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Archive for November, 2010

What could possibly link the children’s story of Watership Down, Thanksgiving turkey and retirement investing risks?

Well, my mind works in strange ways (just ask my wife and I’m sure my 15-month old Spencer agrees as well).

Buy and Hold – A Broken Promise?

After all the troubles in the stock market and in financial markets in general over the past couple of years, I was recently rereading an article in the trade magazine, Journal of Financial Planning. In the September 2009 issue there is a book excerpt by Ken Solow, CFP (R) entitled Buy and Hold is Dead (AGAIN): The Trouble with Quant Models.

Over the past couple of years there has been much written about Buy and Hold investing. You may be familiar with the concept as an approach to investing that focuses on selecting an investment (stocks, bonds, mutual funds, real estate) and simply holding on through good times and bad.  Occasionally, you should rebalance back toward some strategic assert allocation to reduce or minimize certain risks.

The reasoning behind this is simple: humans are bad at financial decisions and by adopting this approach you can take the emotion out of investing.  Too often, we tend to make important decisions with little information and rely on emotions like fear or greed.  In fact, Warren Buffet, investor-extraordinaire of Berkshire-Hathaway fame, has said this many times and by doing the opposite of what the masses do he has amassed a fortune for himself and his investors.

For many, buy and hold was discredited after the great Financial Meltdown that tipped us into the Great Recession.  All asset  classes – whether large company stocks, small company stocks, stocks of foreign firms, bonds from companies large or small and bonds issued by sovereign nations – went down.

Most investors feel cheated, angry and worse. This buy and hold approach was advertised as a way to minimize risk.  Unfortunately, most investors probably misinterpreted the idea of minimizing risk and thought that it eliminated the downside volatility.

As I often say to clients, we know there will be sunny days and rainy days.  Risk management means carrying an umbrella and maybe wearing a rain coat as well.  But just because you are using one or both of them doesn’t mean that you won’t get wet.  You’ll just not get soaked like the guy who’s running from the street curb toward the office door with nothing but a newspaper over his head.

It’s true that Buy and Hold will help take the emotion out of investing. Over the long-term, the Ibbotson Charts will show that all asset classes have gone up since 1926 until now even after the meltdown.

That provides cold comfort to the retiree who is just about to start withdrawals from his portfolio to supplement his retirement income and lifestyle.  There were many who saw their investments drop 30%, 40% or more.  And while their portfolio may have bounced back some with the market rally and over time the market may continue to rise, they just don’t have the time to wait.  They have to start taking out money now.  And each time they take out money to live on, there is less in the pot to grow.

This has happened before.  Remember Enron.  Remember Lucent Technologies.  On one day someone is a paper millionaire.  Fast forward and the companies are in the tank (bankrupt in the case of Enron) and your retirement dream is a nightmare. If you’re at the tail end of a 25 year career, you really don’t have the time to make it up but have to make do with what you have. (Even for these folks, not all is lost and there are things one can do to sustain a retirement as I noted here in a previous post. And I’ll be talking about sustainable withdrawal rates in another post on retirement income planning.)

For the rest of us, there is a lesson in there. And this is where Watership Down and Thanksgiving turkey come into play.

Buy and Hold, Modern Portfolio Theory & The Illusion of Math

Buy and Hold is based on the quantitative model of Modern Portfolio Theory (MPT) first devised Harry Markowitz more than 50 years ago.  Such quantitative models are based on lots of mathematics.  The formulas are complex and elegant.  They are beyond what most of us are comfortable with but they do provide a sense of security.  You input numbers from data on various asset classes and a very precise number comes out the other side of the black box.  This provides a sense of security.  Instead of relying on something subjective like your instinct or your gut feelings, you can put your faith into something objective like the science of math and finance.

Over the past few years and principally from the mid-1990s until our recent meltdown, we have come to rely on ever more complex quantitative models. These complex models drove the markets in real estate and mortgages as we relied more and more on the black boxes of the financial engineers.  But theories are only theories and models are only as good as the assumptions and data used to create them.

A chain is only as strong as its weakest link.  And a model is only as good as the assumptions behind it.  All models are based on past events. And even though we are warned that “past performance is no guarantee of future results” we rely on these backward-looking, statistically-based models for predicting our futures.

In a normal world, the behavior of markets and investors can be assumed pretty well. But in panics, all bets are off.  No amount of modeling can predict how presumably reasonable people will act but it’s safe to say that human nature’s fight or flight syndrome kicks in hard.

Watership Down – A Lesson from Spencer’s Bedtime

What happens is that things go along and work until they don’t.  Assumptions are assumed to be fine until they need to be revised. When I was reading Watership Down there is a scene where the protagonist, a wild rabbit, encounters a number of other well-fed white rabbits.  Our hero tries to get them to follow him but to no avail.  The tame rabbits live in a fine world where they are provided plenty of food, water, shelter and care.  What more is there to go searching for “out there?”

The Thanksgiving Turkey

Our false sense of security and belief in a system like MPT or Buy and Hold can be illustrated in the tale of the Thanksgiving turkey.

As retold by Nassim Taleb in The Black Swan:

Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey:  It will incur a revision of belief.

Unable or unwilling to question its beliefs, the turkey was lulled into a false sense of security by his daily reinforcing experiences. Like the tame white rabbits in Watership Down, the turkey’s world is looking good and life is great.  So much so that neither even think about ways to escape.

At least in the animated movie Chicken Run with Mel Gibson (another soon-to-be Spencer favorite), the chickens are led to question their assumptions about life on the farm and plot ways to escape.

What We Learn from Bedtime Stories for Investing

What we learn from these stories is that just because things have worked in the past, doesn’t mean that they are absolute truths that will hold in the future. The most dangerous thing that an investor can do is simply accept with blind faith the assumptions of the past.  In a changing market, there’s nothing scarier than conventional thinking.

Theories are only theories and while it may seem like heresy to question assumptions, it’s in your best interest to do so.

Does this mean abandoning Modern Portfolio Theory or Buy and Hold? No.

It does mean that it makes sense to add some human judgment to the mix.  Good models can work even better with common sense.

Like the counter-culture of the 1960s would teach, you as an investor will do best to question authority and question assumptions.

Use an Investment Policy Statement as a Better Road Map

Here with the aid of a qualified professional you can walk through and create a personalized investment policy statement as a road map for investing decisions.

Such an approach can combine the quantitative tools to be used along with the more qualitative, value-based criteria that can be combined to help in the investment selection and portfolio management process.

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It’s easy to get tripped up in retirement.  I’m reminded of the expression by the octogenarian to the recent newlywed fretting about life but rejecting out of hand the advice of his experienced senior:

A long time ago I was where you are now.  And later you’ll be where I am now.  But just as you haven’t been your age before, I’ve never been old before.

So for new retirees who “not been there or done that” it’s a whole new world filled with possibility and pitfalls.

Transitioning

Most retirees have an imperfect vision of retirement at best.  And if it hasn’t been discussed or communicated, it could be vastly different from that of your spouse.

Finding meaning in a post-work world can be a real challenge.  If your identity has been wrapped up in what you do, then you might now feel lost.  Your social networks might change.  Your activities might change.

It’s important to reassess your values and envision how you want to live in this next chapter of your life.

Initially, there may be more travel to visit family, friends or places.  You may want to tackle that “bucket list.”

But to live a truly fulfilling and rewarding retirement may require you to take stock in yourself, your values and what gives you meaning.  You may benefit from working with a professional transition coach or group that can help guide you through this period of rediscovery.  One such resource can be found here at the Successful Transition Planning Institute.

Lifestyle Budget

Typically, most retirees may take the rule of thumb bandied about that you will need from 60% to 70% of your pre-retirement income to live on in a post-retirement world.  This is because it is assumed that many expenses will drop off:  business wardrobe, commuting to work, professional memberships, housing, new cars, etc.

The reality is far different.  According to research conducted by the Fidelity Research Institute 2007 Retirement Index, more than two-thirds of retirees spent the same or higher in retirement.  Only eight percent spend significantly lower and about 25% spend somewhat lower. The Employee Benefit Research Institute  reported in its 2010 Retirement Confidence Survey that while 60% of workers expected to more than half of retirees didn’t see a drop in retirement expenditures while 26% of this group reported that their spending actually rose.

It all depends on your goals, lifestyle and what curve balls life throws at you.  If you have adult children who end up in a financial crisis of their own caused by job loss, health issues or divorce, you may be spending more than you expected to help out. Maybe the home you live in will require higher outlays for maintenance or to upgrade the home so you can live there independently. In reality all of that travel and doing things on your bucket list will cost money, too.  So it’s more the rule than the exception to expect spending to increase while you’re still healthy to get up and go.

Over time, the travel bug and other activities will probably decline but even after that these may be replaced by other expenses.

Healthcare

There is an old saying that as you get older you have more doctors than friends.  This is a sad reality for many including my parents.

My father is on dialysis and has complications from diabetes.  His treatments probably cost Medicare (and ultimately the US taxpayer) more than $30,000 each quarter as I figure it.  He takes about 13 prescriptions each day and enters the dreaded “donut hole” about mid-year each year. At one time their former employers (a Fortune 500 company) provided medical insurance benefits to retirees but that became more and more cost prohibitive for their employer and for my parents as premiums, co-pays and deductibles rose.  So now they rely on a combination of Medicare and Blue Cross/Blue Shield and a state program called Prescription Advantage.

As private employers and cash-strapped state and municipal governments tackle the issue, you can expect to pay more for your health care in retirement.

Wealth Illusion

It’s not uncommon to feel really rich when you look at your retirement account statements.  (Sure, the balances are off where they may have been at the peak but it’s probably still a large pot of money). The big problem is that retirees may have no comprehension about how long that pot of money will last or how to turn it into a steady paycheck for retirement.

In reality the $500,000 in your 401k or IRA accounts may only provide $20,000 per year if you plan on withdrawing no more than 4% of the account’s balance each year. Then again if you take out more early on in retirement, you could be at risk of depleting your resources quickly.

Misplaced Risk Aversion & The Impact of Inflation

So as you get older, you’ll be tempted to follow the rule of thumb that more of your investments need to be in bonds. Although this may seem to be a conservative approach to investing, it is in fact risky.

Setting aside that this ignores the risks that bonds themselves carry, it is ignoring the simple fact that inflation eats away at your purchasing power.  Even in a tame inflationary world with 1% annual inflation, a couple spending about $80,000 a year when they are 65 will need over $88,000 a year just to buy the same level of goods and services when they turn 75.  Given the potential for higher inflation in the future that may result from a growing economy and/or current monetary policy, investments need to be positioned to hedge against inflation with a diverse allocation into stocks and not just bonds even when in retirement.

The other risk is trying to play catch up.  As a retiree sees the balances on his accounts get drawn down, he might even be tempted to “shoot for the moon” by investing in illiquid investments like stocks in small, thinly traded markets or in sectors that are very speculative.

Ball games are one by base hits and consistency on the field and at the plate.  Home runs are dramatic but not a sure thing.

Underestimating How Long You’ll Live

We all want a long and productive life.  Many will even say that they don’t want to live to be a burden to their families.  But here again the reality is that most folks do a bad job of guessing how long they’ll live.  A report by the Society of Actuaries notes that 29% of retirees and pre-retirees estimate that they’ll outline the averages but in fact there is a 50% chance of outliving them.

So while they may have enough resources to carry them through the average life expectancy, they will not have enough when they live longer than the averages. And if a couple attains the age of 65, there is a better than 50% chance that at least one of them will live into their 90s.

Given the fact that most women become widows at the age of 53 (Journal of Financial Planning, Nov. 2010), this has a big impact on the availability of resources for retirement.  Too often, a short-sighted approach to maximize current retirement income from a pension is to choose the option that pays the highest but stops when one spouse dies. All too often this puts the widow who may live longer without a reliable source of income to provide for her.

Conclusion

Too often people underestimate how long they will live in retirement, how much they will actually need for living in retirement and how to invest for a sustainable retirement paycheck using appropriate product, asset and tax diversification.

Many people do not save enough for their own retirement.  The social safety net providing support for old age income and healthcare may not be enough to maintain a desired lifestyle.  Women need to understand the risk of living long into retirement and manage resources accordingly.  And because more than 40% of Americans are at risk of retiring earlier than expected because of job loss, family care needs or personal health, there is a real need for proper planning to address these issues.

While retirees will benefit from having a good plan and road map before the final paycheck ends, it’s never too late to start. And for the newly retired with the time to address these issues, now’s as good a time as any to speak to a qualified professional who can help.

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Black Friday is traditionally the day that can make or break a retailer’s bottom line.  But don’t let enthusiasm for the season, the sales or the advertising hype end up putting you into the Red.

Black Friday is here.  Even before you may have had a chance to digest your Thanksgiving feast or recover from a day of football, you may have already been lured into the local mall.  Maybe you were one of those early bird shoppers preparing for a marathon day of shopping at 1 AM.  (It’s not too late to consider these tips for the rest of your shopping season or to teach your kids).

I was not one of them.  I slept in and have probably missed a host of specials and discounts on every imaginable thing sold. While I don’t feel bad I know that I’ll probably be picking on the leftovers like a I will be with the Thanksgiving turkey in the refrigerator.

Although I’m not the best marathon shopper, I thought I’d share a few tips that may help you avoid turning this holiday’s shopping season into a budget-busting hole for your family budget that you’ll be paying for and digging out of long after that snazzy do-dad you bought for Uncle Charlie is lost or breaks.

Have a Budget

No one says that you have to go and take out a second mortgage on your home to buy gifts for the entire world (that’s even assuming that you can qualify for a Home Equity Loan or HELOC).

It’s probably reasonable to budget somewhere around 1% of your gross income for holiday purchases of gifts for others in your family and friend network. Unless you’re buying an engagement or anniversary ring for your significant other, there’s no need to bust the budget here – even then there are limits. (And you really should not be spending more on stuff than you’re putting away in your IRA or 401k).

Are you afraid you’ll be considered the cheap skate relative or office mate? Who cares?  Are those folks going to bail you out if you’re in financial trouble?  Do you really want to be one of the folks who’s still paying off the credit card charges you incurred for this holiday by the time you serve next year’s Thanksgiving turkey?  All of those great savings you got will simply be replaced by interest charges on the balance you carry.

Gifts are barely remembered while memories of sharing time with friends and family have more meaning to most folks.

Make a List and Check It Twice

Just like Old Saint Nick, you should prepare a shopping list. Have a written list of who’s going to be receiving gifts.  If you know them well, you can jot down a few ideas of types of gifts to try to find.  Before you even open up your web browser or step foot in the store, get this done.  Without a list you’re more likely to become an impulse buyer.

Have a Shopping Plan

Experienced shoppers know that it pays to have a plan of attack when those doors open.  You’ve been scouring the newspaper inserts (you do still get the newspaper, right?) and browsing the websites.  You’ve been in the stores before and know the floor layout.  You can bypass all the stuff you don’t need and just go straight to the department in the store where that perfect gift for Aunt Sally is.

Hey, store merchandisers know that you’re only human and easily distracted.  That’s why they’ll stack up stuff near cash registers.  That’s why grocery stores force you to walk through the entire store to get to the dairy case and that quick stop to pick up milk costs you $30 because you pick up a “few things.”

I prefer to use shopping sites that will find and compare items.  Whether you use Amazon.com or MySimon.com or a host of other shopping robots, you can narrow down the price range to expect to pay for an item.  And for the Smartphone set, “there’s an app for that.”  You can download an app that will allow you to scan a product’s UPC which can then pull up product information and comparative prices.

Consider Charity

You might want to give back instead of simply consume.  Sure, we need consumers to buy more stuff to get the economy moving again (we also need corporations to invest their $2 trillion in cash back into their businesses by buying equipment and hiring folks but that’s a different discussion).

But nothing says that you have to stimulate the economy single-handedly.

There are causes and people who need your help throughout the year and providing a donation in lieu of a gift made in China will help them, make you feel good, provide you with a tax deduction, and reduce our trade imbalance which will ultimately improve the strength of the US dollar.

Remember the Spirit of the Season

What do you really want your family to remember about the season?  What values do you want to pass down to your children or grandchildren?

Sure, it can be all about the ostentatious display of holiday lights and some of those displays are really nice and others are just way over the top.

Sure, it can be about buying the biggest, best new shiny thing.

I’m not trying to be Scrooge here. Far from it.  I believe that the holiday is about family and friends.  And more particularly, I think that playing Santa for young kids is magical – for you and them.

When I was growing up, my brother and I typically received one gift each from our parents, aunts, uncles and grandmother. And after we opened them up, our parents let us keep one toy out to play with while the others were put away so we didn’t end up overly distracted and bored with the toys all at once.

On the other hand, I remember going to a cousin’s house and they had TONS of packages under the tree.  Their parents would wrap all sorts of little stocking-stuffers – candy, marbles, even tooth paste and socks.  It was all about showing the quantity of gifts even if they were mundane, everyday sort of things.

I think that I enjoyed our holiday more and better because we weren’t focused on tearing off lots and lots of wrapping paper.

And I think that’s what I want my soon-to-be 15-month old son, Spencer, to take away as part of his understanding of the holiday and our new family’s traditions.

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It’s natural for investors who are still skittish after a decade-long roller coaster ride with the stock market and plummeting real estate values to be risk averse and seek out investment alternatives for protecting their nest eggs for retirement, college funding or simply their emergency cash.

And where there is demand, there will be supply.  So naturally, financial firms will design products geared toward satisfying this demand.

One such product that’s getting more attention recently are Market Linked Certificates of Deposit (CDs).

These are in essence a savings product designed to provide a minimum guaranteed interest rate plus the opportunity to increase the return by linking to the return of a specific market index or in some cases an index for inflation.

Such products are part of the larger class of “structured products” produced by investment banks that can come in many flavors and various strategies:  reverse-convertibles, principal-protected notes, Exchange Traded Notes.  They essentially are debt bundled with a derivative and marketed as a way to bet on stocks and interest rates as a way to manage certain risks. All offer in one package strategies using some sort of derivative and may offer a combination of principal protection, risk reduction and/or enhanced returns.

Recent surveys of more than 17 brokerage firms and more than 38 million investors show that most of these products are used by those with under $500,000 in investable assets.  For those with assets between $250,000 and $500,000, about 1.5% of their assets are placed in such products which is slightly higher than the 1.33% of assets for those with under $250,000 to invest.  (Investment News, 11/15/2010, page 52).

More than $70 billion of such products are held by investors with more than $42 billion bought in 2010 according to Bloomberg data.  And given continued uncertainty about the markets, the demand looks like it will not be abating any time soon especially as financial marketing organizations use investor fears as a selling point. Brokers and banks often receive higher fees and commissions for selling such products.

Keith Styrcula of the Structured Products Association said in a recent interview “these kinds of investments have become so attractive because people can no longer trust stock market indexes to go up.” He added that “there’s a lot of fear in the market right now, and a lot of investors don’t just want one-way exposure anymore.”  (Investment News, 11/15/2010, page 51).

But even though these products are marketed as a way to reduce risk they are not risk free.  There is no free lunch and this is no exception. Such products are subject to liquidity risk, market risk, credit risk and opportunity costs.

Market-Linked CDs are a form of principal-protected note offered by an investment bank.  These are not your Grandmother’s bank CDs.  First, such notes are offered as debt of the sponsoring institution so there is always the potential of credit risk.  Think of Lehman Brothers which was a large producer of such notes.  If the issuing firm fails, as Lehman did, the investment is at risk. While there is FDIC-protection on the principal, that may be small comfort when dealing with the time frame to get access to your money through a FDIC claim process.

They may involve a complex strategy which may be buried in the details of the offering’s prospectus.  For market-linked CDs, for instance, the issuer offers the downside protection by managing a portfolio of Treasury bonds (like zero coupon bonds to meet the projected maturity date of the CD).  The upside potential that is offered comes from investing in the bond yield through various strategies.

In such a low interest rate environment, these notes work only if provided sufficient time for the issuer to implement its strategies.  This is one reason that such CDs typically have long lock up periods that can be five years or more.

An issuer may guarantee a minimum interest amount but this is typically not FDIC-insured.  And this is really an obligation of the issuer so that’s where the credit risk comes into play. And you should note that the minimum guarantee usually only applies when the investment is held to maturity.  An investor will lose this guarantee by redeeming before the contract maturity date. And because of the nature of these products, there really is no secondary market around to allow someone else to buy you out early.

The upside potential is calculated based on the performance of the index chosen.  The CD investor does not own the index or the stocks in the index.  The issuer uses its money to invest and potentially reap the dividends issued as well as the appreciation.

What the issuer offers to the CD investor is a certain percentage of the upside gain of the index (called a participation rate) but limited by a ceiling (called a cap).  This calculation of the gain can be convoluted for an investor to understand. While it’s pretty simple to understand a typical CD (put $1000 in at an annual interest rate of 3% means you have $1,030 at end of the period), the same is not true for market linked CDs.

Your gain may be based on an average (so now the question is how are they calculating that average: monthly,  semi-annually, annually, term of the CD) or a Point-to-Point calculation. (Example: If the market index is 1000 when the account opened, went up to 2000 after one year but drops to 1050 by the maturity date, then the point-to-point is from 1000 to 1050 or 5% in this case).

In many ways these are similar to other structured products like market linked annuities (sometimes referred to as index annuities or equity-indexed annuities).

I addressed many of the same issues about calculating returns and possible risks in a post on the subject a while back.

Bottom Line:

Whether or not such products make sense for your personal portfolio really requires a good, long chat with a qualified financial professional. Like any other investment, the potential risks and opportunity costs need to be weighed against your personal goals, time frame, liquidity needs and the potential offered by other alternative options.

So if you are considering such products, just be aware of all the risks and look beyond the marketing brochure at the local bank.

Resources:

SEC Investor Education on Market-Linked CDs

MoneyLinkPro Blog Post on Market Index Annuities

Wikipedia Definition

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There are so many choices and ways to pay for college.

Let’s look at an overview.

In general in comes down to this.  Find a school and a program that fits your needs and learning style.  Do whatever you can to limit the amount of time you need to stay on campus. Take advantage of every opportunity to work, get financial aid or qualify for scholarships.

You can reduce the time you’re enrolled by getting advanced placement credit for some courses.  You can do this through testing while still in high school or you can apply for classes at the local college that can possibly transfer to the school you enter.  You should also consider taking classes during summer break to accelerate your graduation date.

For financing, consider this:

  1. Choose a school that offers a great financial aid package: There are database search tools that will provide you with a comparison of the kinds of aid packages available.  You can access one of these tools through the Clear View website here.
  2. Consider a state school: Tuition is lower for instate resident students allowing you to save a bundle. If you like a school’s program but you live out-of-state, consider finding a way to qualify for in state residency.
  3. Work during school and more during the off-season: By working an average of 20 hours per week you can earn enough to cover most books, fees and equipment as well as pizza and beer.
  4. Find scholarships:  Getting someone else to pay for school is a real bonanza. So don’t underestimate the value of searching out scholarships.  Many go unclaimed each year.  You can start your free search at www.scholarships.com or www.collegeboard.com under the “Fund Finder” section.
  5. Consider post-college service programs:  By joining certain community service programs some or all of your student loans may be forgiven.  So consider working in an inner city neighborhood program like CityYear or teach.
  6. Borrow if you have to:  While Shakespeare said “neither a borrower nor lender be,” sometimes you can’t avoid it. So here your options are many and varied.  Over 71% of college aid comes in the form of loans.  To navigate your way through this contact a qualified financial planner who can help.

If you follow these steps, you can minimize the amount of debt you or your student will be burdened by.  And your retirement nest egg will remain intact as well.

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Let me offer the classic unsatisfying answer:  It depends.

Before you offer your John Hancock you should understand the risks involved.

Just like any other financial decision, it’s best to try to do this without the emotion, drama and angst that can complicate a relationship.  Easier said than done, I know.

But like your investments, you should do your own due diligence and follow your own values.

Sometimes it’s absolutely necessary to get a cosigner for a loan, credit card or apartment lease.  The best terms are offered to those with the lowest credit risks.  A credit card issuer, mortgage lender or landlord will rightly offer someone with an established good credit history and deeper pockets a whole lot better set of terms than a newly minted college grad or someone with a bunch of blemishes on their credit report.

I remember a favorite uncle of mine.  He was single, very responsible with money, a great saver.  He once went to buy a car but needed a younger nephew to consign for him for the auto loan because our uncle had no established credit.  He had paid cash for everything all his life making him an invisible man to a loan underwriter.

I also remember once walking across campus and a friend stopping me as I passed the financial aid office.  He asked me for a favor.  He needed a cosigner for his student loan and it was my lucky day to be the guy to help him.  Don’t worry about a thing, he told me.  I’m good for it, he had said.

Luckily he was but that’s not always the case.  The FTC reports that three out of four cosigners are asked to pay because the primary borrower hasn’t.

Know the Risks

There are risks in life and in every decision we make.  It’s not a matter of avoiding all risks but managing them, understanding them. Don’t just think that you can walk away once you’re on the hook for the loan.  Just because your signature may not appear first doesn’t mean that you won’t be the person they turn to collect the debt.

Landlords typically require a parent to cosign on an apartment for a child.  They know if the kid skips or the keg party gets too wild that Mom and Dad will not want to risk their good credit and will be there to cover the bill.

Remember that each loan or credit card you have will have an impact on your own credit score.  The payment history and amount utilized compared to the maximum line of credit can have a potential adverse impact on your own credit score.

And the amount of the debt will be counted as if it were your own.  This may make it difficult or impossible to get a loan when you need one.  I had a client who had cosigned for a car loan for her adult son.  The son has made every payment on time.  But when his mom applied for a home equity line of credit the car loan fixed payment was included in calculating the underwriter’s debt ratios.  Combined with her other debts it was enough to push her over the maximum qualifying debt ratio allowed resulting in a loan decline.

Put Yourself in the Lender’s Shoes

If you treat this like an investment or a loan, you should be prepared to ask questions.

You should be asking the same sort of questions that any would.  Why do they need the money?  What’s the default risk? Can they afford the debt?  How will they manage to pay it back?

Curb Your Enthusiasm … Set Limits

Like all financial decisions, consider the risk and find ways to limit it.

For a credit card you can request that the limit be set low so that the card can only be used for emergencies and not big ticket discretionary purchases that will leave you on the hook.

For apartment leases with roommates, make sure that all the parents are also listed on the lease so you’re not the only one that the landlord will call when there’s a problem.

For other large ticket items requiring a loan, consider being listed on the title for the car for example.  If there is a default, you’ll have the right to sell the car.

At the very least you can ask to receive duplicate statements so that you can monitor that payments are being made as promised.

For larger loans like a mortgage, you may even want to consider offer your help in the form of an intra-family loan.  There are services that will manage the payment processing so that it avoids getting ugly if there ever is a payment problem.  Just remember that if you choose to lend a hand to someone to buy a home in this way, they will need to declare it on the application as a debt and they’ll have to qualify for the new loan with this payment as well.


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Secrets are dangerous.  Money secrets can be the worst kind for families.  What should you do if you have a child struggling financially or just needs a helping hand when it comes time to buy a home?

The trend toward “boomeranging” among newly minted college graduates to return to the family nest is a well-known phenomenon. With persistently high unemployment and an ongoing crisis in real estate, it’s now not uncommon to hear of adult children with families of their own seeking a helping hand from parents.

This is certainly not something that was on the radar screen when thinking about retirement.  But more often I’m hearing of parents at or in retirement helping out their adult children who in turn are trying to help out their college age kids, too.

In the past, when I was a mortgage banker I would often need to ask about the source of a down payment for a home purchase.  Many times I would hear that mom and dad or a grandparent or uncle would be helping out to fill in the gap.  Sometimes I would make the suggestion and probe to find out if there was any chance for a family gift.

Because of lending rules, there was a certain way that such gifts needed to be documented.  On more than one occasion, I would find a family member who was not just reluctant but downright belligerent about sharing any information needed to document the gift.

Other cultures while just as secretive were more willing to provide such a helping hand. I found that it was especially common for those who were part of first generation immigrant families to gift money to family members literally from money stashed away in coffee cans and mattresses.

Many people may find it easier to talk about health or sex problems than to talk or share information about money.

Unfortunately, this kind of climate perpetuates poor money management skills.

If you’re in the fortunate position to have extra resources to help a child or family member, then you should consider it a “teaching moment.”

Yes, there are those who will say that it’s your money and you don’t have to tell anybody about what you’re doing.  But consider this:  You could be sowing the seeds of some kind of rift between family members if not know then later when you pass away.

The key here is communication. While you don’t have to tell your children to the penny what kind of gift you’re planning, you should inform them so as to avoid hard feelings later.  Your kids probably know that you wouldn’t offer if you couldn’t afford it.  They may even recognize that one child is in tougher straits than others or that they have other resources as a safety net such as their own in-laws if need be. But don’t assume anything. If they have your best interests at heart, then they may just want confirmation that you aren’t putting your own financial security at risk.

Back to the teaching moment.  Here is an opportunity to ask questions that may help them think about what they are doing.  Are they short on cash because of something beyond their control or do they have trouble handling money?  Are they gambling or overindulging?  You could impart some added wisdom from experience here such as when my aunt told my mother about how she always saved any raises she got instead of counting on it for spending money.

I’ve had a couple of clients who invested money in their son’s businesses.  Each formalized it with a loan agreement and an equity stake. If it’s a business, then treat it like one.

If it’s help for a home purchase, you could help provide some perspective.  Is this really a good neighborhood to invest in? Are there problems with the property that will become an issue when trying to resell later? (Think here about the time you bought the house with the shared driveway).

Remember to be equitable with your family.  You don’t have to offer help in equal amounts since every child’s circumstances is different.

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All your ex-es may live in Texas as the country song says but do you really want your hard-earned money to follow?  And you may be a generous sort but would you rather have your wealth pass on to your family or Uncle Sam?  More examples of smart people doing dumb things when it comes to estate and legacy planning.

What do you think of when someone says “estate plan?”

If you think that it’s only for “old” people or those with lots of money, then think again.  If you have someone or something you care about, then you need a plan regardless of age or the amount of money involved.

Honey, I forgot the kids …

Think of Ana Nicole Smith and her infant daughter.  Think about the King of Pop, Michael Jackson. Take away the money and there is still the drama about custody and guardianship for the children that could have been avoided with a proper plan.  And this sort of thing happens daily with families of much lesser means but the same need for care of a loved one.

There is an old saying:  Those who fail to plan, plan to fail.

What Estate Planning Really Means to You and Your Family

The easiest definition of estate planning is controlling how and who gets what you have when you pass away or become disabled.

As estate attorneys in the Esperti Petersen Model define it:

Estate planning provides the ability to:

  • Give what I have
  • To whom I want
  • When I want
  • The way I want.

Legacy planning takes it a step further and provides for the transfer of wisdom, memories and experiences along with the material wealth.

Most estate attorneys and financial advisers start from the point of view about the money and taxes.  Most clients are categorized into three groups:

  1. Individuals
  2. Married with assets above the federal estate tax exemption (now through December 31, 2010 at $3.5M)
  3. Married with assets below the federal estate tax exemption.

But a more client-focused and value-oriented planning approach to estate and financial planning begins with conversations about what is important to the client.  Only then will a client understand the context of a plan as well as why there may be need for changes to keep it current and aligned with the goals expressed by the client.

Too often, I hear that “I’m all set” because “I took care of it” or drafted a will when their college senior was about 2 years old.

In an increasingly complex world with changing state and federal tax codes, fluctuating asset values and a litigious culture, it is even more important to create a plan and routinely review it.  (If you were traveling on a highway cross-country, you wouldn’t simply turn on cruise control and take a nap, would you? I hope not. Even if you have good insurance, are you sure who’s going to get the proceeds?)

17 Major Mistakes

There are more than 17 significant common  mistakes that people make regarding estate planning.  These include failing to coordinate the financial plan, improperly structuring life insurance policies, choosing the wrong executor, improperly gifting assets, failure to properly create and fund trusts and the list goes on.

We could talk about Qualified Personal Residence Trusts, Installment Sales to Defective Grantor Trusts, Family Limited Partnerships and Credit Shelter Trusts.

But that’s all legalese.  It’s sort of like asking someone for the time and they tell you how to build a watch.  That doesn’t matter to you as much as knowing the time.  There are lots of tools in the tool kit of a qualified estate and financial planner.  You probably don’t care about which tool to use as long as the right tool recommended by a professional does the job.

What happens when you deal with real people? (1)

Jack and Jill and a Boy Named Dale

Jack recently turned 32.  He and Jill have been married for nearly three years. Dale was born nearly 13 months ago.  When not at work as UPS delivery driver, he enjoyed getting his heart pumping by cycling with a local riding club.  During a weekend ride as the group of cyclists were descending a hill quickly, a car being driven by a dentist who was late for a client appointment overtook the riders thinking that he had enough time and distance to safely clear the group.  He abruptly turned right onto the street where his office is located.

Unfortunately, the other car coming from the opposite direction to the stop sign on the street the dentist was driving onto was being driven by a young driver who was distracted by her incoming text message which lead her to cross over her lane.  When the dentist’s car hit her at the corner, it caused the cyclists to swerve in confusion.

In the resulting melee, Jack went down hard breaking his collarbone and vertebrae in his lower back leaving him without the ability to walk more than a short distance and unable to lift more than a couple of pounds.

Richard and Anne and the Day that Changed Everything

Richard and Anne lived in an old colonial overlooking the river in a quaint New England town.  Richard had a successful position with Cantor Fitzgerald, one of the world’s premier bond trading shops located in the World Trade Center of New York City.  While Anne managed the home front and their two rambunctious boys age 7 and 4, Richard would commute by plane to meet clients or for meetings at the corporate offices in New York.

By all accounts, they had an ideal life.  They had family and close ties to the community.  Their weekends were filled with home improvement projects on their home or one of the three investment properties they rented out.

Their world was turned upside down a little after 9 AM on September 11, 2001 when Richard’s plane was flown into one of the World Trade Center towers.

Paul and His Long Lost Love

Paul had been married to Bertie for more than 5 years when Bertie asked for a divorce in 1967 fed up by Paul’s late night carousing. After a couple of years of the single life, Paul found Carol, a long lost love from high school days.

Flirtations became something more and Paul and Carol got married and lived a nice life together.

After more than 30 years of working at his job with the state, he decided to retire. But before he turned in his papers, Paul died suddenly from a heart attack.

Although the loss of Paul, her long time love, was devastating, the news that followed was even worse.  It seems that Paul had never quite gotten around to fixing the beneficiary listed on his pension so the estate of his ex-wife Bertie, long since dead, would be going to Bertie’s younger, sole-surviving sister from Texas leaving Carol without an income source for her retirement.

Sal and Pauline

The romance that would result in seven children, thirteen grandchildren and 4 great-grandchildren began when Sal and Pauline met at a USO dance at Fort Devens in 1943. Before shipping overseas with his Army unit, they got married.  More than sixty years later, they enjoyed the retirement years shuttling between family visits and weekly dances at the local senior center.

Then Sal noticed that Pauline started forgetting things.  With that many kids and grand kids, it wasn’t hard to imagine forgetting all their birthdays but soon she started forgetting to eat and dress.

Eventually, her doctor gave Sal the hard news that Pauline had Alzheimer’s and despite his best efforts she would need professional care.

After Sal and his sons brought Pauline to the nursing home, the reality hit home.  Despite their frugal lifestyle, Sal and Pauline had a sizeable nest egg and home.  After the first 120 days in the nursing home, Sal would need to start writing checks in the amount of $7,500 each month for Pauline’s care.  A lifetime of hard work and saving was being threatened.  What could he do?  Was there any other way?

Lots of Things Can Happen

Divorce.  Disability. Law Suits. Remarriage. Car Accidents. Business Partners.

If you think that these things can’t happen to you, think again.  Seek out the help of a good planning team that can coordinate these pieces.  While no one can predict what may happen, putting together a proper plan will help you and those you love with picking up the pieces after a personal loss or tragedy.  

Value-Oriented Estate Plan Foundation

(1) Note:  All names have been changed and situations presented are a compilation of various facts.

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Recent academic research by Gordon Pye on the impact of emergency withdrawals on retirement planning may put into question the rule of thumb used by many advisers to determine a safe, sustainable withdrawal rate.

For many investors and their financial advisers, the accepted rule of thumb has been to withdraw no more than 4% of an investment portfolio in any given year to provide a sustainable income stream when in retirement.

Is this rule of thumb reasonable given the potential impact of personal emergencies?  And how can a withdrawal strategy be created to account for them and the impact of external forces like a market correction or longer bear market?

Cloudy Crystal Ball

Analytical tools and software have come a long way but even contemporary tools can’t account for everything.

I spoke with an estate attorney the other day.  We were talking about the many challenges for helping clients plan properly for contingencies in the face of so many internal and external variables.

What he said is worth keeping in mind when thinking about any sort of financial planning:  If you tell me when you’re going to die, I can prepare a perfect estate plan for you?

The same sentiment can be adapted for retirement income planning.  Sure, if you tell me how long you’ll live in retirement, how much it will cost each year and when you’re going to die, I can tell you how much you’ll need.

In reality, this is unlikely.  More often than not, the crystal ball is cloudy. So you have two choices here: Wing it or Plan.

Winging it is pretty simple. Nothing complicated.  Simply keep shuffling along. Sometimes you’ll scramble. Other times you’ll be “fat and happy” for lack of a better phrase.

Planning, on the other hand, is a lot like work.  It requires assumptions and conversations.  It may even require bringing in others to help create the framework.

While nobody wants another job to do given an already busy day, there is an upside to investing the time here: Peace of mind.

What the Doctor Says:

Here’s a summary of what Dr. Pye wrote recently in his article.

  • In retirement, you may never have an emergency or you may have one or more.
  • The timing and extent of these emergencies is unknown.
  • While a retiree may be able to reduce the damage caused by a bear market maybe through market growth, other emergencies may require withdrawals that siphon money away from the investment pot that can never again be used to help repair the hole left by that withdrawal.
  • The timing of these emergency withdrawals may cause a retiree to abandon a market strategy at an inopportune time.

The biggest unknown?  Health care is the biggest likely emergency on your retirement budget.  These can be related to your own health or even an adult son or daughter.  Other emergencies may be caused by catastrophic weather (mudslide, wind or flood damage to your home), the extended loss of a job by a son or daughter or a divorce compelling you to help out.

In other research by Dr. John Harris supports the notion that what matters most to all investors – and retirees in particular – is the sequence of returns not simply the average rate of return on a portfolio.

Intuitively, we understand this.  A bird in the hand is worth two in the bush.  Cash now is better than cash later (which may be a deterrent against planning now for a future need).  If you were to just retire and the market takes a nosedive as you are withdrawing funds, you would be in tough shape because you have a smaller base that is invested that has to do double (or triple) duty.  The amount of appreciation needed to make up for the hole left by the withdrawals combined with market losses would be near impossible or require an investor to take imprudent risks to try to regain lost ground.

So what’s an investor to do?

  1. Save more – easier said than done but this is really key or otherwise choose a different lifestyle budget.
  2. Reduce initial withdrawal rates from 4% to 3%.
  3. Follow an “endowment spending” policy instead of a simple rule of thumb.
  4. Invest for income from multiple sources (dividend-paying stocks as well as bonds).
  5. Stay invested in the stock market but change up the players.  Not even a championship ball club has the same line up from game to game.  As markets change, you need to add more tactical plays into the mix of asset types
  6. Separate your investments into different buckets:  short-term lifestyle budget, medium-term and longer-term.  Each of these can have different risk characteristics.
  7. Keep a safety net of near-cash to cover lifestyle needs for 1 to 2 years.
  8. Monitor the buckets so that one doesn’t get too low or start to overflow.  This will require moving funds from one to the other to maintain consistency with the targets.
  9. Don’t let your insurances lapse.  Insurance is there to fill in the gap so you don’t have to shell money out-of-pocket.  Here you want to regularly recheck your homeowner coverage for inflation protection riders, cost of replacement and liability.  Check your coverage and deductible limits for wind, sump pump and other damage.

 

 

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As noted in previous articles and posts, whether or not your student qualifies for federal financial aid for college will depend on the Expected Family Contribution (EFC) calculation.

Typically, almost all assets and income are included in this calculation by financial aid officers.  There are exceptions to all rules and in this case, federal aid formulas (under the “Federal Methodology”) exclude home or family farm equity, money accumulated in tax-deferred retirement accounts and cash value built up in a life insurance policy.  The cash values of fixed and variable annuities are also excluded.

Since these assets are not counted in determining aid, some families may be tempted to consider “asset shifting” strategies.  With such techniques, a countable asset like savings or investments through a brokerage account are used to acquire one or more of these other non-countable asset types.

Friends and clients have attended financial aid workshops sponsored by college aid planners or insurance agents who recommend purchasing annuities or life insurance.  Sometimes these strategies involve doing a “cash out” refinance or drawing on a home equity line of credit. Tapping home equity to fund a deposit into an insurance or annuity vehicle may benefit a mortgage banker and insurance agent but is it in your best interests?

Asset Shifting to Qualify for More Financial Aid: Is it worth it?

Well, that depends on what side of the table you’re sitting on.

Yes, it’s true that anything you can do to reduce your expected family contribution may help boost the amount and type of aid your student may receive.

On the other hand, remember these points:

  • Family assets are counted at a low contribution rate of 5.6% above the asset-protection allowance calculated for your family circumstances.
  • If you put money into a tax-deferred account, it’s locked up.  Access to the funds before age 59 1/2 results in early withdrawal penalties in most cases.
  • You may have to pay to borrow your own money.

Granted, socking away money into tax-deferred vehicles may make sense for you.  And as I’ve noted before, paying for college is as much a retirement problem as anything else so anything you can do to provide for your Golden Years can be a good thing.

But don’t get tempted into long-term commitments to cover short-term financing issues.

By shifting assets you lose access and flexibility for the cash.  If employing such a strategy reduces your emergency cash reserve, then you’ve increased your risk to handle unexpected cash needs.

Cash Value Life Insurance and the Bank of You

Cash value life insurance accumulates its value over time.  Starting a policy within a couple of years of your student’s college enrollment is not going to help you.  During the initial years of such a policy very little cash is built up as insurance expenses and first-year commissions paid out by the insurer to the agent are very high which limit the amount of paid premiums that are actually invested for growth.

But consider this:  For some who have existing policies or are looking for a way to build cash over time that offers guarantees and is potentially tax-free, then by all means use life insurance.  There are strategies commonly referred to as the Infinite Banking Concept or the Bank of You which champion life insurance as a way to build and access your own pot of money available to you to borrow for almost any purpose.

There are many attributes to life insurance that make these concepts useful

  • Tax-free dividends,
  • Access to money without credit or income qualifications or delays from a traditional bank,
  • Guarantees on the cash value from the insurer.

But one downside is the cash flow needed to actually build up a pot big enough to tap into for buying a car much less paying school tuition.  You would in all likelihood need to divert all other available cash and stop funding any other tax-deferred plans to build up the cash.  And then there is the time line needed.  To effectively build up the cash, you really need to bank on at least 5 years before you have a Bank of You to tap. This is why such a solution is not recommended for those with students about to enter college.

Bottom Line:

Don’t let the financial aid tail wag the retirement planning dog here.  Only use these tactics after consultation with a qualified financial professional, preferably one who has no vested interest in whether or not you purchase a particular product.

 

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