Financial Plan Development

Transcription

1 CFP Certification Professional Education Program Capstone Financial Plan Development Carol Craigie, MA, ChFC, CFP 7393

2 This publication may not be duplicated in any way without the express written consent of the publisher. The information contained herein is for the personal use of the reader and may not be incorporated in any commercial programs, other books, databases, or any kind of software or any kind of electronic media including, but not limited to, any type of digital storage mechanism without written consent of the publisher or authors. Making copies of this material or any portion for any purpose other than your own is a violation of United States copyright laws. CFP, CERTIFIED FINANCIAL PLANNER TM, and CFP (with flame logo) are certification marks owned by the Certified Financial Planner Board of Standards, Inc. The College for Financial Planning does not certify individuals to use the CFP, CERTIFIED FINANCIAL PLANNER TM or CFP (with flame logo) certification marks. CFP certification is granted only by the Certified Financial Planner Board of Standards to those persons who, in addition to completing an education requirement such as this CFP Board-Registered Program, have met its ethics, experience, and examination requirements. At the College s discretion, news, updates, and information regarding changes/updates to courses or programs may be posted to the College s website at or you may call the Student Services Center at

3 Table of Contents Preface... i Course Overview... ii The Recommended Learning Process... iii Chapter 1: Financial Planning Process & Ethics... 1 Determining the Scope of Engagement... 1 Meet Your Clients... 2 Gather Data... 3 Statement of Financial Position Annual Cash Flow Statement Assumptions Completed Analyze Develop and Present the Plan Implement and Monitor Plan Chapter 2: Client Cash Flow, Debt & Risk Management Cash Flow Plan Development # Debt Analysis Plan Development # Plan Development # Plan Development # Plan Development # Risk Management Property and Liability Issues Plan Development # Plan Development # Plan Development #

4 Disability Insurance Plan Development # Plan Development # Life Insurance Plan Development # Long-Term Care and Health Insurance Plan Development # Chapter 3: Investment Planning Portfolio Considerations Important Portfolio Considerations for Your Clients Analysis of Current Portfolio Potential Model Portfolios Plan Development # Tax Consequences of Shifting Portfolios Plan Development # Addressing the Annuity Plan Development # Plan Development # Chapter 4: Tax Planning Tax Projection for This Year Identifying Opportunities or Concerns Plan Development # Flexible Spending Accounts Plan Development # Appreciated Stock Gifting Plan Development # Chapter 5: Education Planning Projecting College Funding Plan Development #

5 Chapter 6: Retirement & Social Security Planning Retirement Assumptions and Facts Calculating the Retirement Need Plan Development # Social Security Plan Development # Plan Development # Goals in Retirement: The Mountain Cabin Plan Development # Recommending a Retirement Savings Program Plan Development # Chapter 7: Estate Planning & Legal Documents Analyzing the Client s Estate Plan Development # Basic Legal Documents Plan Development # Asset Titling and Beneficiary Designations Plan Development # Acting as Executor or Power of Attorney Plan Development # Plan Development # Chapter 8: Economic, Political & Regulatory Impacts Plan Development # Chapter 9: Creating Your Executive Summary Compiling Your First Draft After Your First Draft Chapter 10: Client Communications Client Communications Client Confirmation Questions Behavioral Economics

6 Preparing for Your Oral Presentation Summary Appendix A Sample Summary Sample Executive Summary Sample Cash Flow Changes Tracking Appendix B: Scoring Guide Executive Summary Scoring Guide Oral Presentation Scoring Guide Appendix C: Templates Executive Summary Template Cash Flow Changes Tracking Template References About the Author Index

7 Preface W elcome to the Financial Plan Development course. This course is very different from the other courses in the CFP Certification Professional Education Program. You will not be studying for an exam, but instead will be building a detailed, comprehensive, financial plan. Our goal for this course is twofold: one is to complete the CFP Board requirements that you demonstrate that you can deliver a comprehensive detailed plan and second that we help you prepare for the CFP Certification Examination by reviewing some of the major components covered in the exam. This course is designed to simulate parts of the financial planning process and reinforce your learning from the prior courses in the CFP Program. In this course you will synthesize and apply the knowledge you have learned in a real-life situation where things can get messy. There are no multiple-choice questions, and in many cases there won t be just one right answer to the questions you are asked. Many answers to client problems will fall within acceptable planning guidelines and the fiduciary standard. The ultimate objective of this course is for you to deliver a comprehensive, detailed executive summary and oral presentation that demonstrate your understanding of the financial planning process, client issues, and potential solutions. Our hope is that when you finish this course, you will be confident that you can prepare and deliver a comprehensive plan. We will not be using financial planning software in this course. There are two reasons for this. The first is that entering information into software is just part of a plan in some ways, it is the easiest part. The problem is that it doesn t fully take the client through the process of understanding the issues in their plan and consequences for not addressing these issues. It doesn t tell them exactly what they need to do to solve the problems nor how to make a decision when comparing alternative solutions. Software doesn t address issues such as inadequate liability protection or what to do if you are uninsurable and can t buy your way out of the problem. Using software isn t creating a plan; it is just one of the tools a planner uses to do the analysis. i

8 The second reason is that learning a new software takes considerable time and we would prefer you spend your time learning how to complete the rest of the plan. If you used software you were familiar with, it would be impossible for graders to know whether you are accurate. For these reasons, we are giving you the results of analysis from software for several components of the plan. You will be expected to interpret the results of the analysis and build your recommendations from there. In other cases, you will need to do calculations that software doesn t typically do, such as calculating mortgage refinancing or potential tax consequences for shifting a portfolio. Some calculations are included because the Board may test on them and we want you to have the practice. To support you in your quest as you work your way through the materials, there are mentor classes and recordings, and you may also contact the course instructor to help answer any questions you may have. You are on your final step to completing the education requirements for CFP certification, and we are proud that we can help you achieve your goal. If you have any questions as you re working your way through this course, you may contact your course instructor or Carol Craigie, the author of these materials, at [email protected]. Course Overview Upon completing this course, you will be able to: Apply CFP Board s Financial Planning Practice Standards to the financial planning process. Collect all necessary and relevant qualitative and quantitative information required to develop a financial plan. Evaluate the impact of economic, political, and regulatory issues with regard to the financial plan. Analyze personal financial situations, evaluating client objectives, needs, and values to develop an appropriate strategy within the financial plan. ii

9 Demonstrate logic and reasoning to identify the strengths and weaknesses of various approaches to a specific problem. Demonstrate a comprehensive understanding of the content found within the financial planning curriculum and effectively apply and integrate this information in the formulation of a financial plan. Effectively communicate the financial plan, both orally and in writing, including information based on research, peer, colleague or simulated client interaction and/or results emanating from synthesis of material. The Recommended Learning Process This course module contains 10 sections through which you will progress, whether you are working in a self-study, online, or classroom setting. The activities in each lesson are organized to support your development of the comprehensive financial plan through specific steps. Embedded throughout the materials are gray shaded Plan Development boxes containing exercises that will lead to the completion of your executive summary. YOU SHOULD COMPLETE THE BOXES AS YOU READ THE MATERIAL. If you read the entire course and then go back to work through these exercises, you will find it takes much longer. The numbers and statistics in these boxes are the results of current research and calculations from various sources. It is impossible to put all the calculations and underlying information into the text. MoneyGuidePro software was used to create many of the charts and graphs. You can find a copy of the base plan referred to as the Dowler MoneyGuidePro report in the student portal. This plan will be helpful in understanding some of the analysis that has been completed for this course. The material is designed to lead you through the following steps: 1. Analyze the clients data so that you understand their issues and are able to succinctly describe them to the client along with the consequences of not addressing the issues. 2. Evaluate alternatives to solving problems, thus identifying the important characteristics for the solutions that can frame the decision for the clients through the use of advantages, disadvantages, and alternatives. iii

10 3. Select the first and second best alternatives that are in the clients best interest, fit within their budget, and work in conjunction with their other goals. 4. Write your recommendations in client-friendly language in a format that provides clients the critical information they need in order to make a decision. 5. Track the impact of your recommendations by using the Cash Flow Changes Tracking Page. One of the largest obstacles to implementing recommendations is that many clients don t have a great sense of their own cash flow. Understanding how your recommendations will impact cash flow becomes an impediment. You can remove this impediment to implementation by showing the clients that you are paying attention to changes to their cash flow and are not going outside of what was agreed upon. By showing your clients the cash flow changes tracking, they can follow the impact of multiple recommendations so costs become less of an issue and the trust in you builds. Advisers who give clients recommendations that they cannot afford breaks the trust clients have in them. Clients lose faith that you understand them and are vested in their well-being. This is why it s important to estimate the costs of changes and track them so you can build a plan that is within the clients resources. The end result of completing the work in the Plan Development boxes will be the formulation of an issue with recommendations, advantages, and disadvantages that will form your executive summary to the client. You are writing this executive summary to the client, not to an instructor or other financial professional. The appendices contain material that you may find useful to review prior to beginning the Plan Development boxes. Sample Case with Sample Executive Summary & Sample Cash Flow Changes Tracking. This case and the sample executive summary will give you a sense of what your final project should be. Executive Plan Template. When you write your recommendations, you will want to write them or copy them into this template in the order they are iv

11 listed. You can find the basic Word document to use to craft your plan on the student portal with the rest of the course materials. Cash Flow Changes Tracking Template. Similar to the executive plan template, this will be where you track the changes to the client s cash flow as a result of your recommendations. Note that you are not tracking cash flow, but the CHANGES to their cash flow so the client can see that you are staying within the cash flow constraints given. You may wish to put this into an Excel or Google spreadsheet for your convenience so that it automatically calculates, or download the basic Excel file from the student portal. The Dowler MoneyGuidePro Financial Plan report is posted on your student portal. As mentioned previously, software is good at doing the longterm projections such as retirement or life insurance needs, but it is not a substitute for a complete plan. We are providing the basic calculations in this report that you will be using to create your executive summary. You may take screenshots of this or reference sections of it in the executive summary. It does not include any recommendations for shifting vehicles or saving more money, but does provide the basis of the analysis. You are writing your executive summary and the cash flow changes tracking sheet in the same order as the Plan Development boxes. Imagine that your clients will have both the executive summary and the cash flow changes tracking in front of them as you lead them through your analysis and recommendations. By showing them the cash flow, you are building trust that you will stay within the constraints you were given. You are also removing one of the biggest obstacles to implementation for clients: not knowing how costs fit into their budget. The criteria used to grade your executive summary and oral presentation can be found in Appendix B of this module and on the student learning portal. Once you have received a passing grade on your executive summary, you will be invited to make an oral presentation to demonstrate your communication skills along with your planning knowledge. There will be more helpful hints and suggestions in chapters 9 and 10 concerning finalizing your plan. Once you have reviewed the documents mentioned above, it s time to get started! v

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13 Chapter 1: Financial Planning Process & Ethics Determining the Scope of Engagement The first step in the financial planning process is determining the scope of engagement. This is a requirement independent of whether you are providing a financial plan or engaging in non-financial planning work when you are a CFP professional. The CFP Board provides a compliance checklist at to document that you are meeting the Board s Standards of Professional Conduct. The first element is related to establishing and defining the client-planner relationship. During your initial meeting with the client, you must have enough of a dialogue to understand what the client is looking for, determine what services and products you may offer, and determine a scope of engagements. You must also Chapter 1: Financial Planning Process & Ethics 1

14 determine what information you wish to collect. If additional information is needed as the analysis occurs, the client must be notified. Remember that during the process, your relationship may change from a nonfinancial planning engagement to a financial planning engagement, which requires a change in the type of documentation. For example, the amount and type of information collected could change your engagement into one that, from the client s and CFP Board s perspective, is a financial planning engagement. Clients anticipate that you actually do something with data you collect, so if you collect tax returns, investment returns, and wills, they are assuming you are examining the documents and will be providing advice in those areas. This could lead you into having a financial planning engagement, even if you were just trying to determine a beneficiary designation for their annuity! At this point, you would need to modify your scope of engagement, make additional disclosures in writing, and document the process. Meet Your Clients Jim and Anne Dowler Client Health Age Occupation Jim Dowler Excellent 42 Manager Anne Dowler Excellent 42 Administrator Dependent: (no other children planned) Matt Excellent 5 Jim and Anne Dowler have requested that a CFP professional evaluate their personal financial situation. In the first meeting you determine that they want to engage you to provide a comprehensive financial plan. A preliminary scope of engagement is defined and signed. All appropriate disclosures for both you and your company were made in that meeting so you have completed the primary requirements of disclosure. 2 Financial Plan Development

15 Gather Data During the first meeting you identified and clarified the financial goals and questions that you will be addressing through your plan. You provided them with a list of documents and information you needed to collect. Notice the requirement in the CFP Board checklist that you document the following three items: Goals and objectives Discussion of any unrealistic goals and unattainable objectives Data gathered and gaps in data Documenting these three areas is not only a CFP Board requirement, but is also a good business practice. When clients confirm the basic goals and information, you will find that more clients understand the issues and information with less time spent reviewing basic information in client meetings. Additionally, by having the clients sign off on a summary of questions and goals, you will also prevent wasting time by entering or analyzing incorrect information. While the CFP Board does not require you to document assumptions in this phase, it is required in a later step. It makes sense, then, to review and confirm this assumption information with the client in this first phase. Documenting your actions and sending this documentation to the client for confirmation eliminates potential time-consuming errors and builds client trust. At this point, the client has already received disclosures and a copy of the signed engagement agreement. As an example, the following document incorporates Chapter 1: Financial Planning Process & Ethics 3

16 a summary of the questions and goals they would like to have addressed in this plan, with any of your potential concerns about possible unrealistic goals indicated; a statement of financial position; a cash flow statement; assumptions; and any additional information the client needs to provide. Client Letter Dear Jim and Anne, I enjoyed meeting you yesterday and look forward to working with you on developing a realistic financial plan with practical recommendations that will improve your financial life. The first step is making sure that I clearly understand your issues and we are both on the same page as I develop your plan. I am sending several documents for both of you to review and return with any changes before I build your plan. After you return these to me, my assistant will schedule an appointment for approximately two weeks out. At that appointment, I will review the results of my analysis and recommendations. Here are the documents that I need you to carefully review, initial, and return with changes or questions. Summary of Goals and Issues. This is my summary of the goals and issues we discussed. It is important that I capture exactly what you want your money and this analysis to do for you. Please take the time to read it carefully and provide any changes or additions. This document will drive my work and recommendations, and ensures I address what is important to you. The only way for me to be sure I am on target is for you to confirm its accuracy. Please respond by the agreed upon deadline. Statement of Financial Position. If this statement is incorrect, your financial plan will be incorrect. It is easy to miss an asset or liability or simply turn two numbers around, so please review this carefully. 4 Financial Plan Development

17 Annual Cash Flow Statement. I will be utilizing this cash flow sheet to determine whether solutions we explore will fit within your cash flow. If I find a way to solve all your financial issues but you won t be able to pay your mortgage after funding them, I won t have helped you. This document identifies basic inflows and outflows and identifies funds that are available to direct toward achieving your goals. Assumptions. Projecting into the future means making assumptions. This document outlines the assumptions we are making and takes your general goals and turns them into very specific, measurable objectives. Please review and get back to me with any questions, concerns, or potential changes. These will change every year based on market conditions, inflation, taxes, and what is happening in your life, so it s critical we evaluate and agree on these each year. Documents and information needed. The good news is that you were able to give me all the documents I needed, so at this point, there is no additional information I need. I may discover some as I continue your analysis, at which point I will contact you again. Thanks for doing such a great job in getting me what I needed. This will make our process much smoother! I look forward to hearing back from you on changes, additions, or questions about the information in these documents. I will phone you on Thursday, January 6 at 2:00 p.m. to walk through your comments and changes. Sincerely, Your adviser The first document for client review and approval meets the requirement to document goals and raise any issues of unrealistic goals. This letter will also provide you important information that you will need in developing your executive summary. These are the issues that you are committing to address for the client. Chapter 1: Financial Planning Process & Ethics 5

18 Summary of Goals and Issues to be Addressed in Plan Cash Flow We discussed that you both are comfortable with your current lifestyle and are currently saving $9,900 in after-tax investments, in addition to your 401(k) contributions with employer matches. You are also reinvesting all dividends and interest and paying capital gains taxes from your income so that all your money continues to work for you. Combined savings represents close to 16% of your income. Additionally, once your credit cards are paid off, the $6,000 going toward those are available to accomplish your goals. We agreed that, currently, our plan should not include any reduction in your lifestyle. You are willing to redirect any tax refunds or additional funds uncovered through such items as restructuring your mortgage toward achieving your goals. You also have a $5,500 distribution coming from Anne s grandmother s estate that is being disbursed in February, and are willing to put this toward achieving your goals and would like recommendations on the best way to use this money. My commitment is that the recommendations to improve your financial health and achieve goals will stay within these budget constraints. If it turns out you cannot achieve your goals, you will be presented with the information on your alternatives such as reducing lifestyle to free up money or postponing or changing a goal. Consumer Debt Balances on credit cards are not being added to, and you have been paying them off through a combination of monthly payments and tax refunds. You do not anticipate building credit cards up again after these have been paid off. Once they are paid off, you are willing to redirect these payments to achieve other goals. You do intend to continue buying cars and assume you will always have car payments. We will not be addressing car financing in this plan. You replace cars about every seven years. Mortgage You think you would benefit from refinancing your mortgage and have provided information about alternate rates. You plan on remaining in this house in Colorado through retirement. You would like a recommendation concerning 6 Financial Plan Development

19 which mortgage to choose and whether to pay the closing costs from cash reserves or roll it into the mortgage. You would prefer not to have a mortgage in retirement, but are open to options. Your current mortgage ends in 19.7 years, which is right before retirement. Any savings are to be used for accomplishing other goals. Your current interest rate is 6.87%. Current fixed rates (no ARM) are: 20-year: 5.68% 15-year: 4.25% Emergency Funds You would like to have four months of expenses in your reserves. You believe this is adequate given the stability of your jobs, good health, and other financial and family resources. You would like confirmation of how much you should accumulate and recommendations on where to have those funds invested. You currently have $25,000, as some of the cash in your liquid reserves is for paying current bills. Education Providing significant support for Matt s education is an important goal for both of you. You would like to finance $20,000 per year in today s dollars for four years for his education. You are willing to work longer and retire on less if that is what it takes to accomplish this goal. You are willing to accept 4.5% inflation on college expenses and would like to have this goal achieved by the time he starts college since you may need to contribute additional money from current income during his college years. One of your municipal bond accounts has $22,000 and you consider that to be allocated toward education. In addition, Jim s parents have just established a 529 plan for Matt and are contributing $100 per month into the account that will go toward the $20,000 target. Jim s parents have expressed they will continue contributing to the account until he goes to college. Property and Liability You would like a second opinion and some advice on your property and liability coverage. You would like to understand more about what the critical components of coverage are before you meet with an agent. You are especially interested in knowing if there are any gaps in your current plans. You accept that we are not Chapter 1: Financial Planning Process & Ethics 7

20 specialists nor licensed in this area, so we will be providing some understanding, guidelines, and estimated quotes received from an outside agency. You are under no obligation to utilize or even talk with the agent who is providing this information based on our understanding of your current coverage. We do not receive any compensation from this agent. It is simply a service in an area of expertise that we do not have and does not replace meeting with a qualified agent. Disability In case of a disability, you don t really know what would happen or how it would impact your lifestyle or retirement. Anne s cousin was permanently disabled and you are watching the family struggle with current expenses and worries about the children s education and their own retirement. You would like to know what steps you should take and what is realistic to expect in case of a disability so you aren t faced with the same issues as your cousin. Long-Term Care You want to know if you should be concerned about purchasing long-term care insurance now. You have also heard that long-term care insurance is not worth it and don t know what to think. We agreed that inflation for those expenses and premiums should be assumed at 5%. You would like the spouse to be able to remain in your own home and not experience a reduction in lifestyle. You would like advice on the optimal age to address this issue, if now is not the time. Survivor Needs You think that in case of the death of either one of you, $80,000 per year reducing to $70,000 in retirement would be adequate. You would like the mortgage paid off, college funded, and the same lifestyle provided for the survivor now and in retirement. You would like for us to determine how much life insurance and what type of coverage would provide for this goal. Additionally, you would like an initial lump sum available for final expenses and miscellaneous expenses in the first year, and think $60,000 should be adequate. You would rather err on the side of a little too much insurance rather than risk problems for the survivor. You both have clearly stated that you want the 8 Financial Plan Development

21 surviving spouse and Matt to maintain the same lifestyle that they have today and pre-fund retirement and education objectives. You both would like to see the family cabin purchased even if the other is no longer around. You also both want the surviving spouse to be able to retire at age 62 if you can financially afford this along with your other goals. You are willing to accept the Social Security projections provided and 2.5% inflation. You have agreed that 5.5% long-term return is an acceptable rate to use. Investments You are willing to reallocate contributions or funds if it will help achieve your goals, including the $200 per month going into the annuity. You would like our analysis of the annuity and whether you should keep and continue funding it or utilize the funds elsewhere. Jim is more aggressive than Anne, but neither of you really feel that you understand risk. The last downturn has made you nervous, but you are not sure what actions you should be taking. You are willing to take average risk before retirement, which was confirmed by multiple risk tolerance assessments. You would like us to make recommendations on both asset allocation and investment selection. We discussed that this will be a multi-step process. This initial step will be the selection of a model portfolio and calculation of the taxable gains. After agreement upon this stage, we will create an investment policy statement and finally evaluate the individual investments. You are willing to accept the proxies for returns and average risk return assumptions embedded in our software from our portfolio management team, and understand that these are only representative of an asset class, not the individual investments. Tax Planning Advice Your accountant has provided you with a projection showing you are on target to get another refund this year of around $5,600, and the projection for next year is showing another $5,542 refund. This has been consistent for the last several years. You have been using the refunds to pay down debt or invest. Going forward, you are willing to redirect all of those funds to help accomplish your goals. Your intention this year was to again put this refund toward debt, but you are open to other suggestions. Because we are not sure of tax law changes or how Chapter 1: Financial Planning Process & Ethics 9

22 other strategies may impact your goals, we are only going to utilize around 90% of the projected refund your accountant has calculated in our analysis, which we rounded down to $5,000 in order to make sure you do not end up owing taxes. You are also interested in hearing recommendations that would reduce your taxes now and in the future, but accomplishing your goals comes before tax benefits. If we can find strategies that create a tax advantage, we have permission to use any freed-up funds to help accomplish your goals as well. Retirement You would ideally be prepared to retire on $90,000 annual income at age 62 and assume life expectancy of 95. A survivor could live on $80,000 if alone in retirement. However, as we discussed, you may need to readjust your goals. You have identified a willingness to work until age 67 if that is what it takes to create a secure retirement with a minimum income of $80,000. When it comes to prioritizing retirement solutions, you would prefer to drop the income requirement to $85,000 first, and then drop age down to age 62 if your first goal cannot be achieved within your budget constraints. We will adjust your retirement goal so that you continue working until you have the security of reaching the minimum income goal of $80,000. You would also like to buy out Anne s cousin from his half of the family cabin in the mountains at age 62, if possible. It is estimated that the costs would be $100,000 in today s dollars. You can either purchase it outright or carry a 10- year note at 6.5%. We will not know whether these goals are realistic until I complete your analysis. In addition to the retirement parameters identified above, you would also be willing to defer or carry a longer note on the cabin if it can fit within your retirement budget. Estate Planning You want to leave an estate for the benefit of Matt. Anne s inheritance from her parents was what helped you to accumulate your current resources. Jim is an only child and will inherit everything from his parents. They are in their late sixties and in good health, so he does not anticipate receiving an inheritance soon. Jim is also the executor and has power of attorney for his parents. Help in having 10 Financial Plan Development

23 a general understanding of an executor or power of attorney would be appreciated. He is concerned about handling that role and not sure what it entails. Jim s parents currently have investments worth around $3.5 million and their estate is continuing to grow slightly, but they are concerned about inflation and potential long-term care and/or medical costs. You both think you would rather this money go to Matt but do not want to count on it and aren t sure if it is a good idea to do so. You want us to help you prepare for working with an estate planning attorney by understanding what documents you should acquire. The only documents you have are the do-it-yourself wills you put together shortly before leaving on a vacation just after Matt was born. In your current will, everything goes to each other and then to Matt in case of both deaths. We have scheduled a phone conversation to explore secondary estate goals and beneficiaries for next week. Chapter 1: Financial Planning Process & Ethics 11

24 Statement of Financial Position The third document for client review is the Statement of Financial Position. By having clients confirm this is correct, you can eliminate errors and lengthy conversations on resources at the plan presentation. ASSETS 1 LIABILITIES 1, 3 Cash/Cash Equivalents Checking Account $3,623 Credit Cards $6,158 Money Market $25,000 Mortgage $178,392 $28,623 Auto loans $17,447 Invested Assets 2 TOTAL LIABILITIES: $201,997 Jim's whole life cash value $7,466 Joint after-tax investments $134,898 Total: $142,364 Tax-Advantaged Assets Jim's IRA $32,888 Anne's IRAs $83,924 NET WORTH: $784,384 Anne's Deferred annuity $19,524 Jim's 401(k) $183,412 Anne s 401(k) $30,146 $349,894 Use Assets Residence $450,000 Personal property $85,000 Autos $30,500 Total: $465,500 TOTAL LIABILITIES TOTAL ASSETS: $1,086,381 AND NET WORTH: $1,086,381 1 All assets and liabilities are owned jointly, unless indicated otherwise. 2 Details about investment holdings may be found in the Investment section. 3 Details about liabilities may be found in Debt Analysis section. 12 Financial Plan Development

25 Annual Cash Flow Statement The fourth document for client review and sign off for acceptance is the annual cash flow statement. CASH INFLOWS Jim's gross wages $ 98,595 Anne's gross wages $ 53,601 Investment income $ 5,595 Total $157,791 CASH OUTFLOWS Savings and Investments After-tax savings contributions $9,900 Reinvested investment income $5,595 Qualified plan contributions 1 $10,283 $25,778 Fixed Expenses Mortgage (P&I) $16,556 Property taxes $2,352 Homeowners insurance $1,223 Insurance (other insurance) $3,308 Credit card payments $6,000 Car payment $5,412 Total Fixed Expenses $34,851 Variable Expenses Charitable contributions $4,396 Health care out-of-pocket expenses $1,300 Maintenance/ home services/misc. $7,450 Food and supplies $8,020 Utilities/Internet/cable/phone $9,040 Transportation (gas, oil, repairs) $4,750 Personal care and clothing $4,900 Chapter 1: Financial Planning Process & Ethics 13

26 Travel and entertainment $12,500 Total Variable Expenses $52,356 Total Living Expenses $87,207 Employee benefit deductions 2, 3 $4,171 State and local income tax (flat 4.3%) $5,227 Federal income tax 4 $24,032 FICA $11,329 Taxes and Pretax deductions $44,759 Total Expenditures $157,744 Available Cash Flow $47 Net Income (take home pay) $97,353 Gross Wages $152,196 You have given us permission to redirect after-tax investments, tax refunds, and any savings identified in the process toward your goals, including the money paying off credit cards once those are paid off. We are not looking at any changes to lifestyle expenses other than these. 1 Jim contributes 5% and Anne 10% into 401(k)s 2 Employee benefits include Sec. 79 benefit costs plus pre-tax medical and disability payments 3 To replace health insurance benefits in case of lost job would require approximately $10,000 per year. Emergency fund requirement based on total expenses plus cost of replacing health insurance benefit for total of $99,407 annual expenses. Four months reserves are rounded to $33,000 target goal. 4 Clients are in the 25% federal marginal tax bracket. State taxes are 4.63%. Assumptions The fifth and final document for client review and acceptance is a summary of all the assumptions, including goals. This allows us to reinforce goal ranges, expectations, and uncover any objections to assumptions prior to creating the plan. We are also meeting the CFP Board requirement to document assumptions. 14 Financial Plan Development

27 General Assumptions Used In Your Plan Base inflation 2.5% Jim s salary inflation 2.5% Anne s salary inflation 2.5% Emergency reserve goal 4 mo. $33,000 Assumed Rate of Return 5.5% Retirement Anne Jim Desired retirement age Latest acceptable retirement age If spouse retires, how much of other's earned income can be used to meet retirement income goal 90% 90% Desired retirement income goal $90,000 $90,000 Minimum acceptable retirement income (both retired) Amount to reduce income goal for a survivor in retirement $80,000 $80,000 $5,000 $5,000 Plan life expectancy Social Security inflation 2.5% 2.5% Education Matt Education inflation 4.5% Child starts college at age 18 Maximum number of years to fund college 4 Minimum amount of expense willing to pay per year for college (even if you have to extend your retirement age) Maximum amount of expense you are willing to pay per year for college (Your child knows they will have to pick up any balance no exceptions) Outside funding sources included (assets not owned by you or included in your net worth that will be available) (scholarships, student loans, student employment, annual gifts, own current income, etc.) $20,000 $20,000 $100 per month by grandparents just started and continuing until college Chapter 1: Financial Planning Process & Ethics 15

28 Survivor Planning what do you want to plan to fund? If Anne is survivor If Jim is survivor Debts to pay immediately other than residence $23,605 $23,605 Amount of residence debt being paid off $178,392 $178,392 Final expenses & other immediate needs $60,000 $60,000 Other goals funded? Cabin yes yes College funded? yes yes Maximum age to which survivor will work Changes to spouse's income assumptions prior to retirement None None Estimated Income need for survivor prior to retirement Estimated Income need for survivor during retirement $80,000 $80,000 $70,000 $70,000 Disability Planning If Anne is disabled If Jim is disabled Estimated Income need for family prior to retirement (pretax) $123,204 $129,719 Contingency plan for reducing expenses in case of permanent disability not in place not in place Changes in working partner income prior to retirement work until 67 work until 67 Long-Term Care Planning Annual cost in today's dollars of long-term care $82,000 $82,000 Inflation for long-term care expenses 5% 5% Number of years to assume long-term care facility or home support utilized Year at which we assume long-term care facility or home support needed How much will other expenses be able to be reduced for remaining partner $10,000 $10, Financial Plan Development

29 Property & Casualty Protection Liability protection minimum will equal or exceed this net worth Liability protection minimum will equal or exceed annual income times this number $1,000,000 $1,000, Legal Documents & Estate Planning Anne Jim Projected inheritance you may receive 0 $5,000,000 0 Specific bequests Administration fees fixed amount 1% 1% Administration fees % of probate 2% 2% Estimated funeral expenses $15,000 $15,000 Prior gifts you have made 0 0 Income Tax Assumptions Combined Federal & State Marginal Income Tax Rate (25% federal, 4.63% state) 29.63% Combined federal and state effective tax rate 16.58% When the client confirms this information with you, you have completed the first two steps in the planning process plus you have confirmed assumptions, which is also a requirement under the next phase. Completed Establish Relationship Explain services provided, the process, and required documents. Clarify client and planner s responsibilities (define the scope of engagement). Gather Data Obtain quantitative and qualitative information through use of interview/questionnaire. Determine client s goals, needs, and priorities. Assess client s values, attitudes, and expectations. Determine client s time horizons and risk tolerance level. Chapter 1: Financial Planning Process & Ethics 17

30 Collect all applicable records and documents. Analyze You are ready to start analyzing the Dowlers financial situation. It may seem that compiling the information above is analysis, but you have just been organizing and understanding the information. Practice Standard of the CFP Board compliance checklist requires that you now analyze this data. Now examine the information in detail and ask these questions: What are the strengths and weaknesses of their current situation? Which life challenges could they face successfully and which challenges would cause financial hardship and disaster? What questions were not raised that the clients should ask to be addressed? Are there any unrealistic goals or assumptions that need to be discussed with the clients? Are there techniques you can suggest that will improve the efficiency of their plan? Are there challenges they may face that cannot be addressed by purchasing products but must be addressed by planning or changing lifestyle? In this phase, you are to accomplish the following tasks: 1. Analyzing and evaluating the client s financial status a. Current financial status (e.g., assets, liabilities, cash flow, debt management, risk exposure, capital needs) b. Special needs (e.g., divorce/remarriage, charitable planning, dependent needs, education needs, terminal illness planning, small business planning) 18 Financial Plan Development

31 c. Risk management adequacy (e.g., life, disability, health care, long-term care, homeowners, auto, other liability insurance, commercial insurance issues, if any.) d. Investments current investments, strategies, and policies e. Taxation current returns, strategies, and tax compliance f. Retirement current plan, tax exposures, and Social Security strategies g. Employee benefits utilization h. Estate planning documents, strategies, and tax exposures Once you identify an issue or potential areas for improvement, you need to take the next step of developing and presenting recommendations. In your executive summary you will be following the format of describing the problem, making a recommendation, identifying advantages and disadvantages of your recommendation and providing an alternative. Additionally, you are tracking the costs of recommendations to make sure they fit within the client s financial ability. This will be the documentation that you have followed the planning process. Read the requirements below so you can see how this model meets your obligations. Develop and Present the Plan Chapter 1: Financial Planning Process & Ethics 19

32 The detailed steps under developing and presenting financial planning recommendations and/or alternatives include: Prepare and present a financial plan (with client input), tailored to the client that includes analysis of the client s: 1. Financial position (current and projected statements) 2. Cash flow (projections and recommendations) 3. Estate tax (projections and recommendations) 4. Capital needs at retirement (projections and recommendations) 5. Capital needs projection for death (projections and recommendations) 6. Capital needs disability (projections and recommendations) 7. Capital needs for special needs (projections and recommendations) a. Income tax (projections, recommendations, and strategies) b. Employee benefits c. Asset allocation (statement, recommendations, and strategy) 8. Investments (recommendations, policy statement, and policy recommendations) 9. Risks and potential liabilities (assessment and recommendations) 10. Priority list of action items a. List the priority of each area of planning interest. b. Work with the client to ensure that the plan meets the identified goals and objectives. c. Modify the plan as necessary. 20 Financial Plan Development

33 Implement and Monitor Plan The final steps are ones that you will not be addressing in this module, but it is a good idea to review them now as they will be tested on the CFP Certification Examination. It is also suggested that you examine the Code of Ethics and Practice Standards on the CFP Board s website at Responsibilities under implementing the financial planning recommendations include: a. Assist the client with implementation of the plan. b. Coordinate with other professionals as necessary. Responsibilities under monitoring the financial planning recommendations include: a. Regularly monitor and evaluate the progress of the plan. b. Review changes in laws that affect the plan. (1) Update client information regularly. (2) Recommend changes to the plan as required. This completes the review of the Financial Planning Process. You are now ready to analyze and evaluate the client data. Chapter 1: Financial Planning Process & Ethics 21

34 Chapter 2: Client Cash Flow, Debt & Risk Management One of the first steps in analyzing a client s situation is to become familiar with their cash flow and gain an understanding of savings, debt patterns, and available cash flow that will impact their ability to accomplish their goals. Take a few minutes to explore the Dowlers basic information presented in Chapter 1, and then look for opportunities that could create efficiencies that free up money to help them accomplish their goals. The Plan Development boxes below are designed to focus your analysis in areas where you may find opportunities or that should be addressed in your final financial plan. Cash Flow The Dowlers have given you permission to redirect the following cash flow resources to accomplish their goals. You may uncover additional options as you work through this case: Annual current available after-tax savings: $9,900 Annual tax refund/or changed withholding available to reallocate to meet goals: $5,600 refund for this this year and going forward, we are assuming $5,000. (By increasing withholding, this will result in $11,600 available in the first year and $5,000 going forward.) Inheritance lump sum first year only: $5,500 Funds going toward credit cards once those are paid off Emergency Funds Whether you look at emergency funds as cash flow or risk management, everyone agrees this is one of the first goals that needs to be established and one of the most difficult for clients and advisers to accomplish. Research regarding how people make decisions gives us some of the reasons for this difficulty. Optimism bias, immediacy bias, and a whole host of other biases make us 22 Financial Plan Development

35 believe that emergencies won t happen to us in the near future that is, unless we have experienced one recently. Advisers are also reluctant to have money just doing nothing! Planners may have the same biases as clients in believing that nothing bad will happen soon. Jim and Anne have already accumulated a significant portion of their emergency funds with their $25,000. The target for reserves was set and confirmed in the summary of goals and issues. The target included the cost of purchasing unsubsidized health insurance if Jim lost his job. The target is $33,000. You will have to balance meeting other goals from their cash flow with their need for emergency funds. At a minimum, they need to have $30,000 in reserves by the end of this year and the full $33,000 by end of year two. You may fully fund it in year one or shift $3,000 to the second year. Plan Development #1 is a sample recommendation to get you started and provide a model recommendation. Feel free to customize this recommendation for your executive plan. Plan Development #1 This is a sample recommendation to get you started. Please feel free to change it or leave as is. Issue. While you have a good start on accumulating sufficient emergency reserves, your current amount would last 3.4 months without covering any additional out-of-pocket expenses for medical insurance in case of a job loss or medical expenses in case of an illness. Recommendation. Increase emergency reserves this year to at least four months of reserves, including coverage for medical insurance, which requires an additional $8,000 deposited this year. Move the funds from the taxable money market to the Colorado municipal money market, which has a better after-tax return. Chapter 2: Client Cash Flow, Debt & Risk Management 23

36 Advantages Increases your ability to handle any emergencies that come along. Using the municipal money market is more efficient with a better aftertax return than your current money market. As long as one of you is working, this amount would cover six months of the unemployment. Disadvantage Funds invested in safe liquid assets earn less than those that have higher risk. Alternative. Use Roth IRA to begin accumulating more emergency reserves beyond the current $25,000 because you can withdraw your principal at any time without penalty and the funds are protected from creditors. If you use this strategy, you would not count earnings toward your emergency reserves but principal only. (Note: The cost of completing the emergency fund has also been put into the cash flow changes tracking sheet. Each time you write a recommendation, be sure to enter the change to the costs!) Debt Analysis Consumer Debt One of the areas to examine for potential efficiencies or improvement is debt. Table 1 provides details concerning the Dowlers current debt situation. 24 Financial Plan Development

37 Description Table 1: Debt Payment Information Balance Annual Payments Annual Minimum Payments Req d Rate Home first mortgage* $178,392 $ 16,556 $ 16, % Visa Card $ 3,816 $ 3,000 $ % MasterCard $ 2,342 $ 3,000 $ % Car Loan $ 17,447 $ 5,412 $ 5, % $201,997 $27,968 $ 22,940 *Original 30-year mortgage, remaining term 236 months 19.7 years remaining Analysis questions. It helps to complete an analysis of debt ratios so you can evaluate the appropriateness of use of debt for the client. It also lets you know what types of rates the client would qualify for when they refinance their mortgage. Table 2 shows popular ratios: Table 2: Debt Management Rules of Thumb Debt Management Rule of Thumb Nonmortgage debt-to-income ratio Front-end ratio Back-end ratio 20% or less of net income 28% or less of gross income 36% or less of gross income Chapter 2: Client Cash Flow, Debt & Risk Management 25

38 Plan Development #2 Use the following information to complete these calculations for the Dowlers: Net Income (take-home pay) $97,353 Gross Wages $152,196 Calculate the Nonmortgage Debt-to-Income Ratio. The nonmortgage debt-toincome ratio compares the annual MINIMUM REQUIRED payments in Table 1 to service debt. This is because the client could reduce their payments to this when taking on more debt. This measure excludes the mortgage and uses a person s annual take-home pay (or net income). A ratio of 15% or lower is healthy, and a ratio of 20% or higher is considered a warning sign that nonmortgage debt is excessive. The nonmortgage debt-to-income ratio is calculated as follows: Nonmortage debt-to-income ratio = Annual nonmortgage debt repayment Annual net income Gross Income versus Net Income For mortgage lending purposes, the debt-to-income calculation is always based on gross income. Gross income is a before-tax calculation. The reason for the use of gross income in both the front-end and back-end ratios is the tax-favored status afforded mortgage interest payments. Because consumer debt is afforded no such tax-favored status, this calculation is done on a net income (take-home pay), or after-tax basis. Again, because this is being used to calculate the borrower s ability to consistently make payments, only the minimum required payments are considered, NOT the payments currently being made. Calculate the front-end ratio (a.k.a. debt-to-income ratio ). PITI Front-end ratio= Gross income This ratio is similar to the nonmortgage debt-to-income ratio, but it indicates the percentage of income that goes toward housing costs. This includes PITI 26 Financial Plan Development

39 (principal, interest, taxes, and insurance premiums) and also homeowners association dues, when applicable. Use the following information to calculate the front-end ratio: Mortgage (P&I) $16,556 Property taxes $2,552 Homeowners insurance $1,223 Calculate the back-end ratio. This ratio identifies the percentage of income that goes toward paying all recurring debt payments, including those covered by the front-end ratio, and other debts such as credit card payments, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments. Use the income information provided in Table 1 plus Jim and Anne s PITI expenses from the prior question to calculate their back-end ratio: All debt + PITI Back-end ratio= Gross income Now that you have calculated these important ratios, compare them to the rules of thumb provided to determine whether they would fall within an acceptable range, which would indicate favorable refinancing opportunities. This may impact your recommendations to the clients. Use the information you have calculated about the client s debt ratios in your summary of debt uses and strategies so they understand how these ratios impact their ability to acquire favorable debt terms. Debt Strategies Efficient structuring of debt can free up money to accomplish other goals. Evaluate and make recommendations on the Dowlers debt restructuring. Plan Development #3 is designed to help you write your recommendation. This would also impact the debt ratios you just calculated. Sometimes restructuring debt to more efficient strategies can be beneficial in qualifying for even more beneficial strategies! Borrowing short term from a parent can sometimes allow an adult Chapter 2: Client Cash Flow, Debt & Risk Management 27

40 child to restructure their debt to qualify for lower rates in a home equity line and then the debt can be repaid with the lower-costing credit. Learn to look at debt restructuring as an opportunity. Remember that you can immediately redirect the prior debt payments to accomplish Jim and Anne s other financial goals once their debt is paid off. You know you have some money that can be redirected to goals now, and you may uncover more in future analysis. There is enough money that they could pay off their debts immediately. How much cash flow can you add to available cash flow resources if they pay their credit card debts off immediately? Plan Development #3 Write a recommendation concerning paying off their credit cards now. Be specific about the impact to cash flow. Be specific about the advantages and disadvantages. Use the same format that was used for emergency reserves: Issue: (Incorporate facts from your debt ratio analysis from Plan Development #2 and general knowledge to clearly define the issue specific to the client and potential consequences of NOT addressing the issue.) Recommendation: (Recommendations should be short, clear, and actionable statements telling the client what you want them to do.) Advantages: (Your advantages and disadvantages should be the critical components that clients should consider when making a decision about each specific recommendation. Use short bullet points for clarity.) Disadvantages: (No one trusts a person who only shares the advantages. Additionally, the client needs to be able to understand the disadvantages so they can make an informed decision about whether the disadvantages outweigh the advantages or another strategy needs to be considered.) Alternative: (This demonstrates that you have considered other alternatives and are providing them what you believe is the next best alternative. Behavioral research shows that people hesitate to make decisions if they don t know what an alternative is.) When you complete a recommendation, make sure you transfer it to your final executive summary and track the cash flow in the cash flow summary document. 28 Financial Plan Development

41 Both of these formats are in Appendix C of this module. As you work your way through this course, you will be building your executive summary. While you may end up tweaking some of the recommendations in the final stage, you will have all the important information in one place. Mortgage Options Mortgage debt provides many opportunities and pitfalls for clients. Learning to evaluate whether it is better to pay closing costs out of pocket versus cash, or to shift to a different mortgage is an important calculation. Deciding on a fixed or variable interest rate, the best term for the clients, whether to pay points, whether refinancing is worth the closing costs, and whether to pay closing costs from other resources or fold them into the mortgage are all important components. For your case, you are making a relatively simple decision. You have already determined that the loan term must be completed by retirement. The Dowlers are not planning on moving, even in retirement. They want to lock in a fixed rate. Their income is stable and they have other resources so you aren t too worried about needing to lower their payment to protect them from being unable to meet the mortgage. You have narrowed down the options to the ones in Plan Development #4. You need to complete the chart below by calculating the new payments, the difference between their current mortgage payment and the various options, and finally, the break-even period to recover from the closing costs. Plan Development #4 Complete the chart below showing potential mortgage options. Set your calculator to 12 compounding periods per year Make sure it is in end mode PV = the new loan amount after adding in closing costs FV = 0 N = number of years times compounding periods (use shift key) I = the mortgage rate Chapter 2: Client Cash Flow, Debt & Risk Management 29

42 Solve for each payment. Subtract the new monthly payment from the old payment to identify the difference. Recovery period is determined by dividing closing costs by the monthly savings. Obviously if the new monthly payment is greater than the old monthly payment, the answer will be N.A. for the recovery period. A more complex calculation can be done to determine when the amortization schedule will reflect the savings, but that is beyond the scope of this course. Current Mortgage 20 yr. fixed closing costs out of pocket 15 yr. fixed closing costs in mortgage 15 yr. fixed closing costs out of pocket Current balance $178,392 $178,392 $178,392 $178,392 Term (years) Rate 6.87% 5.68% 4.25% 4.25% Closing costs 2% $3,568 $3,568 $3,568 Amount of new loan $178,392 $181,960 $178,392 Payment $1,380??? Monthly savings 0??? Recovery period in months Interest paid over life of loan Mortgage Tax Deduction Impact estimate 0??? $147,549 $120,490 $65,064 $63,169 -$382 -$848 -$822 If you wish to add mortgage rider which pays off mortgage in case of death or total disability after six months for either Jim or Anne, the cost would be $400 per year. Write your recommendation for restructuring their mortgage in your executive summary. Be specific about why you chose the option for the clients and remember to incorporate the impact of your recommendation in the cash flow changes tracking page. 30 Financial Plan Development

43 At this point, you should have a few entries into your three-year cash flow chart showing the results of paying off their credit cards and refinancing their mortgage. By showing the utilization of available resources combined with your changes, you can see what funds you will have available to address their goals in the future. You are using three years because you may need to spend money in the first year or two to accomplish goals that will free up funds in later years. You can see some of these numbers entered already in the cash flow changes tracking form. Make sure you continue to transfer these numbers to the cash flow changes tracking form. Savings Habits Much more important than any improvement in rate of return is how much the client is saving. Rules of thumb (save between 15% 20% of income) are helpful because they provide a framework for clients to evaluate their own behavior. For some people it seems an impossible goal. Remind clients that their employer contributions to qualified plans count too! It is helpful to consistently track and tell a client what their savings ratio is. Clients who are exceeding the ratio can be complimented and shown how that habit relates to financial security. When you are preparing your executive summary, you may want to work in Jim and Anne s savings ratio and how it compares to the 15% 20% savings target. Plan Development #5 What is the Clients Savings Ratio? The Dowlers are saving $9,900 after tax each year and contributing $10,290 to their qualified plans. Jim is contributing 5% of his salary of $98,536. (Taxable income for both clients will be higher because of the inclusion of Section 79 income from the group life insurance, but this income is not matched for 401(k) contributions.) His company matches 100% of the first 3% of his salary. Anne is contributing 10% of her salary of $53,559, and her company match is also 3% of her salary. Chapter 2: Client Cash Flow, Debt & Risk Management 31

44 Retirement Plan Contributions Salary 401(k) Contribution Company Match Total Jim $98,536 $4,927 $2,956 $7,883 Anne $53,559 $5,356 $1,607 $6,963 Total $10,283 $4,563 $14,846 Consider using this information about their saving rates in your executive summary to help the client understand how their habits compare to the standards and how this relates to accomplishing their goals. Risk Management The next category of analysis is examining the risks that could destroy a client s financial security. One in 10 family units will experience a financial crisis in a 10-year period you don t know whether it will be loss of job, serious medical problems, disability, auto accident, lawsuit, home fire, death, etc. Optimism bias makes people believe that they won t be the one and it won t be this year. Part of your job is helping clients see the potential risks and potential consequences. If you hold yourself out as a comprehensive financial planner, you must disclose if you are not going to address certain types of risks such as property and liability. It is perfectly fine to disclose that you are not an expert in these areas and that you are recommending the client work with a qualified specialist. But just like with estate planning, you are frequently the only one who knows the big picture and the small details that are only exposed when a thorough fact find is done. For example, knowing that a client is a snowbird impacts both their estate planning and their property and liability insurance issues. Knowing that a client has a business impacts life insurance, disability, estate planning, and property and liability coverage needs. You don t need to become an expert in solving issues in all these areas, but becoming good at identifying risks and helping motivate the client to address the risks will help make you a great planner. Creating a strong relationship with a P&C specialist will benefit you and your clients. 32 Financial Plan Development

45 Property and Liability Issues Every year homes and businesses are destroyed by fire, floods, and other natural disasters. Lawsuits, car accidents, boating deaths, and bicycle injuries keep happening. Ignoring property and liability issues is like pretending a $100,000 loan outstanding doesn t exist on a balance sheet. Use this section to identify potential risks and solutions. Jim and Anne have purchased insurance policies from various providers and do not typically review their coverage with agents routinely. Homeowners Insurance The Dowlers live in a nice middle-class neighborhood with good schools. The estimated replacement costs for a residence similar to theirs from a reputable online valuation site is $320,000, and the land is valued at $130,000 for a total value of $450,000. Building costs in the area are high and increasing at around 4.5% this year. Land is never considered when determining the amount of property protection because land doesn t go away. (The exception to this is coast or lake property, which requires special coverage.) This is one of the reasons that market value is ignored when it comes to insurance. The replacement costs can be higher or lower than market price, with the value of the land being a piece of the equation. For protection purposes, look at the replacement costs. Getting the replacement costs means working with more than one insurance company and asking them to estimate the costs. To replace their personal property would cost approximately $125,000, but they don t have an inventory. (Hint: Maybe you should suggest one?) In addition to their usual property, Jim and Anne own two snowmobiles and a fishing boat. Since their boat or the snowmobiles are not worth much, they did not mention them to the insurance company or cover them in their policies. Their umbrella policy does not provide ANY coverage unless there is an underlying policy covering the motorized conveyance. Chapter 2: Client Cash Flow, Debt & Risk Management 33

46 Table 3: Homeowners Policy Type H03 Amount on dwelling $310,000 Personal property coverage $155,000 Personal liability $100,000 Replacement cost requirements if partial loss 80% Deductible $500 Endorsements none This section will help you understand some of the critical components of homeowners insurance. There are two parts to coverage: protecting property (structures and possessions) and protecting liability. If an item is not mentioned as endorsed or covered, assume it is not covered for either liability or property damage. The only exception is furnishings, which are covered under the general contents section. The homeowners and auto policies meet the umbrella minimum requirements, and their umbrella policy begins coverage where either home, auto, or both end for liability. If you do not remember the basics behind homeowner s coverage, you may want to go back to the Financial Planning Process & Insurance course materials and review the components. Plan Development #6 Analysis Questions Using Table 3, how much do the Dowlers need to increase their base coverage in order to cover full replacement costs in case of a total loss? At a cost of $3.50 per $1,000, how much will this additional coverage cost? They can increase their deductible with a savings of $25 for every $100 increase. They could add an inflation protection rider that will keep their policy up with building inflation for a cost of $20 per year as long as the base policy is 34 Financial Plan Development

47 insured at 80% or above. It will automatically increase their policy coverage (and premium) by that amount every year. Will you recommend this coverage? Why or why not? (You do NOT need to reflect the annual increases to the policy in cash flow because we are NOT reflecting inflation in income or other expenses to keep it simple for the client.) What are the potential consequences of the boat and snowmobiles not being covered? They can add their snowmobiles and fishing boat for $300 annually. This will provide coverage for potential liability matching their homeowner s liability level and the depreciated property value, and make these liabilities covered under their umbrella policy. Write a recommendation for each change you recommend. Remember, sometimes it is important to explain why you are not recommending certain changes in your overall explanation of the category using the headings Issue, Recommendation, Advantages, Disadvantages, and Alternative. After answering these questions, transfer your recommendations to your executive summary document and the costs to the cash flow changes tracking document. Property and Liability Auto Jim and Anne have not had a review of their policy for four years. They are open to your recommendations. They will be visiting with their agent but want your help in understanding the issues they should discuss and potential problems that should be addressed. Based on your state laws, you will need to make sure you walk the fine line between providing recommendations as a practitioner and avoiding practicing insurance without a license. The best way to address this is to advise the client to check with their agent concerning the issues and potential costs, and that this is simply a way of helping them understand what they should be discussing with their agent. It is much the same line to walk as with an estate attorney. Don t practice law or work in areas you are not licensed for, but make sure the clients know what to discuss! Chapter 2: Client Cash Flow, Debt & Risk Management 35

48 Type Bodily injury Table 4: Automobile Policy Property damage $50,000 Collision Comprehensive Uninsured motorists Personal auto policy $100,000 per person $300,000 per incident $500 deductible $500 deductible $50,000 per person $100,000 per incident Understanding the basics of auto insurance will let you help Jim and Anne raise issues with their insurance agent. Property coverage, while important, is the least of the issues when it comes to auto coverage. Smashing a $200,000 car is trouble; disabling or killing a bread winner is catastrophic. You need to know what is covered when the client is liable and not liable, and potential consequences of being injured by an uninsured or underinsured driver. This coverage is not a stacked policy, which means that only one maximum limit applies to accidents even if both covered drivers are in the car. Their umbrella policy is integrated and starts where this policy ends for liability coverage. In the state they are in, the umbrella policy does NOT impact the coverage for uninsured motorists. Some states and companies have umbrella policies that cover uninsured or underinsured motorists. Plan Development #7 Answer these questions related to automobile insurance using Table 4. If the client is at fault and injured three non-related people between the two cars, what is the maximum benefit that will be paid out through their automobile insurance? Because their umbrella policy will start after the automobile coverage pays out, they do not need to raise this policy to cover liability. There may be other reasons that you would want to increase their basic coverage, such as increasing uninsured motorist s coverage beyond their current split limit coverage. To double the base liability coverage would cost $30 per year. 36 Financial Plan Development

49 If one of your clients is permanently disabled as a result of an injury caused by a noninsured at-fault motorist, what is the maximum benefit that the policy would provide to take care of them and their future? Include an explanation of uninsured motorists coverage and a potential scenario such as their child being permanently disabled. Describe the potential consequences of NOT addressing the issue. What changes would you make to their uninsured/underinsured motorists coverage? Your options are: 1. Increase to $100,000/$300,000 (the same as their current liability coverage) for $ Increase to $200,000/$600,000 for both the base liability coverage and the uninsured motorists coverage for a cost of $110. (The company does not allow the uninsured motorists coverage to be raised above the base policy coverage so you would need to raise the base coverage, which is incorporated into this calculation.) For every $100 of deductible, they can save $25 annually. What changes would you suggest to their deductible? Write a recommendation for each change you are suggesting and show the cash flow changes. Be specific about advantages and disadvantages. Remember that there are more disadvantages than just cost. Time and paperwork can be big roadblocks. Don t forget to put this in the cash flow changes tracking sheet. Property and Liability Umbrella Umbrella policies are a relatively inexpensive and easy way to protect your clients wealth the higher their income or wealth, the more likely they are to be sued. Large judgments can seriously impact the financial security of even the wealthiest clients. In the most penalizing judgments, clients can be sued for 15 times their income plus all of their net worth. Those types of judgments are rare, but in situations where an individual is totally disabled or killed due to negligence, even modest clients can find their wages garnished along with assets, and bankruptcy does not void these judgments. Chapter 2: Client Cash Flow, Debt & Risk Management 37

50 Typically, planners will calculate net worth and a multiple of the client s income and recommend that the client insure the higher of the two. The wealthier the client, the higher the multiples of coverage should be. For example, a young doctor who currently has $150,000 of income and a net worth of $50,000 would most likely want $1.5 million of liability coverage in addition to his professional liability coverage. A 65-year-old working part time making $30,000 but with an accumulated net worth of $950,000 would most likely look at $1 million because of price breaks for the million-dollar coverage. A young family starting out with high debt but some assets may want to have just five times their annual income. Clients who participate in high-risk activities with others (piloting small planes, boating, hosting helicopter skiing trips, etc.) may want to insure both net worth and a multiple of their income. The Dowlers have some assets and a reasonable income, so the lower limits of five times income are too low. For Plan Development #8, you will choose an umbrella policy amount and give your rationale. Plan Development #8 Use the following information to answer these questions: Umbrella Policy Policy limit $500,000 Deductible *integrates with existing policy limits The Dowlers current premium is above the current average premium for similar policies, according to your P&C connection. They purchased this policy separately and have not explored discounts they may receive by combining policies. They are currently paying $125 for $500,000 of coverage. By changing to the same insurance carrier as their homeowners, they can purchase the same umbrella policy for $100. Rates for various options are below. Potential Policy Costs Annual Costs Quote for $500,000 $100 Quote for $1,000,000 $150 Quote for $1,500,000 $200 Quote for $2,000,000 $248 What amount of coverage for their umbrella policy are you recommending? 38 Financial Plan Development

51 This can impact changes you may make to other policies, such as increasing or decreasing limits on liability. What potential changes to other policies will you complete or not complete due to the integration of their umbrella? In real life, you must check the policy to see how it integrates and whether the deductible requirements are being met. Write a recommendation for their umbrella policy. Include a description of the issue, recommendation, cost, advantages, disadvantages, and an alternative just as you have in prior recommendations and remember to track the change in costs in your cash flow document. Disability Insurance The general rule in risk management is to cover the risks that would have catastrophic results independent of frequency and retain the risks through deductibles and elimination periods or self-insurance that are inconsequential. One of the risks that can have catastrophic results is a permanent disability. In case of a disability, Jim and Anne don t really know what would happen and how it would impact their lifestyle or retirement. Anne s cousin was permanently disabled, and they are watching the family struggle with current expenses and worries about the children s education and their own retirement. Anne and Jim would like to know what steps they should take and what is realistic to expect in case of a disability so they aren t faced with the same issues as Anne s cousin. They would like to feel secure in being able to meet their bills, educate their son, and have a secure retirement income, if it is possible. Statistics available from the Social Security Administration indicate that both Jim and Anne would have about a 16% chance of becoming disabled, with the average long-term disability lasting seven years. Other statistical sources from the Council for Disability awareness ( come in around 23% because not everyone who is disabled meets the Social Security definition. The chances of their house burning down are less than 1% (about 1 in 1,200, according to the U.S. Fire Administration) and the chances of premature death at this age are 12%, according to the Centers for Disease Control and Prevention. Obviously, both the probability and severity of loss mean that this area should be given careful consideration. Chapter 2: Client Cash Flow, Debt & Risk Management 39

52 The Dowlers current disability coverage is as follows: Table 5: Company Disability Coverage Insured Jim Anne Description Group Short Term Group Short Term Elimination Period No waiting No waiting Benefit Period 90 days 30 days Disability Benefit 100% of salary 100% of salary Definition Own Occ. Own Occ. Premium payment Employer paid Employer paid Premium Amount NA NA Rating AM Best A AM Best A Insured Jim Anne Description Group Long Term Group Long Term Elimination Period 90 days 90 days Benefit Period to age 65 to age 65 Disability Benefit 60% of salary (no other options) 60% of salary Inflation Rider None None Definition Modified Own Occ. 2 yrs. Any occupation Premium payment Employer paid Paid with pretax dollars by Anne Rating AM Best A AM Best A There is little you can do to change their company disability insurance, but you have acquired quotes for personal coverage for Jim and Anne. Sometimes disability issues cannot be solved by just purchasing a product. The Dowlers need to understand how they would have to adjust their lifestyle if a permanent disability occurs. Follow these steps in analyzing their disability issues, consequences, and options. 40 Financial Plan Development

53 Analysis When setting the goals for disability income, the following assumptions were agreed upon to plan for a permanent disability. While you may not agree with their decisions such as still wanting to plan for some charitable contributions, you must respect the client s right to their own values. 1. They would reduce charitable contributions from $4,396 to $1,000 per year. 2. They agreed that medical expenses and costs resulting from a disability would most likely be $10,000 higher than their current medical expenses after seeing what was happening with Anne s cousin. 3. They would increase the costs of home services and miscellaneous by $2,000 in recognition that each spouse contributes work to the household that may have to be hired. 4. They would reduce travel and entertainment from $12,500 to $3,000 but recognize that they will want some things such as cable TV or children s activities. 5. They recognize that this budget leaves little room for changes such as their child s activities or a car, so they are leaving the $6,000 that they hoped would be free from paying off the credit cards eventually to address the unknown. 6. They would still like to meet college and slightly reduced retirement goals. From these assumptions, you developed the cash flow projections including estimating taxes so that you and they could see the needed income and initial potential surplus or gap. The chart below shows the projected initial budgets. Chapter 2: Client Cash Flow, Debt & Risk Management 41

54 Table 6: Disability Cash Flow Projection CASH INFLOWS ORIGINAL BUDGET Jim's DISABILITY Anne's Disability Jim's gross wages vs. group disability $98,595 $59,160 $98,595 Anne's gross wages $53,601 $53,601 $32,161 Investment income $5,595 $5,595 $5,595 Total $157,791 $118,356 $136,351 CASH OUTFLOWS Savings and Investments After-tax savings contributions $9,900 $0 $0 Reinvested investment income $5,595 $5,595 $5,595 Qualified plan contributions 1 $10,283 $5,360 $2,958 Total $25,778 $10,955 $8,553 Fixed Expenses Mortgage (P&I) $16,556 $16,556 $16,556 Property taxes $2,552 $2,552 $2,552 Homeowners insurance $1,223 $1,223 $1,223 Insurance (other insurance) $3,308 $3,308 $3,308 Credit card payments $6,000 $6,000 $6,000 Car payment $5,412 $5,412 $5,412 Total Fixed Expenses $35,051 $35,051 $35,051 Variable Expenses Charitable contributions $4,396 $1,000 $1,000 Health care out-of-pocket expenses 2 $1,300 $11,300 $11,300 Maintenance/ home services/misc. 3 $7,450 $9,450 $9,450 Food and supplies $8,020 $8,020 $8,020 Utilities/Internet/cable/phone $9,040 $9,040 $9,040 Transportation (gas, oil, repairs) $4,750 $4,750 $4,750 Personal care and clothing $4,900 $4,900 $4,900 Travel and entertainment 4 $12,500 $3,000 $3,000 Total Variable Expenses $52,356 $51,460 $51,460 Total Living Expenses $87,407 $86,511 $86, Financial Plan Development

55 Employee benefit deductions $4,171 $4,400 $4,171 FICA $11,329 $4,100 $7,543 Employer deductions (less fed & state tax) $15,500 $8,500 $11,714 Total Expenditures $128,685 $105,967 $106,777 Projected federal income tax $24,032 $12,484 $17,355 Projected state tax (flat 4.63%) $5,027 $4,753 $5,587 INCOME NEEDED $157,744 $123,204 $129,719 Available Cash Flow $29,106 ($4,848) $6,631 1 Qualified plan contributions show the impact of losing the contributions the employee was making. It does not reflect the loss of employer contributions 2 Health care costs are assumed to increase $10, Loss of spouse's ability to contribute such as lawn maintenance, household chores, sewing, home packed lunches would result in increased costs of $2, Travel and entertainment budget cut but some money left for child activities. Your next step was to utilize this to populate the financial planning software. The assumption is that the Dowlers would need full income for the first three months but then would reduce their required income as projected above. This does not include any saving for college, retirement, or such things as purchasing life insurance or long-term care policies. This is a starting point. The advantage is the clients know that they would need to cut certain expenses immediately in case of a disability. More cuts will be required, as the group benefit stays level and inflation increases lifestyle costs if the disability lasts longer than two years. Since risk management principles say cover the risk if it would be catastrophic, you need to help them understand and make a plan if the disability were permanent. The chart below may not exactly match the details we have laid out above for several reasons. The month of the year that the analysis is done could reflect earning income for the first three months and then going on short-term disability, etc. Do not get caught in the trap of trying to match numbers exactly and help the client avoid that trap also. The second year of the projection is showing the Chapter 2: Client Cash Flow, Debt & Risk Management 43

56 reduced income gap adjusted for inflation and comes close to the number you would get if you projected their expenditures increasing by 2.5% inflation. Remember, however, that while projections look accurate and detailed, they are still just projections. We don t really know what their budget needs would look like in 15 or 40 years. Focus on the long-term trends. The emergency reserves will take care of part of a first year, so focus your attention on the resulting consequences.in the following years. First, examine the chart illustrating their expenses and resources in case of Jim s disability. Figure 1: Jim s Disability Projection 44 Financial Plan Development

57 While the Dowlers may be able to adjust their living expenses in the first few years, you can see that by year 10, their gap is larger than can easily be addressed by reducing expenses. Asking clients what they would cut from their current expenses beyond those already discussed (travel and entertainment) brings home the issue. You can easily bring these numbers back to present value and ask them where they would cut current expenses. For example, in 10 years at age 53 the gap is $32,165. That is like $25,127 in today s dollars. Looking at your current budget, what would you have to change in addition to the changes you ve already identified? Chapter 2: Client Cash Flow, Debt & Risk Management 45

58 The real challenge will come at retirement. Notice that the chart stops at retirement age (65). It is not showing the consequences of a reduced Social Security benefit nor the spousal employment wages dropping off. The gap at age 65 is just the result of the group coverage ending. You can estimate the income they would have in the first year of retirement by simply subtracting the employment income and adding projected combined Social Security benefits of $38,513. To estimate Social Security at retirement, we simply changed the plan of the disabled spouse to unemployed to see the projected benefits. This typically means that the disabled individual receives half of the working spouse s benefit. This method does not work for individuals close to retirement. The reason is that Social Security is based on a 40 year earning history. If the last 20 years are zero income, the projected social security benefit will be dramatically reduced. Most likely, the highest benefit will be that of half of the working spouses benefit unless they are close to retirement. You can create more accurate projections by using the Social Security website. In Plan Development #9, you will complete the analysis of what their lifestyle, including retirement, would look like in case of a disability. Plan Development #9 Write a description of what would happen now, in 15 years, and at retirement under the current scenario in case of Jim s disability. You will need to calculate the gap at retirement. Start by identifying the impact on both lifestyle and savings now. Then look at the gap in 15 years and calculate the percentage that the gap represents. Now put this gap in perspective. Calculate the percentage that the gap represents. This is how much of their current lifestyle they would need to reduce. So, for example, if the percentage gap is 28%, how easy would it be to cut that amount from their current $157,744 of needed income? That would be cutting $44,000! By calculating the percentage the client needs to cut from current lifestyle, you can easily bring the consequences back into something the client can understand. 46 Financial Plan Development

59 To project the gap at retirement follow these steps: 1. Increase the target income of $207,419 by 2.5%. 2. Subtract Social Security benefits of $38, This is the gap that would need to be covered by their retirement savings. 4. Just as you did above, calculate the percentage gap and help them see what the reduction would look like in their lifestyle today. Their investments, if they continue to grow and have not been liquidated to meet any ongoing lifestyle needs, would generate an income of about $50,852 using the 4% rule of thumb. (The 4% rule of thumb says that you can withdraw 4% of a portfolio and it is probable that the portfolio will continue to grow and sustain withdrawals for at least 30 years.) This lifestyle does NOT include addressing funding their child s education or the current gap in retirement savings. You will use this description to describe the issue and the consequences of not addressing a potential permanent disability like their cousin has. In calculating Anne s income need, the numbers would be slightly different because of taxes. Here is what the situation looks like if she were permanently disabled. Figure 2: Anne s Disability Projection Chapter 2: Client Cash Flow, Debt & Risk Management 47

60 The surplus in case of Anne s disability will allow them to save some funds. (Remember that now they are saving $9,900 plus Anne s $5, (k) contribution and employer match of $1,608 for a total of $16,868, so this will be a reduction in savings of $6,255, and will continue to erode with inflation. It is assumed that Jim s 401(k) and employer match continue as is.) In case of Anne s disability, they would most likely be able to sustain a similar lifestyle until close to retirement. At that point, however, they would experience a substantial drop in income. In retirement, they would receive approximately $53,457 in Social Security benefits and $54,676 from their investments, generating income of $108,133, 48 Financial Plan Development

61 which is 46% of their projected goal. They would be unable to fund college for Matt or purchase the cabin. The drop that they experience would not be as severe as the one they would experience if Jim were disabled, but it would still impact their ability to accomplish their goals and they would need to reduce their lifestyle significantly. You can estimate how much additional they would need to accumulate by using the 4% rule of thumb and dividing the amount of income needed by 4%. The question is whether they could achieve that capital with the existing surplus and fund college, or does Anne need additional coverage? Looking ahead, you need to know that they aren t saving enough now to fund college and retirement. This may impact your recommendation. Table 8 shows available coverage that Jim and Anne could purchase along with a description of the policy and various riders. Because the consequences were not as severe and you were concerned about premiums, you asked for Anne s offer to be run with 5- and 10-year options in addition to age 65 and 67. This doesn t mean that your choice should be restricted to these. You will need to complete the analysis of what will happen in case of a disability and make a decision based on group coverage characteristics, financial needs, and cash flow. Table 8: Disability Offers Disability Jim's offer Anne's offer Company rating: A+ A+ Base monthly benefit $1,743 $842 Definition Own Occupation: job which you regularly engaged in at time of disability Elimination period 90 days Rehabilitation benefit pay for reasonable costs subject to agreement Waiver of premium included Compassionate disability benefit Increase of benefit if you are working 20% fewer hours to care for loved one (parent, child, spouse, domestic partner) after serious health condition, benefit up to six times basic monthly benefit 2 times during policy automatic increase of 4% without evidence of insurability for 5 years prior to disability; premiums increase Chapter 2: Client Cash Flow, Debt & Risk Management 49

62 Disability Jim's offer Anne's offer Survivor Mental disorder/substance abuse Partial, residual, recovery benefits Premium guarantee Maximum benefit period Exclusions 50 Financial Plan Development 3 months of disability payments at death covered initial period 6 months full benefits paid then requires either loss of 20% duties or 20% of time then if between 20% 80%, prorated; over 80% no benefit; under 20% full benefit guaranteed renewable age 67 No benefits if caused by war or contributed to by assault, felony, riot, or intentionally self-inflicted injury. Additional 90-day elimination if due to pregnancy or childbirth. Base Premium $ $ OPTIONAL RIDERS Cost of living optional 2.5% increase Rider premium: $147 $114 Non-cancellable rider premium Total premium if all riders taken $147 $146 $976 $753 OTHER PREMIUM OPTIONS (including both riders) 5-year benefit, 365- day elimination not quoted $304 period 5-year benefit,180- day elimination not quoted $346 period 5-year benefit, 90- day elimination not quoted $379 period 10-year benefit, 365- day elimination period not quoted $433

63 Disability Jim's offer Anne's offer 10-year benefit, 180- day elimination period 10-year benefit period, 90-day elimination period To age 65, 365-day elimination period To age 65, 180-day elimination period To age 65, 90-day elimination period To age 67, 365-day elimination period To age 67, 180-day elimination period To age 67, 90-day elimination period not quoted $494 not quoted $542 $721 $559 $816 $637 $890 $699 $790 $602 $895 $686 Current quote Current quote You will need to select the elimination period and benefit period with the corresponding premiums for both Jim and Anne. Illustrate these in the cash flow. If you wish to cover a smaller monthly benefit, drop riders, etc., simply prorate the premium. Be sure to explain the changes in your executive summary. Before you make your decision, examine the consequences of various options after reviewing the impact of purchasing a policy. Jim can purchase annual benefit $20,916 ($1,743 per month) through personal coverage. This will grow at 3% inflation. The chart below is showing this as other income. If they purchase the maximum amount available for Jim, how would that change what they could save for retirement in case of his long-term disability? Figure 3 shows the impact of the $20,916 personal policy increasing at 3% inflation. Chapter 2: Client Cash Flow, Debt & Risk Management 51

64 Figure 3: Impact of Purchasing Personal Policy for Jim What you recommend purchasing for Jim will be different than what you recommend for Anne because of the disparity in salaries and gap. You do not have graphs showing Anne s purchase of disability coverage, as you may choose to purchase an amount lower or for fewer years. You could also choose a longer elimination period for Jim, which would have minimal long-term impact. However, you can easily calculate what it would look like by projecting the income growing with inflation in 10, 20, and 24 years and subtracting that from the gap in the prior chart so you can see the impact it will have. 52 Financial Plan Development

65 Remember that the chart is only illustrating meeting current lifestyle goals and does not include saving for any goals or retirement. Since Anne did not have the same type of gap, does that change your analysis of whether she should acquire disability coverage, or the elimination benefit period or riders you are recommending? Evaluate how much coverage you purchase on Anne with these facts in mind. For example, since she can purchase $10,104 per year benefit, if she purchased a 10-year benefit with 365-day elimination and no inflation rider, and invested the money for college, they would accumulate $130,093, which would cover college. To address the retirement gap may take something different. The point is that it does not have to be an all-or-nothing purchase. In your executive summary, give your reasoning and a clear picture of the implications of your strategy in case of Anne s long-term disability. Plan Development #10 Craft a plan including specific product recommendations with elimination periods and benefit periods that makes sense for Jim and Anne and provide your reasoning. Remember that they also could add a mortgage protection rider for a cost of $400 covering death of either and total disability that uses an any occupation definition. Because not all problems can be solved with product only, your plan may be a combination of products and strategies (such as shifting college goal to living at home or reducing specific expenditures immediately upon a disability). Write a recommendation about purchasing additional disability coverage, including which riders should be included for each person. Be sure to include a summary that helps the clients understand the problem. You may copy any charts you find helpful and incorporate them in your executive summary. Remember to incorporate the costs into the cash flow changes tracking page. You should use some of the calculations you have done to clearly lay out the problem for the clients that you are working to solve with your recommendation. If clients don t clearly understand a problem, they are unlikely to take steps to solve it. You don t need to incorporate complex calculations or long paragraphs. Focus on presenting a clear picture and just use one or two examples to help them understand the problem. Chapter 2: Client Cash Flow, Debt & Risk Management 53

66 Life Insurance Survivor needs. Jim and Anne believe that in case of the death of either one of them, they want to plan for final illness costs of $1,500, $10,000 for funerals, $13,500 to pay estate administration costs, $10,000 for miscellaneous short-term needs, and $25,000 for a spousal adjustment period. This brings short-term needs to $60,000. To pay off the debts and mortgage will take another $201,997. They would like education and the cabin funded also. Finally, they want $80,000 annual before-tax income for the survivor, reducing to $70,000 in retirement. They would rather err on the side of a little too much insurance rather than risk problems for the survivor. They both want the other to be able to retire at age 62. They are willing to accept the Social Security projections you provided them. Below is the information on both their group coverage and personal coverage. Table 9: Group Term Benefits Owner Jim Anne Group Benefit 1 x salary rounded up to next thousand 2 x salary Benefit Calculation $99,000 $107,000 Insured Jim Anne Beneficiary Anne, then Matt Jim, then Matt Premium Amount Company paid Company paid Owner Insured Beneficiary Personal Life Insurance Policy Jim Jim Anne Contingent Beneficiary Matt Face Amount $100,000 Type of Policy Whole Life Cash Value $7,466 Premium $1,104 Basis $6,645 Rating AM Best A Belth Formula Analysis Within acceptable range 54 Financial Plan Development

67 Your options concerning the whole life on Jim include the following: 1. Keep the whole life policy either permanently or until some point in the future. The Belth formula analysis shows that the policy is within acceptable costs and returns for a whole life policy, so it should not be used to replace another whole life policy. 2. Utilize one of the nonforfeiture options. The cash value of the policy will sustain the face amount as extended term for 32 years. Your other option would be to purchase paid-up permanent insurance of $12,500. If you choose the permanent coverage, be sure that you adjust the amount of insurance required to reflect the loss of coverage. 3. Cash in the policy and pay ordinary income tax on the gain. Be sure you adjust the death benefit needed to reflect the loss of the $100,000. If you choose this option, include the taxes in addition to the cash value in your cash flow tracking form exchange the policy into another type of cash value coverage, an annuity, or long-term care policy. The following graph depicts the results of the analysis utilizing this information and assumes the assumed portfolio return and 2.5% inflation. Use this analysis of the Dowlers life insurance needs to determine your recommendation. While the analysis shows amounts to the dollar, we really cannot be that precise in projecting 50 years. Because of breakeven points on life insurance premiums and their desire to over-insure slightly versus underinsure, round Jim s need to $1 million. You may round Anne s coverage to $400,000 or select a different amount with an explanation. Chapter 2: Client Cash Flow, Debt & Risk Management 55

68 Figure 4: Life Insurance Needs Analysis Numbers in a graph don t always mean much to clients. Yes, they see a shortage, but what does it mean? What would happen to Anne and Matt if additional coverage was not purchased? Using the 4% rule of thumb concept, you can estimate what their lifestyle would be like. If you add their existing assets (less cash value of life insurance) of $494,792 plus the insurance of $199,000 you have total assets of $683,792. When you subtract the short-term needs and debt repayment from this amount, you are left with $422,795. At 4%, this would generate $16,912. Their current lifestyle is based on $157,791. If you subtract the debt and some tax reduction, it comes down to about $122,235. Anne s salary plus earnings from investments will generate $70,513. This means cutting the equivalent of around $51,700 from today s lifestyle if the gap is not covered with insurance. Of course that gap would be larger in retirement. The 4% rule incorporates the impact of inflation. What would the lifestyle look like for Jim and Matt? Notice that in both cases, child care was not addressed because it is assumed Jim s parents will continue providing day care. What would happen if their health prevented them from doing so? Will their budget change as Matt gets older? Remember that you are 56 Financial Plan Development

69 projecting over 50 years into the future. How confident are you that you are adequately protecting the family with your recommendations? Are you painting the picture that helps them see the uncertainties in addition to known current lifestyle? Plan Development #11 Write your description of the issues and the consequences for not addressing the issue of life insurance for Jim and Anne. Then explore your options and determine your recommendation. Below are potential costs for purchasing different types of life insurance. Cost of Options for Age 42 Male Female Average premiums per $1,000 of 10-year term $0.68 $0.60 Average premiums per $1,000 of 20-year term $1.09 $0.90 Average premiums per $1,000 of 30-year term $1.86 $1.45 For universal life, average premium per $1,000 $11.21 $9.57 For whole life, average premium per $1,000 $13.20 $10.05 Write your recommendation concerning life insurance for Jim and Anne. Include your recommendations of what to do with Jim s existing policy. Remember to track the costs of your recommendations. Be specific in terms of what lifestyle and goals you are trying to protect, what type of insurance, why, costs, and alternative choices. Use language that clients understand and remember to write it for the clients, not as a paper to a professor! Long-Term Care and Health Insurance Because of their relatively young age, the Dowlers are concerned about purchasing coverage now versus waiting a few years until they have accomplished their other goals. You have both agreed that you will defer this issue until age 50 and re-examine it at that time. The primary disadvantage of this strategy is that if the clients develop health problems before age 50, they may be unable to acquire coverage at that time. Another consideration is that the landscape and policies are changing so rapidly, that in even five years time, you Chapter 2: Client Cash Flow, Debt & Risk Management 57

70 will know whether you regret not locking in a policy or glad that you don t own one that won t meet their needs. You could consider options such as a long-term care rider on the life insurance policy or annuity. It is perfectly acceptable to recommend further research. Health Insurance Health insurance is provided through Jim s employer. Anne does not have the option of employer-sponsored coverage currently because the company is so small. She would need to purchase it on the exchanges, which is part of the reason you increased medical costs in your disability analysis. Open enrollment is held every October, and they have agreed to contact you with their employee benefit options at that time. The plan Jim chose is an HMO, and they are very happy with the plan. Other plans do not appeal to them at this time. The insurance is subsidized about 60% by Jim s employer. No further actions are needed at this time. The issue to be aware of, however, is that if something happens to Jim, Anne will need to rely on unsubsidized coverage through the health exchanges. You are estimating costs of coverage at $10,000 for Anne and Matt in your projections in case of death and disability. Table 10: Health Insurance Information Group open enrollment period: 10/1 12/20 Health ins. premium Deductible Stop loss (family) $3,000 Copay Emergency room without hospitalization $100 Prescriptions $300 per mo. (pretax) $450 per person $20 primary/$40 specialist $10 generic/$125 Sometimes, a planner needs to defer decisions or evaluation until a later date. Rather than just ignoring the issue, it helps set the stage for the future to explain what issue is being deferred, why and a target date for addressing the issue. 58 Financial Plan Development

71 Plan Development #12 Write a brief recommendation explaining why you are deferring reviewing health insurance to next year s open enrollment and deferring addressing long-term care for five years unless new information surfaces about health or policy options. Be sure to include potential consequences for deferring the issue. Set the stage for what types of items may need to be considered at that time. Chapter 2: Client Cash Flow, Debt & Risk Management 59

72 Chapter 3: Investment Planning T here is an inherent conflict between assumptions used for long-term planning and current market rates and assumptions. There is no correct answer as to what is the correct relationship between current returns and those used for projecting goals that are years away. As advisers we know projections are guesses and will not be accurate, but we still must make them. For purposes of projecting retirement, disability, and life insurance needs, this plan is adopting a return of 5.5% with 2.5% inflation. This is a 3% real return assumption. Financial planning software makes sure that assumptions match, taking this issue out of the hands of the user for the most part. Many software programs let you add fees, change inflation rates, or set different assumptions for rates of returns, yields, etc. To simplify the work for this course, we are not requiring that you integrate the calculations, and we have tried to provide any numbers that require calculations beyond those that will be tested on the CFP Certification Examination or those that need spreadsheets or software. Recognize that this will create some discrepancies, but we are asking you to accept the numbers provided without questioning them. (Don t use this approach in real life, however! The best planners question the assumptions in software until they understand them.) Portfolio Considerations There are many factors that must be considered when determining an investment plan for a client. Your first step is identifying characteristics and constraints related to designing the portfolio. Below are the characteristics to consider: Required Portfolio Characteristics Time frames Cash flow requirements Risk capacity Risk measurement Vehicle structure(s) 60 Financial Plan Development

73 Tax issues Estate planning coordination Client Expectations Management In addition to managing the portfolio based on numbers and facts, managing the client will have equal impact. Clients pulling out of portfolios at inappropriate times can have as much impact as a down cycle in the market. Mental accounting Volatility/risk tolerance Return expectations Investment management services expectations Sophistication level Uncommon Issues and Impacts There are also special issues that can have an impact. Uncovering these issues early in the discussion process is important. Not knowing about these can cause plans that were in the clients best interest to become very destructive to their ultimate goals. Unique assets Concentrated positions Asset retitling/gifting plans Business ownership with cash flow and disposition plans Management of special assets impact on insurance needs, etc. Your delivery constraints will also have a major impact. You may believe that the clients could benefit from multiple customized portfolios with integrated reporting or a custom stock and bond portfolio, but if your software/company support makes these extremely time intensive or unavailable, you then have a decision to make from a fiduciary standpoint. Can the clients be served just as well utilizing your delivery capabilities? Most of the time you can work around Chapter 3: Investment Planning 61

74 these constraints, but there are times when it is more appropriate to steer the clients to someone who can deliver what they need. On top of all these considerations, you must overlay economic conditions! Let s examine the considerations in light of the Dowlers. Important Portfolio Considerations for Your Clients You will start the process by evaluating what will be needed from this portfolio as related to the above considerations. The facts that have been identified as relevant are: Time frames. Thirteen years to first planned withdrawal for education funding continuing four years. Twenty years to retirement with 32-year planned distribution period. Cash flow requirements. None from portfolio until education goal. Risk capacity. The maximum losses they could sustain without seriously injuring their financial situation is somewhere between $50,000 $100,000. They have emergency funds, after-tax investments, two steady incomes, adequate (or willingness to implement adequate) insurance plans, and potential family resources with Jim s parents because he is an only child and they have a moderately high level of wealth. Risk tolerance. Tests on three different risk tolerance questionnaires show that they are willing to take average risk for their age group. However, their risk tolerance scores and current portfolios do not match. They also raised the issue that they don t feel they understand risk and investments and tend to pull back during turbulent markets. This implies that it is not appropriate to convince the client to take risk outside of their risk tolerance score. Vehicle structure(s). The clients currently have a mixture of tax treatments with after-tax, before-tax, and-tax deferred annuities. They do not qualify for traditional IRAs but do qualify for Roth IRAs, though they are not currently utilizing this option. They also have room in their qualified plans for additional contributions. 62 Financial Plan Development

75 Tax issues. Clients are in the 25% federal marginal rate with a 4.63% state rate. They have no passive income carryover or loss carryovers that can be used for offsetting portfolio moves. Estate planning coordination. No estate tax concerns at this point. It may become a concern in the future with Jim s inheritance and the ever-present threat of estate tax law changes. Client Expectations Mental accounting. Other than the $22,000 of their current municipal funds that they mentally have allocated to college funding, they have no particular mental accounting. They seem comfortable having a combined portfolio but would also be open to having different buckets for education and retirement. Volatility/risk tolerance. Because their past behavior shows a strong response to market downturns and disparity between stated risk tolerance, behaviors, and current portfolio construction, this will be an area to pay special attention to with these clients. Return expectations. 5.5% total return with 2.5% inflation (real return of 3%) was acceptable to them and will allow the clients to achieve their goals. We are making the assumption in this course that the real return is consistent with current market conditions even though it may not be when you are reading this text! Investment management services expectations. After discussion, you and the clients agreed upon creation of an investment policy statement and quarterly reviews compared to both the investment policy statement and their goals. Little attention will be paid to quarterly returns in client meetings, but annual returns discussions will focus on accomplishment of 3% real return target and how they stand compared to their goals. They are willing to take some loss to protect downside in volatile times. Sophistication level. These clients have experience with mutual funds and ETFs and have a minimal understanding of asset classes, theory, fees, risk, and return measures. They would like a better understanding of investment risk and terms. You will need to avoid jargon and provide explanations of any technical terms and risk. Chapter 3: Investment Planning 63

76 Uncommon Issues and Impacts Unique assets. None Concentrations. None Asset retitling/gifting plans. Willing to consider shifting assets for education and utilizing charitable gifting of appreciated stock within their current charitable plans. Business implications. None Impact on insurance needs, etc. None, since the projections have been based on the same real rate of return. Your constraints. Today you are being constrained to the portfolios being offered. Because incorporating correlation coefficients requires software, you are limited to those portfolios provided rather than the ability to build your own. We recognize that you may be able to build a more efficient portfolio, but we would have no simple way of grading your work without examining your software, economic assumptions, etc. You are being provided the weighted standard deviation of both their portfolio and the optional portfolios to choose from. Your task is to determine which portfolio option you think makes the most sense for the Dowlers and explain it to them. Along the way, you will evaluate portfolio efficiency and compare it to their risk tolerance and other factors as well as calculating the tax consequences for shifting to the portfolio. This review of concepts will have important implications for constructing your portfolio. For example, because the clients are not sophisticated investors and also will react to volatility, you should probably not include complex investments with high volatility in their portfolio. Because their goals are more than 10 years away, you could create just one portfolio allocation and manage the portfolio as one. The other option, considering their mental accounting, is to create two portfolios: one for college funding and one for retirement. This may make sense if you are using a 529 plan as the vehicle for college funding. A third alternative is to create a portfolio that is funding 85% of college and plan on the rest of the money coming from the other portfolio. There can be many variations based on your assessment of the clients, their needs, and your company s ability to deliver the solutions. When you evaluate the portfolio options below, you can decide whether you would 64 Financial Plan Development

77 want one overall asset allocation or different allocations for each goal. There are advantages and disadvantages to both strategies. The next step before evaluating future portfolios is to examine their current portfolio and how it compares to the characteristics defined as important. You can also learn about the client by looking at the choices they have made in the past. Notes on Risk Tolerance Like many clients, Jim and Anne may respond to questions that show a risk tolerance level that has little to do with their current portfolio. Clients frequently don t understand risk overall, don t understand risk of different asset classes or investments, don t rebalance, and a host of other actions that result in no cohesive asset allocation. One common industry issue is advisers increasingly ignoring or completing minimal activities in identifying risk tolerance. As Michael Kitces points out in one of his Nerd s Eve View blogs ( the problem is not that clients risk tolerance changes, but that their perception of risk changes. Clients views of risk are colored by how risky they perceive investments at that moment. There are very few statistically tested risk tolerance survey tools in the marketplace. FinaMetrica is one, and they recently completed research that shows clients risk tolerance is stable but their behaviors are not. Kitces addressed the research in the same blog: The significant implications of the research are that planners struggling with unstable client investment behaviors around risk e.g., buying more in bull markets and selling out in market declines may actually need to focus more on management risk perceptions, rather than blaming the instability of client risk tolerance. When markets are doing well, it is easy to talk clients into taking more risk. The problem comes when the market stumbles. Those clients who are pushed to take higher risk will be the ones to bail quickly. They will need the most handholding and will be the ones least likely to get back into the market. If they are not one of your top clients, they may not receive the handholding within their time tolerance before withdrawing from the market. The result is that their portfolios Chapter 3: Investment Planning 65

78 do not recover at the same rate that someone who is in an appropriate risk level. As Kitces points out, there are times that it may be prudent to encourage clients to take a portfolio slightly below their risk tolerance. All of these factors should be considered when evaluating a client s risk tolerance and appropriate portfolio. For the Dowlers, we utilized the FinraMetrica tool, and two different non-statistically-tested tools from different software companies to arrive at the conclusion that these clients are average risk takers. Figure 5: Risk Tolerance Summary Analysis of Current Portfolio Now let s examine Jim and Anne s current portfolio. From this view, you can see how different Anne and Jim are with their investment strategies. You can also see easily what will cause tax consequences by shifting. Only the annuity, and jointly held accounts will have any tax consequences for shifting. Finally, you also see the types of accounts they are utilizing. There are no Roth IRAs or 529 plans. 66 Financial Plan Development

79 Table 11: Current Portfolio by Asset Class and Vehicle Anne's 401(k) Anne's Fixed Annuity Anne's IRA Jim's 401(k) Jim's Traditional IRA Joint Large Cap Growth Joint Muni Bonds Joint Small Cap Growth Total Cash & Equiv. Short- Term Bonds Int. Term Bonds Long- Term Bonds Large-Cap Value Stocks Large-Cap Growth Stocks Mid-Cap Stocks Small-Cap Stocks Int. Dev. Stocks Int. Emerging Stocks $ $32,889 $32,889 $15,073 $9,762 $83,924 $108,759 $9,762 $67,444 $77,206 $7,537 $7,537 $7,537 $26,987 $34,524 $18,341 $18,341 $40,467 $40,467 $ $165,071 $165,071 Total $30,147 $19,524 $83,924 $183,412 $32,889 $26,987 $67,444 $40,467 $484,794 Basis information: All contributions in 401(k)s and IRAs are before tax. Anne s annuity has a basis of $15,000. Large-cap growth fund is all long-term capital gains with a basis of $20,000. The municipal bonds have short-term gain with a basis of $65,000. The small-cap growth fund gain is all long term with a basis of $30,000. Chapter 3: Investment Planning 67

80 Other questions include: What is their mix between stocks and bonds? What is the standard deviation and return for this portfolio? How efficient is the portfolio? These are calculations that are difficult to assess without appropriate software. However, you must understand that software frequently projects the economic analysis predictions of the company or service supporting the software. Most do not use historical returns, although they will allow you to look at the historical returns and run sensitivity tests. Additionally, proxies are used for asset classes. This means that the returns and risk indicators such as standard deviation and Sharpe ratio are for the model portfolios, NOT the client s actual portfolio, nor the actual portfolio that will be implemented. There are many reasons this is appropriate and many cautions for which an adviser must be prepared. It s appropriate because: The largest component of an individual investment return is based on asset classes, with only a small percentage being the difference between specific investment selections. Historical returns are not indicative of future returns. Multiple-year periods with averaged returns and standard deviation will most likely be more representative of the clients situation since holding the exact same investments over 50 years is unlikely. Cautions include: Since investments must be assigned a proxy and not all investments easily fit into the indexes, the class to which the asset is assigned may have a very low correlation and be totally inappropriate to represent that asset. Clients can easily interpret this to mean this is the return you are going to get for them and this is the exact risk you are taking. It can be easy to decide to move money because of asset allocation, but if you calculate the consequences of capital gains it may take you 10 years to 68 Financial Plan Development

81 recoup the loss, which means you didn t really gain improved return by following the asset allocation model. Company portfolios are placed on the efficient frontier, but that doesn t mean the line you see is the efficient frontier. The software puts the models on the paper and draws a line through them. Only by calculating Sharpe ratios will you have a sense of what the line may really look like. Despite its shortcomings, software that helps us find a combination of asset classes to create more efficient portfolios has been a tremendous boon to the industry, allowing advisers to manage many more client portfolios than before. It s just important you understand the software you are using and the numbers and concepts that are driving it. The information for the exercise below is based on MoneyGuidePro. We utilized their risk and market return assumptions, correlation tables, index proxy tables, and model portfolios. The underlying information was not included for brevity purposes. The software was used to analyze the Dowlers current portfolios and provide you alternative portfolios to evaluate and choose among. Figure 6 shows the efficient frontier and graphically illustrates their current portfolio compared to those available. It does NOT mean that these are the most efficient portfolios available within the investment assumptions. If you were to remove the model portfolios and put the same asset mixes into the software, they would not lay on the line and some would show as inefficient. This is a very important distinction to remember. Any time you are looking at software results, you must explore the assumptions and constraints placed on the software to understand how it is working. Most software takes the portfolios provided by the company and draws a line through them to illustrate the concept of the efficient frontier. The graphs make it easy for clients to see risk/return relationships but planners should be aware of the ways they can be misleading. Chapter 3: Investment Planning 69

82 Figure 6: Efficient Frontier Potential Model Portfolios This next chart shows their current portfolio plus the portfolios available in this software, along with portfolio characteristics. The arrow is pointing at the highest risk acceptable portfolio Balanced II. The only portfolios that you may choose from are the Capital Preservation II, Balanced I, and Balanced II portfolios so that we can simplify this process. Figure 7 shows the Balanced II portfolio as the target choice. You are not restricted to this one. We simply cannot put all available options in the text. Another important fact to remember is that in this illustration, the existing emergency funds and checking account balance have been removed from the asset allocation. The assets to be allocated are $484, Financial Plan Development

83 Figure 7: Model Portfolios and Risk Zone In order to evaluate the portfolios, you will need to calculate the Sharpe ratios. [(Rate of return Risk-free rate)/standard deviation]. You can use 2.5% inflation rate as the risk-free rate for the purposes of this course. Chapter 3: Investment Planning 71

84 Table 12 provides the breakdown of asset classes within each portfolio. Table 12: Asset Classes in Each Portfolio Asset Class Current Value Capital Preservation II Balanced I Balanced II Cash & cash alternatives $0 $24,240 $19,392 $19,392 Short-term bonds $32,889 $179,374 $155,134 $126,046 Intermediate-term bonds* $108,759 $96,959 $92,111 $77,567 Long-term bonds $77,206 $0 $0 $0 Large-cap value stocks $7,537 $77,567 $87,263 $111,503 Large-cap growth stocks $34,524 $43,631 $63,023 $67,871 Mid-cap stocks $18,341 $0 $0 $0 Small-cap stocks $40,467 $24,240 $24,240 $29,088 International developed stocks $0 $38,784 $43,631 $53,327 International emerging stocks $165,071 $0 $0 $0 Total: $484,794 $484,795 $484,794 $484,794 Projected total return 6.05% 5.05% 5.33% 5.71% Projected real rate of return 3.55% 2.55% 2.83% 3.21% Standard deviation 13.06% 7.64% 8.92% 10.59% Risk-free rate 2.50% 2.50% 2.50% 2.50% Sharpe ratio ?? * includes municipal bonds This table helps you see the amount of change that will be needed to bring their portfolio in line with the model portfolios. You will need to determine what the tax consequences will be for shifting to the new portfolio and present this along with your explanation of risk and return and why you are recommending the specific model portfolio. You will not be taking the analysis to the next step because the clients will need to agree with the portfolio choice and then an investment policy statement 72 Financial Plan Development

85 developed. At this point in the process, you are working to get agreement on the model portfolio with its risk/return characteristics only. Plan Development #13 Calculate the Sharpe ratios using 2.5% for the risk-free rate for the remaining two portfolios so that you can use this information when explaining your portfolio choice. Projected Current Portfolio Capital Preservation II Balanced I Balanced II Rate of return 6.05% 5.05% 5.33% 5.71% Real rate of return 2.55% 2.55% 2.83% 3.21% Standard deviation 13.06% 7.64% 8.92% 10.59% Sharpe ratio ?? Write a brief issue summary with the consequences of NOT addressing the importance of picking the risk/return characteristics of the portfolio as the first step. Include an explanation of the Sharpe ratio. This will be your explanation of the issue of portfolio selection. Which assets you place in which type of account can have an impact on the effectiveness of your portfolio. There are many schools of thought on whether it is better for clients whose tax bracket is 25% and above to put after-tax money into investments that will generate capital gains, or whether large growth assets should be in qualified plans and the after-tax money in low-risk investments. Another factor would be calculating the capital gains of moving any assets prior to making the decision. Again, if it would take 10 years to recoup the capital gains caused by reallocating a portfolio to gain a 1% performance enhancement with the same risk level, you may want to evaluate whether you think the portfolio construction is going to change again before the 10 years is up! For this course, you will be evaluating the portfolios and calculating the tax costs of shifting the portfolio to match the asset allocation. We will NOT be evaluating the individual investments. The agreement with the clients is that after this step is Chapter 3: Investment Planning 73

86 completed and agreed upon, the investment policy statement will be defined and the individual investment selection will follow. You will not be completing these in this course. Calculating the impact of the fees on the return is also a critical component, but we will not be doing this in this course. Tax Consequences of Shifting Portfolios Recognizing the tax consequences of portfolio movements is an important component of asset allocation and portfolio management. With this portfolio, the assets you are concerned with are those from after-tax or tax-deferred contributions. Let s examine what would happen if you moved to the Capital Preservation II model. There are several asset classes that would require sales: intermediate-term bonds, long-term bonds, mid-cap stocks, small-cap stocks, and international emerging equities. The mid-cap and international emerging equities are in Jim s 401(k), so there will be no tax consequences for selling and shifting those, which is why they are not included in the chart. The intermediate term bonds are held in Anne s IRA, 401(k), and annuity. If you rebalance the intermediate bonds using the IRA, again there are no tax consequences. We will address the annuity, which holds long-term and some intermediate bonds, in the next section. This leaves us with long-term municipal bonds and small-cap stocks to address. Table 13 summarizes the basis information of the two after-tax accounts impacted: Table 13: Tax Consequences Holdings Value Gain % Gain Tax Type Long-term municipal bonds $67,444 $2, % Short term Small-cap stocks $40,467 $10, % Long term The long-term gains tax rate will be 19.63% (.15 federal plus.0463 state tax rates). Assets that are short term or ordinary income will be taxed at 25% federal plus 4.63% state for a total rate of 29.63%. Multiply the gain percentage by the amount moved in order to determine the taxable amount. Then apply the appropriate tax rate to determine the tax. 74 Financial Plan Development

87 Plan Development #14 You will be calculating the tax consequences for each of the three portfolios. Complete the charts below for each portfolio. You will use this information in the cash flow changes tracking sheet and in the disadvantages when making your recommendation. Capital Preservation II and Balanced I require the same sales. Holdings Amount to Sell % Gain Taxable Amount Tax Rate Tax Long-term municipal bonds $67, %? 29.63%? Small-cap stocks $16, %? 19.63%? Total Tax Due? Balanced II requires selling a smaller amount of Small Cap stocks. Holdings Amount to Sell % Gain Taxable Amount Tax Rate Tax Long-term municipal bonds $67, %? 29.63%? Small-cap stocks $11, %? 19.63%? Total Tax Due? Addressing the Annuity Planners either hate or love annuities when clients bring them to their office. The annuity is a fixed annuity and is considered a blend of both intermediate and long-term bonds. All of the models require no long-term bonds and a reduction in intermediate bonds. The reduction in intermediate can be addressed by shifting assets within Anne s IRA. The annuity has passed its surrender period. It is currently paying 4.25% interest. The fees are moderate for fixed annuities. There are three choices when it comes to the annuity. Chapter 3: Investment Planning 75

88 1. You can liquidate the annuity, paying ordinary income taxes plus a 10% penalty. 2. You can 1035 exchange the annuity into a variable annuity, which will start the five-year surrender period over again. For purposes of this course, the variable annuity has fees that are.5% higher than the fixed annuity. The advantage is that you will be able to use any of the asset classes. If you wish to continue funding the annuity, you must enter it into cash flow since all contributions to after-tax accounts were made available for you to reallocate. 3. You may continue holding the annuity and reduce the amount being held in intermediate bonds by the amount of long-term bonds. This choice would slightly change the standard deviation and return of the model. You do not need to calculate this but you should inform the client of how it would impact the portfolio if you chose this option. Future options include annuitization or 1035 exchange in future years into a long-term care policy. If you wish to continue funding the annuity, you must enter it into cash flow since all contributions to after-tax accounts were made available for you to reallocate. Plan Development #15 1. Calculate the cost of selling the annuity so that you can share this with the client when addressing your recommendations for the annuity. Value Gain Tax Penalty Fixed Annuity (50% int./50% long) $19,524 $4,524?? Preparing Your Recommendation 2. Write your recommendation for the annuity. Include in the advantages and disadvantages, comments on the taxation of annuities and the cost for liquidating it if you did. If you choose to liquidate, include these costs in your cash flow changes tracking sheet. One final note before you adopt the portfolio. Below is a projection utilizing Monte Carlo analysis of the impact the portfolio selection would have on 76 Financial Plan Development

89 retirement goals. As you can see, if the Balanced II portfolio were selected for their entire lives, the results favor the more moderate risk slightly. Not shown here is the higher risk. Higher risk beyond this actually brings down the confidence zone, just as too low risk would. Too much risk means that when money is withdrawn, the chances that there will be withdrawals when the market is down causes difficulty in meeting the increased income needs. If the return is too low, the portfolio doesn t grow. This is only one factor that should influence your decision. It does show the importance of actively monitoring and continuously projecting results when higher risk is adopted. Figure 8: Impact of Portfolio Choice on Retirement You have now assessed the risk/return characteristics and tax consequences for rebalancing and the annuity. Plan Development #16 Write Your Recommendation Select a portfolio and explain your recommendation, the advantages and disadvantages of the portfolio you have chosen, along with your second portfolio alternative to the client. Include a description of the next steps in developing the investment policy statement and how individual investments will be evaluated. The purpose is to paint the picture of the next step as you take over managing their money. Chapter 3: Investment Planning 77

90 Chapter 4: Tax Planning C lients respect and appreciate you when you can help them navigate the tax code. Many tax preparers are great at telling clients the consequences of actions, but frequently the financial planner is the one who will look down the road over several years to identify how strategies can be utilized to positively impact a client s future tax bill. You just completed an analysis and projection of the tax consequences for potential portfolio moves. Another example of how you may be involved in tax planning is planning to shift income because a client is going to be supporting a parent in the near future. Another example is planning to shift income for just one year to create a lower taxable income so you can transition Series EE bonds into a 529 plan. This is a good strategy to use when you believe the client will soon be phased out of that option. This type of integrated planning can make a big difference for clients. You won t be doing any major shifts like that for Jim and Anne, but you do need to understand their situation and identify potential opportunities or concerns that you will want to track as your relationship progresses from this first, full-blown financial plan to ongoing planning in later years. Tax Projection for This Year The Dowlers received a tax projection from their accountant for this next year that they believe is accurate. They have already submitted their tax return for this year and the refund is entered into the cash flow changes worksheet as funds available for you to use. Examine this projection so you can evaluate the consequences of potential recommendations. 78 Financial Plan Development

91 Table 14: Income Tax Projection Income Tax Calculations Wages $137,812 Interest $286 Dividends $4,834 Short-term capital gains $550 Total Income for tax purposes (line 22 on Form 1040) $143,482 Adjustments to income $0 AGI $143,482 Itemized Deduction Calculations: Medical over 10% $0 State taxes ($5,227) Real estate taxes ($2,352) Mortgage interest ($12,228) Misc. deductions over 2% $0 Charitable contributions ($4,396) Total Itemized Deductions ($24,203) Calculating Taxable Income Income after itemized deductions (line 41) $119,279 Tax Subtract exemptions (3 x $4,000) ($12,000) Taxable income after subtracting exemptions $107,279 Amount over $74,901 but under next category. This is amount to be taxed at 25% $32,378 25% of amount over $73,800 $8,095 Plus base amount $10,312 Income Tax $18,407 Capital gains $83 TOTAL TAX $18,490 Alternative Minimum Tax Add-backs less medical (too low under 10%) less state taxes $5,227 Chapter 4: Tax Planning 79

92 less real estate taxes $2,352 Total of add-backs for AMT $7,579 AMT Tax Calculation Start with income after deductions but before personal exemptions (line 41 on Form 1040) $119,279 Add back adjustments $7,579 AMTI $126,858 subtract AMT exemption ($83,400) $43,458 AMT tax multiply by rate 26% = $11,299 Compare to regular tax $18,490 if greater = difference, if lower 0 $0 Child Tax Credit $1,000 per child potential Start with AGI $143,482 Subtract phaseout start ($110,000) $33,482 ROUND UP $34,000 Multiply by 5% (.05) $1,700 Subtract from credit ($1,000) Child tax credit Other taxes Other credits Not Eligible N.A. N.A. Total Due $18,490 Taxes withheld - Jim ($16,672) Taxes withheld - Anne ($7,360) Total withheld ($24,032) Amount Due $18,490 Projected Refund for this year ($5,542) Colorado State Tax 4.63% 80 Financial Plan Development

93 Start with Taxable Income $107,279 Add back state taxes $5,227 Colorado taxable income $112,506 *.0463 Projected State Tax $5,209 Projected State Refund $18 Table 15: Tax Rates Federal State Combined Marginal 25.00% 4.63% 29.63% Effective 12.95% 3.63% 16.58% Identifying Opportunities or Concerns The Dowlers have asked for any advice that you may have on lowering their taxes. Now you need to consider strategies for achieving their goals while utilizing tax benefits. The following exercises will lead you through analyzing possible tax-saving strategies. There are many income limits that apply to the ability to utilize tax credits or savings vehicles like IRAs and Roth IRAs. Sometimes, your actions such as rebalancing a portfolio can increase a client s AGI, causing them to not qualify for certain deductions or credits. Thus, it is important to understand where a client is situated in relation to AGI limitations and other brackets. Other times, increasing contributions to qualified plans or flex plans can reduce the client s AGI, making them eligible for certain strategies or credits. Examine the chart below that shows the Dowlers AGI compared to various tax phaseouts. Identify the potential concerns or opportunities that could realistically apply to their ability to participate in the following accounts or strategies. For example, if you triggered more than $30,000 in income in the current year, they would then be subject to the phaseout of the AMT exemption amount, possibly creating the need to run the AMT calculation. Chapter 4: Tax Planning 81

94 Table 16: Tax Concerns and Opportunities Assessment Personal Exemptions & Itemized Deductions AMT Exemption Phaseout Phaseout Married Filing Jointly Items Based on AGI or Modified AGI Client AGI: $143,482 Client AMTI: $126,858 Change Needed to Trigger Concern or Opportunity $309,900 $166,418 N/A at this time $158,900 AMTI ($16,624) Concern track gains or increase in income to not trigger AMT EE Bonds $115, ,750 ($27,732) Opportunity if reduce income could convert Series EE to 529 plan. Most likely, exclusion will be phased out in future so best not to utilize Series EE bonds for education Coverdell $190,000 $220,000 $46,518 Opportunity eligible to utilize Lifetime Learning Credit American Opportunity Tax Credit Education Loan deduction Child Tax Credit (one child) Traditional IRA (both active) $118,000 $128,000 ($25,482) N/A at this time phased out $160,000 $180,000 $16,518 N/A at this time $130,000 $160,000 ($13,482) N/A at this time but Concern track gains or increase in income $110,000 $130,000 ($13,482) Opportunity if income reduced by more than $13,500 would qualify for some benefit $98,000 $118,000 ($25,482) N/A at this time phased out would have to reduce income by $26,000 at least Roth IRA $183,000 $193,000 $39,518 Opportunity Eligible to utilize 82 Financial Plan Development

95 Plan Development #17 Write your list of realistic potential concerns and opportunities that you will want to keep in mind during your planning based on the clients fact pattern. You may wish to include comments on some of these in your explanation of tax planning recommendations or as part of an advantage when addressing qualified plan contributions in the retirement section. For example, they are eligible for Roth IRAs at this time but not traditional IRAs. That will probably impact potential recommendations. Additionally, if you were able to reduce their income by $15,000 through 401(k) contributions or flex plans, the client may gain back some or all of the child tax credit. Flexible Spending Accounts One obvious tax saving strategy would be utilization of their flexible spending account (commonly referred to as a flex plan ). Jim and Anne asked for your input and help in understanding flexible spending accounts. Their average expenses for medical, dental, and eye care expenses out of pocket is around $1,300 each year, and that has been consistent for the last few years. Both Anne and Jim have access to flexible spending plans. Both plans also allow the client to roll $500 of expenses into the next plan year. Answer these questions related to flexible spending plans. Chapter 4: Tax Planning 83

96 Plan Development #18 Write your recommendation about what they should contribute to a flexible spending account and what will it save them in taxes? (Remember federal + state + FICA.) The tax code changed in 2013 to impact the use it or lose it rules, so make sure you are current with these rules! Be specific about the rules of flex plans in your advantages and disadvantages. You may want to explore what items are deductible in addition to those mentioned above. Transfer the tax savings results to the cash flow changes tracking document but remember that they are already incorporating the cost of medical expenses in their budget so you don t need to show the $1,300. If you have them contribute MORE than $1,300, you would show that as additional deduction on their cash flow. Appreciated Stock Gifting Another available strategy is gifting of long-term appreciated stock versus cash to consistently supported charities. One of the common misperceptions about this strategy is that it is limited to appreciated equities that you want to sell. The client can take the cash they were going to donate and rebuy the same stock! The benefit is that it now has a stepped-up basis. You have given away the capital gains but retained the exact same position. There are no wash rules related to gifted stock. Additionally, the full value of the gifted stock can be deducted as a charitable donation. Be aware that short-term gain stock may be donated but the charitable deduction is limited to the basis. This strategy doesn t work for the small donations that clients make, but Jim and Anne gift $4,000 to one specific charity each year. They have the small-cap stock fund of $40,467 in which 25.87% is long-term gain. You are selling part of it in order to balance out their portfolio. Additionally, the specific fund has been underperforming and has a high fee structure. You and your investment team agree it would be in the Dowlers best interest to eliminate this investment, and 84 Financial Plan Development

97 the clients are willing to sell it over time but are concerned about the taxes. You are considering recommending they gift the stock and use the cash they normally donate to the charity to rebuy the same amount in a new investment. The Dowlers have been making and receiving the tax deduction for their charitable contributions. What you are going to calculate is the tax savings for donating the stock versus selling the investment outright over time. Assume that they will then take the cash that was being donated to charity and purchase a new or the same investment so that their asset base remains the same. This strategy works especially well for high net worth clients who consistently gift. Frequently they are willing to bundle gifts into one year to assist in portfolio reallocation. This strategy is not appropriate for individuals who have not accumulated the wealth, life insurance, and disability protection that they need because charitable giving would be eliminated in case of financial crisis. Plan Development #19 Calculate what the tax savings would be if Jim and Anne gifted $4,000 of appreciated small-cap, long-term gain stock this year rather than selling it, and then write your recommendation. Write your recommendation describing the strategy of gifting appreciated stock. Include an explanation of the tax savings it would create. You can use the first year ONLY to offset a portion of the taxes on the planned sale to bring the portfolio in line unless you are splitting the sale over two years. However, in future years, the cost would not be there if you didn t sell the stock. You would have to show the tax and then the tax offset from gifting so it will NOT create additional cash flow. You can show the cost of selling the stock and then show the tax offset from gifting in your cash flow or you can just explain it in your executive summary. Not all of your recommendations will have cash flow impact. Chapter 4: Tax Planning 85

98 Chapter 5: Education Planning P lanning for their son Matt s education is one of Jim and Anne s top goals. They are not currently utilizing any specific strategies for accumulating funds; however, $22,000 of their municipal bonds were purchased with college in mind. Jim s parents just informed him that they set up a 529 plan for Matt s college education and plan on depositing $100 per month into the account until Matt goes to college. This got Jim and Anne thinking that they should perhaps be gaining some tax efficiency and that there may be a more strategic way of accumulating college funds. They wish to accumulate enough to cover $20,000 of education costs for four years, adjusted for inflation at 4.5%. Part of that will come from the $100 per month from Jim s parents and from the $22,000 they have already accumulated. They would like to know what they need to save in order to have the money accumulated prior to Matt attending college because they believe there may be additional expenses during his college years that will need to be paid from current income. Projecting College Funding Additionally, after discussing the relationship between normal inflation and college inflation, they realize that municipal bonds may not be the best answer. They would like to understand the benefits and drawbacks of both Coverdell and 529 plans. For purposes of this course, we are going to assume that the investments will achieve the same 5.5% after-tax return for both the grandparents and parents contributions. In real life, you would hopefully be coordinating the investments of both plans and the assumptions. Your first step is to calculate what they will need to accumulate at the start of his first year of college. The process of calculating this amount may be tested on the CFP Certification Examination. Once the goal is determined, you will calculate what Jim and Anne would need to save to achieve this goal on a level funding basis. There is a chance that they need to delay saving for a year due to their many other goals. If this is the case, you will have to recalculate the answer based on reducing the time frame by one year. You may complete other 86 Financial Plan Development

99 calculations such as using an increasing payment versus a level payment. The only requirements are: 1. You cannot change their goal, inflation, or interest rate assumptions. 2. There cannot be a negative cash flow in any year on their cash flow changes tracking sheet unless you have saved funds from the prior year to cover the shortage. This means no negative cash flow in the first year! The first step is to project the amount that will be needed over the four years of college. Since the amount will continue increasing due to inflation during those years, you can t simply assume that $20,000 x 4 projected forward is accurate so you need to calculate how both inflation and earnings will impact that amount. You are bringing those numbers back to the BEGINNING of college. You will then calculate how much is needed to be saved to reach the goal at the END. Thinking of problems in this way can help you determine when to use beginning and end mode. Figure 9: Education Savings Calculation Illustration Some of the calculations require an inflation-adjusted return. The formula for creating the inflation-adjusted return is as follows: 1 + interest rate Inflation-adjusted return = inflation rate For a shortcut method of doing this calculation on the 10BII+ calculator (assuming a 4.5% inflation rate for education and a 5.5% investment return), use the following keystrokes: 1. Enter 1 plus the inflation rate (i.e., 1.045) Chapter 5: Education Planning 87

100 2. Press the INPUT key 3. Then enter 1 plus the interest rate (i.e., 1.055) 4. Press the [SHIFT] key 5. Then press the percent change key 6. Your answer should be on the calculator screen as See if you can complete the calculation on your own and then review the answers below. This will be a good test of whether you have mastered your calculator. Table 17: College Funding Calculation Step 1: Estimate amount needed at start of education goal to provide desired income stream. (Use begin mode) Number of years to college: 18-5 = 13 years Number of years in school: 4 years PV: (income goal) $20,000 N = years until college 13 I = education inflation 4.5%? FV = first year required income $35,444 Step 2: Calculate lump sum needed at first year of college to provide increasing education costs. PMT - first year required income $35,444 N = years of college being funded 4 FV = amount desired left at end 0 I = inflation adjusted return * %? PV = lump sum needed $139,773 Step 3: Calculate what current investments will be worth by first year of college and subtract from needed amount. (Use end mode) PV = current allocated amount $22,000 PMT = any LEVEL payments (increasing payment is separate calculation) $1,200 I = portfolio rate 5.50% N = number of years until college 13? FV = accumulation at start of college $66,071 Subtract from target to identify new savings target $73, Financial Plan Development

101 Step 4: Calculate level amount needed to achieve target. PV = 0 $0 FV = target $73,702 I = portfolio rate 5.50% N = number of years until college 13? PMT $4,030 Plan Development #20 Now that you have the minimum dollar amount needed to save calculated above, you need to answer Jim and Anne s questions concerning Coverdell and 529 plans. Calculate the Colorado state tax deduction for the contribution to the 529 plan. Colorado provides an unlimited state tax deduction for contributions to 529 plans. With the state tax rate of 4.63%, what would their state tax savings be on the amount required to save? You may need to recalculate this later if you change the funding amount due to cash flow after you have completed your total analysis. It is helpful to utilize Excel to track your cash flow and enter a formula for tax savings versus a dollar amount. (Note that different states have different rules for deductibility and contribution limits.) Write a comparison between the Coverdell and 529 plans with bullet points highlighting the advantages and disadvantages of each plan. Be sure to include the consequences if their child does NOT spend the money for college. This will be part of your executive summary. Because of the drawbacks and potential penalties, you may choose to recommend that the funding be monitored at some point in the future so that there is no potential for overfunding the plans. Another point to remember is that this calculation is assuming a level, consistent return, which we know is unrealistic. Monte Carlo analysis has Chapter 5: Education Planning 89

102 shown that savings typically need to be higher than this calculation, so this calculation becomes the MINIMUM amount needed if you want a shot at achieving the goal. Write your recommendation for funding college through tax-advantaged vehicles. Be sure to be specific on the advantages and disadvantages of your strategy, including the tax consequences. Remember to add this to your cash flow changes page and include the tax savings if you are using part or all of the contribution into 529 plans. You may make recommendations in the next section concerning retirement that will have tax consequences. Because you are writing your recommendations in the same order as you are developing them here, save the comments on the tax benefits and consequences of retirement plans for the retirement section. While tax benefits may be important components of your choice, they will be driven by the desire to accomplish the goal of creating a secure retirement rather than tax planning. 90 Financial Plan Development

103 Chapter 6: Retirement & Social Security Planning Retirement is consistently the number one concern of clients when they seek the advice of a planner. One of your roles is to help clients set realistic goals for retirement. Letting clients know that goals are unachievable or unrealistic is actually built into the Practice Standards and ethical requirements of a CFP professional. Sometimes, your role is to help clients understand and motivate them to make changes to achieve their goals. But before you can accomplish this, you have to be clear on the projections and variables. Financial planning software is the appropriate place to create a realistic model for retirement projections The closer a client gets to retirement, the more detailed and accurate the projections need to be, especially for those within 10 years of retirement. Our clients are more than 20 years away from retirement. At this point, we are looking for a trend line and to set realistic savings targets. Using software can help you incorporate many variables, make your projections more accurate, and allow you to customize and test out different strategies for retirement. You can do projections without software using the industry standard 4% sustainable withdrawal rule of thumb. This rule of thumb makes the assumption built on research that you can safely withdraw 4% of your portfolio and increase the withdrawals for inflation. It is helpful when initially talking with clients who are a long way from retirement. Under this scenario, the client will have a high probability of not running out of money. There has been much research and there are variations on the 4% rule of thumb (which we strongly urge you to research), but it is a nice way to quickly estimate what a client could safely spend in retirement. For example, if a client wanted $50,000 per year from investments to supplement Social Security and pensions, you would project $50,000 forward with inflation. If it was 20 years at 2.5% inflation, that becomes $81,931. Using the 4% rule, the Chapter 6: Retirement & Social Security Planning 91

104 client would need $2,048,271 to achieve that goal. You now have the target and can compare that against their current accumulations and savings strategies. For this course, we are going to provide you software illustrations of retirement projections to use. Retirement Assumptions and Facts Here are the assumptions that were agreed upon with Jim and Anne. Table 18: Retirement Assumptions Base inflation 2.5% Jim s salary inflation 2.5% Anne s salary inflation 2.5% Assumed rate of return 5.5% Retirement Anne Jim Desired retirement age Latest acceptable retirement age If spouse retires, how much of other's earned income can be used to meet retirement income goal: 90% 90% Estimated Retirement Income goal $90,000 $90,000 Minimum acceptable retirement income (both retired) $80,000 $80,000 Minimum acceptable retirement income for survivor in retirement $80,000 $80,000 Plan life expectancy: Social Security inflation 2.5% 2.5% Projected Social Security benefit at age 62 $16,051 $21,506 Projected Social Security benefit at FRA $22,930 $30,722 Projected Social Security benefit at age 70 $28,434 $38,096 In addition to these assumptions, here is what you know about their retirement plan contributions. 92 Financial Plan Development

105 Table 19: Retirement Plan Contributions Salary* 401(k) Contribution Company Match Total Jim (5%, 3% match) $98,536 $4,927 $2,956 $7,883 Anne (10%, 3% match) $53,559 $5,356 $1,607 $6,963 Total $10,283 $4,563 $14,846 *Salary is before Sec. 79, which is not matched By gathering a range of acceptable retirement income and ages rather than just one target, you have the opportunity to bring back a plan that works. Nothing is more overwhelming than seeing a projection that tells the client they need to save more than they possibly could. In most cases this makes a client give up saving anything since it is impossible to achieve. By starting with worst case and finding a solution, most of the time you can bring a solution back to the client and then offer them the option of saving more to retire earlier or with more money. This helps engage the client and builds a feeling of ownership, which enhances implementation chances. In this course, you will project their ideal goal. If you determine it is unachievable, you may need to project a lower income target or retirement age to provide them as a starting point. Calculating the Retirement Need Before we get into projections, it is important to understand the software and graphs we are showing you. These screen shots are from MoneyGuidePro using their What if Page that allows us to compare various options while building the plan. Probability of success is a concept based on Monte Carlo analysis where the portfolio returns are varied to more accurately portray real life. If you use average returns or even bad returns, where the first two years of retirement have negative returns, the clients look fine. This straight line calculation is misleading. To address this, the portfolio is varied within two standard deviations of the return several thousand times. MoneyGuidePro and other software use a modified Monte Carlo so the results stay close to the same from iteration to iteration. It simulates running the equivalent to 10,000 trials. The results are graphed in Figure 10, showing the Chapter 6: Retirement & Social Security Planning 93

106 number of times that a client will not run out of money compared to those scenarios where they run out of money. The percentage that they do not run out of money is referred to as the Probability of Success. When the client s results are between 70% 90%, they are considered in the confidence zone. Getting to 100% confidence is very unlikely unless you are Bill Gates; this is because very few people can afford to lose money every year between now and retirement. Because of the constraints put on Monte Carlo, at least some of the iterations will have negative returns every year. As you can see from these final results using age 65, in some scenarios, the returns will be high and positive every year resulting in the client passing away with over $90 million in assets. The other end of the spectrum is running out of money in Both of these are unlikely but possible. Seeing this type of variation helps clients understand these are projections that will change over time and reinforce the need for reviews to see what is really happening. As the client gets closer to retirement or is in retirement, the variations will diminish. Rather than attempt to get the confidence zone very high in early years, it is more important to track savings. Next year, if taxes are higher and rates of return are down, confidence will be down. If significant gains were made and inflation is lower and taxes are lower, the probability of success will increase. If the probability of success falls below the confidence zone in a year, it may necessitate a conversation about saving more money. By monitoring it over time, the client and adviser can adjust to changing conditions and achieve confidence in achieving a comfortable, secure retirement. The client can see the direct impact they have on their retirement success. 94 Financial Plan Development

107 Figure 10: Monte Carlo Analysis As shown in Figure 11, when you first projected the Dowlers retirement goals continuing their existing patterns, your results show that they would achieve their ideal goals if all the assumptions were true but if they had any bad timing or variation in returns, their retirement was at risk. If they deferred retirement to age 67 and accepted the lower limit retirement goal, they had high probability of success. The third scenario is retiring at age 65 with the higher goal. Chapter 6: Retirement & Social Security Planning 95

108 Figure 11: Different Scenarios in Retirement So you can see that even if they maintain the same portfolio but push back retirement, they can achieve a secure retirement. Your job now is to identify strategies that improve the position. We are now using the assumption of retiring at age 65 since it seems likely that can be achieved with modifications. As illustrated in the portfolio section, the portfolio choice makes a difference, as shown in Figure 12. Figure 12: Impact of Portfolio Choice on Retirement Success The rest of the projections are utilizing Balanced II portfolio in the illustration. That does not mean that you must put them in this portfolio now, but simply because of space and options, we are limiting the inclusion of graphs. You may use these graphs independent of which portfolio you select. 96 Financial Plan Development

109 Plan Development #21 Write your issue analysis for the Dowlers explaining their retirement goals and how their current accumulation pattern will not achieve their desired goal of age 62 but will allow them to retire at age 65 with their ideal targeted income. Comment on how the portfolio changes you are recommending will help them achieve success. As part of your introduction, explain the concept of confidence zone. Social Security When determining how much a client needs to accumulate in assets, you explore that not all of their desired income of $90,000 will come from their investments. Social Security and any defined benefits or annuity payments must be subtracted. The best method of projecting Social Security is to acquire a client s Social Security statements, which the client can retrieve online. Some advisers have a computer and printer available for clients in their office so they can print any missing information and statements prior to leaving the office, which helps reduce the time from the initial meeting to plan presentation. In addition to knowing the base Social Security benefit, you may want to explore and evaluate alternative strategies when the client is closer to retirement. When the client is over 20 years away from retirement, you don t really know what Social Security options will be available at that time, so it is safer to utilize the projected assumed benefit rather than file and suspend because it may be withdrawn as an option. However, it is important to initiate discussions of various strategies a few years before retirement, with an emphasis on at least postponing collecting until FRA is achieved, independent of the age of retirement. This is part of the value of working with an adviser, knowing that the adviser is tracking strategies that make a difference! Many advisers worry about depleting a client s investment portfolio by delaying Social Security, but delaying Social Security is similar to purchasing an immediate annuity with an inflation rider and a 6% guaranteed yield. It s tough to compete with that on a risk-adjusted basis. A great article on this issue can be found at: Chapter 6: Retirement & Social Security Planning 97

110 Figure 13 summarizes the primary Social Security options available to Jim and Anne. As you can see from the Maximization Based on Cash Received, the impact of choosing a strategy on benefits paid out if the clients live to age 95 is fairly substantial. The breakeven points tell you the age that the client must live to in order to have received an equal lifetime benefit compared to starting the benefit when first available. Figure 13: Social Security Strategies Even though file and suspend would work better, because we are not sure it will be available at that time and for purposes of creating a conservative projection, we are assuming benefits start at age 70, which is only slightly less beneficial. This is an issue that would be reviewed as the clients approach retirement. 98 Financial Plan Development

111 Figure 14: Impact of Social Security on Retirement As you can see in Figure 14, there are an infinite number of variables that can be illustrated and selected. So far, we know that without changing the vehicles they are investing in or how much they are investing, they can achieve their goal to retire at age 65. Simply by improving their portfolio and Social Security strategy, we have improved their odds. If they want to retire at age 62 (which they do), something else needs to change. Plan Development #22 Write a recommendation on addressing Social Security when they are closer to retirement, helping them understand the difference the decision could make. Remember that because they are so far away from retirement now, you are not making a recommendation, merely reminding them that you will need to in the future, but for projection purposes we selected the option of taking it at age 70. With the assumptions so far, you are predicting that they will accumulate $2,899,925 at age 65. At age 62, the portfolio balance is projected to be $2,354,251 under their current pattern of saving, as you can see in Figure 15. Chapter 6: Retirement & Social Security Planning 99

112 Figure 15: Projected Portfolio Value To get them into the confidence zone at age 62, their portfolio would need to be worth $2,861,000 by age 62. If you calculate the savings needed to reach this goal, it is somewhere close to $14,500 more each year. You may not be able to cover that gap, but you may be able to close it so they can retire before age 65. Consider that the mortgage may be paid off early, freeing up cash flow for retirement. Once education funding is complete, the money being saved for that goal can be redirected. Just because a goal cannot be reached today doesn t mean it cannot be reached. Painting the picture of what the client needs to do to accomplish their goal and letting them know that you will be looking for strategies in the future is an important part of a planner s job. You have analyzed which vehicles, such as Roth IRAs or additional contributions to qualified plans, that they have access to. You now need to determine how to place the available money to improve their odds of achieving all of their goals. 100 Financial Plan Development

113 You can tell the Dowlers that, if all your assumptions are correct (inflation, tax rates, return rates, years before and during retirement): IF they save what you are projecting they and their employer are contributing IF they keep the lifestyle you are projecting AND they continue investing the same amount growing with inflation THEN They will most likely be able to live within their acceptable to desired income level starting at age 65. In order to retire at age 62, they will need to save some additional funds or reduce their goal. Other options could include a reverse mortgage or downsizing of the house. Because they are so far away from retirement, you will save this thought for a future meeting. It is an appropriate discussion to start bringing up within 10 years of retirement because clients need time to accept and adjust to potential large changes such as downsizing, reverse mortgages, or changing lifestyle. Part of your job as a planner is to help clients become accustomed to ideas before they need to take action on them. This projection needs to be reviewed at least every couple of years to adjust for reality because it is based on a lot of ifs. In addition to rates of return changing, which is reflected in the Monte Carlo analysis, inflation changes. Tax rates change. Client spending changes. Understand that even though this is a useful projection, it is really only a trend line that says given today s situation and rules, you are on track. The only way to keep the client on track is consistent reviews. The only real promises you can make are that: the number you are projecting will not be the exact number they will have in 20 years, and understanding and tracking the trend line along with shifting strategies to meet a continually changing world of assumptions will result in a much more secure retirement. Chapter 6: Retirement & Social Security Planning 101

114 Plan Development #23 Finalize your retirement issue explanation by explaining approximately how much more they would need to save to retire sooner than age 65 and the choices they may need to make. For now, the agreement is that you will NOT spend any more than has been allocated in cash flow. The clients need to understand what choices they have and what they would have to change to reach their ultimate goal so they can choose whether to work longer or save more money. Goals in Retirement: The Mountain Cabin You have one more goal to address that the clients have asked us to evaluate. Below is the statement from the letter you sent them at the beginning. You would also like to buy out Anne s cousin from his half of the family cabin in the mountains at age 62, if possible. It is estimated that the costs would be $100,000 in today s dollars. You can either purchase it outright or carry a 10-year note at 6.5%. Plan Development #24 Calculate the future value needed and then determine the level savings amount required for purchasing the cabin starting next year. You also need to project what the payments would be on a 10-year note based on the inflated value. Whether or not this goal is more important than retiring at age 62 is something only the client can determine. However, if you have funds available, you may wish to utilize an investment vehicle that would allow the funds to be accessed after age 59½ for either retirement or purchasing the cabin. This way, as their situation and goals change, they have options. Building flexibility into a financial accumulation plan is important because life happens. If someone loses their job or wins the lottery, your plan should be able to adapt. If the Dowlers can afford to save to accomplish this goal in addition to all of their needed risk management solutions, education savings, and retirement 102 Financial Plan Development

115 funding, that will be great. If not, they need to know how to adjust their budget in order to accommodate this goal. Write your summary of the funds that would be needed to purchase the cabin. Based on whether your calculations indicate they have achieved or not achieved their other goals, either incorporate it into your cash flow changes or write your explanation of how they would have to change their current expenditures to meet this goal. While you have completed your evaluation of required payments, there are still issues that could impact the final cash flow. Your next step is to evaluate various vehicles such as Roth IRAs, qualified plans, annuities, or after-tax accounts that could be used to solve the gap. Some of these strategies will have tax implications that would impact the amounts saved or needed. Recommending a Retirement Savings Program Many variables go into choosing how a client saves for retirement and other goals. Eligibility for various plans Contribution limits of the plans available compared to current contributions for each participant Vesting schedules Disparity of ages between client and spouse Client s ability to save on a periodic basis vs. lump sums Income tax bracket; current and projected future bracket Current and projected mix of types of assets related to income tax diversification at retirement Potential need to access funds prior to retirement Other client goals and objectives Potential transition of employment or employment status Chapter 6: Retirement & Social Security Planning 103

116 Nonqualified deferred compensation agreements or other potential cash flows in retirement with tax implications Comparison of potential estate taxes vs. benefit of qualified plan accumulations and gifting strategies Specific qualified plan rules such as loans, company stock requirements, and potential concentrations When considering client factors, the planner should review each plan for items that may affect plan utilization. For example, the client will have an increased degree of flexibility if the plan he or she uses offers plan loans. Investment options within various plans including administrative fees, investment fees, back in loads, deferred sales charges, investment suitability, and performance In summary, prior to making any recommendations about a client s utilization of employer-provided retirement plans, IRAs, Roth IRAs, and other alternatives, the planner must analyze the client s complete financial situation to determine how certain factors interplay with others. With this information, the planner can present recommendations along with the advantages and disadvantages of each. The client then can make a fully informed decision on how to best implement the retirement savings plan. Plan selection is tested heavily on the CFP Certification Examination, and it requires that the candidate have a thorough understanding of the various plans in order to select the most appropriate one for a given situation. Review the Retirement Planning & Employee Benefits course for a discussion of the various plans. The Dowlers situation is not very complex. Both are well under the $18,000 cap on elective deferrals for They are not at an age where they can use catch-up provisions. Their income and active participation status has them ineligible for deductible IRAs but not Roth IRAs. They are the same age and have an existing mix of some after-tax investments and qualified plans. Both Roth IRAs and qualified plan contributions would have benefits for these clients. A third option for saving is after-tax investments or the annuity. 104 Financial Plan Development

117 Plan Development #25 Write a comparison of the advantages and disadvantages of Roth IRAs, qualified plan contributions, after-tax investments, and annuities. Be specific on the tax treatments of contributions, investment earnings, and rules on withdrawals and penalties. You will include this in your executive summary as part of the explanation of issues. This is not to say that you cannot use a combination of the options. You may determine it is in their best interests to use a combination of accounts, but you need to provide advantages and disadvantages of each in your executive summary. Follow the explanation with your recommendation of what vehicle(s) to use with the remaining funds available to accomplish their retirement goal (and cabin if feasible). Incorporate the specific reasons for your choices in the advantages, disadvantages, and alternatives. If you are adding contributions to qualified plans, be sure to place the tax savings in the line right below the contributions using the marginal federal and state rates in your cash flow changes tracking so the client can easily see the tax benefit. Chapter 6: Retirement & Social Security Planning 105

118 Chapter 7: Estate Planning & Legal Documents Estate planning is the process of planning for the accumulation, conservation, and distribution of an estate to effectively and efficiently accomplish both tax and nontax objectives. The job of the planner is to integrate all of the other components of planning into the estate plan to ensure that, in the case of the death or incapacity of an owner, their goals can legally be carried out. The planner walks the line of helping clients while not venturing into practicing law. It is easy to think that you will just send the client to the attorney, but many clients need help clarifying what issues they need to address and preparing to meet with an estate planning attorney. Additionally, the planner can play the role of knowing WHEN to send the client to see the estate planning attorney. Frequently, clients will set up great estate plans but, over time, fail to have the correct beneficiary designations and asset ownership. The planner is the one who will see and identify when changes may be needed. Analyzing the Client s Estate Start by reviewing the Dowlers concerns and questions about estate planning that you documented in their goals and issues letter. Estate Planning You want to leave an estate for the benefit of Matt. Anne s inheritance from her parents was what helped you to accumulate your current resources. Jim is an only child and will inherit everything. He is also the executor and has power of attorney for his parents. Help in having a general understanding of an executor or power of attorney would be appreciated. He is concerned about handling that role and not sure what it entails. Jim s parents are currently worth around $3.5 million beyond their residence and personal property, and their estate is continuing to grow slightly. They are concerned about inflation and potential long-term care and/or medical costs, so they are 106 Financial Plan Development

119 hesitant to gift much. You both think you would rather Jim s parents money go to Matt, but do not want to count on it and aren t sure if it is a good idea to do so. Additionally, if something happens to Matt, you would like the funds to help Anne s sister and disabled cousin. You want us to help you prepare for working with an estate planning attorney by understanding what documents you should acquire. The only documents you have are the do-it-yourself wills you put together shortly before leaving on a vacation just after Matt was born. Each of your wills state that upon your death with a surviving spouse, everything goes to the surviving spouse. If there is no surviving spouse, everything goes to Matt. There were no further dispositions of property in case Matt had predeceased you, and you have named no successor beneficiaries on any of your insurance or retirement contracts. The intestacy statutes in the client s state of domicile would apply. This means that if Matt predeceased the parents, the assets would go to the surviving spouse and then disburse to that person s family, leaving the other spouse s family receiving nothing. It would mean that if Anne and Matt predecease Jim, Jim would inherit everything. At Jim s death, Jim s assets would first revert to his parents. Since he is an only child it would then be disbursed to his aunts and uncles and their descendants who live in Texas if his parents were not alive. Further discussions with Jim reveals that he doesn t really know that side of the family well and while he thinks this distribution pattern is unlikely, he would rather his resources go to his parents if they needed it (which is unlikely), and then have it go to Anne s sister and/or her cousin who is disabled. Anne would like her assets to be distributed between her sister and cousin if both Jim and Matt predecease her. Anne has other cousins, but she is not close to them. The current plan would not accomplish these goals. In addition to concerns about ultimate potential distributions, there are concerns about what would be best for Matt. Anne s sister is Matt s guardian. She is very loving but not very good with money, which also raised a concern. When it comes to Matt receiving a large inheritance outright, they both agreed that in case of their deaths, when combining all of their assets including insurance, that they would prefer Matt not receive all of that money at age 18. Chapter 7: Estate Planning & Legal Documents 107

120 With the specter of adding the grandparents estate in with those funds, they see that it would be too much for an 18-year-old. Start with Table 20, which explores the value of Anne and Jim s estate with and without the current value of Jim s inheritance. Table 20: Dowlers Estate Value ASSETS Joint Anne Jim Total Joint after-tax investments $134,898 $134,898 Jim's IRA $32,888 $32,888 Anne's IRAs $83,924 $83,924 Anne's Deferred annuity $19,524 $19,524 Jim's 401(k) $183,412 $183,412 Anne s 401(k) $30,146 $30,146 Residence (after liability) Personal property FMV $271,608 $271,608 $20,000 $20,000 Subtotal: $426,506 $133,594 $216,300 $776,400 Group Life Insurance $85,118 $99,000 $184,118 Personal Life Coverage Proposed Life Coverage $100,000 $100,000 $400,000 $1,000,000 $1,400,000 Estate of Anne & Jim $426,506 $618,712 $1,415,300 $2,460,518 Jim's Potential Inheritance $3,500,000 Combined potential inheritance for Matt $5,960, Financial Plan Development

121 Plan Development #26 Write the issue explanation of what Matt could potentially inherit if both parents and grandparents were deceased prior to Matt s age of majority. Include any concerns you have about both Matt managing the funds and Anne s sister managing the funds as his guardian. Basic Legal Documents Helping clients become familiar with all of the appropriate basic documents can be a first step. Tying these documents to some of their concerns and goals make it easier for clients to value and act to create the documents. Review these documents and compare it to the list of what the client currently has. Living will. Establishes your wishes regarding life-sustaining or lifeprolonging treatments in terminally ill situations. Medical power of attorney. Appoints another person to make health care decisions for you when you are unable to do so. (Remember that when a child becomes a legal adult, you have no rights when it comes to medical treatment or information about the situation without the appropriate documents.) Financial power of attorney. Appoints another person or institution to handle your financial affairs when unavailable or unable due to mental or physical disability. Will. Even if you have more complex trusts, anyone who owns property needs a will to manage the disposition of personal property. HIPAA authorization. Allows specified individuals to have access to your medical information and discuss issues with your doctors. Without this, doctors may not discuss medical issues even with family. Trusts. There are many different types of trusts that can be customized to address the grantor s wishes. Trusts can be created to allow management and supervision of assets specific to situations such as managing assets for a Chapter 7: Estate Planning & Legal Documents 109

122 minor or young adult or making resources available to one generation but pass on at death to designated beneficiaries. Becoming familiar with the various types of trusts and the benefits and drawbacks will allow you to talk with your clients and their attorneys. While you will not be determining which trusts clients need, you may want to make some recommendations as to what they should explore with their attorney. Some of the more common trusts include: Living trusts that allows a trustee to manage the financial affairs of an individual more easily than powers of attorney and also protects privacy of clients. Testamentary trusts to manage assets for minors or grown children so they are not overwhelmed with managing large sums of money too early or to establish a distribution pattern that prioritizes beneficiaries or distribution patterns over time to multiple beneficiaries based on their needs or specified criteria. Various trusts that can take advantage of estate tax laws when a client will most likely be subject to estate taxes. Plan Development #27 Write a recommendation that the Dowlers visit with an estate planning attorney. Include an explanation of the various legal documents that you believe Jim and Anne should discuss with their attorney. Explain what types of strategies the attorney may recommend to address the issue of Matt inheriting a large sum of money and/or Anne s sister managing the assets. Incorporate the cost of $2,000 into year one for the costs of this. (We recognize that this amount may seem either too high or too low to you based on where you live and types of clients and attorneys you work with. In any case, for this project, just accept it!) Help the Dowlers see how the various documents will help ensure that their entire family is properly protected with the right legal documents. 110 Financial Plan Development

123 Provide a brief description of the trusts that you think may be beneficial along with the advantages and disadvantages. Raise the issue that they will need to readdress their documents regularly and that, especially when Jim s parents pass away, there is the possibility they would be subject to estate taxes. Asset Titling and Beneficiary Designations Another role of the planner in estate planning is to make sure assets and beneficiaries are titled correctly to achieve the clients wishes and to match their estate planning documents. Frequently clients will have good estate documents drafted, but, over time, as they change who is managing assets, companies, etc., their documents, ownership, and beneficiary designations can become disjointed, causing distributions that do not meet their wishes. Collecting beneficiary designations and actual titling of assets every two years can prevent major problems and provide significant value to clients. The larger the estate and more complex the family relations, the more important this becomes. Jim and Anne have a fairly simple estate in this regard, but there are some issues. Plan Development #28 Write a list of the will substitutes that will need to be reviewed once the attorney has completed drafting their documents. Currently, all beneficiaries are established with the same pattern. The assets go to the surviving spouse first and Matt as secondary beneficiary. Considering that they want the assets to then be distributed to Anne s sister and cousin, what is the difficulty with this current beneficiary arrangement? Explain that you will ask the attorney for the correct language for beneficiary designation. Once the estate plan documents are drafted, you can help them make sure that they keep their designations appropriate. The estate planning attorney will be able to provide the correct language for beneficiary designations to accomplish the clients goals. The attorney will Chapter 7: Estate Planning & Legal Documents 111

124 typically suggest the type of client ownership for titling assets. It is a good idea as the planner to keep a record of the appropriate beneficiary designation and titling instructions. This way, as you create new accounts you can make sure that the new accounts or beneficiary designations are in accord with the client s desired plans. Acting as Executor or Power of Attorney Your clients may be named as executors or trustees, or given powers of attorney, or they may be naming their adult children to serve in these roles. You often hear stories of families having difficulties in settling estates, handling conflicts between siblings, losing value in assets, and a host of other problems because they are not prepared to take on the role. Frequently, the family member may not even know they are in the role until the triggering event occurs. You can provide a real service to clients by helping them understand the role they are taking or asking someone else to take on. According to Lawyers.com, duties of an executor include: Protect property and pay outstanding debts Estimate the value of the estate Determine the need for probate Distribute estate property to beneficiaries as efficiently as possible according to legal documents This implies several skills that an executor needs: Organization ability Ability to understand legal document and engage appropriate legal council Financial astuteness Ability to devote the right amount of time Additionally, in the best case scenarios, the executor has full access to information prior to having to be responsible for implementation. In the ideal situation, the executor will meet with the current legal and tax advisers and become familiar with the current financial, legal, and tax situation of the estate 112 Financial Plan Development

125 they may be requested to manage. Sometimes, this can be an uncomfortable situation for parents to allow their child to become completely familiar with their financial situation. Facilitating the conversation between the generations can be helpful. In wealthier families where there may be estate planning consequences, having an intergenerational estate plan makes sense. Plan Development #29 Write a recommendation that Jim and his parents jointly review their estate planning documents and assets to be followed by a visit with the parents estate planning attorney to clarify any questions Jim may have about his role and the documents. Include the advantages and disadvantages and alternatives to your strategy. Jim is also going to serve as the medical and financial power of attorney. His parents may wish to have a living trust established to make Jim s role serving in this function and as executor easier. In any case, it will be important that Jim have HIPAA authorizations filed with his parents doctors and that he understand their living will wishes. Plan Development #30 Write a recommendation concerning what it means that Jim will be serving as medical and financial power of attorney for both his parents and some actions he may wish to take to make sure he can fulfill his role. Once the Dowlers legal and estate documents are drafted and Jim has spoken with his parents, you will want to set up a meeting to review the plans with Jim and Anne and then ensure that your accounts are titled correctly with the appropriate beneficiary language as well as their other accounts and beneficiary designations. Chapter 7: Estate Planning & Legal Documents 113

126 Chapter 8: Economic, Political & Regulatory Impacts If the world stayed the same, clients could come get a financial plan and follow it faithfully with confidence that they would achieve their goals. One of the significant parts of our job is to stay abreast of the economic, political, and regulatory changes that impact our clients, our firms, and our practices. Planners were excited when Monte Carlo analysis came out because we knew that the chances of the stock market returning the exact same rate of return for 50 years was about 0%. By varying the rate of return over their lifetime, planners and clients have a much better understanding of how portfolios may react. That is great, but when was the last time that Taxes stayed the same for over 50 years? Inflation stayed the same for over 50 years? Contribution levels, tax credits, social programs, and government benefits all stayed the same for 50 years? These items are all affected by economic, political, and regulatory changes. If we had software that allowed us to vary all of these elements in addition to investment return, the results would be a totally uncertain future. Financial plans are really trend lines that say If you did what is recommended, you are on the right track for today s world. The strategies and solutions that you recommend today may be totally inappropriate, or even detrimental, in five years. In addition to the world changing, people s lives and spending patterns change. Most people when asked say that 10 years ago they would have been unable to predict anywhere close to what their budget is now. Yet we as planners are sometimes projecting our clients budgets 50 years in advance. As this is being written, there are concerns over rising interest rates, potential changes to the Affordable Care Act, fear of large federal deficit, lack of funding for Social Security, income inequality, fiduciary standard requirements changes, self-driving cars with unclear liability issues, companies exiting from long-term care, potential long-term care premium increases as much as 70% by some state 114 Financial Plan Development

127 commissioners, and a host of other issues that could impact clients and our business. There is also optimism about increases in Australia s and China s economies, continued recovery in jobs, new technologies and medical advances. We have a duty to stay informed on these types of changes and their impacts. We also have a duty to help clients see why and how these changes could impact them and the importance of ongoing planning. A single financial plan is helpful, but the real value that we bring to clients is our ability to help them navigate the future. Coverdell or 529 plans may be helping the client this year, but next year there may be more advantage to utilizing a different type of account. By having us track their trend line year in and year out, we can help clients navigate the changes and keep their financial future secure. Plan Development #31 Write a recommendation concerning establishing an annual review. Incorporate one or two current potential economic or tax law changes as a result of political shifts that may impact the Dowlers and how it could result in a change in their plan next year. Chapter 8: Economic, Political & Regulatory Impacts 115

128 Chapter 9: Creating Your Executive Summary Compiling Your First Draft At this point, you have evaluated various alternatives, completed your analysis of all of the clients issues, determined recommended solutions, tracked the consequences to cash flow, and identified level and serial payments required to accomplish their goals of education, retirement, and purchasing the cabin. You will want to review the prior chapters and all the Plan Development boxes to make sure you have addressed all the required points and transferred the cash flow consequences to your cash flow changes tracking form. Since you are required to stay within their budget, you may have to go back through your recommendations and make modifications. For example, you may elect to fund emergency funds over two years, or use an increasing payment for retirement versus level, or change riders on a disability policy. Money available after managing their risks can be directed between retirement funding, college funding, and cabin goals, with the cabin being the least important. Work with your cash flow until you have created a plan that you believe will best assist your clients. If they cannot achieve their goals with the available cash flow, identify what they would need to change in their lifestyle to accomplish their goals either now or in the future. You have written various recommendations already. You may need to review these to make sure that they have not changed as a result of the balance of your analysis or cash flow constraints. You may also need to enhance your explanations of the issues so that clients understand why you are determining something is an issue. Read your issues and recommendations as a whole and 116 Financial Plan Development

129 from the perspective of the client. Do you believe that the client can tell what the issue is and what the consequences of not addressing the issue would be? An excellent strategy is to have a non-financial friend read the recommendations and tell you what they think you are telling the client to do and why! That process will open your eyes to how non-financial planners are interpreting your recommendations. To help you prepare your executive summary, we have provided a sample summary in Appendix A. Read the sample summary. You are not required to review the case that provided the basis for the recommendations, although this will be used in the Mentor class to demonstrate analysis techniques and strategies. The purpose is to show you the format and give examples of specific advantages and disadvantages. You may use any language you wish from the sample executive summary in your plan. There are no issues with plagiarism, but be sure that what you are copying applies to your client! After Your First Draft When you have completed your first draft, take a step back from the recommendations you have written. Reread the Dowlers goals and what you promised you would answer in your plan. Ask: Have I addressed all the questions I said I would in my scope of engagement? Have I successfully addressed the risks that could damage their financial security even if those risks were not raised by the client as a potential problem? Are the targets for their goals within the constraints they gave me both budget and target ranges such as maximum retirement age and minimum retirement income? Have I used efficient strategies to help them accomplish their goals, taking advantage of tax laws where appropriate? Am I recommending consulting with experts when outside my personal areas of expertise? Chapter 9: Creating Your Executive Summary 117

130 Have I recognized the tax consequences intended and unintended of my recommendations? Is my writing clear and free of jargon, and does each recommendation have advantages, disadvantages, and alternatives? Is this plan realistic, achievable, and within acceptable planning practices from a fiduciary standard? If you can answer yes to all of the above, then congratulations! You are ready to submit your plan along with your cash flow changes tracking page. If your plan needs corrections to pass, it will be returned with instructions on what needs to be corrected. Once you have received a passing grade, you will be provided instructions for your oral presentation. Chapter 10 will provide you some context on what to expect in your oral presentation. 118 Financial Plan Development

131 Chapter 10: Client Communications Client Communications Y ou can be a brilliant technical financial planner, but if you can t effectively communicate your ideas, the reasons behind your recommendations, and lead the client through the decision-making process, you will have wasted both your and the client s time. Clients seldom implement recommendations they don t understand unless the trust factor is extremely high. Building a high trust relationship takes time, which means initial meetings need clear communication to facilitate understanding and allow the client to see the logic behind your recommendations. For this case, we are requiring you to write the executive summary in a method that lets clients see that you have deliberated about their situation and picked recommendations from alternatives with thought about the advantages and disadvantages. The design is intended to build trust while making full and meaningful disclosures about the benefits and drawbacks to your recommendations. Clients know that there are drawbacks, and not providing them creates distrust. Another reason you are writing them is that clients fail to remember details and disclosures, especially in areas with which they are not very familiar. You and the client will have a record six months down the road when the stock market has had a drop and they forget that you explained the standard deviation of their portfolio. While the written report with clear advantages and disadvantages is important, it is the ensuing dialogue with the clients that will determine whether the recommendations are implemented. Some recommendations are so clearly beneficial that there will not be any discussion needed. Others will need to be discussed and possibly explored at a later date with additional information. Leading the clients through the process of exploring and deciding which recommendations to implement, which to explore, Chapter 10: Client Communications 119

132 which to defer to a later date, and which to ignore requires excellent client management and communication skills. The CFP Board s Financial Planning Competency Handbook (p. 589) identifies basic skills to include: Skills to develop a relationship of honesty and trust in client interactions Ability to assess the components of communications, including linguistic signs and nonverbal communications Apply active listening skills when communicating with clients Ability to select appropriate counseling and communication techniques for use with individual clients In addition, the CFP Board Compliance Checklist we reviewed at the beginning of this course mentions understanding the client s interpretation of information, not just your disclosure of information. Our focus in this course will be on the active listening skills used in the client presentation. Note that the written summary of goals and issues is the written result of utilizing active listening and a way of checking whether the adviser s listening, synthesis, and clarification skills were accurate with the client before the financial plan was developed. Active listening is the skill you need to use to clarify client responses and respond to roadblocks and objections. There are many excellent resources that can provide you an understanding of active listening; however, becoming competent takes practice and feedback. Getting the client to tell you what they are thinking and how they are interpreting your remarks is almost reverse active listening. You are trying to get the client to feed back to you what you said so you can assess their understanding. You can set the stage for utilizing this tool at the beginning of a client relationship by explaining how critical clear communication is when addressing important issues. Explain to the client that you aren t always a perfectly clear communicator and you don t always interpret other people perfectly, so the only way you know for sure that you communicated accurately is by asking the client to tell you what they believe you are suggesting. Setting the stage this way makes you responsible for communication errors and lets the client know it is not their 120 Financial Plan Development

133 knowledge you are testing when you ask a question, but that you are trying to see how clear your explanation was. One of the ways you may use this in the plan presentation is to have the client to read one of your recommendations rather than you explaining it. By asking a client to read the recommendation rather than you reading it to them, you are engaging the client s higher level brain functions, which are critical to decision making. It s important to sit quietly so the client can focus. When the client is done reading, you can say Help me out and let me know how clear my written recommendation is. What is it you think I am asking you to do? Follow it up with What would the advantage be for you in implementing this recommendation? or I provided a disadvantage. How could that disadvantage impact your financial situation? These questions will create a dialogue and let you know how well the client understands the recommendation, the benefits, and the risks. You will know much more than if you just asked Does that make sense? or Do you have any questions? If a client can t answer these questions or has misinterpreted your information, you have a chance to try again to clearly communicate. You may choose to identify it as a recommendation that will need to be revisited later with more time or more information. Additional confirmation and probing questions are provided in the following list. Client Confirmation Questions Learning to frame questions that elicit a client s level of understanding takes practice. The key requirements are: Asking questions that can t be answered with yes or no. Asking questions that engage the analytical part of the brain. Making clients feel like they are part of the discussion rather than being patronized, quizzed, or insulted in any way. Here are the two common questions to avoid because these questions typically get very little information from clients: Does that make sense? Chapter 10: Client Communications 121

134 Do you have any questions? Below are some sample questions appropriate to use in client presentations to get you started. Just to be sure I am communicating clearly, what do you think I am suggesting you do? What would the benefits of this strategy be to you? What would the drawbacks be to implanting this and how severely could the consequences be? What factors do you think are most important in evaluating whether to implement this recommendation? How would implementing this or not implementing this impact your life? What will be the consequences for not implementing or delaying implementation be? What would the roadblocks to making a decision about this be? What could I provide or explain more clearly that would be helpful? *Used with permission from Fiscal Fitness Clubs of America Behavioral Economics There has been significant research over the last 20 years regarding client decision making. Some of the concepts that have been incorporated into this course are listed below. It will be worth your time to delve into understanding the biases that are part of the human thinking process and how actions such as writing advantages and disadvantages can help clients make good decisions in spite of our biases. Confirmation bias. People selectively search and interpret information that confirms their own preconceptions. We look for signs that confirm what we believe and ignore clues that are warning signs or are in direct conflict with what we believe to be true. Clients and advisers can be looking at the same page and see different information. Asking a client to verbalize what they understand is the only way to know (confirmation skill). Checking in by repeating back what you 122 Financial Plan Development

135 think the client is implying or saying is the only way to know you have heard and remembered correctly. False consensus effect. People tend overestimate the degree to which others agree with them. Just because a client doesn t say anything or nods, doesn t mean he or she is agreeing with the information or even following the discussion. The bobble-head nod to be pleasant or accepted is a cultural norm. Having clients verbalize what and why can help avoid this effect. Priming. Everything from the pictures on our walls, to magazines and the premeeting questionnaire are priming clients and will impact their decisions. It is all those subtle reminders that surround us besides the direct conversations or papers we put in their hands. How you prime clients prior to presenting the plan can shift the entire presentation. Setting expectations for active participation and dialogue during the presentation will get you different results than if the client expects to listen passively while you present the 20-page report. Your introductory paragraphs into issues in your executive summary is priming the client on how to think about your recommendation. Gain vs. loss. People hate to lose more than they enjoy winning. People will take more risk in order to avoid a loss than they will to win an equal amount. Therefore how we present issues gaining security versus avoiding loss is important. People avoid risk when a positive framing question is presented, but seek risk in order to avoid a negative situation. For example, Would you like to purchase financial security by acquiring disability insurance for $150 per month? or Would avoiding having your home foreclosed on if you are really sick for one year be worth finding a way to afford $150 per month for disability insurance coverage? Which statement creates a stronger reaction? Information bias. This is the tendency to seek additional information even when it can t change or affect an action. This concept applies to both planners and clients. For clients, it is especially evident when a client either doesn t know HOW to make a decision (i.e., lack of understanding about important factors so they can compare options or they don t quite trust the presenter). A sign that a client doesn t really understand is when they keep asking for different scenarios Chapter 10: Client Communications 123

136 to be illustrated in a financial plan. By writing advantages and disadvantages to strategies, you are providing information for clients to make decisions from. Ownership bias. A person s own ideas and solutions are always better than anyone else s. If clients identify problems, potential solutions, and characteristics of the best solution prior to being asked to implement them, they are much more likely to implement the solution. It doesn t take much to create some feelings of ownership. Even having a client explain back a recommendation and why it would be beneficial can create some ownership. Framing effect. How a question is framed can markedly change the results. Prepping our agenda and pre-presentation talk, how we write our recommendations, how we ask for client decisions, etc., are perhaps even more important than the financial plan itself. Becoming conscious about our message and how we frame our questions and presentations can significantly impact our ability to help clients make good financial decisions. This is especially important when asking people to make decisions in areas they are not familiar with. By summarizing the issue prior to your recommendation, you are helping the client frame the consequences of not acting. By giving advantages and disadvantages, you are telling the client what should be considered in a decision. If you don t provide the framework, clients will use ones they know such as cost and hassle versus tax consequences and risk. For example, recognizing that paperwork and time are obstacles gives you an opportunity to reframe this as a cost-effective benefit by stating the advantage to completing the recommendation in spite of the paperwork could result in not having to work an additional month before retiring. You have then reframed the issue to: time now doing paperwork vs. retiring earlier. You introduced a new variable into the decision-making process. As you can see from this partial list of behavioral biases and behavioral economic concepts, there are many implications for our industry. Understanding and crafting your behaviors and practice to account for these biases can make a major difference in your success in helping clients. 124 Financial Plan Development

137 Preparing for Your Oral Presentation In many ways, your oral presentation is the easiest part of this course. You will have already demonstrated your financial planning knowledge by creating your executive summary. You will have done the analysis and thought through why you are recommending your strategies and the advantages, disadvantages, and alternatives. If your executive summary has too many flaws, you will not be participating in the oral presentation until the flaws are fixed. In your oral presentation, you are demonstrating your communication skills that were discussed earlier. When you read the scoring rubric on the student learning portal, you will notice that it focuses on interaction with the client, such as the use of confirmation skills, more than your ability to explain your strategies. In summary, here are the critical components for passing your oral presentation: 1. Be familiar with the rules concerning recommended strategies that are important to the client. Know the tax penalties and rules for flexible spending accounts, Roth and traditional IRAs, etc. You don t need to know what their employer alternative qualified plan choices are because these clients have no influence on that. Focus on knowing what you are recommending and those rules and limits. 2. Remember that there are two people involved, so it should be a conversation, not a speech. We know you understand. How do you know the client understands? We will be looking for your use of confirmation skills that were described in the Behavioral Economics section. Your examiner will be acting in the role of the client. They will ask the types of questions clients ask. They are not going to try to trick you or test your ability to recall specific calculations. Just like clients, they will be asking the questions to help them understand what you are recommending and what it means to them, along with pitfalls. If you don t know the answer, it is acceptable to say, Let me research that and get back to you. I am not 100% sure. One way to fail is to say something emphatically that is not true, like, Roth IRAs are deductible. I m sure! Chapter 10: Client Communications 125

138 Primarily, this will be an opportunity for you to receive feedback on your communication patterns, which are critical to success as a financial planner. Many students have told us that this is perhaps the most valuable component of the course. To prepare for your oral presentation, review your recommendations to make sure you know the rules surrounding them and prepare some confirmation questions that will elicit a client response that signifies they understand. 126 Financial Plan Development

139 Summary The purpose of this course was to help you integrate all of the knowledge from prior courses through the development and delivery of a financial plan. You have identified the clients issues and developed a plan within their constraints that will help them achieve their goals. If they follow your recommendations and continue to work with you, here is what you really accomplished: Made sure that if one of life s common crises occurs to this family they can weather job loss, death, disability, lawsuits, and property loss. They definitely had gaps prior to working with you. You have helped them efficiently fund their child s education. You have made sure they can retire with a comfortable lifestyle, even though they may not get their ideal lifestyle. While they were saving before, this would not have occurred without some changes. You created some of this money from tax savings, debt management, and restructuring strategies. Their legal documents will provide for their family according to their wishes, where it may not have happened without you. Jim is also better prepared to deal with his parents financial situations as a result of meeting with you. You did all of this while maintaining their same lifestyle. I d say that s a good job! We are pleased that you will be helping real clients achieve financial security and are proud that we could provide the education for that. Summary 127

140 Appendix A Sample Summary The case utilized in the My Choice Mentor classes and the sample executive summary was based on the Dudella case. Below is the information that was used to answer the questions and create the financial plan. You can find the Sample Executive Summary and Cash Flow Changes Tracking following this case information. Meet the Dudella Family David and Nancy Dudella David and Nancy, both age 42, believe that family comes first even when it doesn t make financial sense. This is how they open their introductory meeting with the adviser. They have been married for 24 years and have one child. Their daughter is 18 and completing her first year of college. They plan on supporting her through four years, and are currently taking out loans to cover her expenses. She is a reasonably good student and good with money, as she has already saved $2,000 toward the car they committed to purchasing for her at graduation. Providing educational assistance is the number one priority for both of them. They accept that this may mean they have to work longer or live in the basement, if necessary, in retirement. Retirement is their second goal priority. They have never had a retirement projection done, however, and do not have any idea what their income will look like in retirement other than it will be horrible and we are way behind. David was recruited to be a regional manager for a firm eight years ago. He had received several options and restricted stock grants. Because of his achievements, he had received an especially large grant that had a five-year cliff vesting schedule. Unfortunately, the company changed management and decided to lay off many senior managers prior to going public, and David and many other managers were laid off just prior to the vesting of the large grant. At the time, they offered him a restricted stock agreement for part of the value even though he had not vested. He will be able to access the shares in three years. While the 128 Financial Plan Development

141 stock is doing well, he is not sure how to assess the value and is carrying it on his balance sheet that he gave you at 0. He does not want to count on or include the value of it at this time. David was unemployed for a little over two years. As a result of the layoff, counting on the grants that had not materialized, and not changing their lifestyle to accommodate these setbacks, they built up some debt in addition to depleting their reserves and non-qualified funds. David talks openly about the lessons he learned from counting his chickens before they hatched and the need to do a better job managing their resources this time around. While he will be eligible for stock grants at this new company, they do not want to plan on them. The stock grants could be 20% of his salary annually and have a three-year vesting schedule. They may be willing to consider incorporating them into their financial plan in three years but ARE NOT WILLING to use them in the plan now. They talk about having to work forever and not seeing any path to retirement. Nancy works part-time in a dental office, and she likes the flexibility and hours of her current position. She talks about that she may need to look for a full-time position, but hasn t really searched for anything even during this last crisis. About nine months ago, David found a position working for a fast-growing small-cap company and has an excellent position. He feels good about his prospects and his company, but is somewhat cynical after his last experience. David has settled in to his new job and is now ready to address the family finances. They have managed to pay down over $12,000 of debt since he started working, but realize they still have a ways to go to eliminate debt and get on track for retirement and finish paying for college. Throughout the time off, they did manage to keep up with all payments, but their debt-to-income ratio was so high, they couldn t qualify for better rates on cards or loans. At the same time, because of the housing market, their house was underwater. The housing market in Colorado is has turned at the time of this meeting. They are very risk-averse people, especially after the last market downturn. They don t have a problem with living within a budget for routine expenses, but they admit a weakness for funding things for their child, such as promises to buy a car, even though finances had changed significantly since the promise was made 10 years ago. They also have a strong feeling about having safe cars and are uncomfortable with older vehicles or those that don t have good safety records. Appendix A 129

142 Nancy s parents have passed away and David s parents may leave a small inheritance, but they do not wish to count on anything. They came to the meeting to ask for advice on how to manage their investments from prior employers and to get some suggestions on how to best allocate their cash flow given their circumstances. They provided you with the following information on their income: 130 Financial Plan Development

143 David and Nancy also provided the following information about their expenses (rounded): Appendix A 131

144 They also provided this list of assets and liabilities. 132 Financial Plan Development

145 David s Employee Benefits: Group term is 1x annual base salary Short-term disability with 7-day elimination period (covered by personal sick days) for 13 weeks at 90% of base salary Long-term disability has 90-day elimination period and covers 60% of his base salary to age 65. (Options, bonuses, car allowance and section 79 income is not included.) Just this year, his employer offered the option of adding additional life insurance coverage for employees and spouses. They also offered option to increase disability coverage. David missed the deadline for signing up, but was wondering if they should purchase additional coverage next year at open enrollment. Health insurance is $600 individual, $1,200 family deductible with out-of-pocket max of $2,500 for individual and $5,000 family out of pocket. They have $25 copay for doctor visits including specialists, mental health, and chiropractic care. After deductible, the following are covered at 90%: outpatient physical, speech and occupational therapy; prenatal and maternity; inpatient hospital services; outpatient hospital services; home health care; skilled nursing facility; inpatient behavioral health; ambulance services; and durable medical equipment and supplies. Emergency room visits have a $100 deductible. David has a flex plan, which the Dudellas were using above the current cap. It turns out that the paystub they gave you was from last year. They forgot to adjust Nancy s flex plan at open enrollment to make up the difference. The Employee Stock Purchase Plan allows employees to sign up on May 15 and November 15 to participate in plan for next six months. Employees can contribute from 1 10% of earnings. At the end of the period, the funds will be used to purchase stock based on the price that day, discounted at 15%. If they are subject to insider trading rules (David is subject based on his position), they may only sell four specific times a year during the window. David and Nancy hope that these can help pay for college and believe that because the stock is bought at a 15% discount, there is little risk even though it is a small cap company. David s employer will match 100% up to 3%, then 50% up to 6% in his 401(k). Appendix A 133

146 Nancy s Employee Benefits: Because she is part time, Nancy s benefits are limited. She has the 401(k) and a flex plan which they use for the dental expenses of about a thousand last year and will need about the same amount this year. Next year they hope that amount will drop. Nancy s employer will match 100% up to 3% in her 401(k). Personal Policies: In 2004, David purchased 10-year level term policies on himself and Nancy. David is covered for $500,000 and Nancy is covered for $365,000. David s premium is $509 per year and Nancy s premium is $331. David and Nancy let their umbrella policy lapse during his period of unemployment and would like your advice on how to rearrange their insurance. Their policies from different carriers are listed below: Homeowners: residence insured at $270,000 (they did not change the policy after initial purchase even when values dropped and have not had a discussion with their agent in over three years) Property coverage is one-half residence value. They have an antique hutch, significant computers and technology in David s office, and little expensive jewelry, although Nancy s wedding ring set is probably worth $5,000. Deductible is $500. They have replacement coverage on contents and residence. They do own jet skis and snowmobiles that are not listed on their policies, which their daughter and her friends enjoy using. Automobile insurance is 100/300 bodily injury and $50,000 property damage. Deductible is $500 on each car. They carry the same limits for uninsured and underinsured motorists. Below is the letter that was sent to David and Nancy. 134 Financial Plan Development

147 David and Nancy Dudella 1/4/2013 Summary of Goals and Issues GOALS: Providing for your child s education is your number one concern. You are willing to sacrifice in order to provide four years of college at an in-state tuition rate for a public school. Autumn has just completed her first semester of college. You have planned on utilizing loans for the majority of the costs as you do not have the savings available to pay the expenses, although you are open to other suggestions. You committed to buying her a new car at graduation and are willing to spend up to $20,000. Retirement income is your next concern. Your lifestyle for just the two of you is modest and you believe that if you can enter retirement without debt, you could live on $6,000 per month including taxes if it grew with inflation. However, you have not actually created a retirement budget and would like an estimate. This is your current income less house payment and discretionary cash flow. CASH FLOW MANAGEMENT: You would like assistance in creating an efficient strategy for managing your current debt. You would like all debt including your mortgage to be paid off prior to retirement. Other than college loans and Autumn s car at graduation, you do not foresee any additional expenses in the next five years that cannot be met by current budgeted expenses. You would like advice on how to balance investing and debt reduction within the constraints of your current budget. You do not believe that you can reduce your food, gas, and miscellaneous shopping below the $2,000 per month but are willing to track your expenditures through Mint.com for six months to see what your expenses really are so we can project a retirement budget. You believe that your current free cash flow is $2,000 per month and are willing to commit those funds to your goals along with any other funds we can free up. You recognize that you may have significant increases in income from the stock options and Appendix A 135

148 grants in three years but do not wish to count on these so we are deferring any mention or use of these until they materialize. Prior to your period of unemployment, you had three months of emergency reserves built up. Because your unemployment lasted so long, you would like to build reserves up to the six months of living expenses at a minimum, but are not sure where it should fit with debt management and work opportunities to save. RISK MANAGEMENT: When we brought up risk management in our initial interview and some potential gaps in your current plan, you agreed that this area needed some attention as well. You do not want to spend unnecessary money on insurance, but do want to provide a basic safety net. In case of either spouse s death, you would like Autumn s education fund and all debts paid off. You think the surviving spouse would need $5,000 per month income growing with inflation. He or she would plan on working until age 70 and delaying Social Security until that time. We discussed the fact that there was a risk that the spouse would be unable to work to that age or that there could be periods of unemployment. If the cost of providing a cushion was not too great, you are willing to consider utilizing age 65 and providing a six-month emergency fund also. You could sign up for additional term insurance at your next open enrollment but are concerned that if you are unemployed again it would not be there. You would like advice on how much, type, and where you should buy life insurance. Disability is a major concern, and David missed the opportunity at work to sign up to increase your disability coverage from 60% to 80% but have heard that personal coverage may be an option also You would like to see analysis of coverage options and costs and receive our recommendations. If your debt or mortgage were paid off, you think you would be comfortable with an income of $6,000 per month growing with inflation. You are interested in any suggestions we can make concerning your homeowners, automobile, and other property and casualty coverage but are concerned about adding costs at this time. 136 Financial Plan Development

149 Long-term care is a concern, but you feel that, financially, you cannot address it at this time. You are open to discussions about this and would like to understand how it would fit into your long-term plans. INVESTMENT MANAGEMENT Asset allocation is another area you would like to have addressed for both the current and prior 401(k)s. You would like advice on what to do with your old 401(k)s and whether to roll them over into IRAs, leave them at old employers, or roll them into your current plan. You are conservative investors but recognize that some stock would make sense in your portfolios. You would like our advice on the right mix of asset classes and suggestions on how to implement the plan. You would also like our opinion on the restricted stock from your prior company and the stock purchase plan. LEGAL DOCUMENTS & ESTATE PLANNING You recognize that your wills, which were created 15 years ago, are out of date and would like to understand what types of documents and estate issues you need to address. Appendix A 137

150 GENERAL Assumptions Utilized In Your Plan Base inflation: 2.5% David s salary inflation: 2.5% Nancy s salary inflation: 2.5% Emergency reserve goal: $41,500 RETIREMENT David's latest acceptable retirement age: 70 Nancy's latest acceptable retirement age: 70 If David retires, how much of Nancy's earned income can be used to meet retirement income goal: 90% If Nancy retires, how much of David's earned income can be used to meet retirement income goal: 90% Estimated Retirement Income goal $72,000 Minimum acceptable retirement income (both retired): $60,000 Minimum acceptable retirement income for survivor in retirement: $55,000 Plan life expectancy: 100 Acceptable shortest life expectancy: 90 Social Security inflation 2.5% EDUCATION Education inflation: 5% Child starts college at age: 18 Maximum number of years to fund college: 4 Autumn Minimum amount of expense willing to pay per year for college: (even if you have to work past latest acceptable retirement age) $15,000 Maximum amount of expense you are willing to pay per year for college: (Your child knows they will have to pick up any balance no exceptions) $16,000 Inclusion of room and board/living expenses Outside funding sources included: (scholarships, student loans, student employment, annual gifts, own current income, etc.) 0 Outside funding assets included: (assets not owned by you or included in your net worth that will be available) 0 yes 138 Financial Plan Development

151 SURVIVOR PLANNING - what do you want to plan to fund? If Nancy is survivor: If David is survivor: Debts to pay immediately other than residence: $92,187 $92,187 Amount of residence debt being paid off: $221,773 $221,773 Final Expenses $10,000 $10,000 Funds being established for emergency reserve: $41,500 $41,500 Funds being established for college: $50,000 $50,000 Maximum age to which Nancy will work: Changes to Nancy's income prior to retirement: None None Estimated Income need for Nancy prior to retirement: $55,000 $55,000 Estimated Income need for Nancy during retirement: $55,000 $55,000 Estimated Income need for family prior to retirement: $82,000 $82,000 Estimated Income need for family after retirement: $60,000 $60,000 Contingency plan for reducing expenses in case of permanent disability: not in place not in place Changes in working partner income prior to retirement: 0 $15,000 LONG-TERM CARE PLANNING Annual cost in today's dollars of long-term care: $39,948 Inflation for long-term care expenses: 5% Number of years to assume long-term care facility utilized: 6 Year at which we assume long-term care facility needed 80 How much will other expenses be able to be reduced for remaining partner -$500 PROPERTY & CASUALTY PROTECTION Liability protection minimum will equal or exceed this net worth: $460,000 Liability protection minimum will equal or exceed annual income times this number: 5 LEGAL DOCUMENTS & ESTATE PLANNING Projected inheritance you may receive: 0 Specific bequests: $20,000 Autumn s car Administration Fees - fixed amount 0 Administration Fees - % of probate 2% Estimated Funeral Expenses $10,000 Prior gifts you have made 0 Appendix A 139

152 Sample Executive Summary These clients were real clients whose names and identifying information has been changed. David had been a corporate executive who had been let go prior to a sale of the company and lost over $500,000 in unvested stock options that he had been counting on. It took him two years to find a new position. He and Nancy went into debt and spent down their after-tax assets like many people did during the great recession. They are now in a rebuilding phase but have many challenges. Their only child is in college, they have high debt and no after tax resources but they have allocated considerable cash flow to rebuilding their situation. The document is written to the clients and tries to avoid jargon. Without knowing the facts, some of the recommendations may not make much sense to you. This is just designed so you can see a sample executive summary. You can find the information used to develop the sample case. The case will be utilized in the Mentor choice classes to demonstrate case development. Please use the format of identifying issue, recommendation, advantages and disadvantages in bullet point format when you write your plan. David and Nancy Dudella Summary of Issues and Recommendations Congratulate yourselves on doing what less than 5% of the population does: planning for your financial success. Because of your planning, you will also be one of the few who have a secure retirement and accomplish your most important goals while protecting your family! Throughout this document, I am referring to concepts and numbers as if they are concrete and exact. The truth is that taxes, cash flows, premiums, expenses change all the time. This document and the other pages are designed to show you HOW the concepts and spending patterns COULD work. What is important are the concepts and reviewing your actual results on a regular basis. A plan that is not reviewed regularly is not worth much! 140 Financial Plan Development

153 Resources available: You start with reviewing the cash flow that can be utilized to meet your goals. This includes investments you are already making, debt payments for debts that could be restructured and unallocated cash flow that you have committed to using to achieve your goals. You will see that I have created a cash flow changes tracking report that tracks the costs or savings of all of my recommendations and starts with these numbers. I committed to living within your budget and as you will see, you can implement all of the recommendations in this plan within the budget. Unallocated cash flow agreed upon: $28,000 Current Debt Payments: $ 9,228 THE GOOD NEWS: Because of your excellent spending and savings patterns, projections indicate you will be able to achieve ALL of your important goals as long as life doesn t throw you any more curveballs. You will be able to fund your daughter s education, have your debt paid off by retirement, and retire with more than your minimum desired income! Additionally, the gaps I have found in your plan can be corrected within the next few years and funded without sacrificing your goals or current spending patterns. You should feel very good about this, and the steps you are taking today will make that happen. Many people play the role of ostrich and don t address their issues until they have few choices. You are making wise choices! THE BAD NEWS: Cash flow is going to be tight for a few years and you need to improve your risk management position. Additionally, you are underfunded in taxes. Both of these issues are addressed in the plan and cash flow projections. CASH FLOW & DEBT MANAGEMENT: Issue 1: Efficiently pay off all debt prior to retirement. You have many competing demands and goals over the next six years. Balancing your available cash flow between these competing demands requires careful attention and is the key to your future financial success. Recommendation: Restructure your $32,957 of credit card debt into lower interest debt, reducing the long-term cost of credit. Your current best option is to Appendix A 141

154 roll a portion of the smallest of your old 401(k) accounts into your new company and take a loan to pay off the debt with the 5.5% interest rate your company is offering now. Advantages: Lower payments freeing up $1,338 per year Maintains your payback period No prepayment penalty Can pay the debt off sooner if you find additional funds Removes the debt from your credit reports Improving your credit score which will help with refinancing. Disadvantages: If you leave your employer, may be required to pay your loan in full or pay the taxes on the loan amount. Retirement funds and potential funds will be reduced The retirement account will be credited with less than the 5.5% you are paying. If you hit a financial crisis and file bankruptcy, this would have been a bad choice as it will reduce your 401(k) balance rather than the debt be excused. Alternatives: Attempt to find lower interest rate cards to transfer part of your balances and try to qualify for a high loan-to-value home equity line (currently 8.2% and tax deductible, resulting in after-tax equivalent rate of 6.15%). You do not have enough equity to be able to refinance the entire amount. Issue 2: Your current mortgage is a 5-1 ARM, which may increase starting in four years and can increase as high as 9%. This needs to be addressed but I am recommending we defer this discussion to next year. Recommendation 2: Defer discussion to next year when your credit score has improved and you have liquid assets. 142 Financial Plan Development

155 Advantages: To refinance would cost approximately $4,000 Your current rate of 3.5% would increase to 4.5% and extend your loan. Your current loan will be paid off one year prior to retirement. If you refinance, you would need to roll all the costs of refinancing into the loan because you do not have the liquidity right now In three to four years, you will most likely be in a better position for refinancing and may be able to drop to a 15-year loan, which would end your mortgage in your year of retirement. This is an issue that could be addressed immediately if your stock grants or options come to fruition. Disadvantages: Rates could increase and you will not be able to acquire a low mortgage rate. Issue 3: Build emergency reserves to $50,000. You have experienced the value of having reserves and would like to build your reserves up to six months. Establish a target of six months expenses plus non-subsidized medical coverage and the funds you put through your flex plan. Because your required expenses will vary over the next few years, I have built a varying amount being dedicated to emergency reserves. Please see the cash flow sheet for the details. Recommendation 3: Accumulate $50,000 over next six years using the municipal money market until you reach $20,000. After the $20,000 is reached, shift to funding Roth IRA. This year plan on setting up an automatic monthly draft for $950 into your municipal money market for a total annual contribution of $11,400. Next year the amount will be different. Advantages: You will have the confidence you can weather the next storm that life may throw at you without building up credit card debt. This is even more important as you are currently near the maximum credit available to you. The municipal account will keep your taxes low but needs to be evaluated each year to make sure that it remains beneficial for you. The Roth will allow you to pull your contributions out without tax or penalty. Appendix A 143

156 By spreading the goal over six years, you are able to cover the other expenses such as debt reduction, college funding and covering risks. If stock grants or options materialize, this should be your top priority Disadvantages: It will take six years to achieve your goal If things go wrong, you may have to liquidate retirement funds or borrow again. Interest rates and returns on money markets are very low compared to your current debt and financing college costs, so the funds could be more efficient if applied to debt. However, there is no guarantee that credit lines would remain open and available if there is an emergency. This vehicle does not have the same type of advantages as contributing to qualified plans. Alternatives: You could make the contributions into a Roth IRA, which would grow tax free and contributions can be accessed without penalty. Earnings from contributions cannot be accessed for f without penalty except for specific reasons. This is not a good strategy for now, but when your debt has been paid off, you may want to slowly convert the reserves into a Roth IRA. Another alternative is to not accumulate reserves until your debt is paid off, but, as you know, life can happen. If either of you were unemployed for any reason, your only option then would be to liquidate retirement plans or pay extremely high rates on your credit. Issue 4: You are currently under-withholding for this year s taxes. By claiming married 5 on David s income, your taxes are going to be approximately $5,939 more than your withholdings and will incur a penalty. To avoid a penalty without doing anything to reduce your tax liability, you need to increase withholding by at least $4,207. State taxes are also under-withheld by $1,046. Recommendation 4: Increase your federal and state withholding to avoid penalties. If you choose not to implement recommendation about employee contributions, then increase by $5,939 federal and $1,046 for state. Other recommendations may also impact taxes so we will adjust this as soon as all recommendations are decided. 144 Financial Plan Development

157 Advantages: You will not have a large tax bill to pay at the end of the year You will avoid penalties. Disadvantages: You will not have use of the funds during the year and it will take time to complete the transaction and monitor during the year. If we are wrong about your projection, you may owe even more taxes or receive a refund that could have been used more efficiently. Alternatives: Increase qualified plan contributions and ignore the emergency fund or under-withhold and pay taxes and penalty next year. RISK MANAGEMENT: You expressed a desire to protect each other and Autumn from risks including death, disability, serious medical problems, longterm care expenses, liability, and property loss or damage. Issue 5: You are not adequately protected from liability with your property and casualty coverage. If you are sued because someone is injured by a member of your family, one of your possessions, or while on or in your property, you could be liable for up to your net worth and/or between 5 15 times your annual incomes. For a small amount of money, you can remove this risk that would be catastrophic to your financial security. The jet skis and snowmobiles all have liabilities which are not covered because if one of Autumn s friends were seriously injured, none of your policies would cover the liability. Additionally, Nancy s wedding ring, the guns, computers and antiques are not covered under your policy because they exceed the stated amount per item under the exemptions clause. Recommendation 5: Prepare a home inventory and meet with two different agents and discuss the following items: Add jet skis and snowmobiles to policy Discuss antique, guns, computer, and ring Raising deductible to $1,000 Discounts for joint coverage Also get competitive quotes since your coverage is considered high Appendix A 145

158 Raise your auto deductible to $1,000 Adding an umbrella policy coordinated with your homeowners and auto plans for $1,500,000 to protect your financial security Discounts you may qualify for by combining coverage under one company Advantages: In case of any lawsuits, you will be well protected Your personal property would be protected in case of loss Disadvantages: It will take time to address these issues, prepare paperwork, meet with agent, and get competitive quotes Your deductibles are $500 higher if there are claims If you never have a lawsuit, you would have paid the whopping $75 and could have used the money for something else The total premium change is $75 Alternatives: You could increase both homeowners and automobile liability limits to $500,000 or attempt $1,000,000, but typically an umbrella policy is less expensive and more comprehensive. You could also put Autumn s car and auto insurance in Autumn s name to transfer risk to her. Because she has no net worth and little income potential now, liability judgment would probably be within policy limits and this would limit some of your risk. You could also choose to cover yourself for only $1,000,000, which would save approximately $30 per year. Not covering the ring would save about $25 per year also. Issue 6: Lack of clarity on health care spending Recommendation 6: Track expenses and set up plan for FLEX plans next year. At next open enrollment, we have a phone conversation to evaluate and explore your various health care options along with your entire benefit choices, including contributions to your flex plans. Please track health care costs this year. Track what you are spending on Autumn for health care also so we can evaluate whether it would be best for her to remain on your plan or be covered under the 146 Financial Plan Development

159 school program or one of the exchange plans. We may want to explore high deductible plans and use of Health Savings Accounts in the future. Advantages: Flex plans save federal state and FICA so you save 37.28% of every dollar run through a flex plan. New legislation allows you to roll $500 of unused money into next year. A coordinated plan next year at open enrollment may let you take advantage of the best options at open enrollment and consider how they fit with your financial life. You can also avoid some significant pitfalls by learning and managing employee benefits. Disadvantages: It takes time and I know very few people who enjoy digging into the details. Flex plans can be overfunded with money reverting to the employer if not monitored Paperwork! Alternatives: Ignore the issues and potentially waste money and time when issues arise. Issue 7: You are inadequately protected against a disability and the consequences would be severe. At your ages, the chances of experiencing a disability lasting three months or longer prior to age 65 is around 40%. If either of you were disabled now, you would find it impossible to keep current on house and debt payments and could face bankruptcy and loss of your home. You would be unable to save additional funds for retirement. Even after the five years, disability is the biggest threat to your financial security. Between now and retirement, David will earn $2,160,000 without inflation adjustments and Nancy will earn $539,280. David s current disability coverage will provide 60% not growing with inflation, leaving a significant gap as inflation continues. Based upon our discussion of expenses and a projection of the addition of unsubsidized medical insurance, you would need an income close to $109,000 and your group benefit plus Nancy s income would be close to $105,000. This gap would not be problematic if your disability only Appendix A 147

160 lasted a short time. If it were permanent; however, in 10 years the gap due to inflation would be $40,000. At retirement, you would have not been able to save anything and would be living on social security based on Nancy s income only. Retirement would be very bleak. Recommendation 7a: Purchase a $2,621 monthly benefit individual policy to age 67 with an inflation factor of 3% on David. Recommendation 7b: Additionally, cover Nancy s income with $1,749 per month for a five-year period, at which time your non-mortgage debt would be paid off. Recommendation 7c: Add a disability coverage rider to your mortgage. 148 Financial Plan Development

161 Advantages: In case of a disability of either of you, you would be able to pay off your debts, including the mortgage, prior to retirement. Your lifestyle would have to be reduced slightly both now and at retirement, but you would not be in poverty or lose your home. You would be unable to continue paying for Autumn s college. But she could move back home, finish college, and end up with minimal debt in this situation. She might be able to qualify for very low interest student loans. The disability on Nancy and the mortgage rider could be dropped in 5 years when debt is paid off, emergency reserves accomplished and some of college expenses have disappeared. Disadvantages: The funds used to pay the premiums could go to other goals, but with potentially high consequences. You will have to undergo underwriting process and may not qualify. The cost of all of these would be $2,800 (pending health and underwriting and mortgage insurer s rates). In five years, your costs would then drop to approximately $1,400. Continue David s coverage until you have accumulated enough funds for retirement. Prior to dropping any coverage, we should revisit the issue. You currently pay $1,270 to protect $244,000 in your house. Your income potential is 11 times the value of your house. Luckily, you don t need to pay 11 times your homeowner s premium benefit to insure your income potential. Alternative: Increase your work coverage to the maximum rather than purchasing an individual policy. The disadvantage is that if you change work, you may not be able to obtain coverage. There is no inflation rider available on the coverage. The coverage would be taxable compared to a tax-free benefit with a personal policy and the definition of disability is more stringent. The policy would not provide the same level of benefit now and in the future but would cost less. Appendix A 149

162 Issue 8: Your current life insurance amount will not provide desired income plus it is ending this year. In case of either spouse s death, you wanted Autumn s education fund and all debts paid off. You wanted the surviving spouse to have $5,000 per month income growing with inflation. He or she would plan on working until age 70 and delaying Social Security until that time. We discussed the fact that there was a risk that the spouse would be unable to work to that age or that there would be periods of unemployment. If the cost of providing a cushion was not too great, you were willing to consider utilizing age 65 and providing a six-month emergency fund. After completing a budget projection, I believe you need to raise that monthly income to income of $75,000 for Nancy and Autumn and $68,000 for David. The difference is based on the need to replace health insurance which is subsidized through David s work. Please see the projected budget page for the details. To provide for these goals, the life insurance analysis indicates that Nancy and Autumn would need an additional $932,000 to provide the lifestyle discussed. Additionally, your current policy of $500,000 will be expiring this year and while you have the right to renew, the policy will be very expensive. 150 Financial Plan Development

163 Recommendation 8a: Purchase a new 20-year policy for $1 million and a new 10-year policy for $500,000 at an additional cost of $588 per year on David. Need is covered and the premiums will be level. By addressing now rather than when existing policy increases, you will know costs and uncover any problems with underwriting. Because of price breaks, $1 million is just a few dollars more than $932,000. In 10 years, if things go according to plan, your insurance needs would drop because: Disadvantages: College funding would be complete $ 60,000 Non-mortgage debts paid off $ 48,341 Autumn s gift car paid off $ 20,000 Emergency reserve built $ 41, years of supplemental income need gone: $296,000 REDUCING COVERAGE NEEDS BY $465,841 You will have no coverage in retirement. If things do not go according to plan, you may have need for additional coverage in 10 years. You will pay premiums that will be wasted if you don t die. (One case where I d like you to lose money!) Alternatives: One attractive alternative is to purchase a new 20-year term policy for $1.5 million. You would always have the option of reducing the coverage. This will cost approximately $1,650 per year level premium, which is higher than your current coverage by $852. The primary advantage is that if things do not go according to plan, you will have sufficient coverage. The disadvantage is higher current premiums than needed. You will have no coverage after age 67 and will most likely be unable to purchase at that time. If things go wrong, the insurance level may not be adequate. Appendix A 151

164 Another alternative is to increase your group term coverage at work by $100,000 or more to create more financial security and address the insurance when it terminates. The disadvantages are that you cannot enroll until next September so there is a period of risk. If you leave the company, you will be underinsured again. If your health changes before acquiring the new coverage, you will not be able to acquire reasonable coverage. While I believe that you could benefit from some cash value policy, the disadvantage is that your current cash flow would make this difficult to support while funding college. If things go wrong, you may be unable to keep up premiums and would lose coverage. This can be revisited in the future. Recommendation 8b: Purchase 10-year term on Nancy for $250,000. While the life insurance analysis shows you only need $230,000. It assumes that you will liquidate some assets to meet short term expenses. The only assets you could liquidate would be qualified plans. Additionally, there is a price break at $250,000. Advantages: David and Autumn would be able to grieve and not experience financial stress at the same time. Avoid liquidating qualified plans and incurring tax consequences Disadvantages: Minimal outlay plus time and irritation of applying for coverage. Alternatives: Insure only the minimum which would save about $35 per year. Do not cover risks at all or see if you can acquire group coverage through work. Issue 9: You are both concerned about long term care. You both said this is a concern, but you feel that, financially, you cannot address it at this time. You are currently both in good health with no indications that long-term care is needed. Recommendation 9: Postpone addressing that issue until age 56 but revisit every two years. 152 Financial Plan Development

165 Advantages: You are young to purchase coverage now and statistically will be able to purchase at age 56 Policies are still changing and insurance premiums increasing regularly so you could not count on a level dollar amount expenditure At age 56, you will have paid off all of your debt, college, and Autumn s car and be contributing the maximum to your qualified plans at that time Every two years we will look at financial and health issues and reconsider this strategy. Disadvantages: Health problems could arise that make it impossible for you to acquire coverage during this time frame Premiums may increase that could have been locked in or policies may not be as beneficial in the future Alternatives: In two to three years, when funds have improved, consider converting some life insurance into a variable life with a long term care rider. Issue 10: Your current legal documents will not meet your current desires. Your current legal documents were created 15 years ago and much has changed since then, including laws and the value of your estate. Additionally, now that Autumn is legally an adult, if you wish to be able to talk with her doctors or manage her finances if she were unable, you cannot do so unless she has legal documents giving you that power. As a matter of fact, you can t even do that for each other without appropriate documents. If something happened to the two of you, your current net worth is $465,742. But at a death, insurance policies become real value and your estate net worth is much higher. David s estate value today is $1,302,494 and Nancy s assets would be $562,208. After expenses and paying off debts, Autumn would inherit $1,522,392. That would be a lot of money for a young adult to manage, and Autumn could be vulnerable to unscrupulous individuals or simple youthful errors. For this reason alone, you should consider seeking the advice of an estate attorney. I will provide you a list Appendix A 153

166 of documents to assemble and some questions that you will need to discuss between you before visiting the attorney. Recommendation 10: Engage an estate planning attorney to draft wills with testamentary trusts and all of the following documents for the three of you. Estimates from attorneys I know run around $2,000. Living Will establishes your wishes regarding life-sustaining or lifeprolonging treatments in terminally ill situations Medical Power of Attorney appoints another person to make health care decisions for you when you are unable to do so. (Because Autumn is a legal adult now, you have no rights when it comes to her medical treatment.) Financial Power of Attorney - appoints another person or institution to handle your financial affairs when unavailable or unable due to mental or physical disability. Will even if you have more complex trusts, anyone who owns property needs a will. The two of you may need testamentary trusts. Autumn does not. Your attorney may suggest alternatives such as living trusts HIPAA Authorization allows specified individuals to have access to your medical information and discuss issues with your doctors. Without this, doctors may not discuss medical issues even with family. Advantages: In case of any issues such as medical problems, incapacity, financial issues while traveling, or death, your family could function effectively. You will know that your wishes will be implemented and your family protected in case of the death of either of you. Disadvantages: It will take time to work through the questions. It s not fun to think about death disability and medical problems (but of course it would be worse to try to address these issues while having a crisis.) It will cost approximately $2, Financial Plan Development

167 Issues 11: Your portfolio could be more efficient, getting a better return for the amount of risk you are taking. We cannot control what the market does, but what we can attempt to control is the amount of risk you are taking and try to find the right mix of assets. The mix of assets is important because some investments rise when others are going down. By mixing them together, we can keep returns more steady. This does work most of the time, but there are always periods where investments simply don t follow the rules, so it is important to monitor your financial situation on a regular basis. All of the risks and returns are hypothetical and are merely used to illustrate concepts and relative risk and return. The only thing I can guarantee is that your numbers will not match what is on this paper. The attached financial plan has numerous disclosures, which we have reviewed. Please keep these in mind as you read this material. Here is your current portfolio that can be reallocated and risk analysis. Your Present Portfolio: Projected Current Portfolio After Tax Net Return: 5.26% Projected Current Portfolio Standard Deviation: 9.01 Standard Deviation measures how much your portfolio will move. One standard deviation says that 68% of the time, it will vary by this much from the average after tax return of 5.26% In other words, in normal times, you would expect your returns to range from a return of -3.75% (5.26% return % standard deviation) to 14.27% ( ), but still averaging over time the 5.26% return. Projected Current Portfolio Sharpe Ratio:.31 The Sharpe ratio can be used to compare how well your portfolio or an investment does to other investments in terms of the relationship between risk and return in other words, how much bang for the buck (return for the risk) are you getting. Using the same asset class assumptions that we did for your current portfolio, we have created what we believe will be a more efficient portfolio. Our goal is to get you as much return we can for the amount of risk we are taking by trying to mix asset classes that our economists believe will have a better return Appendix A 155

168 for the amount of risk they are taking. We have a sophisticated program and experts who spend time working on this analysis in an effort to bring you the best advice we can. Recommendation 11: Implement the Moderate Conservative Portfolio until some of your debt is retired and emergency funds built, then increase the risk: Comparison of Projected Proposed Portfolio Current Portfolio After Tax Net Return Standard Deviation Sharpe Ratio The new portfolio would be comprised of: Advantages: % Category Total 2.37% Int. Term Gov. Bonds $ 9, % Corporate Bonds $134, % High Yield Bonds $ 48, % Large Value Stock $ 48, % Small Value Stock $ 64, % Small Growth Stocks $ 26, % International Stock $ 53,985 Your investment risk (measured by standard deviation) will increase slightly from projected 9.01 to projected but your return will also increase from 5.26% projected to 6.51% projected. (Remember these are based on asset classes, not specific investments, and are forward looking based on the current economy and anticipated changes.) The proposed portfolio would have a Sharpe ratio (the way we measure how much return you get for the amount of risk you take) of.40, which is slightly 156 Financial Plan Development

169 better than your current portfolio of.31. A slightly higher return between now and retirement will help you achieve your desired retirement income. Once you have some emergency funds rebuilt, we should reevaluate and consider even higher risk. Since all of your money is in qualified accounts, there will be no tax consequences for changing investments. Disadvantages: Increased risk means your portfolio will vary more than the current one. You could lose more money if the market drops just as you could gain more money when the market increases. Paperwork and time to move funds in your 401(k). I will provide the detailed list of what to move but you must make the calls. Alternatives: Move into higher risk portfolio now and hope that no problems occur before your emergency funds are built. Issue 12: Once your allocation is determined, we need to create a strategy for evaluating and selecting your investments. Recommendation 12: We set a separate appointment to develop your investment policy statement, which will drive selection of specific investments within the asset classes. Advantages: You will have a clear understanding of how we pick your investments, when you can expect to hear from us, how often we will be changing investments, etc. You will have the opportunity to make what is important to you incorporated into our design. Disadvantages: Crafting an investment policy statement takes time You will not be invested in the new portfolio immediately Appendix A 157

170 Alternative: We could implement the proposed portfolio immediately and then work on the investment policy statement. If you choose this alternative, I will prepare paperwork for rolling over old 401(k)s into an IRA, select the investments within the asset classes without your input, and send you forms to sign allowing me to implement along with instructions on what changes you should make with your 401(k)s. Issue 13: You are committed to providing for Autumn s college and delivering on your promise to purchase her a car at graduation in spite of changed circumstances. Commitments: $16,885 per year for the next three years paying off the current student loan of $15,386 $20,000 toward car at graduation Recommendation 13: Utilize a combination of available cash flow, stock purchase plan, and loans to pay for college. Make sure that the tax forms for deductions and credits are in your name by paying tuition directly and arranging the loans. Continue investing in the stock purchase plan, which receives a 15% discount on the price. At the end of one year (when it has become a long-term capital gain), sell the stock to pay down the student loans. The key will be to keep a lid on other expenses and not let the college and other debt pile up to greater than you can manage if things go wrong. Based on timing, Autumn s goals, and other debt, you may want to discuss an alternative to buying the car for Autumn immediately when she gets out of school, such as providing a reserve until she gets a job or a down payment on a condo when she is ready. Life changes and your real promise to her was more about supporting her rather than the specific gift. It is worth discussing. Advantages: You will not be drawing down any retirement accounts to meet these obligations You will be able to utilize the American Opportunity $2,000 tax credit 158 Financial Plan Development

171 The good news about student loans is that the interest is deductible (based on limits) The debt disappears at death (based on whose debt it is) Payments can be deferred Interest rate is currently fixed Many student loans allow you to defer payment until graduation but the interest keeps compounding. Disadvantages: Because of competing demands, initial years will be in student loans Once you have reserves built, debt paid down, and Autumn s new car paid off, you will be able to redirect those funds toward college debt, with the goal being to have it paid off by age 62. Loans could extend into your retirement if you defer loans. Alternative: Borrow some of the funds from your 401(k) to fund college. You would not benefit from increasing your 401(k) loan to the maximum of $50,000 and utilizing those funds to pay for most of this next year s college costs. The maximum savings would be under $200, and you would be giving up ability to defer loans, and face possible tax consequences. Another alternative is to gift the stock to your daughter and have her sell it in her tax bracket as soon as it is vested, but that may change your student loan abilities as it is considered 100% student asset, which is expected to be used for funding. Based on stock performance, we may want to evaluate this strategy once you have emergency reserves compiled and some of your debt reduced. Issue 14: You need to accumulate funds for retirement. Your lifestyle for just the two of you is modest and you believe that if you can enter retirement without debt, you could live on $6,000 per month including taxes if it grew with inflation. Additionally, you would like to be able to buy a car after 10 years of retirement and perhaps even a second one 10 years later. That lifestyle amount would not be able to support your current lifestyle because of the need to pay for medical insurance and other considerations. The good news is that you can retire with a Appendix A 159

172 more appropriate lifestyle with a few modifications. Your retirement success will be based on: No debt in retirement Moderately Conservative portfolio now increasing risk slightly in two years and then reducing to Conservative portfolio in retirement Assumed retirement age of 65 or later Target income above $65,000 with maximum $86,000 while both of you are alive and the survivor dropping to between $60,000 $81,000 Utilizing the best available Social Security strategy illustrated from assuming taking benefits at retirement to the best alternative currently of file and suspend. Increasing David s contributions now to capture the additional available employer match. Beginning contributions to Roth IRAs in 2019 and fully funding both of you (currently $5,500 per person) when debt retired and emergency funds accumulated. Increasing contributions to qualified plans as money frees up such as $1,732 starting in 2019 and another $4,427 starting in 2025 until retirement or if (when) stock option grants become vested. Annual reviews and adjustments to this plan and dedication to following it annually. Recommendation 14a: Increase 401(k) contribution by 3% You are leaving $1,800 of employer match in your 401(k) on the table; if you contribute another 3%, your employer will match half of that. Immediately increase your employee contribution by $3,603 per year and acquire the $1,800 company match. Advantages: By contributing 3% ($3,603) more to your qualified plans, you gain the employer s match of $1, Financial Plan Development

173 Creates federal and state tax savings of $1,377. Employer match and tax savings generate $6,780 value for the $3,603 contribution. There is no other way to generate this value. Helps put you on track for a successful retirement! You are working toward accomplishing your retirement goals AND saving taxes! Disadvantages: You will carry student loans much longer and it will take a year longer to build your emergency reserves. If an emergency occurs in the first three years, it will have been a poor choice. If the emergency does not occur in the first three years, the vested match on the employer money and increased account values will more than compensate. Alternatives: Pay the additional taxes and put more money toward debt and reserves now. If you do this you will need to increase your tax withholding by 90% requirement and use the balance to fund emergency reserves. You can pay any additional federal and state taxes from your savings the following April. Complete a projection for yourself in September using your TurboTax and send it to me so we can review your year-end options and discuss tax planning for next year. Recommendation 14b: Redirect savings as they are freed up into retirement plans. This strategy is illustrated in the attached spreadsheet. By doing this, you will achieve your goals and may possibly be able to retire earlier than the 67 you anticipated! Advantages: Increased goal combined with flexibility, reduction in debt and future contributions will allow you confidence that you will not be stressed about money in retirement. The Roth IRAs and qualified plans will give you flexibility and diversified tax advantages and available strategies in retirement Appendix A 161

174 Disadvantages: Tracking expenses and staying on top of your plans and targets take considerable time It is easy to resent giving up current pleasures for a secure retirement, especially when it seems so far away. Much of your success is dependent on employers and market returns. Alternatives: As you can see in the MoneyGuidePro report, there are many alternatives to social security strategies, Roth IRAs and qualified plan alternatives, portfolio alternatives, etc. Many of these strategies are those that will be addressed as cash flow frees up from current requirements. At that point, we will be evaluating them because the only thing we know is that different alternatives will emerge as situations change. My role is to stay on top of these. Issue 15: Your life and the world are constantly changing. Strategies that work with taxes this year don t work in a year from now. Changing inflation, economics, tax laws, spending patterns, and market returns make financial success a moving target. What I am showing you is one vision of how your financial issues can be addressed based on today s situation. We need to consistently reevaluate and create a new moving vision and track your success. Recommendation 15: Set up a review meeting for one year from now with phone calls on a quarterly basis. While the computer modeling allows us to look at success rates for various market returns, the best way to make sure you are on track is to monitor projections and progress every year or two. Advantages: By staying on top of strategies and problems, you can efficiently utilize your resources and most likely retire sooner than without attention to the detail. You will potentially avoid some unpleasant surprises because you will have been addressing risks, identifying problems and working towards solutions. We get to keep in touch! 162 Financial Plan Development

175 Disadvantages: Managing your finances and meeting with me takes time. (Just have to decide if you want to work longer so you don t have to address financial issues!) It s not always the most fun way to spend free time. Alternative: Schedule reviewed every two years. In summary, it is because of your excellent financial habits that you are in a position where you will be able to achieve your goals. You may not have all the toys your neighbors have, but you will most likely have something they won t: financial security! It is a pleasure working with you. This document may be lengthy, but I have found that after a year or so, you may forget some of the reasons for these recommendations and hopefully this will help answer some of the questions you may have. Please do not hesitate to call me with questions now or in the future. I look forward to seeing you for the update next year! Carol Craigie, MA, ChFC, CFP Appendix A 163

176 Sample Cash Flow Changes Tracking Cash Flow Changes Tracking for Dudella family Category Issues raised or uncovered Cash Flow Impact Cash Flow #1 #2 #3 Tax Planning #4 Current unallocated cash flow $28,000 $28,000 $28,000 Old debt payment $8,892 $9,228 $9,228 Restructure debt through 401(k) = 5 yr loan payments ($7,554) ($7,890) ($7,890) Refinance Mortgage - defer decision Target emergency fund of $50,000 - have $1,800 = $48,200 ($11,400) ($10,750) ($8,500) Federal taxes underwithholding ($5,939) ($5,939) ($5,939) State taxes underwithholding ($1,046) ($1,046) ($1,046) P&C Homeowners #5 Prepare home inventory & meet with agent - discuss: Home business coverage ($175) ($175) ($175) Jet skis & snowmobiles ($200) ($200) ($200) Attractive nuisances (horses) ($50) ($50) ($50) antique, guns, computers, ring ($100) ($100) ($100) Raise deductible to $1,000 $150 $150 $150 get combined review quotes $0 $0 $0 164 Financial Plan Development

177 P & C Auto Avg. discounts for joint coverage $100 $100 $100 Create inventory $0 $0 $0 #5 Increase deductible $100 $100 $100 P & C Umbrella #5 Purchase $1,500,000 ($200) ($200) ($200) Health/Employee Benefits #6 Review at open enrollment Disability Consider HSA plan in couple years #7 David ($1,425) ($1,425) ($1,425) Nancy ($951) ($951) ($951) Mortgage Rider ($425) ($425) ($425) Review expenses/create plan Survivor #8 LTC #9 Defer Estate Planning #10 Investments Life insurance David (need $1,500,000) ($588) ($588) ($588) Life Insurance Nancy needs $230,000/$250 for liquidity 10 yr ($150) ($150) ($150) Review expenses/create plan Attorney review & documents ($1,500) Review beneficiaries #11 Change asset allocation Appendix A 165

178 #12 Develop IPS College #13 College costs of $15,000 being borrowed or funded from stock options Loan payments schedule ($2,230) ($2,230) ($2,230) ($2,230) ($2,230) ($2,230) Retirement & other goals in retirement #14a #14b Annual Review Extra payments in future Contribute enough to get employer match ($3,603) ($3,603) ($3,603) Reduces federal and state tax by $1,377 $1,377 $1,377 Start Roth IRA - David in 2018 Start Roth IRA - Nancy More contributions to qual. plans in 2020 #15 ($1,000) ($1,000) ($1,000) Remaining Funds $ 83 $ 3 $ Financial Plan Development

179 Appendix B: Scoring Guide Executive Summary Scoring Guide Writing was clear and concise and used client language and emotional context where possible. Total plan was realistic, achievable and improves the clients financial situation within their cash flow constraints. Adviser clearly understood financial issues, concepts, important details, the power of assumptions, and pros and cons of various solutions. Areas covered with clear summary of issues, actionable recommendations, accurate advantages and disadvantages and alternative. These must be tracked in cash flow for three years and within budget. Cash Flow/Debt/Emergency Planning Property and Liability Planning Disability Planning Survivor Planning Portfolio Planning Income Tax Planning Education Planning Retirement and Goal Planning Estate and Legal Document Planning Oral Presentation Scoring Guide Communication Skills Adviser used confirmation skills and questions to determine client understanding of issue, recommendation and consequences of addressing or not addressing issue. Appendix B: Scoring Guide 167

180 Adviser acknowledged and incorporated client responses into the balance of the presentation. Presenter consistently used confirmation skills with client through each step of process to ensure client understanding (not just receiving false consensus). Client questions and feedback on potential solutions, including drawbacks, were solicited and addressed. Planning Knowledge Adviser knew the rules and features of any recommendation they made such as Roth IRAs, 529 plans, etc. Verbal explanation matched written plan and adviser could articulate accurately the facts surrounding the recommendation including tax consequences, rules for product, etc. When asked questions about the analysis, the presenter easily answered the client questions and demonstrated a thorough understanding of analysis process and important facts/assumptions related to their recommendation. Adviser shared that there was more than one solution and explained why their recommendation was chosen as the best solution. Potential and real drawbacks to recommended solution were explained. If asked a question for which the presenter does not definitively know the answer, presenter admitted it, helped client put consequences of lack of knowledge in perspective, and then adjusted recommendation where appropriate. (GIVING FALSE INFORMATION WILL FAIL YOU IN THIS COURSE. Admitting you don t know something will not.) Adviser exhibited high level of enthusiasm and confidence. 168 Financial Plan Development

181 Appendix C: Templates Executive Summary Template Executive Financial Plan Summary For Jim & Anne Dowler Prepared by: (INSERT OPENING PARAGRAPH INCLUDING REFERENCE TO CASH FLOW CHANGES TRACKING) Issue 1: Emergency funds While you have a good start on accumulating sufficient emergency reserves, your current amount would last 3.4 months without covering any additional out of pocket expenses for medical insurance in case of a job loss or medical expenses in case of an illness. Recommendation: Increase emergency reserves this year to at least 4 months of reserves which requires an additional $5000 deposited this year. Move the funds from the taxable money market to the Colorado municipal money market which has a better after tax return. Additionally, any tax refunds (estimated to be about $500 after changing withholdings) or found money should be dedicated to this goal, increasing it up to $33,000 over the next few years. Advantages: Increases your ability to handle any emergencies that come along. Using the municipal money market is more efficient with a better after tax return than your current money market. As long as one of you is working, this would cover six months of unemployment. Appendix C: Templates 169

182 Disadvantages: Funds invested in safe liquid assets earn less than those that have higher risk Alternative: Use Roth IRA to begin accumulating more emergency reserves beyond the current $25,000 because you can withdraw your principle at any time without penalty and the funds are protected from creditors. In that case, we would not count earnings toward your emergency reserves but principle only. (INSERT DEBT OVERVIEW DESCRIPTION) Issue 2: Credit card debt Issue 3: Mortgage Restructure (INSERT RISK MANAGEMENT OPENING DESCRIPTION) Issue 4: Homeowners Coverage Issue 5: Automobile Coverage Issue 6: Umbrella Coverage Issue 7: Disability Planning Issue 8: Survivor Planning (INSERT INVESTMENT OPENING) Issue 9: Portfolio restructuring (INSERT TAX PLANNING OPENING) Issue 10: Flexible Spending Accounts Issue 11: Gifting appreciated stock 170 Financial Plan Development

183 (INSERT EDUCATION OPENING) Issue 12: Tax Efficient Education Accumulations (INSERT RETIREMENT PLANNING OPENING) Issue 13: Retirement accumulation plan (INSERT ESTATE PLANNING OPENING) Issue 14: Your estate planning issues Issue 15: Your role in your parent s estate (INSERT ANNUAL REVIEW OPENING Issue 16: Returning for an annual review Appendix C: Templates 171

184 Cash Flow Changes Tracking Template Category Notes & Details Cash Flow Impact Cash Flow Year 1 Year 2 Year 3 Savings to be reallocated $9,900 $9,900 $9,900 Tax refund $5,600 Tax withholding change $5,000 $5,000 $5,000 Inheritance $5,500 Emergency Funds Goal 4 mo. reserves - add $8k this year -$8,000 Cash Flow cost of paying off credit cards -$6,158 Cash Flow increased from paying off cards $6,000 $6,000 $6,000 Refinance Mortgage Tax increase for lower mortgage P & C Homeowners P & C Auto P & C Umbrella Disability Survivor 172 Financial Plan Development

185 Estate Planning attorney fee -$2,000 Investments capital gains costs of diversification Tax Planning Flex plan Gifting Appreciated Stock 529 plan contribution 529 tax savings 37.3% Retirement & goals in retirement Net changes to cash flow $15,842 $20,800 $20,800 Appendix C: Templates 173

186 References Below are some of the helpful websites related to the topics covered in this text: Find important tax and annual limits updates and information about our Graduate Studies Program and other designations. Nerd s Eye View to find timely comments on industry issues. The official website and resource for ethics, test information and issues important to CFP certificants. The Financial Planning Association is the premier association for planners and has great connections to keep current. A secure, free cash flow tracking program that helps clients (and their planners) know where money is going and suggestions for saving it. A nonprofit Council on Disability website that provides up-to-date statistics and testimonials about disability and its impact. Provides an advanced life expectancy calculator to predict date of demise (Social Security website has one also). A government website that provides accurate and timely information about long-term care issues. The Center for Disease Control and Prevention, providing information about life expectancy. Insurance Information Institute, providing good information on understanding property and liability insurance. Everything Social Security. Everything on Medicare that you and clients need to know. 174 Financial Plan Development

187 About the Author Carol Craigie, MA, ChFC, CFP is a psychologist turned financial planner who has broad experience in the wealth industry. She was a successful producer and sales manager who personally closed over $74 million in investments in one year utilizing the financial planning process while working for Norwest Bank. Carol became the Director of Financial Planning for several large organizations including Wells Fargo, JPMorgan Chase, and Key Bank, where she designed, implemented, and supervised multilevel financial planning services with thousands of advisers, brokers, trust officers, insurance representatives, portfolio managers, and client wealth advisers. When Carol retired from managing planning in large institutions, she became a consultant on behavioral economics as it applies to financial planning and a full-time professor with the College for Financial Planning, where she has designed and teaches their CFP capstone course, Financial Plan Development. Special thanks and recognition to Joe Clemens from Wisdom Wealth Strategies, who is an adjunct professor, Enrolled Agent, CFP certificant, excellent planner, and active FPA member who was extremely helpful in reviewing this textbook! About the Author 175

188 Index Analysis of current portfolio, 66 model portfolios, 70 tax consequences of shifting portfolios, 74 Cash flow, 22 emergency funds, 22 savings habits, 31 Cash flow statement, 13 Client communication, 1, 119 behavioral economics, 122 confirmation questions, 121 Data gathering, 3 Debt analysis, 24 consumer debt, 24 debt strategies, 27 mortgage options, 29 Determining scope of engagement, 1 Economic, political, and regulatory changes, 114 Education planning, 86 Estate planning, 106 analyzing the client s estate, 106 asset titling, 111 basic legal documents, 109 beneficiary designations, 111 executor/power of attorney, 112 Executive summary, 116 Financial planning process, 1 analyze and evaluate client data, 18 determining scope of engagement, 1, 17 developing and presenting recommendations, 20 gathering data, 3, 17 implement and monitor the plan, 21 Investment planning, 60 portfolio considerations, 60 Oral presentation, 125 Portfolio considerations, 60 client expectations, 61 client expectations, 63 for clients, 62 required characteristics, 60 risk tolerance, 65 uncommon issues/impacts, 61, 64 Retirement planning, 91 assumptions and facts, 92 calculating retirement need, 93 recommending a retirement savings program, 103 Risk management, 32 automobile insurance, 35 disability insurance, 39 analysis, 41 health insurance, 57 homeowners insurance, 33 life insurance, 54 property and liability issues, 33 umbrella policies, 37 Social Security, 97 Statement of financial position, 12 Summary of assumptions, 14 Tax planning, 78 FSAs, 83 identifying opportunities/concerns, 81 projection for this year, 78 stock gifting, Financial Plan Development

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