Moment on Money

Carnival of Personal Finance #106

The latest edition of the Carnival of Personal finance is titled 91 Ways To Wealth and my post Breaking the Law … Of Averages was included.

Some of my favorite posts from this week's carnival:

• Living on interest payments in retirement? Follows the same line of thinking as my recent post Retirement Withdrawal Planning … Understanding the Problem
• A Simple, 3-Step Program takes a humorous look at what you need to do to make sure you are never "burdened" by wealth
• Inflation – Who Wins, Who Loses examines the balance that exists in our economy
• Traditional to Roth IRA Conversion Loophole in 2010 addresses I topic I have in mind for a future post. This is not the last you will hear of this. This topic will be big.
• Ways to Prevent Compulsive Shopping is interesting for those so inclined.
• Hi, I need to speak to Kelly Bejelly.. This is the fraud department is one person's experience with identity theft.

It is not part of the carnival, but you really should read Money Interview with My Kid @ MoneyMusings.com if you want to know how a 4 year old looks at money.

Photo on Flickr by digitaloxygen.ca

A Very Important Question

I started in the financial services industry in late 1989 as a salesman for an insurance company. My only possession in the world was a bicycle without handlebars ... but that was okay because I had no idea which way to turn. I was in my early 20's and had much more enthusiasm than knowledge so I became a student of everything relevant. It did not matter if it was financial, sales, or business in general. I either had my nose in a non-fiction book or listened to tapes in my car.

One of my favorites was a tape series by Hank Trisler, No Bull Selling. At one point I tried to get my hands on the book, but I think it has been out of print for quite some time. Hank Trisler teaches "find out everything your prospect expects a salesperson to do, and then don't do any of it." His point is no one wants to be sold anything. What people really want to know is how they will benefit from the product or service being offered. As a business person, if you can help your clients and prospects with your products or services, there is no need to "sell" them... they will want to "buy". Our aversion to being "sold" runs so strong, that several marketers take advantage of it. This is far too common when it comes to financial advice.

No one gives advice for free. No one. Without exception. Myself included.

• Bob Brinker advocates do-it-yourself investing. He claims professional financial advise advice is an unnecessary expense but he sells a newsletter. Isn't he really saying "buy your financial advice from me"?
• Suze Orman and Jim Cramer have TV shows and sell books
• Dave Ramsey has books and seminars for sale
• Money Magazine writes to increase circulation so it can charge more for advertising
• Financial bloggers look to increase traffic so they can make money via advertising

None of that makes them wrong, but you need to ask yourself what bias they bring.

Here is mine. I am independent which means in my practice I represent my clients, not any particular insurance or investment company. We have relations with hundreds of companies and programs so that our clients have access to a wide variety, but my allegiance and responsibility is to the client. In exchange for my advice my clients compensate me either through fees or commissions, whichever best suits them. Is my practice for everyone? Of course not. But anyone who tells you don't need advice, just their book/magazine/television show/seminar is trying to "sell" you.

Related Posts:

Do You Need a Financial Planner? @ Personal Finance

Do You Need a Financial Planner? @ IGoInvest

Financial Planner: Do I Need One? @ Resident Alien

Photo on Flickr by Richard Holden

Mystified By The Market

With small children my wife and I have learned to appreciate TIVO. Now we get to see all the TV we really want to see, but we rarely watch anything live any more. I recently watched the father's day episode of CBS Sunday Morning. Commentator Nancy Giles had this opinion about why financial "mumbo-jumbo" is so confusing.

If you feel this way, you are not alone. Give me a call and I would be happy to help. Would someone please pass the word along to Nancy?

Financial Skills Inventory

Do you remember the first time you drove a car? It seemed so overwhelming. Especially those of us who learned to drive with standard transmissions.  I remember being very confident before I tried. After all, driving looked easy. Several failed attempts at engaging the clutch and I knew it was more than I anticipated. After a while I got the hang of it but it required complete concentration but it wasn't too much longer before I was driving down the road, adjusting the radio, and singing aloud. (Thankfully I was alone when I was singing. Otherwise I am sure it would have been a traffic offense!)

Learning to drive a car illustrates the four levels of competency:

1. Unconscious Incompetent - being unaware that you lack the skills necessary.
2. Conscious Incompetent - the skills are still absent, but now you know about the skills you lack.
3. Conscious Competent - in possession of the necessary skills, but it takes thought and effort to perform them.
4. Unconscious Competent - the skills are so well developed, that you can perform them without conscious effort.

Like a well cut diamond, financial planning has many facets which require distinct skills, knowledge, and experience. No individual can maintain the highest skill level (unconscious competent) in every discipline. Perhaps the best place to start your financial plan is to take an honest assessment of your own level of expertise in the key financial planning facets:

• Health Insurance
• Disability Insurance
• Property and Casualty Insurance
• Life Insurance
• Long Term Care Insurance
• Understanding Investments
• Mutual Funds
• Managed Accounts
• Qualified Retirement Plans
• Employee Benefits
• Retirement Planning
• Education Funding
• Gift & Estate Taxes
• Income Taxes
• Wills & Trusts

Assess yourself on a 1 - 5 scale for each skill set where 1 is "I don't even know what that is" and a 5 is "I am comfortable doing this without any assistance". Knowing this before you seek financial planning help from a financial planner will not only help you pick the right advisor, but it will also help your planner best serve you.

Learning to Drive photo on Flickr by Mosseby. Diamond photo on Flickr by mnlamberson.

Cash Value Life Insurance

When it comes to understanding the cash value in permanent life insurance, I find that most clients don't really understand it. People tend to see the cash values and the death benefit as separate entities when, in fact, they are very much interconnected.  To illustrate the point, I have developed a simple exercise. Let's do it together. You are going to need a blank piece of paper and pen. Go get 'em, I'll wait right here.

That was fast. Now, on one side of the paper write "Cash Value". On the other side write "Death Benefit". With cash value life insurance you can have whatever you can see if you lay the paper flat on the table. It is the cash value OR the death benefit. How much one effects the other depends on the exact life insurance contract but in the best case scenario, each dollar of cash value removed from the policy will reduce the benefit by one dollar. The worst case is the death benefit can be reduced by many dollars for each dollar of cash value removed from the policy.

My favorite type of cash value life insurance is Universal Life insurance with a no lapse guarantee. There are no guarantees of cash value in these contracts, but the premium and death benefit are guaranteed. In some cases, these policies may accumulate significant cash values and that is my biggest fear. You see if the owner withdraws some of the cash value, the guarantees on death benefit and premium may be affected. I tell clients when they purchase these policies to forget about the cash value and consider these policies to be lifetime term insurance with a guaranteed level premium (all guarantees are based on the claims paying ability of the issuing company).

There are many complex strategies designed to exploit the tax advantages of life insurance. Many of them are sound, but they are all complex. They require a significant degree of expertise to properly design and even more to manage in an ever changing tax environment. Improper management of these strategies can have disastrous consequences, sometimes decades later. A good friend of mine is an attorney for a international banking conglomerate. His job is to design and manage these complex scenarios for extremely wealthy clients (we're talking $100,000,000+ net worths). These clients pay hefty fees to ensure proper strategy management over many decades. If the strategy needs a large cash infusion they can afford to provide it. For those clients, it makes some sense.

As for those of us with lower net worths, I always ask the proponents of these strategies one question. "Can you introduce me to two clients whose retirement was significantly improved by employing this strategy?" So far, no one has been able to. I have met more than two people who have been burned. Seeing is believing. Until I meet these people in person, I will continue to champion life insurance for the death benefit, and only the death benefit.

Photo on Flickr by greefus groinks

Decision Making in the Real World

As a Certified Financial Planner^TM practitioner some of my success stories can be bitter sweet.

Take the case of Bob & Mary for example (not their real names of course). I have worked with them for several years and know them fairly well. Around this past Thanksgiving, Bob (who is in his early 70's) had a stroke. Treating his stroke required months in a rehab facility and eventually lead to the diagnosis of a fatal illness. Bob passed away Memorial Day weekend. Mary tells me she and their grown children were all with him when he died. We all knew it was coming but I was still saddened to hear the news.

I had done my job well for them. When Bob went into the inpatient rehab facility I had to remind Mary that a few years ago they had purchased Long Term Care Insurance. She did not have to worry about the cost of his care. Three years ago we updated their life insurance program. Bob had adequate protection in place and there are other assets as well. Mary (who is in her early 60's) came to my office recently to review her financial condition. We examined her income and determined that she needed an additional $1200 a month in income. The question was where to draw it from.

Mary had started to draw her own social security benefit a few months ago which was prior to her Full Retirement Age (Age 66). Bob had also been receiving Social Security income. She had always thought that if Bob died, she would be entitled to keep his benefit. That is true, but not while she is in the widows blackout period (the time between when the oldest child is 18 and Full Retirement Age). Her options are to wait, or to draw his benefits now and get $222 less per month. The Social Security Administration calculated a break-even analysis for her. They suggested that if she waited and drew the higher benefit, after 95 months she would be ahead. Longevity is common in her family (her mother is in her 90's and still lives on her own). Now she wanted my input.

The key to these decisions is that they are irrevocable. Once made, they can not be undone. So we had better consider all options and be comfortable with our choice.

I pointed out to her what I thought were the key factors:

1. She has enough assets to provide for herself and wait to draw Social Security.
2. Even though longevity is common in her family, no one knows how long they will live.
3. We needed to add the time spent waiting to the break even analysis. Including the waiting it would take 133 months to break even.
4. She has to consider the effect to her children.

I told her that if she spent her own money and then died, her children would get whatever money she had not spent. If she drew social security now, she would spend less of her own money now and if she died there would be more left over for her children. Either way, Social Security would not give her children much (a one time $255 death benefit). That made the decision easy for her. "I'll spend the governments money rather than my own" she said.

I think she made the right choice. Do you?

Photo on Flickr by garrettc

Financial Frivolity For Fun

Indulge me. This post is neither original nor new. I originally saw it several years ago in an email and it showed up in my inbox again recently. I wish I had the authors name or the original source, but I don't. Do you? In the meantime we will just accredit it to author unknown. In light of the upcoming Presidential Elections and the discussion of taxation that will probably develop, I thought it would be fun to post it. Forgive me, but I can see the humor...

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

• The first four men (the poorest) would pay nothing.
• The fifth would pay $1.
• The sixth would pay $3.
• The seventh would pay $7.
• The eighth would pay $12.
• The ninth would pay $18.
• The tenth man (the richest) would pay $59.

So, that's what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily beer by $20. "Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?' They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:

• The fifth man, like the first four, now paid nothing (100% savings).
• The sixth now paid $2 instead of $3 (33%savings).
• The seventh now pay $5 instead of $7 (28%savings).
• The eighth now paid $9 instead of $12 (25% savings).
• The ninth now paid $14 instead of $18 (22% savings).
• The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

"I only got a dollar out of the $20, "declared the sixth man. He pointed to the tenth man," but he got $10!"

"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got ten times more than I!"

"That's true!!!" shouted the seventh man. "Why should he get $10 back when I got only two? The wealthy get all the breaks!"

"Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"

So the nine men surrounded the tenth and beat him up. The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

... At least that is the story that was in my inbox. I don't know about the conclusion. Can the wealthiest Americans just move their money offshore? I don't think so (at least not legally). It does illustrate how the numbers can be twisted for political value.

Photo on Flickr by RW PhotoBug

A Reader Asks... #2

A few weeks ago a great discussion about Flexible Spending Accounts (FSA's) was started at Blueprint for Financial Prosperity. A reader recently asked me:

"If you change employers during the year can you get reimbursed for expenses that were not reimbursed from any other source prior to the start of your second employment? In other words, if you start a second job and open an FSA there on June 1 can you get reimbursed for an expense incurred in May that was not reimbursed by your previous employer’s FSA?"

This is a very interesting question. IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans would be the relevant reference. Under Flexible Spending Arrangements, Distributions it states:

"Distributions from a health FSA must be paid only to reimburse you for qualified medical expenses you incurred during the period of coverage." 

In my opinion, the phrase "during the period of coverage" would indicate that you need to be employed by the employer and participating in the plan at the time of the expense.

It would be worth filing the claim with your new employer anyway. The worst they can do is say no.

Photo on Flickr by Old Shoe Woman

Have Your Cake and Eat it Too - Potential Retirement Planning Solutions

This is the third is a series of three posts with a focus on retirement planning

All this week we have been studying how to withdraw our money during retirement. First we studied Monte Carlo Simulation, then we used a Monte Carlo Simulation based study to determine how fast we should spend our money in retirement.

The problem uncovered in the study was that we could withdraw no more than 4% of our money in any given year to help be confident that we would not run out of money in retirement. In practical terms that means that if you have accumulated $1,000,000 in retirement funds, that you should withdraw no more than $3,333 a month. Folks, that is pre-tax. Do you feel wealthy yet? Worse yet, while it is a reasonable assumption there is still no guarantee we will not run out of money!

The traditional approach to guaranteeing life long income has been annuities. While life income annuities offer certain tax advantages, they also carry several disadvantages. Perhaps the biggest disadvantage is the availability of principal. Once annuitized, income annuity owners have no ownership in the principal. They only own the stream of income. That means that if they needed money, for whatever reason, the annuity is not an option for anything except income. This fact alone has probably kept more people from purchasing income annuities than any other.

As the baby boomer generation is now entering retirement, innovative insurance companies have listened to their concerns. Some modern Variable Annuities now have optional features which can guarantee lifetime income without annuitizing. That means that you can have your cake and eat it too. Guaranteed lifetime income without giving up access to the underlying investments! Of course the guarantees are based on the claims paying ability of the issuing company.

Keep in mind that these benefits are not free. I have seen them add anywhere from 0.4% to 0.8% in additional annual expenses to a contract. That is okay. The only reason to purchase an annuity is for guarantees and the guarantees already take expenses into consideration. If you do not need or want the guarantees there are probably better places to put your money.

I have kept this discussion very general in nature and have not mentioned any specific products. Would you be interested in product reviews?

Photo on Flickr by Red Label

Retirement Withdrawal Planning... Understanding the Problem

This is the second in a series of three posts with a focus on retirement planning. The first one was was about Monte Carlo Simulation.

You have done a great job saving for retirement and are nearing the end of your rainbow. Have you stopped to consider how much you can withdraw from your retirement plans each year? You see, accumulating retirement money is only the first part. Devising a plan to access the money is equally as important. If we could know two key variables in advance it would be easy. Those key variables are How long will you live? and How much volatility will you experience in your investments?

Did you know the life expectancy for a 65 year old is another 19.2 years? Keep in mind this figure means that half of 65 year olds today will live longer than 19.2 years. A healthy 65 year old needs to plan for a retirement which could last 25 to 35 years. Armed with the knowledge that every year you need to access more money due to inflation, how do you plan your access to retirement funds so that you do not run out of money?

A popular method is to invest your money and assume an average rate of return, then withdraw less than that so (in theory) our retirement fund continues to grow and every year we can withdraw more money. For example (Download simple_withdrawal_plan.xls) , if we retire with $100,000 and invest at 8%, withdraw 5% at the end of each year, we can withdraw $5,000 in year 1, over $14,000 in year 20, and over $21,000 in year 35. Best of all our retirement nest egg has grown to over $250,000 for our heirs! Problem solved? Not exactly. You see, real world volatility can destroy that plan.

T. Rowe Price has performed Monte Carlo studies using different portfolio composition, withdrawal rates, and time periods (Download retirement_monte_carlo_by_t_rowe_price.pdf). Yesterday we defined a successful Monte Carlo simulation as one that had an 80% probability of success or greater. Using that definition here is what the T. Rowe Price study tells us:

• In a 25 year retirement we can be confident if our withdrawals are limited to 3% or 4% regardless of portfolio composition. If we withdraw 5% then we had better have a minimum of 60% stocks in our portfolio. Under no circumstances should we withdraw more than 5%.
• For a 30 year retirement we are reasonably confident with 4% withdrawals or less. We can not be confident with a 5% withdrawal regardless of portfolio composition.
• 35 year retirement plans are confident at 3%, but at 4% we can only be confident if our portfolio contains at least 40% stocks but no more than 80% stocks. How interesting that a diversified portfolio balances the need for a higher return with the stability of consistent performance. Too much or too little stocks defeats our objective.

Now that we understand the problem, in our next post we can begin look for solutions.

Photo on Flickr by 4StringsGood

Disclaimer: Monte Carlo simulation is an analytical tool for modeling future uncertainty. In contrast to deterministic tools (e.g., expected value calculations) that model the average case outcome, Monte Carlo simulation generates ranges of outcomes based on our underlying probability model. Thus, outcomes generated via Monte Carlo simulation incorporate future uncertainty, while deterministic methods do not.