The Critical Role of Life Insurance in Financial Planning

Posted on September 3, 2010 by BH&J

As comprehensive wealth managers, we believe that protecting risks through insurance is a foundational element of a financial plan. Investments are important and draw most of our ongoing focus, but without insurance, savings and investments can be lost.

As author Nick Murray writes, “We insure against what can go wrong in order to acquire the luxury of investing for what can go right.”

Before you consider how much you need to save to retire comfortably or fund a child’s education, it’s important to make sure that your risks are protected in case something does go wrong. Unfortunately, we all know someone who has died well before their time. We’re not all as invincible as we like to pretend.

It’s not a pleasant scenario to think about, but not doing so can have serious consequences.

Roughly 70 million adult Americans have no life insurance coverage at all. Many others have employer provided coverage that provides a nominal death benefit—i.e. $50,000 or one or two times annual salary. In most cases, especially with people who are not near the end of their career, this is not enough to provide needed financial security to those left behind.

Consider your needs based on the following three scenarios:

You’re Married With Kids and a Mortgage. Having kids and debt are the most obvious reasons to own life insurance. If you and your income were suddenly gone, would your spouse and kids be okay financially? Life insurance replaces lost income to help make sure those who depend on you will be provided for, no matter what life throws your way. You don’t want to force your spouse to find someone else to help pay bills, save for retirement and put the kids through college. Inexpensive term life insurance can protect against this risk until your family is secure enough to get by without your income.

You’re a Small Business Owner. Life insurance can help protect your business in a number of ways in the event you, your partner, or a key employee dies prematurely. A buy-sell agreement funded with life insurance allows surviving business owners to buy the company interests of a deceased business owner at a previously agreed-on price. Again, relatively inexpensive term life insurance can protect against this risk.

You’re Likely to Owe Estate Tax. If you’ve built significant net worth, a little planning can save a lot of money in estate taxes. Especially if your net worth is relatively illiquid (i.e., lots of real estate or business value) paying the estate tax bill may be difficult. Estate tax payments are due nine months after death. In many situations, affluent individuals can benefit from the use of an Irrevocable Life Insurance Trust (ILIT) to create liquidity at the right time and save heirs and executors a lot of headaches. In this case, a permanent insurance policy may make a lot of sense.

CPA and IRA expert Ed Slott preaches that life insurance is the best leverage of the tax code: “A small amount of money can create huge benefit that is income tax and estate tax free as long as it is set up outside the estate.”

The amount of net worth excluded from estate tax could be as little as $1,000,000 per person in 2011 if Congress allows tax law to proceed as currently written. Anything above $1,000,000 could be exposed federal tax of 55% in addition to state tax.

To adequately address estate planning needs, it’s important to seek legal advice in the context of an overall financial plan.

How Much Insurance Do You Need?

Decisions about the amount and type of life insurance coverage should come after answering the following questions.

  • If I and/or my spouse dies, how much will be required to replace my/our earnings?
  • Do I need permanent or temporary coverage?
  • Who should be the beneficiary of my insurance policy?
  • Should this insurance be held inside our outside my estate?
  • What is the financial condition of the insurance carrier?

You can get a general sense of how well you are protected by using this life insurance needs calculator. Or, we are happy to review your situation to see how insurance fits into your overall financial plan.

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP® — Tacoma, WA

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Exit plan a crucial aspect to small business ownership

Posted on September 3, 2010 by BH&J
Gary’s monthly column in The News Tribune was published in today’s (9/3/10) business section.

http://www.thenewstribune.com/2010/09/03/1326289/exit-plan-a-crucial-aspect-to.html#ixzz0yU1OlMta

By Gary Brooks

Business owners by nature are courageous folks who are comfortable taking risks. But there is one thing that seems to commonly invoke fear for them—the exit strategy.

The exit strategy is a critical element of financial security and yet, even many leading edge baby boomers with retirement in sight have no formal idea how they will get the most out of their business.

Business owners often let inertia stall their progress for one of four reasons:

  1. the business defines their life and they can’t imagine a different situation,
  2. they dread what may happen to the business without their guidance and the goodwill they’ve built with customers or clients,
  3. they fear potential conflict in transitioning leadership of the business,
  4. and/or they have anxiety about defining the value of the business and the financial realities it presents in funding the next stage in life.

Any of these concerns, left to linger, can limit the business owner’s options for an acceptable outcome.

THE SOLUTION

Business owners who are most successful with exit strategies have common attributes. They actively plan several years in advance. They perform due diligence with accountants, appraisers and industry experts to accurately value the business. They incorporate business value and transition timing into a personal financial plan. They understand all their exit strategy options, choose the preferred path, and align all decisions with maximizing the probability of success with the chosen strategy.

Whether the business has made a fortune or is just moderately profitable, the most successful transitions follow one of three planned exit strategies—the groomed successor, sale to an unrelated party, or the managed wind down.

THE GROOMED SUCCESSOR

Indentifying new shareholders among family, employees, or even friendly competition, can ease many fears. It allows the owner to preserve what is important to them and presents the least interruption to the business.

It’s not always simple to design an internal transition, but it may be the most satisfying option. The key is to start the grooming process early so that clear expectations and timelines can be defined, including how to structure the financial aspect of the transition. In some cases, successful businesses grow beyond an internal successor’s ability to afford to purchase it.

ACQUISITION BY AN UNRELATED PARTY

The first step in preparing to review offers for the business is to have a strong understanding of its value. When the right measure of value is determined, it’s important to manage the business toward improving that specific measure as much as possible.

The established value, and ultimately, the sale price, can have significant impact on taxes, retirement income, estate planning, and more inter-related elements of the owner’s financial situation. Sudden liquid wealth presents a whole different set of challenges.

THE MANAGED WIND DOWN

If the business is past its prime or in a dying industry, an option is to take as much earnings as possible out of the business as personal income rather than reinvesting in the company. This way, rather than expecting a future sale to generate a lump sum to retire on, the sum can be accumulated over time.

One risk is that this may be a tax-inefficient way to build financial security. Ordinary personal income tax rates would likely be more harmful than capital gains taxes that could be applied to a lump sum or installment plan sale.

A LESS-DESIRABLE OPTION

For too many business owners, it is a fourth option—closure and liquidation—that becomes the default choice. This often happens for reasons outside the owner’s control such as death, disability for themselves or a family member, or a change in demand (profits) due to the economy, industry evolution, and so on.

The best way to prevent settling for the default choice is to identify the facts, get good advice and use both to support a clearly emotional decision.

Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a Registered Investment Adviser in Old Town Tacoma. Reach him at gary@bhjadvisors.com.

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Don’t let the tax sunset leave your portfolio in the dark

Posted on August 31, 2010 by BH&J

At the end of 2010, tax rates will go up unless there are legislative changes amending the coming “sunset” of current tax provisions. This note takes a brief look at some of the strategies investors can use to ensure their portfolios are tax-efficiently constructed for the tax environment of 2011 and beyond.

Read a brief primer and decision tree from Vanguard related to whether or not to sell or hold assets before tax rates change.

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You Get What You Pay For … Financial Planning Edition

Posted on August 13, 2010 by BH&J

Wall Street Journal columnist Jason Zweig, one of our favorites in the personal finance space, wrote an article August 7 about a new service for delivering low-cost, yet “comprehensive” financial planning to the masses.

Certainly, there are millions of people who are not engaged with a professional advisor and could benefit from guidance regarding their money decisions.

But we wonder whether this new service from Veritat Advisors will demonstrate value given the exceptionally personal and specific questions that most people have about how to protect their risks and build financial security through a lifetime of events and decisions.

In Veritat’s advisory model, customers submit financial information and high-level goals to Veritat’s financial planning engine. A financial plan is produced and customers then meet with a Veritat advisor via video link on the internet.

The advisors then help customers work with other providers to open and manage investment accounts, purchase insurance and complete basic estate planning documents.

Veritat charges a monthly fee from $25-$40, in addition to the initial financial plan fee of $250. It’s a low cost for the basics of a fairly generic, but suitable plan and investment strategy.

Zweig writes that Veritat expects, given the leverage of automated systems, that a single advisor could work with 1,000 clients per year.

Let’s review some basic math about this workload. If the advisor works 50 weeks a year at 40 hours per week, that’s 2,000 working hours. If the advisor had incredible productivity and spent every minute of those hours actually working on a customer’s financial plan or reviewing it with them, the advisor could spend just two hours per year per client. Of course, it’s not possible to be that efficient. There are many other obligations over a year of work that require the time of any kind of employee. So, being generous, a customer’s financial plan and ongoing recommendations likely would get an hour and a half or less of a Veritat advisor’s time over the course of a year.

The upside of this is maybe more people will seek financial advice and be able to better manage their current budget, investments and basic financial decisions. This way, they’ll be better prepared for life’s transitions and retirement.

In our experience, however, providing real value in a financial planning and investment management relationship calls for a much more personal approach, not an “advisor” interpreting the results of a software program and recommending a model portfolio that is “suitable” for someone near the same age, with similar income, assets and tolerance for the ups and downs of investment markets.

Good financial advisors also add value for their clients by being available as often as is necessary to help them through the issues that they face—an important life transition or a question about financial options that they have.

The impact of a relationship with a qualified advisor, personally looking after your finances and how they relate to your goals, is worth far more than $40 a month. This is especially clear when considering that at a minimum, we expect to spend at least 20 hours per year on even the most simple relationship with a client.

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP®

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U.S. Stocks, Municipal Bonds Generate the Best Real Returns

Posted on August 12, 2010 by BH&J

Thornburg Investment Management recently released an annual report analyzing real returns. It is always interesting reading. Thornburg reviews returns for several types of investments and then subtracts expenses, taxes and inflation to determine which investments allow investors to keep the most return.

For example, if you invested $100 in the S&P 500 Index on December 31, 1979 and held it over 30 years to Dec. 31, 2009, the nominal return would have been 11.24% per year.  This increased your  $100 investment to $2,440. However, after subtracting taxes paid on dividends and capital gains and adjusting for inflation, the real return was 5.21% per year, turning $100 into $459.

So, how does this compare to other investment options? Over the 30-year period, the S&P 500 (representing large U.S. companies) provided the highest real return. The runner-up was U.S. small companies (4.81% average annual real return) and international stocks (4.55% real return). Municipal bonds, which are in most cases not taxed, outpaced other fixed income assets over this 30-year period.

Some other interesting points:

  • Over the 5, 10, 15 and 20-year periods ending Dec. 31, 2009, municipal bonds were the real return leader.
  • The 10-year real return of the large-cap S&P 500 Index was -4.21%, the worst of any asset category measured over 10 years.
  • Single-family homes are not a good investment. Over 30 years, their real return averaged 0.36%. Over the five years ending Dec. 31, 2009, they had a -4.19% real return.
  • Commodities have become a popular addition to globally balanced portfolios. There is expectation that commodities of all types including energy, agricultural and livestock will grow in demand as the world population grows. But historically, commodities have not added anything to wealth creation. The 30-year real return was -3.50 – 20 years (-1.84%), 15 years (-0.82%), 10 years (0.51%) and 5 years (-3.85%). The benefit of commodities comes in risk reduction. Since their returns do not typically move in the same direction as stocks and bonds, they can help reduce overall fluctuation in the balance of a diversified portfolio.
  • U.S. Treasury bills, often the preferred “risk-free” investment, are actually plenty risky. They exhibited negative real returns in each time period measured.

For a copy of the full report, including how these return patterns impact the sustainability of portfolios and income in retirement, please contact us at info@bhjadvisors.com or 253-534-8888.

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP®

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Stretch Your View and Grow Your Wealth

Posted on August 12, 2010 by BH&J

Over the past 10 years, bonds have built a meaningful lead over stocks when comparing returns. But how often have bonds outperformed stocks over various historical periods, through all sorts of crises, political changes, recessions, etc.?

Consider the graphs below from Morningstar. They demonstrate multiple rolling periods (starting a new period each month).  The first shows that when evaluating 5-year (60-month) periods, there are several stretches when bonds return more than stocks. But when the returns are measured over rolling 10-year (120-month) and 20-year (240-month) periods, the likelihood of making more money in bonds than in stocks, nearly disappears.

If you’re seriously committed to saving, investing and building a nest egg intended to support a vibrant, multi-decade retirement, 20 years is basically the minimum period of accumulating and growing your savings. Over these years of accumulating a life savings, a portfolio tilted toward stocks can make a big difference.

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP®

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Stocks Don’t Follow the Economy’s Lead

Posted on July 28, 2010 by BH&J

Perhaps more than at any other time, global economic conditions are influencing outlook from investment professionals willing to offer a forecast of the market direction.

Economic data reveals significant headwinds that will likely limit Gross Domestic Product (GDP) growth and drive government debt to seemingly impossible highs. But does the state of the economy dictate the performance of stocks and bonds around the world?

Consider two views of the relationship between economic output and stock market valuation:

1. Fast Growing Economies Don’t Always Translate to Strong Stock Market Returns

Data compiled by Credit Suisse demonstrates that it’s actually markets in countries with the lowest quintile of economic growth that generate the highest investment returns.

Blackrock CIO Bob Doll reviews this information and concludes:

“Investors have not automatically obtained excess returns by investing in higher GDP growth markets (typically emerging economies). Buying stocks in low-growth countries has equaled or exceeded the returns from buying stocks in the high-growth economies. Because developed markets are often underpriced relative to their high-growth emerging market cousins, these slower-growth economies have often delivered superior returns. Because of the cyclical recovery trends, we believe that US stocks, in particular, offer better prospects, and are, in this sense, an attractive ‘value play’ for investors.”

2. Companies are not impacted equally by economic struggle

According to Bill D’Alonzo, CEO of Friess Associates, managers of the Brandywine Funds, the economic cycle does not dictate the return prospects of all companies.

“In our opinion, broad economic signals rarely mark a discernible path for investors to follow, leaving individual-company fundamentals as the best way to navigate the environment ahead,” D’Alonzo writes. “Companies with solid balance sheets and efficient operations that generate strong earnings on tangible revenue gains are well positioned to stand out in the kind of climate we confront as we embark on the second half of 2010.”

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP®

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A Quick Way to a 50% Loss

Posted on July 27, 2010 by BH&J

People often wonder whether it is a good or bad time to be in any particular investment market. Hindsight makes it seem like there are clear indicators either way.

Our friends in the advisor consulting group at Russell Investments have updated a demonstration that shows just how difficult it is to build wealth when trying to time entry and exit points into investments.

Consider the market timing graphic below. It exhibits the impact of missing relatively few high-return days investing in the broad U.S. stock market (Russell 3000) over 10 and 15-year periods.

Pay special attention to this startling evidence from the 10-year period: There are approximately 2,500 trading days over 10 years.  If you missed just the 10 days with the highest daily return – 0.4% of the trading days over a decade – your ending wealth would be reduced by close to 50% from $9,798 to $4,920.

If your situation or your goals change, there is plenty of reason to change your investment strategy. But if it’s just a matter of whether you should be in or out along the way to your goals, this evidence makes it pretty clear why staying invested is important.

Market timing, missed returns

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP®

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The Fiduciary Debate: Does Your Advisor Act in Your Best Interest?

Posted on July 27, 2010 by BH&J

Part of the recently signed financial reform bill addresses the fiduciary standard and how it applies to financial advisors.

Currently, Registered Investment Adviser (RIA) firms (like Brooks, Hughes & Jones) are obligated to act as a fiduciary. This means we must make recommendations and provide advice that is solely in the client’s best interest.

Many other advisors, primarily employed by brokerage firms that spend billions on advertising and lobbying –Merrill Lynch, Morgan Stanley, Edward Jones, etc. – currently have to meet only a suitability standard. This means that products they sell should be suitable for the client, given known information about the client. But they don’t have to be unquestionably in the client’s best interest.

The House of Representatives version of the financial reform bill required all financial advisors to operate from the fiduciary standard. Under heavy influence, however, it was amended before signing. What is written into the bill is the authority for the Securities and Exchange Commission to apply the fiduciary standard to all, but not until the SEC completes a six-month review of the subject.

Since Congress failed to fully approve the fiduciary standard, it’s not hard to imagine brokerage firms successfully lobbying the SEC to maintain status quo.

When this study is completed, the SEC will be able to draft its own rules around who is required to act as a fiduciary.  As it stands now, brokers would have a two-tiered fiduciary responsibility.  If they provide specific, personalized advice, they would have to act as fiduciaries.  After they provide this advice, they will no longer be fully subject to a continuing standard in future investment recommendations.  This means that a broker’s allegiance could change depending on the situation.

In the current bill, the SEC may also allow brokers to sell a limited range of products (even proprietary) provided they give notice to the customer and obtain consent or acknowledgement.

What it comes down to is paying an investment advisor or financial planner for advice or paying a registered representative to sell a suitable product. The difference may be subtle to most but represents a substantial difference in independence, objectivity and understanding of whose side the “advisor” is really on.

There are certainly many good financial professionals who work for wirehouse brokerage firms. And there are RIAs and CFPs who have done wrong. However, given the opportunity to work with the highest standard of stewardship for your life savings, you may want to consider the meaning of the word fiduciary and look for an advisor willing to operate from its definition in all matters.

We’ll closely follow the SEC’s six-month review and follow-up then.

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Stocks are undervalued, stocks are overvalued ― depending on direction you look

Posted on July 21, 2010 by BH&J

The significant lack of consensus outlook for U.S. stock markets comes largely from the direction at which differing parties view the market. Those looking forward, basing market valuation on estimated future company earnings believe that markets could be 25+% undervalued.

Those who prefer to use trailing actual figures to evaluate current stock prices, believe nearly the opposite, that the recovery rally went too far and will correct more than the 16% dip in the S&P 500 between April 23 and July 2.

The Bullish View

Jeremy Siegel is a professor and author whose viewpoint is widely followed. He has tracked stock market performance back over 200 years. He believes in reversion to the mean – over time, no matter whether markets race ahead of fair value to overly correct below it, they will self correct and return to long-term mean returns.

In a July 8 interview, he said: “When I draw that line over 200+ years of return data, I find we are about 25% to 30% under trend. But trend lines are only one aspect of it. There has got to be a valuation behind that. That is very much what supports the position that stocks are undervalued. When I look at earnings going forward on the S&P 500, for instance projections for 2010 and 2011, we are looking at either 13-times earnings this year or 11-times next year’s earnings. In this interest rate environment, that is unprecedented and, again, demonstrates around a 25% or 30% undervaluation in the market.”

Siegel goes on to explain that even if he takes a pessimistic view of future earnings that current prices remain undervalued, just not to the same extent.

Jeremy Grantham, a money manager historically bearish in his outlook, leaves open the possibility for stocks to rally strongly. “Despite growing nervousness and a slowing economy, there is still a 45 percent chance, thanks to low interest rates, that the S&P 500 will rise above 1,400 (1,083 on July 21, 29% increase to reach 1,400) by October of next year, accompanied by a speculative spin. High-quality stocks have been cheap for five years, and may spend most of the next several years underpriced, bouncing back up to fair value from time to time.”

The Bearish View

Other analysts and economically-focused investment managers are more pessimistic given the mix of a rear view of real company earnings in tandem with fairly dreadful economic expectations.

Economist and mutual fund manager John Hussman hasn’t found a reason for a promising outlook.

“I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50% above their historical norms indefinitely,” Hussman wrote July 19. “I can’t emphasize enough that when you hear an analyst say ‘stocks are cheap based on forward operating earnings’ it would be best to replace that phrase in your head with ‘stocks are cheap based on Wall Street’s extrapolative estimates of a misleading number.’ ”

While Hussman thinks that expectations for 25% U.S. stock market gains are misguided, he does not predict extended negative returns. His forecast in the second quarter outlined a scenario where U.S. markets could log 7% average annual returns over the short-to-intermediate term. While that would be a third lower than long-term market returns, 7% annually will still build wealth, especially in a period where inflation is tame.

Others do leave open significant likelihood of negative returns from U.S., and likely European, stocks.

Yale economist Robert Shiller uses a backward-looking calculation of 10-year average actual net earnings and concludes that U.S. stocks are substantially overvalued.

Everyone is right at some point

For another perspective, consider this graph from Morningstar. It charts collective over or undervaluation of the 1,700 stocks that Morningstar rates. This view is of the past year, suggesting a lightly undervalued market in general. It’s important to remember that individual stocks can get wildly undervalued or overvalued with no relation to the overall market.

What do we think?

The tug-o-war between forward-looking optimists and backward-looking pessimists is at a point where each side maintains a lot of strength. It could be that both sides are right. We may see a lot of up and down moves without a clear winner from either viewpoint.

One may be right in the short term but the other over a more meaningful longer term.

We favor evidence over expectations. That leads us to believe that the U.S. stock market is unlikely to add 25% or 30% to its value in the next year. Multi-national companies able to pay increasing dividends and established emerging markets companies appear most attractive. U.S. Treasuries are least attractive.

While we accommodate for occasional tilts in emphasis within our clients’ portfolios, we still operate from a core asset allocation that is globally diversified. This is the best way to remain aligned with client goals that will endure beyond the uncertainty of today.

– Gary Brooks, CFP®

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