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How Safe is Our Clients’ Money
By Helen Modly, CFP®, CPWA®
The recent bankruptcy of MF Global resulting in a reported $1.2 billion of missing client funds has caused many to question the safety of assets held in other brokerage firms. Just how safe is our clients’ money?
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Posted in Uncategorized
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Portfolio Endurance
The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life—and through different economic and market conditions.
Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.
Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.
Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks.2 Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.
Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.
Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:
- Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth.3 Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
- Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.
Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.
Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.
Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.
Considerations
Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.
Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.
Exhibit 1: Basic Tradeoffs in Portfolio Survival
Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.
1 Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” AAII Journal 20: 16–21. Also see: Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning 7: 171.
2 From 1926 to 2009, the S&P 500 Index returned an average 9.8% per year compared to 5.4% for long-term government bonds and 3.0% inflation. Sources: Standard & Poor’s Index Services Group for S&P 500 Index; long-term government bonds and inflation provided by Stocks, Bonds, Bill, and Inflation Yearbook™, Ibbotson Associates.
3 Cooley, Hubbard, and Walz, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” 16–21.
Focus Wealth Management, Ltd. is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.
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Tips for Selecting and Interviewing a Wealth Manager
By: Helen Modly, CFP,ChFC
Wealth Management involves in depth knowledge and experience in a wide range of financial topics. A partial list would include income taxes, investment management, employee benefits, social security, insurance, estate planning and retirement plans.
Wealth Management is proactive in that Wealth Managers anticipate issues that might arise for their clients by thoroughly understanding all aspects of their client’s financial lives. It is also “user-friendly”, in that the Wealth Management team will coordinate the activities of other professional advisors such as attorneys and accountants. Wealth Managers will normally hold one or more of the most respected industry designations, such as the Certified Financial Planner, (CFP® ), Certified Public Accountant/Personal Financial Specialist, (CPA/PFS), Chartered Financial Consultant, (ChFC), or the Chartered Financial Analyst (CFA) designations. Many will have obtained a Masters degree, as well.
You’ll want any potential Wealth Manager to describe their client experience for you. Does every client get the same investment portfolio? Will they calculate their investment performance for you? Will they evaluate outside accounts such as your retirement plans at work? Will they provide education to you? Will they work with your other advisors? How often will you meet? Will you belong to one advisor at the firm or does the firm work as a team? What type of reports or communications can you expect? How much will their services cost? It is perfectly reasonable (and rationale) to ask for referrals, but understand that confidentiality is a hallmark of wealth management and permission to share a client’s name must be obtained first. Most advisors are happy to share the names of local attorneys and CPAs that they have worked with in the past.
It is imperative that you understand how Wealth Managers are paid. All you have to do is ask for a copy of their form ADV Pt. 2. They are required by law to provide this disclosure document prior to, or at the time of beginning an engagement with you. This document will describe in full any and all sources of compensation, whether financial or otherwise that a Wealth Manager will receive. This could include commissions on the sale of investments or insurance, fees for specific services provided, “soft-dollars” from broker-dealers, sharing of fees for referrals to other professionals or a myriad of other sources of income. The most common compensation models are commission, fee-based, and fee-only. For a discussion of these terms and why fee-only is the superior model from the investors’ perspective, see Why Fee-Only Is Important.
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Posted in Focus Wealth
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How to Protect Yourself From Financial Abuse
Check the news on any given day, and you’ll likely run across another sad tale of financial fraud. Even the most sophisticated investors can fall prey to it, as the Bernie Madoff saga clearly demonstrates. Whom can we trust? Where do we turn for guidance? What red flags can warn us of potential trouble? The CFP Board’s “Consumer Guide to Financial Self Defense” is a first line of defense for consumers who may be vulnerable to the minority of financial advisors who do not practice according to the highest ethical standards. To learn how to protect yourself from financial abuse read more.
Posted in Investments
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Planning for Fido and Fifi
By: Sandra Atkins, CPA/PFS
Hopefully, you have done your estate planning and made provisions for passing your estate to your children and grandchildren. But have you thought about what will happen to those other important members of the family – your “other” kids – your pets? You may recognize yourself in this article.
Take a look around and you will see that the baby boomers have substituted furry four-legged creatures for their children who have flown the nest. They treat them like children, but they are easier to get along with and don’t talk back. Boomers spare no expense in catering to these special loved ones and, as a result, have created an entire industry dedicated to pampering their “babies”. They have them coifed at pet spas, dress them in designer accessories, feed them organic meals and take them along on vacation.
So what happens to these treasured family members if the owner dies suddenly, or has to go for an extended stay in a hospital due to an unexpected accident? Who will feed and care for Fifi while her owner is hospitalized? And what will happen to her if her owner never returns?
The sad fact is that many of these pets are taken to shelters, where over half of them are euthanized. This horrible fate, fortunately, can be avoided with some careful planning and it is your job, as the family’s advisor, to raise the issue with your clients.
The new paradigm
Issues relating to the ownership of pets have been growing more complex. Often when parties go their separate ways, problems arise concerning the “custody” of the pets. Traditionally, the courts have viewed companion animals merely as property and have determined ownership based on criteria such as – who owned the pet when the human relationship was formed? Who provides daily care for the animal? Under whose name is the pet registered legally or at the vet’s? Who pays the vet bills?
Recently there have been court cases where the judge has actually considered the “best interest” of the pet, by looking beyond pure ownership and considering other evidence, such as consistency of care and emotional bonding. In some cases, the courts have actually granted joint custody of a pet, much like they would grant for children of a divorcing couple. This is evidence of the importance of the bond between the animal and the owners, and we are likely to see much more of this in the future.
What happens to my pet if I die?
In the past, a person who wanted to provide for their pet in their will had few choices. They might have inserted a clause, such as “I leave my beloved dog, Fifi, to my friend, Ann, plus $5,000 to care for Fifi during the rest of her life.” However, there was no way to protect Fifi if Ann decided to drop her off at the pound and take a trip to Europe with the money.
The strong desire for Americans to provide continuing care for their companion animals resulted in legislation in 1990 and 2000, represented by the Uniform Probate Code (UPC) and the Uniform Trust Code (UTC). As of 2009, 42 states plus the District of Columbia had enacted some type of legislation to allow stand-alone pet trusts or trusts created under a will. For a thorough discussion of this topic, including the provisions specific to each state, read Rachel Hirschfeld’s book, Petriarch: The Complete Guide to Financial and Legal Planning for a Pet’s Continued Care, published by the AICPA.
How do I protect my pet if I have to leave him for awhile?
Another option to provide for a pet, both during the owner’s lifetime and at death, is to create a Pet Protection Agreement. This legally enforceable document was created by Rachel Hirschfeld and is described in her book and on her website, www.Petriarch.com. The agreement is between the pet owner and the pet guardian, and takes effect when the owner is unable to continue to care for his or her pet. It also allows the owner to name a distribution representative who, if appointed, distributes funds to the pet guardian.
Let’s say, for example, that John’s company has assigned him to work overseas for a year. John feels that his dog, Fido, would be traumatized by the plane trip over there, so he wants to leave him in the U.S. for the year. A co-worker, Jean, says that she is willing to take him to live with her family and her two other dogs. John wants to provide money to cover Fido’s expenses while he is gone, but he knows that Jean is sometimes short of money and he worries that she might spend some of the funds for other purposes.
John and Jean enter into a Pet Protection Agreement, where Jean agrees to become the pet guardian for Fido. John names his brother, Mike, as the distribution representative, so that Mike can give Jean funds as needed for Fido’s care. The agreement clearly states that John is Fido’s owner, so that when he returns, he knows he has the right to reclaim the dog, even if Jean thinks he has become a member of her family.
This type of an agreement also works if the pet owner is unexpectedly removed from the home due to an illness or accident. Apparently, it is quite common for people injured and treated by rescue squad personnel to refuse to be taken to the hospital because they have no one at home to care for their pets. The Pet Protection Agreement means that they have made prior arrangements with someone to care for their pet. The type of care will be spelled out, so that the owner knows exactly what will happen to the pets when he or she can’t be home to care for them.
Make plans for your pet
It’s easy to assume that someone will step into your shoes to take over the care of your beloved pet if something happens to you. But do you really want to leave that to chance? You can protect his future by implementing some of these ideas.
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