3. Determine Rates and Ages to Be Used for Calculations The relevant rates required for capital needs analysis are the rate of return on investments and the inflation rate.14 Investment returns can be calculated based on historical rates for stocks, bonds, and money market funds and the particular asset allocation used. Where dif- ferent asset allocations are used before and after retirement, the assumed rate of return will change at retirement. Rates of return should normally be expressed on an after-tax basis, which means that returns on tax-sheltered pensions would be compounding at a different rate than personal sums. Long- term inflation expectations may be estimated based on historical rates, which have averaged 3 percent over the past 20 years, or based on the current or projected time frame. We are concerned with two ages: the retirement age and the number of years we are going to provide funds for in retirement. As already discussed, setting these ages, we com- bine goals and tolerance for risk.

4. Develop Retirement Income, Expenses, and Required Capital Withdrawals Cash flow figures can change materially once retirement begins. Job-related income is replaced by Social Security and company pension payments, if any; personal investment income and sometimes a part-time job are two other sources of retirement income. Returns from financial investments are excluded from this step. They are placed in step 6.

14 The tax rate should be estimated from anticipated growth rates in revenues and deductible expenses and relevant tax-favored rates for investments. Because job-related revenues decline sharply or are elimi- nated in retirement, the marginal tax rate is likely to drop at that time, particularly when private pension and IRA withdrawals are not very high.

Capital Needs Analysis 551

Household expenses should be altered by a number of factors. Outlays for health should be examined carefully and may rise as costs for non- or partially reimbursable drugs and other charges that are not covered increase as the retiree ages. Vacation and other leisure costs also may climb, at least initially. Other costs may decline significantly. For example, job- related transportation, clothing, and food expenditures are eliminated. Household mort- gage and children’s educational debt are often paid off prior to retirement. Very significantly, the household’s tax bill generally declines in retirement because both the amounts subject to taxation and the marginal tax rate frequently drop. In addition, retirees have more time to focus on value-oriented shopping and, in some instances, are given senior citizen discounts to eat out and shop for food, clothing, gasoline, transporta- tion, travel, and so on. On balance, in many cases, the cost of living declines in retirement without a perception of a decline in standard of living. Net cash flow figures should be developed based on the decline in both revenues and costs. Most people in retirement will have to make withdrawals from investment accounts. That was the principal reason they accumulated those assets to begin with. The rate of withdrawals may rise as the cost of living can rise with inflation, but not all revenue sources are indexed for it. In addition, principal withdrawals reduce the amount of investment return, which in turn results in a greater need for further princi- pal withdrawals. A breakdown of income for the average retiree by source is shown in Figure 17.2.

Many people are afraid to take withdrawals of prin-

Practical Comment Withdrawals

FIGURE 17.2 Breakdown of Retirement Income by Source for Average Retiree, 2011

Source: Social Security Administration http://www.ssa. gov/policy/docs/chartbooks/ fast_facts/2015/fast_facts15.pdf

Social Security 34%

Earnings 33%

Asset income

11%

Private pensions

Other 4%

Government employee pensions

552 Integrated Decision Making

5. Calculate Lump Sum Needed at Retirement Once annual withdrawals and the number of years we are funding for retirement are estab- lished, we can calculate the lump sum needed at retirement to fund our retirement needs.

6. Identify Current Assets Available at Retirement Current assets are those that you have on hand today. They can be brought up to the retire- ment date using the assumed investment return. This amount at retirement provides a par- tial funding of the need.

7. Compute Yearly Savings Needed Yearly savings is the sum required to deposit annually to accumulate the shortfall between assets needed at retirement and the amount projected to be available based on existing assets.

8. Project Income, Expenses, and Savings during Remaining Working Years Now that we know how much we need to save each year, we should compare that with our current and projected savings rate. A detailed cash flow statement incorporating income, expenses, and current savings can be developed. The method for making these pro forma statements was shown in Chapter 5. The figures are likely to be segregated by financial period as each may have its own revenues and cost structure. Projected savings figures should be compared with current actual savings with differ- ences reconciled. If there are large unreconciled differences, they often come about through underestimating future expenses. When this occurs, a miscellaneous expenditure figure should be added to projections; the miscellaneous figure should generally grow at the inflation rate over time as well. For people with less complex household operations or who best respond to saving based on need, a simpler approach of saving a fixed sum per year or a fixed percentage of salary can be feasible.

9. Reconcile Needs and Resources The projected yearly savings needed and the anticipated yearly savings to be generated should be compared. In other words, needs should be measured against current and future resources. When resources exceed needs, no other steps have to be made. If not yet retired, household members may, if they wish, retire earlier, raise their standard of living at the current time, or increase it in retirement. Alternatively, they can use the extra money to lower their risk of insufficient funds during adverse circumstances or leave it to their heirs. If there is a shortfall in retirement resources compared with needs, then action is called for. They may cut back expenditures today or generate additional income through changes in work-related positions or additional hours on the job. Alternatively, they may decide to work longer before retiring, work part-time during retirement, or lower their standard of living while working or in retirement.

10. Finalize Plan and Implement Once the calculations are made and needs and resources are in balance, three questions should be asked. The first asks one last time, “Is this particular plan what you want to do, given the resources available to you?” The second is, “Are the assumptions those that you believe in?” The third is, “Will you be able to carry out this plan?” If the answers to all your questions are yes, then the plan can be finalized and implementation should begin.

Chapter Seventeen Capital Needs Analysis 553

11. Review and Update Actual savings and accumulated investment sums should be reviewed against projected sums periodically. Major differences should be accounted for. When actual resources dif- fer substantially from projected ones, particularly when there is a shortfall, a reappraisal of retirement projections may be called for. Similarly, when circumstances change signifi- cantly, an overall review should be undertaken.

PROJECTIONS

Making projections is an inexact science. A 1 percent difference between actual and esti- mated revenues, costs, or investment returns annually can have great impact if taken over an extended period of time. Moreover, given withdrawal risk, when the possibilities of an extreme negative occurrence (particularly at the beginning of retirement) are included, the potential for a retirement planning shortfall can increase significantly. Consequently, it can be advisable to estimate all figures conservatively. If greater-than-needed savings develop, spending can be raised later on. In making retirement projections, to be conservative, financial planners may use assumed investment returns that are a few percentage points lower than historical rates and may use higher end estimates of inflation for cost purposes. When clients are, by admis- sion, optimists, planners may encourage moderation in projecting job-related revenues that are well in excess of inflation, particularly for extended periods of time. Similarly, consid- eration should be given to questioning projections of people who are unduly pessimistic; for example, when they assume flat or declining job-related revenues. If there is a spouse, he or she often can help validate these projections. In many cases, revenue increases that are substantially different from the anticipated annual rises in the inflation rate, for more than 5 to 10 years, whether the projected differ- ences are higher or lower, create results that may not be justified. On the other hand, the planner must take care not to influence assumptions so much that they are viewed as not being credible by household member-owners. When individuals do not believe projections are credible, they find it difficult to implement the plan. For example, a planner who makes too conservative an estimate of increases in wages and in investment returns, even when the prompting to do so comes from the client, can undercut the motivation for savings. The client may ignore the shortfalls as not being believable.

Planning for retirement usually involves a sacrifice of resources to spend today for a higher quality of life in retirement. As a consequence, there often can be a difference between intended and actual savings. Rather than acknowledge to themselves or their advisor that they have spent beyond their plan, peo- ple sometimes attribute shortfalls to nonrecurring expenses. One year it can be fix-up of the house, the next an expensive vacation, and so on. Of course, when nonrecurring expenditures happen frequently,

even if they arise from different causes, they become, in effect, recurring. Therefore, one nonrecurring charge may be over- looked, but a succession of them may have a signifi- cant impact on retirement plans and should be addressed. This can be done by focusing on retire- ment goals and acknowledging that a continuation of the preceding pattern can reduce the household’s quality of life in retirement.

Practical Comment Savings

554 Part Seven Integrated Decision Making

A more systematic method of incorporating risk in retirement planning is given in Chapter 19.

RETIREMENT NEEDS CASE STUDY

In this portion of our chapter, we will go over a discussion and then calculation for a retire- ment needs analysis. We will use the Johnson case discussed earlier. We begin that study at the point where Frank and Sarah have come to terms with their need to save money for retirement. At that time, age 50, they had $35,000 in accumulated savings. Their steps, keyed to the previous discussion, follow.

1. Review Goals The goal for Frank and Sarah is to live a comfortable “middle-class life” in retirement, preferably at the standard of living they enjoy today. The retirement age desired is age 67.

2. Establish Risks and Tolerance for Them The Johnsons are subject to all the normal retirement risk exposures. Their tolerance for retirement risk has been high, as measured by their lack of saving and resultant lack of financial preparation for such exposures as health and longevity risk. There is some indica- tion of a change to a more conservative risk tolerance, as seen in their willingness to face future expenses. They have decided to fund for living expenses through age 92, thereby reducing the longevity risk to about 10 percent.

3. Determine Rates and Ages to Be Used for Calculations We decided to use a 3 percent rate for inflation and a 5 percent after-tax rate for investment both before and after retirement. They have decided to retire at age 67 and to fund for liv- ing expenses through age 92.

4. Develop Retirement Income, Expenses, and Required Capital Withdrawals Income in retirement would come from Social Security. It was estimated at $30,000 a year combined. In addition, Frank would receive $10,000 a year as a pension. Frank grumbled that his architectural firm was cheap with its pension policy. Friends of his were receiving pensions of at least five times that amount. It didn’t help that he had moved to this firm only nine years ago. Because the firm had no 401(k) plan and Sarah didn’t want to put any money in IRA plans that she said “locked it up,” all future savings would have to be in accounts that are not tax-advantaged. Their retirement expenditures would be lower than the $150,000 present rate. Their tax rate in retirement would decline and the mortgage would be paid off at the anticipated retirement age of 67. Vacation expenses, which were already sizable, would not change and other additions and subtractions would cancel themselves out. With some additional effort when prodded by the advisor, they arrived at a figure of $95,000 for retirement expenditures including taxes. The difference between $40,000 in income and $95,000 in expenses was a sizable retirement need of $55,000 annually.

5. Calculate Lump Sum Needed at Retirement The Johnsons decided they wanted to fund for a 25-year retirement that would carry them financially through age 92. Using the $55,000 annual figure, they would need $1,821,708 in lump-sum savings in retirement, as Table 17.3 shows.

Capital Needs Analysis 555

6. Identify Current Assets Available at Retirement Frank and Sarah had saved $35,000 currently. That amount invested for 17 years would only amount to $80,221 at retirement.

7. Compute Yearly Savings Needed The amount available at retirement of $80,221 was meager. There the lump-sum net need at retirement of $1,741,487 was almost as large as the gross need of $1,821,708. The required savings amount was $67,394 annually.

8. Project Income, Expenses, and Savings during Remaining Working Years The Johnsons currently had household income of $150,000 per year growing at the rate of inflation. Their calculations of expenditures including taxes were about $130,000. In real- ity, however, they were spending every dollar that came in. A category of miscellaneous expenses was set up for $20,000. They preferred to wait until their retirement needs were calculated to establish a savings pattern.

9. Reconcile Needs and Resources It was apparent that the required saving of $67,394 per year was too great. The Johnsons had waited too long to begin saving. We discussed ways of reconciling needs and resources. They decided to postpone retirement to age 70. Furthermore, the couple thought they could reduce their retirement living costs to $80,000 from $95,000. Although that level was not what they hoped for, it would meet their minimum goals. Retiring later would add about $5,000 each year to retirement income coming from Social Security and a higher company pension payout. It also would require three years less for retirement funding. Finally, they cut back their funding date one year and assumed they would sell their house at age 91 if necessary. Consequently, retirement funding dropped by a total of four years. When the retirement needs were recalculated, the figure came to $30,540. Sarah thought for just a minute and said she would take a full-time job. She could earn $45,000

TABLE 17.3 Retirement Needs Statistics

As Planned Revised

Preretirement period Ages 50–67 Ages 50–70 Revenues Household income $150,000 $185,000 Expenses Household expenditures $130,000 $134,000 Miscellaneous expenses 20,000 20,000 Total expenses $150,000 $154,000 Cash flow 0 31,000 Postretirement period Ages 67–92 Ages 70–91 Revenues Social Security income $30,000 $33,000 Pension—Frank 10,000 12,000 Total revenues 40,000 45,000 Expenses 95,000 80,000 Cash shortfall ($55,000) ($35,000) Lump sum needed at retirement $1,821,708 $1,102,686 Required savings $67,394 $30,540

556 Integrated Decision Making

a year pretax and $30,000 after taxes as compared with her current income of $10,000 a year pretax and $7,000 per year after-tax. Consequently, there would be a net increase of $23,000 per year in retirement funding. The final piece, then, would be a further cur- rent expense cutback of about $8,000 a year net of higher taxes due to Sarah’s higher income. This would result in total additional yearly savings of $31,000, just enough to meet the need. There are two periods in the Johnsons’ retirement planning horizon: preretirement and postretirement. The retirement needs statistics for these two periods are presented in Table 17.3.

10. Finalize Plan and Implement I summarized the parts of the revised plan. The couple would work until age 70, live on $80,000 a year in retirement, and cut back expenses by $8,000 a year. Sarah was already looking forward to the adventure of a new full-time job. The financial pieces had been agreed to.

11. Review and Update Given the difficulty the couple had with compliance in the past, I strongly suggested meeting every quarter for the first year. I was gratified to see a new purpose and savings discipline in the follow-up meetings. The retirement plan was being implemented accord- ing to schedule. Here we begin by presenting a retirement needs calculation format in Table 17.4 and follow it with the actual calculations for Frank and Sarah in Table 17.6. Notice that the steps are keyed to our discussion. A summary of appropriate capital needs rates to apply under different circumstances is shown in Table 17.5. Table 17.7 provides the calculation rerun based on revised goals. For an alternative calculator method that involves fewer steps, see Appendix II. This retirement analysis and accompanying calculations for Frank and Sarah contrast with the more-involved Dan and Laura retirement case study, which takes place over three chapters—13, this one, and 19.

asset allocation to stocks and risk tolerance when

- -

Professional Advice Making Changes in Projections

TABLE 17.4 Retirement Needs Calculation—Described

Step Item Symbol Explanation or Calculation

3 Investment rate IR The rate of return for investments 3 Inflation rate ER The rate of increase in expenses 3 Real rate RR The combination of the inflation and investment rates

Formula: RR = a 1 + IR 1 + ER − 1b × 100

3 Present time t0 Today 3 Future time t1 Beginning of payout period 3 Number of years for payout period Ntp From beginning to end of payout period 3 Number of years to beginning of period Nt1 From today to start of payout period 3 Number of years to today Nt0 From beginning of payout period to today 4 Cash inflows CIt0 Includes the total of retirement pension investment and other

yearly cash inflows in current dollars 4 Cash outflows COt0 Discretionary and nondiscretionary expenses, capital expenditures,

and other yearly retirement cash outflows in current dollars 4 Cash shortfall CSt0 Current yearly cash inflows – cash outflows

CSt0 = CIt0 − COt0 5 Cash shortfall future CSt1 Current yearly shortfall brought forward to beginning of

payout period. The inflation rate is used to calculate the estimated future cost of the present cash shortfall.

Calculator Solution Input: Nt1 ER CSt0 N I/Y PV PMT FV Solution: Press for CSt1 5 Lump-sum shortfall future LSt1 Amount of full payout period, yearly shortfalls discounted back

to beginning of payout period. Since there are a series of payments occurring over a period of time, both investment and inflation rates are employed through the real rate. Use BEGIN function for beginning of the year payments.

Calculator Solution Input: Ntp RR CSt1 N I/Y PV PMT FV Solution: Press for LSt1 6 Assets accumulated AAt0 Assets available today to help fund retirement shortfall 6 Assets accumulated future AAt1 Assets accumulated brought forward to beginning of payout

period. The investment rate is used to calculate the estimated future value of today’s sum.

Calculator Solution Inputs: Nt1 IR AAt0 N I/Y PV PMT FV Solution: Press for AAt1 7 Additional assets required future ARt1 Lump-sum shortfall less estimated future assets accumulated

ARt1 = LSt1 − AAt1 7 Required yearly savings RSt0S1 The yearly savings required to produce the additional sum

needed at the beginning of the payout period. The investment rate is used because investment return influences the amount required for the series of savings deposits.

Calculator Solution Inputs: Nt0 IR ARt1 N I/Y PV PMT FV Solution: Press for RSt0S1

558 Part Seven Integrated Decision Making

Step Investment Rate Inflation Rate Real Rate TABLE 17.5 Summary of Appropriate Capital Needs Rate to Use

To bring current cash shortfall to future period CSt0 to CSt1 To bring current investment sum to future period AAt0 to AAt1 To establish lump-sum shortfall from the amount of payouts CSt1 to LSt1 To bring lump-sum cash shortfall back from future period to present LSt1 to LSt0 To establish yearly savings needed to fund lump-sum shortfall ARt1 to RSt0S1

Yes

TABLE 17.6 Retirement Needs Calculation—Before Revision

Step Item Symbol Explanation or Calculation

3 Investment rate IR 5% given 3 Inflation rate ER 3% given

3 Real rate RR 1.9417 RR = a1 + 0.05 1 + 0.03 − 1b × 100

3 Number of years for payout period Ntp 25 Age 67 to age 92 3 Number of years to beginning of period Nt1 17 Age 50 to age 67 3 Number of years from future period to today Nt0 17 Age 67 to age 50 4 Cash inflows CIt0 $40,000 given 4 Cash outflows COt0 $95,000 given 4 Cash shortfall CSt0 $55,000 95,000 – 40,000 5 Cash shortfall future CSt1 Inputs: 17 3 55000 N I/Y PV PMT FV Solution: Press $90,907 5 Lump-sum shortfall future (Use BEGIN function) LSt1 Inputs: 25 1.9417 90907 N I/Y PV PMT FV Solution: Press $1,821,708 6 Assets accumulated today AAt0 $35,000 given 6 Assets accumulated future AAt1 Inputs: 17 5 35000 N I/Y PV PMT FV Solution: Press $80,221 7 Additional assets required future ARt1 $1,741,487 ARt1 = LSt1 − AAt1 = 1,821,708 − 80,221 7 Required yearly savings RSt0S1 Inputs: 17 5 1741487 N I/Y PV PMT FV Solution: Press $67,394

Capital Needs Analysis 559

Back to Dan and Laura CAPITAL NEEDS ANALYSIS As the financial plan was drawing closer to its end, Dan and Laura would come in to drop off necessary and not-so-necessary documents. I had the feeling they were trying to influence its results, to make them rosier. At a recent meeting, Dan asked how financial planners went about reaching conclusions. He said that he, as a mathemati- cally oriented person, could handle any simple mathematical discussion I would want to go over. We sat down. Laura had one of those “here we go again” looks on her face. She smiled at me, took out a paperback book, and wasn’t heard from for the remainder of our time together. After my explanation, Dan asked if I would summarize the discussion in writing, which I did.

TABLE 17.7 Retirement Needs Calculation—After Revision

Step Item Symbol Explanation or Calculation

3 Investment rate IR 5% given 3 Inflation rate ER 3% given

3 Real rate RR 1.9417 RR = a1 + 0.05 1 + 0.03 − 1b × 100

3 Number of years for payout period Ntp 21 Age 70 to age 91 3 Number of years to beginning of period Nt1 20 Age 50 to age 70 3 Number of years from future period to today Nt0 20 Age 70 to age 50 4 Cash inflows CIt0 $45,000 given 4 Cash outflows COt0 $80,000 given 4 Cash shortfall CSt0 $35,000 80,000 – 45,000 5 Cash shortfall future CSt1 Inputs: 20 3 35000 N I/Y PV PMT FV Solution: Press $63,214 5 Lump-sum shortfall future (Use BEGIN function) LSt1 Inputs: 21 1.9417 63214 N I/Y PV PMT FV Solution: Press $1,102,686 6 Assets accumulated today AAt0 $35,000 given 6 Assets accumulated future AAt1 Inputs: 20 5 35000 N I/Y PV PMT FV Solution: Press $92,865 7 Additional assets required future ARt1 $1,009,820 ARt1 = LSt1 − AAt1 = 1,102,686 − 92,865 7 Required yearly savings RSt0S1 Inputs: 20 5 1009820 N I/Y PV PMT FV Solution: Press $30,540

560 Part Seven Integrated Decision Making

Here’s what I wrote: Dan, there are several ways that financial planners handle integration. The first is in what I would call an ad hoc way. That is, they do it the way your grandmother might have cooked. There was no fixed recipe. She put in a little of this and that from her memory, integrating all ingredients. If she was an experienced creative cook, the dish might come out well. If not, the results could be poor, each time tasting different. Similarly, the ad hoc way is not scientific and can be off markedly from subsequent out- comes. The ad hoc way is more popular with financial advisors who aren’t financial planners. The second approach, a capital needs analysis, tells you how much money you require to fund your goals. In its simple form, it assesses the cost of your goals and compares that with the resources you are currently generating and what you expect to obtain in the future. Adjustments are made between goals and projected resources to bring them into line. The outcome is often expressed simply as the amount that is needed in savings annually to achieve your goals. As you mentioned to me, you are familiar with Monte Carlo simulation. It can be used as a refinement of simple capital needs analysis. You are probably aware that any single amount of savings cannot predict all outcomes. What is needed is a framework that takes into account the probabilities of an outcome; for example, the probability that the savings rate given in a simple capital needs analysis will come to pass. In other words, Monte Carlo is more sophisticated than the simple method. It doesn’t give the one-figure solution that you might find satisfying, but it is more realistic. Total portfolio management is even more advanced. It takes into account all assets and obligations and their correlations in making investment decisions. It, like Monte Carlo sim- ulation, incorporates risk in capital needs analysis and can be looked upon in mathematical terms as a further refinement of capital needs analysis. It is a planning tool that comes directly from PFP theory and integrates PFP and investments in a way the others don’t. In performing our simple retirement calculations, often the practical reflection of capital needs analysis, we made the following assumptions:

1. An inflation rate and your costs both rising 3 percent a year. 2. Dan’s salary rising 10 percent a year through 2021 and then at the rate of inflation;

Laura’s salary rising at the rate of inflation. 3. Stocks rising 11 percent a year. Bonds increasing 5.5 percent a year. 4. Retirement funding to age 95, as you requested, even though I prefer ages 95 and 91 for

Laura and Dan, respectively, to provide an actuarially derived lower-than-10-percent chance of outliving your money.

The analysis indicates that you will have to save $60,000 in projected savings plus approximately an additional $41,000 per year beginning in year 6 to meet your goal of retiring at age 55. I consider this amount of savings difficult to achieve without further adjustments. I should mention that I have taken the investment return down 1 percent from 8.7 percent to 7.7 percent to be conservative. I recommend that we wait for the results of a risk-adjusted analysis in our final decision-making integration meeting before further discussions on retirement. I have also promised you the outcome of a life insurance needs analysis. Based on your current living pattern, Laura needs $1,289,421 on Dan’s life. If Laura passes away, the need, including the hiring of a household assistant for the children, would be $673,091. You have no current insurance, so the entire amount will have to be purchased. Again, here I think we should wait for the risk-adjusted analysis before making specific recom- mendations of amounts to purchase.

Capital Needs Analysis 561

We will use TPM concepts in completing your plan shortly (shown in Chapter 19). I hope this helps in your understanding of integration. If you have any questions, let me know. The calculations are given below.

RETIREMENT NEEDS ANALYSIS Inputs

General

Dan’s age 35 Laura’s age 35 Dan’s retirement age 55 Laura’s retirement age 55 Dan’s assumed age of death 95 Laura’s assumed age of death 95 Years until retirement period 1 20 Years until retirement period 2 30 Years in retirement period 1 10 Years in retirement period 2 30

Laura

Pension at age 65, today’s dollars $40,000 After-tax pension 28,800 Current salary 0 Salary in five years, today’s dollars 68,000 Annual increase thereafter 3% Social Security benefits at age 67 $21,996

Dan

Salary $100,000 Annual increase through 2021 10% Annual increase beginning 2022 3% Social Security benefits at age 67 $25,512

Expenses

Living expenses, today’s dollars1 $83,452 15% COL reduction in retirement ($12,518) Additional travel expenses $10,000 Total expenses in retirement $80,935

Economic

Inflation 3.0% Tax rate in retirement2 28.0% Investment return 7.7% After-tax investment return 5.5% Real return 4.6% After-tax real return 2.5%

1 Sum of discretionary, nondiscretionary, and capital expenses in year 6, discounted to year 1. 2 Estimated marginal federal and state rate. Assumes flat state tax rate of 5% and blend of ordinary income and capital gains federal rates.

562 Integrated Decision Making

Step 1. Calculate the Amount Needed in Retirement

Retirement Period 1 (55–65)

Living expenses in retirement, today’s dollars $80,935 Laura’s pension in today’s dollars, after taxes 0 Annual shortfall, today’s dollars 80,935 Annual shortfall, age 55 146,177 Lump sum needed to retire mortgage1 156,712 Lump sum needed at beginning of period $1,469,701

Retirement Period 2 (65–95)

Living expenses in retirement, today’s dollars $80,935 Laura’s pension in today’s dollars, after taxes 28,800 Social Security benefits at 65 in today’s dollars, after taxes 31,350 Annual shortfall, today’s dollars 20,784 Annual shortfall, age 65 50,449 Lump sum needed at age 65 $1,086,354

1 Amount owed after 19 years of mortgage payments at normal amortization. Assumes mortgage begins in year 2 of plan.

Step 2. Bring the Lump Sum Needed Back to the Present

Lump sum currently needed, retirement period 1 $499,526 Lump sum currently needed, retirement period 2 215,261 Lump sum needed in year 6, retirement period 11 654,223 Lump sum needed in year 6, retirement period 2 281,924 Total lump sum needed now 714,787 Total lump sum needed in year 6 $936,147

1 Assumes that savings cannot begin until year 6, when Laura returns to work.

Step 3. Repeat Steps for Other Needs

Lump sum needed for college in year 6 $175,665 Total other needs lump sum, year 6 $175,665

Step 4. Establish the Current Value of Projected Future Saving

Accumulated assets as of year 6 $100,003 Projected after-tax savings starting year 6 60,000 PV of future savings in year 6 600,498 Total existing and projected resources in year 6 $700,500

Step 5. Compare Resources and Needs

Total needs in year 6 $1,111,813 Total existing and projected resources in year 6 700,500 Additional resources needed $411,312

Capital Needs Analysis 563

Step 6. Establish Additional Annual Savings Needed

Additional savings needed beginning year 6 (level payment) $41,097 Additional annual savings needed beginning year 6 $41,097

INSURANCE NEEDS ANALYSIS—DAN Inputs

General

Dan’s age 35 Laura’s age 35 Laura’s retirement age 55 Dan’s assumed age of death 35 Laura’s assumed age of death 95 Years in preretirement period 1 5 Years in preretirement period 2 15 Years in retirement period 1 10 Years in retirement period 2 30

Laura

Pension $40,000 After-tax pension 30,000 Current salary 0 Salary in year 6 68,000 Salary after tax 51,000 Annual increase 3% Social Security benefits Laura’s Social Security in retirement 21,996 Survivor benefits until children grown, before tax1 26,250

Expenses

Current expenses $103,032 Expense reduction at Dan’s death 10% Expenses after Dan’s death 92,729 Expenses after children grown 72,841

Available Assets

Investment assets $150,000 Liabilities 86,000 Available assets 64,000

Economic

Inflation 3.0% Investment return 7.7% After-tax investment return 5.5% Real return 4.6% After-tax real return 2.5% Average tax rate, years 1–5 0% Average tax rate, years 6–20 25% Average tax rate in retirement 25%

1 Estimate. Actual numbers will be modestly different because different benefits end in different years.

564 Integrated Decision Making

Step 1. Determine the Amount Needed to Fund the Preretirement Period

Preretirement period 1, years 1–5 (All figures in today’s dollars)

Annual expenses $92,729 Social Security survivor benefits, after taxes 26,250 Laura’s salary, after taxes 0 Total income, after taxes 26,250 Annual shortfall 66,479 Lump-sum shortfall, today’s dollars $316,754

Preretirement period 2, years 6–20 (All figures in today’s dollars)

Annual expenses $92,729 Social Security survivor benefits, after taxes 20,672 Laura’s salary, after taxes 51,000 Total income, after taxes 71,672 Annual shortfall, today’s dollars 21,057 Annual shortfall, year 6 24,411 Lump-sum shortfall, year 6 310,397 Lump-sum shortfall, today’s dollars $237,001

Step 2. Determine the Amount Needed to Fund the Retirement Period

Retirement Period 1 (55–65)

Living expenses in today’s dollars $72,841 Income 0 Annual shortfall, today’s dollars 72,841 Annual shortfall, age 55 131,559 PV lump-sum future survivor benefits 105,816 Lump-sum shortfall, age 55 1,075,874 Lump-sum shortfall, today’s dollars $365,671

Retirement Period 2 (65–95)

Living expenses in today’s dollars $72,841 Laura’s annual pension 30,000 Social Security benefits, after taxes 15,001 Total income 45,001 Annual shortfall, today’s dollars 27,840 Annual shortfall, age 65 67,576 Lump-sum shortfall, age 65 1,455,153 Lump-sum shortfall, today’s dollars $288,338

Step 3. Determine the Total Lump Sum Needed Today

Lump sum currently needed, preretirement period 1 $316,754 Lump sum currently needed, preretirement period 2 237,001 Lump sum currently needed, retirement period 1 365,671 Lump sum currently needed, retirement period 2 288,338 Total lump sum needed, today’s dollars $1,207,764

Capital Needs Analysis 565

Step 4. Repeat Steps for Other Needs

Lump sum needed currently for college $125,657 Burial expenses 20,000 Total lump sum for other needs, today’s dollars $145,657

Step 5. Establish Insurance Need

Total lump sum needed for all needs, today’s dollars $1,353,421 Available assets $64,000 Total insurance needed, today’s dollars $1,289,421

INSURANCE NEEDS ANALYSIS—LAURA Inputs

General

Dan’s age 35 Laura’s age 35 Dan’s retirement age 55 Laura’s assumed age of death 35 Dan’s assumed age of death 95 Years in preretirement period 1 18 Years in preretirement period 2 2 Years in retirement period 1 10 Years in retirement period 2 30

Dan

Salary $100,000 Annual increase through 2021 10% Annual increase beginning 2022 3% Social Security benefits Dan’s Social Security in retirement 25,512 Survivor benefits until children grown, before tax1 24,150

Expenses

Current expenses $103,032 Expense reduction at Laura’s death 10% Expenses after Laura’s death 92,729 Expenses after children grown 72,841

Available Assets

Investment assets $150,000 Liabilities 86,000 Available assets 64,000

Economic

Inflation 3.0% Investment return 7.7% After-tax investment return 5.5% Real return 4.6% After-tax real return 2.5% Average tax rate, preretirement period 30% Average tax rate, retirement period 28%

1 Estimate. Actual numbers will be modestly different because different benefits end in different years.

566 Integrated Decision Making

Step 1. Determine the Amount Needed to Fund the Preretirement Period

Preretirement period 1, years 1–18

Annual expenses $92,729 Social Security survivor benefits, after taxes 17,992 Annual shortfall 74,737 Lump-sum currently needed 1,102,088 NPV Dan’s salary, after taxes 1,445,285 Lump-sum surplus, today’s dollars $343,198

Preretirement period 2, years 19–20

Annual expenses $92,729 Social Security survivor benefits, after taxes 0 Annual shortfall 92,729 Annual shortfall, year 19 157,865 Lump-sum shortfall, year 19 311,925 Lump-sum shortfall, today’s dollars 118,099 NPV Dan’s salary years 19–20, after taxes 147,223 Lump-sum surplus, today’s dollars $29,124

Step 2. Determine the Amount Needed to Fund the Retirement Period

Retirement Period 1 (55–65)

Living expenses in today’s dollars $72,841 Income 0 Annual shortfall, today’s dollars 72,841 Annual shortfall, age 55 131,559 PV lump-sum future survivor benefits 52,737 Lump-sum shortfall, age 55 1,128,953 Lump-sum shortfall, today’s dollars $383,712

Retirement Period 2 (65–95)

Living expenses in today’s dollars $72,841 Social Security benefits, after taxes 16,835 Annual shortfall, today’s dollars 56,006 Annual shortfall, age 65 135,941 Lump-sum shortfall, age 65 2,927,300 Lump-sum shortfall, today’s dollars $580,044

Step 3. Determine the Total Lump Sum Needed Today

Lump-sum surplus, preretirement period 1 $343,198 Lump-sum surplus, preretirement period 2 29,124 Lump sum currently needed, retirement period 1 383,712 Lump sum currently needed, retirement period 2 580,044 Total lump sum needed, today’s dollars $591,434

Capital Needs Analysis 567

College Student Case Study and Review: Amy and John CAPITAL NEEDS ANALYSIS Withdrawal Rate Method Amy and John requested that I help them with their parents’ planning for retirement. They said their parents were “knee deep” in the aid they were giving both their children to help them attend their colleges. At the same time neither had fully recovered the level of income they had prior to the recession. Their choice had been to ignore the issue. Both of them were concerned about their parents’ preparation for retirement. They won- dered whether their parents had presented the gift of sessions with an advisor to help them, even press them to resume savings for retirement. As their undergraduate college graduations got closer and therefore costs were winding down, the time seemed appropriate for a new effort. They spoke to their parents about their concerns and found them receptive to some fact- finding. In fact, they asked their children to find out what the advisor thought they should save annually. I gave them a blank form to give to their parents and instructed them on how to fill it out, including the calculations.

Establish the Assumptions and Facts Retirement Years Their parents indicated they thought that their retirement would

start at age 67 and they would fund to age 87. John objected, indicating that they were in good health and had good health habits. He said they should fund to age 97, which he reasoned was about the age middle income people had about a 10% chance of attaining. He said half kiddingly, I don’t want to sup- port you if you live an extra-long life. They agreed to age 97.

Asset Allocation After much discussion they arrived at a 50% stocks, 50% bonds allocation. They said they were aware that some advisors rec- ommended that the allocation to stocks go down as they aged. However, they believed that with their funding conservatively for a life expectancy and for a long-term asset growth rate, they wanted to maintain that allocation throughout retirement.

Step 4. Repeat Steps for Other Needs

Lump sum needed currently for college $125,657 Burial expenses 20,000 Total lump sum for other needs, today’s dollars $145,657

Step 5. Establish Insurance Need

Total lump sum needed for all needs, today’s dollars $737,091 Available assets $64,000 Total insurance needed, today’s dollars $673,091

568 Integrated Decision Making

Projected Growth Rate Initially they said they had no idea what that figure would be but eventually started with the long-term historical average of about 10% stocks, 6% bonds. To make the projection more conservative they took 2% off stocks and 1% off bonds end- ing up with a projected 8% for stocks, 5% for bonds over their life spans.

Projected Savings They indicated they hadn’t been saving at all, dipping into sav- ings for about $15,000 a year when all the costs of about $40,000 a year for supporting their children were added in. They thought they could save $25,000 a year beginning next year when their two children were out of school and working.

Calculate the Amount of Financial Assets at Retirement Their parents had told them they had saved $310,000, all before their children entered col- lege. Given that they expect to be working until age 67 and they are 52 presently they would have 15 years of making deposits of $25,000 a year.

15 6.5 310,000 25,000

1,401,825

N I/Y PV PMT FV

50% of asset allocation in stocks at 8% and 50% in bonds at 5% 50% × .08 + 50% × .05 4% + 2.5% = 6.5% investment rate of return They would have $1,401,825 at retirement.

Determine the Annual Cost of Living Beginning in Retirement They indicated that excluding college costs and income taxes their cost of living was about $103,800 a year currently. They thought that after the decline in work-related expendi- tures, and income taxes now included in the total costs for simplicity purposes, and the increase in leisure costs including greater travel, their total expenditures would be $103,800 a year in retirement.

15 3 103,800

161,717

N I/Y PV PMT FV

N = 15 years to retirement PV = Current projected retirement expenditures of $103,800 to be adjusted upward due to

inflation to age 67. i = Projected inflation rate of 3%, the long term average for the U.S. The cost of living at retirement would rise to $161,717.

Ascertain the Amount of Annual Income Available for Retirement Both had selected the age of 67 remembering that it was then when normal Social Security payments begin. Both believed given their salaries that they would receive

Capital Needs Analysis 569

the maximum payment, which as of 2013 was $30,396 annually for each or $60,792 in total

15 3 60,792

94,712

N I/Y PV PMT FV

N = 15 i = inflation rate of 3% Their projected income at the beginning of retirement would be $94,212.

Develop the Initial Annual Withdrawal Needed Initial withdrawal need = Retirement living costs − Retirement income

= 161,717 − 94,712 = $67,005

Compute the Annual Withdrawal Rate Annual withdrawal rate = Initial withdrawal rate/Investment assets available

= 67,005/1,401,825 = 4.78% Therefore, the figure for a withdrawal rate and 73% chance of success falls well short of the margin of safety established of 90%.

If Necessary Review and Reconsider Key Figures Amy and John conveyed to their parents that their withdrawal rate was too high. Something would have to be done. They presented a 4% figure as the maximum that would be accept- able. They presented it as:

Annual Withdrawal Rate = Initial withdrawal need Investment assets at beginning of retirement

4% = Initial withdrawal need 1401825

Initial withdrawal need = 1,401,825 × .04 = $56,073

They told their parents they would have to cut their retirement living expenses from $67,005 to $56,073, by a little less than $11,000 a year. Their parents smiled and said they could do so.

Finalize the Savings and Withdrawal Pattern It is clear that savings should amount to $25,000 a year until retirement. Projected spend- ing and the initial withdrawal need in retirement are to be cut back to $56,073 a year.

Review and Update Their parents agreed to meet once a year to determine whether there were any material changes in projected cash inflows and outflows. They agreed that any perceived temporary declines in the stock market, particularly prior to retirement, would not by itself result in a change in the amount placed in savings and later on in withdrawal rate.

570 Part Seven Integrated Decision Making

I took John aside and told him since he had potential interest in becoming a financial advisor I would discuss more extensive retirement planning with him. I told John that the calculation provided used the withdrawal rate method, which was the abbreviated form of capital needs analysis. The regular form of the capital needs analysis was the approach provided in the Dan and Laura case study handed out to both he and his sister earlier. It incorporated all income and expenses and financial assets in a detailed format. However, it did not take into account any risk, which could be done by using Monte Carlo simulation. The TPM® approach, which includes all assets and irregularities and their correlation as well as income and expenses, would be the most comprehensive method to plan for retire- ment needs as well as life insurance planning.

Summary This chapter demonstrated how to do a simple capital needs analysis and outlined other methods. You learned that

withdrawal rate method uses an abbreviated withdrawal method. The regular form is a more involved simple needs analysis than the withdrawal rate method.

uncertainty.

planning. It combines PFP and the calculation of investment returns.

amount of cash shortfall at retirement and the sums needed to meet it.

Key Terms financial integration, 537

Monte Carlo analysis, 539

retirement needs analysis, 549

finplan.com

This site contains a section dedicated to capital needs analysis.

Website

Questions 1. Why perform a retirement needs analysis?

3. Identify the advantages of Monte Carlo simulation. 4. What is total portfolio management? 5. Why is overhead cost considered a liability under TPM? 6. Should a comedian and a government employee receive the same financial asset

allocation if they have similar tolerances for risk? Why? 7. Provide a reason why a real estate salesperson should not have the same amount

allocated to his or her home as the average person. 8. Discuss the planning steps in a simple capital needs analysis.

Capital Needs Analysis 571

9. Why bring figures from today to the beginning of the retirement period? 10. When should the investment rate, the blended rate, and the inflation rate be used,

respectively? 11. List the steps in the retirement needs analysis. 12. What are the weaknesses of the withdrawal rate method? 13. What are the advantages of the withdrawal rate method? 14. Why can it be beneficial to raise or lower the withdrawal rate in response to market

fluctuations? 15. What factors would cause one to increase the withdrawal rate? 16. What factors would cause one to decrease the withdrawal rate?

Problems If the investment rate of return is 7 percent after tax and the inflation rate is 4 percent, find the blended rate of return. Eleanor needs $40,000 a year to live on in retirement net of the income she will receive. She will be retiring in 22 years and is funding for a 25-year retirement. The inflation rate is expected to be 3.5 percent a year and the after-tax return on her investments 6 percent.

a. How much will the shortfall amount to at the beginning of the retirement period? b. What lump sum will she need at the beginning of the retirement period? c. What is the required yearly savings?

Frank, age 28, wants to calculate his resources in real (inflation-adjusted) terms. Calculate the amount of resources made available by age 65 retirement if $18,000 a year is saved. Assume that outflows from ages 65 to 90 are at the rate of $27,000 a year. The projected inflation rate is 4 percent, and the anticipated investment return is 6 percent.

a. How much in new savings will Frank have available at age 65 before subsequent withdrawals?

b. How much will he have left at age 90? c. What is the present value of that sum at age 65? d. How much will he have to save per year to exactly meet his need?

The Smiths had $110,000 in savings at age 51. They had a desired retirement age of 65. They want to fund through age 92. Assume a 4 percent inflation rate and a 5 percent after- tax rate for investment both pre- and postretirement. They have household income of $140,000, which is increasing at the rate of inflation. Their expenditures including taxes are $125,000 a year. They estimate that in retirement they will receive $28,000 a year together in Social Security and Mr. Smith will receive a $12,000-a-year pension, both in today’s dollars. Their retirement expenditures would be $90,000 a year in today’s dollars.

1. Calculate a. The lump sum needed at retirement. b. Current assets available at retirement. c. Yearly savings needed. d. The difference between needs and resources.

2. Analysis a. Is their retirement plan achievable as is? b. If not, what are the alternatives that could help reconcile needs and resources? c. What is your recommendation?

17.1

17.2

17.3

17.4

572 Integrated Decision Making

Magdalena, age 35, has $72,000 accumulated in savings. She projects she will save $23,000 a year until her retirement at age 67. Her current cost of living is $100,000. In retirement, she will receive $31,704 per year in Social Security and $20,000 in pension, both in today’s dollars and both expected to rise by the rate of inflation. Her retirement cost of living is expected to decline by $6,000, in current dollars in the first year of retirement and thereafter grow at the projected inflation rate of 3%. Her projected annual investment return is 6%.

a. Calculate her accumulated savings at retirement. b. Calculate her annual income, expenditures, and annual withdrawal for the first year

of retirement. c. Develop a withdrawal rate. d. Does she meet the withdrawal rate method of deciding whether she will have sufficient

funds to retire? If not, what do you recommend and why?

A client is concerned about the impact that inflation will have on her retirement income. The client currently earns $40,000 per year. Assuming that inflation averages 5.5 percent for the first five years, 4 percent for the next five years, and 3.5 percent for the remaining time until retirement, what amount must her first-year retirement income be when she retires 13 years from now if she wants it to equal the purchasing power of her current earnings?

a. $62,550 b. $68,841 c. $70,520 d. $80,231 e. $83,157

Billy’s objective is to retire at age 65 with $2,000 in monthly retirement income, exclusive of Social Security benefits. He assumes a life expectancy of age 95. The union retirement plan will provide him with $1,000 monthly. (There are no matching contributions from Billy’s employer to the plan, and his income is adequate to have the required level of con- tributions fall within the deferral limits of the plan. Contributions and payments, as appro- priate, are made at the beginning of each month.) If the return in the company’s plan is 10 percent, what monthly amount will Billy have to contribute to that plan for 10 years to meet his objective?

a. $556 b. $566 c. $576 d. $747 e. $1,113

A couple wants to accumulate a retirement fund of $300,000 in current dollars in 18 years. They expect inflation to be 4 percent per year during that period. If they set aside $20,000 at the end of each year and earn 6 percent on their investment, will they reach their goal?

a. Yes, they will accumulate $10,368 more than needed. b. Yes, they will accumulate $47,454 more than needed. c. No, they will accumulate $10,368 less than needed. d. No, they will accumulate $47,454 less than needed.

17.1

17.2

17.3

CFP® Certification Examination Questions and Problems

17.5

Chapter Seventeen Capital Needs Analysis 573

Appendix I

Life Insurance Needs Analysis and Case Study Life insurance needs analysis provides the amount of life insurance that is required to help fund the household’s cost of living if a wage earner were to die. The lump-sum proceeds from the policy generate the income and often the principal as well to at least partially replace the wages lost. The amount of insurance to be purchased with this approach is based on need, not income replacement. In sum, our objective is to identify the amount of capital needed—in this case, life insurance—to fund a comfortable lifestyle for remaining members of the household. Living costs often vary over a life cycle. Therefore, it is useful to separate needs into periods that we can call financial passages. Clearly, passages differ from person to person. We will use one common life cycle period approach. The initial period can begin with the establishment of a separate household. At this time, life insurance may not be necessary. Successive periods can result in marriage, purchase of a home, and children. At this point, life insurance needs are commonly divided into three periods. The first period is for funding until the children are out of the house. Social Security commonly provides assistance in the event of the untimely death of a spouse. The second period is the one without children while the surviving spouse is still working. Living costs may be reduced, given the lower number of household occupants. The final period is retirement, when costs may decline for reasons we have already discussed. Each period has its own cash inflows and outflows. The approach taken is very similar to that for retirement needs. In fact, as you can see, retirement planning can be considered a subset of life insurance planning. One difference in calculation is that in the life insurance retirement calculation, the figures are adjusted for the absence of the deceased household member’s income. The steps in life insurance analysis, then, are very similar to those for retirement needs. Therefore, we will focus on differences and not repeat similar descriptions.

1. Review goals. Here your goal is to fund a given living cost for the surviving spouse and any children in the event of the untimely death of a wage earner.

2. Establish risks and tolerances for them. The risks are provided in Chapter 11, Risk Management.

3. Determine investment and inflation rates and time spans for calculations. The approach is similar to the retirement one as shown on page 550.

4. Project income, expenses, and cash savings during each financial period. This was discussed on pages 550–552. Include amounts for major outlays, which may be handled separately. One example is educational expenditures.

5. Calculate lump sums needed for each period and outlay. The method is shown under retirement needs analysis on page 557. However, the approach here is to bring all figures to the current period rather than the beginning of the future period, as done for retirement.

6. Calculate total current need. In calculating need, include burial costs. 7. Deduct current resources. This step is self-explanatory. 8. Establish total insurance need. Add up all separate insurance needs. 9. Deduct existing insurance. This step is self-explanatory.

574 Integrated Decision Making

10. Determine additional life insurance needed.15 Total needs less the value of existing life insurance.

11. Implement. Obtaining life insurance occurs in steps. One step often required is a phys- ical exam. Procrastination can temporarily postpone or even permanently prevent the purchase of the insurance. Therefore, action should be taken as soon as it is feasible.

12. Review and update. Insurance is a prime example of a changing need. As you age, the amount of total wage earnings lost due to an untimely demise declines. At the same time, your financial assets generally increase. Therefore, the amount of insurance needed tends to decline over time. Of course, for people who don’t save and liquidate existing investments, the opposite is true; for them, life insurance needs increase.

As you can see, the estimation of insurance needs should be updated periodically to accommodate significant changes in circumstances. Here we turn to a practical example of the calculation of life insurance needs. It is an extension of the Johnson case already discussed. It reflects all the adjustments made in the retirement section and the change to an age-70 retirement, including the cost cutback and full-time job for Sarah. We can now gather the key facts in the Johnson case. Frank and Sarah, currently age 50, have only $35,000 in savings and have finally decided to do something about it. They have agreed to fix their current spending including taxes at $154,000 and cut their retirement spending from $95,000 to $80,000. Sarah’s decision to take a full-time job will raise her pretax income to $45,000 from $10,000 and increase her taxes from $3,000 to $15,000. The extra $12,000 in taxes is part of the current spending figure of $154,000. So actually other household spending has declined by $8,000. The retirement age has been pushed back to age 70; the funding for retirement will be until age 91. Let’s summarize and elaborate on the Johnsons’ facts. These facts are all you need to know to complete the life insurance needs analysis.

1. Determine Goals Frank and Sarah, now age 50, finally have decided to save and plan for retirement. Frank wants Sarah to have enough insurance to maintain her current standard of living should he die. Knowing how important it is for them to save, he says to assume that the cost of the insurance will be met by further cuts in other household costs. He doesn’t believe it is necessary to have insurance on Sarah’s life. Should something happen to her, he will live on his salary alone.

2. Establish Risks and Tolerances for Them The Johnsons have described themselves as moderate risk takers in investments and in other areas of their lives.

3. Determine Investment and Inflation Rates and Time Spans for Calculations Based on risk preferences and their feelings, investment rates of 5 percent after tax and inflation rates of 3 percent were established. The couple decided to fund retirement

15 Disability needs can be handled similarly to life insurance. The differences are possible Social Security payments received for the disability and the extra household costs for the disabled person. Also, disability insurance is generally linked to 60 to 70 percent of prior income, regardless of need. Companies don’t want you to be tempted to profit on an after-tax basis because you are disabled. If you expect your salary to climb sharply, you will have to wait to contract for additional coverage.

Chapter Seventeen Capital Needs Analysis 575

expenses from age 70 to age 91, a 21-year life span. Their current working period is for 20 years.

4. Project Income and Expenses during Each Financial Period There are only two periods to be concerned about because the Johnsons’ children are all independent adults. The statistics for each period are shown in Table 17.A1.1. Assume burial costs of $20,000. Steps 5 to 10 utilize the explanations provided on pages 573–574. As we did in retirement needs analysis, we begin by presenting a life insurance needs calculation format in Table 17.A1.2, followed by the actual calculations for preretirement and postretirement periods presented in Table 17.A1.3.

11. Implement After some further reminder, the Johnsons implemented the life insurance recom- mendations. They chose 20 percent whole life and 80 percent term with affordability and an optimistic assessment of working the need down over time. The advisor believed that with retirement and insurance needs on the way to being satisfied, he had accomplished something.

12. Review and Update The advisor knew that further progress would hinge on Frank and Sarah’s continued motivation and a supportive but firm attitude by him. The first follow-up meeting was set up.

As Planned Revised Explanation

Preretirement Period, Ages 50–70

Revenues Frank work $140,000 $0 In the event of Frank’s death Sarah work 45,000 45,000

Total revenues $185,000 $45,000 Expenses 154,000 127,000 154,000 – 27,000

Expenses attributable to Frank Cash flow $31,000 ($82,000)

Postretirement Period— Ages 70–91

Revenues Pension—Frank $12,000 $12,000 Sarah receives some amount if

Frank dies Social Security—Frank 22,000 — Social Security—Sarah 11,000 22,000 Sarah gets only Frank’s pension

Total revenues $45,000 $34,000 Expenses 80,000 53,000

Cash shortfall ($35,000) ($19,000)

TABLE 17.A1.1 Life Insurance Statistics

TABLE 17.A1.2 Life Insurance Calculation Described

Step Item Symbol Explanation and Calculation

3 Investment rate IR The rate of return for investments 3 Inflation rate ER The rate of increase in expenses 3 Real rate RR The combination of the inflation and investment rates

Formula: RR = a 1 + IR 1 + ER − 1b × 100

3 Present time t0 Today 3 Future time t1 Beginning of payout period 3 Number of years for period Ntp From beginning to end of life cycle period 3 Number of years to beginning of period Nt1 From today to start of life cycle period 3 Number of years to today Nt0 From beginning of life cycle period to today 4 Cash inflow CIt0 Includes the total of job, investment, and other yearly cash inflows

for the period in current dollars 4 Cash outflows COt0 Discretionary and nondiscretionary expenses, capital expenditures,

and other yearly cash outflows for the period in current dollars 4 Cash shortfall CSt0 Current yearly cash inflows minus cash outflows CSt0 = CIt0 − COt0 5 Cash shortfall future CSt1 Current yearly shortfall brought forward to beginning of life cycle

period. The inflation rate is used to calculate the estimated future cost of the present cash shortfall.

Calculator Solution Inputs: Nt1 ER CSt0 N I/Y PV PMT FV Solution: Press for CSt1 5 Lump-sum shortfall future LSt1 Amount of full life cycle period yearly shortfalls discounted back to

beginning of life cycle period. Since there is a series of payments involving both investment and inflation factors, the real rate is employed. Use BEGIN function for beginning of year payments.

Calculator Solution Inputs: Ntp RR CSt1 N I/Y PV PMT FV Solution: Press for LSt1 5 Lump-sum shortfall today LSt0 The shortfall for the period brought back to the present to be

aggregated with other life cycle period and specific expenditure needs. The investment rate is used to tell us how much we need to receive in life insurance proceeds and invest today to meet the lump-sum shortfall at the beginning of this period.

Calculator Solution Inputs: Nt0 IR LSt1 N I/Y PV PMT FV Solution: Press for LSt0 6 Life cycle period Each need requires a full separate set of calculations. Each

succeeding life cycle period to be calculated is denoted by a higher time symbol, starting with t0

6 Need period ages 50–70 LSwt0 Life insurance need for preretirement period in current dollars

6 Need period ages 70–91 LSrt0 Life insurance need for retirement period in current dollars

6 Need educational LSet0 Life insurance need for individual expenditure in current dollars

6 Need burial LSbt0 Burial costs in current dollars

6 Total need TLSt0 Gross sum of all separate life insurance needs in current dollars TLSt0 = LSwt0 + LSrt0 + LSet0 + LSbt0 7 Existing investment assets AAt0 The amount of investment assets available today 8 Total life insurance need LINt0 LINt0 = TLSt0 − AAt0 9 Existing life insurance ELIt0 The amount of life insurance available today 10 Additional life insurance required LIRt0 The amount of life insurance recommended to purchase LIRt0 = LINt0 − ELIt0

Capital Needs Analysis 577

TABLE 17.A1.3 Life Insurance Calculation Performed for Working Years 50–70

Step Item Revised Symbol Explanation or Calculation

3 Investment rate IR 5% given 3 Inflation rate ER 3% given 3 Real rate RR 1.9417

RR = a1 + 0.05 1 + 0.03 − 1b × 100

3 Number of years to beginning of period Nt1 20 Age 50 to age 70 3 Number of years for payout period Ntp 21 Age 70 to age 91 3 Number of years future period to today Nt0

20 Age 70 to age 50

Preretirement Period 50–70

4 Cash inflows CIwt0 $45,000 given

4 Cash outflows COwt0 $127,000 given

4 Cash shortfall CSwt0 $82,000 127,000 – 45,000

5 Lump-sum shortfall today LSwt0 Inputs:

20 1.9417 82000 (Use BEGIN function) N I/Y PV PMT FV Solution: Press $1,374,568

Postretirement Period 70–91

4 Cash inflows CIrt0 $34,000 given

4 Cash outflows COrt0 $53,000 given

4 Cash shortfall today CSrt0 $19,000 53,000 – 34,000

5 Cash shortfall future CSrt0 Inputs:

20 3 19000 N I/Y PV PMT FV Solution: Press $34,316 5 Lump-sum shortfall future LSrt1

Inputs: 21 1.9417 34316 (Use BEGIN function) N I/Y PV PMT FV Solution: Press $598,601 5 Lump-sum shortfall today LSrt0

Inputs: 20 5 598601 N I/Y PV PMT FV Solution: Press $225,606 6 Total need TLSt0 TLSt0 = LSwt0 + LSrt0 + LS

1 et0

+ LSbt0 = 1,374,568 + 225,606 + 20,000 = $1,620,174 7 Existing investment assets AAt0 $35,000 given 8 Total life insurance need LINt0 LINt0 = TLSt0 − AAt0 = 1,620,174 − 35,000 = $1,585,174 9 Existing life insurance ELIt0 No existing life insurance 10 Additional life insurance required LIRt0 LIRt0 = LINt0 − ELIt0 = $1,585,174

1 In this case, none was needed.

578 Integrated Decision Making

A Shorter Method for Calculating Retirement Needs This method combines some of the steps shown in this this chapter. It employs the keystrokes used to calculate net present value for uneven cash flows. This allows us to calculate, in one step, the net present value (in current dollars) of all of the outflows that will occur in retirement, taking into account the current assets. We can then use that net present value to calculate the annual con- tribution required to fund retirement. The calculator solution is shown below. Note that the solu- tion uses the same inputs, and results in the same solution, as the method shown in Table 17.6.

Inputs

Investment Rate 5% Inflation Rate 3%

Real Rate 1.9417 a1.05 1.03

− 1b × 100 Number of Years to Retirement 17 Retirement Cash Shortfall 55,000 Current Assets 35,000

In the first step, we calculate the lump sum needed today to fund retirement (assuming no an- nual contributions are made). If the retirement withdrawals will be made at the beginning of the year (as in our case) the frequency of the CF1 gets shortened by one year to account for that.

General Calculator Approach Specific HP12C Specific TI BA II Plus

Clear the register CF f FIN 2nd CLR Work

CHS +/–

Enter current assets g CF0 Enter □ 35,000 35,000

Enter CF1 (preretirement) 0 g CFj 0 Enter □ Enter frequency of CF 16 g Nj 16 Enter □

Enter CF2 (postretirment) 55,000 g CFj 55,000 Enter □ Enter frequency of CF 25 g Nj 25 Enter □

NPV Enter the discount rate 1.94175 i 1.94175 Enter □

Calculate the Net Present Value f NPV CPT

759,805 759,805

The next step is performed using the PMT function on the financial calculator to calculate the annual contribution.

17 5 759,805 0

67,394

N I/Y PV PMT FV

↓

↓ ↓

↓

579

Chapter Goals

This chapter will enable you to:

Dan was feeling anxious. The process was drawing to a close and he wasn’t sure I was aware of the scope of their goals or of the conflicts he and Laura were having.

Real-Life Planning Marisa was V.P. of marketing for one of the country’s largest corporations. She was in charge of a worldwide staff of hundreds of financial people. She had an MBA with honors from a prestigious university paid for by her corporation. She also had a chaotic personal financial situation. Although her salary and bonus amounted to over $1 million a year, she had trouble sav- ing. She called it “easy money,” meaning easy to spend. Each year she would set a target amount of savings and each year she would miss by a mile. Marisa’s job required that she be on top of every major consumer trend in the country. She was very successful at doing that. Her investment policy consisted of buying stocks in com- panies that were also in fashion at the moment. She would swap them frequently for new ones in “hot” areas of the market, almost invariably taking a loss on her initial investment. She was fickle in her attention to her personal affairs. She paid her bills when she felt good about herself and in the mood for doing so, often less than once every three months. Consequently, she had credit card penalties even when there was enough money in her bank account to pay her debts earlier. Her credit rating was poor, and she had been rejected by more than one department store for simple credit. Marisa told the advisor that she was aware of the contrast between her position at work as a capable executive and her shortcomings in personal affairs. The advisor thought to himself, in addition to instructions on the right way to handle financial affairs, why don’t

Chapter Eighteen

580 Integrated Decision Making

more financial textbooks discuss shortcomings in behavior? What this woman needed was someone who understood her weaknesses and found ways of helping her overcome them. Financial planners who had such an understanding of human behavior had one more weapon in their arsenal. The advisor told Marisa she could hire one or more financial people to help her with her personal difficulties on an ongoing basis. It would allow her to focus on her career, which could be the most efficient solution. He wasn’t surprised when Marisa turned the idea down. He knew she was an achiever who wanted to handle her own affairs. The advisor looked for a way to get his message across to Marisa in a way that she would understand and appreciate. He shifted gears and told Marisa to manage her house- hold affairs as though they represented a separate business division of her corporation. By that, he said, he meant to do whatever it took to turn her financial affairs around. He advised her to have her money taken directly from her paycheck and told her to assume it was unavailable. He recommended that she use mutual funds but also told her to con- tinue to select individual trend-setting stocks for 10 percent of her portfolio. That 10 percent would provide her with pleasure and allow the remaining 90 percent of the portfolio to grow for future goals. Marisa agreed to have a close relative come in once a month to pay her bills. The advisor then recommended that she take a course in investments. He told her to be aware of behavioral weaknesses such as impulsive spending and investing in what the crowd is buying, which can undermine assets and PFP overall. As a motivating tool, he told her to visualize her goals and imagine her retirement lifestyle if she continued her current financial patterns versus her retirement situation if she implemented the plan that she and the advisor were now developing together. The next time he saw Marisa, she seemed to be a changed person. No longer did she have an embarrassing private financial situation. Instead, she had developed pride in her investment capabilities. Her individual stock selections began to incorporate fundamental analysis, and she now knew more about individual mutual fund selections than almost any of the advisor’s other clients. Given her large salary, her new savings pattern had placed her close to the right path for her age and goals. Now that her financial situation seemed well in hand, she began to expand on her goals in life, what some advisors call life planning. She wanted a greater profile in her industry and also wanted to do charitable work. After further discussions with the advisor, she realized she was drawn to the option of starting a second career at age 50 with no further need for job-related income. For the first time, she was receptive to the idea of a financial plan to establish the numbers needed to make financial indepen- dence happen, to prepare the groundwork for life planning, and to protect herself against unforeseen circumstances. The advisor reviewed her situation and his role in it. Clearly, her problem wasn’t gener- ating enough financial resources. Her salary was the envy of most people. Instead, it was her behavior patterns that were undermining her progress. Once she had gained some ad- ditional investment knowledge and learned to understand and overcome her behavioral shortcomings, and to get in touch with her goals, her progress was fine. His role in this case was as much behaviorally as financially related.

OVERVIEW

There is a great difference between the way things should be done and the way they actu- ally are done. When we were young, our parents taught us certain rules of conduct and sometimes broke them themselves. Perhaps you’ve heard the expression, “Do as I say, not as I do.” Textbooks often provide ideal rules, formulas, and other courses of action but

Behavioral Financial Planning 581

ignore the fact that humans often fall short of such rules. That is unfortunate, particularly for PFP. Knowledge of actual human behavior is arguably more important for PFP than for any other area of finance, given its closeness to human actions and its emphasis on practicality. In fact, many people come to financial planners as much to “get structured” as for the spe- cific recommendations. They know that structure makes it easier to implement their goals and therefore less likely they will lose control or focus. This chapter examines behavioral finance, the study of how humans actually per- form. Its objective is first to provide information on the reasons that the results of peo- ple’s financial planning often fall short of maximum potential and then to address what can be done about it. Its scope is an unusually wide one for coverage of behavioral finance and it employs practical tools to improve performance, a prime objective of behavioral financial planning. Behavioral financial planning operations can be separated into two components. The first is traditional money planning and making more efficient financial decisions. The second objective is to help clients reach their nonmonetary goals, which are incorporated under the term life planning. Planners vary in the degree to which they deal with this topic, which of course has a financial component. It is considered in a separate part of the chapter. Behavioral characteristics are relevant throughout the financial planning process. However, they may be particularly important toward the end of the process, when integra- tion and decision making occur. It is at this point that a “reality check” is in order. You must shift from what is primarily a numbers orientation to what is achievable. Knowledge and practice of behavioral financial planning can raise that achievement level. Integration, in this sense, means making sure you have folded in human characteristics. We begin by providing an understanding of behavioral finance and what distinguishes it from traditional logical financial behavior. The chapter examines the major reasons for human weaknesses and specific human shortcomings and how to overcome them. It then discusses goals that differ from traditional money planning. Finally, it discusses how fi- nancial planners can be of assistance in modifying patterns of behavior. The chapter has been constructed as a series of steps leading to an assessment of behav- ioral financial planning and its effectiveness in enhancing actual performance. The first step, determine the goal, follows.

DETERMINE THE GOAL

Our goal is to understand and evaluate the contribution of behavioral analysis to PFP. This goal is stated by John in the practical comment above.

Practical Comment John—Part I

582 Integrated Decision Making

ESTABLISH THE ROLE OF BEHAVIORAL FINANCE

To understand the role of behavioral finance, first we must recall what finance is and con- trast finance theory with actual behavior. Finance can be defined as decision making for limited resources over time. Traditional finance is logical finance; the financial person making that decision for household matters is generally assumed to have superhuman characteristics. You are assumed to act logically all the time in seeking to maximize your pleasure. You have perfect knowledge of all the information you need to make proper decisions and have full capability for recalling past experiences accurately. You also have the intellectual capacity to make the right decisions at all times. The markets that you are exposed to are all highly competitive with no opportunity for expect- ing and achieving greater-than-average profits. And finally, you and all other human be- ings have the same tastes, preferences, beliefs, and abilities.1

We can sum up this superhuman person as behaving like a machine, making no errors. Of course, in reality, no such person exists. The advantage of this approach, which comes out of neoclassical economic theory, allows the testing of financial theories in a quantifi- able scientific way. Behavioral economics and behavioral finance take a different approach. Instead of looking at this “ideal” person (we use quotes here because you might disagree, finding such a person boring), they examine people as they actually are. Behavioral finance 2 can be defined as the study of human makeup and actions that result in deviations from logical economic and financial behavior. This broad definition allows us to examine all differ- ences from programmed machine-like behavior so that you can improve your decision- making capability. Behavioral finance is controversial within the discipline. Some critics believe it has no scientific underpinning. They say it can’t represent all people with one analysis, much less measure them numerically. Moreover, critics say, its generalizations come from laboratory experiments and questionnaires, not from how people act in real life. Those who support behavioral finance reply that it is difficult to dispute the premise that some human re- sponses and errors are common, so studying them can help to understand and improve human decision making. (See Appendix I.)

UNDERSTAND WHAT BEHAVIORAL FINANCIAL PLANNING IS

Behavioral financial planning is the action arm of behavioral finance. It can be defined as the analysis of individual conduct and the development of practical techniques to im- prove decision making. From a financial standpoint, it looks at human weaknesses and ways of overcoming them to bring you closer to your goals. Behavioral financial planning continues the broad definition of behavioral finance. Its mandate is to focus on any behavior that provides a shortfall from ideal results and can be improved upon. We will begin by outlining the areas in which human shortcomings arise. A breakdown of human behavior into rational and irrational characteristics is provided in Appendix II.

1 See Richard Blundell and Thomas Stoker, “Heterogeneity and Aggregation,” Journal of Economic Literature 43, no. 2 (June 2005): 347–91. 2 Behavioral economics and behavioral finance are very similar in approach, focusing on the person, with many of the same researchers working in both areas. Here we will combine them.

Chapter Eighteen Behavioral Financial Planning 583

SEPARATE HUMAN SHORTCOMINGS INTO CATEGORIES

Human shortcomings, as they relate to finance, can be thought of as differences between ideal and actual financial outcomes. They restrict our progress toward our financial plan- ning goals. We can separate these shortcomings into two categories: cognitive errors and visceral feelings. We can identify this first grouping of shortcomings as broadly coming from the brain and its reasoning ability. Cognitive errors come from three main areas:

1. Lack of knowledge. 2. Weakness in perception and memory. 3. Limited processing scope and speed.

Knowledge is key. Isn’t that why you are reading this book? You can be highly capable, but, without the information needed to take proper actions, you will fall short of your goals.3

Similarly, if you cannot perceive items correctly or recall them accurately, your decision-making ability is undermined. Example 18.1 presents these weaknesses.

Example 18.1 Lana purchased a health insurance policy online, selecting the one with the lowest cost. Beyond price, she did no research into the available policies. When her financial planner asked about the policy’s details, Lana could not remember any of the policy features; she didn’t even know how much she had saved by buying this policy rather than other choices. When Lana went to see her longtime physician, she later discovered this doctor was not in her plan’s network. Lana’s lack of knowledge, recall, and familiarity with her health care coverage resulted in excess costs that exceeded the amount she had saved with her low-cost selection.

Finally, we know that the brain cannot process at the same pace or with the same range as a computer. A computer has even bested a chess champion. In addition, there are many times when we don’t even want to devote the time and effort to optimal mental processing and prefer a good mental shortcut. For example, the rule of 72 discussed in Chapter 2 is a good shortcut for determining how long it takes for an investment at a given interest rate to double. The second grouping of human shortcomings relates to visceral feelings, or emotions. Emotions, or feelings, can influence our actions. When emotions are thought out and sta- ble, they reflect our preferences and lead to pleasure. On the other hand, visceral feelings can imply urges to take action that are often short term in nature and can cloud mental processing. They can be caused by biological, cultural, psychological, or other variables. Examples of visceral feelings are rage, hunger, fear, pressure, and so on. Finance people might say that those feelings can be irrational because they can result in a very short-term level of satisfaction and long-term dissatisfaction. Full knowledge of the outcomes beforehand might not change the situation because reasoning ability may be cut off. For example, spending money through a credit card can create a temporary emotional high, but it is often followed by a more lasting feeling of depression if it results in an unneeded purchase that will have to be paid off. In sum, all the behavioral characteristics we have discussed are weaknesses. They can still be said to broadly follow a traditional financial model because we still have the desire to maximize the results of our actions in financial terms. We can identify those character- istics as weaknesses because, when given the opportunity to learn or to prevent impulsive behavior, we would take it. This desire to alter our own behavior will be important in dis- tinguishing behavioral weaknesses from nonfinancial goals. (The difference is discussed in the Life Planning part of the chapter.)

3 Financial literacy is covered in Web Chapter A.

584 Integrated Decision Making

PROVIDE SELECTED BEHAVIORAL MODELS AND CHARACTERISTICS

In this section, we will examine models and characteristics of behavioral finance with the objective of better understanding human nature. The models and characteristics shown vary from emotional shortcomings to weaknesses in mental processing. Once you complete this section, you will be better able to identify common mistakes that people make and be prepared to develop ways to overcome them. In other words, you will be able to use behav- ioral planning to improve your financial performance.

Heuristics and Biases Heuristics are simplified human approaches to complex tasks. Our intent in using heuris- tics in day-to-day situations is to reduce decision making to an approach that is easy to handle. Many mental shortcuts result in good decisions.4 Biases, on the other hand, are actions based on a distorted view of reality—and are inevitably harmful in the long run. Flawed heuristics lead to biases.5

Example 18.2 There are a whole host of variables that can go into which television set you decide to buy. You could list them all, assign a relative weight to each based on its importance, then give each television a score for each variable. The outcome would be a weighted average overall score for each television, with the set with the highest score being selected. Although this approach might be a rational way of handling the decision process, few people take it. Instead you use a heuristic, a shortcut to weigh the relative merits of the television set to you. The simplified analysis might include price, quality of picture, reputa- tion of manufacturer, and recommendation of the salesman or of a magazine write-up. Heuristics such as the one for the television may be an effective way to make a good deci- sion. Alternatively, because of a bias (for example, assuming that the reputation of the make as received through its advertising is a benchmark of TV quality), an incorrect outcome could result.

Heuristics and biases were popularized by psychologists Daniel Kahneman and Amos Tversky in their experiments in the 1970s and, as we have indicated, many researchers would probably say they had a great deal to do with the revival of interest in behavioral issues in economics and finance. Here we consider some common heuristics:

Anchoring. Using an outmoded or inappropriate standard can result in making incor- rect decisions when the standard is no longer justifiable. For example, “I know that Sheldon will win the basketball game for us. He always has.” That model may be in- appropriate now that Sheldon is 40 years old. Framing. How you communicate a thought can affect the response. For example, a secu- rity analyst writing a recommendation on a stock may be more likely to find a receptive

4 See Daniel Kahneman and Amos Tversky, “On the Reality of Cognitive Illusions,” Psychological Review 103, no. 3 (July 1996): 582–88; and Gerd Gigerenzer, “On Narrow Norms and Vague Heuristics: A Reply to Kahneman and Tversky (1996),” Psychological Review 103, no. 3 (July 1996): 592–98. In contrast to Kahneman and Tversky, Gigerenzer emphasizes favorable decisions using heuristics, although not necessarily optimal ones. What he calls “fast and frugal heuristics” include such things as rules of thumb, mental shortcuts, and adaptive learning. In “The Power of Heuristics,” ideas 42, January 17, 2014, ideas42.org/new-white-paper-the-power-of- heuristics/, co-authors Antoinette Schoar and Saugato Datta offer examples of effective heuristics-based meth- ods in financial education, agriculture, and medicine. Ideas 42 is a behavioral economics think tank. 5 See Richard Thaler, “Related Disciplines,” Journal of Economic Literature 21, no. 3 (September 1983): 1046–48; and Shlomo Benartzi and Richard Thaler, “Heuristics and Biases in Retirement Savings Behavior,” Journal of Economic Perspectives—Volume 21, Number 3—Summer 2007, pubs.aeaweb.org/ doi/pdfplus/10.1257/jep.21.3.81

Behavioral Financial Planning 585

audience by writing, “Although the company has significant problems, it is highly attrac- tive,” rather than, “The company is highly attractive, but it has significant problems.” Representativeness. Judgments made on the basis of only one or two characteristics instead of embarking on a detailed analysis. For example, “I know that she is a good person; she has a kind face like all the other nice people I interact with.” Availability. Believing that the likelihood that something will occur in the future is determined by how often we recall it. Some people would say, incorrectly, that airplane trips are more dangerous than car trips because they can recall more airplane accidents—clearly, a biased view. Hindsight bias. Believing, after the fact, that an outcome could have been known beforehand. For example, “It was easy to see that McDonald’s would become the number-one fast food chain in the U.S.” The truth is that there were many other chains at the time with similar approaches who either went out of business or re- mained only regional businesses. Often, the observer’s beliefs before an event fade in memory. Salience. Placing too much weight on recent vivid experiences. For example, believ- ing that your favorite baseball team has improved greatly because they won their last two games by wide margins.

Loss Aversion We will go to great lengths to avoid a loss. That is because a loss will create displeasure that is about twice as great as the pleasure from a gain of the same amount.6

Example 18.3 Ryan became extremely uncomfortable with losses in his portfolio. He said it made him feel “dumb.” In fact, he said a loss of $10,000 on one investment would wipe out the pleasure he received from anything lower than a $60,000 gain on another. Ryan recog- nized that this could restrict his investment actions so he bought mutual funds where poor performance of one stock in a portfolio can be offset by gains in many others. In addition, he never looked at his funds when the stock market was weak. He was over- coming loss aversion.

Behavioral Life Cycle Theory The behavioral life cycle theory was formulated by Richard Thaler and H. M. Shefrin,7 two behavioral researchers, both with backgrounds in economics and finance. According to their model, people have two sides to their thinking: personal- ity and actions, called multiple selves. They are the planner side and the doer side. Your planner side acts rationally, always in control, thinking of what is in its longer- term interests. Your doer side is more emotional, reacting impulsively to short-term pleasures without regard to their long-term consequences. Actual behavior comes from a current resolution of the conflict between the two sides, only to be repeated again in future decisions.

6 Amos Tversky and Daniel Kahneman, “Loss Aversion in Riskless Choice: A Reference-Dependent Model,” Quarterly Journal of Economics 106, no. 4 (November 1991): 1039–61. See also Michael S. Haigh and John A. List, “Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis,” The Journal of Finance, Vol. LX, No. 1 February 2005, www2.econ.iastate.edu/classes/ econ642/Babcock/haigh%20and%20list.pdf 7 See Richard H. Thaler and H. M. Shefrin, “An Economic Theory of Self-Control,” Journal of Political Economy 89, no. 2 (April 1981): 392–406, and Shefrin, Hersh and Richard Thaler. 1988. “The Behavioral Life-Cycle Hypothesis.” Economic Inquiry 26, no. 4: 609–43.

586 Integrated Decision Making

Satisficing Satisficing is a term made popular by Herbert Simon, who also introduced the term bounded rationality.8 Simon, a management scientist and economist, defined satisficing as a method by which individuals seek a satisfactory solution, not an optimal one. Once they find that satisfactory solution, they stop the process. A person who purchases apples offered in a clear bag at a store known for its fresh produce and who doesn’t bother to ex- amine each apple closely can be said to be satisficing, not optimizing.9

Mental Accounting Mental accounting, as popularized by Richard Thaler,10 is an attempt to explain the way the brain works in decision making. In this view, the brain compartmentalizes our actions, placing them into certain categories. The categories make sense to us and help motivate us so that we maintain control over our actions. The process may not be rational in the eco- nomic sense of the word, however; for example, you are more likely to save a gift of $10,000 from your parents’ estate than to save $10,000 in winnings from a lottery, perhaps because your parents’ gift is serious money coming from people who raised you to be responsible. The lottery winnings, on the other hand, are considered frivolous—money that came out of the blue and frees you to do what you like with it. To take advantage of such mental accounting, many financial planners recommend that parents of young children establish a dedicated college fund. That money is earmarked for higher education, in the parents’ minds, so it is less likely to be used for other purposes than if the same dollars were held in a regular bank or brokerage account. Additional behavioral models and characteristics are supplied in Appendix III.

LEARN ABOUT WAYS OF OVERCOMING BEHAVIORAL SHORTCOMINGS

As weaknesses in human behavior bring about results that are less than optimal, we turn our attention to ways of overcoming or at least minimizing these weaknesses. Finding the right approach is a prime focus of behavioral financial planning.

Restricting Negative Behavioral Responses—Overall Certain behaviors can inhibit efficient household operations and the achievement of lon- ger-term goals. Following are some of the basic methods for limiting negative responses. Because maintaining control is a very common problem, we give it special attention.

Formal financial learning. To the extent that we can become more knowledgeable about finance in general and useful financial techniques in particular, our actions can improve. Financial literacy is discussed in Web Chapter A.

8 For further details, see Herbert A. Simon, “A Behavioral Model of Rational Choice,” Quarterly Journal of Economics 69, no. 1 (February 1995): 99–118; Herbert A. Simon, “Rational Decision Making in Business Organizations,” American Economic Review 69, no. 4 (September 1979): 493–513; and Patrick Bolton & Antoine Faure-Grimaud, “Satisficing Contracts,” Review of Economic Studies, 2010, Wiley Blackwell, vol. 77(3): 937–71, 07, nber.org/papers/w14654. 9 Satisficing doesn’t fit our definition of bounded rationality given in Appendix II because it lacks a desire for optimization—a necessary ingredient for mainstream, economically rational behavior. 10 Richard Thaler, “Mental Accounting and Consumer Choice,” Marketing Science 4, no. 3 (Summer 1985): 199–214; Drazen Prelec and George Loewenstein, “The Red and the Black: Mental Accounting of Savings and Debt,” Marketing Science 17, no. 1 (1998): 4–28; and James Jinwoo Choi, David Isaac Laibson and Brigitte C. Madrian, “Mental Accounting in Portfolio Choice: Evidence from a Flypaper Effect,” American Economic Review, 2009, vol. 99, issue 5, scholar.harvard.edu/laibson/publications/ mental-accounting-portfolio-choice-evidence-flypaper-effect

Behavioral Financial Planning 587

Experience. Formal learning can be abstract. Experience with real-life financial elements can improve the way we operate. For example, you may notice the impulsive actions you take such as buying a stock after receiving a “hot tip.” As a risk-manage- ment procedure, you might then practice methods such as researching the company online when you are thinking of displaying this behavior again. Self-understanding. The actions we have discussed and will examine further in this section can be identified. Once we understand our shortcomings, we can focus on them to obtain better results. For example, a lack of farsightedness can be helped by thinking about long-term goals and how logically they can be achieved.

Develop Effective Rules of Thumb Keep in mind effective rules of thumb. When you find investments that have attractive operations, compare them with well-tested quantitative criteria. Examples that are given by some are limiting your stock purchases to those that have a price-earnings multiple that is no more than 25 percent higher than the current average market valuation or saving 10 percent of your income.

Limit Reviews of Performance People tend to overemphasize recent results, extrapolating them into the future. For example, in investments, they draw too little distinction between, say, quarterly perfor- mance and a full year’s investment results. Conclusions about performance—whether related to a job, financial investment, or cost increases—should be made over longer peri- ods of time for those susceptible to this human shortcoming.

Obtain Assistance Sometimes others are in a better position to identify our weaknesses and offer suggestions to help overcome them. Objectivity helps. When those weaknesses are difficult to elimi- nate, specialists such as financial planners may be used more frequently.

Savings Mechanisms and Control Saving is a problem for many, and some believe a particular problem for our country. There can be a great disparity between planned and actual savings. We will provide a more detailed list of methods to aid in achieving planned savings. With a few modifications, these methods can be useful in establishing control in a number of other planning areas as well. Several are provided in Table 18.1.

Quarterly Journal of Economics

Handbook of the Equity Risk Premium,

Practical Comment Reviewing Your Investments

588 Part Seven Integrated Decision Making

TABLE 18.1 Methods Helpful for Maintaining Control

Method Explanation

Visualize Visualization can help overcome myopia. Visualize the tangible positive benefits of planned savings and the consequences of not achieving them. Practice mental accounting Saving in separate buckets can assist since it makes the effect of withdrawals more salient. Restrict choices Leaving credit cards at home can reduce impulse buying. Reduce proximity Going to the mall less often can reduce temptation. Utilize commitment devices When control is difficult, have savings wired from bank accounts. In more serious cases, purchase large-outlay whole life instead of term insurance; buy a large home with substantial mortgage payments; join Christmas clubs if that’s what it takes to get you to save. Capitalize on group influence Announce to friends your commitment to save for the year and offer a monetary gift to those who identify a lack of fulfillment. Join with friends who have goals of their own and meet regularly to support those goals. Think about nonessential Overcome impulse buying by providing time between attraction to an item and the actual purchases overnight purchase of it.

APPLY BEHAVIORAL CHARACTERISTICS TO PFP

Table 18.2 provides practical examples of behavioral characteristics. The table presents one characteristic for each major area of personal financial planning and, where appropriate, a method for overcoming the inefficiency. For a more extensive list by PFP area, see Web Appendix C, Behavioral Finance—Applications.

SUMMARIZE “MONEY PLANNING”

In sum, we can say that the goal of behavioral financial planning is to bring actual perfor- mance as close as possible to ideal performance. The difference between the two is, of course, due to human weaknesses. There are a variety of mechanisms for overcoming these weaknesses. The formula given at the top of Figure 18.1 reflects this approach. The expla- nations under the terms are selected characteristics. The approach taken is deliberately expressed financially in order to link behav- ioral with ideal planning. We can call this behavioral approach money planning to distinguish it from life planning, to be discussed next. Money planning can be defined as planning whose goals are strictly financial and do not include life- planning objectives.

= –

Actual dollar goals

Quantitative calculations

Numeric limitations

Ideal dollar goals

Quantitative calculations

Numeric limitations

Lack of knowledge

Weakness in perception and memory

Shortcomings in visceral feelings

Formal learning, experience

Self-understanding

External assistance

Control mechanisms

Actual PFP performance

Ideal PFP performance

Human weaknesses

Weaknesses overcome through selected

methods

FIGURE 18.1 Behavioral Financial Planning: Money Planning

Behavioral Financial Planning 589

TABLE 18.2 Behavioral Examples by PFP Area

PFP Topic and Behavioral Characteristic Example

Financial Investments

Anchoring The financial planner has a trainer who comes in once a week, One time he said to her, “Should I do two more sets than normal?” She said, “It’s good to stretch yourself as long as you don’t think it’s going to be painful.”

That’s the story the planner tells clients who are anchored (wedded) to their current investments but need more diversified portfolios. He tells them it’s time for them to do a little stretching in their portfolio. “Take your 65% stock, 35% bond portfolio and move 5% from bonds to stocks.” So now the client knows that 5% is going to be more volatile than bonds because stocks are more volatile than bonds. Then the planner has the client take 10% of that 70% in stocks and move it into alternatives that follow hedging strategies and thus are going to be less volatile than stocks. If clients do a little stretching, where needed, it can be helpful without being painful.

Taxes

Framing Mason and Marston were twin brothers. Both were in need of cash to live on and told their accountants of their problem. Both had the same stocks with weak outlooks that they had large losses in. Both were told by their accountants to sell the shares. Mason’s accountant said, “Mason, recognize you made a mistake; now sell the shares.” Mason refused. Marston’s accountant had the same request but framed it differently. He said “Marston, let’s ’harvest’ a tax loss by selling the shares and get a significant tax benefit from the government.” Marston agreed to do so.

When the brothers had time to talk about it, they were amused by their different reactions. They decided to confer more closely in the future and to make decisions based on facts, not on the way the facts were “packaged” for them.

Household Investments

Hindsight bias Shane quit her fairly interesting but low-paying job for one that was potentially more lucrative. She thought she was making an investment in her human assets by doing this. As it turned out, the job was a bust. She told everyone what a stupid decision moving was. She said anyone with a brain could see how fortunate she was having her first job. As it turned out, she was able to get her first job back.

Six months after returning, she decided to leave for another potentially more lucrative position. The fact that she left again proved that her after-the-event comment indicating how easy it was to see her mistake in leaving was just hindsight bias. She would be more skeptical of this thinking in the future.

Risk Management

Salience Ben and Len had been close friends since they were very young. Each was highly influenced by the other’s decisions, which meant that often their decisions were similar. Ben bought a long-term care policy at age 51 because another friend’s mother recently had a degenerative disease diagnosis and no long-term care insurance, and his friend was going to have to contribute to her upkeep.

Len, on the other hand, thought long-term care insurance was not productive. He said his wife would take care of him if he got ill. Ben was reacting to a salient event that Len hadn’t witnessed. When they next met, they decided to take a more objective, less personal perspective on frequency of illness before making future purchase decisions.

Educational Planning

Representativeness Hillary wanted to go to a well-regarded graduate school of business in which she would be able to meet other students easily and interact with professors who had practical business experience. She visited the university campus, researched the school’s ranking, and talked extensively with the recruiter. It seemed a good fit, and she accepted.

Unfortunately, the university was large, as were the class sizes, and time with the professors was limited. Hillary’s original analysis and conclusions were based on variables that weren’t representative of her needs. She performed a more extensive analysis of other schools, transferred, and found one that exactly fit her objectives.

(continued)

590 Integrated Decision Making

(concluded )

PFP Topic and Behavioral Characteristic Example

Cash-Flow Planning

Behavioral Life Cycle Planning Don thought about his life cycle–planning “malfunctioning” brain. He could swear he had two inner voices giving him advice. One said plan for the future, calculate how much you can afford to spend today based on life cycle reserves and costs, and stay closely in line with a budget. The second voice said the first voice’s advice was too conservative. It said, Have fun right now; the future will take care of itself; spend and enjoy as much as you can before it is too late.

When he was occupied with doing inexpensive things he enjoyed or was distracted by work, the first voice predominated. When he was depressed or he saw something particularly alluring, the second voice usually won out. He was surprised to find that many people had mixed feelings with two opinion voices about taking spending actions. He decided to try to keep his behavior on more of an even keel.

Don used some of the savings control mechanisms that were discussed in the previous section. As a result, he made significant progress in balancing the multiple- voice advice and in saving more money that would be needed at certain times in his life cycle, particularly retirement. To a material extent, behavioral life cycle planning, which subjected him to inconsistent behavior, was transformed into traditional financial life cycle planning.

Retirement Planning

Satisficing Alex was like other people who came from his family. Even though as a business major at college he was taught to make decisions based on doing the best he could, he retained his family’s values. He took a job that was not too taxing and spent a lot of time on social activities and hobbies. He said he was young and “partying beats retirement planning.” His motto was “Take it as it comes” as opposed to “Live life to the fullest.”

He was aware from college that large early savings in tax-sheltered pension plans would make his later years more enjoyable. He did save some money but never thought of the right balance for himself between fun today and planning for the future, nor did he calculate how much he needed to save to reach his future goals. He read somewhere that people like him were satisficers, not optimizers. He smiled when he saw the article. It seemed to him that many more people were like him as opposed to those who were maximizers.

Estate Planning

Loss Aversion Martha was old and felt that she might not have many more years to go. On the other hand, she was still spry and mentally sharp. She did fairly well in her investments portfolio and had many gains each year that she believed were likely to continue in the future.

She had one stock in her portfolio that she had a major loss in. Her financial planner wanted her to sell the shares and purchase something that he felt was more attractive. She believed he was right but told him she wanted to wait until the shares rebounded and she could recover her original cost. Then Martha’s attorney and financial planner spoke to her together. The attorney told her that if she passed away without selling the shares, her heirs would lose her tax break on sale of a security at a loss. The planner told her the combination of tax loss benefits today, potential elimination of this benefit should she die, and more rapid gain in the new shares would result in more than twice the profit when compared with waiting until the shares recovered. She agreed to sell.

Later Martha thought about her initial reluctance to sell and decided it was due to feeling stupid in buying the shares and having to recognize her mistake when selling. It was only the significant gain that motivated her, which was silly. The shares’ attractiveness was independently determined. Aside from tax impact, the amount any stockholder paid at the time he or she bought as compared with its current price was irrelevant. She decided it wasn’t too late to value securities based solely on her appraisal of their worth. Her ego could withstand any blow due to the sale at a loss. She smiled as she thought, no investor is right all the time.

Behavioral Financial Planning 591

BROADEN BEHAVIORAL FINANCIAL PLANNING TO INCLUDE LIFE PLANNING

Our discussion to date has focused on human weaknesses and ways of overcoming them to bring about more efficient financial operations. Life planning, on the other hand, goes beyond money planning to take into account the analysis and scheduling of steps that will realize personal goals. Therefore, individual motivations cannot be measured in purely financial terms and actions that deviate from money maximization may not be human weaknesses but long-term human preferences. (See Appendix IV.) Life planning is related to what the CFP Board calls values-driven planning or holistic planning. It deals with the personal side of the household enterprise, particularly with the goals of its members. We can use the Practical Comment by a prominent industry spokes- man on the top of the next page as an introduction to the field. Let’s look at life planning more closely, the way many financial planners who prac- tice the approach see it. They believe that what people want or need is a clearer picture of their goals. Some planners would go further and say that people are looking for meaning in their lives.12

Financial planners and/or other client advisors can aid in goal development and the frequent reassessment of those goals. The planners emphasize clarity of goals, thereby starting the client on the path to accomplishing them. They may ask such questions as “If you had five years to live, what would you hope to achieve in that time frame?” or “If you had one day left, what would you regret not having done?” or, more positively, “If you had three very good years, what would you have accomplished toward your goals during that time frame and how would you have done so? How would your life have been different at the end of the period?” Finally, “What additional steps do you have to take to reach your goals?”13 Many types of alternative goals were discussed extensively in Chapter 3. Planners can help in application of procedures to foster development toward those goals. The goals and the process for meeting them influence the planning engagement. Meetings may be held periodically to evaluate progress and ensure that clients are on track toward goal achievement. It is acknowledged that goals may change over time and, once goals are achieved, new ones are often established. Planners who perform these broader services intensively are sometimes called “coaches.” In sum, life planning focuses in depth upon goals and contributes ways of achieving them. It influences all steps in the financial planning process as they are based on the goals established. It extends beyond financial matters, although having money is an important ingredient. The assumptions of traditional financial analysis are questioned in such areas as philanthropy and altruism because assets and time are often given without a direct finan- cial payback. However, life planning takes into account philanthropy and altruism because it emphasizes nonfinancial goals as well as financial ones.14

12 See William Anthes and Shelley Lee, “Experts Examine Emerging Concept of ’Life Planning,’” Journal of Financial Planning 14, no. 6 (June 2001): 90–101; and “Financial Planning: A Look from the Outside In,” Journal of Financial Planning, 6/7/2012, paulahogan.com/images/FE/chain259siteType8/site219/ client/Jrnl_of_Financial_Planning__A_Look_from_the_Outside_In.pdf. 13 For an extensive discussion of this approach, see George Kinder, Seven Stages of Money Maturity: Understanding the Spirit and Value of Money in Your Life (New York: Dell, 2000), and George Kinder and Susan E Galvan, Lighting the Torch: The Kinder Method of Life Planning (FPA Press, 2006). 14 See Joel Sobel, “Interdependence Preferences and Reciprocity,” Journal of Economic Literature 43, no. 2 (June 2005): 392–436.

592 Integrated Decision Making

Life planning is a relatively new area of financial planning. Currently, planners vary greatly in their types of professional practice. Some planners restrict themselves solely to financial matters, while others provide the kind of services described here.16

Life planning belongs under our definition of behavioral finance because it deals with hu- man actions that deviate from the solitary, machine-like financial goal of making as much money as possible. Life planning can be considered a specialty area of behavioral finance. Both financial and nonfinancial goals are considered, and this accentuates the search for client goals and their implementation. The essence of life planning is goal planning. Goal planning is, at least in part, a result of a more affluent society. When people are poor, they concentrate on such basics as food, shelter, and clothing. In middle-class society in the United States today, where the basics are generally taken care of, some people seek to go beyond making as much money as possible.17 Goal planning can be separated into two parts: satisfying basic emotions and achieving nonmonetary goals. Emotions are basic motivational factors. Some examples include feeling secure, having fun, engaging in car- ing relationships, and so forth. Of course, individuals have their own ranking of priorities. The second part of goal planning is involved with the attainment of higher-level goals. These goals may be less concrete and incorporate such higher-level feelings as having completed a primary life goal, living in harmony with nature, and having achieved self- actualization.18 Simply put, it asks such questions as “What do we want to do with our lives?” and “What are our values?” These items under goal planning are difficult or impossible to measure in financial terms. (See Appendix IV.) It is interesting to note that research on happiness by behavioral economists suggests that pleasure from earning more money is temporary. Satisfaction over the life cycle tends to stay level, perhaps regardless of the amount of money earned.19

16 David Dubofsky and Lyle Sussman, “The Changing Role of the Financial Planner Part 1,” Journal of Financial Planning, August 2009, kinderinstitute.com/newsarchive-pdfs/FPA_Journal-August_2009-The_1. pdf. (Part 2, from the September issue of this journal, is at kinderinstitute.com/newsarchive-pdfs/FPA_ Journal-September_2009-The_2-Prescriptions%20for_Coaching_and_Life_Plan.pdf. 17 See Chapter 3 on Maslow’s hierarchy of needs. 18 Humanism is defined in Webster’s dictionary as a way of life centered on human interests or values. Its emphasis on human dignity and worth and capacity for self-realization through reason may best capture this approach. 19 See Bruno S. Frey and Alois Stutzer, “What Can Economists Learn from Happiness Research?” Journal of Economic Literature 40, no. 2 (June 2002): 402–35; Bruno S. Frey and Alois Stutzer, Happiness and Economics: How the Economy and Institutions Affect Human Well-Being (Princeton, NJ: Princeton University Press, 2002); and Bruno S. Frey and Jana Gallus, “Political economy of happiness,” Applied Economics, 2013, Vol. 45, No. 30: 4205–4211, bsfrey.ch/articles/C_556_2013.pdf. Of course, not having sufficient funds to cover basic needs might produce a different conclusion: money alone does not produce a permanently contented person.

Inside Information,

Practical Comment Life Planning Beliefs

Behavioral Financial Planning 593

Example 18.4 From the post–World War II period through the early 1990s, Japan rebuilt itself and in the process moved from a devastated country to the world’s second-largest economy. Yet, during this period, when personal income quadrupled, overall satisfaction in Japan did not go up; it was remarkably level. See Figure 18.2.

Behavioral financial planning is involved in both areas of goal planning. It establishes a money amount required for both basic20 and higher-level feelings. For example, you can- not feel secure unless your elementary financial needs are taken care of. Therefore, tradi- tional financial planning, money planning, must take place. Basic needs should be anticipated and planned for. They necessitate an established bal- ance between work and leisure, ideally incorporating job satisfaction as well as pleasure and caring relationships in your personal life. Knowledge and discipline may be required to establish good health and ethical behavior. Consultations with others and establishing role models can help. Higher-level feelings can require systematic thinking and planning. First, the goals should be analyzed. Questions such as “What do I want to accomplish?” “How can I improve myself?” “What are my true values?” “How can I foster close relationships and help others?” may be asked. Then, whenever possible, concrete goals and a time frame for achieving them should be set out. Experimentation with what are true moti- vations can help. Identifying any career component is useful. Procrastination or slug- gishness in moving toward goals can be overcome by measuring actual against projected progress. And the goals themselves must be reviewed as they can change over time. In sum, life goals are grounded in basic emotions and higher-level feelings. They ex- tend beyond traditional finance but have a financial component. We can distinguish them from shortcomings in behavior because the actions they require are consciously planned for and we want to repeat them. A summary of selected goal-planning characteristics is given in Figure 18.3.

15,000

12,000

9,000

Re al

G D

P pe

r c ap

ita in

c on

st an

t $

Real GDP per capita

Life satisfaction

A ve

ra ge

li fe

s at

is fa

ct io

6,000

3,000

0 1958 1962 1966 1970 1974

Year 1978 1982 1986 1990

3.5

2.5

1.5

FIGURE 18.2 Satisfaction with Life and Income per Capita in Japan between 1958 and 1991

20 Beyond food, clothing, and shelter.

594 Part Seven Integrated Decision Making

BECOME FAMILIAR WITH THE FINANCIAL PLANNERS’ FUNCTION IN BEHAVIORAL ANALYSIS

Financial planners have a multifaceted role in behavioral analysis in both money- and life- planning areas.21 In money planning and life planning, they can provide the benchmark of fi- nancial performance required by clients to achieve their goals as well as the overall planning methods for meeting them. Their role, often as the client’s closest advisor in financial affairs, can provide access to both personality and motivations. They are aware of client weaknesses and can point out specific ways to overcome them. If the problem is one of control, they can establish structures such as savings “buckets” to support control procedures. They can point out unrepresentative feelings such as certain clients’ belief that they are not acting responsi- bly in financial affairs when, in fact, they are. Many financial planners teach their clients how to understand finance and have more positive performance in the future. As discussed, well-being does not just come from monetary rewards. Instead, there are a host of factors that people often look for. They may select an advisor not only for com- petence in financial matters so that they can achieve their money goals but for assistance with human-planning needs.22 Through hard data and a reassuring manner, financial plan- ners can enhance positive feelings. A select number of advisors use their knowledge of clients’ financial facts to help these clients with life planning. Let’s look at some common nonfinancial needs of people that financial planners can help with.

To trust. People seek advisors whom they feel they can trust to represent their best interests and give them straightforward advice. If there are potential conflicts between their interests and those of the advisor, they want them disclosed.

21 See Lewis J. Altfest, “Chapter 10: Motivation and Satisfaction,” 171–188. 22 See Karen Altfest, Keeping Clients for Life (New York: John Wiley & Sons, 2001). While it is still contro- versial, the number doing human planning appears to be growing. On the other hand, some advisors say planning should be restricted to money matters and what they derisively call “therapy” should be left to other professions.

FIGURE 18.3 Behavioral Financial Planning—Goal Planning

Nonmoney goals

Intangible valuations

Feelings

Security

Comfort

Power

Having fun

Caring relationships

Being understood

Health

Religiosity

Ethical behavior

Self-awareness

Contributions to society

Self-improvement

Close relationships

Self-actualization

Strong family unit

Good health

Rewarding spiritual life

Balanced leisure activities

Minimum money contribution

Balance between work and leisure

Formal learning experience

Time devoted to nonmoney planning

Control mechanisms

Consultations with others

Active search for companions

Positive attitude

Focused effort

Constant review

= +Goal planning Basic feelings Higher-levelfeelings

Goals achieved through selected

methods

Chapter Eighteen Behavioral Financial Planning 595

To find an interested person. Talking about a problem can be therapeutic. Advisors who listen with interest to clients’ problems are often viewed as good communicators, not just good listeners, and they are highly thought of even when they are not propos- ing a potential solution.

To understand. People want simple advice that they can evaluate themselves or they at least want to understand why the advisor is making a particular comment or recom- mendation. Communication in easy-to-comprehend terms is part of simplicity. If advice is complicated, people may not take it all or may feel unintelligent.

To help establish goals. Goals are not always immediately known. People appreciate tech- niques provided by advisors such as leading questions or just extensive discussions that as- sist in eliciting those goals. Being nonjudgmental and empathetic can help the process.

To feel secure. Being financially secure and feeling secure, while synonymous in rational finance, are not always the same in practice. For example, a recommendation can be made to establish a core position in real estate investment trusts that is expected to have attractive returns, relatively low market risk, and less correlation with other equities. However, the client may feel very uneasy because of unfavorable past experi- ences with real estate. In general, client feelings should be taken into account and alternatives to initial recommendations may be called for.

EVALUATE THE BENEFITS OF BEHAVIORAL FINANCIAL PLANNING

In this final step, we assess the contribution of behavioral finance to PFP. To do so, we complete the Practical Comment about John begun under the first step. An overall evaluation of the strengths and weaknesses of behavioral versus classical finance is given in Table 18.3.

Helping clients to feel secure can go beyond listen- ing to clients’ fears. When the stock market crashed in late 2008 and early 2009, some financial planners made an effort to contact all of their clients. Reminding clients that stocks had fallen before, and always recovered, helped to keep those clients from panicking. When appropriate, some advisors assured clients that they were still on track for their life goals, even with devalued stock market holdings.

To be served. Service can be used to sum up many other factors such as competence, interest, and con- cern. More specifically, it includes the importance of understanding such things as timely responses, peri- odic meetings, specialized communications, and ac- tions that convey to clients that their interests are being kept in mind. A person who is well served is often able to overlook shorter-term negative out- comes such as recommendations that underperform. To be understood and appreciated. People want to have someone who understands them, their

problems, and their goals, both financial and nonfinancial. To be understood can be comfort- ing in itself and is often an important step in becoming receptive to recommendations. It is of- ten as important for a client to be as aware of his or her strong points as of his or her weak ones. In fact, a reinforcement of the client’s strong points will often boost self-confidence and motivate the client to finally tackle his or her weaknesses. To improve competency. Many people want to become more knowledgeable if only with the goal of self-improvement. This is particularly true in finance, which many view as complicated. Thus, advice should be explained even when it isn’t necessary for decision-making purposes. To enjoy interacting. People want to deal with others they feel good about interacting with. The pleasure can come from the factors listed above and others such as sharing similar interests with people who are lively and empathetic.

Practical Comment Helping Clients Feel Secure

596 Part Seven Integrated Decision Making

John now had the benefit of going through the chap- ter. It was different from the other financial material he had read. Most of the other material was stated as facts, often with numerical examples. Few authors said that planning might depend on individual circum- stances or individual behavior. Yet in many cases, that was just what behavioral finance did. Behavioral finance provided a number of differ- ent theories that analyzed prominent personality traits, including many individual shortcomings when looked at from the standpoint of ideal behavior and money maximization. The trouble was that these traits, including nonmonetary goals, differed in their applicability and intensity from one person to an- other. He wanted hard-and-fast rules and numbers he could measure. Instead, he received soft informa- tion that required judgment to apply. Then he thought, isn’t judgment what is required in practical business and personal situations? The chapter had outlined some basic theories that had fairly widespread applicability to people. The rele- vance of those theories to PFP was demonstrated by illustrating them within different areas of the plan- ning process. In total, examples were shown for the most prominent active areas of PFP. John appreciated the simplification of categories by separating financial shortcomings into cognitive errors and visceral feelings and the use of a model

that didn’t attempt to measure each individual shortcoming but only to provide the potential for quantifying the difference between ideal and pres- ent behavior. He recognized that behavioral planning didn’t promise a full explanation of people’s actions. However, employing his original criteria of useful- ness, John better understood the obstacles to PFP goal achievement and the tools available for over- coming them. In fact, he identified several behavior weaknesses in himself and ways of dealing with them. From a financial planner’s perspective, he be- gan to appreciate the multidimensional role that practitioners play in a client’s financial life and the life-planning extension intensively employed by some professionals. In sum, while he sometimes found behavioral fi- nancial planning less than fully satisfying, John de- veloped a better understanding of himself and how to improve his household operations. He also learned several nonquantitative methods to help others. He thought that behavioral analysis could help people realize their full potential. Consequently, John became more interested in learning about how a broader range of behavioral tools can be applied to each area of the financial plan. (See the listing provided in Web Appendix C, Behavioral Finance—Applications.)

Practical Comment John—Part II

Strengths Weaknesses

Measures what is Can place less stress on what should be More adaptable More difficult to measure More realistic portrayal of human actions Harder to generalize Provides a greater understanding of human motivations Less firm conclusions Can employ tools from other disciplines Less satisfying financial conclusions Permits many more individual differences Less scientific in a financial sense Can employ laboratory tests Difficult to form and use aggregate data Encourages new insight into human financial behavior Many theories overlap Extends beyond quantitative measurement Can introduce bias Allows judgment Judgment can lead to biases

Overall Overall

Can add to planning effectiveness, bringing people No substitute for quantitative figures closer to ideal performance

TABLE 18.3 Behavioral Analysis: Evaluation versus Traditional Finance

As you can see, behavioral financial planning is not so much an alternative way of look- ing at PFP as it is a practical supplement to it. Knowing what motivates people and finding ways of improving results is what behavioral planning is all about. It should be measured by its accomplishments in achieving these objectives.

Behavioral Financial Planning 597

College Age

Twenties

Thirties

Forties

Fifties

Sixties -

Seventies and Beyond

Life Cycle Planning Behavioral Financial Planning

598 Integrated Decision Making

Back to Dan and Laura BEHAVIORAL ANALYSIS Dan phoned me to say that he was feeling anxious about the financial plan. He said the process was drawing to a close and he wasn’t sure I was aware of the scope of their goals or of the conflicts that he and Laura were having. I reminded him that I had tried to delve deeper into their goals originally but was told to keep to the money aspects of financial planning. I thought it was a good idea for the three of us to meet now, before the final plan was drawn up. At the meeting, Dan started the conversation casually by showing me articles about behavioral economics and Nobel Prizes in Economics that have been awarded to research- ers in the area.23 He asked if the discipline was relevant in their situation. He mentioned that he had purchased stock in Earth Foods, as I had suggested, but the stock had lost 10 percent of its value in the following two months and he wondered whether he had made a mistake. Our time at this meeting was limited, so we decided not to deal with any issues at this meeting but to respond in writing in a subsequent communication. I tried to learn more about their values. I asked what the word money meant to each of them. Dan said fear. He was afraid that he would end up like his parents; the absence of money had influenced all their actions and limited their sense of well-being. Laura said she viewed money as an opportunity. Having it bought happiness in both a material and nonmaterial sense. At this point, Dan burst out in emotional terms about how Laura didn’t understand what it was like to grow up poor. She always viewed the future optimistically, believing things would take care of themselves. Nor had she complied fully with the cutback in household outlays. Dan wondered whether they could operate as a team going forward, given their oppos- ing views on financial matters. His parents had always agreed on money matters. All household decisions were made together, without self-interest. Throughout discussions, except for the comment on money, Laura stood by quietly. When he questioned their rela- tionship, Laura just rolled her eyes. I mentioned that in getting to know them, I noticed that they seemed to see eye to eye on other matters and interests. Both quickly agreed. I decided to change the subject somewhat and asked them once again what their goals were. Dan said his goal was to live a middle-class life with a house in a good neighbor- hood, educating his children and feeling secure that this life could not be taken away from him. If necessary, he would retire later then 55. He enjoyed being an engineer and wanted to grow in his job in both responsibility and money. When he retired, he wanted to feel that he had made a material impact on his firm’s success. I asked him what he would like to do in retirement. He responded that retirement was far away, but he thought a combination of active leisure and some charity work was high on his list. Laura’s answer focused to a large extent on different factors. She said she figured Dan’s fear would keep household money in balance. She wanted to make sure her children had the same opportunities she did and would grow up well-adjusted and close to their parents. She too wanted an active retirement life that included sports, vacations, and so- cializing. She said she wanted to improve herself in retirement, perhaps going for a mas- ter’s degree in a liberal arts discipline as well as becoming a good bridge player.

As mentioned, I later replied with written comments. Here’s my response: I have started this section of your financial plan with Dan’s question on behavioral economics. Actually, this question is very relevant to your plan and to financial planning in general. Often the questions and feelings involved are discussed orally. However, given your interest in the subject and your desire that I explain the reasoning behind many issues, I will detail it in writing.

23 To Daniel Kahneman and Vernon Smith (2002) as well as to Robert Shiller (2013).

Behavioral Financial Planning 599

Behavioral economics is the inclusion of human motivations and human weaknesses. Some of those weaknesses are truly human shortcomings. People wish they could rectify them. Others do not fall under the traditional assumptions of economics. Behavioral finance and behavioral financial planning are applications of behavioral economics. Behavioral fac- tors are particularly relevant to financial planning because the term goals in finance conveys a broader meaning to most people than simply making the most money possible. Human shortcomings include weaknesses in knowledge, memory, and mental pro- cesses. Other influences such as our friends or certain religious beliefs about controlling materialistic impulses, even if money is available, can be difficult to measure. Dan felt that a nonlegal obligation to help his parents, if needed, may not comply with classical eco- nomic thought. It can, however, comply with a broader view of receiving pleasure. We can call the process of identifying and achieving nonfinancial goals life planning. So behavioral economics is just studying in a scientific way how people react in certain circumstances. The way they respond is “human,” as in the expression “I am only human,” implying that errors are likely. In that instance, we are not like machines, although being so could help us. In other instances, we have no desire to adhere to businesslike maximiza- tion of dollars. We are too busy having fun in our leisure pursuits and have established an equilibrium between work and leisure based on our preferences. Let’s look at the life-planning goals for both of you. Dan, yours seem to be focused on material items. Your fear of money shortages makes earning a significant amount with a low tolerance for a financial shortfall a high priority. Once you feel secure about your finances, you would like to feel that the work you are doing is worthwhile. In retirement, you would like to remain active in leisure sports and “give back” by spending more mean- ingful time in charitable work. Laura, your goals seem to have more to do with relationships. You do not exhibit fear about money issues. Instead, you see it as an opportunity that is likely to present you with happy alternatives. Specifically, you want to make sure that your children have the right upbringing. It isn’t surprising, then, that you have selected a teaching career. In retirement, you also would like to maintain an active and athletic life. You also would like to further yourself intellectually by pursuing a master’s degree as a leisure pursuit. Your combined goals represent a blend of materialism and noneconomic pursuit. To support both your current standard of living and your potentially costly desire to go back to school, in retirement you will need a significant cash flow. Of course, your most expen- sive goal is to retire at age 55 to pursue these leisure activities. Your financial plan, to be presented soon, will indicate the feasibility of achieving those goals and if they are not achievable given your current resources, what it will take to have them come to fruition. For now, let me handle the rest of the issues in our discussion. It is not surprising that you do not see eye to eye on all household matters. Most people don’t. It is good that you have the courage to voice your disagreements and bring them into the open. You have different personalities and backgrounds. I have found in couples that I advise that frequently people select others who are unlike them in many respects, often within a framework of shared interests and values. A psychologist once termed them “com- plementary dissimilarities.” For example, savers seem to choose spenders and optimists often choose pessimists. I often see spouses in conflict with one another over their opposing views on several issues. When I ask them whether they would like to have married someone just like themselves, they say no. I believe you both exemplify this tendency and balance each other out well financially and otherwise. I know that I had discussed this with you early in our relationship, but I believe now, just before we complete the plan, it is worth repeating. However, Laura, something will have to be done about your difficulty with adhering to the spending plan. This control issue is common in carrying out a financial plan. Try visu- alizing yourself not being able to raise your children the way you want them to be raised if

600 Integrated Decision Making

you don’t change your habits. Don’t procrastinate; turn over a new leaf now. I recommend that you implement my previous suggestions about cash flow planning this week, includ- ing establishing separate savings accounts for each goal and writing a check to each account at the beginning of the period. In fact, I now believe it would be better to have the money wired directly from your main account to these separate savings accounts at regular intervals, perhaps every month. If that doesn’t do the trick, perhaps you should leave your credit cards in a drawer and use them only on vacations. I suggest you find a hobby to at least partially replace going to the mall; it is too tempting for you. Dan, I don’t believe you have nearly begun to be able to make a judgment on Earth Foods. You have only owned that stock for two months. In that time, anything can happen to a stock. You are expressing what we sometimes call “myopic behavior”; we might call it short-term thinking. Wait and watch the fundamentals both in actual operations by visiting local markets and in examining financial results. Ask yourself whether anything fundamentally happened to alter your beliefs in the outlook for this company. If the answer is no, then ignore short- term situations. Stocks can be more representative of actual fair values over the longer term. In sum, I think your questions and reactions are normal. I suggest that if you aren’t doing so already, you try to be tolerant of each other’s positions. Put yourself, as they say, in the other person’s shoes. But I suspect that you are already doing this. Your common interests and bal- anced approach to life seem healthy to a financial person who has seen many couples.

College Student Case Study and Review: Amy and John BEHAVIORAL FINANCIAL PLANNING When I announced that we would cover behavioral financial planning I received a mixed reaction. Amy said it was a “sick topic,” which my daughter had already told me ironically meant it was a good, interesting subject area. John said that after all the maximization eco- nomics and finance he had taken he thought behavioral planning was an offshoot of “voo- doo economics,” a term that George H.W. Bush used to deride Ronald Reagan’s economic policies when the two men ran for the Republican presidential nomination in 1980. I as- sured John that was not the case and informed him that the behavioral area had received respect by many academics in both economics and finance. Besides, discussing people’s “quirks” and how to overcome them could be very interesting. As I told Amy and John, behavioral finance can be differentiated from established fi- nance in that it involves the study of individuals as they are today, as opposed to often as- suming that they are perfect maximizers. One approach acknowledges human imperfections, the other views humans as ideal persons resembling well-tuned machines. Behavioral financial planning is the action arm of behavioral finance. It analyzes individ- ual conduct and develops practical techniques to improve decision making. From a finan- cial planning standpoint, this method looks at human weaknesses and ways of overcoming them to bring clients closer to their goals. Human shortcomings can be divided into two categories—cognitive errors and visceral feelings. Cognitive errors broadly come from the brain and its reasoning ability. They can be divided into three categories: lack of knowledge, weakness in perception and memory, and limited processing capabilities. (For example, humans cannot process as quickly or as accurately as a computer.) The second group of shortcomings relates to visceral feelings. They are not intellectual; they come from emotions. Visceral feelings can create urges that are often short term in nature and can cloud mental processing.

Behavioral Financial Planning 601

Below are selected models and characteristics, many of which illustrate human weaknesses.

Heuristics and biases Heuristics are simplified human approaches to complex tasks. Biases are actions based on distorted views of reality.

Academics such as Nobel Prize winners Daniel Kahneman and Amos Tversky have popularized heuristics and biases in lab tests, some of which are listed below.

Anchoring Basing opinion on an outmoded or inappropri- ate standard leading to the wrong conclusion.

Framing How you communicate a thought can affect the response.

Representativeness Making judgments based on only one or two characteristics.

Availability Believing that something will occur in the future by determining how often we recall it.

Hindsight bias Believing after the fact that an outcome could have been known beforehand.

Loss aversion Going to great lengths to avoid a loss because losses give about twice the displeasure as comparable gains give pleasure.

Behavioral life cycle theory To academics such as Richard Thaler and H.M. Shefrin, people have multiple selves in thinking and doing. The planner self is a ratio- nal long-term thinker while the doer self is more emotional and short term. Actions re- solve the conflict, which is endlessly repeated.

Satisficing Herbert Simon, another academic, asserted that people don’t maximize; they “satisfice” on their efforts, stopping when they find just a satisfactory solution.

Mental accounting According to Thaler, the brain compartmental- izes actions by placing them in certain catego- ries that control our actions. These actions may not be fully rational.

We can overcome behavioral shortcomings through formal learning, experience, and understanding ourselves. With these tactics, we can develop effective rules of thumb and, for those who overemphasize recent results, we can limit reviews of investment perfor- mance. Often, obtaining the assistance of professionals familiar with acting more ratio- nally can provide impressive results. For example, to control poor spending and savings habits, you might try:

Visualizing Thinking about future impact of current actions.

Restricting choices Leaving credit cards at home, for example.

Reducing proximity Staying away from alluring places like malls.

Utilizing commitment devices Having a portion of each paycheck wired automatically into a savings account, for instance.

602 Integrated Decision Making

Life planning goes beyond money planning to take into account the analysis and sched- uling of steps that will realize personal goals. It deals with the personal side of the house- hold enterprise. In summation, life planning focuses in goals and contributes ways of achieving them. Higher-level feeling asks such questions as What do I want to accomplish? How can I improve myself? The outcome of such systematic thinking can be a planned process for achieving goals.

Summary Behavioral financial planning is a discipline intended to express finance in a way that goes beyond ideal quantitative finance. Its goal is to improve performance through use of mech- anisms that humans can relate to. Among the chapter’s points are

and less-than-ideal processing scope and speed.

while biases can result in incorrect choice.

chapter.

goals. PFP is involved because cash flow often, directly or indirectly, helps fund these goals.

and life planning.

Key Terms behavioral finance, 582 behavioral financial planning, 582 biases, 584

cognitive errors, 583 heuristics, 584 life planning, 591 mental accounting, 586

money planning, 588 satisficing, 586 visceral feelings, 583

dremanbehavioralfinance.org/index.html Institute of Behavioral Finance A section on the website presents the research done by the institute. It is also the home page of the Journal of Behavioral Finance. The list of published articles in the journal back to 2000 is available online. There is an online information section about seminars and events.

behaviouralfinance.net Behavioral Finance This site offers a number of links with behavioral finance terms with definitions pro- vided and links to related articles.

befi.allianzgi.com Center for Behavioral Finance The Center for Behavioral Finance was founded in 2010 by Allianz Global Investors. Its goal is turning academic insights into actionable ideas and practical tools that fi- nancial advisors and plan sponsors can use to help their clients and employees make better financial decisions.

Websites

Behavioral Financial Planning 603

Questions 1. What is behavioral financial planning? Differentiate it from behavioral finance. 2. Indicate what a heuristic is and give four examples of it. 3. Discuss behavioral life cycle theory. Do you believe it is realistic? 4. Melinda thought about going to a dealership two hours from her location to buy a new

car. She was told she might be able to save $2,000 over purchasing it locally. She de- cided against it. What are possible reasons for doing so?

5. How does satisficing compare with classical economic goals? Illustrate. 6. Name three behavioral weaknesses that might apply to investment analysis and give

examples of them. 7. Name one behavioral characteristic in each part of active financial planning other than

investments. Indicate how they can affect the financial planning process. 8. Do you believe loss aversion is practiced widely? Justify your answer. 9. Some people say that money is the only goal that counts, while others indicate that

once living costs are covered, it hardly matters at all. Indicate which statement you believe to be more accurate. Justify your answer.

10. What is happiness research? Does this research indicate that money brings happiness? 11. Contrast money planning and life planning. 12. What are human weaknesses under both money planning and life planning? 13. How do basic feelings differ from higher-level feelings? 14. Indicate the mechanisms for enhancing savings practices. Are they realistic? Discuss. 15. Should goal planning be part of the financial planning process or should there just be

a numbers-only approach?

604 Integrated Decision Making

Case Application BEHAVIORAL ANALYSIS Monica asked that we meet to see if I could help to reduce the differences between them. When the time came, she started the conversation by saying that Richard wasn’t saving any money at all. They hadn’t started implementing. She said he spent a good deal of time buy- ing and selling stocks. He seemed to be influenced by the weekly ups and downs of the market. At least temporarily, however, he had raised the quality of the stocks he was buying. Richard seemed a little annoyed and said that Monica never wanted to sell any securities. She almost always told him to wait. She said the shares would come back. When I asked what money meant to them, Richard said an opportunity to gamble and Monica replied a chance to lose what you’ve accumulated. As far as their long-term goals were concerned, Richard said he had no real long-term goals. The future was too fickle. He said who knew what fate had in store for them. Monica’s goal was to feel secure. I had the feeling that her remark was in response to Richard’s behavior. She wouldn’t allow herself to think of anything beyond security until Richard’s activities could be controlled.

Case Application Questions 1. What should be done about Richard’s spending? 2. What kind of investment behavior is Richard demonstrating? What can be done about it? 3. What is Monica’s investment behavior called? How can it be helped? 4. Contrast their two views of money. Do you have any recommendations? 5. How can Monica’s fears be dealt with?

Behavioral versus Rational Finance Behavioral financial planning is an alternative way of looking at finance. It makes use of approaches from psychology, sociology, and other disciplines to explain human behavior. Many financial researchers have disagreed with its premises and conclusions. They raise the following objections: 1. Behavioral traits presented were often obtained through laboratory experiments and

questionnaires, not through real-life actions of individuals. Until they are thoroughly empirically tested, they have no validity.

2. There is no overall theory of behavioral finance that explains all or most of the indi- vidual research conclusions. The separate characteristics can be identified solely through observation and have no logical basis.

3. The observations can be true only for a segment of the population and sometimes can be in conflict.

4. In market observations, overreaction and underreaction relative to fair values are split, which is what you would find in a random reaction. Therefore, as there is no bias, the results are consistent with market efficiency.24

24 Eugene F. Fama, “Market Efficiency, Long-Term Returns and Behavioral Finance,” Journal of Financial Economics 49, no. 3 (September 1998): 283–306. Fama, a 2013 Nobel Prize winner in Economics, told a con- ference in 2014 that active investing “is still a zero-sum game” because investments are efficiently priced.

Behavioral Financial Planning 605

5. Many seeming irrationalities, particularly in the market, are due to problems in the test- ing methods used and ultimately may be explained away by improved methods.

6. If irrational behavior occurs, it will be quickly eliminated by rational investors. 7. Fully embracing behavioral financial planning could involve losing the ability to mea-

sure overall economic data with a single approach.

The behaviorists say, among other things,

1. The test results indicate anomalies that are too widespread to be due to chance. 2. Financial planning requires knowledge and processing power that the average person

does not have. 3. When the bias in investing is shared by many investors in the market, it can overwhelm

rational players.26

4. What good is the ability to measure overall data with one approach when the results have so many anomalies?

To some extent, the two approaches have difficulty in reaching agreement because they use different methods. As we’ve seen, traditional finance employs scientific quantita- tive methods and seeks ways of generalizing about overall data. It values tangible results that can be expressed in money terms. Psychologists may value the process rather than the results.27

- -

Practical Comment Integrating Behavioral Finance

26 Many would say rationality returns to the market or individual investment over the longer term. See Andrei Shleifer and Robert Vishny, “The Limits of Arbitrage,” Journal of Finance 52, no. 1 (March 1997): 35–55. In a 2011 paper about the worldwide financial crisis of 2008–2009, Princeton professor Burton Malkiel wrote that the emerging markets hypothesis “implies that arbitrage opportunities for riskless gains do not exist in an efficiently functioning market and if they do appear from time to time that they do not persist.” See russellsage.org/sites/all/files/Rethinking-Finance/Malkiel.%20The%20Efficient- Market%20Hypothesis%20and%20the%20Financial%20Crisis%20102611.pdf. 27 See Karl-Erik Warneryd, The Psychology of Saving: A Study on Economic Psychology (Cheltenham, UK: Edward Elgar, 1999); Karl-Erik Warneryd, Stock-Market Psychology: How People Value and Trade Stocks (Cheltenham, UK: Edward Elgar, 2001); and Mathilde Almlund, Angela Lee Duckworth, James J. Heckman, and Tim D. Kautz, “Personality Psychology and Economics,” Published: in Handbook of the Economics of Education, Amsterdam: Elsevier. (2011) nber.org/papers/w16822.pdf

606 Integrated Decision Making

The results that say that characteristics vary by person but are difficult to measure may be satisfying to psychologists and behavioral economists but can be of little use to finance professors looking for generalizations on overall data that can be confirmed objectively. Many behavior-oriented researchers as well as economics and finance people consider ra- tional economists to be closed-minded, only willing to express things in economic terms.

Categories of Human Behavior There are three categories of human behavior: rational, irrational, and boundedly ratio- nal.28 Rational behavior refers to logical behavior. It can be logical in a financial sense, in measurable dollars, or, more broadly, in any action we select that brings us more pleasure29 than any alternative decision. Irrational behavior is illogical behavior economically or, in broader terms, behavior that results in displeasure. Robbing a general store to receive money to spend in the short term has the potential of a lengthy jail sentence, which would result in net displeasure and is therefore irrational behavior. Boundedly rational behavior, more commonly called bounded rationality,30 is conduct that resembles economically rational behavior but falls short. Rational behavior is maximizing behavior, doing the best you can do. It represents the dif- ference between rational economic behavior, also called ideal behavior, and actual economic behavior. We use economic behavior because it is measurable, thereby fitting in with traditional finance. Bounded rationality is where many behavioral finance theories can be placed.

Example 18.A2.1 Alfred wanted to make as much money as possible in his position as an independent accoun- tant. He wanted to live the good life. He majored in accounting as an undergraduate and be- came a CPA. In promoting his career, he did all the right things except for one: he didn’t finish his thesis for a master’s degree in taxation. That degree would have attracted a high-paying new clientele. Rational behavior would have had him spend the time to finish the thesis. Irrational behavior would have been yelling at every client that walked through the door. Instead, he engaged in bounded rationality, pursuing rational maximization of profits but ig- noring one area—completing the degree.

28 Actions can overlap and also change category depending on severity of occurrence. Each was placed into its principal or most frequently employed category. 29 Defined as net pleasure, more pleasure than displeasure. 30 John Conlisk, “Why Bounded Rationality?” Journal of Economic Literature 34, no. 2 (June 1996): 669–700. Daniel Kahneman, the winner of the 2002 Nobel Memorial Prize in Economic Sciences (with Vernon L. Smith). Also “Maps of Bounded Rationality: Psychology for Behavioral Economics,” The American Economic Review, December 2003, econ.tuwien.ac.at/lotto/papers/Kahneman2.pdf.

III

Additional Behavioral Models and Characteristics In this appendix, we provide additional approaches to behavioral financial models and characteristics.

Behavioral Financial Planning 607

DELIBERATION COST Deliberation cost is the mental time devoted to evaluating and making decisions; it is an at- tempt to present behavioral human actions in rational terms. It says that decision making incor- porates many logical factors, most of which are not currently recognized in classical economics. There is no rigid formula used.31 Choice may involve such variables as the cost of time, the lack of knowledge, the intensity of feeling concerning the task itself, the time period in per- forming the task,32 the uncertainty about the exact time necessary to perform the task satisfac- torily, and the possibility of a negative outcome. All these variables, some of which involve risk, are influenced by the knowledge and capabilities of the person performing the search.33

Example 18.A3.1 To finance the purchase of his new home, Seth selected a 30-year mortgage from the bank on the corner. He had been told that he could possibly save 0.5 percent per year if he performed an Internet search of all the availabilities. Seth said the bank rate he selected was generally competitive and certainly convenient because he already knew the bank’s manager, who would take care of the entire process. He believed that an in-depth Internet search for the low- est rate would take many hours, involving detailed work that he particularly hated doing. Moreover, given his busy schedule at his job and his other commitments, he would have to do the search on weekends, which would cut into his “time off” from work worries. He wasn’t sure how long it would take to find the lowest-cost reputable bank and, although it was un- likely, he was unsure that the rate of interest at the closing would not rise by more than the local bank rate. Seth also thought there was an outside chance that because he was a novice and did not know all the factors involved in a mortgage, he might end up with the local bank’s mortgage anyway. He understood that the savings in interest would likely well exceed the cost of time as represented by his $30-per-hour charge multiplied by any reasonable estimate of the number of hours necessary to arrive at a decision. Seth thought about all these factors for a few days, wondering which way to go, and he de- cided that the benefits of the local bank narrowly exceeded its cost. In other words, the deliberation cost of the search including the risks attached to an unlikely but possible lack of success exceeded its benefits. Although he knew he couldn’t express his decision in a strictly quantifiable way, he was proud that he had arrived at his decision using what he learned was a logical method. Had he known about the online services that provide detailed competitive information and telephone num- bers with an implied representation of at least some screening on lender reliability, he would have had a lower deliberation cost and would have made a different decision.

AGENCY THEORY Agency theory provides an alternative approach to classical economics in household mat- ters. As we saw in Chapter 4, classical economic theory assumes that members of a house- hold have the same interests. Therefore, a household and the people living within it can speak as one voice in attempting to maximize. Agency theory uses a managerial-organiza- tional approach to decision making. According to agency theory, owners delegate operat- ing responsibilities including decision making to managers of activities for the businesses or household organizations.34 As the owner’s agents, these managers are supposed to act in the best interests of whichever organization they work for.

31 This interpretation of the term is the author’s. 32 In his original article, Becker distinguished between the cost of time during the week and the cost on the weekend. See Gary Becker, “A Theory of Allocation of Time,” Economic Journal 75, no. 299 (1965): 493–517. 33 Stigler’s search behavior is a related approach. See George Stigler, “The Economics of Information,” Journal of Political Economy 69, no. 3 (June 1961): 213–25. 34 See Michael Jensen and William Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3 (October 1976): 305–60.

608 Integrated Decision Making

In contrast to the classical approach, however, agency theory acknowledges that indi- vidual goals can diverge from those of the organization. For example, supervisors might keep workers they like even though their output is inefficient and will not lead to profit maximization. Alternatively, one household member might want to purchase an expensive car even though it is detrimental to overall budgetary goals and household quality-of-life considerations. In economic terms, under agency theory, the agents attempt to incorporate their own separate utility functions. Households tend to be smaller units than many businesses and the participant members generally are what we have called member-owners; they work in, make overall supervi- sory decisions in, and share the benefits of the household they occupy. Thus, conflicts of interest tend to be concentrated among member-owners.

INTRAHOUSEHOLD ALLOCATION An approach to household conflict related to agency theory occurs under what has been called intrahousehold allocation.35 Intrahousehold theorists believe that the household is the organiza- tional entity for individuals but that the traditional single-agent model of household behavior is not appropriate. They say individual household members have separate goals. Decisions are made through bargaining, during which such factors as the relative incomes of the members, their gender, and the household’s overall wealth come into play.36

Example 18.A3.2 Sam and Martha disagreed about whether to buy a new air conditioner now. Sam, the sole wage earner, wanted one purchased on credit immediately, while Martha, concerned about their already high debt, preferred to save for it. They compromised. Martha recognized that Sam had been hav- ing difficulties sleeping on hot summer nights, which had resulted in his being late to work. And perhaps influenced by the fact that she was in a weaker position because she did not work, she agreed that they purchase an air conditioner right away. In return, Sam agreed to take $100 a month out of his account so that they could pay off their credit card debt within one year.

Conflict resolution through bargaining and other methods can be a normal and even efficient way of handling differences in interests. On the other hand, disputes, vindictive- ness, and intransigent narrow-minded behavior also can lead to less-than-optimal household actions. These actions can be regarded as human weaknesses as such inefficien- cies as impulsive short-term behavior can result in negative operational consequences. Intrahousehold allocation models are more complex than the classical one-voice model. They make overall economic generalizations much more difficult than with a single-agent model because bargaining and the influence of each member can vary significantly from household to household. Clearly, intrahousehold allocation provides a similar challenge to classical economics that agency theory does for business finance’s classically assumed one-voice owner and employee goal of maximization of profits.37

35 Martin Browning, Francois Bourguignon, Pierre-Andre Chiappori, and Valerie Lechene, “Income and Outcomes: A Structural Model of Intrahousehold Allocation,” Journal of Political Economy 102, no. 6 (December 1994): 1067–96. Martin Browning, Francois Bourguignon, and Pierre-Andre Chiappori subse- quently authored “Efficient Intra-Household Allocations and Distribution Factors: Implications and Identification,” Review of Economic Studies 76, no. 2 (2009): 503–52, columbia.edu/~pc2167/bbcresre- submissionpacs.pdf. 36 See Francine D. Blau, Marianne A. Ferber, and Anne E. Winkler, The Economics of Women, Men, and Work, 7th ed. (Upper Saddle River, NJ: Prentice Hall, 2013). See also Peter Kooreman and Sophia Wunderink, The Economics of Household Behavior (New York: Palgrave Macmillan, 1997). 37 The author of this text has polled his financial planning classes over time as to which predominates in marriage: overall household goals or separate individual goals. Invariably, a large majority say overall household goals.

Behavioral Financial Planning 609

DISCOUNTING Discounting is a basic economic operation. It assumes that we would prefer a plea- surable activity today to one in the future. In order to motivate us to postpone expen- ditures and save money, an attractive rate of interest must be offered. The mathematical equivalent of this process—evaluating future outlays to find their present value—is basic to finance and underlies much of our discussion in this book. It is important because it places an objective numeric value, the interest rate, on our economic actions. It therefore allows economics and finance to go forward in a rational scientific way. Two of discounting’s assumptions can be questioned. The first is that we need a posi- tive return to delay an outlay. We often save for emergencies and for retirement, and many of us would do so even if the investment rate were zero or even negative. In fact, those who place their money in low-interest-bearing money market accounts may earn a negative return after taxes and inflation are taken into account. Yet few people would consider the precautionary and retirement reasons for savings irrational, even in the absence of attrac- tive returns. The second assumption of discounting we may question is that the return we require for an action stays constant as the time to the activity date diminishes. On the contrary, it has been shown that people’s preferences and therefore the discount rate are not stable but change as the activity date draws near. Specifically, the return needed to perform unpleas- ant tasks and to postpone pleasant ones increases as the scheduled date approaches. This has been termed hyperbolic discounting; the discount rate rises at an increasing rate in the period prior to performance time.38

Example 18.A3.3 Renee had two things she wanted to do. The first was to take her car in to be fixed. It had a loose bumper and some other items that, if handled now, would cost $1,250. If she waited more than three months, the bumper would be further damaged, and the charge would be $1,350. She found the experience unpleasant in that she would have to stay around the ga- rage for a full day, Saturday, her day off. She decided to have the car fixed now to save the $100. She thought the amount saved was just enough to motivate her to take the repair within three months. She resolved that if she did it soon, she would spend up to $440 on a bicycle, which, if she waited until the winter to buy, nine months from then, would be avail- able for $380. Three months later when the last time came to bring the car in at the lower repair cost, she postponed it, saying to herself that she would do it later. She thought to herself, if the savings were $200, I would do it now. She didn’t postpone the purchase of the bicycle, how- ever. She indicated it would take a $120 savings to get her to forsake use of the new bicycle over the summer. As you can see, her preferences for discomfort (repairs on the car) and pleasure (buying a new bicycle) changed as decision time came close. In effect, her new discount rates at the time of decision as represented by the new dollar figures were different from the original ones. Approaches such as hyperbolic discounting are an attempt to apply a boundedly rational framework to human behavior. With time-varying discount rates, the framework for measur- ing preferences can still go forward.

38 See David Laibson, “Golden Eggs and Hyperbolic Discounting,” Quarterly Journal of Economics 112, no. 2 (May 1997): 443–77; and Partha Dasgupta and Eric Maskin, “Uncertainty and Hyperbolic Discounting,” American Economic Review, September 2005, scholar.harvard.edu/files/maskin/files/uncer- tainty_and_hyperbolic_discounting_aer.pdf.

610 Integrated Decision Making

Noneconomic Behavior The economics and finance disciplines generally assume that only money matters as an operating goal. However, many human actions are not motivated by money. Others can result in a decline in money without a tangible benefit to the person. We can call these actions noneconomic behavior. Economic measurement may be difficult or impossible to use because a different model or discipline of behavior is involved. For example, human feelings may be best analyzed using psychology.39

Or our feelings and actions may be the result of our background, how we are brought up and whom we interact with, a sociologist’s specialty. Our behavior may be affected by cultural influences throughout the ages, an anthropologist’s role.40 Finally, our actions also may be affected by how our brains are “wired,” a biologist’s territory. These influences may be perfectly consistent with a traditional financial view of goals. For example, the lifestyles of our parents and friends may teach us to keep up with the Joneses and buy more material goods. On the other hand, these actions may be irrational from the standpoint of traditional financial thought. Yet, the same actions can be perfectly logical from the point of view of an individual’s standpoint. The criterion for affirming a perfectly logical personal goal would be that if supplied with information concerning your nonfinancially efficient actions, you would still repeat them.

Example 18.A4.1 Sherry gave $10,000 a year anonymously to a lung cancer society. She received no economic benefit from it and, in her tight current economic circumstances, it was an unpleasant gift. She did it because her father had died of lung cancer and she felt she had to show her respect for him in this way. When others told her that, given her modest income, it was not in her best interests, she just shrugged her shoulders. From a financial standpoint, her action was irratio- nal. She had a reduction in assets without receiving enjoyment from it. From a personal stand- point, it was logical. It was her preference. The criterion of knowledge of actions was fulfilled. Whether it was custom given her family background or because, as a psychologist said, she unknowingly received pleasure from this “unpleasant gift,” it was a conscious action.

Life planning further complicates traditional economic and financial analysis. Given tradi- tional assumptions, activities can be segregated neatly into work and leisure. The amount of time we spend in work is limited to the point at which the pleasure we get from work dollars just equals the pleasure we receive from using the time in leisure pursuits (see Chapter 4, Appendix I). The behavioral approach has been a basic assumption of PFP theory. It has allowed us to say that the household operates somewhat like a business, with hours spent at work intended to operate efficiently and maximize cash flow. Life planning can alter that separation into work and leisure by providing pleasure for work-related activities. Indeed, it is often the goal that makes that happen. The solution can be to allocate work time and, significantly for PFP, work dollars into work and leisure. For example, a doctor making $150,000 a year who quits and becomes a teacher who works the same number of hours making $50,000 could be said to have made a yearly leisure expenditure of $100,000.

39 Actions may be logical or illogical. They don’t conform to the economic definition of logic but may conform to our broader definition of logical, in pleasure terms. 40 See Kent C. Berridge, “Irrational Pursuits: Hyper-Incentives from a Visceral Brain,” in The Psychology of Economic Decisions: Rationality and Well-Being, ed. Isabelle Brocas and Juan D. Carillo (New York: Oxford University Press, 2003).

Behavioral Financial Planning 611

Life planning involves more than work-leisure time, however. It involves feelings and preferences. Economics and finance acknowledge preferences and a world related to feel- ings and tastes. However, those disciplines are more comfortable with generalizations rather than analysis that concludes, “It depends on the person.” The difficulty is often in measurement. Feelings are often left to the field of psychology.41

We have choices with life planning and feelings in theory issues. We can define them as part of preferences, part of our objective; we can ignore them as being noneconomic choices; or we can allocate among these alternatives. To include them, we would have dif- ficulty in measurement. For our purposes, in a practical text, we will simply refer to them as part of behavioral financial planning.

41 Some of those who practice life planning believe it difficult to separate feelings from intellect.

612

Chapter Nineteen

Completing the Process Chapter Goals

This chapter will enable you to:

The big day had finally arrived. Dan, Laura, and I were to meet and finalize the pro- cess. Unlike many other planning meetings, this one would deal almost exclusively with integration. In other words, it was decision time. As it turned out, there was a shortfall.

Real-Life Planning As soon as Walter walked in, the advisor knew that he was not an ordinary client. He had the self-assurance of someone who was used to delegating tasks to others. The easy way he combined thoughts and expressed them quickly made clear that he was unusually intelligent. It turned out he was the president of a consulting firm that specialized in financial matters. Rather than engaging in small talk, he set the tone almost immediately by listing his needs. He wanted someone to tell him what he could spend under various alternatives for income, each involving a seven-figure sum. His cost of living was tiered according to the number of homes he would own, alternative retirement dates, and whether he could afford a yacht, an airplane, and multiple vacations each year. He said that he wanted the work to incorporate risk and that if all we were going to give him was a one-figure estimated retirement needs analysis and some recommendations on investments and insurance, he wasn’t interested. Others might be satisfied with that, but he could do that by himself. He thought for a second and said he wanted a financial plan that was as sophisticated as the plans he provided for his business clients. Walter wanted all recommendations to be supported by numbers and expected his advi- sor to be prepared to defend assumptions and recommendations. He indicated he wanted a

Chapter Nineteen Completing the Process 613

comprehensive plan, which included all household assets to arrive at integrated solutions. His wife, Marilyn, was very interested in the results as well. Walter indicated that while the conclusions would be the same, the requirements to satisfy each spouse would be different. Like his clients, he would be willing to pay a siz- able fee if it could be achieved. Did the advisor believe it to be feasible? The advisor thought the amount of work involved for Walter would be well in excess of the average plan. However, he believed that he understood what motivated Walter and his concerns that he could meet them, and he accepted the invitation to do what he termed integrated financial planning. The amount of work exceeded expectations as the number of alternatives rose. However, the possible outcomes were placed in perspective and the marketable investments portion was treated together with salary, homes, and other assets as consistent with total portfolio management. The approach would comply with the request to incorporate risk, and the recommendations would be consistent with the couple’s tolerance. Most plan presentations, in addition to the numbers, involve a behavioral theme. It can be empathy, taking control, friendship, fatherly advice, awakening to reality, and so on. This one would likely be firmness. The advisor met each of Walter’s questions with a specific answer and often with a reference in the written plan including numbers-laden appendixes, which virtually no other clients bothered to read. It reminded the advisor of the defense of his doctoral dissertation many years ago. Hours later, the plan had been discussed and all questions were answered. Then Walter got up somewhat abruptly. A faint smile broke out across his otherwise tight face, and he said what all financial planners hope to hear: “Thanks, it was just what I was looking for.” Then he strode out of the room. This chapter will explain how to construct and integrate a financial plan in the manner that Walter and his wife wanted. The approach taken is relevant for most people.

OVERVIEW

Integration is the process of combining, of making something into a completed whole. In personal financial planning, it means evaluating costs and benefits over time to find the best path to our goals. Integration is often overlooked or given less emphasis than is warranted. Given limited resources, you cannot make correct choices without weighing alternatives for spending your monies. In this book, we have looked at the household as a type of enterprise with the objective of delivering those goals. We have said that major decisions are made on an overall basis combining all household activities. In PFP terms, that becomes integration of all sources and uses of cash ranging from job-related revenues and current living costs to savings for retirement and other future household activities. In the last two chapters, we have provided you with the building blocks for inte- gration. Chapter 17 provided the mechanisms for ideal financial integration and Chapter 18, an approach to behavioral variables that reflect human shortcomings and nonfinancial goals. In this chapter, we will focus more on the practical aspects of completing the planning work. We will incorporate both money planning, the bedrock of PFP and this book, and human planning. We will place a great deal of emphasis on real-life process issues. This approach is taken to achieve the chapter’s planning objective of learning how to complete the PFP process in a way that provides an integrated path to your goals. A completed financial plan for Dan and Laura is provided in Web Appendix D, Comprehensive Financial Plan—Dan and Laura.

614 Integrated Decision Making

We will begin by reexamining PFP theory and the financial ways of integrating goals. We will then detail the PFP process, which, as you will see, will be helpful in ensuring that we have covered all major factors as we move toward completion. We also will discuss three tools that are helpful in an overall planning review. In the final section of this chapter, we complete and implement the financial plan, intended to be the practical embodiment of the PFP process.

PFP THEORY

A theory is a set of concepts that unifies a body of knowledge and helps you make better decisions in practice. It helps if the theory explains things simply and provides greater in- sight into the area being studied. The body of knowledge we are interested in, of course, is personal financial plan- ning. It can be defined as the process of programming future actions to help fulfill life’s goals. Put simply, PFP lays the groundwork for goal achievement. Let’s summarize PFP theory discussed in Chapter 4, but in a somewhat different way, and see how it assists with understanding personal finance and leads to better decisions. We’ll start with its set of concepts.

1. The household is an enterprise that operates like a business. It has revenues and nondis- cretionary and discretionary costs. The activities for this “household firm” have a purpose: to make logical decisions and promote efficient operations. For a breakdown of the specific similarities and differences between the household and a business, see Appendix I.

2. The goal of PFP is to provide the highest standard of living possible for household “member-owners” over their life cycle. The standard of living is a practical way of expressing utility maximization. It consists of a blend of money outlays and time spent on pleasurable activities. This standard of living goal is not just a current one; it incor- porates the entire life cycle of the household members. Thus, some restraints are placed on current spending in order to have funds to invest for retirement.

3. For a given time devoted to work, the goal becomes maximization of discretionary expenditures. The breakdown between work and leisure time is based on household values. At equilibrium, the benefits from revenues through one additional hour of work are equal to the costs in disutility of giving up one additional hour of leisure time. Consequently, each household has its own blend of work time, leisure time, and discre- tionary expenditures.

Once that work-leisure equilibrium is established, the sole focus of the work side of the household is on generating the highest cash flows possible for discretionary expendi- tures.1 Discretionary expenditures are the only outlays that give us pleasure. Therefore, we want to maximize them for the time allocated to work. We seek to minimize nondis- cretionary costs.

4. Household finance supports the enterprise, which needs cash flow and appropriate methods for allocating its limited resources over time. Once we discuss cash flow and decisions over time involving uncertainty, finance becomes involved. Its tools—time

1 Over the life cycle. During interim periods, reinvestment may be made for capital expenditures and savings-investment.

Chapter Nineteen Completing the Process 615

value of money, capital budgeting, risk–return, and portfolio management—are power- ful methods for household decision making.

5. Personal financial planning provides the strategic approach for solving household financial decisions. PFP is the thinking and action arm of household finance. Its most significant tool is capital budgeting. PFP uses capital budgeting to help make resource decisions through evaluation and selection among alternative expenditures and then as- sists in implementing them.

6. Personal financial planning decisions are made on an integrated basis that takes into account all household assets and liabilities. Each household activity—ranging from current living (cash flow) needs to future life cycle requirements such as retirement, estate, education, and risk management—has resource requirements. The savings and other current and projected inflows are assets used for these purposes. Our obligations, legal or otherwise, are our liabilities. For example, our desire for providing funds to educate our children can be considered a liability even though we may not have a legal obligation to do so. We include all assets and liabilities in making capital budgeting decisions for our limited resources. That is what comprehensive financial planning is all about.

7. Total portfolio management provides the solution for personal financial planning’s overall objective and the household’s overall goal. TPM’s optimization model has as its payoff the asset-liability mix providing the highest return possible, given the household’s tolerance for risk. This return figure is the maximum amount that can be outlaid for discretionary items. It simultaneously solves the household’s maximiza- tion of discretionary expense goal and PFP’s objective of helping the household reach that goal.

The distinguishing features of PFP theory in finance and its practical benefits are given in Table 19.1.

TABLE 19.1 Distinguishing Features of PFP Theory

Feature Benefit

Uses household framework Places it on par with other enterprises such as a business for improved analysis. Highlights similarities with business Stresses businesslike behavior—logical and efficient. Allows use of sophisticated

business tools. Expresses personal goals in money terms Individual goals expressed in utility terms are often thought not measurable. The

equilibrium approach is consistent with classical theory. It explains why household revenue and profit maximization are established, given the individual’s limited time devoted to work.

Divides consumption into pleasurable and nonpleasurable expenditures

Aggregating these expenditures can lead to incorrect decisions. Discretionary and nondiscretionary expenditures (which are the financial expressions for pleasurable leisure outlays and nonpleasurable maintenance costs) are fundamentally different.

Places personal financial planning and capital budgeting at the center of household finance

Expresses what PFP does in a broader framework, links it more solidly to business finance, and leads to better financial decisions.

Uses an integrated portfolio approach for financial decision making

Improved decision making more closely parallels the way people do or should think.

Incorporates risk, return, and correlation in framework

Improved decision making by providing greater dimension in inputs and conclusions.

TPM, by using all assets and liabilities, integrates PFP and investment decisions

Better financial decisions. Use of all resources over a life cycle in arriving at conclusions. More closely resembles the way practitioners perform comprehensive financial planning.

616 Part Seven Integrated Decision Making

In short, PFP theory highlights integration and the strong relationship PFP has with traditional business finance. Its concepts are intended to make PFP’s role easier to under- stand and lead to improvements in the way it is practiced.

THE FINANCIAL PLAN

PFP theory explains how the PFP process should ideally be done. The financial plan, using the theory as an underpinning, is a mapping out of the practical steps through which a par- ticular goal or goals are to be accomplished. For comprehensive financial planning, a de- tailed written financial plan is desirable. A financial plan has several advantages:

1. It imposes overall structure on the process through specific steps that should be taken. 2. It compels you to order your priorities and provide a specific financial solution using

integrative techniques. In other words, it aids decision making. 3. It presents a document to refer back to so that you can compare actual with projected

results and refresh your memory as thoughts of the original steps fade. 4. It provides a numerical base for adjustments as goals and resources change in the future.

The need for the plan to integrate all financial actions arises from the limited resources households have. Actions in one area often affect planning for other activities, as shown in Example 19.1.

Example 19.1 Liu was a successful businesswoman who earned hundreds of thousands of dollars annually but spent every dollar she made. Consequently, she had no money in her personal or pension account. Her accountant proposed that she place $100,000 in the defined benefit pension plan set up for her business. Liu recognized that her prior spending habits were extreme but

As we move toward completing the plan, you should be aware of planning theory and its goals in simpler, more practical terms. People run or help run house- holds they live in, which in many ways are operated like little businesses. Their businesses produce reve- nues from the human services offered. They have overhead costs from the commitments they have made and the necessities of life and profits that provide you with your standard of living. The more efficiently you operate, the higher your standard of living. Existing finance theory in the form it is in now doesn’t quite suit your needs. It tends to focus on fi- nancial assets alone, as if that were all that counts for the household. We know the household has hu- man assets, homes, pensions, and other assets as well. We also know that the household has liabilities, not only legal ones but the obligations that arise from its living costs. Total portfolio management is a way to express this broader view of household

operations and to solve for optimal cash flows. While at first glance TPM looks like an asset man- agement system alone, it represents all household activities and the way of planning and operating them in an integrated manner. At this point in the financial planning process when we draw together all parts of the financial plan, we also need to think again about goals and limitations based on available cash flows. We should recognize the financial planning techniques that can be useful in integration, many of them coming di- rectly from businesses. We should keep in mind the significance of the word personal in PFP. In contrast to traditional investment management, which is in- volved with supervision of financial assets alone, per- sonal financial planning helps people with all their financial needs. Being conscious of PFP’s broad scope and its specific planning components can help ensure that all resources and our intended uses for them have been taken into account in decision making.

Practical Comment PFP Theory in Simpler, More Practical Terms

Chapter Nineteen Completing the Process 617

Note that

1. Some of this benefit is taken back due to taxation on pension distributions. On the other hand, tax deferral can reduce or even eliminate its net impact.

2. Obviously, the sum cannot be planned for both retirement and estate uses.

After seeing its impact on virtually all key financial planning functions and the effect on current lifestyle moderated by lower taxes, Liu decided to save the money.

Before making final judgments, it is advisable to examine your work by reviewing each step in the financial planning process and adding new tools that can help you in making integrated decisions. The series of steps listed below can help provide a framework to ensure that you will complete the process properly. Note that to ensure that your review process is broad in scope, the steps presented for reviewing your planning work are the same as those provided in Chapter 1 in outlining the planning process.

Establish the Scope of the Activity Have you analyzed all areas that you intended to? Is the scope established broad enough? For example, in a comprehensive plan, if provisions have been made for retirement, has long-term care insurance been considered?

Gather the Data and Identify Goals Has all information been gathered and is it available for use? Sometimes other information surfaces after the planning process has been completed that could change its conclusion. Two areas of data gathering sometimes omitted are the health of household members and the possibility of inheritances from parents and other relatives. Costs that are sometimes left out are purchases of cars and other durable goods, household repairs and improve- ments, and outlays on weddings. Has the true goal been ascertained? Sometimes identifying the real goal may not be as simple as it appears. It may emerge only after considerable work or discussion or thought. For example, the statement “I am satisfied with my current lifestyle; my main goal is to have a roof over my head” can mask larger goals. The real goal can involve a much more elaborate lifestyle at a commensurate increase in costs.

Compile and Analyze the Data Have all relevant data been analyzed? Have you given those data the depth of analysis they merit? Have SWOT (strengths, weaknesses, opportunities, threats), sensitivity, and

Planning Area Financial Impact Explanation

Investment +$100,000 Savings immediately placed in investment vehicles. Tax −$40,000 Pretax dollar allocation into pension saves taxes,

$100,000 × 40%. Retirement +$100,000 Investment sum is available for ultimate retirement use. Estate +$100,000 Investment sum not used when alive will be available for

heirs. Insurance −$100,000 Greater assets reduce need for life and disability insurance. Cash flow −$60,000 Impact on current standard of living less than expected as

$100,000 outlay is reduced by $40,000 in tax savings.

still wanted to know what the $100,000 in savings would do for her as compared with con- tinuing her previous practice. She was in the 40 percent marginal tax bracket. Her financial planner drew up a list showing the potential impact of saving $100,000 on the parts of the plan that were most likely to be affected.

618 Integrated Decision Making

scenario analysis been considered? (They will be explained shortly.) As you have learned, personal financial planning involves dealing with risk. Therefore, whether for a detailed quantitative risk analysis or even for a mental “what if” process, the consequences of potentially not meeting goals should be thought through. The evaluation process is the heart of planning integration in practice, and we therefore will discuss it in significant detail. The household is faced with many choices as to how to prorate its limited resources. The financial plan is the response. It specifies what the house- hold intends to do with its current and future resources. This book has presented the various parts of your financial activities over your house- hold’s life cycle. They were discussed in separate chapters that together formed household operations. Let’s look again at the household as an organization that resembles a small business. Each segment of the financial plan can be viewed as a separate household operation with a separate function. Each supplies capital, requests it, or does both. These functions are shown in Table 19.2. The household resource problem—what you should do with your current and future cash flow—can be viewed as a series of integrated capital expenditure decisions. Each part of the financial plan, each “division,” competes for capital. Separate “divisions” make requests to be funded. The household has to decide which capital expenditures to fund and in what amounts. Importantly, the plan looks at these decisions not only as current ones but as those that will take place over the entire life cycle. In other words, our capital expenditures over time, to the best of our ability, are planned for today even though they take place at different points in our life cy- cle; for example, when you will buy a home, how often to purchase a new car, and so forth. Figure 19.1 is a visual portrayal of the same planning process; the arrows indicate whether a given segment of the plan is a user or provider of cash. Because the household decides how much cash is to be taken in and the amount to be outlayed, we have called the centralized decision-making function PFP integration. The household’s decision-making function is enhanced by a few tools that are particu- larly relevant when the preliminary asset and liability mix, as established in each part of

Operating Segment of the Plan Cash Relationship1 Function

Revenues Inflow Job and investments liquidation upon retirement fund household activities

Living costs Outflow The costs of current overhead and pleasure-related activities

Debt Inflow, then outflow Supplies funds when current cash flow inadequate, followed by repayment of those funds

Capital expenditures (household investments) Outflow2 Outlays for household work-related efficiencies and pleasure-related activities

Financial investments Outflow, then inflow Initially invest savings held for future utilization; this segment, along with job revenues, then funds the rest of household activities

Risk management Outflow3 Protects the household and brings about desired tolerance for risk

Retirement planning Outflow Appropriates so as to generate investment resources to be employed when working stops

Estate planning Outflow Used for people we care for to the extent we desire Educational planning Outflow4 Provides for household members’ education Special circumstances planning Outflow Outlays money for special uses

TABLE 19.2 Operating Parts of the Financial Plan

1 At the time service is performed, except for debt and financial investments, which, as financial capital transactions, have two-part transactions, as indicated. For example, savings for retirement, which can be thought of as a multistep process with an initial outflow for the savings followed by an inflow to fund the actual expenditure when made; alternatively these two steps could be incorporated under financial investments with only the final step, the actual outflow itself, handled under retirement planning. 2 To the extent outlays provide cash benefits, those benefits will be shown in revenues as an inflow and living costs as a deduction from outflows. 3 Also will provide inflow if actual loss occurs. 4 If used for spouse or other permanent member, may be covered under household investments and provide an inflow as an outcome.

Chapter Nineteen Completing the Process 619

the financial plan, has been drawn up. These tools include SWOT analysis, sensitivity analysis, and scenario analysis.

SWOT Analysis SWOT analysis represents an appraisal of all the major factors that can enhance or detract from the outlook for goal achievement. As mentioned, SWOT analysis stands for strengths, weaknesses, opportunities, threats. Strengths and weaknesses are part of the internal household analysis. Opportunities and threats are identified through an examination of the external environment. SWOT analysis provides an overall assessment of the household’s situation. It is often used as a strategic tool; that is, it is for planning beyond a year or two. It goes well beyond the best estimate of savings needed. The strengths of the household might include a conservative balance sheet that is avail- able for borrowing; a job that holds promise for greater income in the future; or a strong household structure with two household member-owners working, thereby reducing the impact of potential revenue interruptions through layoffs or sickness. The weaknesses in the household might include insufficient savings for goals such as retirement at an age approaching its date, an impulsive nature that leads to unnecessary spending, and an investment portfolio too concentrated in a few assets. The external environment has an impact on the household. It includes political, legal, tax, social, economic, and technological variables closer to home as well as the industry you work in. Opportunities could arise from new regulations that result in a decline in in- come tax rates if you shift the way you handle household transactions, changes in industry that present the potential for higher income if you retrain, or the potential to purchase new labor-saving durable goods. Threats could incorporate the distinct possibility of higher energy prices, which could result in a decline in your discretionary outlays; an increase in the popularity of larger houses, which could make your modest-sized home less valuable; and involvement in an industry with declining prospects.

FIGURE 19.1 Life Cycle Source and Uses of Cash Revenues

Living costs (including

taxes)

Debt

Capital expenditures (household

investments)

Financial investments

Risk management

PFP Integration

Retirement planning

Estate planning

Educational planning

Special circumstances

planning

620 Integrated Decision Making

SWOT analysis, then, is intended to uncover new information and form a realistic ap- praisal for the planning future. It also can lead to changes in projections or practices. For example, a prior strong accumulation of financial investments and a careful spending pat- tern may allow a step-up in the current standard of living. Our first choice is to overcome our threats by changing our practices. Yet we cannot deal with all threats directly nor do we want to. For example, if we have a job that is lucra- tive and enjoyable, but it is in a highly risky industry, we may counter the threat by accu- mulating extra savings in case our income drops or we are laid off. In any event, we will want to compare our SWOT assessment with our goals and plans. We may then provide for contingencies by taking additional risk management steps with the degree of alteration in plans dependent in part on our tolerance for risk. In Table 19.3, you can see a representative sampling of internal and external environ- mental variables that affect each area of financial planning. To simplify the presentation, the items have been listed as strengths or weaknesses, or as opportunities or threats.

TABLE 19.3 SWOT Analysis by Planning Area

PFP Area

Internal Environment =

Strengths or Weaknesses

External Environment =

Opportunities or Threats

Balance sheet Amount of assets Degree of liquidity

Ability to fund needed outlays arising from change in environment

Goals Ability to ascertain deep-seated goals Skill in matching goals with externally derived resources

Cash flow Size of free cash flow Ability to fund needed outlays arising from change in environment

Debt Obligations in relation to assets and cash flow Change in projected inflation rate Tax planning Availability of viable tax reduction strategies Shift in tax rates Investments Nonfinancial Prospects for existing job Economic outlook

Ability to invest in job-related education Industry-related job opportunities Productivity and enjoyment-related durable goods Changes in technology

Financial Degree of asset diversification Economic outlook Understanding of investment dynamics Projected inflation rate Ability to fund needed investments Degree of speculation in markets

Risk management State of personal health Safety practices Proper insurance coverage

Government attitude toward assistance for risk-related needs External risk-related exposures Changes in insurance policy coverage

Retirement planning Accumulated assets Change in Social Security benefits Annual savings Opportunity for part-time consulting

Educational planning Money accumulated for higher education Ability to qualify for assistance

Government and college changes in assistance policy

Employee benefits Quality of employer-funded programs Medical reimbursement policy

Changes in government-mandated assistance and tax policy Trends in overall corporate benefits

Other planning State of physical and mental health Structure and closeness of current household relationships

Government policies toward aiding special needs Changes in society’s opinion of marital and nonmarital relationships

Estate planning Resources accumulated relative to goals Employment of well-thought-out legal documents

Change in allowable estate tax planning strategies Society’s opinion changes and estates are taxed more lightly or more heavily

Chapter Nineteen Completing the Process 621

Example 19.2 Doreen, a financial planner, was completing planning work for a young couple. Both spouses had jobs with a promising future. Unfortunately, the couple was significantly in debt, which was used to finance current living standards. Doreen had completed a preliminary figure of overall savings needed to fund their goals. However, she was uncomfortable because she wondered whether there was a greater- than-average risk that they might not reach their goals. She decided she would do an assess- ment of their situation to see if she had handled the planning correctly. She decided to perform a SWOT analysis to aid in the review process. Following are the highlights of her analysis:

Strengths: The couple had attractive jobs with a good outlook. They were young, healthy, well-educated, and flexible people.

Weaknesses: Their spending pattern placed too much emphasis on living for today. They acted impulsively and sometimes regretted their wasted expenditures.

Opportunities: The rapid growth in high-level jobs in their industry created a potential op- portunity to raise their incomes over the next several years, which could lessen their cash squeeze. A discussion on the need to begin focusing on the goals they themselves had chosen could create the motivation to save any extra income they might receive.

Threats: The main threat came from a continuation of their current spending habits. An anticipated rise in external inflation and interest rates would raise their costs and vulnerabil- ities. The outcome could be a severe cutback in current living expenditures or, in an extreme case, a reduction in their long-term quality of life.

Conclusion Doreen decided that no change in projections was needed. She knew that the spending behav- ior was fairly common among certain types of recently married couples. She believed her cli- ents’ savings behavior would change as their goals for a home and other needs drew closer. She believed they had an understanding of the behavior that was right for them and had the flexibility to achieve it. Doreen decided, however, to recommend some changes in practices such as taking money directly out of their savings account to repay debt. She would explain to them that paying down, say, credit card debt with a 12 percent interest rate would be equivalent to a 12 percent investment return, after tax, with no market risk. In fact, Doreen would suggest that this young couple target being out of debt in two years. She also decided to present them with the sum- mary of the SWOT analysis as part of the final meeting. If it were presented properly, it could serve as a motivating tool.

Sensitivity Analysis Sensitivity analysis is identifying those factors that could significantly alter antici- pated planning results. It may be performed as part of SWOT analysis or as a stand- alone supporting analysis. Sensitivity analysis is sometimes more quantitatively based than SWOT. For example, retired people are highly sensitive to changes in inflation because they are often on fixed incomes.2 In doing a sensitivity analysis for retired couples, you could raise an assumed inflation rate by 1 percent, thereby boosting costs 1 percent a year, and see what it does to outcomes and required savings. You could lower the investment return for working people and observe its effect. Most people’s outcomes are highly sensitive to as- sumed rates of return if projected over long periods of time. Consequently, it is important to consider return projections carefully and perhaps conservatively. Perhaps the most popular form of this type of analysis is Monte Carlo simulation. A Monte Carlo analysis, as you have learned in Chapter 17, isolates some key planning variables such as investment return and inflation and assesses how these affect planning outcomes. Consider Example 19.3’s use of sensitivity analysis.

2 Dramatic changes in inflation and interest rates have occurred over the last 40 years. Higher rates in the future could have significant effects on the elderly, as Example 19.3 demonstrates.

622 Integrated Decision Making

Example 19.3 Trina is a schoolteacher. Because of excellent employee benefits, well over half of her pro- jected retirement revenues will come from her public school teacher pension. She went to a financial planner to see if she was on track to reach her overall goals, including funding for retirement. The planner did a capital needs analysis including retirement income suffi- ciency. He used a 5 percent after-tax return for financial investments and a 2 percent infla- tion rate for cost increases. The calculations showed that Trina could retire comfortably with funds to spare. The planner was about to complete the financial plan and set up an appointment to present it when he decided to do some further analysis. He raised the inflation assumption to 3 percent and, as a believer in modern investment theory, raised the return assumption to 6 percent. The planner figured that using the same difference between revenue and cost increases (real rate of return of 3 percent) for both cases would result in the same outcome. Instead, Trina suddenly had a shortfall in projected resources related to expense demands. The advi- sor was puzzled. What was the reason that the conclusion was exactly the opposite of the original one? He then remembered the above-average importance of the pension to Trina’s retire- ment. Although her costs and her Social Security benefits were going to rise steadily with inflation, her teacher’s pension would not. (Trina’s pension would be a fixed monthly pay- out, set at the time of her retirement, with no cost-of-living adjustment.) The increase in financial investment return would not help much because investments of this type were a relatively small part of her financial picture. Over long periods of time, her pension would shrink in inflation-adjusted terms and create a serious shortfall, particularly if Trina lived into her 90s. The advisor performed other sensitivity and scenario analyses and revised his projected out- come, saying that Trina had vulnerability. Trina instructed the planner to assume she would work a few years longer than originally anticipated and would place a little more into savings each year. The advisor made a mental note to become familiar with Monte Carlo analysis, which could shed light on the probability of that shortfall. In the meantime, he was pleased he had at least utilized a form of sensitivity analysis.

Scenario Analysis Scenario analysis observes the effect of changes in multiple variables or in one variable that influences many situations. Its stress on creating an overall changed environment dis- tinguishes it from one-variable scenario analysis. For example, our projections of financial and other asset returns may be based on his- torical returns and the continuation of a normal economic environment. We may want to look at the impact of an alternative scenario—for example, one in which the economy is weak for an extended period of time. Given that scenario, our ability to save will be altered and we may have to consider the possibility of a temporary period of unemployment. In the event of such an economic outcome, the result could be a higher level of liquid savings to be drawn down.

- nancial planning are aware that clients appreciate

Practical Comment Use of Multiple Scenario Analysis

Chapter Nineteen Completing the Process 623

At this point, the review process has taken place. We have applied some additional “what if” tools such as SWOT, sensitivity, and scenario analysis, which help us in making decisions on an overall household basis. This integrated look at future household plans and the reality check on what is doable often results in a modification of intended actions. We are now ready to run the final numbers. Most often, the simple capital needs analysis or the risk-adjusted capital needs analysis is used. A growing number of financial planning practitioners are using Monte Carlo simulation alone or as a supplement to the simple method. The output tells us the amount we have to save per year or, in the case of over- funding, how much we can raise our standard of living.

Develop Solutions and Complete the Plan Have all feasible solutions been considered? Some solutions may not give the highest reve- nues or result in the lowest risk but may cost significantly less to implement and therefore be the preferred course of action. For example, the purchase of a disability policy that doesn’t include some less important benefits upon disability but costs 25 percent less may be the best choice. If cost is a concern, you might choose an “any-occ” policy, which will pay benefits only if you can’t work at any occupation, rather than a more expensive “own-occ” disability policy that will pay if you are unable to perform your own particular occupation. Once the solutions have been completed in all areas of the plan and made to agree with current and projected resources, the plan is almost ready to be written. At this point a review of overall decision making, as discussed in the Practical Comment above, and of behavioral factors, which follows, can be particularly helpful.

Reviewing overall decision making at this point has a number of benefits. First, it tests the decisions about to be made, and this can lead to more rational outcomes. Second, by its nature it focuses on inte- gration, which we have said is often the most over- looked part of the planning process. Finally, particularly in multiperson households, it can ap- proximate the way the household does or should operate, which can bring about better decisions. Along the same lines: How are we to determine quantitatively which capital expenditures are most desirable? It is not always possible to calculate re- turns. The answer can be through ranking based on a combination of hard numbers, sound mental shortcuts, and feelings. Often, the greater the use of quantitative business techniques employing IRR and NPV, the better the result. Feelings typically serve for such things as hard-to-quantify leisure expendi- tures. For a discussion of one ranking procedure that discounts the cost of each goal separately to the present, see Appendix III. Finally, in some financial plans integration may stop short of a quantitative capital needs analy- sis. There should be no doubt, however, that such

an analysis is required for a realistic assessment of a household’s financial situation relative to its goals.3

3 Retirement planning often serves as the area that presents the integration function. The feeling by many is if, after including other goals and needs, you have provided for retirement, you have covered the integration requirement.

Simple retirement needs analysis, the most popular method used by practitioners, isn’t as sophisticated as TPM, with no separate provision for risk and correlation. On the other hand, it is significantly better than no integration at all, which can lead to misallocation of resources and literally running out of portfolio assets. Retirement needs analysis often attempts to cover risk by using a conservative investment return and a higher inflation rate and providing for long lives.

Monte Carlo analysis provides a more precise detailing of risk. Its results are expressed in probabilities instead of the one-outcome retirement needs approach. Given the potential for negative outcomes if investment performance is poor at the beginning of the retirement payout period (withdrawal risk), Monte Carlo’s role is a distinct improvement. It can be used as a stand-alone system or as support for simple retirement needs analysis. Both can be manipulated to come up with an “optimum” resource allocation, although with much more effort than TPM.

Practical Comment Reviewing Overall Decision Making

624 Integrated Decision Making

Behavioral Review As we have said many times, personal financial planning is more than a straight financial exercise. As even doctors using advanced scientific techniques to cure illness have discov- ered, dealing with human needs, communicating well, and ensuring that advice is being followed contribute to the success rate. Similarly, it is often not sufficient to identify a number: a required annual savings amount to ensure financial success. The financial plan must take into account human behav- ioral shortcomings. As we saw in Chapter 18, these may include an inability to recall past events accurately, limitations in processing power, and inappropriate emotional responses. It can help prospects for ultimate success if the financial plan deals with all of these factors by using the tools discussed in that chapter. Finally, financial plans need not be restricted entirely to numbers-oriented goals but can incorporate whatever goals people may have. The steps taken toward meeting those goals often have a financial component such as being free of continuing financial concern or having the ability to pursue a nonfinancially rewarding career at an earlier age. Importantly, now is the moment to ask, perhaps for the last time, Does this plan make sense? Is it feasible to do? In reality, will it be carried out? If not, what can be changed to make it more practical?

Writing the Plan When the behavioral review has been completed, it is finally time to write the financial plan. Plans depend on the style of the writer. Some advisors prefer to create long detailed plans with explanations for each recommendation while others prefer to get right to the point. Whatever the approach, a plan must be descriptive enough to refer back to and to be communicated to others. Recommendations should be linked to goals. The advantages and disadvantages of advice provided should be provided as well as the type of future events that could change these recommendations. The plan should provide a road map for imple- mentation. An ideal financial plan should have a summary at the beginning, detail in each planning part, and a summary perhaps more oriented toward implementation at the end. It should have a mix of written information, numbers through tables, and figures that illus- trate and enliven the text.

Delivery of Plan Where the plan is to be presented to others, the relationship between recommendations and goals should be highlighted. An assessment of the person’s understanding of the plan should be made and assistance provided when necessary. Where it is apparent that the findings have not been fully comprehended, it is often advisable to let the person read the plan and “digest it.” Another face-to-face or phone meeting may be set up. The components of a sample financial plan and their key contributions are presented in Table 19.4. Once the plan has been written, a problem can arise in execution of it. Too often, plan- ning conclusions and actual implementation of plans are not the same. Sometimes plans requiring great effort, even those done by professionals at great expense, lie dormant. Having an implementation schedule with specific dates can help set the required steps in motion. One such schedule is shown in Table 19.5. Beyond the implementation schedule that begins the planning period is the problem of control. Control can be viewed as continuing to implement the plan over time. Visceral responses such as overreaction to recent information or impulsive spending regretted later can reduce household efficiency. To meet these problems, the plan may provide for specific control mechanisms discussed in Chapter 5 such as automatic savings withdrawals

Chapter Nineteen Completing the Process 625

Parts of the Plan Key Contribution

Description and scope of plan Indicates what a plan does overall and what this specific one is to accomplish.

Statement of goals Sets planning focus. Helps establish balance between spending for today and investing for the future.

Summary of plan recommendations Summarizes the methods for achieving the household goals. Balance sheet presents current resources available.

Cash flow statement Examines past and often projected future household sources and uses of funds, typically on a yearly basis.

Cash flow planning Provides reality check through its role as a funder for all activities.

Debt planning Either as part of cash flow planning or as a separate section, it can generate extra cash flow for current use.

Educational planning Maps out funding method for improvement in household human assets.

Tax planning Indicates how to anticipate and reduce this major operating expense.

Retirement planning Determines amount and funding schedule for period when work ceases.

Investments Nonfinancial Correct capital expenditure process yields operating

efficiencies for the household. Financial Determines appropriate financial asset allocation. Generates

the return on funds saved for future. Risk management Establishes appropriate level of household risk. Focuses on

reducing exposures through use of insurance and other tools that adjust and make more efficient household operations.

Estate planning Determines who gets what in the most efficient way upon our death.

Special circumstances planning Special requirements of all types for household members. Employee benefits Points to approach employees should take in deciding on

employer-provided benefits (sometimes this section is included in other areas).

Integration Looks at PFP from an overall point of view, establishing priorities between goals and needs leading to appropriate decision making. The calculation and discussion is sometimes combined with retirement planning.

Summary Provides specific steps to be taken, often with implementation dates.

Appendixes Present additional information, both written and numerical.

TABLE 19.4 Components of the Financial Plan

into dedicated accounts such as college funding. The plan may provide for additional education to reduce or eliminate overreaction. When these weaknesses cannot be over- come or when people find it preferable to continue certain questionable behavior patterns, financial planners can help on an ongoing basis.

Example 19.4 Dustin was a successful lawyer whose problems were in perception and execution. He overre- acted to any change in economic circumstances. He sold at the first sign of stock market prob- lems and bought back after he developed confidence again. In the meantime, he kept his investment dollars in money market accounts. The upshot was substantial underperformance versus a simple buy-and-hold policy. Dustin’s tendency to operate by emotion, not intellect, carried over into purchasing deci- sions. He always bought the latest electronic gadgets, often at $5,000 to $10,000 a clip. He “had to have” the latest status car, selling last year’s preferable pick at a loss. At the beginning

626 Integrated Decision Making

of each year, he would make a New Year’s promise to turn over a new leaf, and before the week was over he had broken it. He went to a financial planner for assistance. The planner drew up a financial plan that was highly specific as to what should be done. The plan was very blunt about the seriousness of noncompliance and discussed the poor investment performance in the past. The planner rec- ommended a broad variety of index mutual funds for both stocks and bonds and told Dustin not to sell them after purchase. To cover his desire to invest frequently, Dustin was to be given 10 percent of his savings to invest in whatever he wished. Planners may use such a “Las Vegas” or “fun money” account for selected clients who need this type of outlet for their speculative urges. The planner recommended many control mechanisms, one of which was having the fund management firm, which invested a preplanned amount of Dustin’s money, send the planner a duplicate statement each month. He told Dustin he would be watching his monthly statement and would call if the automatic withdrawals from his paycheck were altered in any manner. The plan provided for quarterly meetings to discuss progress. Dustin was told that veering from the steps in implementation of the financial plan without a planner’s approval could jeopardize his financial future. In addition to these requirements, as a hedge against some noncompliance, the planner re- duced the projected growth rate for Dustin’s blend of stocks and bonds by 1 percentage point a year as compared with market averages. He required that Dustin save additional amounts even beyond the impact of the lower investment growth rate. The planner said that after three years of following the plan, they would consider some reduction in these restrictive practices. Dustin appreciated this “tough love” approach and said that it covered what other financial plans he had made for himself in the past had lacked. It provided structure and control.

Area Recommendation Timing

Cash flow Cut back on spending by $8,000 per year Immediately Save $100 per week or $5,000 per year through automatic withdrawals from paycheck

Begin next week

Debt Repay credit card debt of $3,000 Within one year Tax planning Save 10 percent of salary in

tax- sheltered 401(k) Begin next week

Investments Implement a 70 percent stock, 30 percent bond allocation

Within two weeks

Sell Low Flying Fund This week Buy Rocket Man Fund This week

Risk management Place jewelry in safe deposit box Within two weeks Increase coverage on property by $10,000 In a month Buy additional term insurance In a month Start a liquid savings account of $20,000 Accumulate over 18 months

Retirement Save 10 percent of salary in 401(k) each year

Begin next week

Place additional $8,000 per year in personal savings once mortgage is repaid

Starting in four years

Other Establish special needs trust Contact lawyer within two weeks Estate Draw up a will Contact lawyer within two weeks

Draw up a medical power of attorney Contact lawyer within two weeks Draw up a statement of personal wishes Contact lawyer within two weeks

TABLE 19.5 Implementation Schedule

Chapter Nineteen Completing the Process 627

Monitoring the Financial Plan People’s lives can undergo significant change, so financial plans should be reviewed peri- odically. Such changes may involve one’s personal life; for example, a marriage, a divorce, having children, health problems, or the death of a loved one. Business changes may involve a job; the outlook for income; or economic, inflation, or investment assumptions. Or there may be overall changes in goals or risk tolerance. In addition, plans should be reviewed periodically to measure actual results versus projected ones. When figures are materially different, reasons for the discrepancy should be found. If the reason stems from unrealistic plan assumptions, they should be changed. Reviews should identify systematic, not cyclical, differences. For that reason, reex- amining plans too often can be counterproductive. For example, we have seen that people tend to overemphasize the impact of relatively short-term changes in asset prices4 and that those who refrain from making frequent changes in investments may actually come out ahead.5 On the other hand, extraordinary expenses that result in cash flow shortfalls each year as compared with projections should be considered recurring annual charges and should result in alterations in either practices or future projections for the financial plan. Appendix II provides some financial statements that can be useful for review purposes.

4 See Shlomo Bernatzi and Richard H. Thaler, “Myopic Loss Aversion and the Equity Premium Puzzle,” Quarterly Journal of Economics 110, no. 1 (February 1995): 73–92; and Nicholas Barberis and Ming Huang, “The Loss Aversion/Narrow Framing Approach to the Equity Premium Puzzle,” Handbook of the Equity Risk Premium, Chapter 6, 2008, Elsevier BV, forum.johnson.cornell.edu/faculty/huang/ review_ on_EP.pdf. 5 Brad M. Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55, no. 2 (April 2000): 773–806; and Brad M. Barber and Terrance Odean, “The Behavior of Individual Investors,” in Handbook of the Economics of Finance, 2013 Elsevier B.V., faculty.haas.berkeley.edu/odean/papers%20current%20versions/behavior%20 of%20individual%20investors.pdf.

- -

Professional Advice Keys to a Successful Plan

628 Integrated Decision Making

College Age

Twenties

Thirties

Forties

Fifties

Sixties

Seventies and Beyond

Life Cycle Planning Completing the Process

Chapter Nineteen Completing the Process 629

Back to Dan and Laura INTEGRATION The big day had finally arrived. Dan and Laura were to meet with me and finalize the plan. Unlike many other planning meetings, this one would be concerned almost exclusively with integration. All Dan and Laura’s preferences and the costs attached to them had been gone over in separate meetings for each part of the plan. We had discussed capital needs analysis as it pertained to how much was required for retirement and insurance coverage a few meetings back. However, we really didn’t get into an extended discussion of savings needed versus amounts likely to be generated by their current financial path. I had told them we would postpone such considerations for today, when I would introduce risk, prob- ability analysis, and total portfolio management into asset selection and calculations of capital needs. I decided to devote some space in the financial plan to explaining how the system worked. As indicated, the figures demonstrated in our capital needs analysis–retirement plan- ning meeting showed that that there was a shortfall. Dan and Laura would not have enough money to support their living costs. This was not surprising to me given their life- style and desire to retire as early as age 55. I thought of the financial alternatives—a cut- back in their cost of living today. That didn’t seem feasible. We were already cutting back. Nor did I think they had a particularly lavish lifestyle for a middle-class family. Retirement lifestyles at such a young retirement age didn’t seem amenable to cutting back either. Nor did additional work-related income seem appropriate. Both spouses were happy and com- mitted to a full-time track in their current positions. Usually, I didn’t believe in materially increasing a client’s risk tolerance. Their current allocation didn’t seem severely conservative, which might have prompted a different con- clusion. However, I decided to wait until I used a TPM approach before coming up with a definite answer to the asset allocation question. Both had already indicated that they felt strongly about fully financing their son Brian’s college education and that of the baby they were expecting. That left two major areas. The first was the retirement date. I calculated that each ad- ditional year in which retirement was postponed would reduce preretirement savings needed by $10,000 a year in today’s dollars or raise allowable discretionary expenses in retirement by $6,000 per year in today’s dollars. Dan had resisted the idea that if their retirement living period was unusually long, they would have to sell the house they would live in. I thought it was not my decision to make. I could only provide insight and an opinion if they wanted it. I gave them a choice of alternatives and asked both to rank their prefer- ences for maintaining their current lifestyle as adjusted recently versus making further alterations. Delaying retirement age and selling the house came out at the bottom of the ranking. Dan became somewhat anxious at the line of questioning. I made a mental note then to insert an extra reassuring comment in the financial plan, if merited. I also decided not to burden them with a repeat of the sections of the plan that we had already gone over. I would provide a summary and integration of the key points and a detailed backup of the TPM approach and of the new capital needs analysis, including revised cash flow and tax statements if necessary. The result of the risk analysis was a real eye opener. Whereas I thought I was being conservative in reducing their assumed returns by one percentage point, I wasn’t. Given Dan’s fear of running out of money, the couple had decided they wanted a 90 percent cer- tainty of having enough resources to last until age 95. At their present asset allocation, that would require about a 3 percent reduction in assumed return.

630 Integrated Decision Making

I was apprehensive about telling this to Dan after having presented both of them with an already-restrictive budget. But there was no pleasant way to explain it, and I decided to present it in writing as follows.

This is what I told them: As we discussed when we started the process, a financial plan represents the carving out of a course of action to enable you to reach your objectives. Both the objectives and the indi- vidual parts of the plan have already been worked out in our previous meetings. As I indicated, most of these recommendations did not incorporate risk directly. Let me explain the risk procedures: Risk is the potential for having your plans derailed by an unexpected occurrence. I have employed risk management procedures to reduce or eliminate the possibility of these occurrences. Some of the factors already discussed are diversification, insurance, and health and safety procedures. In this section of the plan, I will focus on those that still remain. To do this I will call on total portfolio management (TPM), which I explained in a previous meeting, but this time I will emphasize risk. TPM is the method of bringing together all of your assets and liabilities into one group- ing. This grouping is broader than just the marketable financial investments’ portfolio, which reflects only your stocks, bonds, and mutual funds. We bring all of your assets and liabilities together to develop returns and overhead expenses that are to be paid against those returns. In doing so, we are equally interested in risk. Risk is not, as you might think, adding up the risks of the individual assets and liabilities. Risk is reduced by the fact that the assets are not all affected to the same degree by an outside negative event. In effect, it is an elaboration on the term diversification. By solving for the return and risk on the household portfolio, we can arrive at the amount you can spend on leisure activities, according to your tolerance for risk. Your household portfolio is presented in the attached schedule. Notice the difference between it and the balance sheet presented after our very first meeting. This balance sheet incorporates your purchase of a home. Congratulations on closing on the $250,000 pur- chase, financed by a mortgage of $237,500 and by using part of the parental gift of $65,000 for the down payment. Perhaps more importantly, it incorporates all your nonmarketable assets and liabilities, including your human-related assets. They consist of the net present value of each of your jobs and your anticipated Social Security benefits. In addition, this schedule incorporates the value of Laura’s expected government pension. I call this state- ment your broader balance sheet. At this point, you may be asking how I am going to use this material. After all, the same information was available for projections of income and expenses, for the capital needs analysis, in the retirement planning section. The difference is in the use of the items in a TPM framework to analyze risk. In the human-asset category, your jobs are not correlated, and, of course, Dan’s job as a technology consultant possesses much more risk than Laura’s essentially tenured teaching position. Dan’s job correlates to some degree with overall economic variables and, spe- cifically, the outlook for technology. Social Security and Laura’s school pension can be considered low-risk investments that, in my opinion, have little chance of a material change: possible modest revisions include an extension of the full pension retirement age to 70 from 67 for Social Security benefits and three years added to the school pension be- fore Laura becomes eligible. We have assumed that you would liquidate your home to cover such an outcome or borrow against it. Finally, the house you selected in a fast-growing part of the suburbs, attached to a broad-based metropolitan area, seems to have an outlook not related to other assets in the household portfolio. In sum, you have a well-diversified mix of largely uncorrelated assets. Noncorrelated assets, as you probably remember, diversify risk and can prevent an adverse impact on reaching your goals.

Chapter Nineteen Completing the Process 631

The interest on your mortgage and your other maintenance costs have grown, given your soon-to-be two children and housing outlays. Nonetheless, given Laura’s relatively secure pension, two full Social Security incomes likely, and an inheritance, I would char- acterize your nonmarketable securities portfolio as having below-average risk. I have attached Table 19.7, which presents a TPM balance sheet. It includes nonmarket- able assets and maintenance liabilities in addition to the figures in a traditional balance sheet. As mentioned, this balance sheet, while untraditional, presents a broader view of your assets as well as providing the fixed-cost obligations that are necessary for you to support your intended standard of living. If you had substantial financial assets, I would run the purest TPM system that takes into account all assets and liabilities and solve for the optimal asset allocation between stocks, bonds, and money market funds. But since financial assets currently account for about 2 percent of total household assets, I don’t see the point. Any asset allocation for stocks and bonds right now won’t make much of a difference, which will be true for the next several years as well. You won’t begin meaningful savings until 2021. However, permit me to make a recommendation anyway. In the investment section, we agreed upon a 60–40 stock-bond mix influenced by Dan’s innate conservatism. My recommendation is that we raise that to 70–30. The original allocation recommendation was made based on financial assets alone. In retirement calcu- lations, I prefer using a historic long-term return assumption for stocks. For this reason, I assume the return on stocks to be 10 percent. The return on bonds is projected to be 5.5 percent. This revision virtually offsets the higher equity allocation and your overall investment return remains unchanged. Here is why I changed my thinking. The new asset allocation incorporates the generally lower-risk nature of your nonfinancial assets. As you will see, even though the principal option you may want to exercise over your life cycle is in the financial area, in making decisions it is important to take into account all your assets. Incidentally, as retirement comes closer, these low-risk pension assets, which are bond-like, comprise a greater proportion of assets. The same is true of the house, whose price volatility is also lower than that for stocks. The result can be the ability to sustain an even greater weighting in equities over time. My final thought on financial investments is that you should consciously avoid a heavy weighting in technol- ogy shares, given their correlation with Dan’s job. Your recommended asset allocation is provided in Table 19.6. I have one final new fact for you. Unfortunately, it is not positive. I had originally thought that by reducing your assumed investment return by 1 percent, I was being conser- vative about your needs. However, in performing a Monte Carlo analysis, an approach that takes into account risks in key variables such as below-average investment returns and higher-than-average inflation, I have found that figure needs to be revised. We have to take into account the risks that become clear under our Monte Carlo probabilistic analysis. Specifically, the risks of below-average returns in early retirement years, called withdrawal risk, and of above-average expenses due to inflation. The upshot is a further decline of 2 percent in the assumed investment return, from 7.7 percent to 5.7 percent. There are a number of alternatives that you have. We will provide you with the impact of a change in each alternative on your capital needs. It is called sensitivity analysis. In addition, the amount of insurance will change to about $1,300,000 on Dan’s life and approximately $700,000 on Laura’s life.6 The higher amount than indicated in our retirement meetings is due to the lower assumed return to place you at the 90 percent confidence level.

6 The insurance need did not change materially from the original calculation in Chapter 17; the higher income earned by the surviving spouse due to the five-year extension in working years is offset by the lower rate of return assumption.

632 Integrated Decision Making

ASSETS LIABILITIES

Financial Assets Financial Liabilities Cash $3,000 Revolving credit $20,000 Money market funds 7,000 Mortgage1 237,500 Bonds and bond funds 34,000 Other 66,000 Stocks and stock funds 96,000 Total Financial Liabilities $323,500 Pension assets 10,000 Total Financial Assets $150,000

Real Estate Maintenance Liabilities Home1 $250,000 Fixed-cost liabilities $4,775,894 Total Real Estate $250,000 Total Maintenance Liabilities $4,775,894

Household Assets Auto2 $42,000 Furniture 7,000 Other 5,000 Total Household Assets $54,000

Nonmarketable Assets EQUITY

Human $4,050,496 Social Security 900,782 Household equity3 $130,500 Pension 394,071 Nonmarketable equity4 569,454 Total Nonmarketable Assets $5,345,348 Total Equity5 $699,954 Total Assets $5,799,348 Total Liabilities and Equity $5,799,348

1 Projected. 2 Includes the projected purchase of Dan’s new car. 3 Excludes nonmarketable assets and maintenance liabilities. Represents a traditional balance sheet’s equity. 4 Difference between nonmarketable assets and maintenance liabilities. 5 Includes nonmarketable assets and maintenance liabilities.

TABLE 19.7 Dan and Laura’s TPM Balance Sheet

Asset Category Current

Allocation Strategic

Allocation Tactical

Allocation

Standard Deviation 10 Year1

Stocks

Small cap 10% 13% 20% 19.6 Mid cap 8% 12% 10% 18.1 Large cap 20% 22% 18% 15.6 International 17% 18% 17% 19.6 Real Estate Funds2 5% 5% 5% 23.5 Total Stock 60% 70% 70% 18.4

Bonds

Short-term 10% 5% 8% 2.0 Intermediate 15% 8% 5% 3.5 Long-term 5% 5% 5% 10.0 High-yield 5% 7% 7% 9.5 Total Bond 35% 25% 25% 4.2

Money market 5% 5% 5% 0.5

Total 100% 100% 100% 13.3

1 10-year data from Morningstar® Office® for the period November 11, 2004, through November 11, 2014. © [2014] Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc., of any investment philosophy or strategy presented in this publication. 2 Includes traditional real estate funds and REIT funds.

TABLE 19.6 Dan and Laura’s Asset Allocation

Chapter Nineteen Completing the Process 633

I have stated all the major alternatives except for one, but they all contain weaknesses. As it stands now, you will be unable to save any money for six years. Given your wishes, I don’t believe that a cutback of the magnitude needed could be absorbed easily. And given Laura’s priority on helping raise the children, extra income doesn’t seem feasible. Any part-time work by Dan could hurt his progress within his field. Nor, given your retirement priorities, does a significant paring of expenses seem an option you would find attractive. Finally, I agree with your preference for holding your house for what I call longevity risk; that is, the possibility that you might live to even longer than age 90. If that were to hap- pen, the house could be sold or borrowed against if necessary. Based on our indicated preferences, the option I am recommending is postponement of retirement until age 60. Both of you have said you like your careers and retirement at age 55 had been selected without much strong feeling. I believe most people will be retiring later, not earlier, and an age-60 retirement will still be early relative to your peer group. It still is likely to leave plenty of time for new leisure pursuits. Taking into account the impact of a postponement in the retirement age to 60 and the lower assumed investment return of 5.7 percent, you will need projected savings of $60,000 plus extra savings of about $8,000 per year as compared with the previous figure of $60,000 in projected savings plus $41,000 in extra savings provided in the capital needs analysis meeting. This flat yearly savings figure will average about 18 percent of your in- come throughout your working years. In sum, you have many options to select from. As you can see, this meeting on integra- tion carries great significance. To borrow a term from automobiles, Dan’s great interest, it is where the “rubber meets the road.” Whatever your decision, I want to stress the generally favorable outlook you both have. Your diversity of assets enhances your prospects. Assuming you adhere to the plan and, in particular, exercise a little more control over spending, it will be difficult to throw you off course. I am confident you will move forward without too much trouble, and I will be available to continue to advise you when needed.

I was very concerned as to how Dan would take the news of the modification in the projections. Would he become fearful or cynical about the whole planning process? What would each of them think about the recommendation to postpone retirement? I had delib- erately included some words of support, which I believed were true, at the end of the plan. It turned out that my recommendation to move back the retirement date was agreed upon after only a brief discussion of the alternatives. I mentioned to them that there was no need to revise most of what transpired, given the fact that we were only changing retire- ment dates. I noticed that Laura kept looking over at Dan as if concerned that he take a positive view of what was going on. Finally, she asked him if the revisions were something he would worry about. He just smiled broadly and said, “I can handle it.” We made an appointment to meet next on the implementation steps.

RETIREMENT NEEDS ANALYSIS Inputs

General

Dan’s age 35 Laura’s age 35 Dan’s retirement age 60 Laura’s retirement age 60 Dan’s assumed age of death 95 Laura’s assumed age of death 95 Years until retirement period 1 25 Years until retirement period 2 30

(continued)

634 Integrated Decision Making

Step 1. Calculate the Amount Needed in Retirement Retirement Period 1 (60–65)

Living expenses in retirement, today’s dollars $80,935 Laura’s pension in today’s dollars, after taxes 0 Annual shortfall, today’s dollars 80,935 Annual shortfall, age 60 169,459 Lump sum needed to retire mortgage1 110,686 Lump sum needed at beginning of period $940,200

Retirement Period 2 (65–95)

Living expenses in retirement, today’s dollars $80,935 Laura’s pension in today’s dollars, after taxes 32,400 Social Security benefits at 65 in today’s dollars, after taxes 33,138 Annual shortfall, today’s dollars 15,396 Annual shortfall, age 65 37,371 Lump sum needed at beginning of period 964,635

1 Amount owed after 24 years of mortgage payments at normal amortization. Assumes mortgage begins in year 2 of plan.

Years in retirement period 1 5 Years in retirement period 2 30

Laura

Pension at age 65, today’s dollars $45,000 After-tax pension 32,400 Current salary 0 Salary in five years, today’s dollars 68,000 Annual increase thereafter 3% Social Security benefits at age 67 $24,196

Dan

Salary $100,000 Annual increase through 2022 10% Annual increase beginning 2023 3% Social Security benefits at age 67 $26,022

Expenses

Living expenses, today’s dollars1 $83,452 15% COL reduction in retirement ($12,518) Additional travel expenses $10,000 Total expenses in retirement $80,935

Economic

Inflation 3.0% Tax rate in retirement2 28.0% Investment return 5.7% After-tax investment return 4.1% Real return 2.6% After-tax real return 1.1%

1 Sum of discretionary, nondiscretionary, and capital expenses in year 6, discounted to year 1. 2 Estimated marginal federal and state rate. Assumes state tax rate of 5% and blend of ordinary income and capital gains federal rates.

(concluded)

Chapter Nineteen Completing the Process 635

Step 2. Bring the Lump Sum Needed Back to the Present

Lump sum currently needed, retirement period 1 $343,981 Lump sum currently needed, retirement period 2 288,629 Lump sum needed in year 6, retirement period 11 420,602 Lump sum needed in year 6, retirement period 2 352,921 Total lump sum needed now 632,610 Total lump sum needed in year 6 $773,523

1 Assumes that savings cannot begin until year 6, when Laura returns to work.

Step 3. Repeat Steps for Other Needs

Lump sum needed for college in year 61 $230,488 Total other needs lump sum, year 6 $230,488

1 From college planning section.

Step 4. Establish the Current Value of Projected Future Saving

Accumulated assets as of year 6 $89,479 Projected after-tax savings starting year 61 60,000 PV of future savings in year 6 807,961 Total existing and projected resources in year 6 $897,441

1 Assumes that saving is not possible until Laura returns to work.

Step 5. Compare Resources and Needs

Total needs in year 6 $1,004,011 Total existing and projected resources in year 6 897,441 Additional resources needed $106,570

Step 6. Establish Additional Annual Savings Needed

Additional savings needed beginning year 6 (level payment) $7,914 Additional annual savings needed beginning year 6 $7,914

INSURANCE NEEDS ANALYSIS—DAN

Inputs

General

Dan’s age 35 Laura’s age 35 Laura’s retirement age 60 Dan’s assumed age of death 35 Laura’s assumed age of death 95 Years in preretirement period 1 5 Years in preretirement period 2 13 Years in preretirement period 3 7 Years in retirement period 1 5 Years in retirement period 2 30

(continued)

636 Part Seven Integrated Decision Making

Laura

Pension $45,000 After-tax pension 33,750 Current salary 0 Salary in year 6 68,000 Salary after tax 51,000 Annual increase 3% Social Security benefits Laura’s Social Security in retirement 24,196 Social Security after taxes 18,147 Survivor benefits until children grown, before tax1 26,250 Survivor spousal benefits at age 60, before tax 10,725

Expenses

Current expenses2 $103,032 Reduction at Dan’s death 15% Expenses after Dan’s death 87,578 Expenses after children grown3 68,794

Available Assets

Investment assets $150,000 Liabilities 86,000 Available assets 64,000

Economic

Inflation 3.0% Investment return 5.7% After-tax return 4.1% Real return 2.6% After-tax real return 1.1% Average tax rate preretirement period 14 0% Average tax rate preretirement period 2 25% Average tax rate preretirement period 3 25% Average tax rate retirement period 1 10% Average tax rate in retirement 25%

1 Estimate based on 175% of Dan’s primary insurance amount at the time of his death. Actual numbers will be modestly different because different benefits end in different years. 2 Average of living expenses over next seven years. 3 85 percent of what they would spend as a couple in retirement. 4 All tax rates are estimates based on income projections.

(concluded)

Step 1. Determine the Amount Needed to Fund the Preretirement Period

Preretirement Period 1, Years 1–5

Annual expenses, today’s dollars $87,578 Social Security survivor benefits, after taxes 26,250 Laura’s salary, after taxes 0 Total income, after taxes 26,250 Annual shortfall 61,328 Lump-sum shortfall, today’s dollars $300,203

(continued)

Chapter Nineteen Completing the Process 637

Preretirement Period 2, Years 6–18

Annual expenses, today’s dollars $87,578 Social Security survivor benefits, after taxes 20,672 Laura’s salary, after taxes 51,000 Total income, after taxes 71,672 Annual shortfall, today’s dollars 15,906 Annual shortfall, year 6 18,439 Lump sum shortfall, year 6 225,034 Lump-sum shortfall, today’s dollars $184,039

Preretirement Period 3, Years 19–25

Annual expenses, today’s dollars $68,794 Laura’s salary, after taxes 51,000 Total income, after taxes 51,000 Annual shortfall, today’s dollars 17,794 Annual shortfall, year 19 30,294 Lump-sum shortfall, year 19 205,428 Lump-sum shortfall, today’s dollars $99,597

(concluded)

Step 2. Determine the Amount Needed to Fund the Retirement Period

Retirement Period 1 (60–65)

Living expenses, today’s dollars $68,794 Social Security spousal survivor benefits, after tax1 9,813 Annual shortfall, today’s dollars 58,981 Annual shortfall, age 60 123,493 Lump-sum shortfall, age 60 604,508 Lump-sum shortfall, today’s dollars $221,165

Retirement Period 2 (65–95)

Living expenses, today’s dollars $68,794 Laura’s annual pension, after taxes 33,750 Social Security benefits, after taxes 16,501 Total income 50,251 Annual shortfall, today’s dollars 18,544 Annual shortfall, age 65 45,010 Lump-sum shortfall, age 65 1,161,829 Lump-sum shortfall, today’s dollars $347,632

1 Estimate based on Dan’s primary insurance amount.

Step 3. Determine the Total Lump Sum Needed Today

Lump sum currently needed, preretirement period 1 $300,203 Lump sum currently needed, preretirement period 2 184,039 Lump sum currently needed, preretirement period 3 99,597 Lump sum currently needed, retirement period 1 221,165 Lump sum currently needed, retirement period 2 347,632 Total lump sum needed, today’s dollars $1,152,636

638 Integrated Decision Making

Step 4. Repeat Steps for Other Needs

Lump sum needed currently for college $179,479 Burial expenses 20,000

Total lump sum for other needs, today’s dollars $199,479

Step 5. Establish Insurance Need

Total lump sum needed for all needs, today’s dollars $1,352,116 Available assets $64,000 Total insurance needed, today’s dollars $1,288,116

INSURANCE NEEDS ANALYSIS—LAURA

Inputs

General

Dan’s age 35 Laura’s age 35 Dan’s retirement age 60 Laura’s assumed age of death 35 Dan’s assumed age of death 95 Years in preretirement period 1 18 Years in preretirement period 2 7 Years in retirement period 1 5 Years in retirement period 2 30

Dan

Salary $100,000 Annual increase through 2022 10% Annual increase beginning 2023 3% Social Security benefits Dan’s Social Security at age 67, before tax 26,022 Social Security at age 67, after tax 19,829 Survivor benefits until children grown, before tax1 24,150 Survivor spousal benefits at age 60, before tax 9,867

Expenses

Current expenses2 $103,032 Expense reduction at Laura’s death 15% Expenses after Laura’s death 87,578 Expenses after children grown3 68,794

Available Assets

Investment assets $150,000 Liabilities 86,000 Available assets 64,000

Economic

Inflation 3.0% Investment return 5.7%

(continued)

Chapter Nineteen Completing the Process 639

(concluded) After-tax investment return 4.1% Real return 2.6% After-tax real return 1.1% Average tax rate, preretirement period4 30% Average tax rate, retirement period 1 10% Average tax rate, retirement period 2 28%

1 Estimate based on 175% of Laura’s primary insurance amount at the time of her death. Actual numbers will be modestly different because different benefits end in different years. 2 Average of living expenses over next seven years. 3 85 percent of what they would spend as a couple in retirement. 4 All tax rates are estimates based on income projections.

Step 1. Determine the Amount Needed to Fund the Preretirement Period

Preretirement Period 1, Years 1–18

Annual expenses, today’s dollars $87,578 Social Security survivor benefits, after taxes 17,992 Annual shortfall, today’s dollars 69,586 Lump-sum shortfall, today’s dollars 1,145,779 NPV Dan’s salary, after taxes1 1,612,183

Lump-sum surplus, today’s dollars $466,404

Preretirement Period 2, Years 19–25

Annual expenses, today’s dollars $87,578 Dan’s income2 118,452 Annual surplus, today’s dollars 30,874 Annual surplus, year 19 52,561 Lump-sum surplus, year 19 356,428

Lump-sum surplus, today’s dollars $172,806

1 Net present value calculation assumes 10 percent annual increases first eight years, 3 percent increases thereafter, and discount rate equal to rate of inflation. 2 Calculated future salary based on assumptions in Footnote 1, then found present value based on inflation rate.

Step 2. Determine the Amount Needed to Fund the Retirement Period

Retirement Period 1 (60–65)

Living expense, today’s dollars $68,794 Social Security survivor benefits of age 60, after taxes1 9,028 Annual shortfall, today’s dollars 59,766 Annual shortfall, age 60 125,137 Lump-sum shortfall, age 60 612,554

Lump-sum shortfall, today’s dollars $224,109

Retirement Period 2 (65–95)

Living expense, today’s dollars $68,794 Social security benefits of age 65, after taxes 16,225

(continued)

640 Integrated Decision Making

Annual shortfall, today’s dollars 52,569 Annual shortfall, age 65 127,599 Lump-sum shortfall, age 65 3,293,652 Lump-sum shortfall, today’s dollars $985,497

1 Estimate based on Laura’s primary insurance amount.

(concluded)

Step 3. Determine the Total Lump Sum Needed Today

Lump-sum surplus, preretirement period 1 $466,404 Lump-sum surplus, preretirement period 2 172,806 Lump sum currently needed, retirement period 1 224,109 Lump sum currently needed, retirement period 2 985,497 Total lump sum needed, today’s dollars $570,396

Lump sum needed currently for college $179,479 Burial expenses 20,000 Total lump sum for other needs, today’s dollars $199,479

Step 4. Repeat Steps for Other Needs

Total lump sum needed for all needs, today’s dollars $769,875 Available assets $64,000 Total insurance needed, today’s dollars $705,875

Step 5. Establish Insurance Need

College Student Case Study and Review: Amy and John COMPLETING THE PROCESS I could sense that Amy and John were up for the occasion. This would be the last lesson. They would be on their own after this. Moreover, unlike a college course there would be no formal exam, yet there was a feeling of accomplishment upon “graduation.” I began by mentioning integration, which differentiated PFP from the financial work done by professionals in other areas. It involves evaluating costs and benefits over time to find the best path to specific goals. Then I proceeded to review the approach, starting with PFP theory and its elements.

1. The household is an enterprise like a business. 2. The goal of PFP is to provide the highest standard of living possible for a given time

devoted to work; the goal becomes the maximization of discretionary expenditures. 3. Household finance supports the enterprise, which needs cash flow and appropriate

methods for allocating limited resources. 4. PFP provides the strategic approach for solving household financial decisions.

Chapter Nineteen Completing the Process 641

5. PFP decisions are made on an integrated basis that takes into account all household as- sets and liabilities.

6. Total portfolio management provides the solutions for PFP’s overall objectives and the household’s overall goal.

The financial plan maps out the practical steps through which a particular goal or goals can be accomplished.

1. Such a plan improves structure. 2. It makes you order your priorities and obtain a financial solution based on individual goals. 3. It can be used as a reference in future years. 4. It provides a numerical base from which changes over time can be made.

The planning process begins with the following three steps:

Establish the Scope of the Activity Gather the Data and Identify Goals Compile and Analyze the Data

Three overall steps can be taken:

SWOT analysis Analyze the strengths/weaknesses in internal house- hold analysis and analyze opportunities/threats in analysis of the external environment, all in order to evaluate the household’s financial future.

Sensitivity analysis Examine how a change in the outcomes of key factors can significantly affect planning results.

Scenario analysis Evaluate how changes in one or more variables can affect many situations. The emphasis is on an overall changed environment as opposed to a one-variable sensitivity analysis.

Once these steps are taken, a planner can proceed to develop solutions and complete the plan by performing a behavioral review and asking if the plan will work well for the person at hand. Then it’s time to write and deliver the plan. To create a successful plan make sure the recom- mendations are doable, state the assumptions on key variables, make sure that steps have been take to overcome human shortcomings, and consider alternative solutions. Finally, make sure that plans are reviewed periodically to see if actual results have been in line with projections and that future circumstances haven’t changed materially. Therefor the planning process is completed with these three steps:

Develop Solutions and Complete the Plan Implement Monitor and Review Periodically

Summary This was the final chapter. It stressed how to complete the planning process using integration of the parts of the plan and overall completion techniques. Among its critical points were

improve decision making and household performance.

process by providing “what if” analysis.

642 Part Seven Integrated Decision Making

Key Terms 613 622

621 619

quickmba.com

Website

Questions

Problem

Chapter Nineteen Completing the Process 643

A young couple (both age 30) come to a financial planner with the desire for assistance in improving their family’s financial position. They have two healthy children, ages three and six. The husband is a foreman for a manufacturer of auto parts. His current salary is $30,000 per year. The wife is a marketing professor for a state university. Her current sal- ary is $40,000 per year. The couple recently purchased a riverfront home for $100,000 using their entire savings of $20,000 as a down payment. In addition to an $80,000 mort- gage, the couple’s only debt is an automobile loan having the balance of $12,000. Both husband and wife have very good family health insurance from their employers. The wife has employer-paid life insurance equal to two times her annual salary.

A. The couple wants to start an investment program as soon as possible. To correct the weak- ness in their financial planning before beginning the investment program, they should

1. Establish an emergency fund with stock mutual funds. 2. Start a college savings fund for the children. 3. Purchase disability insurance for the wife and the husband. 4. Prepare wills for the wife and the husband. 5. Secure credit life insurance for the auto loan.

a. (5) only b. (1) and (2) only c. (1) and (3) only d. (3) and (4) only

B. When the couple are able to begin an investment program, they want to begin making investments for their retirement and their children’s education. All of the following ac- tions will help accomplish their goals in a tax-efficient manner except

1. Investing in individual Roth IRAs. 2. Investing through a 403(b) program for the wife. 3. Investing in a growth and income mutual fund. 4. Investing in education IRAs for each child.

Harold and Mary Anne Miller are a married couple in their early 40s with three children, ages 7, 10, and 12. Harold earns $350,000 per year as General Counsel of a mid-sized IT firm and Mary Anne is a homemaker. They have major assets of $1,500,000 cash and $1,000,000 in stock options. They have done no estate planning. Harold has life insurance of two times his salary from his employer. Harold plans on working full-time until age 62. Harold has the potential to receive more options and restricted stock based on his compa- ny’s performance, but has requested that this not be included in his assets for now given the uncertainty. College planning is of great concern to the Millers, currently they have no plan in place. They estimate that they will need $150,000 for each child in current dollars to fund their education. The Millers have constructed a budget and have determined that their household expenses are $12,000 per month, after tax. Assume that the Millers are in the 35% tax bracket and 6% state bracket. Given the facts above, which is the most important piece of the plan that the Millers should implement first?

a. Establish wills with guardianship b. Exercise stock options c. Diversify cash investments d. Establish an irrevocable life insurance trust (ILIT)

19.1

19.2

CFP® Certification Examination Questions and Problems

644 Part Seven Integrated Decision Making

Case Application INTEGRATION In working out the capital needs analysis, it became apparent that there was need for an additional $17,000 of savings annually over what was previously calculated. The first reason had to do with a recent job development that resulted in a projected moderation in Richard’s raises in salary to a level 1–2 percentage points below the inflation rate and that made his job more risky. The second was the running of the total portfolio manage- ment approach, which indicated that the assumed investment rate needed to be lowered to 5 percent. Richard took the news in stride and said he thought I was too negative. Things would work out in the job. He would just have to invest more aggressively than originally planned. Monica, on the other hand, was shaken. She thought that their tolerance for risk would have to be cut back. She said she would consider taking a full-time job if necessary. Richard shook his head as if to say no but didn’t speak. Monica thought they could down- size by selling their house and realizing an extra $100,000. She wondered what level of insurance she could afford and whether they should cut back on the amount. Richard didn’t like that idea. Monica said disagreement on financial matters was a feature throughout their marital lives. She thought that I should make the recommendations. She pledged to follow them. Somewhat surprisingly to me, Richard agreed as well.

Case Application Questions 1. Go over the alternatives for increasing savings. 2. What do you think of Monica’s offer to take a job? 3. Under the TPM approach, should the risky portion of their asset allocation be raised or

lowered? 4. Should their insurance be raised or lowered? 5. Do you feel they should downsize their dwelling? 6. What are your recommendations? Incorporate savings, investing, life insurance, and

other relevant areas. 7. Should there be controls set up to assist in ensuring that the recommendations are

followed? 8. What kind of follow-up with the advisor would you recommend? 9. Complete the financial plan.

Appendix I

Household and Business Characteristics A breakdown of some of the many similarities and differences between a business and a household is detailed in Tables 19.A1.1 and 19.A1.2. On balance, the similarities appear more substantive than the differences. Therefore, the household can be characterized as an organization that in many ways resembles a business, and this has been a substantial organizing factor developed throughout this text.

Chapter Nineteen Completing the Process 645

Review Statements There are two special statements that can provide insight into PFP matters. The first, a summary of cash flow considerations for the period, helps identify the differences between projected and actual performance and the reasons for them.

TABLE 19.A1.1 Household and Business Characteristics: Similarities

Item Business Household

Strategic planning Business plan Personal financial plan—overall approach similar to the business plan

Analytical money—decisions performed by

Internal financial planner, sometimes helped by a consultant

Internal “financial planner,” sometimes helped by an external one

Organizational goal Maximize profits Maximization of utility approach, which uses maximization of profits

Organizational operations

Series of activities called divisions Series of activities called functions

Production function

Products and services sold to others; some produced internally for workers

Labor services sold to others and utilized internally for benefit of member-owners

Types of capital expenditures

Machinery Plant Plant—home Human capital—education and training

Human capital—education and training

Types of assets Real, human-related, financial Real, human-related, financial Risk management Practices, insurance, marketable

financial instruments Practices, insurance, marketable financial instruments

Investment tools Time value of money Time value of money NPV, IRR NPV, IRR Portfolio management concepts Portfolio management concepts

Use of profits— cash flow generated

Reinvested or paid out as dividends Reinvested or paid out as dividends, called discretionary or leisure outlays

TABLE 19.A1.2 Household and Business Characteristics: Differences

Item Business Household

Scope of operations Responsibility stops at payout of dividend

Responsibility includes how dividend is spent

Centralized integrated decision making

Can be difficult in larger firms Relatively simple to perform

Specialization of function

Done particularly in larger firms Limited; only available in multiperson household or when specialists are retained

Life span Theoretically unlimited Limited by remaining life span of members

Ability to expand Unlimited Generally limited to two adult members

Specificity of goals Limited to money maximization Financial and nonfinancial goals Separation of owner and manager

Common, particularly in larger firms

Major decisions typically made by member-owners

Role in society To improve consumer standard of living

To improve consumer standard of living, but organization has closer function in performing that role

646 Integrated Decision Making

The second, the special balance sheet factor statement, is important because it more accurately portrays what transpired during the period. It not only incorporates traditional fi- nance’s transactional cash flow orientation but also includes appreciation/depreciation in bal- ance sheet factors not sold. Moreover, it also can include nonmarketable assets normally left off a balance sheet. This way of looking at household assets in their totality can shed some light on certain household actions. For example, many households may feel they have saved when their houses have risen in value even though they have not placed more cash into savings accounts. Use of these statements by households can be instructive about how much of the change in net worth came about through conscious savings and the amount from market factors. These can be compared with previous projections for these factors by households and plan- ners. The net cash flow in Table 19.A2.1 can serve as an input for or a check on the cash flow figures in Table 19.A2.2 as well as in assessing actual versus expected cash flows even when the second schedule is not employed.

TABLE 19.A2.1 Cash Flow Performance for Period

Category Actual Projected Difference Explanation

Cash inflows Salary Business Investment Other Total Nondiscretionary expenses Discretionary expenses Operating Cash Flow Capital expenditures Financing activities Cash flow Targeted savings Net Cash Flow

TABLE 19.A2.2 Statement of Changes in Balance Sheet Factors Category

Amount Beginning of Period

Cash Inflows

Cash Outflows

Unrealized Appreciation/ Depreciation

in Assets

Amount End of Period

Assets Cash Bond Stock Pension Other Total financial Home Auto Furniture and fixtures Jewelry Other Total real Total Assets

Financial Liabilities Revolving credit Mortgage Other Total

(continued)

Chapter Nineteen Completing the Process 647

Appendix III

The Money Ladder The money ladder, discussed in a goals context in Chapter 3, is an easy-to-understand method of presenting capital needs analysis. Financial needs can be separated by activity. The activities are parts of financial planning such as current revenues, current expenses, future needs for retirement, estate, education, and so on. Each activity’s outflow or inflow is discounted to the present. Together they represent all the cash flows for the household over its life cycle. Use of this approach makes the in- tegrative nature of PFP simple to comprehend. Actions in one area can affect the others, as shown in the Liu example on pages 616–617. This type of approach lends itself to a practical form of incorporating risk. It is an alter- native to assigning a mean and standard deviation. You are asked to separately disclose not only your target goal, called the satisfactory goal, but your minimum and higher-level goals. The minimum goal is the most fundamental; if you could not obtain it, you would be profoundly disappointed. A higher-level goal is a “reach.” Each goal in each activity is translated into dollars needed to achieve the objective. The system is called a financial ladder because each rung further up the ladder represents a greater necessary expenditure for a greater reward. Based on your current practices, the system can tell you where on the ladder you are positioned now and how much saving it will take to reach a higher position. The system can interact with risk by assuming that the difference between the satisfac- tory and minimum goals is equal to the standard deviation or by using the actual standard deviation not only to determine the probability of achieving the satisfactory level but also to assign a very high probability of at least reaching the minimum level, which is equiva- lent in ways to what is called the “downside risk” in financial investments.7