Cfp board financial planning competency handbook 9781119094968, 1119094968, 9781119095002, 9781119094982

Table of contents :
Content: Acknowledgments xiii About the Book xv Preface xvii Charles R. Chaffin, EdD, CFP Board About the Practice Questions xxiii About the Contributors xxv Part One Introduction 1 Charles R. Chaffin, EdD, CFP Board 1 Theory and Practice 5 Charles R. Chaffin, EdD, CFP Board 2 Function, Purpose, and Regulation of Financial Institutions 15 John E. Grable, PhD, CFP(R), University of Georgia Sonya L. Britt, PhD, CFP(R), Kansas State University 3 Financial Services Regulations and Requirements 25 John E. Grable, PhD, CFP(R), University of Georgia Sonya L. Britt, PhD, CFP(R), Kansas State University 4 Consumer Protection Laws 35 John E. Grable, PhD, CFP(R), University of Georgia Sonya L. Britt, PhD, CFP(R), Kansas State University 5 Fiduciary 45 Martie Gillen, PhD, University of Florida 6 Financial Planning Process 51 John E. Grable, PhD, CFP(R), University of Georgia Ronald A. Sages, PhD, AEP(R), CFP(R), CTFA, EA, Kansas State University 7 Financial Statements 63 Thomas Warschauer, PhD, CFP(R), San Diego State University 8 Cash Flow Management 73 Martie Gillen, PhD, University of Florida Michael Gutter, PhD, University of Florida 9 Financing Strategies 81 Martie Gillen, PhD, University of Florida Michael Gutter, PhD, University of Florida Jorge Ruiz-Menjivar, University of Georgia 10 Economic Concepts 89 Dave Yeske, DBA, CFP(R), Golden Gate University 11 Time Value of Money 97 Jorge Ruiz-Menjivar, University of Georgia Martie Gillen, PhD, University of Florida Michael Gutter, PhD, University of Florida 12 Client and Planner Attitudes, Values, Biases, and Behavioral Finance 107 Dave Yeske, DBA, CFP(R), Golden Gate University 13 Principles of Communication and Counseling 115 John E. Grable, PhD, CFP(R), University of Georgia Kristy L. Archuleta, PhD, LMFT, Kansas State University 14 Debt Management 127 Joseph W. Goetz, PhD, University of Georgia John E. Grable, PhD, CFP(R), University of Georgia 15 Education Needs Analysis 137 Taylor Spangler, MS, University of Florida Michael Gutter, PhD, University of Florida Martie Gillen, PhD, University of Florida Sailesh Acharya, University of Florida 16 Education Savings Vehicles 145 Michael Gutter, PhD, University of Florida Martie Gillen, PhD, University of Florida 17 Financial Aid (Education) 153 Martie Gillen, PhD, University of Florida Michael Gutter, PhD, University of Florida 18 Gift and Income Tax Strategies (Education) 159 Martie Gillen, PhD, University of Florida Michael Gutter, PhD, University of Florida 19 Education Financing 165 Martie Gillen, PhD, University of Florida Michael Gutter, PhD, University of Florida 20 Principles of Risk and Insurance 173 Dave Yeske, DBA, CFP(R), Golden Gate University 21 Analysis and Evaluation of Risk Exposures 183 Dave Yeske, DBA, CFP(R), Golden Gate University 22 Health Insurance and Health Care Cost Management 189 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 23 Disability Income Insurance (Individual) 197 Dave Yeske, DBA, CFP(R), Golden Gate University 24 Long-Term Care Insurance 205 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 25 Annuities 213 Andrew Head, MA, CFP(R), Western Kentucky University John Gilliam, PhD, CFP(R), Texas Tech University 26 Life Insurance (Individual) 225 Dave Yeske, DBA, CFP(R), Golden Gate University 27 Business Uses of Insurance 233 L. Ann Coulson, PhD, CFP(R), Kansas State University John Gilliam, PhD, CFP(R), Texas Tech University 28 Insurance Needs Analysis 245 Thomas Warschauer, PhD, CFP(R), San Diego State University 29 Insurance Policy and Company Selection 253 Thomas Warschauer, PhD, CFP(R), San Diego State University Andrew Head, MA, CFP(R), Western Kentucky University 30 Property and Casualty Insurance 263 Derek R. Lawson, MS, Sonas Financial Group, Inc. and Kansas State University Sarah D. Asebedo, MS, CFP(R), Virginia Tech Martin C. Seay, PhD, CFP(R), Kansas State University 31 Characteristics, Uses, and Taxation of Investment Vehicles 275 Swarn Chatterjee, PhD, University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia 32 Types of Investment Risk 283 Thomas Warschauer, PhD, CFP(R), San Diego State University 33 Quantitative Investment Concepts 291 Thomas Warschauer, PhD, CFP(R), San Diego State University 34 Measures of Investment Returns 299 Thomas Warschauer, PhD, CFP(R), San Diego State University 35 Asset Allocation and Portfolio Diversification 307 Dave Yeske, DBA, CFP(R), Golden Gate University 36 Bond and Stock Valuation Concepts 315 Dave Yeske, DBA, CFP(R), Golden Gate University 37 Portfolio Development and Analysis 325 Thomas Warschauer, PhD, CFP(R), San Diego State University 38 Investment Strategies 335 Dave Yeske, DBA, CFP(R), Golden Gate University 39 Alternative Investments 343 L. Michael Ladd, CFA, CAIA, CMT, CFP(R) 40 Fundamental Tax Law 353 Lance Palmer, PhD, CPA, CFP(R), University of Georgia 41 Income Tax Fundamentals and Calculations 363 Lance Palmer, PhD, CPA, CFP(R), University of Georgia 42 Characteristics and Income Taxation of Business Entities 373 Webster Hewitt, CPA, CFP(R), University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia 43 Income Taxation of Trusts and Estates 383 Martin C. Seay, PhD, CFP(R), Kansas State University Lance Palmer, PhD, CPA, CFP(R), University of Georgia 44 Alternative Minimum Tax (AMT) 391 Webster Hewitt, CPA, CFP(R), University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia 45 Tax Reduction and Management Techniques 399 Lance Palmer, PhD, CPA, CFP(R), University of Georgia 46 Tax Consequences of Property Transactions 409 Lance Palmer, PhD, CPA, CFP(R), University of Georgia Martin C. Seay, PhD, CFP(R), Kansas State University 47 Passive Activity and At-Risk Rules 417 Lance Palmer, PhD, CPA, CFP(R), University of Georgia 48 Tax Implications of Special Circumstances 423 Lance Palmer, PhD, CPA, CFP(R), University of Georgia 49 Charitable/Philanthropic Contributions and Deductions 431 Webster Hewitt, CPA, CFP(R), University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia 50 Retirement Needs Analysis 439 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 51 Social Security and Medicare 447 Sarah D. Asebedo, MS, CFP(R), Virginia Tech Martin C. Seay, PhD, CFP(R), Kansas State University Thomas Warschauer, PhD, CFP(R), San Diego State University 52 Medicaid 463 Katie Seay, CFP(R), The Trust Company Martin C. Seay, PhD, CFP(R), Kansas State University 53 Types of Retirement Plans 471 John E. Grable, PhD, CFP(R), University of Georgia 54 Qualified Plan Rules and Options 479 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 55 Other Tax-Advantaged Plans 485 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 56 Regulatory Considerations 491 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 57 Key Factors Affecting Plan Selection for Businesses 495 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 58 Distribution Rules and Taxation 501 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 59 Retirement Income and Distribution Strategies 509 Dave Yeske, DBA, CFP(R), Golden Gate University Elissa Buie, MBA, CFP(R), Golden Gate University 60 Business Succession Planning 515 John E. Grable, PhD, CFP(R), University of Georgia Joseph W. Goetz, PhD, University of Georgia Kevin Valentino, MS, University of Georgia 61 Characteristics and Consequences of Property Titling 527 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 62 Gifting Strategies 533 Elissa Buie, MBA, CFP(R), Golden Gate University 63 Estate Planning Documents 541 Andrew Head, MA, CFP(R), Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive) 64 Estate Tax Compliance and Tax Calculation 547 Elissa Buie, MBA, CFP(R), Golden Gate University 65 Sources for Estate Liquidity 555 Elissa Buie, MBA, CFP(R), Golden Gate University 66 Types, Features, and Taxation of Trusts 561 Elissa Buie, MBA, CFP(R), Golden Gate University 67 Marital Deduction 569 Elissa Buie, MBA, CFP(R), Golden Gate University 68 Intra-Family and Other Business Transfer Techniques 575 Elissa Buie, MBA, CFP(R), Golden Gate University 69 Postmortem Estate Planning Techniques 585 Elissa Buie, MBA, CFP(R), Golden Gate University 70 Estate Planning for Non-Traditional Relationships 591 Elissa Buie, MBA, CFP(R), Golden Gate University Supplement: CFP Board s Code of Ethics and Professional Responsibility 601 Part Two Introduction 605 Charles R. Chaffin, EdD, CFP Board Thomas Warschauer, PhD, CFP(R), San Diego State University 71 Establishing and Defining the Client-Planner Relationship 609 Elissa Buie, MBA, CFP(R), Golden Gate University Dave Yeske, DBA, CFP(R), Golden Gate University 72 Gathering Information Necessary to Fulfill the Engagement 617 Elissa Buie, MBA, CFP(R), Golden Gate University Dave Yeske, DBA, CFP(R), Golden Gate University 73 Analyzing and Evaluating the Client s Current Financial Status 625 Thomas Warschauer, PhD, CFP(R), San Diego State University Vickie Hampton, PhD, CFP(R), Texas Tech University Andrew Head, MA, CFP(R), Western Kentucky University 74 Developing Financial Planning Recommendations 635 John E. Grable, PhD, CFP(R), University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia 75 Communicating the Financial Planning Recommendations 653 Dave Yeske, DBA, CFP(R), Golden Gate University John E. Grable, PhD, CFP(R), University of Georgia 76 Implementing the Financial Planning Recommendations 665 Ronald A. Sages, PhD, AEP(R), CFP(R), CTFA, EA Kansas State University 77 Monitoring the Financial Planning Recommendations 677 Thomas Warschauer, PhD, CFP(R), San Diego State University Sharon A. Burns, PhD, CPA (Inactive) Part Three Introduction 685 Charles R. Chaffin, EdD, CFP Board 78 Gathering Data from Clients: Insights from Cognitive Task Analysis and Requirements Engineering 687 Kelly S. Steelman, PhD, Michigan Technological University Jason S. McCarley, PhD, Flinders University John E. Grable, PhD, CFP(R), University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia Dave Yeske, DBA, CFP(R), Golden Gate University Charles R. Chaffin, EdD, CFP Board 79 The Need for Education 703 Joyce Schnur, CFP(R), MBA, ChFC, Kaplan University Charles R. Chaffin, EdD, CFP Board 80 Financial Planning Standards Board 709 Michael Snowdon, CFP(R), Financial Planning Standards Board 81 Behavioral Finance and Its Implications for Financial Advisors 737 Keith Redhead, PhD, Coventry University 82 Applications of Behavioral Economics in Personal Financial Planning 751 Swarn Chatterjee, PhD, University of Georgia Joseph W. Goetz, PhD, University of Georgia 83 Marriage and Family Therapy Applications to Financial Planning 763 Kristy L. Archuleta, PhD, LMFT, Kansas State University D. Bruce Ross III, MS, University of Georgia 84 Financial Therapy: The Integration of Financial Planning and Theory 779 Kristy L. Archuleta, PhD, LMFT, Kansas State University Bradley T. Klontz, PsyD, CFP(R), Kansas State University Sonya L. Britt, PhD, CFP(R), Kansas State University 85 Aging Clients: Special Considerations 795 Deanna L. Sharpe, PhD, CFP(R), University of Missouri 86 Accounting for Time: Important Distinctions and Concepts for Financial Planners 829 John E. Grable, PhD, CFP(R), University of Georgia Robert Rodermund, MS, Lindenwood University 87 The Psychology of Decisions: A Short Tutorial 843 Jason S. McCarley, PhD, Flinders University Kelly S. Steelman, PhD, Michigan Technological University John E. Grable, PhD, CFP(R), University of Georgia Lance Palmer, PhD, CPA, CFP(R), University of Georgia Dave Yeske, DBA, CFP(R), Golden Gate University Charles R. Chaffin, EdD, CFP Board Conclusion 88 Moving Forward 861 Charles R. Chaffin, EdD, CFP Board Elissa Buie, MBA, CFP(R), Golden Gate University Sharon A. Burns, PhD, CPA (Inactive) Vickie Hampton, PhD, CFP(R), Texas Tech University Lance Palmer, PhD, CPA, CFP(R), University of Georgia Thomas Warschauer, PhD, CFP(R), San Diego State University Dave Yeske, DBA, CFP(R), Golden Gate University Index 879

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CFP Board Financial Planning Competency Handbook Second Edition CHARLES R. CHAFFIN, EdD Editor

Cover design: Wiley Copyright © 2015 by Certified Financial Planner Board of Standards, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 7508400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 7486008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. Library of Congress Cataloging-in-Publication Data: Financial planning competency handbook. CFP Board financial planning competency handbook / CFP Board. — Second Edition. pages cm. — (Wiley finance series) Includes index. ISBN 978-1-119-09496-8 (cloth) ISBN 978-1-119-09500-2 (ePDF) ISBN 978-1-119-09498-2 (ePub) 1. Financial planners. 2. Investment advisors. 3. Finance, Personal. 4. Financial planning industry. I. Certified Financial Planner Board of Standards. II. Title. HG179.5.F5663 2015 332.024—dc23 2015018032

Contents Acknowledgments About the Book Preface NOTES About the Practice Questions About the Contributors PART ONE Introduction 1 Theory and Practice PART ONE CHAPTER INTRODUCTIONS STUDENT-CENTERED LEARNING OBJECTIVES BASED ON CFP BOARD PRINCIPAL TOPICS IN CLASS BLOOM’S TAXONOMY PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE PART TWO PART THREE NOTES 2 Function, Purpose, and Regulation of Financial Institutions CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 3 Financial Services Regulations and Requirements CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS

PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 4 Consumer Protection Laws CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 5 Fiduciary CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 6 Financial Planning Process CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 7 Financial Statements CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES

8 Cash Flow Management CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 9 Financing Strategies CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 10 Economic Concepts CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 11 Time Value of Money CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE 12 Client and Planner Attitudes, Values, Biases, and Behavioral Finance CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES

IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 13 Principles of Communication and Counseling CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 14 Debt Management CONNECTIONS DIAGRAM OVERVIEW LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 15 Education Needs Analysis CONNECTIONS DIAGRAM INTRODUCTION NEEDS ANALYSIS CALCULATION LEARNING OBJECTIVES: IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 16 Education Savings Vehicles CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE

17 Financial Aid (Education) CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 18 Gift and Income Tax Strategies (Education) CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 19 Education Financing CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 20 Principles of Risk and Insurance CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 21 Analysis and Evaluation of Risk Exposures CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS

PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 22 Health Insurance and Health Care Cost Management CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE 23 Disability Income Insurance (Individual) CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 24 Long-Term Care Insurance CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 25 Annuities CONNECTION DIAGRAM INTRODUCTION FREQUENCY OF CONTRIBUTIONS DISTRIBUTION ALTERNATIVES DISTRIBUTION OPTIONS INVESTMENT OPTIONS TAXATION OF ANNUITIES

FEES AND CHARGES IN ANNUITIES PENSION PROTECTION ACT OF 2006 LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 26 Life Insurance (Individual) CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 27 Business Uses of Insurance CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 28 Insurance Needs Analysis CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 29 Insurance Policy and Company Selection CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES

IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 30 Property and Casualty Insurance CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE 31 Characteristics, Uses, and Taxation of Investment Vehicles CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE 32 Types of Investment Risk CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 33 Quantitative Investment Concepts CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 34 Measures of Investment Returns

CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE 35 Asset Allocation and Portfolio Diversication CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 36 Bond and Stock Valuation Concepts CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 37 Portfolio Development and Analysis CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 38 Investment Strategies CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES

IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 39 Alternative Investments CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 40 Fundamental Tax Law CONNECTION DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 41 Income Tax Fundamentals and Calculations CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 42 Characteristics and Income Taxation of Business Entities CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 43 Income Taxation of Trusts and Estates CONNECTIONS DIAGRAM INTRODUCTION

LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 44 Alternative Minimum Tax (AMT) CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 45 Tax Reduction and Management Techniques CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 46 Tax Consequences of Property Transactions CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 47 Passive Activity and At-Risk Rules CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 48 Tax Implications of Special Circumstances CONNECTIONS DIAGRAM

INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 49 Charitable/Philanthropic Contributions and Deductions CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 50 Retirement Needs Analysis CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 51 Social Security and Medicare CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 52 Medicaid CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE

NOTES 53 Types of Retirement Plans CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 54 Qualied Plan Rules and Options CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 55 Other Tax-Advantaged Plans CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE 56 Regulatory Considerations CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 57 Key Factors Affecting Plan Selection for Businesses CONNECTIONS DIAGRAM INTRODUCTION

LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 58 Distribution Rules and Taxation CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 59 Retirement Income and Distribution Strategies CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 60 Business Succession Planning CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 61 Characteristics and Consequences of Property Titling CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 62 Gifting Strategies

CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTES 63 Estate Planning Documents CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 64 Estate Tax Compliance and Tax Calculation CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 65 Sources for Estate Liquidity CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 66 Types, Features, and Taxation of Trusts CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES

IN PRACTICE NOTES 67 Marital Deduction CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 68 Intra-Family and Other Business Transfer Techniques CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVE IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 69 Postmortem Estate Planning Techniques CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE 70 Estate Planning for Non-Traditional Relationships CONNECTIONS DIAGRAM INTRODUCTION LEARNING OBJECTIVES IN CLASS PROFESSIONAL PRACTICE CAPABILITIES IN PRACTICE NOTE Supplement: CFP Board’s Code of Ethics and Professional Responsibility PART TWO Introduction THE JAMESON FAMILY

NOTE 71 Establishing and Dening the Client-Planner Relationship DEFINITION PURPOSE TECHNIQUES IN PRACTICE NOTES 72 Gathering Information Necessary to Fulfill the Engagement DEFINITION PURPOSE TECHNIQUES IN PRACTICE NOTES 73 Analyzing and Evaluating the Client’s Current Financial Status DEFINITION PURPOSE TECHNIQUES IN PRACTICE NOTES 74 Developing Financial Planning Recommendations DEFINING A RECOMMENDATION PURPOSE OF A RECOMMENDATION TECHNIQUES IN DEVELOPING A RECOMMENDATION IN PRACTICE NOTES 75 Communicating the Financial Planning Recommendations DEFINITION PURPOSE IN PRACTICE NOTES 76 Implementing the Financial Planning Recommendations DEFINITION PURPOSE IN PRACTICE

NOTE 77 Monitoring the Financial Planning Recommendations DEFINITION PURPOSE TECHNIQUES IN PRACTICE NOTE PART THREE Introduction 78 Gathering Data from Clients:: Insights from Cognitive Task Analysis and Requirements Engineering APPROACHES TO KNOWLEDGE ELICITATION SOME KNOWLEDGE ELICITATION TECHNIQUES KNOWLEDGE ELICITATION FOR FINANCIAL PLANNING NOTES 79 The Need for Education JOHN AND JOANN KATHY AND MARIO LOU AND KAREN 80 Financial Planning Standards Board INTRODUCTION FINANCIAL PLANNER ABILITIES FRAMEWORK FINANCIAL PLANNING FUNCTIONS CORE FINANCIAL PLANNING COMPETENCIES FUNDAMENTAL FINANCIAL PLANNING PRACTICES FINANCIAL PLANNING COMPONENTS TERMS USED IN THE FINANCIAL PLANNER ABILITIES MATRIX FINANCIAL PLANNER PROFESSIONAL SKILLS FINANCIAL PLANNING KNOWLEDGE BASE FPSB FINANCIAL PLANNING TOPIC LIST FINANCIAL PLANNING CURRICULUM FRAMEWORK LOOKING FORWARD WORKING TOGETHER NOTE 81 Behavioral Finance and Its Implications for Financial Advisors

HEURISTIC SIMPLIFICATION SELF-DECEPTION AFFECTIVE AND SOCIAL INFLUENCES UNCERTAINTY, COMPLEXITY, AND TIME CONSTRAINTS IN PRACTICE NOTES 82 Applications of Behavioral Economics in Personal Financial Planning INTRODUCTION THE FINANCIAL DECISION-MAKING PROCESS HEURISTICS AND BIASES PROSPECT THEORY MENTAL ACCOUNTING THE OSTRICH EFFECT RISK TOLERANCE OVERCONFIDENCE FINANCIAL LITERACY SELF-REGULATION PSYCHOPHYSIOLOGICAL ECONOMICS SAVE MORE TOMORROW PROGRAM SUMMARY NOTES 83 Marriage and Family Therapy Applications to Financial Planning APPLICATIONS FROM MARRIAGE AND FAMILY THERAPY SYSTEMS THEORY ECOLOGICAL THEORY SIMILARITIES AND DIFFERENCES BETWEEN SYSTEMS AND ECOLOGICAL THEORY SYSTEMS AND ECOLOGICAL PERSPECTIVES IN THE FINANCIAL PLANNING PROCESS IN PRACTICE STRATEGIES FOR WORKING WITH MULTIPLE FAMILY MEMBERS CONCLUSION NOTES 84 Financial Therapy: The Integration of Financial Planning and Theory

INTRODUCTION AND RATIONALE FOR FINANCIAL THERAPY IN FINANCIAL PLANNING KEY CONCEPTS IN FINANCIAL THERAPY MONEY SCRIPTS MONEY DISORDERS MULTICULTURAL CONSIDERATIONS THEORETICAL PERSPECTIVES IN FINANCIAL THERAPY COLLABORATIVE RELATIONAL MODEL TOOLS FOR EDUCATION CONCLUSION NOTES 85 Aging Clients: Special Considerations SEASONS OF RETIREMENT LIFE CRITICAL CONVERSATIONS RELATED TO LIFESTYLE THREATS TO LATER LIFE COGNITIVE FUNCTION CLIENT COGNITIVE ABILITY AND PLANNER FIDUCIARY RESPONSIBILITY ELDER ABUSE CRITICAL CONVERSATIONS RELATED TO DECISION-MAKING CAPACITY CRITICAL CONVERSATIONS RELATED TO HEALTH HOME IS A NEW PLACE HOME IS IN THE SAME PLACE … OR CLOSE TO IT AGING IN PLACE EMERGING HOUSING ALTERNATIVES CRITICAL CONVERSATIONS RELATED TO HOUSING LATER TIMED PARENTING LATER LIFE DIVORCE LATER LIFE COHABITATION MAY–DECEMBER MARRIAGE CAREGIVING CONCERNS RECEIVING CARE CLIENT CONVERSATIONS CONCERNING FAMILY PROFESSIONAL PRACTICE CONSIDERATIONS NOTES

86 Accounting for Time: Important Distinctions and Concepts for Financial Planners TIME PERSPECTIVE THEORY PREDICTING BEHAVIOR USING TIME PERSPECTIVES EMPIRICAL EVIDENCE USING TIME PERSPECTIVE TO HELP CLIENTS SUMMARY NOTES 87 The Psychology of Decisions: A Short Tutorial INTRODUCTION ATTRIBUTE SUBSTITUTION: THE AVAILABILITY, REPRESENTATIVENESS, AND AFFECT HEURISTICS THE REPRESENTATIVENESS HEURISTIC THE AVAILABILITY HEURISTIC THE AFFECT HEURISTIC ANCHORING LOSS AVERSION UNREALISTIC OPTIMISM CONCLUSION NOTES CONCLUSION 88 Moving Forward DEVELOPMENT OF A PROFESSION CAREER PATH DEMOGRAPHICS RESEARCH IN FINANCIAL PLANNING FOCUS ON PLANNING NOTES Index Access Code EULA

List of Tables Chapter 4 Table 4.1

Chapter 14 Table 14.1 Chapter 29 Table 29.1 Chapter 30 Table 30.1 Chapter 37 Table 37.1 Chapter 39 Table 39.1 Chapter 53 Table 53.1 Chapter 78 Table 78.1 Table 78.2 Chapter 85 Table 85.1

List of Illustrations Chapter 6 Figure 6.1 The Systematic Financial Planning Process Chapter 78 Figure 78.1 A Concept Map on the Topic of the U.S. Government Figure 78.2 Financial Planning Concept Map Chapter 83 Figure 83.1 Systemic Model of Family and Business Figure 83.2 Similarities and Differences between Systems and Ecological Theory Chapter 85 Figure 85.1 Population 65+ in the United States, 1900–2050 Figure 85.2 Budget Shares Illustrated

Figure 85.3 Housing Continuum Figure 85.4 Phased Relocation Figure 85.5 Marital Age Difference Chapter 86 Figure 86.1 Categories of Time Orientation

Acknowledgments A work of this magnitude could not come to fruition without the commitment of a large number of dedicated, accomplished individuals. First, I want to thank the 39 contributors, consisting of practitioners, researchers, and educators from within the profession and beyond, who shared their scholarship and practice experience for this book. I am grateful for their generosity and collaboration throughout this immense project. I suspect that as you read each chapter, you will witness the dedication of these individuals to both this book as well as the profession as a whole. I want to thank them for allowing me to pester them incessantly regarding deadlines, revisions, and content. They are a respected group of individuals with whom I am lucky to have had the pleasure to collaborate throughout this important project. Thank you to Tula Batanchiev, Stacey Rivera, Laura Walsh, and all of my friends at John Wiley & Sons for their help throughout this process. Wiley continues to be a wonderful partner in this important endeavor, encouraging creative ideas and helping us expand the body of knowledge for this young yet dynamic profession. I would like to thank the board of directors at CFP Board for their unwavering commitment to this project. I also would like to thank the CFP Board Education and Examinations staff for their years of hard work in helping develop and refine the certification requirements that help serve as the basis for this book. I am grateful to the Professional Standards, Marketing, and Public Relations departments for their generosity in supporting several key components of this project. Also, thank you to Lisa Braverman and Nancy Odenthal for their assistance in providing some vital support to this immense, year-long endeavor. I am grateful to Kevin Keller, CEO of CFP Board, and Michele Warholic, CFP Board Managing Director—Examination, Education, and Talent, for their support and encouragement throughout each stage of the development of this book. CFP Board is a special place that cultivates creativity and innovation for a common purpose and I hope the CFP Board Financial Planning Competency Handbook is representative of that special environment. In the end, I take responsibility for this work—this snapshot of the living, breathing body of knowledge for our profession. A body of knowledge that, similar to the profession it supports, continues to grow through the collaborative work of practitioners and academics. It is my hope that this book will not only expand the current thinking of practitioners and academics alike, but also serve as a time capsule for this profession, illustrating how far we as a discipline, as a profession, will grow in the years and decades to come. Charles R. Chaffin, EdD

About the Book CFP Board is pleased to develop this important work that outlines the knowledge, actions, and contexts associated with financial planning. This book represents the advancement in the profession by practitioners, educators, and researchers in moving toward a universal body of knowledge for the discipline as a whole. This publication is not meant to replace any existing textbook or provide any specific examination preparation, but rather to further the theoretical knowledge base of our growing discipline. This book serves the entire financial planning profession, including students, faculty, researchers, and practitioners in financial planning and related professions. The book was designed to treat theory and practice not as binary functions, but as one entity, where content was defined but also applied, both within the learning environment and in practice. Part One outlines the 78 topics required to meet the CFP Board Education requirement. Each topic is defined specifically with regard to financial planning and presented in the form of studentcentered Learning Objectives. These objectives indicate what the student should be able to do relative to a given concept. The In Class section illustrates ways to facilitate higher-order cognitive thinking relative to each topic in both the traditional classroom as well as the online learning environment. Professional Practice Capabilities outline what practitioners should be able to do relative to three distinct career stages. Vignettes in each chapter, In Practice, illustrate how each particular concept is applied and/or exists in practice. Part Two outlines the domains that are part of the CFP Board Examination requirement. This section defines each of the domains and presents the associated Techniques for completing the domains as well as how they occur In Practice. There are questions specific to each of the chapters in Part One that assess the reader’s content knowledge relative to each of the topic areas. Students can benefit from these questions to test their understanding of these vital areas, as well as CFP® professionals who can also choose to obtain the full 28 credit hours by taking and passing the test. Visit www.wiley.com/go/wileycfpboard2e for more details. Part Two is devoted to the financial planning process, illustrating the rationale, techniques, and contexts where the process takes place. In this edition, a case, The Jameson Family, runs through each stage of the financial planning process, outlining how each step affects the context as well as how the context can impact each step. Finally, Part Three focuses on the interdisciplinary nature of financial planning, focusing on both the theory and practical implications of related disciplines such as behavioral finance, marriage and family therapy, psychology, communication, and others. The purpose of Part Three is to bring new theory into this discipline for faculty and researchers while driving implications related to this theory directly to practitioners. It is important to note that this book is designed to have universal applicability for the profession of personal financial planning. However, certification and practice requirements vary depending upon location of residence. The reader is encouraged to visit www.CFP.net for

information about requirements for certification within the United States and www.fpsb.org for information about requirements outside of the United States.

Preface Charles R. Chaffin, EdD CFP Board Personal financial planning has grown and evolved considerably over the past several years. The field hardly existed just four decades ago.1 As the population’s financial planning needs have grown, so too has practice. As of 2015, there are over 71,000 CFP® professionals in the United States, and the designation exists in 24 countries worldwide.2 Many labor forecasts are predicting a significant rise in the number of employment opportunities in personal financial planning even in the midst of a stagnant global economy. In order to meet this need, an increasing number of institutions and countries are preparing and certifying individuals to become personal financial planners. With an increased need has also come a growing complexity in the financial planning needs of the client. This increased complexity requires higher skill on the part of the practitioner. Practitioners must demonstrate proficiency relative to a broad range of content areas, from retirement planning and estate planning to insurance, taxation, and investments. Within all of this complexity, financial planners are also required to communicate with the client in an effective manner. This communication may be as involved as presentation of complex information in an accessible manner or as simple as listening and empathizing with a client regarding a serious life event. Given the increased need and complexity of this growing field, personal financial planning has taken some important steps in the past several decades. However, has it matured into a profession? In the last analysis, the law is what the lawyers are. And the law and the lawyers are what the law schools make them. —Felix Frankfurter3 A profession, at its foundation, entails a specialized body of knowledge and skills. Education precedes any other attribute of a profession. Wilensky explains how the University of Pennsylvania Medical School was founded in 1795, long before the development of the American Medical Association in 1847.4 As Abbott suggests, there have to be doctors before one can develop an association of them.5 This specialized body of knowledge is developed through practical experience as well as empirical study of every facet of the discipline. The knowledge gained from practical experience and research is then disseminated to current and future professionals. The dissemination, and therefore acquisition and application, of this body of knowledge, occurs at institutions of higher learning where prospective professionals learn how and when to solve real-world problems relative to a chosen profession. At these institutions, the individuals entrusted to prepare these future professionals have both a high level of education relative to this field of study as well as practical experience. The experiences of the faculty members within these institutions enables them to devise learning experiences that bring the subject matter to life, offering opportunities for the prospective

professionals not only to hone their new skills relative to a specific problem, but also to learn when to utilize these skills in contexts they will encounter in practice. In financial planning, the colleges and universities that offer CFP Board registered programs are locations where individuals learn specialized knowledge relative to several content areas across financial planning. This specialized knowledge is more than just the memorization of a series of inert facts, but is instead a basic theoretical understanding, most immediately followed by application and creation that directly relate to contextual settings within the discipline of personal financial planning. The aspiring professional needs to be able not only to comprehend and subsequently apply basic theoretical content relative to a given content area, but also to ascertain how this content area directly relates to the other basic content areas across the discipline of financial planning. For example, estate planning and taxation do not exist in a vacuum relative to a client’s needs, but may directly relate to the investment and retirement needs of the future client. The financial planning professional must have a working knowledge of the relationships among these key and vital content areas. The education of the financial planning professional goes beyond basic theoretical content and actions in practice, but also teaches important communication skills. The successful financial planning professional must be able to develop a plan for the future client relative to the client’s needs and situation, and, just as importantly, must communicate it to this client in an effective manner. Successful personal financial planners are ones who can effectively present, articulate, listen, and in many cases show care and empathy for their clients. This success is no different from that in many other disciplines where communication and engagement are vital to success. In his book, Blink: The Power of Thinking without Thinking, Malcolm Gladwell discusses the reasons why doctors get sued by their patients: The overwhelming number of people who suffer an injury due to the negligence of a doctor never file a malpractice suit at all. In other words, patients don’t file lawsuits because they’ve been harmed by shoddy medical care. Patients file lawsuits because they’ve been harmed by shoddy medical care and something else happens to them. . . . What comes up again and again in malpractice cases is that patients say they were rushed or ignored or treated poorly.6 It is, therefore, the relationship between the personal financial planning professional and the client that is a key contributor to success. It is not that doctors, lawyers, or personal financial planning professionals do not need to have achieved a high level of understanding and application relative to the demands of their field of study; it merely means that these professionals must also possess the ability to communicate, engage, and, on some level, care for their clients and patients. The act of communicating in personal financial planning is one that requires education, where the individual learns how to present complex areas such as investments in a way that is both accessible and relevant to each client. Within any society, professions hold an extraordinary amount of power and influence. Members of this group have a specialized expertise that provides great value to the population as a whole. This value to society is inherently provided with little or no self-interest.7 This

notion of specialization also creates an element of autonomy for the profession, as these individuals exercise authority in determining right and wrong relative to their service.8 Individuals within this profession have the responsibility to act in a competent, ethical manner that will be in the best interests of the greater population. Thus, a given trade or occupation must have professional ethics in order to be called a profession. As Hughes suggests: Not only do the practitioners, by virtue of gaining admission to the charmed circle of the profession, individually exercise a license to do things others do not, but collectively they presume to tell society what is good and right for it in a broad and crucial aspect of life. Indeed, they set the very terms of thinking about it. When such a presumption is granted as legitimate, a profession in the full sense has come into being.9 Within this license to which Hughes is referring, practitioners in a given profession must have the highest level of competence in serving the public as well as specific guidelines relative to ethics and professional conduct. This competence and ethical conduct is recognized as valuable to the general population. Without this recognition from the public, the profession would likely be unsustainable. Almost all professions have some sort of code of ethics. The first profession to establish a modern code of ethics was medicine in the eighteenth century.10 The medical profession developed these codes to ease internal strife among members of the profession as well as to raise the status of the profession as a whole. The profession felt the need to defend itself from fraudulent individuals who misleadingly characterized themselves as medical experts. Ethical codes most often occur in writing and generally develop after a profession becomes organized. These codes require that the individual maintain a higher level of standards than what is required by law.11 The requirements are not developed in isolation, but rather with the objective of service to the population as a whole. These codes outline how professionals are to pursue a common cause with minimal cost to themselves or to the general population.12 The requirements also evolve based on events, such as government law and economic and social changes in the environment. For example, in medieval England, in response to growing hostility toward the legal profession, regulation of the legal profession began with adoption of a series of requirements to curb incompetence, unethical practices, and conflicts of interest.13 It is important to note that a code also protects members from certain pressures, such as cutting corners, cheating, or other forms of misconduct. A code of ethics is a guide to the professional, and the profession at large, concerning certain practices and expectations regarding aspects of one’s service to the population as a whole. Practitioners in a given profession benefit from a code of ethics that is required of their members, and therefore they should follow this code for the benefit of the entire group of professionals. Further, professionals must adhere to the code of conduct or be subject to discipline. Financial planning contains a set of Standards of Professional Conduct that outline the ethical standards for CFP® professionals. The CFP Board’s Code of Ethics expresses the professional’s recognition of his or her “responsibilities to the public, to clients, to colleagues,

and to employers.”14 Given the important responsibilities of the personal financial planner, the CFP® professional must adhere to a variety of rules of conduct in order to serve the public in a competent, ethical manner. It is not enough, however, to merely have a code of ethics; it is vital that there exists evidence of enforcement of this code as well. Individuals within a profession must identify themselves as part of that profession. The objective of service to the general population and the notion of competence and ethical responsibilities associated with such service become a guiding philosophy to members of a given profession. Practitioners in a given profession, therefore, identify themselves as serviceoriented, competent, and ethical, and most importantly, their actions and decisions reflect this philosophy and ultimately their membership in a given profession. Individuals who are attracted to a given profession are attracted because of the guiding principles of the profession. Organizations within a profession can provide unity to practitioners relative to common goals and shared problems. Associations within a profession provide opportunities for engagement through social functions as well as group problem solving of shared concerns. Associations work so that the practitioner does not cope with social and economic matters relative to the profession alone. Within financial planning, the Financial Planning Association (FPA®) and the National Association of Personal Financial Advisors (NAPFA) provide a voice to practitioners regarding issues and challenges within financial planning as well as opportunities to engage through conference and electronic means. Personal financial planning has grown and evolved considerably over the past several decades. As described earlier, the field contains many of the primary attributes of a profession. The education, objectives, professional code of ethics, and associations have provided financial planning with the framework to become a robust profession. However, there is considerable work yet to be done in each of these areas. Education of current and future practitioners requires additional qualified faculty providing contextual learning experiences based on practice and empirical research. Leaders in education and the profession must be equally skilled in professional practice as well as in conducting lines of inquiry that will challenge and refine all areas of practice. Practitioners must continue to wholeheartedly embrace the notion of service and the responsibilities that come from serving an important function to the general population. Professional standards and ethical codes within financial planning must continue to be followed and enforced by leaders in the profession such as the CFP Board and the Financial Planning Standards Board. Finally, professional organizations must continue to provide a platform for practitioners to engage one another as well as explore critical problems and opportunities within this exciting and growing field. It is our hope that this book, a handbook outlining the what, why, how, and when of this exciting field, can enable personal financial planning to take one more critical step toward becoming a mature profession.

NOTES

1. E. Denby Brandon, Jr., and H. Oliver Welch, The History of Financial Planning: The Transformation of Financial Services (Hoboken, NJ: John Wiley & Sons, 2009). 2. CFP Board, CFP® Certificant Profile (November 30, 2012). Retrieved from www.cfp.net/media/profile.asp. 3. Quoted in H. T. Edwards, “The Growing Disjunction between Legal Education and the Legal Profession,” Michigan Law Review (1992): 34–70. 4. Harold L. Wilensky, “The Professionalization of Everyone?” American Journal of Sociology 70, no. 2 (1964): 137–158. 5. Andrew Abbott, “The Order of Professionalization: An Empirical Analysis,” Work and Occupations 18, no. 4 (1991): 355–384. 6. Malcolm Gladwell, Blink: The Power of Thinking without Thinking (New York: Little, Brown, 2005). 7. L. H. Furguson and J. D. Ramsay, “Professional Issues Development of the Profession: The Role of Education & Certification in Occupational Safety Becoming a Profession,” Professional Safety 55, no. 10 (2010): 24. 8. Andrew Brien, “Professional Ethics and the Culture of Trust,” Journal of Business Ethics 17, no. 4 (1998): 391–409. 9. Everett C. Hughes, “Professions,” Daedalus 92, no. 4 (1963): 655–668. 10. Jeanne F. Backof and Charles L. Martin, Jr., “Historical Perspectives: Development of the Codes of Ethics in the Legal, Medical and Accounting Professions,” Journal of Business Ethics 10, no. 2 (1991): 99–110. 11. Ibid. 12. Michael Davis, “Thinking Like an Engineer: The Place of a Code of Ethics in the Practice of a Profession,” Philosophy and Public Affairs 20, no. 2 (1991): 150–168. 13. Jonathan Rose, “The Legal Profession in Medieval England: A History of Regulation,” Syracuse Law Review 48, no. 1 (1998). 14. CFP Board, Code of Ethics and Professional Responsibility (July 2003). Retrieved from www.cfp.net/for-cfp-professionals/professional-standards-enforcement/standards-ofprofessional-conduct/code-of-ethics- professional-responsibility.

About the Practice Questions Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

About the Contributors Charles R. Chaffin, EdD Dr. Charles Chaffin arrived at the CFP Board in March 2010, where he provides guidance and oversight to the 378 CFP Board registered programs. His educational background has focused upon teaching pedagogy, curriculum and instruction, educational and cognitive psychology, learner assessment, and higher education administration. He has taught all levels of learners, from elementary school, baccalaureate, graduate, and doctoral studies, through a variety of instructional platforms. He has published several papers that have focused upon the cognitive workload of learners in different task settings, reflective practice, and best practices in higher education curriculum and instruction. He holds a Doctor of Education degree from the University of Illinois at Urbana- Champaign with an additional graduate degree from the University of Michigan. Sailesh Acharya Sailesh Acharya is a Master’s student in the department of Family, Youth, and Community Sciences at the University of Florida. His current research focuses on decision making about taking student loans and its implications. Kristy L. Archuleta, PhD, LMFT Kristy L. Archuleta, PhD, LMFT, is Associate Professor of Personal Financial Planning at Kansas State University. Archuleta holds a Bachelor’s degree in Family Relations and Child Development with a minor in Business Management from Oklahoma State University and Master’s and Doctoral degrees in Marriage and Family Therapy with an emphasis in Personal Financial Planning from Kansas State University. Sarah D. Asebedo, MS, CFP® Sarah D. Asebedo, MS, CFP®, is Assistant Professor of Practice in Financial Planning at Virginia Tech and is currently pursuing a doctorate in Personal Financial Planning from Kansas State University. Her research interests focus on the connection between well-being and economic behavior for individuals and families. She has been a practitioner for over 10 years and is currently President of Perennial Wealth Group, Inc. Sarah also serves as a board member for the Financial Therapy Association. Sonya L. Britt, PhD, CFP® Sonya L. Britt, PhD, CFP®, is Associate Professor of Personal Financial Planning at Kansas State University. She holds a Bachelor’s degree in personal financial planning and a Master’s degree in marriage and family therapy from Kansas State University and a PhD in personal financial planning from Texas Tech University. Elissa Buie, MBA, CFP®

Elissa Buie, CFP®, earned an MBA from UMD and a BS in commerce from the University of Virginia. Elissa is past Chair of the Foundation for Financial Planning and Financial Planning Association (U.S.). She is Dean for FPA’s Residency Program and was named to the inaugural Financial Times Top 100 Women Financial Advisers list. Additionally, Elissa received the prestigious P. Kemp Fain, Jr. Award, the financial planning profession’s equivalent of a lifetime achievement award. She holds an appointment as Distinguished Adjunct Professor at GGU. Sharon A. Burns, PhD, CPA (Inactive) Sharon Burns served as a clinical associate professor at Purdue University from 2009 to 2012, teaching retirement planning and negotiations. She is an expert in retirement planning, the economics of aging, and financial planning for women. Swarn Chatterjee, PhD Swarn Chatterjee, PhD, is Associate Professor of Financial Planning at the University of Georgia. He has published more than 40 peer-reviewed papers and teaches classes in investing, portfolio management, and behavioral finance. He serves as co-director of the Financial Planning Performance Laboratory at the University of Georgia. L. Ann Coulson, PhD, CFP® L. Ann Coulson, PhD, CFP®, is a faculty member in Personal Financial Planning at Kansas State University. She earned her BS and PhD from the University of Missouri and her MS from the University of Arkansas. Additionally, she earned the CFP designation in 1991. Dr. Coulson serves as the CFP Board Registered Program Director for the BS, MS, and graduate certificate programs at Kansas State University. Martie Gillen, PhD Martie Gillen is Assistant Professor in the Department of Family, Youth, and Community Sciences at the University of Florida. She earned her doctorate in family studies from the University of Kentucky. Her research interests include behavioral economics, the economic well-being of older adults, Social Security retirement benefits, and retirement planning. Dr. Gillen teaches undergraduate courses in research methods and personal and family financial planning, as well as courses for the Graduate Certificate in Personal and Family Financial Planning Program, a CFP Board registered program. John Gilliam, PhD, CFP® John Gilliam, ChFC, CLU, is Associate Professor in the Department of Personal Financial Planning at Texas Tech University. His academic interests are strongly influenced by more than 30 years of professional experience as a financial and insurance advisor. Joseph W. Goetz, PhD Joseph W. Goetz, PhD, is Associate Professor of Financial Planning at the University of Georgia, co-founder of the ASPIRE Clinic, and a founding principal of Elwood & Goetz

Wealth Advisory Group. He has authored numerous publications in the areas of financial planning pedagogy, investment risk tolerance, and financial planning communication. He received his Bachelor’s degree from the University of Missouri–Columbia, and completed three graduate degrees in the areas of financial planning, psychology, and consumer economics at Texas Tech University. John E. Grable, PhD, CFP® John E. Grable, PhD, CFP®, holds an Athletic Association Endowed Professorship at the University of Georgia. Dr. Grable served as the founding editor for the Journal of Personal Finance and the founding co-editor of the Journal of Financial Therapy. His research interests include financial risk-tolerance assessment, behavioral financial planning, and psychophysiological economics. He is Director of the Financial Planning Performance Laboratory at the University of Georgia. Michael Gutter, PhD Dr. Michael Gutter is Associate Dean for Extension and State Program Leader for 4-H Youth Development, Families, and Communities for the Institute of Food and Agricultural Sciences at the University of Florida. He serves as the current program director of the three certificate programs. Dr. Gutter’s research focuses on examining how socioeconomic status, financial education, personal psychology, and financial socialization are related to financial behaviors. His outreach focuses on improving financial behaviors by increasing knowledge, skills, and access to services. Vickie Hampton, PhD, CFP® Vickie Hampton is Professor and Department Chair of Personal Financial Planning at Texas Tech University. She has authored articles on career development, determinants of success on the CFP® Certification Examination, and financial planning benchmarks for measuring financial well-being. Vickie has been active on national boards, serving on the Board of Trustees for the American College, the Certified Financial Planner (CFP) Board of Governors and Board of Examiners, the Academy of Financial Services Board, and the Louisiana State University CFP Advisory Board. She received her MS and PhD degrees in family and consumption economics at the University of Illinois at Urbana-Champaign. Andrew Head, MA, CFP® Andrew Head, MA, CFP®, joined Western Kentucky University in 2010 and teaches courses on personal finance, estate, tax, and insurance planning, among others, in addition to serving as the Director of the WKU CFP® Board Registered Financial Planning Programs as well as the WKU Center for Financial Success. He is faculty advisor to the WKU FPA™ Student Chapter and Membership Chair for FPA™ of Kentuckiana. Andrew is also managing partner of Journey Financial Management, LLC, a multistate RIA. Webster Hewitt, CPA, CFP® Webster Hewitt owns a fee-only financial planning firm, Hewitt Lane, with his wife Mandy,

located in Athens, Georgia. He has earned both the CPA and CFP® designations and is working toward his PhD. Bradley T. Klontz, PsyD, CFP® Bradley T. Klontz, PsyD, CFP®, is Associate Professor in Financial Planning at Kansas State University, a Partner at Occidental Asset Management, LLC, and Co-Founder of the Financial Psychology Institute™. He is a co-author/editor of Mind Over Money: Overcoming the Money Disorders that Threaten Our Financial Health (Broadway Business), Facilitating Financial Health: Tools for Financial Planners, Coaches, & Therapists (National Underwriter Company), Wired for Wealth (HCI), The Financial Wisdom of Ebenezer Scrooge (HCI), and Financial Therapy: Theory, Research, & Practice (Springer). L. Michael Ladd, CFA, CAIA, CMT, CFP® L. Michael Ladd has been an investment manager and analyst for over 20 years and has covered a host of the world’s stock, bond, and currency markets throughout his career. He is currently the President and Chief Investment Officer of an SEC-registered investment advisory firm, as well as an Adjunct Professor teaching investments at both Point Loma Nazarene University and San Diego State University. Michael received his MBA from the University of Oklahoma. Derek R. Lawson, MS Derek R. Lawson, MS is a financial planner at Sonas Financial Group in Kansas City, Missouri. Beginning August 2015, he plans to pursue a PhD in financial planning with an emphasis in financial therapy and behavioral finance. Derek is the Director of NexGen for the FPA of Greater Kansas City, and is the Social Media Coordinator for NAPFA Genesis. Additionally, he is a member of the Financial Therapy Association. Ruth Lytton, PhD Dr. Ruth Lytton is a professor and Director of the CFP Board Registered Financial Planning Program at Virginia Tech. Dr. Lytton has received various student association, college, university, and professional association awards for her contributions as a teacher, researcher, and career/academic advisor. In 2009 she was awarded the John H. Cecil Lifetime Service Award from the Central Virginia Chapter of FPA, and in 2012 she was awarded the national FPA Heart of Financial Planning Award. Jason S. McCarley, PhD Jason S. McCarley holds a PhD in experimental psychology from the University of Louisville. He is currently a professor in the Applied Cognitive Psychology program in the School of Psychology, Flinders University of South Australia. Lance Palmer, PhD, CPA, CFP® Dr. Palmer received his Bachelor’s and MBA degrees from The University of Utah and his PhD from Utah State University. He is Associate Professor at the University of Georgia

Financial Planning Program, where he teaches courses in financial planning with a focus on retirement and tax planning. Dr. Palmer is a CFP® professional and Certified Public Accountant. He has served on multiple editorial boards and is active in financial planning research. He was a recipient of the Richard B. Russell Excellence in Undergraduate Teaching Award at the University of Georgia and also received the university’s Engaged Scholar Award. Working in tandem with Tom Cochran and Georgia United Credit Union, Dr. Palmer has helped to expand the service-learning Volunteer Income Tax Assistance program in Athens, Georgia. Students studying financial planning and accounting complete hundreds of tax returns for families and individuals in the local community each year and provide thousands of hours of financial education and planning assistance to these households. Keith Redhead, PhD Prior to his retirement in 2014, Dr. Keith Redhead was Principal Lecturer in Finance at Coventry University (UK), where he established a degree program for the education of prospective financial planners. He taught in universities and financial institutions for more than 42 years. Dr. Redhead authored numerous journal articles and nine books in the area of finance. His books included Personal Finance and Investments: A Behavioural Finance Perspective. Robert Rodermund, MS Robert Rodermund is Assistant Professor of Finance at Lindenwood University in St. Charles, Missouri. Prior to his academic career, he was an executive at a large, independent brokerage firm. He holds a BSBA from Washington University in St. Louis, an MSCFE from the University of Missouri, Columbia, and is currently working to complete his PhD at Kansas State University. His research interests include time perspectives and risk tolerance. D. Bruce Ross III, MS D. Bruce Ross III, MS, is a marriage and family therapist working on his PhD in Human Development and Family Science with an emphasis in Marriage and Family Therapy at the University of Georgia. He earned a Master’s degree in couples and family therapy at the University of Maryland. While working toward his PhD, he works as a traditional marriage and family therapist, as well as a financial practitioner at the ASPIRE Clinic at the University of Georgia. Jorge Ruiz-Menjivar Jorge Ruiz-Menjivar is a doctoral student in the Department of Financial Planning, Housing, and Consumer Economics at the University of Georgia. His current research focuses primarily on financial risk tolerance, its assessment, and cross-cultural applications. Ronald A. Sages, PhD, AEP®, CFP®, CTFA, EA Ron is co-founder and President of Chapin Asset Management, a boutique wealth management firm with offices in Greenwich, CT and Hilton Head Island, SC, and Assistant Professor of Personal Financial Planning at Kansas State University. His research interests are in behavioral finance, risk management, and financial literacy. A financial planner since 1973,

Ron earned his PhD in personal financial planning from Kansas State University in 2012. Joyce Schnur, CFP®, MBA, ChFC Joyce joined Kaplan University School of Professional and Continuing Education in 2006, and her responsibilities as Dean include oversight of Kaplan’s Financial Services businesses, which include security and insurance licensing, wealth management, and professional development. Kaplan’s reach in the financial services industry extends globally, and in 2014 Joyce was named as a global sector leader for wealth management. Throughout her career, Joyce has been a frequent instructor and lecturer on many financial planning topics including tax topics and estate planning. Prior to joining Kaplan, she had over 20 years of financial counseling experience, during which time she advised many executives and directors of Fortune 500 companies, as well as small business owners. Katie Seay, CFP® Katie Seay is Assistant Trust Officer and the Director of Financial Planning at The Trust Company in Manhattan, Kansas, where she provides in-depth and long-term financial and retirement planning expertise to clients. Previously, Katie worked with a large financial planning and counseling firm in Atlanta, Georgia that mainly serves Fortune 500 company executives. Katie is a graduate of the Family Financial Planning Program at the University of Georgia and is a CFP® professional. Martin C. Seay, PhD, CFP® Martin C. Seay, PhD, CFP®, is Assistant Professor of Personal Financial Planning in the School of Family Studies and Human Services at Kansas State University. His research focuses on borrowing decisions, the role housing wealth plays in family finances, and how financial behavior is shaped by an individual’s psychological profile. Dr. Seay currently serves on the editorial review board for the Journal of Financial Planning and the Journal of Financial Therapy, as well as serving as Vice President of Communications for the Academy of Financial Services. Deanna L. Sharpe, PhD, CFP® Deanna L. Sharpe, PhD, CFP®, is Associate Professor in the Personal Financial Planning Department at the University of Missouri–Columbia. Her research and teaching focuses on relationships between the household and market economy. She has won awards for research on grandparent-headed households and financial issues of having a child with autism. The courses she has taught include Financial Counseling, Personal and Family Finance, Assessing the American Dream, Tax Planning, Employee Benefit and Retirement Planning Family Economics, and Personal Financial Issues of Older Adults. Michael Snowdon, CFP® Michael Snowdon, CFP®, is director of education and professionalism at Financial Planning Standards Board Ltd. (FPSB). Michael oversees education and training content development to support FPSB’s professionalism and certification standards. A former practicing financial

planner and financial planning educator, Michael has more than 30 years of experience in the financial planning profession, and has authored nationally acclaimed financial education and training materials. Michael received a Master’s in psychology and administration from Cincinnati Christian University and a Bachelor’s in education from Ozark Christian College. Taylor Spangler, MS Taylor Spangler is an Adjunct Lecturer in the Family, Youth, and Community Sciences Department at the University of Florida, focusing on personal finance topics. She is also the state coordinator for the Florida Master Money Mentor Program, a UF/IFAS Extension volunteer financial mentoring program sponsored by a gift from Bank of America. Kelly S. Steelman, PhD Kelly S. Steelman is Assistant Professor in the Department of Cognitive and Learning Sciences at Michigan Tech University. Her research focuses on human attention and cognition, with an emphasis on helping people to find and use information in data-rich, technological environments. She completed her PhD in psychology at the University of Illinois at UrbanaChampaign in 2011. Kevin Valentino, MS Kevin Valentino is a graduate student studying financial planning at the University of Georgia. He holds a Bachelor’s degree in finance from the University of Georgia and lives and works in Atlanta where he practices as a financial planner. ​ Thomas Warschauer, PhD, CFP® Thomas Warschauer is Professor of Finance, Emeritus, at San Diego State University. He founded the first CFP Board registered financial planning degree programs. He was formerly on the CFP Board of Examiners, was the first president of the Academy of Financial Services, and is Associate Editor of the Financial Services Review. Ann Woodyard, PhD, CFP® Ann Woodyard is Assistant Professor in the Department of Financial Planning, Housing, and Consumer Economics at the University of Georgia where she is the program director for the online Master’s program. She holds degrees from Kansas State University and the University of North Carolina at Chapel Hill. Her research interests include financial knowledge, gender issues in financial planning, and the role of philanthropy in personal wellness. Dave Yeske, DBA, CFP® Dave Yeske, DBA, CFP®, is Managing Director at Yeske Buie and a past chair of the Financial Planning Association. Dave received FPA’s Heart of Financial Planning award in 2012. He earned a BS in applied economics and an MA in economics from the University of San Francisco, and a DBA from Golden Gate University, where he holds an appointment as Distinguished Adjunct Professor in the Ageno School of Business. Dave co-teaches GGU’s capstone cases course with frequent co-author Elissa Buie.

PART One Introduction Charles R. Chaffin, EdD CFP Board Part One outlines much of the theoretical content of financial planning, exploring what the practitioner needs to know in order to effectively serve the client. Each of the chapters focuses on one specific topic area of financial planning, allowing the reader to use this book as a reference either throughout a given program of study or throughout practice. The connections diagram at the beginning of Part One chapters provides a visual representation of how a particular topic relates to the content areas in financial planning. A short paragraph below each of the diagrams provides a general analysis of many of the main connections relative to a given topic. For example, a given topic may have specific connections to three or four content areas across the discipline of financial planning. Students and faculty are encouraged to use these diagrams to facilitate dialogue in the classroom or online learning platform regarding how the particular subject area impacts others across the curriculum. Faculty may consider going around the different illuminated topic areas, discussing specific instances or circumstances where these content areas are related. Faculty teaching within a financial planning program may find it beneficial to review many of these diagrams with the objective of making explicit connections across the curriculum. Whether students are new to financial planning or have years of experience, providing key examples of how content areas are interrelated can help further the student's understanding of key concepts within financial planning practice. With regard to practice, given the diversity of positions within financial planning, practitioners are encouraged to use this connections diagram as a reminder of the interrelatedness of financial planning content areas. The opening of each chapter provides an overview of the topic as well as historical background of the topic. This overview is meant to provide a basis for how this topic sits within personal financial planning. The content in this area is not meant to replace the specifics that come from a standard textbook. Rather, it is designed to provide a framework for the topic relative to financial planning practice. Each of the chapters in Part One of this book contains a section devoted to student-centered learning objectives. These objectives are designed to outline what the student should be able to do relative to the particular chapter topic. Practitioners are encouraged to examine each of these outcomes to determine their own effectiveness relative to the topic area. Whether working in the field of personal financial planning or a related discipline, practitioners can benefit from a better understanding of their own effectiveness relative to these important concepts in personal financial planning. It may be that if the practitioner self-identifies areas of specific weakness in these objectives, he or she may decide to enroll in a continuing education

program that can assist in improving efficacy relative to this topic. The In Class sections of Chapters 2 through 70 note the learning experiences and assessment possibilities for facilitating higher-order cognitive thinking in the financial planning classroom. These tables should assist faculty in developing class activities and assessment avenues that further higher-order cognitive thinking in financial planning preparation programs. These charts are designed for all program types and delivery methods. In this book, the professional practice capabilities are divided into three levels based on this Dreyfus model—entry-level, competent, and expert—each of which illustrates the financial planning professional's ability to make appropriate decisions within a complex environment as well as the planner's progression from strict adherence to rules to use of past experiences to define future action. The reader is encouraged to use these practice capabilities to both self-assess competency relative to a given concept as well as plan future education and experience that may facilitate a higher level of expertise. Financial planning firms may utilize these capabilities to facilitate formal and informal mentorship programs within their organizations. Each of the chapters in Part One outlines many of the contexts that exist in financial planning, specifically relative to the topic of that particular chapter. These contexts, or vignettes, are designed to provide the student, practitioner, and instructor with specific situations in which this concept arises in real life as well as to offer some of the variables that may impact the decisions of the financial planner. Relative to each of these contexts, the reader is encouraged to consider altering some of the fact patterns in the scenarios to see if the actions by the financial planner would change under different circumstances. Students and faculty are encouraged to discuss these scenarios and offer alternative actions that the financial planner could take relative to this or other scenarios and contexts. Nearly 400 practice questions are available at www.wiley.com/go/wileycfpboard2e. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 1 Theory and Practice Charles R. Chaffin, EdD CFP Board This book is designed for the discipline of financial planning—practitioners, faculty, and students. Regardless of discipline, practitioners gain from reconnecting with theory as well as questioning how it may relate to practice and their specific work. Faculty gain from witnessing how their work, whether research or teaching, relates to practice as a whole. Students wishing to join a given profession gain not only from acquiring a basic understanding of the theory associated with a given field, but also from learning, observing, and ultimately demonstrating the necessary skills and abilities associated with current practice. At the risk of oversimplifying, this book is essentially divided into three parts: What a financial planner should know, what a financial planner does, and a systematic expansion of the body of knowledge for this discipline, incorporating related topics and disciplines. Chapters 2 to 70 outline the topics that encompass the content found within many financial planning preparation programs. The objective within Part One is to outline the topic and then discuss competencies relative to a given area. Competencies may be defined relative to a financial planning classroom or online learning platform or may be relative to the career track of the individual with years of financial planning practice. Just as important, this part outlines the contexts in financial planning practice in which these competencies are needed. It is not enough to merely know a particular area; the practitioner must also know when to utilize such competencies in a given context or scenario. The second part of this book, Chapters 71 to 77, explores what a financial planner actually does in practice. Based on the steps of the financial planning process, this section outlines the action performed by the financial planner as well as the rationale for such action. These chapters then outline some of the techniques utilized in practice. Finally, as with each concept, vignettes outline the contexts in which such actions would be necessary and appropriate given client situations or professional rules of conduct. The vignettes in each chapter follow one specific case through each step of the process, highlighting the need for this process relative to one specific context. Part Three provides an opportunity to expand financial planning research and practice into related disciplines, exploring the theory and implications of psychology, marriage and family therapy, behavioral finance, and others. In each of these chapters, the hope is for the diverse audiences of this book to gain insight into their particular areas: for the researcher to think about new lines of inquiry that will expand the body of knowledge; the practitioner to think about the implications of these disciplines and develop new tools that bring them into practice; and the students to make the connection between this new theory and its connection to practice

as they aspire to become the next generation of financial planning practitioners, faculty members, researchers, or a combination of all three. Finally, Chapter 88 offers a vision for the profession of financial planning, examining the changing demographics of the client and financial planner, future areas of research within the discipline, and the evolution of the role of the financial planner.

PART ONE The purpose of this first chapter is to provide an overview and the rationale of many of the sections of this book. Part One outlines much of the theoretical content of financial planning, exploring what the practitioner needs to know in order to effectively serve the client. Each of the chapters focuses on one specific topic area of financial planning, allowing the reader to use this book as a reference either throughout a given program of study or throughout practice. The diagram at the beginning of Chapters 2 through 70 provides a visual representation of how a particular topic relates to the content areas in financial planning. A short paragraph below each of the diagrams provides a general analysis of many of the main connections relative to a given topic. For example, a given topic may have specific connections to three or four content areas across the discipline of financial planning. Students and faculty are encouraged to use these diagrams to facilitate dialogue in the classroom or online learning platform regarding how the particular subject area impacts others across the curriculum. Faculty may consider going around the different illuminated topic areas, discussing specific instances or circumstances where these content areas are related. Faculty teaching within a financial planning program may find it beneficial to review many of these diagrams with the objective of making explicit connections across the curriculum. Whether students are new to financial planning or have years of experience, providing key examples of how content areas are interrelated can help further the student’s understanding of key concepts within financial planning practice. With regard to practice, given the diversity of positions within financial planning, practitioners are encouraged to use this connections diagram as a reminder of the interrelatedness of financial planning content areas.

CHAPTER INTRODUCTIONS The opening of each chapter provides an overview of the topic as well as historical background of the topic. This overview is meant to provide a basis for how this topic sits within personal financial planning. The content in this area is not meant to replace the specifics that come from a standard textbook. Rather, it is designed to provide a framework for the topic relative to financial planning practice.

STUDENT-CENTERED LEARNING OBJECTIVES BASED ON CFP BOARD PRINCIPAL TOPICS The notion behind the development of student-centered learning objectives is certainly not new to higher education, but it is part of a significant shift in the development of learning experiences across all disciplines. The shift is from an input-oriented curricular design to a student-centered outcomes approach where theoretical content, learning experiences, and assessment are based on predetermined student achievement benchmarks. As Toohey suggests: A teaching strategy is . . . a plan for someone else’s learning, and it encompasses the presentations which the teacher might make, the exercises and activities designed for students, materials which will be supplied or suggested for students to work with, and ways in which evidence of their growing understanding and capacity will be collected.1 The purpose of student-centered learning objectives is to develop concrete benchmarks for students relative to content. These objectives, developed by academics and practitioners from across the profession and validated by a separate group of faculty and professional peers, can assist with not only determining what a student should be able to do relative to content, but also how to assess whether the student has acquired the necessary skills under the correct context. Each of the chapters in Part One of this book contains a section devoted to student-centered learning objectives. These objectives are designed to outline what the student should be able to do relative to the particular chapter topic. Practitioners are encouraged to examine each of these outcomes to determine their own effectiveness relative to the topic area. Whether working in the field of personal financial planning or a related discipline, practitioners can benefit from a better understanding of their own effectiveness relative to these important concepts in personal financial planning. It may be that if the practitioner self-identifies areas of specific weakness in these objectives, he or she may decide to enroll in a continuing education program that can assist in improving efficacy relative to this topic. Students enrolled in personal financial planner preparation programs are encouraged to examine these learning objectives not only to determine their own levels of preparation for entering the field of personal financial planning, but also to better understand the requirements associated with their particular programs of study. Although each program is different, the topics contained in this book have been determined by faculty and practitioners to be integral

to personal financial planning. Faculty teaching in personal financial planning courses or related fields of study are encouraged to explore these objectives to determine appropriate program and course outcomes, learning experiences, theoretical content, and assessment measures. Some faculty teaching in related fields may have students enrolled in their courses who aspire to become personal financial planners. Although some faculty may not be personal financial planners themselves, their content is critical to preparing future practitioners and thus necessary in the program of study. Faculty in these related disciplines are encouraged to examine these outcomes to learn how their content directly relates to personal financial planning and perhaps explore ways of making their course work more directly applicable to financial planning if at all possible. Higher education in many countries is evolving toward a more student-centered approach to instruction, meaning that it is no longer the objective of a unit, course, or program of study to merely cover a list of topics relative to a specific discipline. Rather, the success of instruction is dependent upon whether students are able to achieve at a predetermined benchmark relative to a unit, course, or program of study. Assessment has become a driving factor in higher education reform around the world. Institutions, and therefore faculty, are asked to document student achievement relative to concepts and subject matter. The development, identification, and utilization of these objectives provide a template for faculty when developing student assessment tools. These objectives can assist not only in determining student achievement and placement, but also in assessing instructional effectiveness at the unit and program levels.

IN CLASS2 One of the general objectives in education is to facilitate learning at higher cognitive levels. The idea here is that if learning takes place where the student is applying and creating, then these new skills will be generalizable beyond just the context of that given skill. If the learner is only remembering and regurgitating facts, then he or she may remember them long enough to take a test or recite something, but forget them or have difficulty applying them to other contexts. Bloom’s Taxonomy3 was developed not only as an effective measurement tool for student learning, but also as a way to develop common language regarding learning goals and curriculum development across multiple instructors relative to a given subject area.4 Bloom’s Taxonomy also provides the opportunity to explore the depth to which a given subject area can be studied. Updated in 2002, Bloom’s Taxonomy consists of the following levels relative to the cognitive domain:5 Remember: Remembering, the least complex of the categories, is a process of storing and retrieving knowledge from long-term memory through processes such as recognizing or recalling relevant facts or attributes.

Understand: The next category, understanding, involves determining the meaning of instructional messages and communication, including oral, written, and graphic messages. This can include classifying, summarizing, or explaining a given text or communication. Apply: Applying is the process of using or carrying out a procedure in a given situation. This can involve executing or implementing a system or procedure for a new context or set of facts. Analyze: Analyzing involves breaking material down, identifying how its constituent parts relate to one another, and identifying how these parts relate to an overall structure or purpose, including differentiating and organizing the material. Evaluate: Evaluating is the process of taking criteria and standards and using them to make judgments or assessments. This involves drawing on a set of criteria to check or critique material. Create: Creating involves the formation of an original product or a novel, coherent whole by combining elements or putting them together. This includes generating, planning, or producing new material. The In Class sections of Chapters 2 to 70 note the learning experiences and assessment possibilities for facilitating higher-order cognitive thinking in the financial planning classroom. These tables should assist faculty in developing class activities and assessment avenues that further higher-order cognitive thinking in financial planning preparation programs. These charts are designed for all program types and delivery methods.

BLOOM’S TAXONOMY Category

Applying: Carrying out or using a procedure through executing or implementing Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing *This note will mark activities that are appropriate for on-campus course. **This note will mark activities that are appropriate for both on-campus and distance courses.

Class Student Activity Assessment Avenue

It is important to note that the first two levels of Bloom’s Taxonomy have generally been omitted in this book. Remembering and understanding are common actions in any classroom or online learning platform and would not be as useful to the reader. The suggested student assessment avenue may consist of both formal and informal assessments.

PROFESSIONAL PRACTICE CAPABILITIES Almost any individual working within a given profession or occupation, or any other activity for that matter, strives to take the journey from novice to expert. The path to expertise is more than mere education and repetition; rather, it requires individuals to move from a reliance on rules and principles to contextual experiences and to change their perception or understanding of a given context or situation from bits of information to a composite whole.6 The Dreyfus Model of Skill Acquisition is a five-step model that outlines the path from novice to expert relative to these two paradigms. The stages are: Stage One—Novice: This first stage of skill acquisition is characterized by the novice becoming familiar with a set of features that are recognizable without any experience. These features can be described as context-free or non-situational. In addition, the novice is then given a set of rules that determine actions on the basis of these features. At this stage of skill acquisition, the novice learns to follow these rules consistently. Stage Two—Advanced Beginner: In the advanced beginner stage, while consistently following the given rules, the student begins to recognize examples of new features that can be effectively identified or learned only through experience. These new situational features are added to the context-free features that the student recognizes, and new rules are introduced that incorporate these examples. The advanced beginner continues to learn to follow given rules in a consistent manner, but is able to incorporate situational as well as non-situational factors when learning and applying these rules. Stage Three—Competence: At the skill acquisition stage where students attain competence, they have absorbed enough features and rules that attending to all potentially relevant features and analytically applying rules has become overwhelming, and they must develop an approach where they can differentiate among more and less important elements of a situation. Competent performers learn to choose a perspective or formulate a plan that allows them to effectively make decisions by restricting them to only a few of the possibly relevant features of a situation. Through this, competent performers also become emotionally involved in the outcome of their decision making because this outcome depends not only on the adequacy of the rules that they have been given but on their accuracy in choosing a plan or perspective. Stage Four—Proficiency: At the proficiency stage of skill acquisition, the emotional involvement developed at the competence stage, which strengthens the performer’s ability to distinguish between successful and unsuccessful perspectives, allows the proficient performer to accurately assess situations and choose relevant plans and perspectives. This intuitive situational awareness, though, does not extend to decision making, and proficient

performers fall back on the analytic rules they have learned to respond to the goals they have identified and the features that they have identified as being important. Stage Five—Expert: At the expert stage of skill acquisition, performers then move past the situational awareness that distinguishes the proficient performer to both divide these situations into nuanced subclasses and to attach reactions to them that have, in their experience, been successful. The expert both assesses situations and responds to them intuitively, drawing on his or her vast experience to identify desired outcomes and relevant situational features and also to determine which course of action will be most effective. In this book, the professional practice capabilities are divided into three levels based on this Dreyfus model—entry-level, competent, and expert—each of which illustrates the financial planning professional’s ability to make appropriate decisions within a complex environment as well as the planner’s progression from strict adherence to rules to use of past experiences to define future action. The reader is encouraged to use these practice capabilities to both self-assess competency relative to a given concept as well as plan future education and experience that may facilitate a higher level of expertise. Financial planning firms may utilize these capabilities to facilitate formal and informal mentorship programs within their organizations.

IN PRACTICE Each of the chapters in Part One outlines many of the contexts that exist in financial planning, specifically relative to the topic of that particular chapter. These contexts, or vignettes, are designed to provide the student, practitioner, and instructor with specific situations in which this concept arises in real life as well as to offer some of the variables that may impact the decisions of the financial planner. Relative to each of these contexts, the reader is encouraged to consider altering some of the fact patterns in the scenarios to see if the actions by the financial planner would change under different circumstances. Students and faculty are encouraged to discuss these scenarios and offer alternative actions that the financial planner could take relative to this or other scenarios and contexts.

PART TWO Part Two of this book discusses the actions of the financial planner. These chapters focus on aspects of the process of financial planning, from establishing and defining the client recommendation to monitoring the recommendations. The definition, rationale, techniques, and contexts for each of these domain areas are presented, providing the reader with both an overview of the specific action as well as ways to complete it, plus a determination of when the action is necessary within financial planning practice. One case, containing a rather complex familial and economic context, runs through each chapter of Part Two, illustrating how each step of the financial planning process exists within practice and a real-life scenario.

PART THREE Part Three is devoted to many of the related areas to the discipline and profession of financial planning. Many of these areas involve areas such as psychology, sociology, behavioral finance, marriage and family therapy, and elements related to certifications in this profession. The goal with this section is multi-faceted. The hope is that practitioners will read these chapters and begin to visualize how theory from other disciplines can be applied to their work, questioning current assumptions and considering new strategies for serving clients based upon the work of practitioners and researchers from other academic disciplines. For faculty, the hope is that these chapters will fuel new ideas for lines of research that incorporate theory from other disciplines into financial planning, engaging bodies of knowledge and researchers from other areas into financial planning. Many of the topics that are part of this section have been tested in multiple contexts and are grounded in theory that has been part of research and practice in other contexts for decades. It is our hope that regardless of experience in research or practice, that the reader be challenged relative to many of the important facets of financial planning.

NOTES 1. Susan Toohey, Designing Courses for Higher Education (Buckingham, UK: Society for Research into Higher Education and Open University Press, 1999). 2. The “In Class” sections of the chapters are based on the revised Bloom’s Taxonomy, as presented in D. R. Krathwohl, “A Revision of Bloom’s Taxonomy: An Overview,” Theory into Practice 41, no. 4 (2002): 212–218. 3. B. Bloom, ed., and M. D. Engelhart, E. J. Furst, W. H. Hill, and D. R. Krathwohl, Taxonomy of Educational Objectives: The Classification of Educational Goals (New York: Longmans, Green, 1956). 4. Krathwohl, “A Revision of Bloom’s Taxonomy.” 5. Ibid. 6. Stuart E. Dreyfus, “The Five-Stage Model of Adult Skill Acquisition,” Bulletin of Science, Technology & Society 24, no. 3 (2004): 177–181.

CHAPTER 2 Function, Purpose, and Regulation of Financial Institutions John E. Grable, PhD, CFP® University of Georgia Sonya L. Britt, PhD, CFP® Kansas State University

CONNECTIONS DIAGRAM

The marketplace for consumer deposits, loans, insurance, and investments exists as a mechanism to facilitate the creation and use of capital. Banks, trust companies, credit unions,

insurance companies, and other investment firms operate and compete in this large and interrelated marketplace. There are seven primary laws—each of which is discussed in more detail later in the chapter—and one federal depository insurance system that governs financial institutions and the securities industry.1 These laws have emerged over time in reaction to changes in consumer expectations and corporate responsibilities. Financial planners have an obligation to fully understand and apply regulations of financial institutions in their daily practice of financial planning. As illustrated in the diagram, these regulations impact every aspect of financial planning. When combined, the laws form the foundation for financial institution regulation and the functioning of financial institutions.

INTRODUCTION Financial planners work in a highly regulated environment. Often, financial planners must work within both state and federal regulatory guidelines. There are seven key pieces of federal legislation that impact almost all aspects of financial planning. Many of the rules that dictate current practice were enacted in the 1930s in the wake of the Great Depression. The first legislative rule-making action at that time was the Securities Act of 1933. This Act was written to ensure that investors receive financial and other relevant information concerning securities being offered for public sale, and to prohibit fraud, deceit, and misrepresentations associated with the sale of securities. The Act of 1933 clearly defines a security, when and how a security can be sold to the public, and what type of disclosure must accompany the sale of a new security. Further, the law dictates that every financial planner who deals with the sale of new securities must possess an appropriate securities license and exhibit a fundamental understanding of the rules, regulations, and procedures of the Securities and Exchange Commission (SEC) (created the next year). While this law specifically outlines requirements for broker-dealers, it was not until 1940 that investment advisors—those who provide investment advice for a fee—were specifically required to follow federal regulations. It is interesting to note, however, that rules from the Securities Act of 1933 are often breached. When this happens, both investment advisors and financial planners come under criticism and increased scrutiny. Consider a 2010 Securities and Exchange Commission ruling regarding World Trade Financial Corporation of San Diego, California. During the period from 2004 to 2005, brokers associated with the firm sold to the public more than 2.3 million shares of a company called iStorage. Investors paid nearly $300,000 for the shares, resulting in more than $9,000 in commissions. Unfortunately for all those involved, the stock was essentially worthless and unregistered. iStorage was the creation of a stock promoter who was known to create companies and subsequently “pump and dump” the stock—a process of stock promotion to increase share prices in an attempt to defraud investors. As a result of the securities violation, the iStorage creator was sentenced for securities fraud, while the firm and its planners were fined and temporarily suspended from conducting business.2 As this example highlights, understanding financial institution laws, rules, and regulations provides only a minimal level of protection for financial planners and their clientele. It is equally important to work within the law and to constantly monitor client portfolios to preempt unscrupulous

planners who may attempt to fraudulently deal with clients. The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC). According to the SEC, “The Act empowers the SEC with broad authority over all aspects of the securities industry. This includes the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation’s securities self-regulatory organizations (SROs). The various stock exchanges, such as the New York Stock Exchange and American Stock Exchange, are SROs. The National Association of Securities Dealers, which operates the NASDAQ system, is also an SRO. The Act also identifies and prohibits certain types of conduct in the markets and provides the Commission with disciplinary powers over regulated entities and persons associated with them.”3 Until the late 1930s, the sale of bonds and debt instruments was largely unregulated. The Trust Indenture Act of 1939 required debt securities such as bonds, debentures, and notes to be registered if offered to the general public. This was another important regulatory law that was passed during the Great Depression. The Investment Company Act of 1940 was written to regulate “the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation was designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments.”4 Of particular importance to financial planners, however, is the Investment Advisers Act of 1940. This law established investment advisor regulations. The Act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors, unless otherwise exempted in the law. Beginning in 2010, planners who have at least $100 million of assets under management, or advise a registered investment company, must register with the SEC. Other planners are required to register at the state level. Of course, the 1940 Act covers many more aspects of investment. Today, most states require investment advisors to pass a test (Series 65) verifying that they have read the Act and understand the many nuances of the law. Federal regulations occurred only incrementally from the 1940s through the later part of the twentieth century. A major law impacting financial planners was drafted in 2002—the Sarbanes-Oxley Act. This law mandates corporate responsibility and enhanced financial disclosures to combat corporate and accounting fraud. The Act also created the Public Company Accounting Oversight Board to oversee the activities of the auditing profession. More recently, the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was instituted as the most far-reaching piece of financial industry regulation since the Great

Depression. The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010. The SEC describes the Act as follows: “The legislation set out to reshape the U.S. regulatory system in a number of areas including but not limited to consumer protection, trading restrictions, credit ratings, regulation of financial products, corporate governance and disclosure, and transparency.”5 Potential impacts of the law on financial planners include likely changes to state and federal regulations defining more explicitly what financial planning entails from a consumer perspective, who may practice as a financial planner, and how financial planners may be compensated.6 Although many financial planners are less directly impacted, financial planners also need to be aware of banking and insurance regulations. For example, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, the Fair Debt Collection Practices Act, the S.A.F.E. Mortgage Licensing Act, the Truth in Lending and Savings Acts, the Sarbanes-Oxley Act, the Fair and Accurate Credit Transactions Act, and laws related to privacy of consumer financial information all come into play during the course of a planner’s career. Thus, it is important not only to be aware that these types of banking and insurance regulations exist, but also to acknowledge that certain planning activities may fall under the watchful eye of non-traditional financial planning regulators. For example, financial planners should be mindful that in 1945 the McCarran-Ferguson Act granted the states, rather than the federal government, regulatory authority of insurance companies and products. Although some aspects of the Gramm-LeachBliley Act conflict with the 1945 law, it is essential for any planner who works with, provides recommendations about, or sells insurance products to understand the unique laws and rules issued by each state in which the planner works. Rather than reporting to one federal agency or self-regulatory organization, those who practice financial planning using insurance products might be subject to multiple regulatory constraints.

LEARNING OBJECTIVE The student will be able to: a. Compare the secondary market institutions and their regulators for each security (stocks, bonds, ETFs, real estate, commodities, and options exchanges) and of primary market institutions (investment banking firms, mutual funds, and hedge funds).

Rationale Each country regulates securities markets, broker-dealers, insurance professionals, and financial planners differently. Nearly all federal rules, regulations, and laws directed at the oversight of American financial institutions have resulted from abuses observed in the marketplace. Although financial institutions serve a multitude of stakeholders, including governments and firms, federal regulators tend to introduce laws that limit the market power and scope of operations of banks, trust companies, credit unions, insurance companies, and other investment companies when consumers at the household level are harmed. As such, regulation tends to be reactionary, which often results in a time lag after abuses are noted and

laws are enacted to counter such abuses. It is important for financial planners to have a working knowledge of not only how financial institution regulation is created and applied, but also which regulator deals with what type of entity. For example, the Securities and Exchange Commission (SEC), which was created with passage of the Securities Exchange Act of 1934, regulates both secondary market institutions as well as certain primary market firms. The SEC also plays a role in regulating how financial planners interact with consumers. Regulation of the secondary markets occurs through a number of mechanisms. Financial planners may fall under the enforcement power of state and federal regulators. It is equally likely, however, that a financial planner will have more contact on a regular basis with selfregulatory organizations. Brokers, dealers, and registered representatives typically fall under the rules and regulations of the Financial Industry Regulatory Authority (FINRA). Financial service professionals who deal most often at the primary and secondary market level will interact with numerous self-regulatory organizations, including the Chicago Board Options Exchange (CBOE), Municipal Securities Rulemaking Board (MSRB), National Futures Association (NFA), New York Stock Exchange (NYSE), and the Options Clearing Corporation (OCC). Planners who deal primarily with insurance products will find it useful to be well informed of the National Association of Insurance Commissioners’ (NAIC) rule making.

Related Content Areas Associated with the Learning Objective This learning objective is conceptually related to all aspects of the financial planning process. Financial regulations serve to provide a working framework for financial planners when interacting with clients. The function and purpose of financial institution regulations is closely aligned with business law, financial services requirements, and consumer protection regulations.

IN CLASS Category

Class Activity

Applying: Carrying out or using a procedure through executing or implementing

Invite a member of the State Securities Ask students to prepare a question for the Commissioners Office to speak to guest lecturer before class.** class.** Assign students to write a 10-page Assign students to draft a time line of reaction paper to the following: “The key regulatory events and explain how Consumer Financial Protection Bureau the regulations will influence their regulation of home mortgage disclosures future careers.** ensures that all Americans are treated fairly in the mortgage market.”** Discuss events that led to a need for the Dodd–Frank Wall Street Reform

Student Assessment Avenue

and Consumer Protection Act of 2010.** Analyzing: Breaking material into constituent parts, determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating,

Investigate, as a class, cases of violations of financial service regulations by visiting the SEC and FINRA websites.**

Class discussion: Ask each student to choose an inherited regulation from the Consumer Financial Protection Bureau’s website (www.consumerfinance.gov/regulations/ and then discuss the way in which the regulation protects consumers while also providing potential loopholes that can cause harm to consumers.** Assign students to find and read relevant aspects of the Investment Advisers Act of 1940 related to who must register as an investment adviser; ask students to provide examples of those who are exempt from registration.**

Split students into seven groups. Assign each group to identify the key aspects of one of the federal financial institution regulatory acts and to relate the law to the way financial planners interact in the marketplace and with clients.**

Ask students to prepare a list of possible revisions to existing financial institution regulations or to offer new regulations that may be needed in the future.**

Randomly assign students to a “support” or “oppose” group. Use regulatory information posted at www.consumerfinance.gov/regulations to find a proposed finance reform regulation. Prepare a one-page summary of the regulation and ask students to debate the pros and cons of the proposed law.

Assign students to design a onepage summary, using their own words and knowledge of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, that would be appropriate to share with prospective and current clients. Using this form, ask students to write a brief paper describing the formation of a new regulation based on current financial conditions; divide the class into those who support and those who oppose the regulation.**

planning, or producing *Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level planner working in a financial planning office environment should be able to differentiate among commercial banks, credit unions, trust companies, insurance companies, and brokerage firms as sources of consumer loans and investment assets. Additionally, entry-level planners should be well versed in basic financial institution and securities regulations and laws. The planner should be able to explain the fundamental aspects of the seven most important financial institution laws as outlined by the SEC, as well as explain the role and limitations associated with Federal Deposit Insurance Corporation (FDIC) deposit insurance. Competent: A competent personal financial planner will have either completed Form ADV— application for registration of investment advisor—or, if not required to register, will have completed disclosure forms similar to what a registered investment advisor would provide clientele. Expert: An expert personal financial planner should fully understand the history of financial institution regulation, SEC rules, rule-making procedures, and sources for researching rules and procedures. Additionally, someone who is an expert will monitor, on a regular basis, regulatory actions as published in the Federal Register, as well as regulatory actions, proposed rules, and rules releases as published by the SEC. This knowledge, when combined with experience and professional judgment, allows a financial planner to predict real and perceived violations of financial institution laws and ethical guidelines. An expert will be able to anticipate which, and when, personal and business actions will lead to violations of known laws.

IN PRACTICE Rebecca Rebecca has been working in the financial services marketplace for 10 years. She began her career as a stockbroker at a regional firm. She easily passed the Series 7 licensing requirements necessary to sell securities to the general public. About three years ago, she started the process of converting her practice away from compensation strictly by commission to one primarily based on assets under management fees. She recently resigned her position as a broker and opened her own firm. She has $73 million in assets under management. Given her new business model and compensation approach, she must register as an investment advisor. Because her asset base is less than $100 million, she will register at the state level, unless her

state does not require investment advisors to register. Rebecca must also hold either a nationally recognized certification, such as the CFP® mark, or a Series 7 and 65 license, in order to start her new practice.7 When the total value of assets managed by Rebecca exceeds $100 million, she will fall under the jurisdiction of the SEC; in the meantime, she must complete and file Form ADV as outlined in the Investment Advisers Act of 1940.

Janie Is Janie a fiduciary? This is a question that has marked the twenty-first century as being unique in the history of financial planning as a profession. For many years, financial planners considered themselves primarily to be engaged to transact business for clients. Many planners still consider themselves in this role. Janie, however, views her position as a financial planner differently. She advertises her services to be fair and balanced. She believes in disclosing all real and perceived conflicts of interest. Rather than acting as an intermediary in the purchase and/or sale of a product or service, Janie considers herself to be a fiduciary—someone “who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client.”8 Although national and international guidelines regarding fiduciary standards for financial planners are not uniform or necessarily similar, the Uniform Prudent Investor Act of 1994 helped promote discussion within the profession about the functioning of planner-client relationships. Some, such as Janie, would argue that all financial planners are, in fact, acting as fiduciaries. The debate regarding who is and who is not a fiduciary within the profession is certain to continue.

NOTES 1. Securities and Exchange Commission: www.sec.gov/about/laws.shtml. 2. Securities and Exchange Commission: www.sec.gov/litigation/opinions/2014/34-66114court-opinion-2014.pdf. 3. U.S. Securities and Exchange Commission, “The Laws That Govern the Securities Industry,” August 2012. Retrieved from Securities and Exchange Commission: www.sec.gov/about/laws.shtml. 4. Securities and Exchange Commission: www.sec.gov/about/laws/ica40.pdf. 5. Securities and Exchange Commission: www.sec.gov/about/laws/wallstreetreform-cpa.pdf. 6. www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf. 7. K. C. Garrett and J. E. Grable, “State Investment Adviser Representative Examination and Waiver Requirements,” Journal of Personal Finance 6, no. 1 (2007): 38–43. 8. CFP Board, Rules of Conduct, 2015. Retrieved from Certified Financial Planner Board of Standards, Inc.: http://www.cfp.net/for-cfp-professionals/professional-standards-

enforcement/standards-of-professional-conduct/rules-of-conduct. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 3 Financial Services Regulations and Requirements John E. Grable, PhD, CFP® University of Georgia Sonya L. Britt, PhD, CFP® Kansas State University

CONNECTIONS DIAGRAM

The regulation of financial services markets and professionals is integrated into nearly every aspect of the financial planning process. At its core, however, is the requirement that financial planners understand and determine how they interact with clients. Some planners provide advice for a fee. Others transact trades for clients. Some financial planners provide a number

of related but technically different services. In general, those who provide services for a fee are considered investment advisors. Those who transact trades and other business for a commission are known as brokers, agents, or registered representatives. The form of regulation differs based on each financial planner’s responsibilities. The nature, type, and extent of regulation are briefly described in this chapter.

INTRODUCTION The regulation and licensing of securities professionals has a long and vivid history. King Edward of England, in the thirteenth century, was the first to decree that brokers in London should be licensed.1 The United States was somewhat late in implementing regulations. The state of Massachusetts drafted the first securities regulation in 1852, but it was not until the early twentieth century that the regulation of securities and financial advisors became widespread. In 1911, the state of Kansas took the first step in enacting wide-ranging securities regulations, which became known as blue-sky laws. The name blue-sky referred to the practice of salespeople touting worthless investments (e.g., gold mines) that had no value other than the “blue skies of Kansas.” Blue-sky laws eventually paved the way for what is known as merit review authority, or a state regulator’s right to refuse licensing to a person or firm whose business practices are deemed unfair, unjust, inequitable, or oppressive. By 1913, another 23 states had implemented some type of merit review authority regulation. The year 1929, the beginning of the Great Depression, ushered in sweeping financial regulation reform. Congress enacted the Securities Act of 1933 (“truth in securities” law) in reaction to the stock market crash of 1929. Congress passed four additional acts that further implemented securities regulation. The Securities Exchange Act of 1934 prohibited insider trading and instituted regulation of securities trading, creating the Securities and Exchange Commission (SEC). The Public Utility Holding Act of 1935 was designed to curb corporate accounting fraud. The Trust Indenture Act of 1939 extended equity regulation to the bond market. An important piece of legislation was the Investment Company Act of 1940, which established rules for the development of mutual funds and other similar pooled investment companies. Of primary importance for financial planners and advisors is the Investment Advisors Act of 1940. This law codified regulations regarding the licensing of investment advisors who render investment advice for a fee, or provide analyses or securities reports. These Great Depression–era regulations remain as foundational aspects of all modern securities markets regulations. It was not until 1956 that additional broad legislative action was reviewed again. States attempted to bring uniformity to securities and insurance laws by establishing the National Conference of Commissioners on Uniform State Laws (NCCUSL). This group approved the Uniform Securities Act, which has been adopted, in some form or another, by 40 states. While there is a tendency to focus on federal regulations, it is important to note that individual states have retained considerable regulatory authority in the financial services marketplace. This is particularly true in relation to insurance products and services.

The period between the mid-1950s and the 1990s saw numerous policy updates and modifications to existing laws. The Employee Retirement Income Security Act of 1974 (ERISA) was a notable event during this period. ERISA impacts the practice of financial planning in many ways. The law describes fiduciary responsibilities and, through amendments, Consolidated Omnibus Budget Reconciliation Act (COBRA) and Health Insurance Portability and Accountability Act of 1996 (HIPAA) provides provisions for health insurance plans. In 1996, Congress enacted the National Securities Markets Improvement Act. This law updated and amended numerous provisions of: The Securities Act of 1933. The Securities Exchange Act of 1934. The Trust Indenture Act of 1939. The Investment Company Act of 1940. The Investment Advisers Act of 1940. Following these changes, NCCUSL revised the Uniform Securities Act in 2002. The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act is the most important regulatory reform since the Great Depression.2 Although many provisions of the law were focused on corporate reform and regulation, key aspects impact securities transactions and the practice of financial planning. The Act established a new federal agency, the Consumer Financial Protection Bureau (CFPB), as an independent bureau of the Federal Reserve System. The CFPB has rule-making, supervisory, enforcement, and other authorities related to consumer financial products and services.3 The Consumer Financial Protection Bureau has the authority to issue regulations concerning more than a dozen federal consumer financial laws to ensure that all consumers have access to consumer financial markets, products, and services. The Bureau is also charged with regulating consumer markets to guarantee fairness, transparency, and competitiveness. In addition to state and federal securities laws and regulations, nearly every financial planner also interacts with either self-regulatory organizations (SROs) or a credentialing body. An SRO is an organization that has been granted statutory functions by the federal government to monitor, regulate, and sometimes license its own members to ensure that business practices are conducted fairly, efficiently, and in an ethical manner. The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all securities firms doing business in the United States. FINRA oversees over 4,450 brokerage firms, 161,065 branch offices, and nearly 630,000 registered securities representatives.4 Other SROs include national commodities and securities exchanges. The role of the organization is to protect consumers and the general public by upholding standards of practice and ethical standards. While nearly all financial planners work, in some way or another, within these regulatory frameworks, it also is important to note that the majority of financial planners conduct business in ways that require knowledge of banking, real estate, and tax laws. For example, the Federal Reserve Board, the Federal Deposit Insurance Corporation, state banking regulators, and the

U.S. Treasury all issue and enforce regulations that can impact recommendations made to clients. Additionally, financial planners should have a working knowledge of real estate regulations, such as the Fair Housing Act, Real Estate Settlement Procedures Act, Equal Credit Opportunity Act, Home Mortgage Disclosure Act, Community Reinvestment Act, Fair Credit Reporting Act, Homeowners Protection Act, Fair Debt Collection Practices Act, and GrammLeach-Bliley Act. It almost goes without saying, but it is worth emphasizing, that keeping abreast of Internal Revenue Service (IRS) and state tax authority mandates and tax code changes is essential to the prudent practice of financial planning.

LEARNING OBJECTIVES The student will be able to: a. Identify the regulatory authorities that impact elements of the financial planning process. (Examples include regulation of accountancy, legal practice, real estate law, insurance regulation, etc.). b. Differentiate between investment knowledge that is proper to use in the evaluation of securities and insider information. c. Demonstrate a comprehensive understanding of investment advisor regulation and financial planning aspects of ERISA. d. Explain the relevant licensing, reporting, and compliance issues that may affect the business model used by a financial planning firm.

Rationale The purpose of a financial planner having the ability to understand, follow, and adapt to financial services regulations and requirements is to ensure that planning services are provided in a highly ethical manner. Financial planners work in an extremely regulated environment. Consumers, regulators, and planning colleagues expect financial planners to know existing rules and guidelines. While financial planners are assumed to be familiar with the SEC, FINRA, and state securities and insurance regulators, there are a host of other regulatory organizations that impact the work of some financial planners. Examples include the Municipal Securities Rulemaking Board, the National Futures Association, and the major stock exchanges, including the New York Stock Exchange (NYSE) and American Stock Exchange. Additionally, designation and certification organizations, such as Certified Financial Planner Board of Standards, Inc. (CFP Board), enforce rules related to client interactions, ethics, and practice standards. Of particular importance is the Employee Retirement Income Security Act of 1974 (ERISA). According to the U.S. Department of Labor, ERISA is a federal law that sets minimum standards for pension plans in private industry. ERISA does not require any employer to establish a pension plan. It only requires that those who establish plans must meet certain minimum standards. The law generally does not specify how much money a participant must be

paid as a benefit. ERISA requires plans to regularly provide participants with information about the plan including information about plan features and funding; sets minimum standards for participation, vesting, benefit accrual and funding; requires accountability of plan fiduciaries; and gives participants the right to sue for benefits and breaches of fiduciary duty.”5 Fiduciary definitions and rules are also important. Any financial planner who operates or performs functions related to a qualified retirement plan is considered to be a fiduciary. Fiduciaries must act solely in the interest of plan participants and their beneficiaries, be prudent in carrying out duties, follow plan documents (unless inconsistent with ERISA), diversify plan assets, and pay themselves only reasonable expenses. The topic of fiduciary status has expanded beyond retirement planning. An ongoing active debate is unfolding that would require all financial planners to maintain a fiduciary relationship with clients. At this time it is not known whether this will ever occur. Financial planners should be familiar with all FINRA and SEC licensing and registration requirements. As a reminder, financial planners who provide advice for a fee generally must register either with the SEC or with their state securities enforcement office. Financial planners who work on a commission basis must hold a qualifying license issued by FINRA. Examples of licenses include: Series 6: Investment Company Products/Variable Contracts Limited Representative Series 7: General Securities Representative Series 14: Compliance Officer Series 24: General Securities Principal Series 26: Investment Company and Variable Contracts Series 42: Registered Options Representative Series 52: Municipal Securities Representative Series 63: Uniform Securities Agent State Law Series 64: General Securities Principal Series 65: Uniform Investment Adviser Law Series 66: Uniform Combined State Law Financial planners who sell insurance products must additionally hold at least one of the following licenses: Life and accident Health Fire and casualty Limited lines automobile Personal lines

Related Content Areas Associated with the Learning Objectives Financial planners must have a strong grounding in SEC regulations and FINRA policies. It is also important that planners understand how financial services regulations and requirements integrate into the planning process. This learning objective is linked with the function, purpose, and regulation of financial institutions, as well as consumer protection laws.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Show slide show highlighting important regulatory events.**

Have students prepare a question for the guest lecturer before class.**

Invite member of state Securities Commissioners Office to speak to class.**

Assign students to write a 10-page reaction paper to the following: “All financial planners are fiduciaries.”**

Assign students to make a time line of key regulatory events and explain how the regulations will have an influence on their future careers.** Analyzing: Breaking material into constituent parts, determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Investigate, as a class, cases of violations of federal and state securities regulations by visiting the SEC, FINRA, and CFP Board websites.**

Class discussion: Ask each student to examine a CFP Board practice standard and explain to the class how the standard should be followed in practice.** Write both an obvious and a complicated regulatory/ethics scenario. Ask students to prepare a written analysis of each situation, documenting the key facts of the case and how they would rule in each case if they were a regulator.**

Evaluating: Making Choose a specific federal or Ask students to prepare a list of judgments based on criteria state securities violation. possible revisions to existing

and standards through checking and critiquing

Ask students to work in groups to identify the key facts of the case and recommend a punishment that would be appropriate. Creating: Putting elements Use a chart program to together to form a coherent develop, as a class, a or functional whole; flowchart starting with an reorganizing elements into a illegal or unethical situation new pattern or structure and ending with both through generating, potential and likely outcomes planning, or producing at the federal, state, and certification levels.

securities regulations or to offer new regulations that may be needed in the future.**

Assign students to draft an individual plan of study that will enable them to prepare and sit for at least one securities license and one insurance license.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner can identify key elements of the following securities licensing examinations and match each license with the appropriate product sale: Series 6: Mutual Fund and Annuity Representative Series 7: General Securities Representative Series 24: General Securities Principal Series 26: Investment Company and Variable Contracts Series 55: Equity Trader Limited Representative Series 63: Uniform Securities Agent State Law Series 65: Uniform Investment Adviser Law Series 66: Uniform Combined State Law (combines Series 63 and 65 examinations) In addition to these securities licenses, entry-level financial planners who provide life, accident/health, property and casualty, personal, crop, or title insurance services can recall state licensing rules and regulations. They can pass the test for a basic life insurance license if required. Entry-level financial planners can also identify SEC and state investment advisor registration requirements, regardless of their current compensation method. Competent: The transition from entry-level to competent status in the financial planning profession tends to be relatively quick. This is the result of increasing state and federal regulation of the financial services marketplace and an amplified attention by firms to educate their employees on regulation compliance. Many proficient financial planners hold the Series 6, Series 7, or Series 63 and 65 licenses, depending on the services provided. One who

provides services for a fee should also be registered either as an investment adviser or as an investment advisor representative. Generally, planners who manage for a fee less than $100 million in client assets must register at the state level. Expert: An expert commission-based or fee-based financial planner will additionally hold a Series 24 General Securities Principal license. This license verifies that the financial planner fully understands and can interpret and enforce all FINRA regulations, brokerage firm operations, and other supervisory requirements. In other words, a Series 24 license allows an individual to supervise and manage brokerage firm operations. An expert financial planner who is compensated by way of client fees holds a Series 65 license or a combination of Series 66 and 7 licenses,6 or is currently certified as a CFP professional.7

IN PRACTICE Shaylea Shaylea Mueller is a new financial planning graduate. She just received a job offer from a large financial planning company that requires Shaylea to pass a series of examinations before meeting with clients. Shaylea has researched the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) websites to learn more about the examinations she may need to take. As a registered representative, Shaylea has learned that she is subject to suitability standards and will be required to pass a series of FINRA examinations. Specifically, Shaylea is required to take the FINRA Series 7 and 65 examinations in order to sell most of the investment products offered by her firm. Now that Shaylea has a job, her employer is able to sponsor her to take these examinations.

Jorge Jorge recently joined a financial planning firm. His primary responsibility involves meeting with employees of large firms to promote participation in each firm’s defined contribution plan, in which Jorge’s planning firm manages accounts. Jorge receives a base salary and a commission based on the total value of assets contributed by a firm’s employees. It is possible for Jorge to generate well over $100,000 per year in commission income. Recently, a newly hired employee asked Jorge how he was paid. Jorge told the employee that he earns a salary from his planning firm. He also noted that the new employee would not be responsible for paying any other fees other than ongoing fund management expenses. Six months later, Jorge received a reprimand from regulators based on the level of disclosures made to the new employee. By suggesting that he was only paid a salary, Jorge was found to have misrepresented his compensation method. Under fiduciary rules, Jorge should have disclosed the commission portion of his compensation when asked.

NOTES

1. www.wdfi.org/fi/securities/regexemp/history.htm.

2. A brief review of the Act can be found at: www.banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive summary_Final.pdf. 3. For more regulatory information about the Bureau, see: www.consumer finance.gov/strategic-plan/. 4. Source: www.finra.org. 5. Source: www.dol.gov/compliance/laws/comp-erisa.htm. 6. K. C. Garrett and J. E. Grable, “State Investment Adviser Representative Examination and Waiver Requirements,” Journal of Personal Finance 6, no. 1 (2007): 38–43. Available at: www.iarfc.org/documents/issues/Vol.6Issue1.pdf. 7. Other certifications can be used to waive licensure requirements for investment advisers, including the ChFC, PFS, CFA, and CIC. See Garrett and Grable (2007) for more information. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 4 Consumer Protection Laws John E. Grable, PhD, CFP® University of Georgia Sonya L. Britt, PhD, CFP® Kansas State University

CONNECTIONS DIAGRAM

Consumer protection laws, a combination of federal, state, and local regulations, impact every aspect of financial planning. These laws, in conjunction with the work of consumer advocacy groups, exist to empower consumers in the marketplace. Policies and rules also help guide how financial planning is delivered either as a service or as a product at the household level.

Each law provides consumers with legal protections to combat fraud, misrepresentation, discrimination, and illegal behavior on the part of producers and service providers. When combined, these laws, rules, and regulations work to provide a safety net of consumer finance protection.

INTRODUCTION The United States has a long and lively history related to consumerism, which is defined as the notion that goods and services help explain the role of individuals in society.1 At the outset of the Industrial Revolution, interactions between producers and consumers were dictated by the concept of caveat emptor, which means “may the buyer beware.” Problems associated with a marketplace in which consumers undertake non-regulated risks when making financial products and other financial decisions include lack of choice, lack of information, lack of redress to resolve grievances, and lack of representation. According to Garman, consumer protection laws have been systematically enacted as a way to protect and secure the following consumer rights:2 Choice

Redress

Information

Environmental health

Safety

Service

Voice

Consumer education

LEARNING OBJECTIVE The student will be able to: a. Describe consumer laws that impact clients, including bankruptcy, banking, credit, privacy regulations, and other relevant laws.

Rationale A key element associated with the practice of financial planning involves providing advice in the consumer interest. Consumer protection laws provide a framework for nearly all client– planner interactions. Some laws dictate what actions may be appropriate, whereas other regulations provide a means of redress for consumers. The ability to discriminate between and among appropriate and problematic advice, policies, and projected client outcomes, using consumer protection laws as a guide, is an essential planning skill. In addition to understanding the role of consumerism in the United States and laws associated with protecting the consumer interest, it is also important for financial planners to have a working knowledge of relevant laws that can impact how a client interacts in the marketplace, such as the six legal forms of bankruptcy, as shown in Table 4.1. Privacy rules are also important. Consider the Health Insurance Portability and Accountability Act of 1996 (HIPAA) rules that protect individual

medical records and personal health information.3 More broadly, Federal Trade Commission rules, under the Gramm-Leach-Bliley Act, have a direct impact on the day-to-day practice of financial planning. These privacy rules require any financial institution that provides services to consumers to disclose firm policies on the dissemination of non-public information to third parties. Custodians must adhere to these rules, and therefore financial planners should also consider establishing their own client privacy guidelines and annually disclosing this information to clients. As is the case with other aspects of consumer regulation, these examples highlight only a few of the relevant laws financial planners must consider when working with clients.

Related Content Areas Associated with the Learning Objective Financial planners must have both theoretical and applied knowledge of financial and consumer regulations. This learning objective is associated with knowledge about regulations of financial institutions, financial services laws, and general legal and ethical requirements for financial planners. Table 4.1 United States Bankruptcy Laws Bankruptcy Provision Chapter 7 Chapter 9

Purpose Total consumer debt liquidation Reorganization of municipalities (does not apply to most financial planning situations) Corporate reorganization (limited application in financial planning situations) Reorganization by family farmers and fisherpersons Consumer debt adjustments and repayments Reorganization in cross-border cases

Chapter 11 Chapter 12 Chapter 13 Chapter 15

IN CLASS Category

Class Activity

Applying: Carrying out or using a procedure through

Present slide show highlighting consumer protection activities, events, and agencies as noted in the chapter introduction; follow the slide show by visiting a fraud and scam website (e.g., www.usa.gov/topics/consumer/scamsfraud.shtml). Choose one fraud example and ask students to

Student Assessment Avenue Assign students to make a time line documenting

executing or describe, either in writing or through class discussion, ways implementing in which a consumer would know that the offer was fraudulent and what steps could be taken to report the fraud to appropriate authorities.**

when key consumer laws were enacted with a short description of event(s) prompting the laws.** Have students survey friends, family, or other students outside of class to see if they are familiar with key consumer protection laws and ask consumers where additional protection is needed. Based on their findings, assign students to write a 5- to 10-page summary of their findings.** Analyzing: Investigate, as a class, common consumer fraud traps and Assign Breaking pitfalls, and laws designed to protect consumers against fraud. students to material into For example, visit the Consumer Fraud Reporting website to explore their constituent identify current spams, hoaxes, scams, and frauds campus or parts, (www.consumerfraudreporting.org/sweepstakesscams.php).** larger determining community to how the parts identify relate to one possible another and to consumer an overall fraud traps.

structure or purpose through differentiating, organizing, and attributing

Based on their research, ask students to draft a reaction paper summarizing identified consumer fraud traps.** Evaluating: Choose a specific federal or state consumer protection law Ask students to Making and find examples of how the law is or has been violated. Ask prepare a list judgments students to work in groups to identify the key facts of the case of possible based on and recommend a punishment that would be appropriate. revisions to criteria and existing standards consumer through regulations or checking and new consumer critiquing laws that may be needed in the future to combat fraud and rip-offs; compile a comprehensive list of studentcompiled data and circulate this among students in class.** Creating: Visit your state’s consumer affairs and/or attorney general’s Ask students to Putting website; use site to obtain information about the process of identify a elements reporting frauds and rip-offs and how consumer complaints needed area together to are handled at the state level. for consumer form a protection coherent or (e.g., car title/ functional payday whole; lending, reorganizing renter’s elements into protection, a new pattern Internet or structure privacy, etc.).

through generating, planning, or producing

Assign students to develop a comprehensive framework that includes proposed rules, regulations, and/ or laws that could be implemented at the local, state, or federal level to deal with the protection need. Based on class discussion, one or more projects should be chosen and sent to a local, state, or federal representative; a grading rubric should be developed for use in assessing each student’s project.**

*Appropriate for on-campus course. ** Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify the key aspects associated with the following consumer laws, rules, and regulations:

Sales Transaction Laws Federal antispam law. National Do Not Call Registry rules. Telemarketer regulations. Switching/slamming telephone rules. Postal Service gift rules. Federal Trade Commission mail-order merchandise return rules. Door-to-door cooling-off period rules. Regulation M (Federal Reserve Board Consumer Leasing Act regulations). Lemon laws. Rent-to-own laws. Gramm-Leach-Bliley Act regulations regarding sales of insurance through federally insured banks.

Privacy Laws Privacy Act of 1974. Cable Privacy Protection Act of 1984. Electronic Communications and Privacy Protection Act of 1988. Right to Financial Privacy Act of 1978. Video Privacy Protection Act of 1988. Telephone Consumer Protection Act of 1991. Health Insurance Portability and Accountability Act of 1996. Children’s Online Privacy Protection Act of 1998. Gramm-Leach-Bliley Act of 1999 (opt-out privacy options). Fair and Accurate Credit Transactions Act of 2003.

Consumer Credit Laws Truth in Lending Act of 1968. Fair Credit Reporting Act of 2003. Fair Credit Billing Act of 1975. Equal Credit Opportunity Act of 1975. Fair Debt Collection Practice Act of 1977.

Fair Credit and Charge Card Disclosure Act of 1988. Lost credit card liability protection. Lost debit card liability protection. Electronic Funds Transfer Act. Credit reporting correction rules. Check Clearing for the 21st Century Act of 2004. Identity theft rules. Federal Deposit Insurance Corporation (FDIC) guidelines. Credit Card Accountability Responsibility and Disclosure (Credit CARD) Act of 2009.

Housing Laws Home Ownership and Equity Protection Act of 1994 (as an amendment to the Truth in Lending Act). Home Equity Loan Consumer Protection Act of 1988. Regulation Z (Federal Reserve Board). Fair housing antidiscrimination rules. Mortgage disclosure rules. Competent: In addition to having a working knowledge of the laws, rules, and regulations listed, a competent personal financial planner has the skills necessary to help a client file a complaint or obtain redress under an appropriate consumer protection rule. Expert: An expert personal financial planner can work with and inform a client’s legal representative in relation to consumer protection laws. Further, an expert planner can anticipate threats to a client’s financial situation and predict ways to counter such threats through legal and regulatory remedies. In some situations, an expert financial planner can help inform public policy by providing advice to lawmakers and regulators.

IN PRACTICE Sarah Terrance is a new financial planner whose target market clientele includes single and widowed retirees. He loves working with older clients because he sees himself as a defender of elder rights, as well as a caretaker of client assets. Recently, one of Terrance’s clients, Sarah, received a phone call from someone claiming to be a financial planner who insisted on talking to her about opportunities to invest in new gold-producing firms in Alaska. Unsure what to do, Sarah consulted Terrance, who explained that the call was likely a scam. Terrance then worked with Sarah to add her name to the National Do Not Call Registry. All was well until

last week when, at 7:30 in the morning, Sarah received a call from the same broker. This time Sarah asked that the caller provide his name and return telephone number. The broker did not answer directly but instead attempted to promote another gold mining company. Finally, the broker revealed his name and a phone number. Sarah ended the call but was confused because she thought that she would not receive these types of phone solicitations. Again, she talked with Terrance. Terrance was perplexed because he knew the broker was in violation of the Telephone Consumer Protection Act of 1991: First, the broker had called someone who was on the National Do Not Call Registry; second, he had called Sarah before 8:00 a.m. Both actions are prohibited by the law. Based on this, Terrance helped Sarah file a complaint with the Federal Communications Commission, which took action against the broker and his firm.

Wilma The possibility for a criminal to steal a client’s identity continues to increase as the world of consumer finance becomes more electronically interconnected. Consider the case of Wilma Jee. She recently returned from a two-week vacation when she realized that she had forgotten to request that her mail be held at the post office. When she arrived home she was concerned that she had just a few catalogs and other pieces of junk mail in her mailbox. Her concern became alarm when a few days later she received a call from the fraud department of a credit card company. Apparently, someone had stolen Wilma’s mail while she was on vacation. The thief used one of her credit card billing statements to access her credit. The individual used her credit line to purchase several high-cost items at a large online discount retailer. When the thief attempted to purchase gas, the credit card company put a hold on the card. Unfortunately, damage had already been done to Wilma’s credit history. Given her sense of panic, she turned to her financial planner to learn more about credit and identify theft. Wilma learned that under the Truth in Lending Act, she is protected if a thief uses a credit card account illegally. The maximum out-of-pocket expense associated with a lost or stolen credit card is $50. While this may be the maximum financial responsibility, Wilma was startled to learn that the true cost associated with a stolen identity is the time it can take to repair the damage caused by a thief. The Federal Trade Commission, according to the FDIC,4 reports that consumers have been denied loans, deprived of mortgages, and accused of shoplifting as the result of credit reports that inaccurately record charges made by a thief. It can take anywhere from a few months to several years to fix credit reports, records, and related financial damage associated with identity theft. The FDIC recommends the following seven steps as a way to help clients avoid becoming an identity theft victim: 1. Protect key accounts and information, including Social Security numbers, credit card numbers, passwords, and personal information. 2. Never carry a Social Security card in a wallet. 3. Don’t let mail sit in a mailbox for an extended period of time. 4. Shred all receipts, account information, and credit card statements. 5. Use a safe to store important personal information, data, and unused credit cards, checks,

and other valuable items. 6. Check each expense on a credit card statement. 7. Review with clients their credit reports at least once each year. Wilma’s financial planner provided the following federal resources to help her navigate issues associated with credit and identity theft: FDIC, Federal Reserve Board, Office of the Comptroller of the Currency, and Office of Thrift Supervision or the National Credit Union Administration: www.fdic.gov/consumers/consumer/news/index.html. Federal Trade Commission: www.consumer.gov/idtheft or 877-ID-THEFT (877-4384338). U.S. Department of Justice and the Federal Bureau of Investigation (FBI): www.usdoj.gov/criminal/fraud/idtheft.html. Social Security Administration: Fraud Hotline 800-269-0271 or www.ssa.gov website.

NOTES 1. E. B. Goldsmith, Consumer Economics: Issues and Behaviors (Upper Saddle River, NJ: Prentice Hall, 2009). 2. E. T. Garman, Consumer Economic Issues in America, 9th ed. (Mason, OH: Thomson, 2006). 3. www.hhs.gov/ocr/privacy/hipaa/administrative/privacyrule/index.html. 4. Source: www.fdic.gov/consumers/privacy/criminalscover. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 5 Fiduciary Martie Gillen, PhD University of Florida

CONNECTIONS DIAGRAM

CFP Board’s Standards of Professional Conduct require that all CFP® professionals who provide financial planning services be held to the duty of care of a fiduciary. A fiduciary is defined by CFP Board’s Standards of Professional Conduct as “one who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client” (p. 4). Individuals should always consider when the fiduciary standard applies. The Rules of Conduct address the fiduciary standard of care. Rule 1.4 provides direction to CFP® professionals who

provide financial planning or material elements of financial planning to clients. The financial planner must adhere to ethical standards of professional conduct and fiduciary responsibility by providing unbiased recommendations that are in the best interest of the client. Violations may result in discipline of the CFP® professional.

INTRODUCTION As defined by CFP Board’s Standards of Professional Conduct, a fiduciary is “one who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client” (p. 4). CFP® professionals have a fiduciary responsibility to their clients when they are providing financial planning services or material elements of financial planning services. Professional judgment is at the forefront of acting as a fiduciary by recommending financial products or services that are believed to best serve the client. As detailed in the Rules of Conduct, Rule 1.4 regarding professionals who provide financial planning or material elements of financial planning to clients, the CFP® professional owes to the client the duty of care of a fiduciary as defined by CFP Board (p. 9). A financial planner’s fiduciary status supersedes the baseline standard of care expected of all CFP® professionals. One who acts as a fiduciary has the highest ethical obligation to put the client’s best interests ahead of every other consideration as related to the principles of integrity, objectivity, fairness, and professionalism. How is a client’s best interest determined? Financial planners should identify the options, and should use their reasonable professional judgment to identify the best options based on client facts and circumstances. While it is impossible to review the infinite number of options, it is expected that the financial planner will provide the best services and recommendations available to reasonably meet the client’s needs, goals, and priorities. Disclosure is needed when business or regulatory requirements may limit the types of products or services available to the client. Financial planners must disclose limitations to the client such as contractual or agency relationships that may potentially affect the client. Financial planners must also disclose to the client conflicts of interest; compensation structure, including compensation arrangements and any other sources of compensation; and costs of products and services, including all expenses the client will incur. A best practice is to follow up all verbal disclosures with written documentation. After a financial planning relationship exists, the fiduciary duty applies to all future services provided to that client by that planner. Violations may result in discipline of the CFP® professional.

LEARNING OBJECTIVE The student will be able to: a. Discuss the fiduciary standard and its importance to the planner–client relationship.

IN CLASS Category

Class Activity

Student Assessment Avenue

Remembering: Retrieving, recognizing, and recalling relevant knowledge from long-term memory

Reading appropriate sections of course materials. Lectures and discussion on fiduciary responsibilities. Provide specific contexts and situations for class discussion.

Multiple-choice quiz and exam questions accessing students’ knowledge regarding fiduciary responsibilities.

Have an interactive class discussion of various fiduciary scenarios. Have students discuss opportunities and challenges related to providing the best recommendations to the client. Applying: Carrying out or Class can discuss various using a procedure through client scenarios. Ask executing or implementing students to evaluate options and make recommendations to the client. Analyzing: Breaking Ask students to complete material into constituent case study analysis parts, and determining how focusing on client the parts relate to one another recommendations. Students and to an overall structure or will identify challenges purpose through and opportunities and make differentiating, organizing, recommendations. and attributing Evaluating: Making Continuation of above case judgments based on criteria study analysis. and standards through Ask students to present the checking and critiquing results of each case study to the class. Students will receive feedback from the class and instructor and can learn from the other case Understanding: Constructing meaning from oral, written, and graphic messages through interpreting, exemplifying, classifying, summarizing, inferring, comparing, and explaining

Essay exam questions where students identify and explain opportunities and challenges related to providing client financial planning recommendations.

Students work on problems to evaluate client options and identify the best client recommendations.

Based on the case study, students evaluate client options, make client recommendations, and provide justification for said recommendations. Students also identify limitations that require disclosure to the client. Students present the findings of their case study to the class. Students critique their classmates’ analyses and provide feedback.

study presentations. Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Students each create a case study where fiduciary responsibilities were not fulfilled. Students then analyze their classmates’ case studies to identify fiduciary-related issues and make recommendations to address the issues.

Students each create a case study where fiduciary responsibility was not fulfilled. Students then analyze another student’s case study. The analysis should include identifying issues and limitations and making recommendations.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify fiduciary duties and related parties. Competent: A competent personal financial planner acts as a fiduciary for the client by evaluating options, making recommendations in the client’s best interests, and disclosing any limitations. Expert: An expert personal financial planner acts as a fiduciary for the client by creatively and strategically evaluating options, making recommendations in the client’s best interests, and disclosing any limitations.

IN PRACTICE Amanda Amanda is a relatively new CFP® professional. She has been brainstorming ways to solicit new business, and makes a list of family members, friends, and acquaintances to call on for initial business. After talking with Amanda, her sister Tonya and Tonya’s partner Harley decide they could use a financial plan and would like Amanda to make recommendations. Amanda knows she must disclose to her clients any actual or perceived conflicts of interest, so she discusses with them the potential conflict of advising a family member. Amanda tells them that they would need open communication to explore their values, attitudes, expectations, and time horizons as those attitudes/orientations affect their goals, needs, and priorities. Amanda reminds them that she would need full disclosure, including in-depth quantifiable financial information, to be able to complete a comprehensive financial plan and make recommendations that would be in their best interests.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 6 Financial Planning Process John E. Grable, PhD, CFP® University of Georgia Ronald A. Sages, PhD, AEP®, CFP® , CTFA, EA Kansas State University

CONNECTIONS DIAGRAM

The financial planning process underlies the foundation of both comprehensive and modular financial planning.1 The process of financial planning is highly integrated into every aspect of financial advice giving. The systematic process is shaped and guided by many factors,

including a financial planner’s commitment to disclosure, practice standards, professional conduct, and ethical standards. Communication and counseling skills also are essential to making the process work most effectively for clients. The financial planning process connects the core content areas of planning, including cash flow and net worth, tax, insurance, investment, retirement, and estate planning.

INTRODUCTION The process of financial planning is generally conceptualized as a six-step activity, as described by the Certified Financial Planner Board of Standards, Inc. (CFP Board):2 1. Establishing and Defining the Client–Planner Relationship: This first step in the financial planning process is important because it sets the stage for client–planner interactions by clarifying issues and concepts related to responsibilities of both parties in the relationship. CFP Board rules require financial planners to specify and document their services. CFP Board Practice Standard 100-1 further requires financial planners to specifically provide clients with the following information:3 Disclosures related to the practitioner’s material conflict(s) of interest. Disclosures of a practitioner’s compensation arrangement(s). Explicit disclosure of the client’s and the practitioner’s responsibilities. Establishment of the duration of the engagement. Any additional information necessary to define or limit the scope of the engagement. 2. Gathering Client Data, Including Goals: Gathering client data begins following the establishment of the client–planner relationship. According to CFP Board, data gathering includes interviewing or questioning clients about various aspects of their financial resources, obligations, and expectations. Data gathering also includes collecting all necessary documents necessary to perform analyses. This step in the process is most often used by financial planners to help their clients define and better understand financial goals and objectives, needs, desires, and priorities. 3. Analyzing and Evaluating the Client’s Financial Status: According to CFP Board, within the context of the financial planning process, examining and evaluating client data begins with a review of current cash flow needs. The analysis procedure continues with a review of risk management, investment, tax, retirement, employee benefits, estate planning, and special situation topics. Understanding a client’s values and attitudes, and determining the client’s time horizon, risk capacity, and risk tolerance, are important elements associated with this step in the planning process. 4. Developing and Presenting Financial Planning Recommendations and/or Alternatives: Financial planning recommendations should meet the unique goals and objectives of each client, reflecting his or her values, traditions, risk profile, and unique situation. Financial planners are expected to present, review, and discuss recommended strategies with clients

to ensure that expectations and desired outcomes are maximized, and that recommendations are thoroughly understood by the client. It may be necessary to revise recommendations or alternatives based on client–planner discussions. 5. Implementing the Financial Planning Recommendations: Without client action to put recommendations into place, the likelihood that clients will reach their financial goals becomes uncertain. Clients and planners should agree on the steps necessary to move recommendations from theory into practice. During the implementation state of the planning process, financial planners will either carry out services for the client or counsel the client in coordinating efforts with other professionals. It is important for financial planners to use counseling and communication skills in this process. 6. Monitoring the Financial Planning Recommendations: Monitoring the soundness of implemented recommendations and progress toward goal achievement is a crucial aspect linked with the planning process. The client and planner must agree on who will monitor the financial progress. If it is the planner, then he or she should openly communicate with the client and make any necessary, ongoing adjustments to the plan relative to changes in the client’s life. Financial planner and client situational factors play an important role in shaping applications of the financial planning process.4 Important financial planner situational factors include temperament, personality, attitudes, beliefs, behaviors, knowledge, and expertise. Client situational factors include risk tolerance, risk capacity, financial knowledge, personal/household characteristics, socioeconomic status, lifestyle, attitudes, beliefs, temperament, and personality. Planner and client situational factors combine to influence how goals are framed and how recommendations are formed in the areas of cash flow management, income tax planning, risk management, investment planning, retirement planning, education and special needs planning, and estate planning.

LEARNING OBJECTIVES The student will be able to: a. Describe the personal financial planning process as defined by the Financial Planning Practice Standards. b. Recognize unethical practices in the financial planning profession based on the CFP Board Standards of Professional Conduct.

Rationale Financial planners should be proficient in explaining, documenting, and diagramming the financial planning process. The financial planning process, as defined by CFP Board, can be diagramed in a number of ways. Consider the example presented in Figure 6.1. The illustration shows how the process begins by establishing and defining the client–planner relationship and ends with monitoring tasks. It is important to note that this process is cyclical, and feedback

from each step informs the ongoing planning process and client–planner relationship.

Figure 6.1 The Systematic Financial Planning Process The diagram shown in Figure 6.1 illustrates the sequence of logical, organized steps that a personal financial planner follows when working with clients to develop a comprehensive financial plan. Each step in the process flows seamlessly to the ensuing step; this process ensures that nothing is inadvertently overlooked that might result in a less than optimal client experience. Personal financial planning is extremely detail-oriented, and it entails gathering and interpreting information of a sensitive and confidential nature. Clients seek assurance that this information will be handled with discretion and with proper regard for recommendations that will ultimately be made. Financial planning shares practice requirements that are unique among established professional endeavors in that practitioners must abide by various professional, local, state, and federal rules, regulations, and ethical guidelines. The wide variety of regulatory oversight, and sometimes conflicting ethical standards, has often been justified as a way to protect the consumer interest. Increasingly, however, many financial planners have adopted Certified

Financial Planner Board of Standards, Inc. Standards of Professional Conduct to guide their interactions with clients.5 The Standards provide guidance on: (1) the material elements of the financial planning process, (2) obligations owed to prospective clients, (3) disclosure obligations, (4) the use of written agreements, (5) compensation disclosure, (6) obligations to the profession and other professionals, and (7) standards of care. CFP Board’s Code of Ethics and Professional Responsibility outlines principles that are aspirational and a source of guidance for CFP® practitioners.6 These include integrity, objectivity, competence, fairness, confidentiality, professionalism, and diligence. CFP® professionals are expected to both know these principles and be able to apply them in their practice. In summary, ethical guidelines represent the basis on which the personal financial planning profession exists. Clients expect not only that financial planners are technically proficient in all facets of personal financial planning, but that they will always place the client’s interests above everything and everyone else. Merely the appearance of impropriety or lack of objectivity can trigger a loss of confidence in the client’s immediate situation as well as the overall profession. Clients seek professionals who will be advocates for meeting their goals and objectives without distraction or other consideration. A personal financial planner should always be mindful of situations and circumstances that could potentially result in a loss of objectivity and impartiality.

Related Content Areas Associated with the Learning Objectives The function and purpose of fully understanding the process of financial planning is to help frame the client–planner alliance. Ethical standards serve as a guide for planners before, during, and after services are provided to clients. Ethical rules and regulations provide a working framework for financial planners when building a business model.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Illustrate the financial planning process during a class lecture. Based on the illustration, ask students to diagram the process and to select one of the steps and develop a list of possible ethical conflicts associated with performing the step.**

Analyzing: Using a case study, ask students in Breaking material class to document the information

Student Assessment Avenue Assign students to use a client data-gathering intake form to obtain demographic, financial data, and goals from a case study or an acquaintance; this will help students match client assessment tools and techniques to each stage of the process.** Using a case study, assign students to apply their knowledge of the

into constituent parts, determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

needed from a client at each stage of case client to identify clientspecific attitudes, beliefs, and the financial planning process.** behaviors that may impact the type of recommendations made in a written financial plan; require students to document at what stage of the planning process each attitude, belief, and behavior might be of importance.**

Develop a role-play activity, asking one student to play the part of a client and another to play the role of planner; the planner should walk through the first two steps in the planning process; other students should then document and evaluate how effectively the planner was able to connect with the client and gather important information.* Creating: Putting Split the class into two teams. Using elements together a financial planning mini-case, ask to form a coherent the first team to develop a series of or functional client recommendations directed at whole; meeting the key goals and objectives reorganizing outlined in the case. Once elements into a established, ask the second team to new pattern or develop a checklist of monitoring structure through activities that will be needed to generating, ensure that actions achieve the case planning, or client’s objectives. producing

Prepare a nearly completed datagathering client intake form. As homework, ask students to review the document and mark areas on the form where additional information is needed.**

Ask students to create/ draft a documentation checklist of information needed from a client that can be used to support the financial planning process; the checklist should include actions a planner should take at each step of the process with the information provided by the client.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: As an entry-level employee in a personal financial planning firm, assigned tasks and responsibilities will vary based on the type of firm, compensation structures, and targetmarket clientele. For many entry-level financial planners, assigned tasks will also differ based on the size of the firm and the value of assets under management. Regardless of these firm

characteristics, entry-level employees will be expected to know the six steps of the financial planning process and be capable of assisting the primary relationship financial planner in the completion of any assigned tasks within the six steps. For entry-level employees, a major transition takes place in their knowledge and experience as theory and policy morph into practice and reality. The entry-level employee gains a solid appreciation for the need to stay abreast of changes in various laws and regulations affecting the personal financial planning process. The entry-level employee is introduced to local professional associations that provide visibility and credibility for furthering the planner’s education and the mission of the personal financial planning firm. The entry-level employee takes direction from a firm principal in discharging duties and must strictly follow internal policies and procedures when working with clients and client information. The entry-level planner’s understanding of the position and approach to the daily routine tends to be task-oriented, with a finite duration. Specific activities include: 1. Establishing and Defining the Client Relationship Specifically, new hires will be expected to understand the process of, and approaches to, probing clients as a means of helping them to focus on their financial goals and objectives. Various strategies may be employed, including separate and joint interviews among clients that are designed to confirm areas of agreement and points of possible conflict, so that consensus may be obtained. Consider a situation where the desires of a married couple differ. Until a consensus can be obtained between the wife and husband, a financial planner will find it difficult to define the scope of the planning engagement or ascertain which documentation to gather in the planning process. Further, the emerging professional should be capable of drafting an engagement letter setting forth the specific components and limitations of the plan for review and refinement by the firm partner-in-charge. 2. Gathering Client Data Based on information shared by the clients in the first stage of the financial planning process, an entry-level employee should readily recognize which common pieces of information and documentation will need to be collected from the client, regardless of stated client needs and objectives. This responsibility may entail the preparation of checklists to aid clients in assembling the necessary information, and the subsequent organization of information as received that will help to expedite the planning process. This may also include preparing, in draft, information release requests from other allied professionals (accountants, attorneys, investment counselors, and insurance professionals) serving the clients that may require client signatures in order to obtain copies of legal documents, tax information, portfolio statements, and insurance policies. 3. Analyzing and Evaluating Client’s Financial Status Once necessary information is collected from clients and their advisers, the process of analyzing and assessing this information begins, much of it with the use of spreadsheets, calculators, and personal financial planning software. Entry-level employees must be completely proficient in time value of money (TVM) principles, in-house planning

software, and their application and use to stated client needs and objectives to ensure that information is entered into software packages accurately. 4. Making Recommendations At this stage of the financial planning process, the entry-level employee becomes more of an observer as the planning principal begins to establish a road map for presentation to the client. An entry-level employee may be asked to prepare alternate what-if scenarios as a means of presenting concise and clear options to clients. Ultimately, collateral presentation materials will need to be prepared to bolster recommendations, and the entry-level employee will likely play an integral part in the drafting of such information for review and comment. 5. Implementation Once a clear path has been established and approved by the client(s), the entry-level employee will frequently provide assistance in preparing the necessary documents that are designed to fulfill the specific plan elements. Entry-level employees may also be asked to circulate the necessary paperwork for signatures, establish client accounts, and assist in the funding of these accounts. 6. Follow-Up and Monitoring Some clients are notorious for procrastination and hesitation. Others launch into the process expecting immediate results. Either way, periodic follow-up and monitoring is required to bring the financial plan to fruition and to establish a baseline for future changes. Entry-level employees may be asked to prepare a series of reminders that serve to ensure that no aspect of the plan is overlooked. At specific intervals, entry-level employees may also assist in preparing annual or more frequent updates and reports for submission to clients. Competent: The competent planner is experienced in handling all aspects of a client engagement. This includes the solicitation of prospective new clients, guiding and mentoring entry-level employees in the planning process, and brainstorming/strategizing with other allied professionals in the best options for client consideration. The proficient planner should be capable of following each stage of the financial planning process without routine supervision, and be alert to those prospective situations that may be outside the scope of the firm’s capabilities or target market. The proficient employee is expected to be capable of making decisions on straightforward client matters, but to know when to seek the guidance and collaboration of more senior firm colleagues for addressing the unusual or highly specialized client need or situation. The proficient planner will begin to exhibit a high level of effectiveness in decision making and strategizing. The ability to initiate and conduct research will be commonplace. Discussions with allied professionals will demonstrate a high level of maturity and critical thinking. Problem solving will play an ever-increasing role in the proficient planner’s daily routine. Weighing options, analyzing probable outcomes, and establishing clear and efficient paths leading to desired client outcomes will be the norm. In summary, the proficient planner

begins to see how the various tasks performed in the entry-level years fit together to form a seamless product for serving client needs. Expert: The expert personal financial planner functions at the highest possible level when serving firm clients. Over the years, the expert has likely encountered myriad client situations of varying sophistication and complexity. Consequently, the expert is capable of assessing client needs, organizing information, and formulating plans to fulfill objectives of clients. The expert gives clear direction to firm support personnel and instinctively knows when and where potential complications may surface in addressing client needs. The expert will also frequently participate in various pro-bono financial planning activities as a means of giving back to the profession. Both proficient and expert planners exhibit behaviors within the firm and in public that embrace, establish, and demonstrate a culture of the highest technical proficiency, as well as impeccable ethical standards. These high-level standards continue to evolve with the passage of time; proficient and expert planners welcome opportunities to expand their knowledge base and routinely share their knowledge and experiences within their firms to promote consistency.

IN PRACTICE Prospective Client Frequently a prospective financial planning client will be referred to a personal financial planner to solve an immediate, pressing need. This need may initially reside in only a single financial planning content area and may, at the moment, be the prospect’s sole focus. However, by closely following the financial planning process, the planner may uncover additional client planning gaps that need to be prioritized and addressed over time. Consider the following case: In 1995, the prospect’s father passed away at the age of 73. Under the terms of the patriarch’s last will and pour-over trust, a charitable lead annuity trust (CLAT) was to be created and was designed to mitigate the impact of federal estate taxes in the father’s estate. Though married, the patriarch’s estate, at $5 million taxable, was considerably smaller than the estate of his surviving spouse. The prospect was designated as co-trustee of the CLAT. The family had worked for many years with the trust department (corporate cotrustee) of a super-regional banking institution; however, CLAT arrangements in estate planning were not as common in the early 1990s, and the professionals in the trust department were unfamiliar with how to administer and manage the trust. Since the trust would be funded with $2.7 million in investable assets, the family was most interested in working with a corporate trustee firm that had experience with more sophisticated transfer tax arrangements. Provision existed in the pour-over trust agreement for the resignation or removal of the designated corporate co-trustee and the appointment of a successor corporate co-trustee. The initial meeting with the prospect entailed a probing process to understand specific family needs so that the prospect relationship could be established and properly defined. The personal financial planner employed by the prospective corporate trustee took pains to discuss

the firm’s capabilities and services, with specific attention paid to the responsibilities to be assumed by the successor corporate co-trustee and those retained by the individual co-trustee. Since the prospective corporate co-trustee was one of three firms being considered by the family, a period of several weeks elapsed before the family concluded the interview and evaluation process. Once the family had made a decision, appropriate legal steps were taken to have the firm of choice formally appointed as successor trustee. At this point, the financial planning process resumed with gathering client data and establishing goals for the CLAT. Since the purposes of the trust were to provide an annuity to a designated charity for a 20-year period followed by a distribution of the trust remainder to the patriarch’s three adult children, an extensive amount of information was collected from each branch of the family in order to design an efficient and effective investment plan. Once developed, the recommendations were presented for the family’s consideration and to obtain the individual co-trustee’s concurrence with the outlined strategy. The proposed investment plan was implemented, and the CLAT began to function as the patriarch had envisioned and directed under the terms of his pour-over trust agreement. Based on confidential information collected during the client data-gathering process and during subsequent family meetings over several years, the personal financial planner identified additional financial planning issues where the family might benefit from an expanded engagement. The family concurred, and what initially started as a $2.7 million investment management relationship blossomed into a $40 million comprehensive engagement involving assessment of banking, credit, insurance, income tax, estate, and retirement planning needs.

Kariga Kariga Lawrence is a new financial planning practitioner. He has been very active volunteering in local community service programs, as well as serving on several non-profit advisory boards. Kariga believes that these activities serve as a form of marketing, and he hopes his volunteer services will soon bring many new clients into his practice. Another innovative marketing approach used by Kariga involves paying a referral fee to anyone who refers clients to him. He also accepts payment from accountants, attorneys, and other professionals when he refers his own clients for services provided by others. During the initial client meeting, Kariga discusses his financial planning approach, attitudes regarding macroeconomic events, and views regarding the securities markets. He is diligent about providing a brochure and marketing material to clients. Because of his unique marketing procedures, he sometimes tells new clients that they can receive a referral fee. He never tells prospective or current clients about fees received when he refers his contacts to other professionals. Even though Kariga may feel that the way he is compensated is unrelated to the financial planning process, the fact that Kariga does not fully disclose his methods of compensation is a violation of the CFP Board of Standards, Inc. Standards of Professional Conduct. In effect, lack of disclosure at any step in the planning process can jeopardize the planner–client relationship and, in some situations, result in compliance complaints and sanctions.

NOTES 1. R. H. Lytton, J. E. Grable, and D. D. Klock, The Process of Financial Planning: Developing a Financial Plan (Cincinnati, OH: National Underwriter, 2006). 2. The financial planning process can be found under the Guide to CFP® Certification: www.cfp.net/become/experience.asp. 3. www.cfp.net/for-cfp-professionals/professional-standards-enforcement/standards-ofprofessional-conduct/financial-planning-practice-standards/practice-standards-100. 4. See Lytton et al., Process of Financial Planning, 159. 5. www.cfp.net/for-cfp-professionals/professional-standards-enforcement/standards-ofprofessional-conduct/financial-planning-practice-standards. 6. Ibid. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 7 Financial Statements Thomas Warschauer, PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

Many topics use financial statements as a basis for their analyses. For example, cash flow statements are necessary for insurance needs and retirement planning computations. Virtually all accumulation goals depend on funding based on either appropriating investment assets or allocating cash flow. An understanding of these funding sources is based on an analysis of these financial statements. Statements of financial position are necessary for investment analysis and determining appropriate financing strategies. Tax and estate evaluation also begin

with an evaluation of the client’s financial statements. Evaluation of financial statements results in observed strengths and weaknesses of the client’s fiscal situation, which is discussed in Chapter 77.

INTRODUCTION Finance professionals agree that financial analysis virtually always begins with the construction and evaluation of financial statements. The construction of financial statements is an ancient art, although statements for business analysis are much more developed than those for individual or family analysis. Financial planners need to be familiar with both corporate/business accounting techniques and individual financial statements. Given that the purpose of financial statements prepared by a financial planner is different than that of corporate financial accounting, standardization of statements is less important than it is for public reporting of business entities. Thus, financialplanner-produced statements need not be compliant with generally accepted accounting principles (GAAP) unless they are also to be used in public reports or are being prepared by certified public accountants based on the Financial Accounting Standards Board rules and U.S. Securities and Exchange Commission policy. The basis of a sound financial statement is grounded upon an understanding of basic accounting principles. Underlying accounting principles that are important to individual and family accounting statements include the following: Objectivity principle—quantities must be verifiable. Materiality principle—the amount of detail depends on its cost to collect and its relative importance. Consistency principle—similar situations call for similar treatment. Conservatism principle—reporting revenues or assets only when they are assured. Full disclosure principle—all material facts are disclosed. Some accounting principles are of less importance in individual accounting, but essential to business reporting. These include: Historical cost principle. Revenue recognition principle requiring accrual basis accounting. Matching principle (expenses have to be matched with revenues). The key statements in business accounting are the income statement (also called the profit and loss statement), the statement of financial position (often called the balance sheet), and the statement of cash flows. In addition, firms sometimes present statements explaining changes in equity or net worth. In general, planners should be familiar with business statements because sometimes their clients own businesses. Also when planners recommend the purchase or sale of individual securities, they must analyze and interpret GAAP-prepared statements of the

prospective investments they are considering. An individual company security analysis recommendation is based on intimate and detailed knowledge of these statements and their associated accounting footnotes. For a planner who is not dealing with these situations, only a very general understanding of business accounting is necessary. The key statements for individual or family accounting are different. Whereas the income statement is generally considered to be the most important statement for businesses, it does not exist in individual accounting. The statement of financial position and cash flow statements are the most important statements in family finance. Budgets are actually pro-forma or forecasted cash-flow statements that are used for the purpose of tracking actual expenses relative to the amount budgeted for them. The importance of financial statements to the financial planning process may be, to some, a bit debatable. It would be possible to complete even a comprehensive financial plan without ever creating or analyzing a financial statement. However, most finance professionals agree financial statement analysis is the normal starting point for the evaluation of a company’s or individual’s financial condition, and is thus an excellent source of evaluating a client’s strengths and vulnerabilities of their current condition. Although it is not a clear practice standard that financial statements always be generated and evaluated, it is clearly a useful practice. The learning objectives reflect the needs of all planners to generate and analyze their clients’ financial positions and for planners who engage in specific areas to fully understand business accounting techniques.

LEARNING OBJECTIVES The student will be able to: a. Construct statements of financial position and cash-flow statements as applied to clients consistent with sound personal accounting standards. Certain common conventions are widely practiced within financial planning. First, assets listed on balance sheets are properly listed with the safest and most liquid types first and the riskiest and least marketable last. Although grouping of assets into categories varies, at least three groups are common: safe (sometime called liquid or cash assets) are usually listed together, as are all investment assets and all personal (or use) assets. There is no agreement on whether business ownership (partnerships or proprietorships) should be listed separately, with investments, or with use assets. Another important tool is the use of footnotes to the statements a planner creates. Footnotes may list contingent assets (e.g., an expected year-end bonus or inheritance) or contingent liabilities. In fact, footnotes should list or explain any item whose omission would cause a material misunderstanding of the client’s financial position. The AICPA Personal Financial Statements Guide provides specific instructions for the construction of financial statements for individuals. Probably the most important innovation

is the computation of taxes due on the liquidation of assets as a reserve liability account that results in an after-tax and more meaningful valuation measure of an individual’s net worth. Although most planners do not show this figure, its use would improve the usefulness of the net worth figure. Cash flow statements show revenues first and expenses later, sometimes in the following manner: Salary Investment Income Other Income Less: Taxes Fixed Expenses Variable Expenses Net Funds Available for Savings Alternatively, instead of “fixed” and “variable” expenses, planners sometimes list categories of expenses, such as home ownership costs, food and restaurants, automobile expenses, and so on. b. Evaluate client financial statements using ratios and growth rates and by comparing them to relevant norms. Analysis of corporate statements usually begins with the computation of standard ratios and growth rates and the comparison of those ratios and rates with industry norms, usually adjusted for the size of the firm. Common ratios used in corporate analysis include liquidity ratios, profitability ratios, debt ratios, activity ratios, and investment valuation ratios. There are dozens of commonly measured ratios used to analyze a business’s financial condition. DuPont analysis is a common analyst’s tool. It decomposes return on equity into several components such as profit margin and asset turnover.

DuPont System1

Once ratios are computed, they are compared with those of similar companies. That means companies of comparable size and in the same or a similar industry. A common source of comparison ratios is Risk Management Associates (RMA).2 It is important to note that, apart

from profitability measures, there is no such thing as a “good” ratio. The purpose of computing ratios is to better understand the nature of the firm. For example, a high liquidity ratio may be desired by a lender, but if it is too high it may indicate a lack of investment prowess by the firm’s management. Whereas ratios make comparisons among accounts in a business’s or client’s financial statement, growth rates review changes over time. The two most important growth rates are growth in gross income over time compared with growth of net worth over time. The computation of ratios for individuals is a newer and less developed science than for businesses. Bankers have used debt ratios to determine whether it is a good idea to lend to a family. But just because a family is able to borrow does not mean it should borrow. There are several good sources of ratios for use in evaluating family statements; some even contain norms for purposes of comparison.3 They divide ratios into various types: liquidity, savings, asset allocation, inflation protection, tax burden, housing, and solvency. In the introductory section, we mentioned some key differences in accounting principles for individual financial statements and corporate statements. However, probably the biggest difference is the use of market valuation of investment assets and replacement cost for individuals’ personal assets. This would be problematic for businesses because it would enable managers to easily manipulate earnings. Further, most business assets are not valued by the market directly. Whereas the single most important number in corporate accounting is net income, probably the most important number in individual statements is net worth. However, net worth is commonly overstated for individuals who own appreciated assets or tax-deferred assets (individual retirement accounts [IRAs], for example). The solution to this problem, employed by the American Institute of CPAs (AICPA), is to reduce net worth by taxes that would be paid if all investments were shown after tax. The AICPA calls this amount the estimated income tax on unrealized appreciation, but we could simply call it a tax reserve. It is important to remember that the sole purpose of planner-prepared statements is a better understanding of a client’s financial position.

IN CLASS

Category

Class Activity

Given raw data, as part of a class discussion, create meaningful financial statements. Examples of this data might include liquid/emergency accounts, a wide variety of investments with market valuation, and depreciation where relevant for personal assets. In addition, cash inflows such as salary and investment income and expenses such as taxes, debt payments, and living expenses should be provided for cash flow analysis.** Analyzing: Breaking Given financial data, as part of a class discussion, material into create meaningful categories for financial constituent parts, and statements. For example, if a cash flow statement is determining how the provided in the fixed and variable format, translate parts relate to one that to a categorical configuration (housing costs, another and to an transportation costs, etc.) that lists all expenses in overall structure or the same category together. For example, purpose through transportation expense might include auto differentiating, payments, gasoline, maintenance, and auto organizing, and insurance).** attributing Evaluating: Making Given financial statements, as part of a class judgments based on discussion, compute and evaluate the financial criteria and standards position for a client.** through checking and critiquing Applying: Carrying out or using a procedure through executing or implementing

Student Assessment Avenue Given a case with data randomly spread throughout, ask students to create meaningful statements.**

Given a statement with illogical or inappropriate asset classes, ask students to reorganize it in a meaningful way.**

Given financial ratios and a set of recommendations, ask students to indicate which are appropriate and which are not appropriate under the circumstances.**

**Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can prepare and evaluate financial statements for a family. Competent: A competent personal financial planner can compute growth in earnings and net worth to determine if the client is making good progress toward stated goals.

Expert: An expert personal financial planner can evaluate a firm’s financial condition given its 10-K and 10-Q reports and determine for whom, if anyone, it would make a good investment.

IN PRACTICE Patricia After establishing the client–planner relationship, Patricia Planner starts into the data-gathering phase of planning. She has asked a client couple to bring in a list of assets, debts, and cash flow items. The clients provided the following list: Robert and Mary Client (dated end of last calendar quarter) Robert: Age 41 Mary: Age 40 Home: $445,000 (cost basis $220,000) Gross income: $120,000 (annual) 2010 model car (60,000 miles), good condition Checking account balance: $3,641 Personal property (worth approximately 25 percent of home) Variable housing expenses: $3,600/month Other variable expenses: $8,600/month Income tax (state/federal): $18,000 annual Life insurance cash value: $8,450 XYZ municipal bond fund: $5,650 (cost basis $6,000) Auto company stock: $22,400 (cost basis $14,500) Raw land held for second home to be built: $43,000 (cost basis $20,000) Tech stock: $32,400 (cost basis $8,250) Social Security/Medicare tax: $6,000 annual Salary income: $125,000 Jewelry (appraised value): $14,500 Credit card loan (12.8 percent interest): $12,600 Mortgage: $333,330 Mortgage payment (monthly): $1,666 Certificate of deposit (matures in 24 months, 1 percent interest): $10,000

401(k) retirement plan: 2009 model SUV (40,000 miles, excellent condition) 2007 model car (75,000 miles, good condition) 25 percent interest in bakery business—appraised value of firm: 2010 model car loan balance: Car payments:

$145,000

$220,000 $1,850 (4 percent APR) $300/month

Other debt payments: $100/month All asset and liability data are for the end of the last calendar quarter. Other facts computed by Patricia: Net worth decreased 15 percent from last year. Inflation is 2.4 percent. Investment assets decreased 14 percent from last year, and home decreased $80,000 from 2008. Capital gains bracket 15 percent, average combined tax bracket 25 percent. For car valuations use www.kbb.com trade-in value. Patricia now sets out to create and evaluate a statement of financial position and a cash flow statement. The first step would be to separate assets, liabilities, cash inflows, and cash outflows. The second step would be to categorize assets into safe, investment, or use assets, and to categorize expenses into taxes, fixed, or variable, or by use categories (auto, home, etc.). After creating the statements, Patricia could evaluate the financial condition of the clients by computing ratios and comparing them with norms, by evaluating the changes in net worth, and by observing the clients’ financial condition relative to their situation. This leads to observing a series of strengths and weaknesses regarding their current situation. Although practice standards do not permit giving advice until Patricia’s analysis is complete, she can see some obvious recommendations right away. She might begin with the evaluation of the investment assets relative to the clients’ income, ages, and goals. Are the investments diversified? Do they provide inflation protection? Does the income statement indicate past savings or the potential for savings? For example, Patricia might use the financial statements to explain to her clients that using the $10,000 CD, which is earning 1 percent per annum, to pay off most of the credit card balance on which they are being charged 12.8 percent per annum, would result in no change in net worth, while it would improve annual cash flow by $1,180.

NOTES 1. Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 9th ed. (New York: McGraw-Hill

Irwin, 2011), 635. 2. www.rmahq.org. 3. Sue Greniger, Vickie Hampton, Karrol Kitt, and Joseph Achacoso, “Ratios and Benchmarks for Measuring the Financial Well-Being of Families and Individuals,” Financial Services Review 5, no. 1 (1996): 57–70. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 8 Cash Flow Management Martie Gillen, PhD University of Florida Michael Gutter, PhD University of Florida

CONNECTIONS DIAGRAM

Cash flow management is a fundamental aspect of financial planning. Therefore, cash flow management connects to all areas of financial planning. The construction of financial statements provides a foundation for identifying opportunities and challenges related to a client’s cash inflows and outflows. The financial planner can use this information to help

clients develop a plan for reaching long-term financial goals such as planning for education, special circumstances, and retirement. Financing strategies may be utilized to aid the client in reaching goals such as buying a home. Cash inflows and outflows play an important role in determining whether obtaining new debt is the best alternative, including the debt level. Time value of money (TVM) is an important financial planning concept and includes calculations needed to assist with financial goal planning. TVM can be used by the financial planner to help a client compare alternatives among investments, loans, mortgages, leases, savings, and annuities. The financial planner should communicate recommendations to assist clients in meeting their current financial needs and long-term financial goals, including the need for liquid assets and emergency funds, as well as recommending strategies for accumulating the appropriate levels of funds. The financial planner must adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION Cash flow management is an essential component of financial planning. Cash flow management involves understanding the components that make up where the client’s money comes from, where it goes, and what choices are appropriate in meeting the client’s needs and goals. It is critical that financial planners understand cash flow management to be able to make recommendations to clients to assist them in meeting their current needs and long-term financial goals. The overall goal of cash flow management is to efficiently meet current consumption needs while maximizing capital for additional financial management activities needed to reach clients’ objectives. The primary components of cash flow management include income, fixed expenses, variable expenses, and savings contributions. Income earned by the client may include salary, interest, dividend, pension, business income, and alimony received. Examples of fixed expenses include mortgage payments, automobile payments, student loan payments, property taxes, insurance premiums, and federal and state income tax withholdings. Variable expenses are more discretionary than fixed expenses over the short term, and include items such as entertainment expenses and vacation expenses. The statement of income and expenses is a financial statement that represents all of the client’s income, including both earned and expected income, less all expenses incurred during the specified time period. This statement is typically prepared on an annual basis but can be prepared for a monthly or quarterly period of time. Additionally, the statement of income and expenses does not include non-recurring transactions such as the sale of stock or an employer’s contribution to a retirement plan. Understanding a client’s cash flow can provide valuable information in understanding a client’s financial priorities by providing a snapshot of the client’s financial situation. The statement of income and expenses should be viewed with the balance sheet to provide the financial planner with a more accurate picture of a client’s financial situation. The financial planner should identify opportunities and challenges related to a client’s cash

inflows and outflows. For example, having a positive cash flow will afford the client options to save for long-term goals such as education and retirement. Conversely, a negative cash flow may lead the client to having excess debt and additional costs due to interest. The financial planner should calculate the amount of savings required to meet the client’s financial goals and recommend how to incorporate planned saving contributions into the cash flow plan. The financial planner should also communicate the need for liquid assets and emergency funds and recommend strategies for accumulating the appropriate levels of funds. The financial planner should also work with clients to identify non-financial resources that clients may use to achieve financial goals. Understanding a client’s cash flow plan is essential to financial planning. An analysis of a client’s cash flow may serve as a wake-up call. By all accounts, the United States recently went through its longest (December 2007 through June 2009) and by most measures worst economic recession since the Great Depression, labeled the Great Recession. Leading up to the Great Recession, housing prices soared and consumerism was rampant. A bubble in home prices allowed many consumers to borrow massively. The economic downturn was marked with rising unemployment, decreasing spending, and falling housing prices with threats of foreclosure. Many families continue to struggle daily to make ends meet as they try to recover from the recession. At a time when many Americans are trying to claw their way out of debt, they have no emergency funds and little or no retirement savings. Additionally, workers who faced long periods of unemployment may have depleted their savings.

LEARNING OBJECTIVES The student will be able to: a. Identify opportunities and challenges related to a client’s cash inflows and outflows and make recommendations to assist the client in meeting their current needs and long-term financial goals. b. Communicate the need for liquid assets and emergency funds and recommend strategies for accumulating the appropriate levels of funds. c. Calculate savings required to meet financial goals and recommend how to incorporate planned savings into the cash flow plan.

IN CLASS Category Applying: Carrying out or using a procedure through

Class Activity Student Assessment Avenue In-class or online Students will work on problems that apply the core discussion of issues of cash flow management. examples of families in different cash flow management

executing or implementing

scenarios. Ask students to make recommendations to assist clients in improving their cash flows so the clients can meet current financial needs and fund long-term financial goals. Analyzing: Ask students to Breaking complete a case study material into analysis, focusing on constituent the individual parts, and components of cash determining flow management, to how the parts gain an understanding relate to one of the process. another and to Students will then an overall examine the client’s structure or cash flow purpose management and make through recommendations. differentiating, This could be done organizing, and individually or attributing completed in groups, depending on the size of the class. Evaluating: Continuation of the Making previous case study judgments analysis. Ask students based on to present the results criteria and of each case study to standards the class. through Students will receive checking and feedback from the critiquing class and instructor and can learn from the other case study presentations. Creating:

Continuation of case

Based on the case study, students will calculate savings required to meet financial goals and recommend how to incorporate planned savings into the cash flow plan. Students will make recommendations regarding strategies for accumulating the appropriate levels of liquid assets and emergency funds. Based on the case study, students will identify non-financial resources for use by individuals and families in reaching financial goals.

Students will present the findings of their case studies to the class.

Students will write a letter to the client for the

Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

study analysis. Ask students to write a letter to the client focused on cash flow management.

respective case study to (1) identify opportunities and challenges related to a client’s cash inflows and outflows and make recommendations to assist the client in meeting current needs and long-term financial goals, (2) communicate the need for liquid assets and emergency funds and recommend strategies for accumulating the appropriate levels of funds, (3) calculate savings required to meet financial goals and recommend how to incorporate planned savings into the cash flow plan, and (4) identify non-financial resources for use by individuals and families in reaching financial goals.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the cash flow management process and identify opportunities and challenges related to a client’s cash inflows and outflows. The professional can communicate the need for liquid assets and emergency funds. Competent: A competent personal financial planner can make recommendations to assist clients in meeting their current needs and long-term financial goals. The planner can recommend strategies for accumulating the appropriate levels of funds of liquid assets and emergency funds. The planner can calculate savings required to meet financial goals and recommend how to incorporate planned savings into the cash flow plan. Expert: An expert personal financial planner can creatively and strategically identify financial and non-financial resources for use by clients in reaching financial goals.

IN PRACTICE Thomas At age 52, six months ago Thomas Allen experienced a job loss due to company cutbacks. He had earned $65,000 annually. Thomas is married to Monique (age 42); they have three children: Terrell (age 17), Thomas Jr. (age 12), and Mia (age 6). Monique is a teacher in a local school system and earns $42,000 annually. Unfortunately, the Allens’ expenses haven’t decreased accordingly. In fact, expenses have increased. Over the past six months, the couple’s credit card balances have soared to a total of $24,600 as they took several cash advances to pay household bills. The Allens have known for some time that they are spending more than they earn. What they are unsure of, however, is by how much their expenses exceed their income. They have also depleted their emergency savings. Before Thomas lost his job, the couple had $20,000 in savings. Household debts total $249,000 and include a $201,000

mortgage balance, $24,600 on four credit cards, $3,200 (five more payments) on Thomas’s car lease, and $22,200 on Monique’s car loan. The Allens recently got hit with a $35 late fee when they were unable to make a payment on one of their credit cards by the due date. To add insult to injury, the annual percentage rate (APR) on that credit card increased from 14.9 percent to 28.4 percent. The Allens’ largest household expense is their $2,225 monthly mortgage payment. The interest rate charged is 5.75 percent. They are also paying about $800 monthly for minimum payments on their credit cards and have a $640 car lease payment and a $525 car loan payment. They admit that they’ve never kept good financial records. They have also lived paycheck to paycheck for over a decade and have little retirement savings or education funds for their children. Their oldest son Terrell is currently applying to colleges and they are not sure how his future tuition will be paid. “As soon as we got paid, the money was gone,” said Thomas. They have taken several vacations over the past few years. The couple has come to a financial planner to provide recommendations regarding their cash flow management and how to turn around their cash flow crisis. The personal financial planner knows they first have to determine their expenses by examining records or tracking expenses.

Joseph A client, Joseph (age 42), who is a single dad to five-year-old twin girls, came into your office today. His wife passed away last year and he received $200,000 in life insurance. He provides you, the financial planner, with the following information for the upcoming year: income $95,000; principal and interest payments on his home mortgage $14,000; homeowner’s insurance $1,000; property taxes $5,500; living expenses $45,000, including after-school care for his daughters; credit card debt payments $7,500; savings $5,000; student loan payments $6,000; and car payments $6,000. He plans on using the life insurance to fund his daughters’ college educations; unfortunately, he has needed to dip into the funds to pay for living expenses and only $160,000 remains. An examination of Joseph’s cash flow may allow for him to free up future cash flows so he can replenish some of the funds he hoped to use for his daughters’ educations. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 9 Financing Strategies Martie Gillen, PhD University of Florida Michael Gutter, PhD University of Florida Jorge Ruiz-Menjivar University of Georgia

CONNECTIONS DIAGRAM

Clients often face decisions involving financial goal setting, including the funding vehicle, such as savings. Financing strategies are essential factors that play significant roles during the

lifetime of a client to assist clients in meeting financial goals such as with education planning, investment planning, retirement savings, and income planning. With an uncertain economy, a financial planner is needed to help consumers prioritize their finances in order to achieve longterm financial stability throughout these tough times. There are a number of options for financing financial goals. These many options often make financial management much more difficult for a client. As part of the financial planning process, recognizing and evaluating financing strategies is of the utmost importance in helping clients set and achieve short-term and long-term goals. This recognition will also aid clients in their financial decision making and provide a consistent track to meet these financial goals. A financial planner should stress the importance of financing strategies, including cash flow management, debt management, borrowing, and financial goals.

INTRODUCTION A financial planner must be able to efficiently explain the complete spectrum of financial strategies by evaluating each stage. Financing strategies undergo five stages of a client’s life, and each milestone has meaning related to the overall financial assessment. The first stage is the “Starting-Out Years,” ranging in age from 18 to 25. This stage is important as clients are beginning adulthood and trying to understand their financial capabilities. At this stage, the choices about education, employment, and debt management will likely have a major impact on a client’s financial status for many years and decades in the future, including retirement. A financial planner consulting with a client within this stage must be able to help the client prioritize goals and ideas for establishing his or her financial status. Also, the financial planner should monitor how clients choose to spend their money and what types of financial decisions they make. If clients accumulate a high level of debt, it may reduce their ability to obtain affordable credit, both in terms of new credit awarded and interest rates charged for transactions such as financing a car or house. The second stage is the “Nesting Years,” which range from age 25 to 40. This phase marks the beginning of making meaningful financial decisions such as starting a career, getting married, and buying a house. A financial planner must be able to understand the importance of the financial implications of these decisions, as this phase is critical to lifetime financial stability. Financial planners should explain the value of saving and investing in retirement accounts such as a traditional individual retirement account (IRA), Roth IRA, and 401(k) that make contributions toward retirement income. This phase begins the client’s lifestyle where everything starts to settle in. For example, the financial planner may need to educate clients about mortgages and car loans. The ability to successfully execute these types of financial decisions will result in financial stability for not only the client, but the client’s family as well. The financial planner should inform the client about setting financial goals for the future. This foundation gives both the financial planner and the client a financial guideline by which to abide in case emergencies occur. In this phase it is also important for clients to have strategies that can help them reach short-term and long-term financial goals. The third stage is the “Prime Time Years,” which range from age 40 to 55. A financial planner

must be mindful of a client’s discretionary income. Discretionary income is the amount of income left for spending, investing, or savings after taxes and personal necessities such as food, shelter, and clothing are paid for. A financial planner must realize that a client has more financial freedom due to this discretionary income, thus establishing how valuable making rational financial decisions will be in both the short term and the long term. During this phase, a client likely has more discretionary income than in prior stages. This can be both good and bad for the client. The guidance of a financial planner is mandatory to assist in managing this newfound income. A client may feel that this discretionary income can be used to splurge on items or simply spend it all each pay period or annually. A financial planner should introduce ways a client can use this income to contribute toward reaching his or her financial goals by following the financial strategies. The fourth stage is the “Wealth Accumulation Years,” which range from age 55 to 65. The decisions on investing, spending, and lifestyle come into view. A financial planner has to assess a client’s retirement financial goals because this transition is quickly approaching. Financial planners should help guide clients on retirement and investment options that may enhance their future retirement funds. This phase closely examines the results of previous financial decisions on retirement income. If clients do not prepare appropriately, the growing rate of inflation and possibly diminishing Social Security benefits may leave them at a financial disadvantage. A financial planner should be able to evaluate the plan created at the initial stage and see if a client financially maintained that course. The fifth and final stage is the “Reinvention Years,” which include ages 65 and older. The success of this phase is dependent on making good financial decisions and using financial resources that match a client’s financial status. A financial planner is needed to help organize how a client maintains retirement income and expenses in terms of participating in leisure activities such as traveling and vacation trips with family, interest in part-time work to steadily create more income without a full-time working status, or the ability to assist with various projects in the community, including making monetary donations.

LEARNING OBJECTIVES The student will be able to: a. Analyze the various sources of borrowing available to a client and communicate the advantages and disadvantages of each for meeting a client’s financial goal. b. Create a debt management plan for a client that minimizes cost and maximizes the potential to reach financial goals. c. Explain appropriate housing financing strategies.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Ask students to complete case study analysis focusing on debt management.

Students will design a debt management plan for a client that minimizes cost and maximizes the potential to reach financial goals.

Ask students to complete case Students will analyze the study analysis focusing on sources different sources of of borrowing. borrowing available to a client based on the client’s current financial status and make recommendations regarding financing strategies. Continuation of the previous case Students will assess how the study analysis. Ask students to financial strategies present the results of each case recommended for each case study to the class. Students will study will affect a client’s receive feedback from the class financial status and whether and the instructor and can learn the strategies assist the client from the other case study in reaching the client’s presentations. financial goal. Creating: Putting elements Continuation of previous case Students will summarize the together to form a coherent study analysis advantages and or functional whole; disadvantages of each source reorganizing elements into a of borrowing to meet the new pattern or structure client’s overall financial goal through generating, based on the case study planning, or producing presentations. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can help the client organize his or her financial goals. An entry-level planner can gather information from the client and understand what financial goals are feasible. There are instances where the client’s financial goals may not be realistic. At this point, a financial planner has to communicate efficiently to the client about short- and long-term financial goals. An entry-level financial planner can inform clients of the importance of maintaining a high level of financial management. Competent: In terms of financing strategies, a financial planner should stress the importance of debt management. A competent personal financial planner can create a debt management

plan that allows a client to manage his or her finances without accumulating detrimental debt in both the short term and the long term. A competent planner should inform clients regarding the risks behind certain financial decisions that may affect their credit and ability to reach financial goals. A competent personal financial planner can address the pros and cons of making financial decisions such as paying for a home, a car, and vacations. Competent financial planners can create an overall debt management plan that minimizes the costs and enhances the benefits for a client for the long term. Expert: An expert personal financial planner can explain to clients their borrowing options based on their current financial status. An expert financial planner will have a combination of exceptional knowledge and experience to combine all aspects of financing strategies, which include debt management, borrowing, and financial goals, to create a complex financial plan for a client. This plan will serve as a financial guideline for a client with which an expert financial planner explores a client’s strengths and weaknesses based on the client’s finances and accumulated debt. This will give the client greater flexibility when contemplating financial decisions by considering his or her risk tolerance.

IN PRACTICE Clarence and Robin Clarence (age 48) and Robin (age 40) have been married for 15 years. They have three children: Marcus (age 14), Carrie (age 10), and Brittany (age 6 months). Clarence recently received a promotion resulting in a substantial pay raise and now earns $135,000 annually, an increase of $45,000. Since receiving Clarence’s salary increase, the couple has decided that Robin will stay at home to care for their children and her aging parents, who reside next door. To date, the couple has been very frugal in their spending and debt accumulation. They are interested in buying a larger home, but would like your recommendations as a financial planner. They currently have $186,000 remaining on their current mortgage. They would like to sell their current home, but only after they have moved into their new home. They will have to pay two mortgages for a period of time depending on how long it takes to sell their current home. They have found their dream home; the asking price is $325,000. They have $60,000 in a savings account at their local bank. Robin also has $25,000 in a Roth IRA. They are thinking about using all of their savings for the down payment on the new home, meeting the 20 percent required needed to avoid private mortgage insurance (PMI). They would like you, the financial planner, to make recommendations regarding the purchase of the new home related to financing strategies and debt management. As a financial planner, you know there is much more to this picture that needs to be considered. For example, the planner must first determine their other expenses, including accumulated debt, and the couple’s financial goals, including strategies for meeting their current goals such as education planning for their children.

Stanley and Simone Stanley and Simone have come to you for recommendations. They are having financial

problems and are considering bankruptcy. They provide you with the following information: They have three children, ages six months to 18 years. Their bills include a mortgage of $150,000 at 5 percent, a second mortgage of $20,000 at 7.5 percent (because they had too much credit card debt), additional debts to various credit cards totaling $10,000 with interest rates varying between 12 percent and 28 percent, a lease on Stanley’s new truck of $28,000, a car loan on Simone’s car for $7,000, and past-due medical bills totaling $4,000 from the delivery of their last child. They have $5,000 in savings. As a financial planner, you know more information is needed to examine the couple’s cash flow management and to be able to create a debt management plan. An examination of the couple’s cash flow may free up funds that could be used to pay down debt. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 10 Economic Concepts Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

This particular chapter and its learning objectives are primarily focused on macroeconomic variables, and as such, connect primarily to three content areas: general financial planning principles (under which this topic resides), investment planning, and retirement saving and income planning. Effective investment planning requires an understanding of financial markets and the ways in which changes in gross domestic product (GDP), interest rates, and inflation rates can impact the value of investment securities. Likewise, it is important for the financial

planner to understand how exchange rates impact a globally diversified portfolio. Finally, when developing retirement planning strategies, key inputs include assumptions about inflation rates, interest rates, and capital market returns. Only planners with a fundamentally sound understanding of basic economic concepts will be able to develop or evaluate appropriate assumptions for these variables.

INTRODUCTION Macroeconomic conditions encompass and influence many of the fundamental assumptions used in the financial planning process, including but not limited to interest rates, inflation rates, and capital market rates of return. An understanding of the interrelationship between economic variables allows the financial planner to better interpret evolving conditions in the external environment and explain to clients how these relate to planning assumptions and projections. Thus, an understanding of economic concepts not only improves the quality of the assumptions used in developing planning recommendations, but also helps to create appropriate expectations in the minds of clients, helping to keep them committed to a consistent course of action. Furthermore, the aims and tools of economics are mirrored in the aims and tools of the practicing financial planner. Consider the following definition of economics, first offered by Lionel Robbins in 1932 and now the dominant description of the economic enterprise: Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.1 The financial planner likewise grapples with the concept of scarcity, the allocation of a client’s scarce resources in the face of competing goals and objectives. Thus, one of the financial planner’s most important roles is to make explicit the trade-offs faced by clients so that clients might ultimately choose a set of objectives that are both feasible, given available resources, and likely to produce the greatest satisfaction.

LEARNING OBJECTIVES The student will be able to: a. Apply the following economic concepts and measures in making financial planning recommendations. 1. Supply and demand. From a microeconomic perspective, supply and demand provide a model for explaining the dynamic by which an equilibrium (or market-clearing) price for goods and services emerges. This is the price at which the quantity of a good or service offered (supplied) is matched by the quantity demanded. There are several concepts related to supply and demand that are relevant to financial planners. One element is the importance of understanding the differences between shifts in the supply and demand curves and shifts along such curves. Another is the concept of

price elasticity of demand and supply. That is the degree to which the quantity supplied and demanded responds to price changes. Planners should understand the effect of tax increases on the equilibrium prices as well. Finally, planners should distinguish among the types of equilibrium resulting from specific supply and demand: momentary, shortrun, and long-run equilibrium. From a macroeconomic perspective, the concept can be applied to the supply and demand for labor, with wages being the price. It can also be used to explain the relationship between interest rates, real output, and the money supply via the investment–saving/liquidity preference–money supply (IS-LM) model.2 An understanding of the application of supply and demand models in both microeconomic and macroeconomic contexts helps the financial planner to develop appropriate assumptions for financial projections, as well as a greater ability to explain the implications of economic conditions to clients. 2. National Income Accounts (including GDP). National Income and Product Accounts (U.S.) are maintained by the Bureau of Economic Analysis of the U.S. Department of Commerce. They represent the aggregate income and output of different segments of the economy, including households, businesses, and government. The aggregate of the income earned or product produced (they must equal each other) in all sectors of the economy is known as the gross domestic product (GDP). Understanding how economic output is measured and reported allows the financial planner to form appropriate judgments as to the direction of the economy and to relate financial planning assumptions and recommendations to larger economic trends. 3. Business cycles (unemployment, recession, fiscal and monetary policy). The business cycle refers to the pattern by which economic phenomena emerge from and give rise to changes in the general level of economic activity, as measured by the gross domestic product (GDP). Economies are subject to alternating periods of expansion and contraction, during which rates of unemployment, inflation, and output rise and fall, along with the aggregate valuation of financial markets. Understanding the nature and implications of business cycle fluctuations allows financial planners to form appropriate financial planning recommendations for clients. Such planning recommendations may include, inter alia, the establishment of liquid reserves to carry clients through periods of unemployment, portfolio diversification, and safe withdrawal policies to ensure spending needs can be met during market downturns, and the establishment of other contingency reserves for known expenses (e.g., college tuition). An understanding of the business cycle also prepares financial planners to better manage client expectations and keep the client committed to a consistent and prudent course of action in the face of economic and financial market fluctuations. 4. Interest rates (including their term structure and the yield curve) and inflation. As with all economic phenomena, interest and inflation rates are deeply entwined with each other and with other economic factors and can both give rise to broader changes in the economy and in turn be influenced by such changes that arise from other sources.

Among other things, understanding the relationship between the general level of interest rates and implications for the bond market helps the financial planner make more appropriate investment recommendations. Likewise, understanding the implications of high or low levels of inflation for retirement and other goal planning allows the financial planner to make more realistic projections and to better manage client expectations with respect to current and future saving and spending needs. 5. Exchange rates. Understanding the impact of changing exchange rates on a globally diversified portfolio helps the financial planner to develop investment recommendations that are more appropriate to a client’s risk profile and to better manage client expectations.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Instructor lecture on the linkages between economic variables (e.g., interest, inflation, and exchange rates).

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through

Small groups work together to collect data from financial publications and organize it into a summary of National Income Account data or construct a yield curve.

Student Assessment Avenue Students are given case scenarios that allow them to demonstrate their ability to describe economic linkages. The case will describe the economy at a particular point in the business cycle, and the students will be asked to describe how a change in one economic variable will affect other variables. For example, when the unemployment rate falls below the frictional rate of unemployment, wage inflation would typically follow, causing price inflation; bond investors fear inflation would drive bond prices down, causing interest rates to rise, which in turn would slow the rate of business investment and raise financing costs for consumers, which would cause unintended inventory investment on the part of businesses, which in turn would cause businesses to reduce output and lay off workers, and so on. Students collect data from financial publications and arrange or manipulate it in order to make it more meaningful (e.g., collect yield and maturity data and create a yield curve).

differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Student-led discussion of current economic reports and what they imply for the state of the economy (e.g., what the current unemployment rate, interest rate, and inflation rate imply about where we are in the business cycle). Creating: Students make Putting presentations to elements the class, each together to addressing a form a specific coherent or planning issue functional and how it is whole; affected by reorganizing current elements into economic a new pattern conditions. or structure through generating, planning, or producing

Students interpret and explain the implications of economic information (e.g., describe the shape of the yield curve and interpret the implications for other economic variables).

Students are asked to make a specific recommendation that is justified by current and projected economic conditions (e.g., develop a recommendation for a client considering a mortgage refinance based on the emergence of an inverted yield curve).

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can define and describe economic terms, basic linkages between economic variables, and implications for a change in one or

more variables. For example, this planner will be able to describe to clients in an accurate and comprehensible way how supply and demand influence asset prices. Competent: A competent personal financial planner’s understanding of economics is sufficiently deep to allow him or her to make concrete investment, refinance, and other recommendations that are demonstrably connected to current and projected economic conditions. Expert: An expert personal financial planner can develop integrated financial planning recommendations that encompass current and prospective economic conditions. This planner can explain how changes in economic conditions are accounted for in the financial planning recommendations.

IN PRACTICE Pema Pema Chaudry is meeting with her financial planner, Brent Emerson, to discuss bad economic news she has been seeing reported on television and her fear of investment losses and the consequent erosion of her lifestyle in retirement. Brent begins with a review of the latest economic statistics for the U.S. and world economies. He then puts those into context and explains why the dire predictions Pema has been hearing on the news are out of line with the economic evidence. Finally, he discusses the business cycle and the related cycles in the securities markets, which move in sympathy with the real economy, noting that cyclical downturns are common and to be expected and Pema’s investment strategy has been designed with those in mind. Pema is reassured by Brent’s explanation and returns home with a renewed determination to avoid television news.

NOTES 1. L. C. Robbins, An Essay on the Nature and Significance of Economic Science (London: Macmillan, 1932), 15. 2. John R. Hicks, “Mr. Keynes and the ‘Classics,’” Econometrica 5, no. 2 (April 1937): 147– 159. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 11 Time Value of Money Jorge Ruiz-Menjivar University of Georgia Martie Gillen, PhD University of Florida Michael Gutter, PhD University of Florida

CONNECTIONS DIAGRAM

Time value of money is an essential component of financial planning and connects to all areas of financial planning. Time value of money calculations can assist clients in meeting their

financial goals such as in education planning or retirement and income planning. Time value of money (TVM) refers to the notion that money received today is not worth the same as an equal amount of money received at a future date. For example, $100 received today is worth more than $100 that would be received 10 years from now, as today’s amount can be saved or invested, earning interest, and could subsequently compound in value. TVM calculations serve as tools for comparing prospective investments and projects, making sound financial decisions, and properly planning for clients’ objectives. Indeed, TVM calculations are essential in the world of financial planning. TVM is the foundation for financial modeling, stock and bond pricing, insurance, and pension fund valuation. Therefore, it is crucial that professionals in the field of financial planning master these fundamental concepts and calculations.

INTRODUCTION The main types of time value of money (TVM) calculations are (1) converting present values to future values, and (2) estimating the future values of known present values. The computation varies for each type depending on whether the structure of the asset under consideration consists of a lump sum or a series of payments or deposits, also known as annuities.1 Serial payment, net present value (NPV), and internal rate of return (IRR) are other derived TVM calculations extensively used in the area of financial planning. The formula for each time value of money calculation is discussed in this chapter. Present value (PV) refers to the current worth of an asset (or stream of assets) that will be received at a specific time in the future. Present Value of a Lump Sum (11.1)

Where i denotes the interest rate and n the number of time periods. Present Value of an Ordinary Annuity (11.2)

Where C = cash flow per period; i = interest rate; n = number of payments. Future value (FV) is the future value estimation of an asset (or stream of assets) invested today, and expected to end at a defined particular point in the future.

Future Value of a Lump Sum (11.3)

Where i denotes the interest rate and n the number of time periods. Future Value of an Ordinary Annuity (11.4)

Where C = cash flow per period; i = interest rate; n = number of payments.

Ordinary Annuities and Annuities Due The financial planner should understand the differences between the two types of annuities: ordinary annuities and annuities due. An ordinary annuity refers to a series of payments made at the end of each period over a definite amount of time (e.g., interest payments from bond issuers usually paid semiannually or quarterly dividends from a company). Equation (11.2) and equation (11.4) demonstrate how to calculate the present value and future value of an ordinary annuity. Alternatively, an annuity due differs from an ordinary annuity in that the payments are made immediately or at the beginning of each period (e.g., lease and rental payments). The formulas for computing present value and future value of an annuity due are provided in equation (11.5) and equation (11.6). Present Value of an Annuity Due (11.5)

Where C = cash flow per period; i= interest rate; n = number of payments. Future Value of an Annuity Due

(11.6)

Where C = cash flow per period; i = interest rate; n = number of payments.

Even and Uneven Cash Flows We have assumed thus far that the cash flows of time value of money calculations remain constant over the evaluation period (e.g., bonds and annuities). This broad category in TVM is called even cash flows calculation. However, often in practice the cash flows of investments or projects are not equal during every evaluation period. This type of TVM calculation is referred to as uneven cash flows. An example is provided later in this chapter.

Serial Payments The term serial payment refers to a payment that increases at a specific constant rate (usually the rate of inflation) throughout the payment period (accumulation or payout). For example, in cases such as calculating education and retirement needs, it is significant to considerer this factor and adjustment. Regarding the computation of serial payments, the formula follows the same equation as an annuity (ordinary or due); see equations (11.2), (11.4), (11.5), and (11.6). The only element that is adjusted is the interest rate, i. (11.7)

Where i denotes interest rate. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. It refers to the subtraction of the initial cash investment (outflow) from the present value of the discounted cash inflows. In the context of financial planning issues, NPV analysis is widely used in the capital budgeting area to evaluate capital projects and/or investments and their associated expenses. This analysis aids in determining whether to make an investment based on its profitability. For instance, if the NPV of a prospective investment is positive, then the investment should be accepted, as the positive NPV of that particular investment indicates positive cash flows. However, if the NPV is negative, the project then should perhaps be rejected or reconsidered.

(11.8)

Or (11.9)

Where –C0 = initial investment; C = Cash flow; i = interest rate; n = number of payments. Note that the initial investment, –C, is represented as a negative number indicating that money is going out as opposed to coming in. Internal rate of return (IRR) is the discounted interest rate at which the net present value (NPV) of a particular investment or project is equal to zero, meaning that the present value of the cash inflows and the initial cash outflow are equal. Similarly to the NPV, the IRR is employed to assess the attractiveness of a project or an investment. IRR can be thought as the rate of growth a project or investment is anticipated to generate. In general, the higher the internal rate of return of an investment or project, the more desirable the investment or project is. However, this is relative, as objectives by investors or firms vary. For instance, if the IRR of a potential investment surpasses the minimum accepted or required rate of return, then the investment should be accepted. Conversely, if the IRR is below that desired or required rate of return, the investment should be rejected. It is significant to note that IRR is also known as economic rate of return (ERR).

Where –C0 = initial investment; C = Cash flow; IRR = internal rate of return; n = number of payments.

LEARNING OBJECTIVES The student will be able to:

a. Calculate present value and future value of single amounts, annuities, annuities due, uneven, and serial payments. b. Calculate NPV and IRR and be able to apply the techniques to financial planning problems.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Provide examples on how time value of money calculations are utilized in the context of financial planning.

Students solve practice problems in financial planning that require the use of time value of money formulas. Students use the correct TVM calculation to solve the problems.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Discuss examples in financial planning in which combined time value of money calculations are required (e.g., the future value of an account with an initial lump-sum deposit followed by a series of annual deposits after a certain period). Have a case study completion where students have to determine which time value of money calculations are required.

Provide students with a case scenario in the area of financial planning in which several time value of money computations are involved and interconnected.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Create practice vignettes related to financial planning issues in which combined time value of money calculations are needed.

Students should differentiate and utilize different time value of money formulas depending on the context of the problem.

Students will complete mini-cases in financial planning issues in which they have to determine which time value of money calculations need to be employed in order to make specific suggestions for the particular scenario. Students will recommend to clients whether to pursue a project or investment based on the calculation and analysis of net present value and internal rate of return. In groups, students will create scenarios in which multiple time value of money calculations are required. These scenarios will be shared with other groups and solved conjunctively.

PROFESSIONAL PRACTICE CAPABILITIES

Entry-Level/Competent/Expert: After analyzing the client’s information, it is expected that professionals at every level of expertise can identify, remember, and apply the appropriate and required time value of money calculations and techniques and make appropriate recommendations.

IN PRACTICE Brad and Emily Upon retirement, Brad and Emily want to receive $45,000 in today’s dollars at the beginning of each year. They expect to live 20 years after retiring. Assume the inflation rate is 3 percent over the long run. What amount would they have to invest in the present time in order to accomplish this goal? Assume the investment earns 6 percent per year and is annually compounded. The first step in this scenario would be to identify the time value of money calculations. Because Brad and Emily want to know what amount of money they need to invest in today’s dollars in order to receive payments for a specific amount of time, and inflation is taken into account, it is evident that a present value of a serial payment is required in this case; see equations (11.5) and (11.7). Therefore, in order to attain this goal, Brad and Emily should invest $694,585.10. Interest rate adjusted for inflation,

Alba and Douglas Alba and Douglas own a small family business. They are considering expanding operations and would like to invest $100,000 in such an expansion. They are aiming to at least reach the break-even point from the investment after five years. If the projected cash inflows of such an investment are $35,000 in year 1, $30,000 in year 2, $25,000 in year 3, $15,000 in year 4, and $10,000 in year 5, should they pursue the expansion? In this scenario, the net present value (NPV) analysis can be used as a tool to respond to this financial planning question. The NPV in this case is equal to $15,000; see equation (11.8). Thus, under the given conditions and assumptions, because the NPV is positive, Alba and Douglas should pursue the expansion of

their small business.

David David is expecting to receive the following cash flow in the next four years: $330 in year 1, $410 in year 2, $340 in year 3, and $200 in year 4. Every time David receives a cash flow, he decides to invest it in an account that earns 5 percent per year, compounded monthly. What will the future value of this cash flow be? This is an example of an uneven cash flow. In this particular case, in order to find the total future value of the uneven cash flows, the formula of the future value is required [see equation (11.3)] for each expected payment. They are then added together. Hence, by the end of four years, David will have $1,393.71. First cash flow

Second cash flow FV2 = ($410) * [1 + (0.05/12)]12*2 = $453.03 Third cash flow FV3 = ($340) * [1 + (0.05/12)]12*1 = $357.40 Fourth cash flow FV4 = ($200) * [1 + (0.05/12)]12*0 = $200 Thus, the FV of uneven cash flow = $383.29 + $453.03 + $357.40 + $200 = $1,393.71.

NOTE

1. E. T. Garman and R. E. Forgue, Personal Finance, 10th ed. (Mason, OH: South-Western Cengage Learning, 2010). Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 12 Client and Planner Attitudes, Values, Biases, and Behavioral Finance Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

In all aspects of financial planning, an understanding of both the client and planner’s attitudes, values, and biases is needed to effectively gather client information and communicate recommendations. The field of behavioral finance has provided insights and tools that aid in this process.

INTRODUCTION The purpose of financial planning is to develop strategies to help individuals and families most effectively mobilize their human and material resources in pursuit of personal goals and objectives in a way that is consistent with the client’s personal values. The only way to fulfill that purpose is to develop a deep understanding of a client’s personal and family history, learning style, risk tolerance, and personal values. For a given endowment of human and financial capital, there are multiple paths to achieving a given financial goal. The financial planner’s role, therefore, is not simply to identify a technically feasible solution but to identify one that also is uniquely matched to a client’s personal profile. Clients are more likely to implement recommendations in which they see their own personal preferences and values reflected. To a very significant degree, clients turn to financial planners to help them manage change in their lives. Such change may take three forms: (1) environmental, (2) volitional, and (3) life cycle; each type embodies unique challenges. Environmental changes are those imposed on clients, including things such as death, disability, divorce, inheritance, job loss, financial market losses, and financial windfalls. Volitional changes are those that a client desires to make, such as paying for a child’s college education or achieving a comfortable retirement. Finally, life-cycle changes involve those that individuals experience as they pass through major life stages, such as school, first career, marriage, children, midcareer, pre-retirement, and postretirement. Clients often turn to financial planners because change is not easy to achieve. A study by the World Health Organization showed that the leading cause of disability worldwide was depression, and that the leading cause of clinical depression was an inability to adapt to unexpected change, or even, in many cases, “important and normal” life transitions.1 Yet another perspective on the difficult task faced by financial planners when assisting clients to manage change was offered by Stuart Heller, who pointed out that in every conversation with clients, the planner is having two conversations: one with the client and one with the client’s “bureaucracy of habits.” Heller then goes on to state that “habits eat change!”2 So, what is required for planners to fulfill their roles as change agents? Resistance to change finds its source in the client’s interior realm of personal preferences, experiences, risk tolerance, and personal values. Being able to uncover those interior factors allows planners to recommend strategies that leverage a client’s propensities and maximize the probability of success. Likewise, effective communication has been shown to be associated with a higher propensity for clients to reveal personal and financial data and to implement planner recommendations.3 Thus, when financial planners understand client learning styles and possess effective communication techniques, they will tend to maximize the probability that clients will implement actions to manage the desired change. Developing financial planning policies that incorporate client values and are structured to take advantage of identified biases can also be used to “nudge” them in the direction of better financial decisions.4

LEARNING OBJECTIVES

The student will be able to: a. Analyze a client’s degree of risk and loss aversion and insure recommendations are consistent with a client’s risk propensity, attitudes, capacity, knowledge, and needs. The risk-assessment process requires financial planners to measure, at a minimum, three main components consisting of risk tolerance, risk perception, and risk capacity. Risk tolerance represents the trade-offs that individuals are willing to make between potential risks and rewards; risk perception is the individual’s assessment of the magnitude of the risks being traded off; and risk capacity represents the degree to which a client’s financial resources can cushion risks. If clients are to adopt strategies to which they can remain committed over the long run, those strategies must properly account for a client’s risk tolerance and risk perception. Thus, the financial planner must be able to identify the client’s risk tolerance and be able to communicate effectively so as to keep the client’s risk perception aligned with reality. While client risk tolerance is often invoked when discussing investment strategies, this important psychological characteristic should be accounted for when making any kind of planning recommendations. For example, decisions related to financing a child’s college education, choosing a pension payout option, or purchasing a second home all properly involve the client’s risk tolerance. b. Explain how a client’s psychological profile, such as a Myers-Briggs assessment, learning style, and values impact the format of the plan produced and presented. Understanding a client’s learning style is crucially important for the financial planner when developing and communicating recommendations. It is also important when gathering information about goals, objectives, and preferences. For example, a client with a kinesthetic learning style may prefer to communicate goals and preferences by completing a mind map, compared to a client with an auditory learning style, who will likely prefer to narrate goals and preferences. By being able to gather information and communicate recommendations in a way that is matched to a client’s preferred learning style, the financial planner maximizes the probability of developing and successfully implementing financial planning solutions. c. Evaluate how a client’s values, including cultural and religious values and attitudes will affect his/her goals and a planner’s recommendations. A client’s cultural and religious background will often influence attitudes toward financial decisions as a consequence of varying beliefs related to such things as borrowing and debt or acceptable investment categories. Cultural and religious background can also influence how competing financial goals are prioritized. By uncovering a client’s cultural and religious background and the ways in which it influences the goals clients wish to achieve and what they’re willing to do to achieve them, planners will be better able to develop recommendations that will be acted upon. Planners must at all times avoid imposing their own beliefs, values, and priorities on clients when developing financial planning recommendations.

d. Describe how behavioral psychology, such as a client’s comfort zone, impacts a client’s objectives, goals, understanding, decision making, and actions. Individuals choose goals that are consistent with their prior experience and the cognitive models they have evolved from these experiences. For example, someone who used excessive debt to purchase a home the person couldn’t afford during a time of rapidly rising home prices will likely have a different attitude toward leverage and the uses of debt than someone who purchased a home during a period of falling prices who ultimately sold at a loss. Likewise, someone might commit his or her entire investment portfolio to a single stock that subsequently produced a rapid and sustained price rise. Convincing such a person to adopt a diversified portfolio may be a difficult task for the financial planner. The planner will need to be able to frame and effectively communicate the risks and rewards of different client scenarios in a way that acknowledges the client’s prior experience and reframes it in a way that makes it easier for the client to adopt recommended changes.

IN CLASS

Category

Class Activity

Applying: Carrying Instructor lecture on out or using a learning styles. procedure through executing or implementing

Student Assessment Avenue Students pair off and take turns interviewing each other in order to determine their partner’s learning style, after which they communicate a predetermined concept in a way that is congruent with that learning style.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Instructor lecture on the three elements of risk assessment.

Students are given a client profile and a series of statements related to that client (e.g., “believes the markets will be a losing proposition for years to come,” “has employer-provided disability insurance, a defined benefit pension plan, and highly stable employment prospects”) and are then asked to explain which of the three elements of risk assessment each statement most relates to.

Student-led discussion of how cultural and religious background may affect goals and objectives and/or may put boundaries on what clients are willing to do in order to achieve goals.

Students are given a client case history and asked to identify key personal, cultural, and religious factors that the planner must account for in developing the financial plan. The student should explain how these different factors will reinforce each other or be at cross-purposes, and which elements of the financial plan will be most impacted by each factor, individually and in combination.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Classroom role-play in which instructor plays client and students interview with the aim of uncovering goals and objectives, as well as personal factors such as risk tolerance, learning style, personal financial history, family, and cultural and religious background.

Students write an integrative analysis in which they identify the personal factors that will most affect the client’s goals and objectives. The analysis should also address the communication techniques that would be most appropriate given the client’s personal history and learning style.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can name the major learning styles and practice the appropriate communication techniques (e.g., mirroring, reframing, illustrating). This planner can also explain the three elements of the risk assessment process. Competent: In addition to the aforementioned, a competent personal financial planner can conduct client interviews that uncover personal history, attitudes, and values. A competent planner can communicate recommendations in a way that integrates client history and learning styles. Expert: In addition to the aforementioned, an expert personal financial planner can develop integrative recommendations that are demonstrably connected to clients’ preferences, values, and risk tolerances, and structured to maximize the probability of implementation.

IN PRACTICE Myra Myra Ogletree is meeting with her new financial planner, Kathrine Schwartz, for what was described as a discovery meeting. Kathrine begins by asking Myra a series of open-ended questions about her personal and family history. Myra feels very comfortable in answering these questions, perhaps because of Kathrine’s subtle body mirroring, steady eye contact, and periodic restatement of what she is hearing. Myra also appreciates that Kathrine seems very comfortable discussing some emotionally difficult parts of her personal history. Noting Myra’s tendency to handle the objects on the conference table while talking, her propensity for note taking and doodling, and from elements of her personal history, including her preference for making decisions while walking or hiking, Kathrine determines that Myra has a kinesthetic learning style. In deference to this, Kathrine asks Myra to answer several additional openended questions using a mind map format. By the end of the meeting, Myra feels that she has been heard and deeply understood, and, as a consequence, her confidence in the financial planning process has greatly increased.

Myra’s Learning Style Myra has returned to Kathrine’s office for the initial plan presentation. Kathrine has been careful to craft recommendations that reflect Myra’s personal history and values. As she shares her analysis via a large-screen monitor mounted on the wall, Kathrine relies on graphs and other visuals that distill financial concepts into simple, compelling images. Myra is able to manipulate the output on the screen via a tablet interface that includes slider controls for several key variables, such as the age at which she will retire. In making her explanations, Kathrine uses language that is consistent with Myra’s preferred learning style and at all times relates the recommendations back to Myra’s expressed values and beliefs. Many of the recommendations take the form of financial planning policies, simple decision rules that embody Myra’s personal goals and values, as well as financial planning best practices. As part

of her process, Kathrine makes the adoption of these policies interactive by offering Myra alternate formulations and allowing her to choose from among them and then edit the words until they feel like her own. Through this interactive, kinesthetic process, Myra ultimately comes to feel that she truly owns her financial planning policies and that they will be a touchstone and source of confidence through the coming months and years.

NOTES 1. The Lancet 370, issue 9590. 2. Stuart Heller and David Sheppard Surrenda, Retooling on the Run: Real Change for Leaders with No Time (Berkeley, CA: North Atlantic Books, 1995). 3. Carol Anderson and Deanna L. Sharpe, “The Efficacy of Life Planning Communication Tasks in Developing Successful Planner-Client Relationships,” Journal of Financial Planning 21, no. 6 (June 2008): 66–77. 4. Dave Yeske and Elissa Buie, “Policy-Based Financial Planning as Decision Architecture.” Journal of Financial Planning 27, no. 12 (2014): 38–45. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 13 Principles of Communication and Counseling John E. Grable, PhD, CFP® University of Georgia Kristy L. Archuleta, PhD, LMFT Kansas State University

CONNECTIONS DIAGRAM

Communication and counseling skills are at the center of the work financial planners do on a daily basis. These skills are an important professional competency shared by successful financial planners. Those who are able to communicate effectively while implementing counseling techniques into the client–planner relationship often find that current and

prospective clients are more willing to work through the entire financial planning process. Although financial planners have long acknowledged this fact, it was only in 2012, following the 2009 Job Analysis Study conducted by Certified Financial Planner Board of Standards, Inc. (CFP Board), that principles related to communication and counseling were added to the job task domains in the United States. The logic underlying the inclusion of this important topic involves recognizing that communication and counseling skills often are more difficult to teach than, say, the fundamental aspects of cash flow or estate planning, but without such skills, the effectiveness of a financial planner can be marginalized. Unfortunately, communication and counseling skills are not well taught from only a textbook. Instead, experiential learning and practicing the skills are the optimal ways to learn effective communication and counseling skills.

INTRODUCTION Financial counseling, as a professional career activity, began in earnest during the 1970s.1 Financial counseling has its roots in the blending of traditional consumer finance topics and psychological, sociological, and therapy techniques. Although this learning outcome implies that there is one overarching theory of counseling, this is not precisely true. Examples of theoretical perspectives commonly used by financial counselors and financial therapists include (1) economic and resource management, (2) classical economic, (3) strategic management, (4) cognitive-behavioral, and (5) psychoanalytic. See Grable, Archuleta, and Nazarinia (2010) for a description of each of these perspectives.2 Regardless of which theoretical approach a financial planner chooses, it is important to understand how to apply basic counseling skills when working with clients, including concepts such as open-ended versus closed-ended questioning, probing questioning, and cultural sensitivities. Although technical competencies related to time value of money concepts, cash flow and asset tracking, and planning projections often dominate the training process for new financial planners, it is equally important to acknowledge that the implementation of recommendations hinges on a financial planner building a trusting client–planner relationship. Recent evidence suggests that one way to build effective client interactions is to construct environments, both physical and emotional, that promote honest dialogue and disclosure.3

LEARNING OBJECTIVES The student will be able to: a. Explain the applications of counseling theory to financial planning practice. b. Demonstrate how a planner can develop a relationship of honesty and trust in client interaction. c. Assess the components of communications including linguistic signs and non-verbal communications.

d. Apply active listening skills when communicating with clients. e. Select appropriate counseling and communication techniques for use with individual clients.

Rationale At its core element, effective communication entails understanding and applying basic linguistic and non-verbal skills when working with clients. Examples of skills needed to be an effective communicator include: (1) maintaining eye contact, (2) monitoring voice pitch and tone, (3) evaluating facial expressions, and (4) utilizing non-verbal tools, such as mirroring and gesturing. Active listening by the financial planner allows clients to express their opinions, emotions, attitudes, and preferences in an open and trusting environment. The process of active listening involves repeating what a client has stated, paraphrasing what was heard, and reflecting on the meaning of the client’s words. It is important to stay focused on the client’s emotions, words, and feelings rather than jumping to conclusions, interrupting, or shifting the conversation back to what is most comfortable for the planner. Financial planners who incorporate appropriate linguistic, non-verbal, and active listening skills into their practice will be in the best position to connect emotionally with clients.4 Jaffe and Grubman (2011) summarized the situation this way: “The most effective and successful advisers in the industry are ones who can truly listen, build trust, interview effectively, make the client feel understood, and manage the delicate issues money can evoke” (p. 1).5

Related Content Areas Associated with the Learning Objectives Communication is conceptually related to all aspects of the financial planning process. Communication and counseling skills are an important part of the daily work performed by financial planners. The function and purpose associated with appropriate communication techniques helps clients move through the financial planning process.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Show video and lecture using examples of financial planners working with clients during the datagathering phase of the planning process; this may require creating videos, as few commercial videos are available; students should then

Participation points can be awarded for participating in the in-class activity; additionally, the use of a faculty-developed checklist—provided to students—indicating both positive and negative actions that should be identified in the roleplaying sessions* or in the video** should be used to evaluate student communication applications.

participate in a mock clientplanner communication session; roleplaying can be accomplished in groups of three where one acts as the client, one acts as the planner, and the other acts as the observer, observing the planner-client relationship and providing constructive feedback to the planner. Analyzing: Students, working individually Breaking or in small groups, should material into watch a financial counseling constituent video in class and then parts, critique the financial planner’s determining communication approach; this how the parts in-class assignment may relate to one require the instructor to create another and to a counseling video prior to an overall class. structure or purpose through differentiating, organizing, and attributing For the advanced communication and counseling student, the faculty member should invite colleagues and graduate students to class to participate in live discussions; students should be assigned at random to illustrate how communication skills can be used to facilitate clientplanner interactions; each session should be videotaped and analyzed in class.

Assign students to apply basic communication skills with a friend or family member; for example, ask students to engage someone in a discussion while using basic communication techniques such as mirroring, paraphrasing, and so on. Require students to write a reaction paper (one to three pages) documenting the outcome of the discussion; that is, did the communication techniques improve the discussion? The in-class assignment can be self-evaluated with individual effectiveness assessed from the perspective of (1) client, (2) planner, and (3) compliance officer, using facultydeveloped grading rubric; additionally, faculty and students can engage in discussion of counseling session effectiveness.**

Ask students to make an appointment with a local financial planner; request that the planner complete a short pretest of the planner’s mood and general attitude prior to the discussion; have each student ask a series of career objective questions (e.g., planner’s perception of financial planning as a career, income prospects, career recommendations, etc.); students should use as many communication tools and techniques as possible during the short interview; before leaving, have the planner complete a posttest asking about how well the interview flowed; students should write a reaction paper and discuss the interview with the faculty member

in a way that leads to analysis of techniques that can be improved with practice; a grading rubric for the reaction paper should be used. For the advanced student, ask the financial planner if he or she is willing to be videotaped; if yes, the faculty member should review the session with the student (and planner if possible) and analyze all aspects of the session, including client-planner dynamics, as well as the communication patterns of both planner and client. A rubric or checklist may be used to provide a formal grade. Evaluating: Making judgments based on criteria and standards through checking and critiquing

Students should videotape themselves during mock planner-client communication session and evaluate their own skills. Each student should develop guidelines based on evaluation of peer-counseling session that can be used by other students.

At this level of review, students should be required to review the video and critique themselves using a grading rubric designed by faculty; as a validity test, student videos can be reviewed by a faculty colleague or graduate student.**

At the evaluation level of assessment, it is appropriate for students to engage in one-onone evaluations of video work with a faculty Advanced communication and member, rather than in class; it is important counseling students should for faculty to provide feedback to the student; engage in a practicum formal feedback needs to be based on a experience and videotape faculty-developed rubric.* session. The students should Students should be encouraged to review and evaluate their own skills. edit their videos to showcase their best work; when this assignment is used, students should summarize in written form how their best work meets the requirements of effective communication and counseling using a facultydeveloped checklist or rubric.**

Creating: Putting elements together to form a coherent or

Students should create a communication and counseling portfolio that includes the following elements: (1) Identify one area where financial planners can improve

As a possible final assignment, ask students to review CFP Board Student Learning Objective 1, which deals with the financial planning process. Ask students to review a typical client data-gathering questionnaire; based on the questionnaire, assign

functional their client communication whole; strategies; students reorganizing elements into a new pattern or structure through generating, planning, or producing should write a paper on the topic as to why their chosen topic needs attention and how effective communication and counseling skills can help financial planners who encounter this issue. (2) Locate an empirical article or review a book on the topic of effective communication and counseling and summarize the reading, highlighting how it can specifically be applied to financial planning. (3) Create a rubric that can be used by other students in analyzing and evaluating communication and counseling skills. (4) Create a professional checklist to be used in a professional setting of useful techniques and important skills that are crucial to effective communication and counseling skills. (5) Design a one-hour client communication training workshop for professional financial planners, including

students to create a financial planner script that can be used to solicit questions from clients as a means for completing the datagathering questionnaire; in order to receive full points, students must draft specific questions, as well as insert planner notes regarding specific communication techniques that can or should be used to facilitate client communication and disclosure; grading should follow a checklist to ensure minimum elements of communication theory are incorporated into the script.**

presentation slides and notes, workshop activities, and handouts. *Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: Regardless of skill level, all financial planners should possess communication and counseling capabilities, although the level of skill will differ based on education, experience, and professional practice. At all levels, planners should recognize when a referral to another professional with a particular expertise is warranted. Those entering the financial planning profession should exhibit the following capabilities and skills: (1) establish the client–planner relationship by engaging in joining activities with clients and respecting differing opinions from the planner’s own opinions, and (2) implement effective communication skills by applying active listening skills; being aware of client’s and self’s verbal and non-verbal cues; paraphrasing, reflecting, and summarizing client statements; offering brief statements rather than long lecture-type statements; and probing for more information by asking open-ended questions. Competent: A competent personal financial planner has mastered the following communication skills: (1) establish trust within client–planner relationship in addition to entrylevel planner skills, such as offering compliments associated with clients’ positive financial behaviors; (2) implement effective communication skills in addition to entry-level planner skills, such as clearly stating what the planner intends to say, mirroring client’s behaviors, and avoiding “you” statements such as “You should do . . .” “You did . . .”; (3) pace the session; (4) provide a safe environment for the client to communicate sensitive information related to finances by lowering stress and helping the client to feel comfortable; (5) recognize and be respectful of client characteristics that may be different from the planner’s (value diversity); and (6) understand the usefulness of counseling theory and its application. Expert: An expert personal financial planner can masterfully exhibit all of the aforementioned skills, and additionally can (1) implement effective communication skills and use silence when necessary; (2) recognize transference and countertransference between client and planner, and implement necessary interventions to address these dynamics; (3) implement theoretical counseling approaches; and (4) recognize relational dynamics of couples and family clients and intervene or make referrals when appropriate.

IN PRACTICE Haley

It was late in the day when Haley met with a prospective client. Haley knew something was wrong immediately. The client was seated on the edge of his chair in the office waiting area. When Haley walked into the room to introduce herself, she noticed the client was reluctant to make eye contact. She also took note of his weak, cold handshake. Undaunted, she led the prospective client into her office. Immediately, he sat down in the first chair available. He crossed his legs and folded his arms firmly across his chest. When she started asking openended questions, he tended to respond with short and basic answers. “I don’t know” was a common answer. Sensing that the client was stressed, Haley attempted to use techniques she had learned in a counseling theory and skills class. One thing became apparent to her: She needed to spend more time getting to know her prospective client as a person rather than simply as a client; she knew this technique would help him become more relaxed. She also recognized her tone of voice and her own non-verbal cues. She realized she was tired and that she was looking forward to going home. With this self-reflection, she was able to identify a few tweaks she could make in the way she communicated with the client. She put down her pen and leaned in toward the client to signal that she was really interested in what he had to say. She then crossed her ankles and placed her hands comfortably on her lap to indicate that she was open and comfortable in the conversation. Once she relaxed and changed her non-verbal communication, she asked him open-ended questions about his day, the weather, his week, and if he had any plans for the weekend. Surprisingly, the client slowly began to give longer answers to every question she asked. As his answers grew longer, his arms unfolded and he uncrossed his legs. She could tell he was becoming increasingly comfortable. Haley learned that he planned to meet his older son and his grandkids to go to the local train show. This gave her an opportunity to ask about his family and his hobbies and interests, which happened to be trains. Haley began thinking, “Wow! The simple communication techniques I learned in the counseling class are sure paying off!”

Mr. and Mrs. Jones A strong, trusting client–planner relationship is the key to obtaining new clients and retaining them. Implementing communication and counseling techniques is imperative to building a longlasting and trusting client–planner relationship. These planner skills are also key to managing diversity of clients with regard to (1) income/assets, (2) race, (3) gender, (4) sexual orientation, (5) religion, (6) age, and (7) various physical, mental, and emotional capacities. Consider the following example of a male planner working with an older married couple, Mr. and Mrs. Jones, where the planner tends to agree most of the time with Mr. Jones. Without being aware of the clients’ verbal and non-verbal cues, and most importantly the planner’s own communication skills, the planner may easily disregard Mrs. Jones’s non-verbal cues of her displeasure with the planner’s bias. The planner may inadvertently say something that offends Mrs. Jones or indicates to her that the planner is taking the husband’s side. Consequently, Mrs. Jones may decide to leave the session in frustration and the couple may not return for another meeting. Although this is an extreme case, the planner in this situation may likely be left wondering what happened. In this case, an entry-level planner should be able to read non-verbal cues and recognize that

the wife has crossed her arms and is no longer participating in the conversation. The entrylevel planner should be able to ask both clients, including Mrs. Jones, about their thoughts regarding each question that he asks, engage in active listening, and be respectful of any difference of opinions or viewpoints. A competent planner would be able to offer compliments associated with the client’s positive behavior and be able to recognize the negative non-verbal cues of Mrs. Jones. The competent planner will be able to politely inquire about Mrs. Jones’s non-verbal cues as well as respecting any differing views or opinions that she may offer in the meeting. An expert planner will recognize that countertransference is likely playing a role in the dynamics of the client–planner relationship. Recognizing countertransference can lead to the planner acknowledging that his reaction to side or agree with Mr. Jones more often is a result of his own feelings. For example, it may be that the financial planner feels hostility toward his own mother-in-law. In this case, Mrs. Jones may remind him of his mother-in-law, with whom he does not get along. By being aware of his own feelings, the planner is better equipped to interact differently with the couple because he will be able to separate his feelings toward his mother-in-law from the female client in the professional client–planner relationship. The situation described requires training and supervision, as well as self-reflection, for the skill to become a natural process when working with clients. In addition, the expert planner will recognize negative couple dynamics, such as poor communication and lack of trust between Mr. and Mrs. Jones, and refer or collaborate with a marriage counselor in order to move forward in the financial planning process.

NOTES 1. J. E. Grable, K. Archuleta, and R. Nazarinia, Financial Planning and Counseling Scales (New York: Springer, 2010). 2. Ibid. 3. www.investmentnews.com/article/20120325/REG/303259993#.

4. N. V. Van Zutphen, “Interpersonal Communication Skills Matter More Than Technical Expertise,” Journal of Financial Planning (Between the Issues), June 2007. Retrieved from www.fpanet.org/journal/BetweentheIssues/LastMonth/Articles/InterpersonalCommunicationSkillsM 5. D. T. Jaffe and J. Grubman, “Core Techniques for Effective Client Interviewing and Communication,” Journal of Financial Planning (Between the Issues), October 2011. Retrieved from www.fpanet.org/journal/BetweentheIssues/LastMonth/Articles/CoreTechniques.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 14 Debt Management Joseph W. Goetz, PhD University of Georgia John E. Grable, PhD, CFP® University of Georgia

CONNECTIONS DIAGRAM

Debt management is interconnected with nearly every other aspect of the financial planning process, particularly cash flow planning, tax planning, and retirement planning. It is imperative for financial planners who are practicing comprehensive financial planning to consider a client’s liabilities within the context of their overall financial plans. For example, allocating

greater cash flow toward a mortgage may adversely affect a client’s overall financial plan if this results in less available cash flow to be allocated toward pre-tax retirement plans, and consequently, increased tax liability and loss of investment return. Conversely, allocating greater cash flow toward a mortgage may positively affect a client’s overall financial plan when this results in greater equity, and subsequently, the opportunity to refinance the mortgage into a loan with a substantially lower interest rate. The ability to accurately evaluate the financial and psychological impacts of reducing or increasing debt on a client’s probability of success in meeting short-term and long-term goals is a skill set that differentiates the top financial planners from the rest.

OVERVIEW Optimal debt management is integral to the financial planning process. Helping clients manage debt appropriately and efficiently provides financial planners a tremendous opportunity to make a substantial, positive impact on a client’s overall financial plan. Debt, or leveraging, is a common and important tool used in the acquisition of a home, pursuit of desired lifestyle and opportunities, development of human capital (e.g., education and training), or creation of financial capital (e.g., investing and entrepreneurship), and thus should be viewed as an important strategy to wealth accumulation and financial success. Overleveraging at the household level and high-interest debt, however, can be detrimental to a client’s overall financial plan. As such, debt can be viewed as problematic or strategic depending on myriad contextual factors, including, but not limited to, interest rate structure, tax-deductibility of interest, expected invested return, cash flow requirements, loan forgiveness opportunities, creditor rights, and other factors. Debt management decisions are further complicated by the fact that individuals (and financial planners) experience varying degrees of psychological comfort with debt. This occurs, in large part, because of financial socialization factors. Emotional and cognitive biases often lead to suboptimal decisions regarding the prioritization of debt repayment, use and misuse of debt, or the avoidance of debt altogether. Financial planners working under a fiduciary standard of care have a responsibility to clearly and objectively evaluate and communicate the financial implications of decisions surrounding the management of debt. A household financial stability framework (i.e., evaluation of current stability and probability of household experiencing a future financial shock and its ability to absorb shock) should be utilized when making recommendations related to debt management. This framework is necessary because optimal debt management recommendations vary based on the overall financial stability of the client. For example, if a client has a high net worth with high job security, then a debt prioritization plan (i.e., strategic repayment plan) should typically be based on optimal financial outcomes given interest rates (adjusted for tax advantages), as compared to expected investment returns on monetary or other assets. However, if a client is financially insolvent or potentially unable to repay all debts over a reasonable amount of time, then the debt prioritization plan should be based on different

criteria; namely, prioritizing secured over unsecured debt, regardless of interest rates. For example, consolidating high-interest credit card debt or student loan debt into a lower-interest rate home equity loan that allows for tax-deductible interest and accelerated debt reduction may be appropriate for a financially stable client. However, this same recommendation may be inappropriate for a client who potentially may not be able to make minimum payments in the future, because now the client has traded unsecured for secured debt and consequently increased risk of foreclosure (i.e., the legal process for a bank repossessing a home). With this said, fully addressing guidelines for debt management when working with clients in financial distress (e.g., clients in danger of foreclosure or considering a consumer bankruptcy) is beyond the scope of this chapter. An excellent information resource for serving clients in financial distress is the National Consumer Law Center, particularly their publication called Guide to Surviving Debt.

LEARNING OBJECTIVES The student will be able to: a. Review all types of client debt and provide recommendations on optimal management of debt within the context of the client’s overall financial plan. b. Calculate required payment, interest owed or saved, and the new payment term in developing the debt prioritization plan for the client. c. Evaluate the financial effects of reducing or increasing debt on a client’s probability of success in meeting short-term and long-term goals. d. Illustrate the effect of the debt management decisions on long-term goals. e. Review the client’s credit report and identify how different debt management approaches will impact the client’s credit score and develop a plan to maximize the client’s credit score over the short and long run.

Rationale The practical implications associated with helping a client manage debt can get complicated. For example, assume a client is relatively financially stable. In this case, greater focus can be given to the long-term impact of debt management decisions on a client’s financial plan. For other clients with less stable financial situations, it may be more important to deal directly with debt management issues by recommending debt repayment strategies and other techniques to control debt accumulation. Although financial planners sometimes largely ignore debt management topics, there exist significant savings opportunities in fully addressing the management of all debts, the most common of which are mortgage, student loan, and credit card debt. Table 14.1 provides a summary of the most widely used forms of debt, considerations for financial planners in meeting the learning objectives, and resources for use in teaching about debt management.

Table 14.1 Table 14.1: Forms of Debt and Management Considerations Considerations Mortgage Interest Rate Analysis Refinancing Opportunities Type and Term Cash Flow Implications Tax Benefits Student Forgiveness Programs Repayment Term Reduced Loan Payment Programs Refinancing Opportunities Cash Flow Implications Tax Benefits Credit Card Review Debt Consolidation Rate Card Negotiation Debt Management Plans Behavioral Intervention 401(k) Opportunity Cost Job Security Cash Flow Loan Planning

Resources Consumer Financial Protection Bureau (CFPB) Rate Tracker U.S. Department of Education (DOE) and National Student Loan Data System (NSLDS) National Foundation for Consumer Credit Counseling (NFCC) and CFPB Employer/Plan Vendor

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Provide a class presentation wherein instructor identifies and explains major components of a mortgage with a sample mortgage note. This can be repeated with a sample student loan promissory note, credit card statement, etc. Analyzing: Breaking Break students into groups and material into have them brainstorm a list of all constituent parts, and types of debt potentially determining how the experienced by clients. parts relate to one Continuing in small groups, have another and to an students categorize those debts overall structure or based on interest expense, taxpurpose through deductible interest, consequences differentiating, of non-payment, and potential organizing, and forgiveness. attributing Evaluating: Making Provide client case scenarios and judgments based on how optimal debt management criteria and standards recommendations vary based on through checking and interest rates, tax-deductibility, critiquing expected investment return, and

Student Assessment Avenue Provide copies of various loan documents and have students identify important data for consideration within the context of debt prioritization planning and a client’s overall financial plan. Ask students to individually list out all types of debt experienced by clients and to differentiate which are considered secured and unsecured. Ask students to order debts based on typical interest rates in marketplace and then differentiate debts based on whether interest expense is potentially taxdeductible. Provide students client case scenarios with all relevant data and have them develop financially optimal debt prioritization recommendations with rationales.

marginal tax-rate and opportunity to increase pre-tax savings. Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

The instructor facilitates a roleplay exercise dividing students into groups of three with one student serving as client, one as planner, and one as observer. Students rotate positions over three client scenarios provided by instructor and involving debt management decisions.

Students will individually write a one-page reflection paper on the role-play exercise experience, including the following components: Determination of overall financial stability and risks of client, as well as goals of client. Describe how their personal comfort with debt is affecting or not affecting their recommendations. Identification of which debt management strategies are financially optimal, along with psychological considerations. Debt prioritization recommendations for each debt with rationale addressing contextual factors learned from client in role-play exercise.

As with all forms of debt, the optimal use of credit cards can benefit a client’s financial plan in numerous ways. It is important to point out that for business owners and clients, credit cards offer short-term, interest-free loans, as well as cash back rewards and numerous consumer protections. Credit cards are also important tools for facilitating cash management payment strategies and for credit score planning (i.e., developing and maintaining an optimal credit score). It is important to point out that making payments on time and maintaining a low debt-tocredit ratio increases a client’s credit score, potentially allowing for lower interest expense across other debts. To review credit card and other debts of clients, it is often useful to review credit reports, which can be obtained through the government-based website annualcreditcard.com. A fun and engaging way to introduce students to debt management issues involves focusing on the use of credit cards. Ask students to contact five friends and family members and assess their attitudes toward credit cards and debt. Have the students write a one-page reflection paper describing common themes in the responses they received and how their beliefs about debt correspond with, or were influenced by, those they interviewed. Another related activity involves helping students prioritize debt according to interest rate, duration, and purpose. For example, credit cards typically carry higher interest rates relative to mortgage and student debt, and thus should be prioritized in terms of debt repayment when a

client is relatively financially stable. Within the context of multiple credit card balances, it is helpful to document how high interest rate cards should be paid off first, while maintaining only the minimum payments on the others. Due to mental accounting and other biases, clients often spend discretionary cash flow to pay down lower interest rate debts or all debts equally, resulting in substantially higher interest expense and additional time in carrying debt. Have students make up different balances and research interest rates for five different credit cards, and then compute the payoff schedules under various scenarios using Excel.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner should be able to competently and quickly identify all forms of debt held by a client. Further, an entry-level planner should be able to use standard financial ratios (e.g., debt-to-income ratio, front- and back-end mortgage ratios, etc.) to estimate a client’s debt load and flexibility. Competent: A competent financial planner should additionally be able to identify opportunities to maximize leverage to enhance a client’s overall financial position. In situations where debt is excessive, a competent financial planner will have the skills to develop a financial stability framework to help the client manage their debt. Expert: An expert financial planner will be able to structure a debt prioritization plan to strategically integrate debt repayment into a client’s cash flow, net worth, tax, and estate situation. In addition, an expert financial planner will have a working knowledge of debt forgiveness and repayment options that can be used by clients and their family members.

IN PRACTICE The Home Purchase Decision For many clients, one of their largest investments over the lifetime is the purchase of a house. Clients, however, often fail to accurately conceptualize the impact of seemingly small differences in interest rates; in fact, according to the National Survey of Mortgage Borrowers, 77 percent of 2013 borrowers applied to only one lender and almost half failed to shop around at all prior to application. Financial planners should recommend the use of mortgage brokers and competitive rate negotiation, since rate differences commonly translate into tens of thousands in savings over the course of a loan. The Consumer Financial Protection Bureau (CFPB) recently launched an information program (i.e., Rate Tracker) to allow consumers (and financial planners) to evaluate the range of interest rates on mortgage loans in a specified geographic area. Data on daily mortgage rate quotes indicates that the range of interest rates on loans is significant (i.e., 50–100 basis points), even after accounting for loan size, mortgage type, down payment, and credit score. Once a mortgage is in place, a common practice by mortgage holders (and a key recommendation made by financial planners) is to accelerate mortgage debt reduction (i.e.,

making extra or greater payments than are required). Although this may be a personal goal to accelerate the payoff of a low-interest (relative to expected investment return) mortgage, it is important for financial planners to objectively illustrate all cash flow alternatives (i.e., opportunity costs). For example, rather than applying additional cash flow to mortgage debt, there may be opportunities to apply the same discretionary cash flow to higher-interest, nontax-deductible auto loan debt, or to increase 401(k) contributions to maximize an employer match and reduce (i.e., defer) current year taxes. Illustrating to the client the long-term impacts of these alternatives on their net worth and success probabilities is very important as this illustration may have a psychological impact as well.

Funding College Expenses: The Debt Dilemma Student loan debt has become increasingly common, with even higher balances for clients with graduate and professional degrees. All federal loans can be identified through the National Student Loan Data System (NLSDS). The vast majority of student loans are funded by the federal government rather than private institutions (i.e., bank, credit union, state agency, or school). A variety of federal government programs are in place to assist in the management of this debt. The provisions of the programs periodically change, thus financial planners should regularly review programs for changes that may benefits their clients. The two most beneficial programs currently available to clients are the Income-Based Repayment (IBR) and the PayAs-You-Earn (PAYE) programs offered through the Department of Education (DOE). Even though both of these programs provide potential payment reduction and loan forgiveness, the programs are substantially underutilized. Additionally, many professional associations offer loan forgiveness programs that should be reviewed as part of the debt management section of the financial plan. For example, the American Veterinary Medical Association outlines loan forgiveness programs for those veterinarians who choose to work in an underserved geographic or specialty area. Similar programs are available for teachers, attorneys, physicians, psychologists, and other professionals. Financial planners should be reviewing their clients’ eligibility for these programs, as loan forgiveness can have a significant impact on all aspect of a client’s financial plan. It has become more common for families to use home equity loans and lines of credit to refinance student loans into lower interest rate debt. Before recommending a home equity loan to pay off student loan debt, however, financial planners should first review other student loan refinance products and government programs, such as IBR, PAYE, and other loan forgiveness programs. It should also be noted that if a client is affiliated with the military, additional options are available and should be reviewed. When addressing the question of whether to cover college expenses with either a family’s current cash flow or student loans, a financial planner should help clients consider all opportunity costs; for example, if using current cash flow reduces pre-tax retirement plan contributions and expected investment returns are higher than interest rates on students loans, in certain situations it will be financially optimal for a client to borrow money in the form of

student loans even when able to pay with current cash flow, particularly when potential loan forgiveness is a factor. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 15 Education Needs Analysis Taylor Spangler, MS University of Florida Michael Gutter, PhD University of Florida Martie Gillen, PhD University of Florida Sailesh Acharya University of Florida

CONNECTIONS DIAGRAM

INTRODUCTION Education planning involves the process by which a planner (1) determines education goals of the client, (2) analyzes the client’s current situation and plan for the education goals, (3) identifies possible strategies, (4) recommends strategies for meeting the education goal, (5) educates or assists the client to implement the recommendations, and (6) reviews and updates the plan over time. Education planning may have implications for a client’s tax planning, investment planning, and estate planning. This chapter will focus on how to determine a client’s education goals, calculate funds needed to meet goals, and recommend appropriate strategies, including funding sources. Chapter 16 on education savings will explore savings vehicles suited for funding education goals in greater detail, including impacts on need-based financial aid qualification and tax consequences. The first step in the education planning process is determining the client’s education goals. A financial planner must assist clients in prioritizing all of their financial goals, including saving for educational goals in line with their values and attitudes toward higher education. Financial planners should not make assumptions about the educational goals of clients, who may not wish to fund their children’s educations, even if they have the means. Similarly, not all children will attend college after high school, and financial planners should consider all post-secondary education and training, including trade and vocational programs. While students may receive scholarships, grants, and other awards to reduce the cost of education, or borrow at reduced rates to finance their education, these programs do not exist for client goals such as retirement. The second step in the education planning process is analyzing the client’s current situation and corresponding plan for education. Financial planners must determine whether clients intend to pay for all of their children’s or grandchildren’s educational expenses, or if they will only cover certain costs (e.g., a percentage of tuition or living expenses). Households will vary in qualification for need-based financial aid, and each child will differ in qualification for meritbased scholarships and grants. Financial planners may need to work with some households to ensure that parents, who may still be paying off their own student loans, do not over-prioritize funding the educational goals of their children, risking their own current or future financial security. Wealthier clients may be more interested in the tax savings available through education savings programs. After the planner and client have mutually agreed on the client’s education goals and have analyzed the current situation, including savings and assets designated to fund educational costs, the planner can focus on the actual strategies to reach the educational goals. Strategies for funding education, identified in step (3) in the introduction to this chapter, may include payments from the parents or grandparents, the utilization of savings vehicles (refer to Chapter 16, Education Savings Vehicles), scholarships, grants, fellowships/assistantships, work-study (refer to Chapter 17, Financial Aid (Education)) as well as student loans (refer to Chapter 19, Education Financing).

NEEDS ANALYSIS CALCULATION

For every child, the financial planner will need to create an education needs analysis based on current financial situation, including all relevant assumptions, and anticipated post-secondary plans. Use the following tables to determine the client’s education needs based on expected attendance cost, timing, and assets. Factors affecting need Present cost of attendance at anticipated institution (including tuition/fees, books/supplies, room and board) College expense inflation rate (approximately 5% average) Number of years until child begins college (or other postsecondary program) Total Education Need Use a TMV calculation to determine the total education need for one child (Less) Future value of current savings Use a TMV calculation to determine the value of savings when child begins Future value of contributions from grandparents or other family members (Use a TMV calculation to determine the value of savings when child begins) Future value of anticipated scholarships, grants, or fellowships Total Unmet Need, or Future Value of Amount Needed to Be Saved

Your figures × # of years of attendance

18 (or anticipated matriculation age) – child’s current age

A: Future Cost of first year of college:

$

Use formula: FV = PV (1 + G)^N to determine the future value cost (including tuition/fees, books/supplies, room and board) of the first year of college (PMT) Present value (PV) cost of attendance at anticipated institution (including tuition/fees, $ books/supplies, room and board) College expense inflation rate (G): historically approximately 5% average

%

Number of years (N) until child begins college (or other post-secondary program)

yrs

B: Future cost of all years of college at the beginning of college:

$

Use formula: PVGA = (PMT/(I – G))*(1 – ((1 + G)/(1 + I))^N) to determine the total future value education need for one child Note: Serial rate can also be used to determine the total cost. Future value (PMT) cost of attendance at anticipated institution (including tuition/fees, books/supplies, room and board) of the first year Expected rate of return (I) on savings College expense inflation rate (G): historically approximately 5% average Number of years (N) to complete college (or other post-secondary program) C: Future value of all sources of potential funding for college Use formula: FV = PV (1 + G)^N to determine the future value of current savings Use formula: FVA = (PMT/I)*((1 + I)^N – 1) to determine the future value of expected periodic savings Use formula: FV = PV (1 + G)^N to determine the future value of other contributions from grandparents or other family members Use formula: FV = PV (1 + G)^N to determine the future value of anticipated scholarships, grants, or fellowships Total Unmet Need (B – C) This Is the Future Value of Amount Needed to Be Saved

LEARNING OBJECTIVES: The student will be able to: a. Calculate the dollar amount needed to meet the education goals of the client. b. Evaluate the client’s ability to meet the savings requirements.

$ % % yrs $

$ $ $

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using Ask students to analyze case Students will work on cases a procedure through executing examples of families in that apply the core issues of or implementing different situations and estimating needs and balancing discuss how different financing and funding education funding strategies strategies. could work better in some situations than others. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

The class examines the assumptions and calculations in determining the cost of the education goal.

Evaluating: Making judgments Have a case completion based on criteria and standards where students have to through checking and critiquing determine the education funding needs and then defend it in class.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Create videos, as a group, showing vignettes of scenarios students envision as illustrative aspects of the education planning process.

Students calculate the cost of attendance considering the average increase in tuition as well as other factors such as room and board. This should consider direct cost and opportunity cost. Students will explore various mini-cases requiring them to determine basic education funding needs including any assumptions required based on given scenarios. Students each contribute aspects of their scripts for their group videos.

Each student conducts assessments of other students’ Students review and critique videos. each other’s videos.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can help the client identify assumptions and preferences to clarify and define education goals. An entry-level planner can gather information and help the client determine what the needs are and feasibility of the

educational goals. There are instances where the client’s financial goals may not be realistic. At this point, a financial planner has to communicate to the client about other short- and longterm financial goals. An entry-level financial planner can inform clients of the importance of maintaining a high level of financial management. Competent: In terms of education needs analysis, a financial planner should stress the importance of determining what level of support they want to provide for education. A competent personal financial planner can create a plan that determines the need and timing of cash flows for education and create a plan that considers financing, savings, and other strategies that allows a client to manage his or her ongoing obligations without accumulating detrimental debt in both the short term and the long term. A competent planner should inform clients what assumptions need to be considered that may affect needs determination and possible strategies to reach education goals. Competent financial planners can create an overall cash flow/savings plan that minimizes costs and enhances benefits for a client relative to other goals and objectives. Expert: An expert personal financial planner can fully explain to clients their education funding needs based on their current financial status, as well as the tax, investment, and estate planning implications. An expert financial planner will effectively combine all aspects of savings and other educational funding strategies to create a complex financial plan for a client. This plan will serve as a financial guideline and will give the client greater flexibility when contemplating financial decisions relative to other goals.

IN PRACTICE Stephanie and Ryan Stephanie and Ryan are a married couple with a 5-year-old child, Brittany. The couple wants to start saving for her college expenses, and they are wondering how much they need to save each year so their daughter can attend college without taking out any loans. Assume that the current cost of attendance at the couple’s alma mater is $20,000, the inflation rate is 5 percent, their investments are earning an average annual rate of return of 10 percent, and Brittany will likely attend the four-year degree program when she is 18 years old. Stephanie and Ryan want to know how much they need to save at the end of every year to pay for Brittany’s college education. The financial planner knows that the time value of money calculation will be required to find out how much the couple needs to start saving each year to meet their education goal. In this case, the present value is $20,000, which increases at the rate of 5 percent for 13 years. The future value will be $36,657.88. The next step is to calculate the total cost of attendance for four years. With the payment of $36,657.88 on the 18th year, the total cost will be $130,708.89. Finally, taking $130,708.89 as the future value, with the inflation of 5 percent, the amount the couple needs to save annually is $7,379.27.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 16 Education Savings Vehicles Michael Gutter, PhD University of Florida Martie Gillen, PhD University of Florida

CONNECTIONS DIAGRAM

Planning for education relates to various financial planning issues that must be addressed for clients. This includes goal setting, cash flow management for funding savings and investment vehicles, tax considerations, estate planning, and certainly professional conduct and regulation in conducting the analysis. Clients have several methods for funding education. Assuming the

child or children will not receive scholarships or other resources, families must decide how best to fund the cost of education. Some possibilities, in addition to saving strategies, include: gifts from a relative, paying out of cash flows, financing through student loans, or leaving the burden to the children. There are a number of options for saving for educational goals. These different options may be confusing for clients and result in inefficient plans. As part of the financial planning process, recognizing and evaluating savings strategies is of utmost importance in helping clients set and achieve education goals. A financial planner should stress the importance of savings strategies, including selecting the account, which assets to hold, and how to build the required capital into the cash flow management plan.

INTRODUCTION A financial planner must be able to efficiently explain the complete spectrum of savings strategies available to clients for education planning. Each strategy has advantages and disadvantages associated with it. By properly formulating financial objectives with the client and determining financial position and preferences for funding strategies, a planner can suggest the appropriate savings vehicle for the client. Each plan is unique and will be briefly highlighted.

529 College Savings Plan Funding a 529 College Savings Plan is an income tax strategy that can be used to provide taxfree gifts and tax-exempt earnings, assuming all rules and regulations are met. A 529 plan is a special educational account that allows funds to accumulate tax-free for a single beneficiary. Withdrawn earnings are not taxed, provided the funds are used for post-secondary education. Each state sponsors at least one 529 plan. Contribution amounts vary but allow for significant savings accumulation to provide for the beneficiary’s education expenses. Qualified educational expenses include tuition, fees, books, supplies, and some room and board, among others. The client (owner of the account) can generally change the account beneficiary to another family member without tax consequence. Another advantage is that the client has control over the account and can decide how much of the investment is required and distributed. A client can also set aside up to five years of the annual gift exclusion amount, or twice the exclusion amount for a married couple agreeing on a joint gift, for one child’s future education costs. However, once the client takes advantage of a five-year plan, he or she cannot give additional annual gifts to the same child for five years without incurring gift tax consequences and filings. Additionally, if the client dies within five years of the date of their gift, a prorated portion of the original gift will be included in their estate tax calculation (any growth will not be included).

The Health and Education Exclusion Trust The Health and Education Exclusion Trust is an irrevocable trust established either during a

client’s lifetime or by his or her will to provide payments for medical expenses and tuition for his or her descendants. The Health and Education Exclusion Trust (HEET) is designed to minimize the generation-skipping tax and is particularly appropriate for grandparents seeking to make transfers to grandchildren. Everyone has a GST tax exemption that allows them to make transfers to their grandchildren, but a HEET allows funds to be paid for the benefit of grandchildren even if the client has already used up their GST exemption. To qualify, funds from the trust must be paid for tuition directly to the educational institution.

Traditional or Roth IRA Clients can use a traditional IRA or Roth IRA as a savings plan to pay for qualified higher education expenses. Withdrawals before age 59½ to pay qualified higher education expenses are not subject to the additional penalty tax on early withdrawals. However, to avoid the 10 percent tax, the client must pay education costs that at least equal their withdrawal amount. Qualified education costs include tuition, fees, books, room and board, supplies, or equipment at a qualified educational institution and they must be for the client, their spouse, or the children or grandchildren of the client or their spouse. The qualified educational institution may be any college, university, vocational school, or other post-secondary school that is eligible to participate in federal U.S. Department of Education aid programs.

Coverdell Education Savings Accounts (CESA) The Coverdell Education Savings Account is a trust or custodial account established to pay for a qualified beneficiary’s higher education expenses. As such, it is recognized as an asset owned by the beneficiary and he/she can use the principal and interest to pay for qualified expenses such as tuition, fees, books, supplies, and room and board. The advantage of opening this account is that distributions are tax-free as long as the distributed amount does not exceed the beneficiary’s education expenses. This account can be rolled over into a 529 plan. Also, another advantage of this account is that the beneficiary can claim the Hope Credit or Lifetime Learning Credit for qualified education expenses even if making withdrawals from a CESA. However, the beneficiary cannot claim the credit for the same educational expenses covered by a CESA. Some restrictions apply to this account. When the account is established, the beneficiary needs to be less than 18 years old. The total contribution made to a CESA for a beneficiary cannot exceed $2,000 for one tax year. The balance in the account should be distributed within 30 days after the beneficiary reaches the age of 30. If the balance is not used by the beneficiary’s 30th birthday, the owner of the account will incur income tax and a 10 percent penalty on earnings.

Series EE and Series I Savings Bond Series EE and Series I Savings Bonds, under certain restrictions for purchase and use, are purchased for higher education funding. With a limit of $15,000 for single clients and $30,000 for married couples, these bonds (both principal and interest) can be cashed in tax-free for

paying college tuition for the beneficiary. The important thing to remember is that the qualified educational expenses include tuition and fees only; costs for books and room and board are not eligible. The disadvantages associated with these bonds are that they offer a relatively low rate of return. Hence, one cannot expect to earn much interest with the bonds. Also, the household needs to be careful about the household income limitation that applies to this tax benefit. Additionally, there is an early withdrawal penalty associated with these bonds during the first five years.

Variable Universal Life Insurance (VUL) Though VUL is an insurance product, it can also be used as an educational savings tool. This strategy is useful if the variable subaccounts can offer a high rate of return over time. However, it is necessary to understand that the promise of a higher rate of return comes with higher risk as well. Ideally, the account provides the opportunity to take out loans to pay for college loans, with the remaining subaccount assets earning enough to pay for loan interest and other charges. The cash value accumulation in the policy is not considered when calculating the expected family contribution (EFC) for federal financial aid. If the insured dies, the policy proceeds are available for covering educational expenses. As to disadvantages, the premium cost of a VUL is usually high. There are also higher administrative and account fees. These hidden fees can affect the rate of return on assets. Also, clients need to take careful consideration while taking out loans. This account needs to be managed carefully to ensure adequate funding to prevent the policy from lapsing; if it lapses, there could be income taxes due on any gains distributed.

Crummey Trust A Crummey Trust is an irrevocable trust used for gifting to a minor and maintaining some level of control over the distribution of the assets. This trust can have multiple beneficiaries and removes the assets from the estate of the grantor. A disadvantage associated with this trust is that any distribution used by the child for educational purposes is considered as his/her income. This will significantly impact the calculation of financial aid for students.

UGMA/UTMA Assets A client can transfer assets to minors as gifts in the form of Uniform Gifts to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) accounts. The gifts made through these accounts are irrevocable. There is a tax benefit to the donor when he/she transfers the incomegenerating assets to minors. Again the important thing to keep in mind is that the assets belong to the child and can impact eligibility for financial aid. The custodian manages both of these types of accounts until the minor reaches the age of majority. There are important things to consider while parents or relatives make decisions regarding which kind of education savings vehicles to use for a child’s education. As noted, there are

trade-offs associated with each of the strategies in terms of tax-advantages, rate of return, amount of funds required, irrevocable nature of some funds, and the impact on financial aid needs to the child. Prudent decisions need to be made in choosing the savings vehicle or combination of vehicles based upon the educational needs analysis, the family’s financial situation, and tax implications.

LEARNING OBJECTIVES The student will be able to: a. Compare and contrast the tax implications and other features for the primary account types or strategies used for saving for higher education expenses. b. Recommend appropriate education savings vehicles given tax implications, dollar amount of savings needed, and the client’s preferences and situation. c. Recommend appropriate investment alternatives for the education accounts chosen given the client’s risk tolerance and risk capacity.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Ask students to complete case study analysis focusing on savings plan decision making management.

Students will design a savings plan for a client that minimizes cost and maximizes the potential to reach financial goals.

Analyzing: Breaking Ask students to complete case material into constituent study analysis focusing on parts, and determining how education savings vehicles. the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Continuation of the previous case study analysis. Ask students to present the results of each case study to the class. Students will receive feedback from the class and the instructor and can learn from the other case study presentations.

Creating: Putting elements Continuation of previous case together to form a coherent study analysis. or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Students will analyze the different types of accounts available to a client based on the client’s current financial status and make recommendations regarding financing strategies.

Students will assess how the savings strategies recommended for each case study will affect a client’s financial status and whether the strategies assist the client in reaching the client’s financial goal. Students will summarize the advantages and disadvantages of each savings vehicle that can be used to meet the client’s overall financial goal based on the case study presentations.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can help the client understand different savings strategies for funding education goals. An entry-level planner can gather information from the client and understand what client situational factors are important to the selection of educational savings strategies for the client.

Competent: In terms of education saving strategies, a financial planner should stress the importance of cash flow planning to fund the savings. A competent personal financial planner can create a cash flow/savings plan that allows a client to manage his or her ongoing obligations without accumulating detrimental debt in both the short term and the long term. A competent planner should inform clients regarding the risks behind certain investment options within the savings vehicle that may affect asset performance and ability to reach financial goals. Competent financial planners can create an overall cash flow/savings plan that minimizes the costs and enhances the benefits for a client for the long term. Expert: An expert personal financial planner can explain to clients their education savings options based on their current financial situation. An expert financial planner will have a combination of exceptional knowledge and experience to develop a plan that effectively combines education savings strategies to create a complex financial plan for a client matched to all relevant investment, tax, financial aid, or other considerations. This plan will serve as a financial guideline for an expert financial planner to monitor a client’s goal progress and accumulated savings.

IN PRACTICE Ben and Colleen Ben (age 42) and Colleen (age 41) have been married for 15 years. They have two children: Marcus (age 11) and Alice (age 3). Ben makes a good living and is currently making $121,000 annually; Colleen just went back to work and is earning $32,000. Since they have more disposable income, they have contacted you because they would like help putting something away for their children’s educations. Assuming that they would plan for their children to attend an in-state public university, they need to determine their education funding need. The average increase in tuition is roughly 5 percent for the institution. They would like to fully fund both of their children for four years each. Ben said if it takes them longer, then they are on their own. The current annual cost of attendance, including tuition, books, and housing, is $12,500. They would like you, the financial planner, to help them determine which education savings accounts they could consider. As a financial planner, you know there is much more to this picture that needs to be considered. For example, what are their other expenses, including debt, and the couple’s other financial goals, including strategies for meeting their current goals such as retiring at age 60? In addition to the federal income tax implications of the different savings strategies, their state of residence may influence the tax implications, such as for a 529 plan. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 17 Financial Aid (Education) Martie Gillen, PhD University of Florida Michael Gutter, PhD University of Florida

CONNECTIONS DIAGRAM

For many families, financial aid, both need-based and merit-based, is an important component of education planning. According to the U.S. Department of Education, the majority of full-time undergraduate students receive some type of financial aid. Financial aid may come from the U.S. government, the state of residence, the college, or a non-profit or private organization.

Federal financial aid programs are authorized under Title IV of the Higher Education Act of 1965. Financial aid may include grants, loans, and work study programs. A financial planner can help clients evaluate the availability of and qualifications for various forms of financial aid. The eligibility for such aid would be dependent on the Expected Family Contribution as determined by the Free Application for Federal Student Aid (FAFSA) process. The financial planner must adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION Completion of the Free Application for Federal Student Aid (FAFSA) form begins the financial aid application process. Since parental assets and income count differently than those of a child, a financial planner should be aware of how the Expected Family Contribution is determined. The Expected Family Contribution (EFC) is an estimate by the U.S. Department of Education of the amount of money that a family can contribute to their child’s education based on information provided in the FAFSA. The federal methodology determines the EFC using three methods: (1) regular formula, (2) simplified method, and (3) automatically accessed formulas. The regular formula takes into account the family’s income and assets as well as dependency status, household size, number of children in college, and cost of supporting the family where 12 percent of the parent’s discretionary net worth is considered available for education expenses. Adjustments to the net worth calculation are made to exclude certain assets such as a family business. When considering the student’s income and assets, 50 percent of their income and 35 percent of their net worth is deemed available for education expenses. The EFC combines expected contributions from both the parent and student. The simplified method excludes family assets. However, to qualify for this method, the parents must file either a 1040A or 1040EZ federal income tax form or not be required to file a federal income tax. Additionally, the parent’s total adjusted gross income must be less than $50,000. If the student was not claimed as a dependent, then the student (and spouse, if married) would need to meet the same federal filing requirements and income limitations as described for the parent. The automatically accessed formulas calculate the EFC at zero. To qualify for this method, the student or parents must file either a 1040A or 1040EZ federal income tax form or not be required to file a federal income tax form. Additionally, the parent’s total adjusted gross income must be less than $20,000. Once the EFC is calculated using one of the three methods described above, the EFC is then subtracted from the cost of attendance to determine financial need. The cost of attendance can include living expenses. Students will then request that the information contained in the completed FAFSA be provided to the colleges or career schools of their choice. A copy of the student aid report can also be requested by the student or parents. The student aid report includes information provided on the FAFSA including the EFC. Next, a financial aid package will be prepared by the college or career school. The financial aid package may consist of

grants, loans, and/or work study programs. Federal student aid includes grants, loans, and work study programs to eligible students enrolled in college or career school. Grants are generally based on financial need and generally do not require repayment. However, certain stipulations may have to be met. For example, the Teacher Education Assistance for College and Higher Education Grant requires students to teach in a public or private elementary, middle, or high school that serves a community of low-income families. If the student fails to meet this requirement, then the grant is converted to a Federal Direct Unsubsidized Stafford Loan, which must be repaid. According to the U.S. Department of Education, Federal Pell Grants are one of the most common grants received by students. Campus-based aid may also be available and is administered directly by the college. Campusbased aid may include Federal Supplementary Educational Opportunity Grant, Federal Work Study, and the Federal Perkins Loan Program. Federal Work Study provides part-time employment opportunities for undergraduate and graduate students to earn money to help pay for their educational expenses by either working on or off campus. Since this money is earned, it does not require repayment. Please note that once the campus-based aid has been exhausted at the college, no further aid can be allocated until the next year. Clients should be aware of the deadlines for requesting such resources. Clients should work with their children on setting cash flow plans to efficiently use these resources, as payments are generally dispersed to the students once a semester. The college generally first applies grant or loan funds toward tuition, fees, and if the student resides on campus, to room and board. Any money left over is paid to the student for other expenses. Loans are another option commonly used by parents and students to meet education goals. The use of loans to meet education goals is further discussed in Chapter 19, Education Financing.

LEARNING OBJECTIVES Students will be able to: a. Review and describe the likelihood and types of qualifying financial aid generally available. b. Evaluate the client’s qualifications for various types of financial aid as part of an education plan. i. Determine to what extent education tax credits may be utilized to reduce the net cost of education.

IN CLASS

Category

Class Activity

Applying: Carrying out or using a procedure through executing or implementing

Class discussion of examples Students will work on problems of families in different that apply the core issues of financial aid scenarios. Have financial aid. students make recommendations to assist the client in using financial aid to meet their educational planning needs.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Have students complete case study analysis focusing on using financial aid in the education planning process. This could be done individually or completed in groups, depending on the size of the class.

Students will explore various mini-cases requiring them to determine basic recommendations for qualifying and selecting among the different financial aid options based on given scenarios.

Evaluating: Making Students will present the judgments based on criteria findings of their case study to and standards through the class. checking and critiquing

Continuation of above case study analysis. Have students present the results of each case study to the class. Students will receive feedback from the class and instructor and can learn from the other case study presentations.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Divide the students into groups. Create videos in groups showing vignettes of scenarios students envision as illustrative aspects of using financial aid in the education planning process.

Student Assessment Avenue

Students each contribute aspects of their scripts for their group videos. Each student assesses other students’ videos.

Students review and critique each other’s videos.

PROFESSIONAL PRACTICE CAPABILITIES

Entry Level: The professional can explain the role of financial aid in the education planning process and identify opportunities and challenges related to a client’s education planning and the use of financial aid. Competent: The professional can make recommendations to assist clients in meeting their education planning goals, using financial aid as appropriate. The professional can evaluate the availability of and qualifications for various forms of financial aid. Expert: The professional can creatively and strategically include the use of financial aid in any education scenario as appropriate.

IN PRACTICE Betsy Betsy is a 40-year-old single mother with two children, Michael, age 18, and Emily, age 15. Both children attend public high school. Michael will be graduating from high school this year and plans to start college in the fall. Betsy has a stable income as a certified nursing assistant —she currently earns $38,000 per year. While her employment has been stable, she has not been able to save money for her children’s education. The family has limited assets. She hopes Michael attends college in state so they can still see each other often. She is worried about Michael’s education expenses and knows he will need financial aid. However, she is unsure as to the various types of aid for which the family might qualify. Betsy has never worked with a financial planner but knows she needs to start the process. Betsy is somewhat familiar with the financial aid process as she previously completed the FAFSA for herself when attending vocational school. The planner has suggested a mix of financial aid to meet the family’s higher education goals. Her planner suggested that she could use a combination of grants, loans, and work-study to provide enough resources for Michael to attend college.

Joel and Charmaine Samuel lives about four hours away from the university he plans on attending next year, making living in a residence hall necessary. He is an only child. His parents, Joel and Charmaine, are married and earn $180,000 annually. They also have $35,000 in savings. The financial planner should obtain the needed information to calculate the Expected Family Contribution (EFC) and will likely find that the EFC exceeds Samuel’s cost of attendance. Based on this information, Samuel would not receive need-based financial aid. The financial planner should help the family identify other education planning options to meet their education goals. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 18 Gift and Income Tax Strategies (Education) Martie Gillen, PhD University of Florida Michael Gutter, PhD University of Florida

CONNECTIONS DIAGRAM

Education represents a substantial financial commitment. A client can give an unlimited amount for tuition on behalf of any individual tax-free. However, the client must pay the amount directly to the educational provider. In addition, the client could pay college tuition bills on behalf of their child or grandchild and still be allowed to give that child additional tax-free

annual gifts up to the exclusion amount. Other education savings options that allow tax-free gifts specific to post-secondary education such as a 529 College Savings Plan are discussed in the Education Savings Vehicles chapter. The use of tax credits and deductions are other income tax strategies relevant to education planning. The financial planner must adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION Gifting may be an important part of a family’s education funding plan, as well as efficient intergenerational wealth transfers. If tuition is paid directly to the provider, then the gift is not included in the client’s annual gift exclusion amount. For example, if a client pays $23,000 for their grandchild’s tuition directly to the school, they can still gift up to the annual exclusion amount ($14,000 in 2015 or $28,000 for a combined gift from the client and spouse) tax free to the grandchild during the same year. In the case of a grandparent paying a grandchild’s tuition, it also qualifies for a special exemption from the generation-skipping transfer (GST) tax. The gift tax exclusion is only available for tuition to a qualified educational organization for any level of education. Thus, the client cannot reimburse someone or pay the parents directly and ask them to pay the tuition. The gift tax exclusion does not include room and board, books, or other education expenses. Qualified educational organizations may include both domestic and foreign organizations such as primary schools, secondary schools, colleges and universities, as well as preparatory and vocational schools. Another income tax strategy for education planning involves using tax credits. Two tax credits are available for education costs: (1) the American Opportunity Credit (formerly the Hope Credit) and (2) the Lifetime Learning Credit. These credits are available only to taxpayers with adjusted gross income below specified amounts and who do not file as married filing separately. The amount of the credit a client can claim depends upon the amount the client paid for qualified tuition and other expenses for students and the client’s modified adjusted gross income (MAGI) for the year. The client also must report the eligible student’s name and Social Security number on his or her tax return to claim the credit. The credit may not be allowed in all situations, or not fully available, if another education tax benefit is claimed. The financial planner should determine which tax rule offers the greater benefit to the client. Additionally, a client cannot claim both credits for the same person in the same tax year. However, a client can claim one credit for one or more family members and the other credit for expenses for one or more other family members in the same tax year. For example, the client could claim the American Opportunity Tax Credit for their child and a Lifetime Learning Credit for the client. If education expenses are paid with a tax-free education assistance such as a tax-free scholarship, Pell grant, tax-free distribution from a savings plan, or employer-provided educational assistance, then credit for those amounts cannot be claimed. The American Taxpayer Relief Act of 2012 extended the American Opportunity Tax Credit (AOTC) through the 2017 tax year. The maximum credit ($2,500) is only available for the first four years of postsecondary education. The AOTC is calculated as 100 percent of the first

$2,000 of qualified education expenses plus 25 percent of the second $2,000 of qualified education expenses. Qualified education expenses include tuition and activity fees paid directly to the college and books, supplies, and equipment. (The latter do not have to be purchased directly from the college.) In addition, 40 percent of the credit is refundable, meaning a client can receive up to a $1,000 refund even if no taxes are owed. A client can claim the credit for each eligible student. To qualify, the student must also be enrolled in a program that leads to a degree, certificate, or other recognized credential; must be taking at least half of a normal full-time load of courses for at least one semester or trimester beginning in the year for which the credit is claimed; and not have any drug-related felony convictions. The AOTC is phased out based on MAGI. Another tax credit is the Lifetime Learning Credit of up to $2,000 per family. The credit is calculated as 20 percent of qualified education expenses, up to $10,000. The credit is available for undergraduate, graduate, and professional degree courses, including courses to improve job skills. In addition, the credit can be claimed for an unlimited number of years. Qualified education expenses include tuition, but activity fees, books, supplies, and equipment are only eligible if they must be paid directly to the college for enrollment or attendance. A qualified postsecondary institution includes those eligible to participate in a student aid program from the U.S. Department of Education. This credit is also phased out based on MAGI. Another tax strategy is the use of deductions. The Tuition and Fees Deduction expired at the end of 2014. This deduction allowed clients to deduct up to $4,000 from their income for qualifying tuition expenses paid for the client, their spouse, or their dependents (with certain restrictions). This adjustment to income reduced a client’s taxable income, thereby reducing the tax the client paid. The student loan interest deduction is another adjustment to income for interest paid on a qualified student loan. Income restrictions applied/apply for the Tuition and Fees Deduction and the student loan deduction. The business expense deduction is allowed, without a dollar limit, for education that serves the client’s business or employer by maintaining or improving job skills or for education that is required to keep the employment (i.e., salary, status, or job).

LEARNING OBJECTIVES The student will be able to: a. Calculate the funds needed to meet the gifting goals of a client. b. Evaluate and recommend the availability of and qualifications for gift tax exclusions for the client’s gifting goals.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing, or implementing

Class can discuss examples of families in different financial situations and make recommendations on using gift and income tax strategies to assist the client in meeting their educational planning needs.

Students will work on problems that apply the core issues of gift and income tax strategies related to education planning.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Have students complete case study analysis focusing on using gift and income tax strategies in the education planning process. This could be done individually or completed in groups depending on the size of the class.

Students will explore various mini-cases requiring them to determine basic recommendations for gifting and income tax strategies for education expenses based on given scenarios.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Continuation of above case study Students will present the analysis. Have students present findings of their case study the results of each case study to to the class. the class. Students will receive feedback from the class and instructor and can learn from the other case study presentations.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

In small groups, students create videos showing vignettes of scenarios that students envision as illustrative of using gift and income tax strategies in the education planning process.

Students each contribute aspects of their scripts for their group videos. Each student assesses other students’ videos.

Students review and critique each other’s videos.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: The entry-level professional can explain the role of gift and income tax strategies in the education planning process and identify opportunities and challenges related to a client’s use of these gifts and income credits and deductions. Competent: The competent professional can make recommendations to assist the client in

meeting their education planning goals using gift and income tax strategies as appropriate. The professional can evaluate the availability of and qualifications for gift and income tax strategies as related to education expenses. Expert: The expert professional can creatively and strategically include the use of gifts and income tax strategies in any education scenario as appropriate.

IN PRACTICE Mason and Emily Mason’s daughter Emily is attending the local state university. Emily is in her second year of studies as an undergraduate. Emily received a Pell Grant in the amount of $3,500. Qualified tuition expenses for Emily to attend the university are $8,000 per year. Mason can only use $4,500 ($8,000 – $3,500) of the qualified education expenses to calculate the AOTC.

Henry and Jasper Henry’s grandson Jasper is attending the local community college where he is a first-year student pursuing an associate’s degree in horticulture. His education expenses total $7,000 per year, of which $5,000 per year is tuition. Henry decides that he would like to pay for Jasper’s tuition. Henry has regularly met with a financial planner for the past 20 years and has contacted the financial planner to determine the best strategy for paying Jasper’s tuition and other education expenses. Henry also states that if Jasper transfers to the state university that he would like to continue to pay his education expenses. They first discuss what education expenses Henry would like to pay for his grandson. Henry would like to pay for Jasper’s tuition, fees, and books. His planner discusses gift and income tax strategies to help him meet his education planning goals for Jasper. His planner explains that the gift tax exclusion does not include room, board, books, or other education expenses. His planner said that he will need to pay the tuition directly to the college to benefit from the gift tax exclusion. He cannot give the funds to Jasper or his parents to pay the tuition. The planner also discusses his eligibility for income tax credits and deductions related to these expenses. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 19 Education Financing Martie Gillen, PhD University of Florida Michael Gutter, PhD University of Florida

CONNECTIONS DIAGRAM

Financing may be a necessary component of education planning for many families. Financing may come in the form of loans from the federal government, the college, or a non-profit or private organization. Some student loans, such as the subsidized Stafford Loan, are needsbased while other loans are not based on financial need. A financial planner can help clients

evaluate the availability of and qualifications for various forms of financing for education funding. Interest paid on student loans, depending on the loan type and other restrictions, may be an adjustment to income for tax purposes. The financial planner must adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION The U.S. Department of Education and many colleges offer low interest rate loans for educational purposes. There are maximum limits on the amount that can be borrowed for a full academic year. Loans differ from grants in that they are not typically based on financial need but are part of the overall financial aid package offered to students. However, the Federal Perkins Loan and subsidized Stafford Loans are based on financial need. The eligibility for such aid would be dependent on the Expected Family Contribution as determined by the Free Application for Federal Student Aid (FAFSA) process. A cosigner is not needed for these types of loans. Stafford Loans are administered by the U.S. Department of Education. Students may qualify for subsidized or unsubsidized Stafford Loans as based on their financial need. Both have a sixmonth grace period after graduation before payments are due. A subsidized loan means that the federal government pays interest on the loan while the student is attending school and during the six-month grace period after graduation before repayment begins. Interest accrues from the time the funds are dispersed for an unsubsidized loan. Students have the option of paying the interest as it accrues or allowing the interest to be added to the loan’s outstanding principal. There are also different repayment options that vary based on qualifications such as extended repayment, graduated repayment, and income repayment among others. The Federal Perkins Loan program is for students with exceptional financial need. Funds depend on the student’s financial need and the availability of funds at the college. The interest rate is 5 percent. In this case, the college serves as the lender and the federal government provides the funding. This loan has a nine-month grace period after graduation before repayment begins. Parent PLUS loans, available as Direct PLUS loans from the U.S. Department of Education, are an option provided to parents to help pay for a dependent’s undergraduate education expenses and are not based on financial need. However, the dependent must attend an eligible school at least half-time and be in an eligible program. The amount that may be borrowed is based on the cost of attendance less any other financial aid awards. The grace period is 60 days after final disbursement. However, deferment of up to six months after the student is no longer enrolled at least half-time may be elected. Graduate PLUS loans are also available to students who are seeking graduate or professional degrees. The loan is not financial needs based, but is based on the borrower’s credit history. To qualify, students must have applied for the maximum Stafford Loan amount available to graduate students. The amount that may be borrowed is based on the cost of attendance less any other financial aid awards. The grace period to begin repayment of principal and interest is 60

days after final disbursement for the loan period. However, deferment of up to six months is available while the student is enrolled at least half-time, with an additional six months available after the student graduates or is no longer enrolled at least half-time. As mentioned above, private loans are available from a lender such as a bank, credit union, state agency, or a school. Private student loans may require payment while the student attends school instead of upon graduation. Private student loans may also have variable interest rates, which are often higher than student loans financed by the federal government. Origination and other fees may be incurred. A student may also need a cosigner for a private loan. The cosigner is responsible for repaying the loan should the student become delinquent on the loan. In some situations, the interest paid may not be tax deductible. Private lenders may also not offer forbearance or deferment options. Regardless of the lender, a client may be able to deduct interest paid on student loans for qualified higher education expenses including tuition and fees, room and board, books, supplies, equipment, and other necessary expenses, such as transportation. The interest paid may be deducted even if the loan is in deferment. Parents may use equity in their home as a way to finance their child’s education expenses. For example, a parent might take out a new mortgage or refinance their home in order to pay for college where the lender pays off the existing mortgage and gives the borrower “cash-out” in the amount of the difference between the new higher loan and what was owed on the existing loan. Another option is tapping into the home’s equity through a home equity loan where the borrower would receive the funds and have a variable or fixed interest rate for a fixed period. Yet another option is a home equity line of credit (HELOC). A HELOC is a line of credit that can be used as needed. In this case, payments are made based on the amount of the available credit that has been used. The interest rate is usually variable. The interest paid may be tax deductible. However, all of these options are collateralized by the client’s home, and if the client cannot make the payments on the loan, the lender can foreclose and the client may lose their home. Families may want to consider loan consolidation. Consolidation loans bundle all of a student’s outstanding loans and consolidates them into one payment where the interest rate is based on a weighted average of the individual loans. Only certain loans are eligible for consolidation including subsidized and unsubsidized Stafford Loans, Federal Perkins Loans, Parent PLUS Loans, and Graduate PLUS Loans. The advantages, such as making one monthly payment and possibly lowering the payment, must be carefully weighed against the disadvantages, such as increased length of repayment that will likely result in paying more in interest. Families may also want to consider the availability of repayment options for each loan type as well as possible forgiveness of the loan. For example, if trouble repaying the loan is experienced, federal loans may offer the option of temporarily postponing or lowering the payments. Federal loans may offer repayment options that base the payment amount on the client’s income. Loan forgiveness may also be an option. Private loans are generally less likely to offer loan forgiveness.

The consequences of defaulting on student loan debt are many and can be severe. Student loan debt is not a dischargeable debt in bankruptcy. Loan servicers report all delinquencies of at least 90 days to the three major credit bureaus. The loan may be called due, meaning that the entire unpaid balance of the loan and any interest is immediately due and payable. Federal and state taxes may be withheld through a tax offset where the Internal Revenue Service can take refunds to offset the defaulted debt. Loss of eligibility for deferment, forbearance, repayment plans, and additional federal student aid are other consequences of defaulting. Wages may also be garnished.

LEARNING OBJECTIVE The student will be able to: a. Evaluate and recommend the availability of and qualifications for financing education expenses as part of an education plan.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing, or implementing.

Discuss examples of families in different financing situations and have students make recommendations using education financing strategies to assist the client in meeting their educational planning needs.

Students will work on problems that apply the core issues of education financing related to education planning.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing.

Have students complete case study analysis focusing on using education financing in the education planning process. This could be done individually or completed in groups depending on the size of the class.

Students will explore various mini-cases requiring them to determine basic recommendations for education financing based on given scenarios. Evaluating: Making judgments Continuation of above case study Students will present based on criteria and standards analysis. Ask students to present the the findings of their through checking and critiquing. results of each case study to the case study to the class. class. Students will receive feedback from the class and instructor and can learn from the other case study presentations. Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing.

Create videos in groups showing vignettes of scenarios students envision as illustrative of using education financing in the education planning process. Students review and critique each other’s videos.

Students each contribute aspects of their scripts for their group videos. Each student assesses other students’ videos.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: The entry-level professional can explain the role of education financing in the education planning process and identify opportunities and challenges related to a client’s potential use of education financing. Competent: The competent professional makes recommendations to assist the client in meeting their education planning goals using education financing as appropriate. The

professional can evaluate the availability of and qualifications for education financing. Expert: The expert professional can creatively and strategically include the use of education financing in any education scenario as appropriate.

IN PRACTICE Marcus and Stacey Marcus and Stacey have a son, Jack, in high school. Jack would like to attend his state university where all of his friends are going. However, his parents have not been able to save for his education. His parents are meeting with a financial planner for the first time in hopes of receiving information that can help with planning for his education. In meeting with their planner, they learned that Jack would qualify for federal Stafford Loans as determined by his FAFSA. They have ruled out private loans. Their planner did mention that they could help finance his education by saving toward paying off his loans as they accumulate or when repayment must begin six months after graduation. The planner also suggested that they pay the interest on the loans as it accrues.

Shaun and Tyler Shaun and Tyler were married in 2013. Shaun has a son, Amari, age 17 from a previous marriage. Amari is planning on attending college starting in the fall at a private school in another state. Shaun and Tyler recently began working with a financial planner. They have scheduled an appointment with their planner to discuss education planning options for Amari. No funds are saved for Amari’s education. They know he will not likely qualify for needsbased financial aid due to income and net worth and that financing his education will likely be necessary. The planner helps them evaluate the availability of and qualifications for student loans that can be used to finance Amari’s education expenses. The planner also discusses the tax implications of each option. The planner suggests they exhaust loan options from the federal government before considering private student loans. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 20 Principles of Risk and Insurance Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Many insurance products, including life insurance and annuities, are used in retirement planning and the investment of retirement plan assets. Life insurance plays a large role in estate planning, including as a means of providing estate liquidity and facilitating equalization among beneficiaries when there are assets (such as a closely held business) that may be hard to equitably divide. As with all aspects of financial planning, the ability to effectively communicate with clients and allied professionals is essential to uncover relevant information

and communicate recommendations.

INTRODUCTION Financial planners use many assumptions that involve uncertainty when analyzing client goals and developing strategies to achieve them. For example, a planner might assume that a 40year-old wage earner will continue to save 10 percent of her earnings until age 65 in pursuit of a comfortable retirement. However, there exists some probability that job loss, disability, or premature death will invalidate this assumption, potentially derailing the financial plan. Thus, it is extremely important that the financial planner be able to identify relevant risks and recommend ways to mitigate or eliminate them, thereby maximizing the probability that clients will achieve their financial goals. For individuals and families, the concept of risk involves both uncertainty and the possibility of non-trivial loss, whether loss of property or loss of income to the household’s wage earners. The potential for such losses has existed in all times and places where individuals have had the right to property, wages, or profits, as have efforts to avoid such losses. However, even though a form of shipping insurance is mentioned as far back as the Code of Hammurabi (ca. 1700 BCE), it was only with the development of probability theory in the mid-seventeenth century and the law of large numbers at the beginning of the eighteenth that the modern conception of risk management and insurance became possible.1 If risk is uncertainty, the advent of probability theory created the basis for quantifying the regularities that often manifest at the heart of uncertain phenomena. One could now determine not just what was possible, but also what was probable, with the law of large numbers asserting that the larger the number of observations, the more profound these regularities would be. Among other things, this made possible the pooling of risk in a systematic way, which is the very foundation of insurance.

LEARNING OBJECTIVES The student will be able to: a. Explain the risk management process. The risk management process involves the following elements: 1. Identify relevant risks. The risks must be both relevant and non-trivial. For example, the risk of premature death is not relevant for a wage earner with no financial dependents, while that same risk is relevant but financially trivial for a wage earner with dependents who is one month away from retirement. Scenario learning can be a useful approach to identifying relevant risks in more complex circumstances.2 2. Assess and quantify the risks. Once the relevant risks have been identified, it is necessary to first determine if the probability of occurrence is known or knowable, and next to quantify the potential financial loss. Quantifying the potential financial loss will

often involve applications of time value of money analysis. For example, the discounted present value of a wage earner’s projected future earnings stream will suggest the magnitude of the potential loss from disability or premature death. 3. Evaluate resources. Once the potential magnitude of a loss has been identified, it is evaluated in terms of available resources. For example, do sufficient resources exist to cover the potential loss and still achieve client goals? Are those resources in the appropriate form (e.g., sufficiently liquid and/or marketable to be designated as risk reserves)? 4. Evaluate available techniques. The four primary techniques for dealing with risk— avoidance, reduction, sharing, and retention—are not equally applicable to every type of risk. Likewise, a client’s financial circumstances and risk tolerance will influence the choice of one technique, or combination of techniques, over another. For example, even though a financial planner has determined that her client has sufficient financial resources to meet the need for long-term care (LTC), a low risk tolerance might lead the client to prefer the purchase of LTC insurance (risk sharing) over self-insurance (risk retention). 5. Implement, monitor, and repeat. As with all other elements of the financial planning process, risk management must be treated as part of an ongoing process of assessment and action. The risks faced by clients will continuously change due to personal choices, external circumstances, and life cycle shifts. b. Provide examples of the four primary risk management techniques available to clients. 1. Avoidance (eliminate). This technique involves any strategy that makes the risk irrelevant. For example, choosing to give up skydiving eliminates all risk of injury or death from that activity. 2. Reduction (mitigate). This technique involves actions that reduce the probability or magnitude of a loss from a particular source of risk. For example, mowing the area around a house in a fire-prone neighborhood reduces—but does not eliminate—the probability of the house suffering fire damage if there is a wildfire in the area. As another example, giving up smoking and losing weight will generally reduce the probability and/or severity of health-related losses. 3. Sharing (transfer). This technique involves shifting some or all of a particular risk to a third party, and generally involves the use of insurance. Life insurance, for example, can be used to shift the financial risk of the premature death of a wage earner away from the wage earner’s household and onto an insurance company. 4. Retention (accept/budget). This technique involves the concept of self-insurance, which in turn involves not just retaining exposure to the risk, but also the need to make adequate provisions to finance or reserve against that exposure. For example, if one decides to increase the elimination period on a disability income policy by three months, the exposure to the risk of income loss has risen by that amount. It is important

to reserve against that increased exposure by increasing the emergency fund accordingly. Likewise, with an increase in the deductible on an auto policy, the loss exposure has increased by the marginal amount of the larger deductible. Therefore, the financial planner and the client must budget adequate additions to the emergency fund for that greater potential loss. c. Describe how insurers use risk pooling to pay for losses incurred by policyholders. As expressed in the preamble to a 1601 Act of Parliament,3 in relation to the regulation of maritime insurance, risk pooling involves spreading risk across a large number of participants so that any particular loss results not in “the undoing of any man, but the loss lighteth rather easily upon many than upon a few.” The technique of risk pooling is effective only for risks that have a known probability and follow the law of large numbers. For example, if we know that 2 percent of all men will die from all causes in any given year, we need to collect but $1 of premium from each member of a risk pool of 1,000 men for every $50 of death benefit promised (ignoring overhead and profit). Specifically, $1,000 of premiums would be collected ($1 from each of 1,000 participants) and $1,000 of benefits would be paid ($50 in death benefits to the beneficiaries of each of the 20 participants who would be expected to die). The law of large numbers is an important consideration since the smaller the risk pool, the greater the chance that the actual losses in any given year will vary from the expected losses. Conversely, as the size of the risk pool grows, the actual losses tend to converge on the expected losses. More formally, if there are n policies, each with an independent probability p of a claim, the number of claims will follow a binomial distribution (given that the possible outcomes are binary: claim or no claim). The standard deviation of the proportion of policies resulting in a claim is the square root of p(1 – p)/n. The law of large numbers says that the standard deviation of the observed outcomes approaches zero as n becomes very large. d. Explain the factors that affect policyholder premiums and recommend appropriate methods for reducing household insurance costs. There are three main factors that will affect policyholder premiums: 1. The deductible, which can take the form of a specified dollar amount of loss that must be incurred before an insurance benefit is available, or, alternatively, a period of time over which a covered loss must be incurred before the policyholder begins earning benefits (e.g., as found in disability and long-term care policies). This deductible or waiting period represents that portion of the risk borne by the policyholder; the larger it is, the lower the premium. Thus, one way a policyholder may reduce premiums is to increase the policy’s deductible. 2. The size of the insurance benefit is also positively related to premiums; therefore, reducing the benefit will reduce the premium. It is important to note that the ratio of the benefit to the premium charged is generally not a constant proportion. Specifically, additional increments of insurance coverage often cost progressively less per unit of coverage due to the increasingly smaller probability of incurring the additional

increment of loss. Thus, increasing the deductibles generally has a proportionally larger impact on premiums than reducing coverage does. 3. The probability of loss is positively related to the premium charged, with the premium rising as the probability of loss increases. Anything that reduces the probability of loss will generally reduce the premium. For example, many auto insurance companies will discount auto premiums for policyholders who take a driving safety course. Likewise, writers of homeowners insurance often offer premium discounts for homes that have smoke detectors and other safety features that reduce the probability of loss.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Class presentation in which the instructor identifies the major components of a sample policy declaration page. This can be repeated with individual medical, disability, long-term care, life, auto, homeowners, and excess liability policies.

Provide the students with sample insurance policy declaration pages and ask them to identify the key components of coverage for each type of insurance, including deductible, copay, elimination period, indemnity, benefit period, and any riders.

The summary declaration page (SDP) for employer-provided group benefits would also be appropriate for class review. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Class exercise in which students are presented with different components of an insurance policy and asked to indicate whether a larger value would increase premiums or decrease premiums. For example, a bigger deductible would lower premiums, while a larger indemnity would increase premiums.

Students complete a quiz in which they are presented with various types of insurance and asked to identify the ways in which premiums can be reduced. For example, when presented with a disability income policy, the appropriate responses would be the following: Lengthen the elimination period. Shorten the benefit period. Reduce the monthly

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Creating: elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

indemnity. Class exercise in which students are asked Rather than a matching to indicate which risks are present in exercise, students would be different client scenarios. For example, a given a series of client 40-year-old wage earner with no financial scenarios and asked to dependents would be subject to the risk of independently name all income loss due to disability, while a 40- types of risk present in each year-old wage earner who did have scenario. financial dependents would be subject to both the risk of income loss from disability and income loss from premature death. The instructor engages the students in a role-play exercise, posing as a client and allowing the students to question her about her life circumstances and goals.

Students will individually write a risk management plan based on the role-play exercise. The plan must include the following elements: Identification of relevant risks. Identification of which risk management techniques are available and appropriate to address each risk. Recommendation for meeting each risk, with specific reference to how and why this is a fit for the client’s circumstances, based on what was learned during the role-play exercise.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can extract key information from an insurance policy’s declaration pages, including the deductible, co-pay, elimination period, indemnity, benefit period, and riders, depending on the type of insurance. An entry-level personal financial planner understands the relationship between an insurance policy’s premium

and the policy’s deductible, elimination period, indemnity, benefit period, and various riders (e.g., cost-of-living adjustment [COLA]). An entry-level personal financial planner can also use time value of money techniques to calculate the magnitude of a potential loss, such as the disability or premature death of a wage earner, using a spreadsheet or financial calculator. Competent: A competent personal financial planner can identify which configuration of the four basic risk management techniques is available and suitable for different client circumstances. For example, when considering the risk of income loss due to disability, this planner will identify the primary risk management techniques, such as retention and transfer, and recommend an appropriate balance between them in terms of the elimination period (the longer the elimination period, the greater the tilt toward retention); basic monthly indemnity (the larger the basic monthly indemnity, the greater the tilt toward transfer), and benefit period (the longer the benefit period, the more the tilt toward transfer, or, alternatively, the shorter the benefit period, the greater the tilt toward retention). The particular recommendation for meeting the preceding risk would take into account client circumstances, including financial and other resources, stability of employment, and time to retirement. A competent personal financial planner will also understand and be able to explain in detail the structural differences among the various types of life insurance, including term, whole life, universal life, variable life, and second-to-die policies. This planner can likewise explain in detail the structure and function of disability, long-term care, medical, homeowners, auto, and excess liability insurance. Expert: An expert personal financial planner can apply the risk management process in an integrated manner, taking into account the linkages between cash flow, insurance, employee benefits, retirement, and other goals. Someone practicing at this level can make recommendations that account for these linkages, as well as balance costs and benefits in the context of the client’s specific goals and circumstances. For example, this planner can recommend an emergency fund that is logically consistent with a client’s employee benefits (including disability coverage), the size of deductibles on homeowners and auto policies, stability of employment, and family structure. Likewise, an expert planner can recommend the appropriate type of life insurance policy (e.g., term versus whole life), taking into account retirement goals, college funding, and estate objectives.

IN PRACTICE Marilyn and Jonathan Marilyn and Jonathan Skaff ask their financial planner, Yvonne Bright, to tell them how much life insurance they need. Marilyn and Jonathan are a married couple in their thirties who have two small children under the age of five years. Jonathan is a stay-at-home dad. Yvonne first gathers information about the family’s financial resources, income, and plans for retirement and educating their children. She then performs a discounted present value analysis to determine the lump sum necessary to replace Marilyn’s lost earnings in the case of premature death and also the present value of the cost to replace Jonathan’s domestic and child-care services to the

household in order to determine how much life insurance each of them needs. A further analysis of the Skaffs’ estate plan allows Yvonne to determine that the couple has no need for estate liquidity, only the need to replace lost earnings or domestic services until enough capital has been accumulated to support the clients’ retirement and college funding goals. Yvonne therefore recommends that Marilyn and Jonathan meet their life insurance need using levelpremium term insurance in amounts equal to the sums calculated in her discounted present value analysis.

Skyla and Brent Skyla and Brent Witherspoon inform their financial planner, Yusuf Mustafa, that their eldest daughter, Selena, has just received her driver’s license and is now using the family car on a daily basis. Yusuf suggests that this development has increased the potential for liability claims against Skyla and Brent due to car use by their daughter, who is a minor and for whom the couple bears financial responsibility. As a consequence, Yusuf recommends that they obtain a $2 million umbrella (or excess) liability policy, which will extend the underlying liability limits on the couple’s existing homeowners and auto policies. Yusuf explains that the cost of excess liability coverage is relatively modest because it provides coverage only when the underlying liability limits of the homeowners or auto policies are exhausted and thus has a lower probability of payment. He goes on to note that they have very low deductibles on both their homeowners and auto policies and further recommends raising those deductibles, thus lowering the cost of coverage to help finance the addition of the umbrella liability policy. The recommended approach, by combining two risk management techniques—risk retention through higher deductibles and risk transfer through higher liability limits—allows the Witherspoons to have a more appropriate level of protection for relatively little additional cost.

Nancy Nancy Mignette visits her financial planner, Stephanie James, to tell her about her new job. After studying the employee benefit booklets provided by Nancy, Stephanie determines that the disability income coverage offered by Nancy’s new employer has a longer elimination period than her prior plan: six months versus three. The new plan leaves Nancy with more retained risk than she has provided for with her current emergency fund. In order to ensure adequate protection, Stephanie recommends that Nancy increase her emergency fund by an amount equal to an additional three months’ worth of monthly spending. This would ensure that Nancy could meet her spending needs during a period of disability that had not yet satisfied the six-month waiting period before the commencement of disability income benefits.

NOTES 1. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, 1998), 92, 100. 2. Jeff Ellis, Steve Feinstein, and Dennis Stearns, “Scenario Learning: A Powerful Tool for the

21st Century Planner,” Journal of Financial Planning (April 2000). 3. Sir William Blackstone, Edward Christian, Joseph Chitty, Thomas Lee, Eykyn Hovenden, and Archer Ryland, Commentaries on the Laws of England: In Four Books; with an Analysis of the Work, vol. 2 (New York: Collins & Hannay, 1832), 58. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 21 Analysis and Evaluation of Risk Exposures Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

When evaluating risk exposures, it is important to understand cash flow needs and cash reserves (general principles); the structure, liquidity, and marketability of invested assets (investment planning); retirement assets and cash benefits (retirement planning); and the needs of financial dependents (estate planning).

INTRODUCTION Every client faces the risk of financial loss, the nature and magnitude of which will vary based on his or her individual circumstances. Such losses might arise from damage to the client’s property, liability for damage to the property of others, and loss of income due to disability or premature death, among many other causes. These losses hold the potential to both degrade current lifestyle and negatively impact the attainment of future family goals. Analyzing and evaluating these risk exposures is the necessary first step financial planners must take in developing recommendations for mitigating or eliminating the potential for loss. To be of interest to the financial planner, a risk must be both non-trivial and of consequence to the client or client’s family. For example, while loss of earnings due to disability would be a relevant risk for any client who depended on earned income to maintain his or her lifestyle, loss of earnings from premature death would generally be relevant only to a client who had financial dependents. Other risks might arise from owning property, operating motor vehicles, or practicing in a high-liability profession (e.g., the practice of medicine or law), all circumstances that will be unique to individual clients. The financial planner, therefore, must first consider the client’s circumstances and identify the relevant risks. Next, the planner must assess the magnitude of identified risks in order to determine which risk management techniques will be indicated. When the risk under consideration involves the potential for loss or damage to property, measurement will involve estimates of replacement cost. When, on the other hand, potential losses involve a stream of earnings over time, as in the case of the premature death of a wage earner, the financial planner will employ time value of money techniques in order to determine the present value of that future stream of earnings. As is true with all aspects of financial planning, the planner must also be able to clearly communicate the nature and magnitude of risks that a client faces and to do so within the context of the client’s overall financial plan.

LEARNING OBJECTIVES The student will be able to: a. Identify and measure liability, automobile, homeowner’s, flood, earthquake, health, disability, long-term care, and life risks. While it is not necessarily the financial planner’s role to make specific recommendations with respect to policy and insurer selection, calculation of the magnitude of a potential risk exposure is an essential part of the planning process. Such calculations involve both an assessment of the current value of property that may be subject to loss and the use of time value of money calculations to determine the present value of a stream of earnings lost over time or of expenses that may be incurred over time (e.g., long-term care expenses). b. Explain maximum possible and maximum probable loss amount to a client.

When making recommendations for mitigating or eliminating a risk exposure, the financial planner must be prepared to help clients arrive at an appropriate balance between the costs and benefits of doing so. Among other things, this will require a discussion of both the potential magnitude of a loss and the probability of its occurring.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Plan a guest presentation by a property and casualty insurance agent on the types of losses that can occur from the ownership of property and the operation of motor vehicles. Incorporation of real-life examples would be encouraged.

Have each student prepare a question for the guest presenter. Provide students with a list of potential risk sources and ask them to identify and explain each related risk that may arise from each primary source of risk (e.g., source of risk: operation

Instructor lectures on the multiple dimensions of loss that can arise from of a motor vehicle; types of risk a single source (e.g., a disability may that students would be expected to involve loss of earnings, losses due to identify and explain: damage to the medical expenses, and loss of function operated vehicle, damage to other [ADLs], causing long-term care vehicles or property, medical expenses). expenses arising from injury to the passengers of the operated vehicle, the passengers of any other vehicle involved in an accident, and any pedestrians involved, additional financial liability arising from damage to property or harm to persons). Analyzing: Instructor solves a problem with the Assign students to use a financial Breaking material class demonstrating the use of time calculator to determine the present into constituent value of money techniques to value of the potential loss parts, and determine the magnitude of different resulting from the disability or determining how losses. premature death of a wage earner the parts relate to with financial dependents. one another and to an overall structure or purpose through differentiating,

organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Ask students to indicate which risks are present in different client scenarios. For example, a 40-year-old wage earner with no financial dependents would be subject to the risk of income loss due to disability, while a 40-year-old wage earner who did have financial dependents would be subject to both the risk of income loss from disability and income loss from premature death.

Students are given a series of client scenarios and asked to independently name all types of risk present in each scenario.

Create a role-play exercise, posing as a client, and allow the students to question the client about his or her life circumstances and goals.

Students will individually write a risk analysis based on the roleplay exercise. The plan must include the following elements: Identification of relevant risks. Measurement of the magnitude of each risk. Recommendation for meeting each risk, with specific reference to how and why this is a fit for the client’s circumstances, based on what was learned during the roleplay exercise.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify the main types of risk present given a client’s overall circumstances (e.g., family structure, employment, property, etc.). An entry-level personal financial planner will also be able to apply time value of money concepts to quantify the magnitude of potential losses (e.g., calculate the inflation-adjusted discounted present value—the present value of a growing annuity—of the earnings that would be lost to a household if a wage earner were to die prematurely). Competent: In addition to the foregoing, a competent personal financial planner can perform an integrative analysis that accounts for the connections between the different types of loss that a client faces. In developing her analysis, a competent personal financial planner will account for the interplay among emergency reserves, deductibles, elimination periods, and the timing

and duration of future goals, as well as the impact of changing family circumstances (e.g., the need to increase liability limits when teenage family members begin to drive). Expert: An expert personal financial planner can apply judgment in situations where potential losses are not unambiguously clear. In addition to identifying risks and the potential (possible) losses associated with them, this planner will be able to identify the mitigating factors that are present and discuss with clients the probable loss in addition to the possible loss. For example, while all houses in an earthquake zone face the same probability of an earthquake occurring, not all those houses face the same probability of severe damage as a consequence of such an earthquake. The identification of those mitigating factors that might leave a particular home more or less likely to suffer severe damage will be incorporated into the planner’s risk assessment when recommending earthquake coverage.

IN PRACTICE Marie and George Marie and George Claude meet with their financial planner, Jonathan Davies, to discuss their life insurance needs now that they have a child. Having previously gathered information related to the Claudes’ employment, spending needs, and retirement plans, Jonathan now asks them for their thoughts about funding future college expenses for their newborn daughter. As a consequence of their own struggles to pay off college debt, the Claudes have a very strong desire to pay for all of their daughter’s education. Furthermore, Marie and George both graduated from the state university and would like to plan for the expenses associated with this type of education. Jonathan proceeds to calculate the discounted present value of Marie’s and George’s respective contributions toward household spending needs. In doing this, Jonathan calculates the present value of a growing annuity (PVGA) in order to incorporate the impact of future inflation. Jonathan then calculates the discounted present value of future college expenses, again calculating a PVGA but this time using a higher assumed inflation rate to account for the higher inflation rate of college expenses. This number is added to each of the prior calculations and represents the magnitude of the risk of premature death for Marie and George. In comparing this number to the amount of life insurance currently in force, Jonathan finds that there is a shortfall and recommends the purchase of additional coverage sufficient to bridge the gap.

Franklin Franklin Desplains has just acquired a new home in San Francisco’s Pacific Heights neighborhood. Discussing this new development during his annual update meeting with his financial planner, Sylvia Glass, he asks if she thinks he should add earthquake insurance to his current coverage. Sylvia reviews with Franklin the various factors that the U.S. Geological Survey (USGS) has identified as most relevant when considering this question, including proximity to an active fault, time since the last earthquake, building construction, materials used, quality of workmanship, and the extent to which earthquakes were considered by the

designer, among other factors. Sylvia further considers the value of the house in relation to the rest of Franklin’s real and financial assets, the amount of potential loss that must be retained (available policies carry a 20 percent deductible), and the cost of insurance. While the maximum possible loss is equal to the full replacement cost of the home, Sylvia suggests that the maximum probable loss is considerably less in light of the factors highlighted by the USGS and, also accounting for Franklin’s other resources, Sylvia ultimately recommends against obtaining an earthquake policy. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 22 Health Insurance and Health Care Cost Management Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

The cost and acquisition of health care are primary components of a family’s financial and life planning. A cash flow plan must allow for the purchase of health insurance and savings needs analysis for funds to use as deductible and co-insurance payments. A retirement plan must consider the cost of health insurance, particularly if plans include retiring before Medicare is available. Last, the current income tax regulations allow for significant health care costs to be

deducted from income before taxes are assessed and for employer-provided health insurance costs to enjoy a tax-free status.

INTRODUCTION It is imperative that the financial planner have a deep understanding of the myriad aspects of the health insurance market. Clients are often confounded by the complexities and choices available to them and an effective financial planner must be able to help them navigate these issues. Doing so may help alleviate fear and anxiety in addition to mitigating financial risk exposures, leading to quality of life improvements on multiple fronts. The medical care industry comprises nearly 18 percent of the gross domestic product of the United States. It is costly, and sometimes difficult, to access health care required to prevent and treat illnesses and injuries. The acquisition of health care and health insurance are separate events but often are confused in the marketplace. In the United States, health insurance is most often received as an employment benefit, further complicating labor decisions. Typically, the need for health care increases as one ages, and the cost of health care naturally increases with the increased risk. Most individuals and families use health insurance to manage health care cost risks. Furthermore, since the passage of the Patient Protection and Affordable Care Act in 2010, with few exceptions, all Americans are required by law to carry health insurance coverage. For 2015, the penalty for foregoing coverage is the higher of either 2 percent of household income beyond the minimum filing threshold or $325 per person ($162.50 per child) up to a maximum of $975. This penalty has been increasing each year and will indeed do so again in 2016 to the higher of 2.5 percent of household income or $695 per person. After 2016, the penalties will be adjusted for inflation. Health insurance may be acquired individually, in the private market, through an employer group plan, or through government programs such as Medicare and Medicaid. Regardless of the source of insurance, buyers must thoroughly understand the type of insurance plan in which they enroll. There are two basic forms of health insurance. These include the fee-for-service model and the managed health care plan. A fee-for-service model permits the insured to select any health care provider for any health care service. If a service is covered, the insured pays his or her share of the cost and the insurance company pays the remainder. A managed health care plan generally limits the insured to a predetermined selection of providers who are either contracted with or employed by the insurer. The insured will pay his or her share of the cost according to the provisions of the plan, and the insurer will cover any remaining cost. Insured participants may choose to use a provider outside the plan (or network) but will usually pay a greater share of the cost of service. Regardless of the form of health insurance or the insurer, there may be five costs to insured persons. First, they will pay a premium for the insurance coverage. Second, they will pay a deductible (the first dollars of cost for service in a period, usually a year). Third, they will pay

a co-insurance amount or a percentage of every invoice for care up to a predetermined limit. Fourth, in managed plans, the insured may make a co-payment of a flat dollar amount every time he or she uses a specific service. Last, insured individuals who are covered by policies with annual or lifetime maximum benefits may have to absorb any costs that exceed the maximum annual or lifetime coverage amounts. Most individuals receive health insurance coverage through a group plan that is offered as a benefit of employment. Group plan coverage is generally cheaper than buying private insurance, as risks are spread among a larger pool of insured individuals. In addition, most employers pay a significant share of the monthly premium. The employer’s share of the monthly premium is not taxable to the employer, and employees can pay their shares on a pretax basis. A person who is separated from service with his or her employer may have the right to continue in the employer’s health insurance plan. These rights are included in the Consolidated Omnibus Budget Reconciliation Act (COBRA). COBRA rules allow former workers of an employer with at least 20 employees to continue receiving coverage through the employer plan for a period of 18 months. In some cases, former workers or their family members may enjoy up to 36 months of COBRA protection. The former employee, however, must pay the full premium out of his or her own pocket. Employers are allowed to charge an additional 2 percent for management costs if they desire. Because many employer group plans provide very good coverage at a commensurate price, former employees may not be able to take advantage of COBRA protections. Their budgets may permit them to buy only bare-bones individual coverage in the private marketplace. Medicare is a government health insurance program available to individuals over the age of 65. Medicare coverage is provided in three parts: A, B, and D. Medicare Part A covers hospital costs at no premium for participants who are eligible to receive Social Security. Medicare Part B pays doctors and surgical costs; monthly premium payments are required and increase with income. Part D offers prescription drug coverage and is optional; the insured pays a monthly premium for Part D coverage. Certain insurers offer private plans that pay the co-insurance amounts required by Medicare. These policies, called Medigap policies, may also pay for treatments not covered by Medicare. The policies are heavily regulated.1 Another government program, funded by both federal and state governments, is Medicaid. Medicaid is a health insurance program for poor individuals and children. There is no premium cost for Medicaid coverage. However, the program is means tested: covered individuals must have incomes below a certain level and few economic assets to qualify for benefits. Individuals who do not receive health insurance through an employer, Medicare, or Medicaid can find insurance in the private marketplace. However, coverage is usually expensive. To mitigate the expense, individuals may often select plans with large deductibles, co-insurance rates, or co-payment requirements. It is important for financial planners and clients to prepare for health care and health insurance costs. At a minimum, the client should have enough savings to pay the annual deductible. The

client’s spending plan should include the cost of premiums as well as expected co-insurance and co-payments for the client’s normal health care usage patterns.

LEARNING OBJECTIVES The student will be able to: a. Compare and contrast group and individual health insurance alternatives, including fee for service and managed health care plans. b. Incorporate expected retiree health costs into a client’s retirement plan, in consideration of household financial resources, existing or future coverage under group insurance plans, and Medicare. c. Explain alternatives for acquiring health coverage including COBRA and Medicaid.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

In-class or online discussion comparing the cost of health insurance using various coverage, deductible, and coinsurance assumptions.

Case study where the student is asked to determine the out-of-pocket costs for a loss event using a group employer managed plan.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

In an in-class or online discussion, give students a group health insurance explanation of benefits (EOB). Ask students to supply potential loss events. Explore the EOB to see if such events are covered in the plan.

Prepare a Schedule A given loss and insurance purchase events.

In-class or online discussion focusing on options for funding health care costs that exceed the coverage limits. Explore what events might cause such a loss. Creating: Putting elements In-class exercise: Create an together to form a coherent or annual medical care budget, functional whole; including cost of premiums, reorganizing elements into a deductibles, and co-insurance for new pattern or structure expected health care use. through generating, planning, or producing

Ask students to write a 250word explanation of COBRA coverage for a newly displaced worker.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Ask students to determine the effect of purchasing private insurance on a current worker’s and a retiree’s cash flows.

Ask students to make a health insurance plan for a family throughout their life stages, showing source of insurance, average costs of premiums, and annual expected out-of-pocket costs.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the financial exposure to the costs of accessing health care for typical illnesses and injuries. Entry-level planners should be able to review the explanation of benefits from an employer-provided group plan or an individual policy to calculate an annual out-of-pocket maximum. In addition, they can determine what risks the client is assuming. Competent: A competent personal financial planner can assist clients in selecting insurance appropriate to their needs at various life stages. Competent planners can build health care cost projections into the client’s cash flow plan. Last, they can advise the client regarding

qualifying for government health insurance programs. Expert: An expert personal financial planner can design a long-term health care cost plan.

IN PRACTICE Jacob Jacob Bittner is a retired 62-year-old. He lost his job due to a corporate restructuring, and his employer has told him he is COBRA eligible. After analyzing his previous employer’s plan, his financial planner determines that Jacob’s monthly COBRA premium would be $865. Jacob can buy health insurance through a private insurer for $450 per month. However, he would have to assume a $5,000 deductible (the employer plan’s deductible is $1,500) and a 30 percent co-insurance amount (the employer’s plan calls for 20 percent co-insurance). Because Jacob has $60,000 in liquid savings at a low interest rate and is healthy, the planner advises Jacob to buy the private plan instead of using his COBRA benefits.

Aretha Aretha Charles has taken a new job. Her husband has provided health insurance for the family through his employer at a monthly cost to the family of $890. The premium for single coverage for him would be $30 per month, as his company would subsidize the remainder of his premium. Aretha is uncertain about whether she should buy individual coverage from her employer for $60 per month, dependent coverage for $490 per month, or total family coverage for $900 per month. After discovering that the coverage from Aretha’s employer and her husband’s employer is the same, they decide that Aretha will insure herself and the children at $550 per month, and her husband will purchase single coverage from his employer at $30 per month. The total monthly cost for health insurance would decrease from $890 to $580 per month.

Carlos Carlos Rivas is a single, active, healthy entrepreneur. He recently left his corporate job to launch a logistics consulting firm. He has dramatically scaled back his personal expenses in order to make ends meet and has decided to forego health insurance for the time being. He expects to make $50,000 in 2015. His financial planner informs him at an update meeting that his decision to go without health insurance is unwise. Not only does being uninsured carry significant financial risks, the financial penalty assessed will be approximately $400.

NOTE 1. For more information, visit www.dol.gov/ebsa/faqs/faq-consumer -cobra.html, www.healthcare.gov, and www.medicare.gov.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 23 Disability Income Insurance (Individual) Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

The taxability of disability income benefits can be affected by tax elections made with respect to payment of premiums (tax planning). Disability insurance provides income replacement that helps to ensure that a retirement plan will be successful (retirement saving and income planning), and is a fundamental tool of risk management (risk management and insurance planning).

INTRODUCTION According to the Social Security Administration, more than one in four of today’s 20-year-olds will become disabled before they retire.1 This is vastly greater than the number of premature deaths that will occur over that same period and highlights the importance of planning for income protection in the event of a disability. While only those with financial dependents generally have a life insurance need, everyone who depends on earnings to meet their spending needs faces the risk of income loss due to disability. While disability benefits are provided by Social Security under the Social Security Disability Income (SSDI) program, and five states and one commonwealth provide short-term state disability benefits meant to bridge the gap to SSDI, most individuals require additional sources of income replacement to fully meet their spending needs while disabled. And although some employers provide short-term disability (STD) and long-term disability (LTD) coverage under group policies, many if not most individuals must still consider an individual disability policy to fully address the risk of income loss from injury or illness. This is partly due to the limits on coverage amount imposed by insurers, who like to see a “corridor of self-insurance” in place to ensure that policyholders remain motivated to return to work. Along these lines, a Society of Actuaries study found that the length of a disability claim was directly proportional to the replacement ratio on a policy, with higher replacement ratios associated with longer claim durations.2 When advising clients with respect to risk of income loss from disability, the financial planner must have an understanding of the various forms of coverage and how they are structured. SSDI, for example, is typically available only to those whose disability is expected to last longer than a year or result sooner in death. The definition of disability under SSDI is also more restrictive than those found in either employer-provided STD and LTD plans or individual disability income (DI) policies, making it more difficult to qualify for benefits. Employer-provided plans, meanwhile, often have coordination of benefits provisions that will reduce coverage if benefits are received from another source, such as SSDI. All of these must be accounted for when considering the selection of a DI policy. In addition to other benefits, the planner must consider the client’s financial resources when recommending or assessing a DI policy. The structure of DI coverage will depend on several factors, including the definition of disability, the elimination period (EP), the benefit period (BP), and the base monthly indemnity (BMI). Additional structural elements may include alternative definitions of disability (e.g., “own occupation”), residual benefits for partial disabilities, and options to acquire additional coverage in the future without medical underwriting. Finally, the planner must understand the tax implications related to how benefits are paid for and received. Since tax benefits claimed at the time premiums are paid will likely result in more taxes being paid on benefits received, and since a client’s spending needs must be met with after-tax dollars, this is an essential element of the disability income planning process.

LEARNING OBJECTIVES The student will be able to:

a. Describe differences between short-term and long-term disability plans and identify the policy provisions that should be included in privately purchased disability policies. Individual disability income (DI) policies come in two broad forms: guaranteed renewable and non-cancelable. While guaranteed renewable policies are, as the name implies, guaranteed with respect to the policyholder’s ability to continue coverage from year to year, the premiums are not guaranteed. Non-cancelable policies, in contrast, are guaranteed with respect to both the right to continue coverage and the premium to be paid, which is often a level amount for the life of the contract. The following are four key elements that must be accounted for when selecting an individual DI policy: 1. Definition of disability. The definition of disability describes the conditions under which a policyholder will qualify for benefits. The definition will typically contain the following three elements: 1. The insured must be unable to work in his or her regular occupation due to injury or illness. 2. The insured is not actively engaged in another occupation. 3. The insured is under the continuing care of a licensed physician. An alternative “own occupation” definition is sometimes offered, which removes the second element of the foregoing definition and requires only that the insured be unable to work in his or her own occupation. 2. Elimination period (EP). The elimination period is a form of deductible and represents the number of days that the insured must satisfy the definition of disability before beginning to earn a benefit. The longer the elimination period, the lower the premiums, and the shorter the EP, the higher the premiums. Further definitional issues here include whether the elimination period must be satisfied by a continuous period of disability or may be satisfied by non-continuous periods of disability occurring within a specified time frame. Strategically, it is important to remember that when the EP has been satisfied, the insured begins to earn a benefit but that benefits are typically paid monthly in arrears, so it will be another month before any income replacement is received. 3. Benefit period (BP). The benefit period specifies the number of months or years the benefit will be payable for a continuous period of disability. The BP may be as short as two to five years or as long as the insured’s lifetime. The most typical period is “to age 65” or not less than 24 months for disabilities commencing prior to age 65. 4. Partial or residual benefits. This feature provides for a benefit to be paid if the insured’s ability to work is reduced but not eliminated. The benefit is typically proportional to the loss of earnings (i.e., a 40 percent reduction in earnings due to disability would qualify the insured for 40 percent of the policy’s basic monthly benefit). b. Create a plan for meeting individual disability income needs, in consideration of

household financial resources, and existing coverage under employer plans, Social Security, and disability income insurance options. It is important to integrate the individual disability income policy with a client’s other resources. For example, the elimination period should be coordinated with the size of a client’s liquid reserves; if a client has only three months’ worth of spending in liquid reserves, a 90-day EP would be indicated more than a 180-day one. Employer-provided sick leave and disability benefits would also need to be considered, along with accumulated vacation leave. For example, a client who has group LTD through work would not want to add a Social Security rider to her individual DI policy, as it could result in a double offset if she were to qualify for SSDI. c. Calculate the tax implications of paying for and receiving disability benefits. The tax elections that are made with respect to the payment of disability income premiums have a direct impact on the tax treatment of benefits. If a DI policy is provided under a qualified salary continuation plan, the employer’s costs need not be recognized as taxable income to the participating employee. However, if that employee becomes disabled, the fact that the premiums were paid pretax results in the benefits being treated as taxable income. Alternatively, if the employee chooses to have the premiums treated as taxable compensation, any benefits would be received tax-free. One way to think about this tradeoff strategically is to consider that the “corridor of self-insurance” mentioned previously results in income replacement ratios that may seem very low in relation to an insured’s earnings. Choosing to have one’s premiums treated as taxable effectively raises the aftertax benefit, and the additional income tax liability can be thought of as an insurance premium paid for that additional net benefit.

IN CLASS Category

Class Activity

Applying: Carrying out or using a procedure through executing or implementing

Instructor lecture on the basics Students complete a disability policy of the disability risk, including data form and gather quotes based on probability of occurrence, their selections/choices. sources of risk, changes over time (e.g., individuals in their 20s and 30s are more likely to be disabled from accidents, while those in their 40s and beyond are more likely to be disabled from illnesses). The basic elements of any form of disability protection would also be reviewed (i.e.,

Student Assessment Avenue

definition of disability, EP, BP, BMI, COLA). Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Instructor lecture on the structure of different kinds of disability plans, comparing group STD and LTD with Social Security SSDI and individual DI.

Students are provided with a comparison chart that has columns listing the key kinds of disability coverage (STD, LTD, SSDI, DI) and rows listing the key elements of coverage (definition of disability, EP, BP, BMI, COLA, coordination of benefits provisions, etc.) and are asked to fill in each cell, making sure to highlight the differences where they exist.

Students are provided with a set of case facts, and through an interactive, student-led discussion, the group answers a series of questions related to the availability of different types of coverage, limits on combining different coverages, and tax considerations. The instructor engages the students in a role-play exercise, posing as a client and allowing the students to question her about her life circumstances and goals, with special reference to uncovering facts and circumstances relevant to the disability income need.

Students are provided with a second set of case facts and asked to complete the same exercise individually.

Based on the classroom role-play exercise, students prepare a plan for meeting the client’s individual disability income needs, taking into account household financial resources, existing coverage under employer plans, Social Security, and disability income insurance options. Students prepare a five-year cash flow statement detailing the different sources of income replacement at each stage.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify when the risk of lost income due to disability is present and will also understand the basic tools available for addressing this risk, including SSDI, STD, LTD, and DI. This planner can also name the basic

elements of the different types of disability insurance and explain how each works. Competent: In addition to the aforementioned, a competent personal financial planner can develop a disability income plan that accounts for and coordinates among the various types of coverage currently or prospectively available to the client. This plan will also take into account household financial resources, time to retirement, and cost factors. Expert: When developing a disability income plan, an expert personal financial planner will balance financial and non-financial considerations—including a client’s risk tolerance—in making integrated recommendations that account for all relevant financial planning factors, including the taxation of premiums and benefits.

IN PRACTICE Patricia Patricia Davenport has just changed jobs, and with her new position came a new, somewhat diminished, array of employee benefits. She visits her financial planner, Seth Bronkowski, in order to review her new benefits package and discuss any adjustments that might be required. Seth observes that the major difference between Patricia’s prior benefits and the new coverage is the absence of any kind of long-term disability (LTD) coverage. Seth notes that Patricia has an individual, non-cancelable disability income (DI) policy but that it is not sufficient to meet her needs. The DI policy’s underwriters limited the amount of monthly benefit they would originally issue to account for the LTD coverage provided by her prior employer. Seth recommends applying for additional benefits based on the insurer’s maximum replacement ratios, now that there is no longer group coverage in place. He also recommends using a “social insurance” rider as part of the increase in benefits. The social insurance rider will provide an additional $1,500 per month of coverage if Patricia applies for and is denied SSDI benefits from Social Security. This rider would have been inappropriate while Patricia was with her prior employer, as the group LTD plan also offset for any Social Security or state disability benefits and would have caused a double offset if the social insurance rider had been added to her former DI policy.

William Financial planner Aisyah Saunders is meeting with her client, William Smithers, to review the tax election he has to make related to his disability income plan. William’s employer currently provides executives at his level with supplemental disability income protection in the form of an individual, non-cancelable disability income (DI) policy. William has the option to have the premiums his employer pays for his DI coverage reported on his W-2 as taxable income. Aisyah reminds him that disability benefits paid for with pretax dollars will be taxable as ordinary income, while disability benefits paid for with after-tax dollars are received tax-free. The challenge is weighing the value of tax-free premiums against the possibility of owing taxes on any benefits received, which would effectively reduce the size of his net benefit. William notes that he is currently subject to the top marginal tax rate, so avoiding taxation on the

premiums is especially attractive, all the more so considering his excellent health and firm belief that he is unlikely to become disabled. Aisyah grants this point, adding to it by observing that William’s financial arrangements generate very little taxable income other than from employment, so that benefits might well be taxed at relatively low rates. However, Aisyah reminds William that he was originally unhappy with the maximum benefit that the insurer would issue, feeling that it was disproportionate to his current income and lifestyle spending needs. While paying tax on the premiums would be expensive, it could also be viewed as the cost of buying more insurance. In the end, William decides that he prefers maximizing his potential after-tax benefit, even through the relatively expensive mechanism of paying taxes on premiums.

NOTES 1. Social Security Administration, Fact Sheet, March 18, 2011. 2. Charles E. Soule, Disability Income Insurance: The Unique Risk, 5th rev. ed. (Bryn Mawr, PA: American College, 2001). Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 24 Long-Term Care Insurance Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

Long-term care (LTC) is for the aged or infirm. This is exactly why it should be included in discussions of income tax and retirement planning. The cost of long-term care may be prohibitive, thus reducing the financial resources available for other living expenses during retirement or during periods of extensive medical care. Because a portion of long-term care is considered to be for medical treatments, the Internal Revenue Code allows those who purchase

LTC insurance to deduct a portion of the premiums as a medical expense on Schedule A of their tax returns. Financial planners need to be aware of the effect that long-term care expenses may have on retirement income and assets, as well as the eventual estate legacy.

INTRODUCTION According to the U.S. Department of Health and Human Services, at least 70 percent of people over age 65 will require long-term care at some point in their lives. In 2012, the average cost of stay in a nursing home ranged from $131 per day in Texas to $687 per day in Alaska, while the cost of assisted living facilities ranged from $2,355 per month in Arkansas to $5,933 in Washington, D.C. In contrast, the average cost of home care ranges from $13 per hour in Shreveport, Louisiana, to $32 per hour in Rochester, Minnesota.1 The average length of stay in a nursing facility is 2.4 years.2 Most policies are those where the policyholder will pay a premium, (plans exist with numerous premium frequency options) until such time that the insured requires care. As with all insurances, the devil is in the details. Long-term care is strictly defined as needing assistance with activities of daily living (ADLs). There are six ADLs: bathing, dressing, toileting, transferring, continence, and eating. In addition, illnesses that require treatment from medical personnel (such as changing IVs or administering drugs) or involve significant cognitive impairment (such as Alzheimer’s disease) also qualify one for long-term care. Most long-term care insurance will reimburse for care provided in the home or in a licensed facility. Most policies provide benefits subject to either a daily or monthly limit. Others provide benefits on a per-diem basis. Additionally, most policies offer an inflation protection rider; that is, coverage would increase as prices of care increase. In addition to the daily, monthly, or per diem limits associated with LTC insurance, policies are generally sold with lifetime limits. Beyond some predetermined number of years, assuming the policy has been paying out at its maximum daily/monthly/per diem rate, the policy will no longer provide benefits, necessitating other options be available beyond this point. Furthermore, it is standard practice for policies to carry a deductible in the form of an elimination period during which time the insured must pay for care using some other means. Common elimination periods are 90–100 days. This is due to the fact that, assuming proper protocol is observed, Medicare will pay for the first 100 days of LTC facility costs. The basic principles of insurance require careful analysis when determining how much coverage a client may need. First, a risk assessment should be undertaken. What is the likelihood the client will need long-term care? Second, what is the amount of financial resources (income or wealth) that would be lost due to an insurable event? Third, what other resources are available to pay for the long-term care costs? Both public and private insurance programs exist to mitigate the costs of long-term care. These include Medicaid, long-term care insurance, and, for veterans and their survivors, VA benefits. A personal financial planner will consider a client’s total insurable risk and insurance

premium budget when determining the need for long-term care insurance. LTC insurance will be less expensive when purchased early in a client’s life because the years until need are greater. However, clients have other insurance needs when they are young—primarily health, disability, and life. And many clients only realize the need for LTC insurance when they become aware of the risks (usually while caring for older parents or friends). Therefore, they are most likely to begin buying LTC insurance in their forties or fifties. Generally, the cost of LTC insurance is prohibitive if purchase is delayed until clients are in their seventies. Because long-term care is expensive, the commensurate cost of insurance is expensive, too. The National Association of Insurance Commissioners has issued model pricing guidelines. Reviewing these guidelines before shopping for insurance would be helpful. The LTC market, as compared with most other lines of insurance is, quite young in that it has only existed for approximately 30 years. Due to this short history, many carriers have experienced significant losses and issues with mispricing. Many policyholders have experienced substantial premium increases causing many consumers and financial planners alike to be wary of traditional policies. Indeed, many of the insurers who were once seen as financially strong and reliable as to benefit payouts have now entirely exited the business. The future of this market is unclear and other options for addressing the risk of LTC costs are regularly being developed to compete with or complement the traditional stand-alone policy. For example, hybrid products such as variable universal life policies that carry LTC riders have been gaining popularity in recent years.

LEARNING OBJECTIVES The student will be able to: a. Identify activities of daily living that can trigger the need for long-term care. b. Develop an appropriate long-term care insurance plan based on needs, financial resources, policy coverage, and cost.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

In-class or online exercise designed to find the average cost of assisted living, residential health care, and Alzheimer’s care for three facilities in your local community. Calculate the present value (at projected date of retirement and projected date of entry) of the current cost for a 2-, 3-, and 10-year stay in an assisted living facility. Repeat for a stay in a health care

Students are asked to complete an exam with questions regarding coverage of Medicare, Medicaid, and Medicare supplement policies for a loss event.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating,

unit. Determine the Medicare reimbursement and relevant out-of-pocket cost for a 75-day skilled nursing care loss event.

Ask students to analyze a case study determining the out-of-pocket costs for a loss event. For example, assume a single woman in her 70s who suffered complications of a hip replacement and was in a nursing home for 18 months. Use the average cost in your local area.

Analyze the potential for each of the losses determined in the activities above (applying), and discuss in class or online whether a LTC policy will cover a specified event.

Students are asked to prepare a Schedule A given loss and insurance purchase events.

In-class or online discussion calculating the tax Ask students to determine benefits of deducting out-of-pocket costs for a the effect of purchasing loss event. private insurance (both long-term care and Medicare supplement policy) on an individual’s current and future cash flow.

organizing, and attributing Ask students to write a 300-word recommendation to buy or not buy insurance to cover a potential loss event. Specify the age, income, and marital status of the client, and provide information regarding other financial and non-financial resources available to cover long-term care needs. Creating: In an in-class or online discussion, visit the Given a case study of a Putting elements websites of Medicare, Medicaid, and the client entering a long-term together to form Veterans Administration to determine a client’s care facility, ask students to Evaluating: Making judgments based on criteria and standards through checking and critiquing

In-class activity: Calculate the effect of not purchasing external coverage on an estate and retirement cash flow if the uncovered loss event occurs.

a coherent or ability to qualify for coverage. functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

create a funding plan. Provide cash flow information for expenses prior to the need for longterm care and asset/liability data.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the financial exposure and the costs of providing formal long-term care over an estimated period of time. An adequate explanation should include listing and defining the activities of daily living. In addition, the planner can ascertain through public data or private commercial sources the current costs of care and calculate the present value of those costs at the point of retirement or estimated date of need. Competent: A competent personal financial planner can assist the client in determining how to fund potential long-term care needs. This includes explaining the options for funding, including public (Medicaid and Medicare), private (individual), and external (Medicare supplement insurance) programs and the impact the various funding options have on current income tax liability. If appropriate, the planner can search for, make selection recommendations, and acquire long-term care insurance on behalf of the client. Expert: An expert personal financial planner can translate the financial exposure and mitigation techniques to the impact on the client’s estate, tax, and retirement plans. The planner can also assist the client in applying for Medicaid and other public funding.

IN PRACTICE Dale and Jaquatta Dale and Jaquatta Summers are concerned with the possibility of devastating financial costs associated with long-term care. Both of them have a family history of longevity and worry what would happen to their assets in the event that one or both of them needed skilled care. Current costs for nursing and assisted living facilities in the region of the country where they live average about $6,000 per month. In order to mitigate this future risk, Dale and Jaquatta each purchase traditional long-term care policies through their financial planner. Each policy has a 120-day elimination period, after

which it will provide the insured with $300,000 of funds, up to $5,000 per month in benefits, up to a maximum of five years. If the policyholder does not require the entire $5,000 in a given month, the funds remain untouched for future use. For example, if Jaquatta only required $2,500 of reimbursement each month, the policy would last for 10 years. At their planner’s recommendation, the couple purchase inflation riders for the policies that will increase the value of the monthly benefit on a yearly basis based on the increase in the urban Consumer Price Index. While the policies may not cover the entire potential cost of future care, Dale and Jaquatta rest assured that a significant amount of the expenses will be covered.

Madeline Madeline Dew is a 62-year-old Air Force veteran in good health. She retired from the military five years ago after 30 years of service. Since that time, she has held a job as the director of a small non-profit organization in her community. She is concerned about the need for long-term care, as her mother has spent five years living at home with a good deal of assistance and the past year in an assisted living facility. Should Madeline need care, she would likely qualify for Veterans Administration (VA) benefits to pay for the cost. However, it may take a year or longer before she receives approval for services. During that time, she would have to pay the cost of care out of her current income or by liquidating assets on an as-needed basis. Her VA benefits would not be taxable.

Emma and Donald Emma and Donald Storm have been married for 60 years. Donald is suffering from Alzheimer’s disease and needs full-time care in an institutional setting. The Storms have only $60,000 in financial assets, although their home, valued at $180,000, has no mortgage. Their only income is from Social Security and amounts to $2,200 per month. Medicare will pay a good portion of 100 days of care for Donald. However, after that time, the Storms will have to apply for Medicaid. While Emma will be allowed to remain in the home, Medicaid will expect a portion of the $60,000 of financial assets to be applied to Donald’s care. In addition, a small portion of their monthly Social Security income will be applied to the cost of care before Medicaid benefits are applied to the remainder.

NOTES 1. MetLife Mature Market Institute, “Market Survey of Long-Term Care Costs,” November 2012. Retrieved from https://www.metlife.com/assets/cao/mmi/publications/studies/2012/studies/mmi-2012market-survey-long-term-care-costs.pdf. 2. U.S. Department of Health and Human Services, “The National Nursing Home Survey: 1999 Summary” (June 2002).

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 25 Annuities Andrew Head, MA, CFP® Western Kentucky University John Gilliam, PhD, CFP® Texas Tech University

CONNECTION DIAGRAM

While an annuity is a packaged product of an insurance company, it affects numerous areas of the financial planning process. Annuities of course connect with the risk management and insurance planning content areas in that they provide protection against longevity on their most basic levels. They are often used as investment and retirement income products either as a

replacement for or complement to traditional means of portfolio construction and management. Annuities come with unique tax advantages and complexities of which the financial planner must be aware. Finally, they may be used as an estate planning tool in certain circumstances, such as probate avoidance or legacy planning.

INTRODUCTION At its heart, the annuity contract is longevity insurance. In exchange for a premium or series of premiums, the annuitized contract provides an income to the purchaser for his or her life regardless of how long the person may live. The annuity contract is often used as a taxdeferred retirement savings strategy once other qualified options have been exhausted. Annuities provide investment structures that may be viable alternatives to portfolio strategies outside of an annuity contract. These alternatives may come with various company-backed guarantees of value or investment performance in addition to potential death benefits coupled with probate avoidance, which could be appealing to certain consumers. With that said, the method and calculation of growth in the contract and the taxation of distributions from the contract have unique complexities with which the financial planner must be familiar. Annuities are financial instruments primarily used for retirement planning that combine elements of insurance and investments into one contract. In its simplest sense, the annuity contract is the opposite of a life insurance contract; whereas a life insurance contract protects against the possibility of untimely death, the annuity is designed to protect the client from living too long (i.e., outliving one’s financial resources). The insurance component utilizes mortality data to guarantee a lifelong income stream to individuals, couples, or a group of individuals. It is the insurance component that makes annuities a unique financial instrument for retirement planning, as planners can establish a base of income for the client. They also provide the client with a tax-deferred method of accumulating additional funds when qualified plan contributions have been fully funded. Annuities are categorized in several different ways based on the frequency of contributions, the date distributions begin, and the investment options chosen. Due to the complexity, wide availability, and potential controversy of annuities, financial planners must be intimately knowledgeable about the various forms of annuity contracts.

FREQUENCY OF CONTRIBUTIONS Flexible-premium annuities are deferred annuities with flexible contributions that are made over a period of time prior to the distribution stage. These contributions can vary in their amount and frequency, both of which will have a correlation to the total accumulations in the contract. Single-premium annuities can be either immediate or deferred, allowing for current income or tax-deferred growth. These contracts are often used when a retirement plan lump-sum distribution occurs or when the client has accumulated a large sum of money that needs to be converted into an income stream.

DISTRIBUTION ALTERNATIVES Immediate annuities provide an income stream following the initial contribution made by the annuitant. These contracts are also known as single-premium immediate annuities (SPIAs), named for the single contribution and subsequent distributions. For monthly income, the initial distribution occurs at the end of the month following the single payment. Deferred annuities have two stages, an accumulation stage and a distribution stage. Contributions can be made throughout the accumulation stage or as a single premium. Earnings during the accumulation are tax deferred until constructively received during the distribution stage of the contract. It is important to note that during the past decade, variable annuity contracts have been offering “living benefit” riders that offer income options without annuitization. Various methods of income calculations are offered that have varying annual costs. One possible method might be an annual income after age 60 equal to 5 percent of the contract’s highest anniversary value or initial contribution amount, whichever is higher, regardless of the current market value of the subaccounts. These benefits require careful study and explanation to a client before selection due to their complexity.

DISTRIBUTION OPTIONS The distribution options available for annuities are similar to those of qualified pension plans. The options distribute the value of the annuity in various lifetime income options, distributions over a certain time period, or in a lump sum of cash. The lifetime income options include life only, life with a period certain, and life with a refund guarantee and a joint and survivor option. Period certain options make income payments for a predetermined time span such as 10 or 20 years.

INVESTMENT OPTIONS There are several different investment options for clients who want to put contributions into the annuity. These include a fixed interest option, a variable investment option, and an indexed option. Annuities that are immediate, deferred, flexible, or single contributions can include these investment options. Understanding the client’s risk tolerance and time horizon is important when selecting investment options. Fixed annuity contributions are invested in the insurance company’s general account, which usually consists of bonds, mortgages, and other conservative investments. These contracts declare a fixed rate of return for a stated period of time, and most have surrender charges for distributions prior to the end of the stated period. If there is a distribution prior to the stated period, some fixed annuities also include an adjustment based on the market value of the bonds in the portfolio. Surrender periods may last from 3 to 15 years or more. Many fixed annuity contracts offer a teaser rate during the initial year or years, after which the rate may be reduced

to some guaranteed minimum. Long-surrender contracts may pose serious challenges on this front, as a client may end up owning a contract with an interest rate significantly lower than prevailing rates and will not be able to move the contract without incurring steep surrender charges. Variable annuity contributions are placed in a separate insurance company account to protect the general account products from the potential impact of underlying investments. The contracts provide an option to invest in various stock, bond, real estate, and specialty subaccounts, as well as a fixed interest account. These subaccounts mirror mutual funds but differ in their distribution options as well as the fact that the variable annuity version of a mutual fund will typically have higher annual expenses than its non-annuity counterpart. They include tax deferral, and most contain a death benefit. Each contribution purchases a number of units that represent the underlying subaccount. Upon distributions, these units provide an income that fluctuates with the market. They can also be exchanged for a fixed distribution option. Indexed annuities are complex financial instruments that combine aspects of fixed and variable annuities. Like a fixed annuity, an indexed annuity provides a guaranteed minimum interest rate that is credited to the contract’s initial contribution, but this guarantee may not be credited to the entire amount. It is similar to a variable annuity because the rate credited to the contract is based on changes in an index such as the S&P 500, the Dow Jones Industrial Average, the Barclay’s Capital Aggregate Bond Index, or the Nasdaq-100 index. However, there are limits to how much the amount in these indexes can change and how they are calculated. One method for calculating this change is the point-to-point method, which measures the index change between two dates that, depending on the issue date of the policy, are usually a year apart. There are several averaging methods that use daily or monthly changes, averaged out over the year, to determine the crediting rate. After the rate has been determined, a participation rate or cap may be applied to the crediting rate. The crediting rate is multiplied by a participation rate, such as 75 percent or 100 percent, to determine the amount applied to the investment in the contract. Some contracts use a cap to limit the amount of growth in the contract to a stated percentage. There are several other charges that may be applied in place of, or combined with, the participation rate. In addition, indexed annuities impose surrender charges, which can be up to 15 to 20 percent in the first few years of the contract. These charges decline to zero over a period of time that can add up to 15 years or more.1 The client and financial planner should be aware that most insurers reserve the right to change their crediting rates during the life of the contract, leaving the client with a low rate of return while faced with high surrender charges should they wish to withdraw or transfer their money.

TAXATION OF ANNUITIES During Accumulation Internal Revenue Code (IRC) Section 72 provides for the tax-deferred accumulations in annuities until payments are constructively received during the contract’s distribution stage.

Distributions are subject to taxation on a last in, first out (LIFO) basis. This means that all of the contract’s growth is distributed and taxed first as ordinary income. In addition, there is a 10 percent penalty imposed on distributions made prior to age 59½.2 There are several exceptions that can avoid the 10 percent penalty. The 10 percent penalty tax does not apply to the following eight distributions:3 1. Distributions made on or after the date on which the annuitant turns 59½. 2. Distributions made on account of the annuitant’s death or disability. 3. Distributions that are part of a series of substantially equal periodic payments paid at least annually for the life, or life expectancy, of the annuitant, or for the joint lives, or joint life expectancies, of the annuitant and his or her beneficiary. Such payments, however, may be subject to recapture if the payment series is modified (for reasons other than death or disability) prior to the annuitant reaching age 59½ or within five years of the first payment, even if the annuitant has reached age 59½. 4. Distributions from immediate annuity contracts, defined as contracts purchased with a single premium or annuity consideration, with an annuity starting date of no later than one year from the purchase date that provides a series of substantially equal periodic payments made at least annually during the annuity period [IRC Sec. 72(u)(4)]. 5. The distribution can be used to invest in contracts made before August 14, 1982, including earnings on pre-August 14, 1982 investments. To determine the purchase date of an annuity acquired through a 1035 exchange, the purchase date of the original annuity, not the new annuity, is used (Rev. Rul. 92-95). 6. Distributions made from a qualified pension, profit sharing, or stock bonus plan; from an annuity purchased by such a plan; or from a Section 403(b) tax-sheltered annuity or from an IRA. Distributions from these plans are subject to their own premature distribution limitations and penalties [IRC Sec. 72(t)]. 7. Distributions made from an annuity purchased by an employer at the termination of a qualified plan as long as the employer holds the contract until the employee’s separation from service. 8. Distributions from an annuity purchased because of a personal injury settlement (a qualified funding asset).

During Distribution If the contract is annuitized, the taxation of the payments is based on the chosen distribution option and includes a portion of the basis in the contract, as well as the tax-deferred growth. This is referred to as the exclusion ratio. It differs for fixed and variable distributions. The formula for the fixed option is: investment in the contract/expected return = exclusion ratio.4 The exclusion ratio is applied to the fixed monthly payment to determine how much of the

payment will be excluded from taxation. The expected return for life income options is based on the mortality tables used by the IRS for individuals (IRS Table V) or joint life and last survivor expectancy (IRS Table II or III). The exclusion ratio for variable annuities differs because the estimated distribution is uncertain. The formula for these annuities is: investment in the contract/annuitant’s life = exclusion ratio.5

FEES AND CHARGES IN ANNUITIES Annuities can have many different fees and charges that should be reviewed by the planner and disclosed to the client. The first of these is a surrender charge, which can range from a few years to as many as 10 to 15 years, and, in some cases, longer. The rate charged during these years can decrease with time or level and drop off at the end of the surrender period. The charges can range from 1 percent to 20 percent based on the type of annuity purchased. Annuities with longer surrender periods and higher charges often include an interest rate bonus on the contributions made to the contract. Variable annuities include mortality and expense charges, administrative fees, and underlying fund expenses charged by the investment manager. There are also charges for optional benefits that include guaranteed income options, long-term care benefits, and increases in the contract’s death benefit. It is not uncommon for the various fees and charges in a variable annuity to exceed 3 percent of contract value per year, requiring significant cost-benefit analysis on the part of the financial planner. No-load annuities typically do not have surrender charges, and their fees are less than those of other annuities. As with all recommendations made by planners, due diligence requires a thorough investigation of each aspect of the product.

PENSION PROTECTION ACT OF 2006 The Pension Protection Act of 2006 established guidelines that allow distributions from life insurance and annuities to fund purchasing long-term care insurance. The act also changed the tax rules on hybrid life and annuity products that offer long-term care provisions, allowing the distributions from these products to be income tax free when used for qualified long-term care expenses.

LEARNING OBJECTIVES The student will be able to: a. Explain the characteristics of an annuity including contribution and distribution options and differentiating between immediate and deferred annuities. Students should be able to differentiate between single-premium and flexible-premium annuities and be able to accurately describe the situations that might call for the use of one or the other. The knowledge must go hand in hand with the accurate depiction of the types of client situations that would call for the use of immediate annuity payouts or those that

would call for the deferral of income until some later date. This knowledge should also include a demonstrable grasp of the differences in payout options from annuities such as straight life, life with period certain, joint and survivor payouts, as well as living benefit rider options available in many variable annuities. Students should be able to accurately identify client situations where the use of an annuity would be appropriate, as well as when it is not appropriate. b. Compare and contrast annuities (fixed and variable) with other investment alternatives, including an analysis of costs, contract terms, and taxation. Students should be able to describe the differentiating features of the fixed, variable, and indexed annuity. They should be able to discuss the technical attributes, including concepts such as mortality and expense (M&E) ratios, subaccount charges, income-crediting methods, surrender charges, and the tax implications of contributions as well as distributions. Students should also be able to plainly communicate these features to a client who may not have a firm grasp of financial planning concepts. Students should be able to accurately describe alternatives to each of the annuity types as well as the appropriate place of each in the financial plan.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through

Class Activity Discuss the types of annuities and the appropriate application of each based on the client’s goals, time horizon, and risk tolerance. Break students into groups and assign each group a different case scenario based on client’s time horizon, risk tolerance, and life expectancy. Review the individual components of each type of annuity. Include: underlying investments, insurance company’s general portfolio and separate accounts performance, fees, all charges, earning caps, participation limitations,

Student Assessment Avenue Using vignettes, ask students to complete a written assignment that recommends an annuity based on the client’s situation, goals, and risk tolerance. This should include justification for the recommendation.

Using vignettes, ask students to complete written projects that include an analysis of the recommended annuity and examinations of the underlying investments, the insurance company’s general portfolio and separate accounts performance, fees, all charges, earning caps, participation limitations, and distribution options. Additionally, examine the use of optional benefits and the

differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

optional benefits, and distribution options.

justification of their cost to accomplish the client’s goals.

Using a client’s goals and risk tolerance, discuss the annuity that would be the most appropriate fit. Review alternative types of annuities that might also be suitable.

Break students into groups to debate the suitability of each type of annuity for the client’s given situation. Follow with a roleplaying activity in which each group makes a presentation to the client (instructor) using different annuities.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Discuss the interaction of annuities with other retirement plans.

Based on the student’s recommendations, show how the annuity supplements the total retirement plan with a focus on distribution option and taxation.

Review the distribution options and how they can be used to complement/ maximize other retirement plans. Give considerations to the tax implication of the distributions.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner understands the various types of annuities and how they fit into a client’s retirement plan given the client’s goals, risk tolerance, and time horizon. Competent: In addition to the aforementioned, a competent personal financial planner knows the tax implications of annuities, the various distribution options, the optional benefits available, and how they can be used to accomplish the client’s goals. Expert: In addition to the aforementioned, an expert personal financial planner will understand how to use annuities to complement or leverage other retirement plans, including Social Security. An expert personal financial planner understands the potential estate tax implications if annuity distributions exist after the annuitant dies.

IN PRACTICE Ann Ann (42) is a partner in an accounting firm. She is making maximum contributions to her

qualified retirement plan and would like to increase her retirement savings on a tax-deferred basis. She has come to Sabina, a financial planner, seeking advice as to whether an annuity would be an appropriate investment for her. Having watched the fluctuations in the market the past 10 years, Ann is very risk-averse. She has expressed that even small movements in the market have made her sick with worry in the past when it comes to her retirement savings through her employer. With any new money she plans to save, she “just cannot stand to watch it fluctuate.” She feels like she cannot take a great deal of risk since she is single and will rely on her income alone in retirement. While she plans to retire at normal retirement age, she does not plan to stop working. Over the past 10 years, she has volunteered one day per week as a consultant for immigrants who are starting new businesses, and she would like to expand her time doing this during retirement. Her family has a history of longevity; her great-grandparents are still living at 102 and lead an active lifestyle. Sabina feels that in light of all of the information that Ann has disclosed, the use of a fixed or indexed annuity may be appropriate. She explains that while there is certainly less volatility with one of these products, they carry other risks that Ann must be aware of. First, she must understand that these products are not designed to deliver market-like returns, or anywhere near them in fact. It is entirely possible, Sabina explains, that Ann’s returns may lag inflation at times. There is an issue of liquidity risk to some degree as the contracts severely limit penaltyfree withdrawals. Ann listens carefully and tells Sabina that she appreciates the frankness. Ann goes on to explain that in all honesty, she feels that many of the risks associated with the annuities that Sabina has described are quite similar to those associated with certificates of deposit. She knows that annuities do not carry FDIC insurance of any sort, but due to the slightly higher expected returns and financial stability of the companies being presented, she would feel comfortable with these alternatives.

NOTES 1. Securities and Exchange Commission, 17 CFR Parts 230 and 240 [Release Nos. 33-8996, 34-59221; File No. S7-14-08] RIN 3235-AK16. 2. IRC Sec. 72(q). 3. IRC Sec. 72(q)(2). 4. IRC Sec. 72(b)(1). 5. Reg. Sec. 1.72-2(b)(3).

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 26 Life Insurance (Individual) Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Variable life insurance policies have investment features that require investment management of internal subaccounts, and retirement plans may invest in life insurance policies (investment planning). There are many tax considerations to be managed with life insurance policies, including employer deductibility of premiums and the tax treatment of loans from and surrenders of cash-value life policies (tax planning). Life insurance policies may be used as investments within retirement plans and for plan completion purposes (retirement saving and

income planning). Life insurance is a source of estate liquidity and can be used to meet the needs of financial dependents in case of a wage earner’s premature death (estate planning).

INTRODUCTION Financial planning strategies for attaining future goals often vary depending on a client’s ability to save and invest from earned income. If those goals encompass financial dependents, the possibility of a client’s income ending as a consequence of premature death becomes a significant risk exposure. One of the most important methods for dealing with this exposure is to transfer the risk to a third party through the purchase of a life insurance policy. Therefore, financial planners must be capable of identifying the presence of this risk exposure, measuring its magnitude, and recommending an appropriate type of life insurance policy based on the client’s overall financial and family circumstances. Another circumstance where the purchase of life insurance may be useful is the need for funds from which to pay estate taxes, also referred to as a need for estate liquidity. This is relevant when a significant portion of the client’s estate is composed of illiquid assets that would be difficult to sell on short notice or that the client wishes to pass intact to estate beneficiaries (e.g., a family business). In the two foregoing examples, the type of insurance policy indicated will often be very different. For example, the need to protect earnings is usually viewed as temporary insofar as financial dependents are expected to eventually become independent or future goals are expected to eventually be funded from savings, at which time the risk exposure will cease to exist. If the need is temporary, the use of term insurance may be indicated. Alternatively, the need for estate liquidity will generally be viewed as a permanent need and will therefore most often be funded with permanent insurance, such as whole life insurance, universal life insurance, or a second-to-die policy. As always, the financial planner’s advice must be contextual and integrated with all other planning considerations, and a thorough understanding of the available types of life insurance and relevant underwriting considerations is essential.

LEARNING OBJECTIVES The student will be able to: a. Explain the underwriting factors commonly used in the life underwriting process. In order to competently guide clients in the selection of appropriate life insurance, a financial planner must understand the factors involved in the life underwriting process. For example, the cost and availability of life insurance may be adversely impacted by lifestyle choices over which the client may exert control (e.g., smoking, obesity, or avocational risks such as skydiving). Likewise, a client who may be difficult to insure individually may qualify for coverage under a second-to-die policy. b. Differentiate between term, whole life, variable, universal, and (VUL) policies and

select the most appropriate type of coverage to match a client’s specific circumstances. As noted in the introductory section, the type of life insurance policy that will be most appropriate for meeting a given risk exposure will depend on a client’s overall goals and circumstances. Thus, planners must have a thorough understanding of the different types of life insurance policies that are available in order to appropriately match recommendations to circumstances. c. Calculate a client’s insurance needs using alternative approaches, including the capital needs, human life value, capital retention, income retention, and income multiplier methods. Different methods for calculating the client’s life insurance needs will be called for based on a family’s overall circumstances and goals, and may include such other factors as these five: 1. The certainty with which future needs can be quantified. 2. The presence of other assets and sources of income. 3. Length of income replacement or dependency period for surviving family members. 4. Debt repayment objectives. 5. Legacy desires. d. Recommend whether a policy should be replaced based on quantitative and qualitative factors. In order to competently advise clients with respect to policy replacement, the financial planner must understand and account for various factors, including these eight:1 1. The client’s health and insurability. 2. Surrender charges. 3. Cost of acquiring a new policy. 4. Cost of continuing the existing policy. 5. Tax implications of replacement. 6. Incontestability clause. 7. Suicide clause. 8. Potential compensation of person making the recommendation. With respect to comparing the cost of current and proposed replacement coverage, the financial planner should be capable of employing the following nine comparison methods:2 1. Baldwin method. 2. Belth methods.

3. Cash accumulation method. 4. Equal outlay method. 5. Interest-adjusted cost method. 6. Interest-adjusted net payment cost index. 7. Interest-adjusted net surrender cost index. 8. Linton yield method. 9. Traditional net cost method. e. Describe common life insurance termination options. While the two most common reasons for a life insurance contract to end are that it lapses from non-payment of premiums or that the death benefit is paid out due to the death of the insured, other options exist and will be employed based on the individual needs and circumstances of the client. For example, a cash-value life insurance policy may be surrendered for the net cash value or, alternatively, the cash value may be transferred to an annuity via a Section 1035 exchange. Each of these alternatives has income or estate tax implications, so the financial planner must have a thorough understanding of each in order to competently advise the client. f. Recommend life insurance purchase and benefits distribution options based upon needs, financial resources, and cost. There are many options for structuring the purchase of life insurance, and the choice appropriate for each client will depend on the client’s overall goals and circumstances. Different purchase options include, but are not limited to, these five:3 1. Limited-pay whole life insurance. 2. Ordinary level-premium whole life insurance. 3. Single-premium life insurance. 4. Term insurance, including level-premium term. 5. Universal life insurance, which has many premium options, including guideline premium, minimum funding, and maximum single premium. Distribution options, also known as settlement options, are many, and the appropriate choice will depend on client needs and circumstances. The primary settlement options include these five:4 1. Cash. 2. Annuity: interest option. 3. Annuity: fixed-period option. 4. Annuity: fixed-amount option. 5. Annuity: life income option.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Instructor lecture on the nature of the risks life insurance is meant to address and the circumstances under which the use of life insurance is appropriate. The lecture would cover the concepts of insurable need (are there financial dependents or an estate liquidity issue?), insurable interest (does the beneficiary suffer an economic loss at the death of the insured?), and approaches to measuring the potential loss, including net present value analysis.

Students are given a quiz that requires them to answer questions related to identifying the presence of a risk exposure, the presence of an insurable interest, and whether life insurance is appropriate. Example: Mary is single and works in a law office; she lives alone and has no children. Mary has a $60,000 student loan that her parents co-signed. a. Mary has no need for life insurance. b. Mary needs life insurance. c. Mary’s parents have an insurable interest in her life. d. a and c are true. e. b and c are true.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating:

Instructor lecture on the different types of life insurance policies, including how they are structured, key differences, and situations in which each type might be most appropriate. The instructor then describes a number of client scenarios and in each case asks students to suggest the most appropriate type of life insurance policy and explain why.

Students are provided with a set of

f. None of the above are true. Students are provided with a comparison chart that has columns listing the primary types of individual life insurance policies (term, traditional whole life, variable life, universal life, variable universal life, second-to-die) and rows listing the key elements of life insurance policies (premiums, cash value, investment options, dividends, loan provisions, death benefits, other benefits) and are asked to fill in each cell, making sure to highlight the differences, where they exist.

Students are provided with a second

Making judgments based on criteria and standards through checking and critiquing Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

case facts and through an interactive, student-led discussion, the group answers a series of questions related to the need for life insurance; most appropriate type of coverage given client needs, goals, and circumstances; and availability based on client health and other underwriting considerations. The instructor engages the students in a role-play exercise, posing as a client and allowing the students to question her about her life circumstances and goals, with special reference to uncovering facts and circumstances relevant to the life insurance need.

set of case facts and asked to complete the same exercise individually.

Based on the classroom role-play exercise, students prepare a plan for meeting the client’s individual life insurance needs, taking into account household financial resources, income and other financial needs, and estate considerations.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify when the risk of premature death is present, measure its magnitude, and determine whether it is best met with the use of life insurance (i.e., conduct a life insurance needs analysis). An entry-level planner can also name the different types of life insurance and explain the key differences between them. Competent: A competent personal financial planner will be capable of making recommendations that take into account the income and estate tax implications of purchasing and owning different types of life insurance, as well as the techniques for minimizing such tax impact. Expert: An expert personal financial planner can make insurance recommendations that take into account all of the foregoing issues and implications, but also the personal preferences, values, and risk tolerance of the client. An expert personal financial planner can make recommendations that weigh the relative risks, estate structure, and other contingencies as part

of a comprehensive, integrated assessment of the client’s needs, goals, and circumstances.

IN PRACTICE Miriam Miriam de Souza has scheduled an appointment with her financial planner, Trevor Martin, in order to discuss whether she needs additional life insurance. Her brother recently became licensed as an insurance agent and has suggested that she should buy a life insurance policy specifically intended to pay off her mortgage in the event of her death. Her brother further recommended that the policy should take the form of universal life insurance since such policies are “a good investment.” Trevor begins by reminding Miriam that, while she does indeed have a need for insurance to replace earnings upon which her two young daughters depend, this is a temporary need and is most appropriately met with temporary coverage in the form of term life insurance. Since Miriam is on track to accumulate enough retirement and other savings to meet her daughters’ long-term needs within the next 10 years, there is little need for life insurance coverage beyond that point. Trevor also notes that Miriam’s estate plan names her sister as guardian for her daughters, with the expectation that the daughters would live with Miriam’s sister in another part of the state. As a consequence, the estate plan directs that Miriam’s house would be sold and the proceeds added to the trust for her daughters. Thus, Trevor concludes, it is not necessary to acquire a life insurance policy specifically to pay off the home mortgage and it is also not appropriate to own permanent life insurance like universal life based on Miriam’s overall needs and circumstances.

Georgette and Willem Georgette and Willem Straud have come to their financial planner, Henrietta Bourdo, to discuss several new developments that may adversely impact their estate plan. The Strauds own a paper supply business, Ponderosa Paper, which is their primary source of income and single largest asset. Willem founded Ponderosa 40 years ago and he continues to manage the company on a day-to-day basis. A large competitor recently approached Willem with an offer to buy Ponderosa and, since Georgette and Willem have been talking about retiring in a few years, it seemed like this might provide the additional capital they would need. However, their eldest daughter Felicia, who has worked as a manager at Ponderosa for the past 10 years, has for the first time expressed an interest in succeeding her father as the head of the company. Since Georgette and Willem could continue to receive distributions from the company to meet their spending needs in retirement, allowing Felicia to run the company with the intention that she would eventually inherit it from her parents is an acceptable, even desirable, solution. The potential difficulty lies in the fact that Ponderosa is the Strauds’ single largest asset and its value greatly exceeds their combined estate tax credit. This means that Felicia might well be forced to sell the company upon her parents’ deaths in order to pay the estate taxes that would be owed. When Henrietta observes that the obvious solution would be to obtain life insurance, Willem reminds her that when he sought a small life insurance policy five years previously as

a legacy for his alma mater, he was told that he was uninsurable for medical reasons. Henrietta observes that Willem had at that time been applying for an individual life insurance policy and that the most appropriate policy to meet the current need is a second-to-die policy, which is much more likely to be issued jointly on Willem and Georgette. Henrietta also suggests that the Strauds should establish an irrevocable life insurance trust (ILIT) to own the second-to-die policy in order to avoid having the policy also included in their estate.

NOTES 1. George E. Rejda, Principles of Risk Management and Insurance, 9th ed., Addison-Wesley Series in Finance (Boston: Pearson Education, 2005). 2. Stephen R. Leimberg and Robert J. Doyle, Jr., Tools and Techniques of Life Insurance Planning, 3rd ed. (Cincinnati, OH: National Underwriter Company, 2004). 3. Ibid. 4. Rejda, Principles of Risk Management and Insurance. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 27 Business Uses of Insurance L. Ann Coulson, PhD, CFP® Kansas State University John Gilliam, PhD, CFP® Texas Tech University

CONNECTIONS DIAGRAM

Insurance is protection. Business use of life insurance is a layer of protection that can provide for those left behind following the death of a business owner or a key employee. Business uses of life insurance relate to estate planning as the insurance proceeds may be used to buy the business from heirs and thus provide estate liquidity as well as retirement planning for key

employees through the use of non-qualified deferred compensation.

INTRODUCTION Ownership entails a variety of forms across the 5.75 million small businesses in the United States, and for each type, the death of an owner creates unique concerns.1 For example, sole proprietors face particular challenges when no family members are interested in taking over the business. In the absence of planning, the business may be sold or even forced to liquidate, which may not provide desirable results for the survivors of the deceased. The death of a sole corporate owner presents similar challenges, even though the corporation does not dissolve. Understanding the unique planning considerations for the business owners and key executives who operate these organizations is paramount in comprehensive financial planning. This chapter focuses on transferring business interests upon the death of a business owner, protecting the company from financial distress due to the sudden death of a key employee, and providing non-qualified benefits to owners and select employees.

LEARNING OBJECTIVES The student will be able to: a. Recognize the complications of closely owned and/or family-owned businesses. A business grown over the owner’s lifetime presents unique challenges at the time of the owner’s death. A plan for the orderly transfer of business interests through the use of life insurance can mitigate the financial challenges. Without this type of planning, partners or shareholders and/or family members of the deceased owner can be left without the resources to continue the business. b. Distinguish the difference between the three types of buy/sell agreements and their appropriate uses. The planning process varies according to the unique challenges of each form of business ownership, as do the tax ramifications for the surviving partners or shareholders. Whether for sole proprietors, partnerships, or closely held corporate entities, buy/sell agreements are recommended to facilitate an orderly business transfer. In general, the three most commonly used buy/sell options are: 1. The Cross Purchase Agreement. The surviving business owner(s) are obligated to purchase the business interest from the decedent’s estate. Each business partner must be the owner and beneficiary of a life insurance policy on the lives of the other business owners. After the death of a business owner, the life insurance would allow the purchase of the deceased owner’s business share. The surviving owners get a basis in the purchased business equal to the purchase price. Disadvantages exist when there are multiple owners, thus requiring each business owner to own multiple life insurance policies or when there is age or health disparity among the owners which causes more

expensive premiums for policies on older or less healthy owners. 2. The Entity Purchase Agreement. Although entity purchase agreements lack the tax advantage of the increased basis available in a cross purchase plan, they do have other advantages. With the entity buy/sell (also called stock redemption buy/sell), the business purchases a life insurance policy on the life of each owner in the amount representing each proportional share; thus, the entity is the owner and beneficiary of one life insurance policy on each business owner. When the entity purchases the decedent’s interest, each surviving owner’s interest increases proportionately. For example, if there are five owners, each owning 20 percent, and one of them dies, the 20 percent interest of the decedent is distributed to the remaining four owners, increasing their interest to 25 percent. The agreement benefits businesses that have a large number of owners by reducing the number of life insurance policies that must be purchased. This arrangement also resolves the issue of disparity in age and/or health, but it does so by shifting the burden of cost to those who have a greater percentage of ownership. C corporations using this alternative should consult their tax professionals, as this arrangement can result in adverse taxation under the family attribution rules, and the life insurance proceeds may trigger the alternative minimum tax. 3. The Wait and See Agreement. The wait and see agreement contains elements of both the cross purchase and entity purchase agreements. The wait-and-see agreement states that the business will have the first right to purchase the decedent’s ownership interest. If the entity declines to purchase the decedent’s interest, the surviving owners are given the option to purchase the interest from the estate. Finally, if any business interest remains, the business is obligated to purchase the balance. This method allows owners to choose the option that is best suited for them at the time of death, whether it be to purchase the interest from the estate or to contribute additional capital to the business in order to fund the entity purchase plan. Whatever the case, the life insurance funding is typically structured like a cross purchase arrangement with each business owner being the owner and beneficiary of policies on the lives of the other business owners. Structuring the life insurance in this manner allows the business owners to lend the death proceeds to the business in the event it is determined that the business should purchase some portion of the deceased owner’s business interest. c. Explain the potential financial risk to the company due to the loss of a key employee. Successful businesses seek to attract and retain key employees. The death of a key employee poses an inherent risk to the profitability and stability of the business. The need to suddenly replace a key employee can result in decreased revenues in addition to increased expenditures needed to attract and train a replacement. Additionally, there may be disruptions in business relationships that unsettle investors. Protecting the business through the purchase of life insurance on key employees is an attractive solution due to the fact that the occurrence that causes the problem also provides the solution. The IRS discusses key employee valuation in its Valuation Training for Appeals Officers course book. In summarizing the method suggested from the course book, Pratt (2009)

states that “One way to quantify the key person discount is by calculating the difference between the present value of the expected cash flows with and without the key person, as opposed to taking a percentage discount from enterprise value.”2 Other methods used by industry include the multiple of earnings method, which is based on five to seven times the key person’s income; the capitalization method, which discounts the revenues generated by the key person; and the replacement method, which considers the cost to attract and train the new employee, as well as the loss in revenue until the new employee is functioning at full capacity. d. Identify the opportunity to provide non-qualified benefits for business owners and key executives. 1. Section 162 Executive Bonus Plan. The executive bonus plan is a way that companies can provide tax-deductible funding for key executives to purchase life insurance with little or no out-of-pocket expense. This benefit can be made available to select employees and does not require IRS approval. There are several attractive features about this plan for both the company and the executive: The plan is completely portable and owned by the employee; the company is able to choose who receives these plans and can terminate the plan at any time; and premium payments are tax deductible by the company as long as the total compensation for the employee does not exceed the Section 162(m) limitations. The employee is required to include the premiums paid for the life insurance as taxable income. In order to limit the executive’s outlay, the company can bonus an amount equal to the tax due by the executive. However, this bonus must also be included as ordinary income. In cases where the company does not want the executive to incur any out-of-pocket expense, a double bonus arrangement can be established whereby the company pays the premium and all taxes due by the employee. 2. Non-Qualified Deferred Compensation. A non-qualified deferred compensation plan allows a key executive to voluntarily defer compensation from the year in which it was earned to some future point. Generally, these plans supplement a corporate qualified retirement plan for highly compensated employees by allowing them to more fully fund their retirement beyond the limits of Section 415. These plans are legally binding written agreements between the corporation and the executive that defer a specified amount of income until the time or event specified by the contract. The agreement also includes the requirements that the executive must meet in order to receive the defined amount of compensation from the corporation. Historically, non-qualified deferred compensation arrangements were easy to establish and administer, but with the enactment of Internal Revenue Code Section 409A these arrangements have become more complex to establish and administer. In addition, Section 409A provides significant penalties for the failure to comply with its requirements.

IN CLASS

Business Transfer and Key Person Protection Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Business Transfer

Business Transfer

Discuss the different forms of business ownership (sole proprietor, partnership, sole corporate owner, corporations) and the unique planning considerations for each. Introduce the three types of buy/sell agreements.

Break students into groups based on the different forms of ownership. Assess students’ knowledge by asking them to list the potential problems and solutions in business transfer. Key Person Using vignettes, ask students to select a key employee and discuss the potential business risk associated with the sudden loss of the chosen individual.

Key Person Discuss financial risk associated with the loss and replacement of a key person. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Business Transfer

Business Transfer

Identify the most appropriate type of buy/sell agreement based on facts presented in vignettes for various forms of business ownership.

Break students into groups that are based on separate forms of ownership; assign individual vignettes (sole proprietor or corporate owner, partnership, corporation) to each group and ask them to analyze the case facts and develop recommendations for the business and family. Ask students to present the pros and cons of their recommendations to the rest of the class. Follow Explore the unique problems for each form presentations by a discussion of similarities and unique planning obstacles for each type of of business (i.e., marketability for sole business ownership. proprietors, inactive Key Person heirs in a corporation, Use vignettes to identify a key person, and partnership dissolution employ several methods to calculate valuation. or reorganization if there is not a buy/sell agreement prior to death, etc.).

Key Person Discuss the various methods of key person valuation, including the IRS recommended method, multiple earns, capitalization, replacement, and discounted revenue methods. Evaluating: Making judgments based on criteria and standards through checking and critiquing

Business Transfer

Business Transfer

Discuss methods for funding a buy/sell agreement. Consider types of life insurance: their cost, ownership, and tax implications. Discuss the implications of the agreement on family, estate planning ramifications, and surviving owner(s).

Break the students into groups; each group of students should discuss their recommendations for funding the buy/sell agreement, including the cost, burden of payment, and implications for all parties involved. Key Person Students should discuss the various types of life insurance that might be appropriate for a given vignette, then select the most relevant type. Discuss the ownership arrangements and requirements for business- owned life insurance.

Key Person Discuss the use of life insurance to solve the financial problem created by the loss of a key person. Also discuss the ownership arrangements and requirements for business-owned life insurance.

Creating: Putting Business Business Transfer/Key Person elements together Transfer/Key Person Based on the classroom interviews with the to form a coherent Using the various client, have students prepare a presentation of

or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

forms of ownership their recommendations; students should present included in the this to the client (instructor). Afterward, engage vignettes, design a all students in class discussion of the activity. role-playing activity in which the instructor acts as a client. In each case, ask the students to interview the client about the business and family situation/feelings.

Non-Qualified Benefits Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Discuss problems in providing additional benefits for key executives and owners on a selective basis.

Ask students to list the issues in providing benefits to key executives and owners.

Introduce the use of executive bonus plans, non-qualified deferred compensation, and split-dollar plans as methods for providing additional benefit with little or no cost to the key executive/owner(s).

Also have students list the pros and cons of the business owner versus key employee when selective benefits are provided.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria

Identify the most appropriate type of benefit based on the objectives of the owner and key executive. Discuss the ownership of the life insurance contract and the ramifications on the business owner or executive.

Break students into groups that are based on key employees and business owners. Using vignettes (executive bonus and nonqualified deferred compensation), discuss the most desired benefit from the key executive’s and owner’s perspectives. Debate the ownership of the life insurance issue and the ramifications for the business owner and key executive.

Determine amount of premium expenditure by the business-based amount of benefit and underwriting

Ask students to design additional benefits for the key employee and owner. Students should list type of

and standards through checking and critiquing Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

considerations of insured. Review the tax ramifications and obligations of the business owner and key executive. Design a role-playing activity using vignettes (executive bonus and nonqualified deferred compensation) in which the instructor acts as either the key executive or the owner. Using the various forms of ownership, discuss the element of control by the executive and/or owner included in the vignettes. In each case, ask the students to interview the client to determine their perception of the benefit provided.

benefit and the obligations for both parties (taxes, cost, control, etc.). Based on the classroom interviews with the client, have students prepare a presentation of their recommendations; students should present this to the client (instructor). Afterward, engage all students in class discussion examining the advantages and disadvantages for both the owner and the key employee.

PROFESSIONAL PRACTICE CAPABILITIES Business Transfer Entry-Level: An entry-level personal financial planner will be able to recognize the need for business transfer planning for business owners who have partners, family members, or shareholders, and identify the potential purchasers of the business interest. When appropriate, the planner will be able to address the unique needs of each type of ownership, including sole proprietor, partnerships, and corporations, by selecting either a cross purchase, entity purchase, or a wait and see buy/sell agreement. Competent: In addition to the aforementioned, a competent personal financial planner will understand the income and estate ramifications for the decedent’s family and the surviving owners. A competent planner will also recognize the different methods for funding the agreement. When life insurance is used, the planner will be able to recommend the appropriate type of life insurance based on the circumstances of the owner(s) and will understand how to meet the necessary requirements if the business is the owner of the life insurance. Expert: In addition to the aforementioned, an expert personal financial planner will be able to make recommendations that consider the interaction between the buy/sell agreement and its ramifications on estate planning considerations for the owner, the family, and the surviving owner(s). An expert planner will understand the possible complex family circumstance involving estate equalization and family members’ continued involvement in the business for both the decedent and the surviving owner(s). Finally, an expert personal financial planner will possess the communication skills to negotiate a fair and reasonable agreement among all parties involved.

Non-Qualified Benefits

Entry-Level: The entry-level planner will be able to recognize the need for additional benefits for key executives and owners. The planner will understand the basic concept of executive bonus and non-qualified deferred compensation as additional benefits. When appropriate, the planner will utilize the resources of an individual who specializes in executive compensation to learn the details of setting up a plan. Competent: In addition to the aforementioned, a competent planner will know how to set up these plans, refer the client to an attorney to draft documents for the plan, understand the ownership issues of the life insurance, and understand the income tax ramifications for the business owner and/or key executive. The competent planner will be able to recommend the appropriate type of life insurance based on the circumstances of the key executive/owner(s) and will be able to implement the necessary requirements if the business is the owner of the life insurance. Expert: In addition to the aforementioned, the expert planner will also be able to make recommendations that consider the interaction between the additional benefits and other benefits provided by the business and its potential ramifications on financial and estate planning considerations for the key executive or owner. Finally, the expert planner will possess the communication skills to negotiate a fair and reasonable agreement to accomplish the goals of both the key executive and the business owner.

IN PRACTICE Zhang Wei and Li Yin Zhang Wei and his future wife Lì Yin came to the United States as college students; Zhang Wei studied electrical engineering and Lì Yin, a brilliant concert pianist, enrolled in a music conservatory. Just after completing their undergraduate degrees, they decided to get married and go on to graduate school. After graduate school, Zhang Wei worked for Electronics Plus as a project manager in its utility services division. He and Lì Yin had a son, Zhang Jun, and a daughter, Zhang Mei. After six years with Electronics Plus, Zhang Wei developed an idea for a utility system controller and decided to leave the company to establish this new system. The next year, he obtained a patent for his controller and opened his company, AirStar, Inc., in Chicago. As a gift, his family provided him with the initial capital to open the business. AirStar took off, and Zhang Wei decided to hire Sylvia Sanchez, CPA, as his chief financial officer (CFO) and Richard Brighton as his chief marketing officer (CMO) to develop a sales team. AirStar has grown significantly since its beginning and the company is now valued at $11,500,000. Zhang Wei (48) is concerned that if he were to die, the value of the business would drop significantly. He has become very close friends with Sylvia and Richard and would like to approach them about buying his company; however, he feels conflicted because he hopes that his daughter Zhang Mei will join him in the business. Zhang Mei, like her father, decided to pursue engineering and is about to finish her undergraduate degree. She hopes to attend graduate school. His son Zhang Jun has just earned his PhD in math and will start his

academic career as a professor. As a financial planner, you have been asked to suggest possible alternatives for the business transfer that will be fair to Sylvia and Richard, provide for Lì Yin, and accomplish estate equalization between the children after Zhang Wei and Lì Yin’s deaths.

Rafael and Angela Rafael and Angela Perez have been close friends with Enrique and Kristina Jimenez since they all attended Hidalgo High School together. For many generations, their families had been involved in the agricultural industry. After high school, Rafael and Angela went to college, where Rafael earned a business marketing degree and Angela an accounting degree. Enrique and Kristina married after high school and immediately started a family. Enrique took a job with a local air conditioning contractor, where he was quickly promoted to manager of the commercial division. Seeing the boom in fruits and vegetables imports coming across the border from Mexico, the Perez and Jimenez families proposed a partnership between them that would combine their collective talents in opening a cold storage warehouse in Mission, TX. Both families backed the venture, and a Small Business Administration (SBA) loan was secured. As soon as the warehouse was built, business started rolling in and some 3.8 billion pounds of produce moved across the Texas border. As the business grew and the loan was paid off, their families grew as well. Rafael and Angela (now 42) have three children, Rafael Jr. (18), Benita (16), and Lora (12). Rafael hopes that his son will decide to follow in his footsteps. Enrique and Kristina (42) have two children, Jon (23) and Lela (18). Jon is now in his third year of law school, and Lela is starting college next year and still unsure of her degree plans. As both families’ financial planner, you want to make sure the generations of goodwill between these families continue, which is why you have scheduled a meeting to discuss business succession and key person insurance.

Dan, Cindy, and Sean Dan Watanabe (32), Cindy Smith (34), and Sean O’Brien (35) were great friends in graduate school, where they studied wind science and engineering. While there, they attended the classes of Vinati Chandra, PhD (60), who quickly became their favorite professor. They each found jobs in the alternative energy industry after graduation. After several years in the workforce, they returned to their alma mater for a reunion. It was during a conversation about what they had learned from Dr. Chandra that they decided to ask her to join them in starting a new company in southern California called Renewable Energy Resources (RER), Inc. Dr. Chandra was ready for retirement from academia and thought that this new challenge would lead the way in the next chapter of her life. Together, the four of them were able to contribute $50,000 each to the formation of RER, Inc. With the high cost of fossil fuel, clean air regulations, and the contacts they had retained from

their former jobs, RER enjoyed an explosive start. They knew they were on the ground floor of an industry that would only expand as they grew older. As the company developed, they hired four office staff and six other engineers. The owners understood that as business increased, they would have to expand even further. Now, after five years, RER shows a net worth of $1 million, an impressive 37.63 percent growth per year. As their financial planner, you recognize the need for an agreement that would protect RER if the company were to lose an integral member of their ownership team. You also want to make sure that if Vinati, Dan, Sean, or Cindy died, their spouses would be fairly compensated for the contributions each owner made to the company.

Jim Jim McLean (67) is the owner of Commercial Molding Inc. (CMI), a manufacturing company that specializes in making plastic bottles for a soft drink company. Jim has recently started a new company, New Wave Plastics, Inc. (NWP), by developing a manufacturing process for precision components that will be used in hybrid cars. This expansion was made possible through Jim’s substantial cash holdings, personal wealth, and a 20-year contract to supply parts for a new line of hybrid cars made by Meridian Motors. Jim is very excited about NWP and expects to continue working full-time until the age of 75, after which he plans to take a reduced role in the management of the company. Jim has just hired Jerome Washington (35), to run NWP. Jerome was named in the Continental Business Network’s top 10 up-and-coming corporate executives five years ago. He earned his undergraduate degree in supply chain management and then went on to earn an MBA. NWP has been very successful in the five years since Jerome took the helm. Jim is interested in providing an extra benefit that will keep Jerome with NWP. An agreement for an executive bonus plan has been signed, and Jim wants to determine that Jerome has no additional outlay for this new benefit. Jerome is making a comfortable salary and is interested in deferring the new raise he has just received from NWP. An agreement for a non-qualified deferred compensation plan has been signed.

NOTES 1. Taken from the “Statistics of U.S. Businesses” report (2009), released November 2011, U.S. Census Bureau, U.S. Department of Commerce, www.census.gov/econ/susb. 2. Shannon P. Pratt, Business Valuation Discounts and Premiums, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2009).

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 28 Insurance Needs Analysis Thomas Warschauer, PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

The evaluation of insurance needs interacts with various groups of financial planning topics. Every type of insurance product has a cost to the client, sometimes a substantial one. So, cash flow management is significantly affected by the purchase expense of insurance products. This is true to the extent that the selection of the features of insurance products is, in part, determined by their ability to fit within the client’s budget (see Chapter 8, Cash Flow Management). Life insurance needs are often selected on the basis of present value

computations (see Chapter 11, Time Value of Money). The Insurance Needs Analysis topic interacts with all the other insurance chapters (see Chapters 20 to 30). Insurance needs interact with taxation from the point of view of the taxation of proceeds received either from a claim or from a return of capital from a savings-type insurance product. Finally, estate taxation and liquidity are often provided for by insurance products.

INTRODUCTION Risk management is an essential element of any financial plan. The reason is simple: Other important financial goals, even if well-funded, may not be attained if an adverse-risk event is unprotected. Insurance needs are complicated by their sometimes high cost. That is, nearly everyone would purchase large amounts of life, disability, long-term care, casualty, and liability insurance coverage if the costs were sufficiently low. But they are not low, because both the coverage of the perils and the administrative costs of insurance are significant. Therefore, the substantial cost of insurance is not surprising. Thus, the role of the planner is to help clients find the delicate balance between desirable and affordable coverage. Each type of insurance has its own method of evaluation, so it is worthwhile to discuss the topic of insurance one type at a time. Further, while many financial planners are licensed in the fields of life, disability, and long-term care insurance, relatively few are licensed to sell or advise regarding health, property, and liability insurance. Regardless of the business structure of the planner, the client must rely on the planner to assure adequate, cost effective, and appropriate coverage of all insurable risks. It is important, consistent with standards of professional conduct, that planners mutually agree on each recommendation, particularly the decision to acquire, and more importantly, not to acquire risk coverage. If the planner feels unqualified to help in one or another of these areas, he or she must ensure they are adequately reviewed by another independent expert as part of a comprehensive financial plan.

LEARNING OBJECTIVE The student will be able to: a. Perform an insurance needs analysis for a client, including disability, life, health, longterm care, property, and liability. Probably the easiest risks to evaluate are property, liability, and health insurance perils. That is so because state insurance codes often require policies available to be of a comprehensive and consistent nature. Also, as mortgage companies generally require homeowners insurance, and state law and lenders require auto insurance, it is typical to expect clients to have these forms of insurance. Because both homeowners and auto insurance policies inevitably cover liability insurance, clients generally come to the planner with coverage for these risks. That is not to say that planners should not evaluate these policies, but their role is usually to assess the adequacy, appropriate deductible

amounts, and cost of coverage for these types and to recommend improvements. Planners should also review the need for flood and earthquake/earth movement insurance for homeowners living in flood- or earthquake-prone areas. If the clients (or their children) are renters, the need for renters’ insurance should be explored. Adequacy of coverage involves a review of policy breadth of coverage, exclusions, and limitations. Because of the common exclusion of jewelry, collectibles, artwork, silverware, antiques, and firearms, planners should evaluate the need for floater policies to insure those items. The cost of coverage involves a competitive analysis and a review of deductibles. Liability limitations on homeowners and auto policies are often inadequate, so planners need to evaluate the need for umbrella policies. A short digression is in order here. Ordinarily, planners are not concerned with coverage of the adult children of their clients. However, planners must take care to ensure that clients have no residual liability for their children’s actions regarding automobiles. As an example, it is common for parents to co-own a car with their teenagers. As the children grow up it is important to ensure that that incidence of ownership does not continue into adulthood, or the parents may find themselves liable for their adult children’s actions. Ordinarily, health insurance is provided by employers, and clients typically have chosen their preferred type prior to meeting with a financial planner, if choices are available at all. If not, the planner must help clients arrange for coverage in this vital area. In some states this includes coverage under the Affordable Care Act. It may also be incumbent upon parents to consider health care insurance for their adult children, at least on a major medical basis. This not only is helpful to their children but also protects the clients themselves from huge medical bills their adult children may incur. The possible use of health savings accounts should be explored, particularly for small business owners. Computation of life insurance adequacy and policy evaluation are essential ingredients in the planning process. With regard to the needs computation, there are many methods of making a quick evaluation of the amount of life insurance each client may need. But all methods are an approximation of a true capital needs analysis. This is a present value computation based on the assumption that the client dies immediately after the purchase of the policy. Using this approach, clients specify what proportion of their cash outflows they wish to replace, taking into consideration all the client goals they want to insure for their survivors. These flows are sometimes offset by Social Security survivors benefits. The present value of the flows is then offset by wealth already accumulated and by any existing life insurance that will be continued. Inflation is addressed by forecasting nominal cash flows and discounting with expected discount rates or by using real cash flows discounted with real discount rates. This computation can be repeated assuming clients live for each additional year. That analysis provides a pattern of insurance needs that will help with the selection of the type of insurance product to be purchased. There are a number of approaches other than the capital needs analysis discussed here, including the human life value approach, the capital retention approach, the income retention approach, and the multiplier approach to a needs analysis. These are sometimes simpler than the capital needs analysis suggested here, but typically result in a higher insurance need, often more

than the true need determined by a full capital needs analysis. Financial planners should investigate the type of life insurance most appropriate for their clients who are considering the purchase of savings-type, cash-value life insurance. Cashvalue life insurance (e.g., whole or universal life) is considered for clients who are very risk averse and are in a higher tax bracket, and term life insurance is commonly used for those clients who are neither. Depending on a planner’s view of variable policies, they may be considered because of their tax advantages or because of the permanent need for life insurance to insure a bequest, to fund estate taxes, or to fund business buyouts. As life insurance is often sold inappropriately, planners must review existing policies to consider replacing inappropriate or excessively expensive policies, while being aware of the costs to the client that such replacement may incur. A remaining issue is selecting the appropriate policy owner and beneficiary for estate and tax purposes. Disability and long-term care insurance needs are complex, and the related insurance policies can be quite expensive. But rare is the client whose financial plan would not be severely harmed without this coverage. Periods of coverage, qualifying criteria, elimination periods, renewability, inflation protection, and cost are among the selection criteria. It is unusual for a client to be able to afford as much disability income protection and long-term care coverage as we might desire. The delicate balance referred to earlier is particularly troublesome here, lest clients be left well insured but without resources to accomplish their other goals.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Through classroom or online discussion, given an insurance policy, determine the adequacy of coverage.**

The provided policy can include planned deficiencies. Ask students to write an evaluation of the flawed policy, and a class discussion could debate their findings.

Ask students to evaluate the needs computation for inclusion of all relevant elements. Students could participate in a debate arguing for or against the need for various features and the amount of coverage. Through classroom or Ask students to conduct a panel online discussion, given a discussion with the results of series of life insurance their analysis, debating their policies, determine which differing recommendations. are appropriate to maintain and which should be replaced.** Creating: Putting elements Given a comprehensive Ask students to explain their together to form a coherent or case situation, balance the recommendations in view of functional whole; reorganizing needs for additional competing needs. elements into a new pattern or insurance of various types structure through generating, with the budget needs of planning, or producing generating cash flows for other goals.* Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Through classroom or online discussion, given a case situation, compute life or disability insurance needs.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can differentiate among the different forms of property and casualty, disability, long-term care, and life insurance products and understand how each product fits into a client’s comprehensive financial plan. Further, an entry-level employee can compute a client’s need for life and disability income insurance using generally recognized techniques, such as a needs analysis. Competent: Most planners go beyond determining the need for additional insurance of all types. They must choose the specific policy and company they wish to recommend. Therefore, the competent personal financial planner must determine which policies best fill various

insurance needs. Expert: Insurance needs involve multiple stochastic variables. An expert personal financial planner must be able to use statistical tools, including sensitivity analysis and Monte Carlo simulation, to determine the likely adequacy of a life insurance capital needs computation.

IN PRACTICE Marie and Steve Marie and Steve Oswello (both aged 55) live in eastern San Diego County, California, in a wooded area near Julian Mountain. They own a home currently worth $350,000. They have $300,000 of homeowner’s insurance coverage. The replacement cost of the structure, however, is close to $400,000 because of the high cost of rebuilding in the mountains. Their homeowners and auto insurance has $100,000 liability limits. They have $150,000 in investment assets held in a fairly marketable account, consisting mostly of mutual funds. They are, however, spending their full income; that is, they are not saving. They both work, and each earns $55,000. They both plan to retire at age 66 on Steve and Marie’s state pension fund (they are both teachers) and Social Security retirement benefits, which they believe to be adequate. They are eligible for Social Security survivors and disability benefits and are fully insured for retirement benefits, currently available equal to $2,400 per month in today’s dollars. They have no children. Neither has any disability insurance, but Steve has $100,000 of life insurance. Colleen Jenkins, their financial planner, has been asked to evaluate their life, disability, liability, and homeowners insurance needs. Colleen begins with their homeowners policy. She notes that their policy fails to include at least 80 percent of the replacement cost of the structure, so she will suggest raising the insurance coverage amount. Colleen will ensure that the policy is sufficiently broad and that it covers the replacement cost of contents and structures. She will inquire as to the presence of excluded items such as jewelry and collections. She will inquire about the ownership of boats or other sporting equipment. Colleen will inquire about the ownership of earthquake insurance, as this is a high-risk area for that peril. As the coverage is low for liability insurance, and because California is litigation prone, she will recommend the purchase of at least $1 million of umbrella insurance. In order to evaluate the need for disability insurance, Colleen inquires about the nature of the jobs that the Oswellos have, to assure disability income coverage is available. If it is, she will determine the cost-benefit relationship between the various coverage types and select an insurance company and policy. As the clients have Social Security disability coverage, that would need to be taken into account. Colleen considers recommendation of long-term care coverage, which is available through California Public Employees’ Pension System. The Oswellos felt strongly that at this time they would prefer not to purchase this insurance. Colleen notes this preference in her written plan and decides to revisit this issue next year after more pressing needs are incorporated into the

Oswellos’ plan. Finally, Colleen turns to the life insurance area. She is aware of a number of methods for computing life insurance needs, including the (1) needs-based approach, (2) human life value approach, (3) capital retention approach, (4) income retention approach, and (5) multiplier approach to a needs analysis. As Colleen evaluates the needs approach, she realizes the only reason these particular clients need life insurance is for the replacement of income during their remaining working years. They have no bequests planned and are not in a position to be liable for estate taxes, so term insurance is appropriate. Although Colleen generally prefers the needs-based approach, she concludes that each client should purchase insurance based on the human life approach. Using that method she arrives at $450,000 of insurance needs for each of the clients. Recognizing the investment assets and present life insurance coverage, Colleen recommends that Steve purchase an additional $250,000 and Marie purchase $350,000 of annual renewable term life insurance. It would be appropriate for a planner to compute insurance needs based on each of the listed methods, but Colleen feels this simple calculation is appropriate in this case. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 29 Insurance Policy and Company Selection Thomas Warschauer, PhD, CFP® San Diego State University Andrew Head, MA, CFP® Western Kentucky University

CONNECTIONS DIAGRAM

The selection of insurance policies and companies derives directly from the insurance needs analysis discussed in the previous chapter. These two topics taken together connect to various elements of the financial planning subject areas. Although most insurance products are not assets, cash-value type life insurance is and so it is reflected on the client’s statement of

financial position (Chapter 7). As insurance costs are significant, there is an impact on the client’s cash flow (Chapter 8). Insurance recommendations and the ways they are presented to clients are regulated by state insurance commissioners and others, as described in Chapters 3 and 4. Insurance contracts in the form of cash-value life insurance as well as annuities of all forms would also potentially play a significant role in retirement planning. This discussion, of course, links to all areas of insurance (Chapters 20 through 30). The taxation of premiums and benefits is a significant consideration. Variable insurance products have investment characteristics based on the selection of alternatives chosen. And finally, insurance products are often used to effect estate planning goals.

INTRODUCTION Policy selection is derived directly from an analysis of the client’s insurance needs discussed in the previous chapter. As stated there, each type of insurance has its own selection criteria. So once the need is established, the policy is chosen based on a joint analysis of policy and company characteristics. A planner needs to be aware of appropriate selection criteria and of the costs for each policy type involved. The importance of the financial planner having significant knowledge in this area is further compounded by the fact that he or she often acts as the intermediary between the client and an insurance agent who may or may not have the ability or incentive to give unbiased advice.

LEARNING OBJECTIVES The student will be able to: a. Define and communicate key insurance policy terms, coverage, conditions, and exclusions. Although most clients come to the planning process with auto insurance in hand because of state and auto-lending policy, the planner needs to ensure that the policy is adequate for the client’s needs. These needs include liability limits, deductibles, uninsured and underinsured coverage, medical payments coverage, and physical damage coverage. Particular attention needs to be paid to the client’s liability coverage, for, unlike the potential losses due to damage to one’s own property, liability to others is essentially unlimited and can potentially permanently destroy a client’s financial situation. In many cases, the greatest liability a client will ever face is that arising from the operation of a motor vehicle. With that said, many clients maintain only the minimum coverage required by their state statutes or only nominally more in order to reduce premiums, not understanding the potentially devastating risk they are choosing to retain. Along with auto insurance coverage, similar notions derive from boat and recreational issues. Coverage should be coordinated with the title on the property. That is, if the client is an owner of a car, motorcycle, boat, or RV, the need for coverage exists, at least for liability. Planners may want to prepare clients for budget increases for auto insurance rate changes if they have children approaching driving age. Sometimes auto coverage limits are a problem

when loan values exceed the replacement cost of a car. This is a common problem with auto rentals. Homeowners’ policies need to have adequate coverage as well. At the very least, that means the insured value should be above 80 percent of replacement cost. Though this level is necessary to avoid coverage gaps for partial loss, this would still leave the insured in a position of 20 percent loss retention in the event of total loss, and thus, true 100 percent replacement-cost coverage should be seriously considered. Inflation endorsements are desirable to ensure that coverage grows along with building costs in a specific locale. Coverage for additional structures and personal property is also important. Many policies include benefits for “loss of use” coverage while claims are processed and the occupant is displaced. It is useful for a planner to recommend an inventory of personal property be maintained along with receipts and appraisals for major items. While the standard HO-3 policy insures the dwelling on a replacement-cost basis, it is important to note that the contents of the dwelling are insured on a named-peril basis for actual cash value only, even though the total dollar coverage may be equal to 50 percent of the dwelling amount. Therefore, the financial planner should carefully evaluate the need for a contents replacement-cost endorsement, or HO-5 policy, to cover this potentially damaging loss. Flood and earth-movement coverage is generally recommended for those properties in areas where those perils are more common. It is important to note that all policies exclude these perils without specific endorsement. Even when the possibility of a loss due to flood or earthquake is perceived as small, coverage may still be warranted due to the fact that these endorsements are sometimes not financially burdensome, and the possibility of devastating loss is enormous if the peril arises. All property insurance has listed exclusions and significant limitations of coverage for certain items. It is appropriate to evaluate whether the client owns such property and then recommend “floater” policies or recommend they purchase riders for this coverage. This is common for artwork, jewelry, collections, firearms, and other generally excluded or limited items. Special policies are used for condominiums (the building’s external aspects are usually insured by the condo association) and for renters, whose personal property needs coverage. The purchase of umbrella liability coverage is one of the most common planner insurance recommendations. By coordinating auto and homeowners liability coverage, this excess liability coverage is frequently desirable in our litigious society. Health insurance provisions are not commonly reviewed for clients who have employer coverage. However, as health costs rise, it is increasingly common for clients to have inadequate health insurance or none at all. Further, a client’s adult dependents need coverage, even if just major medical, in order to protect the client’s assets. Major types of health coverage (with generally increasing costs) are health maintenance organization (HMO), preferred provider (PPO), point-of-service (POS), and fee-for-service (FFS) insurance. Affordable Care Act requirements have been beneficial in making health insurance available to some but has also resulted in sometimes very complex health

insurance issues. Some clients may have access to health savings accounts (HSAs) or flexible spending accounts (FSAs). Each has unique advantages and disadvantages, and planners should be prepared to evaluate the potential for these devices and to recommend their creation for small business owner clients. Disability income insurance should be considered for all wage-earning clients. Policies should be evaluated from a perspective of the definition of disability, daily levels of benefits (as a percentage of income normally earned), the elimination period, the maximum payment period, the cause of the disability (both accident and illness), the renewability, and the policy being non-cancelable. It is not uncommon for clients to mistakenly believe that they have adequate coverage when in reality they may have only a short-term disability policy or a long-term disability policy with very limited coverage or highly restrictive definitions of disability. As with all types of insurance, the financial planner should take time to review the actual policy documents rather than relying on the client’s description of coverage. Long-term care insurance has similar characteristics. Policies should be evaluated from a perspective of which activities of daily living qualify the insured for benefits, what other certifications are necessary to qualify, daily or monthly levels of benefits, the elimination period, the maximum payment period, the renewability, and that the policy is noncancelable. This field of insurance is relatively new, and special care should be taken when evaluating this type of coverage. It has been common in the past two decades for insurers in this market to exit the line of business and limit future coverage or regularly raise premium rates on existing policyholders. A client must be adequately prepared for this possibility. Life insurance policies are in some respects the most complex and important choices a planner has to make. Any carefully designed plan needs to contemplate what happens if a client dies. As described in the previous chapter, planners need to choose among various types of life insurance. Here the decision is based more on the type of insurance rather than on policy features. The most common types include level term, decreasing term, whole life/permanent insurance, universal, variable, and variable-universal. The first two types of insurance have no cash value feature, whereas the others do. First and foremost, an evaluation of the length of time the client requires his or her life to be insured is necessary. In the majority of cases this need is temporary, typically ceasing once a client’s dependents have become self-supporting, and thus the use of term insurance is often more appropriate. If the need for insurance is lifelong, for example in the case of parents of special-needs dependents, high-net-worth clients in need of estate settlement funds, or high-income earners in need of alternate tax deferral, the use of permanent insurance in the form of whole life or universal life insurance policies may be warranted. Additionally, permanent insurance may be used to fund bequests, fund business transfers at death, and arrange for estate tax payments. In very general terms, permanent insurance is more likely to be indicated with a high-tax-bracket, risk-averse client, though planners have often expressed

concern with the high administrative costs of the various types of cash-value life insurance. Life insurance may be coupled with additional riders. These include waiver of premium, disability income, guaranteed insurability, multiple indemnity, and accidental death and dismemberment riders. Planners are generally not enthusiasts of the last two features because they provide benefits different from what may be needed and can lead to clients thinking they have more insurance than they actually do. Life insurance premiums vary much more than other types of insurance, partly because their sales costs differ significantly due to varied channels of distribution and other company costs and profitability measures. For example, mortgage life insurance policies often cost two times what decreasing term policies cost even though they are essentially identical policies. Planners need to ensure that the right type of policy is held but that it is cost efficient. b. Recommend appropriate insurance products, given a client’s stage in the life cycle, family circumstances, and needs. There are no hard-and-fast rules for when policy needs arise. Obviously, if a client is missing adequate insurance when a loss occurs, he or she will feel insurance should have been recommended. For example, it is unusual but not unheard-of for a young adult client to need long-term care insurance. Were cost not an issue, planners would recommend coverage. However, if clients are already wealthy, they are self-insured and therefore do not need coverage. So when a planner is looking to find the optimum use of scarce resources, the planner will seek insurance when a claim is more likely, when it can be afforded, and when the client is not already self-insured. Except for very wealthy clients, most clients need auto and homeowners insurance. Even (and maybe especially) wealthy clients need umbrella insurance. Table 29.1 outlines insurance needs at various life stages. c. Recommend insurance companies based on an evaluation of service, personnel, financial risks, company ratings, and claims processes. Property and liability insurance companies’ products are more consistent in pricing and characteristics than other types of insurance. The planner should ensure that companies are “admitted to practice” in the client’s state (or at the location of the property, if that is different). The planner may want to assure the company’s financial strength through its rating, and assure it has adequate size and adequate financial strength. The latter can be reviewed using the risk-based capital (RBC) system developed by the National Association of Insurance Commissioners. Insurance company experts often use ratios developed for the Insurance Regulatory Information System to evaluate insurance companies, but this probably goes beyond normal financial planner functions. Life insurance, particularly life insurance with cash value, is a very long-term asset for the client. As such, the financial strength of the company is very important. Various rating services are available (A.M. Best, Duff & Phelps, Moody’s, Standard & Poor’s, and Weiss). Only Weiss, however, has ratings paid directly by the consumer and therefore is arguably the most independent rating.

Policies differ because of a number of factors, including investment earnings, mortality experience, expenses, lapse rates, contingency reserves, taxes, and difference in actual methods. There are a number of methods available when making cost comparisons between cash-value policies, including the net cost method, interest-adjusted cost method, the Belth method, and the Linton index. Although it is difficult to measure issues of claims processes, service, and personnel for life insurance companies, planners who have worked with many companies over the years have at least anecdotal evidence of these dimensions of company selection. J.D. Power & Associates publishes consumer satisfaction surveys regarding various types of insurance companies. Table 29.1 Table 29.1: Insurance Needs Young adults Young families Mature families Retired Aged

Renters, auto Life, auto, homeowners, disability Life, auto, homeowners, disability, umbrella, long-term care Auto, homeowners, umbrella, long-term care, Medicare supplemental Long-term care, Medicare supplemental

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Given an auto or homeowners policy, determine if the policy meets the client’s needs.

Student Assessment Avenue Assign an in-class case study of a predefined auto insurance policy, complete with policy declarations and booklet. Ask students to form small groups where they must identify the different parts of the policy that provide coverage given several scenarios. Include several scenarios that might be excluded or limited.*

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Given a case situation, evaluate the adequacy of insurance coverage.

Ask the students to perform a written analysis of their own auto policies or those of their parents if still insured there. Present numerous scenarios that must be answered and cited using their own policy declarations and policy booklet, which must be submitted with their answer sheets. Direct them to obtain quotes for coverage on their own if insured under a parent’s policy, or alternate company if independent.**

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Determine if selected policies and companies are appropriate for a specified client situation.

Present the students with a long-term care planning case where existing coverage is in place.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Given a complex planning situation, balance a client’s other needs against the higher costs of more comprehensive coverage.

Create comprehensive case data for a fictional client family.

Give the students access to the current policy and alternatives. Ask them to assess current coverage and the need for more (or less). Ask them to also research the insurer’s financial health and ratings, as well as any history of problems with claims and/or rate increases on existing policyholders.**

Ask the students to direct the interview in which they must assess current coverage, needs, and goals. Ask students, in small groups or by themselves, to write and present their recommendations to the class for current or needed coverage. Part of the grade for the assignment could be based on their feedback for others’ presentations and recommendations.*

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can determine the appropriate types of insurance coverage necessary given a client’s specific situation. Competent: A competent personal financial planner can evaluate various policies to ensure clients have needed, adequate, cost-efficient, and appropriate coverage. Expert: An expert personal financial planner can evaluate potential insurance firms to determine which are safest and have the best claims history.

IN PRACTICE Stuart and Liza Stuart and Liza Spring, a married couple from Kentucky who are both 40 years old, have just inherited $400,000 from a deceased parent and are seeking the advice of Erica Cutright, a personal financial planner, as to how best to invest the money. They have never had a financial

planning analysis and, while they are eager to get to the investments discussion, the financial planner explains to them that it would be improper to start making recommendations without a full picture of their financial situation. They are both employed at different blue-collar factory jobs, though Stuart makes nearly 60 percent of their joint income of $80,000 per year as a skilled welder. They are very frugal and have excess cash flow that they have been using to pay down their mortgage, though their interest rate is low and they have more than 65 percent equity in the property. They have four children ranging in age from 1 to 10 years old. Neither Stuart nor Liza has any life insurance coverage due to the fact that both of them are smokers and have been told it would be expensive. While this health characteristic will indeed increase premiums twofold or threefold, it is clear that both of them need coverage on the other’s life due to the number and ages of their dependents. Ms. Cutright, their financial planner, spends a great deal of time in the discovery process determining the kinds of financial legacy that each of the Springs would like to leave in the event of an untimely death. They are in agreement that if one of them were to die, they would each want the option of being able to stay home with the children rather than have to work fulltime and raise four kids. Once the youngest child reaches high school age, they feel that the surviving spouse would likely return to work. They would like each of the children to be able to attend college, though they have never had any intent to pay for it and will instead encourage their kids to work to receive scholarships. They are not overly concerned with leaving financial legacies to their children at their deaths beyond what was already discussed. The Springs, per her request, provide Ms. Cutright with copies of their most recent Social Security statements to determine the amount of any survivor benefits that may be available. They also work together to determine the household spending needs in the event of the death of either one of them. Using all of this information, Ms. Cutright is able to determine a reasonable amount of insurance on each spouse using term policies that will stay in force for 20 years. All are in agreement that permanent insurance is not necessary. Ms. Cutright presents quotes from a number of different companies with Weiss ratings of B or better. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 30 Property and Casualty Insurance Derek R. Lawson, MS Sonas Financial Group, Inc. Kansas State University Sarah D. Asebedo, MS, CFP® Virginia Tech Martin C. Seay, PhD, CFP® Kansas State University

CONNECTIONS DIAGRAM

Property and casualty insurance planning is critical for clients, as it is relevant to many

different client assets and situations. For example, property and casualty insurance is necessary if a client owns a car, rents or owns a home, owns a small business, is involved on a professional board, or simply needs personal liability protection. Consequently, property and casualty insurance concepts are firmly rooted in General Financial Planning Principles, with their overall content domain in Risk Management and Insurance Planning. Additionally, given its application to small business owners, an understanding of personal liability associated with business entities, a subcomponent of Tax Planning, is required.

INTRODUCTION Property and casualty insurance is a vital component of almost any client’s financial plan. Planners must analyze client situations to identify areas of potential risk related to the property clients own and the personal and professional activities in which they, and their family members, take part. Although it is only a component of a comprehensive risk management strategy, property and casualty insurance covers a wide array of topics. Personal financial planners must be well-versed in homeowner’s insurance, auto insurance, personal liability insurance, and business and professional liability insurance to accurately and effectively create strategies to minimize clients’ risk exposure. Homeowner’s policies were first introduced in the 1950s but have been revised many times.1 Forms drafted by the Insurance Services Offices (ISO) are most common; however, some insurers use forms from the American Association of Insurance Services (AAIS) or even draft their own. A homeowner’s insurance policy (HO) covers both property and liability; therefore, it is termed a multiline policy. This helps the insured to avoid having gaps in insurance coverage. There are many different forms of homeowner’s insurance, with each divided into two sections: Section I, which outlines property coverage and loss of use and variations between policies, and Section II, which outlines liability coverage and is typically consistent between policies. Like homeowner’s policies, personal auto policies (PAP) include both property and liability coverage. Most insurers use the 2005 ISO version of the PAP, the most recent update to personal auto policies. It is extremely important for a financial planner to review an auto policy’s declarations page to identify the covered vehicle(s) and the named insured(s). Resident family members and anyone given permission to use the car by the named insured are covered by the liability section of the PAP. Similar to homeowner’s policies, the PAP is broken down into four primary coverages: liability (Part A), medical payments (Part B), uninsured/underinsured motorists (Part C), and coverage for damage to your auto (Part D). Given the potential loss magnitude associated with a liability insurance claim, financial planners must have a thorough understanding of the various types of liability insurance and the sources of personal and business liability risk. Underlying homeowners and auto liability insurance limits are often insufficient and may leave a client’s personal assets exposed. A personal umbrella liability policy (PUP) is a common, cost-effective form of additional liability insurance and provides an essential layer of protection for a client’s financial

resources. Planners working with clients who are business owners, involved in professional boards, or considered an employer of in-home employees (e.g., a nanny or housekeeper) must also understand business liability insurance. If a client has a personal umbrella policy, he or she will not be covered from a liability ensuing from the course of business activities. As such, the client’s personal assets may be exposed—the main reason for purchasing a personal umbrella policy. For this reason, clients who run their own businesses and/or pay employees should consider purchasing a business liability insurance policy.

LEARNING OBJECTIVES Students will be able to: a. Identify the primary components of property and casualty insurance and how each component fits into a client’s comprehensive financial plan. Without appropriate property and casualty insurance coverage, a client’s financial resources may be subject to unexpected losses (e.g., inadequate liability coverage in the event of a lawsuit), thereby jeopardizing the client’s goals and objectives for the future (e.g., retirement). A financial planner must be able to identify and distinguish between the primary components of property and casualty insurance (homeowner’s, automobile, personal property, personal liability, and business and professional insurance) in order to competently assess and provide solutions for property and liability risk areas relevant to a client’s comprehensive financial plan. First, a financial planner must have the ability to describe and classify (e.g., personal or business) the risk areas associated with a client’s current financial situation, including their personal and professional activities (e.g., board of director participation). Second, a financial planner should be proficient in interpreting a client’s current insurance Declarations Pages, Insuring Agreements, Exclusions, and Conditions. Third, a financial planner must be able to compare a client’s current coverage and areas of risk exposure in order to identify and discuss appropriate risk management solutions. Fourth, recognition and assessment of available discounts and cost saving opportunities is necessary in order to maximize the client’s financial resources, including analyzing the break-even point for premium savings resulting from an increase in risk (deductible). Finally, a financial planner must synthesize each component into a client’s comprehensive financial plan and identify when revisions are needed to the property and casualty insurance coverage based upon changes in other planning areas. The addition of a new teenage driver, purchase of personal property (e.g., jewelry or other collectibles), or property ownership changes due to estate planning (i.e., Revocable Trust) are examples of client issues that should be incorporated into property and casualty insurance policy requirements. b. Differentiate among the basic homeowners insurance (HO) forms and features and explain how to evaluate and compare policies. The basic homeowner’s insurance forms include HO-2 Broad Form (named perils), HO-3

Special Form (open perils), HO-4 Renters, HO-5 Comprehensive Form, HO-6 Condominium Owners, and HO-8 Older Home Form. Several factors distinguish each policy form, including property type, ownership status, covered perils, and replacement cost methodology. A financial planner must be able to differentiate between each homeowner’s insurance form (including the differences between open perils and named perils), describe the coverage and exclusions associated with each form, and assess the conditions under which each form may be appropriate for a client. Table 30.1 is a list of the various forms of homeowner’s insurance and the type of perils covered for each. When reviewing Section I coverages on homeowner’s policies, it is important for a financial planner to articulate whether or not the client’s policy covers perils (a cause of loss) on a named perils or open perils basis. This is because a named perils policy only covers losses of the specific perils named within the policy, such as lightning and fire. An open perils policy will cover any loss except those that are specifically excluded within the policy. Planners need to be able to illustrate an understanding of the types of coverage provided in their client’s homeowner’s policy and be able to communicate how that may or may not be adequate for the client given the rest of their financial plan, cash flow, and risk tolerance. All of the listed policy forms provide the same amount of coverage for personal liability (Part E) and for medical payments to others (Part F). Both of these coverages make up Section II within a homeowner’s policy. When examining a client’s dwelling insurance coverage, it is of extreme importance to consider the amount of insurance carried. If the amount is less than 80 percent of the replacement cost, then the insured will be reimbursed in one of two ways: (a) actual cash value of the damaged part(s) taking depreciation into consideration, or (b) the amount of the loss multiplied by the amount of insurance carried divided by 80 percent of the replacement cost. For example, if a client owns a home with a replacement cost of $160,000 and insurance coverage in the amount of $120,000, they would have less than 80 percent of the replacement cost insured. Should a loss occur totaling $40,000, they would only recover $37,500 less the deductible. Guaranteed replacement cost can be purchased as additional coverage within a HO insurance policy to mitigate potential exposure due to the coinsurance clause, although the insurer may require specific policy conditions be met in order to put guaranteed replacement cost coverage in place for the structures (Parts A and B). A replacement cost endorsement for personal property (Part C) provides additional protection for all personal property or selected items. Homeowner’s policies also offer endorsements that can be added to the policy should the insured have a need for such coverage. A financial planner will need to work with the client to determine if the additional cost of adding endorsements to the policy is financially beneficial. These endorsements are broken out into Section I and Section II endorsements. There are nine Section I endorsement categories that a client can add as a scheduled personal property endorsement: (1) jewelry, (2) furs and fur-trimmed garments, (3) musical instruments, (4) silverware, (5) golfer’s equipment, (6) cameras, projectors, films,

and equipment, (7) fine arts, (8) rare and current coins, and (9) postage stamps. Coverage for these are covered on an open perils basis and are covered for the replacement cost rather than the actual cash value. Section II endorsements include (1) watercraft endorsement, (2) business pursuits, and (3) personal injury (such as libel, slander, and false arrest). Other endorsements provide protection for inflation, earthquake, identity theft, building code upgrades, mold abatement, and other needs. When purchasing a home, it is important, and often required by institutional lenders, to purchase a title insurance policy in order to protect against any financial loss that may occur as a result of a title that is defective, or has a lien against it. The purchase price paid for the property is usually the amount covered and the premium is based on the purchase price. It is typically a one-time, upfront premium and only available at closing. In summary, to competently evaluate the coverage within a HO insurance policy, a financial planner should be able to describe the coverage provided under Section I (dwelling, other structures, personal property, and loss of use, Part D) and Section II (personal liability and medical payments) coverages. Additionally, a financial planner should be able to define coinsurance, calculate the required coinsurance amount, and determine if the dwelling insurance amount is sufficient to meet the coinsurance requirements. Existing and available policy endorsements should be incorporated into the evaluation of the HO policy and the assessment of when particular endorsements may be appropriate for a client’s situation. Liability coverage, through the HO or personal umbrella liability policy, also should be carefully matched to the client’s situation. Finally, title insurance is critical to real estate transactions and a financial planner should be able to explain the basic characteristics of title insurance as it relates to a client’s ownership interest and rights. c. Identify the primary components of automobile insurance and assess any potential property damage or liability exposures. Automobile insurance is a critical component to property and casualty insurance planning and is required in almost all states. In order to evaluate and explain a client’s automobile insurance coverage needs, a financial planner must first be able to identify the four primary components of an automobile insurance policy, including liability (Part A), medical payments (Part B), uninsured/underinsured motorists (Part C), and damage to auto (Part D). Liability coverage (Part A) is the most important and is required in almost every state. It covers bodily injury and property damage for which the insured is legally responsible (i.e., the other driver’s medical, vehicle repair, and other costs). State laws set the minimum amount of coverage needed. The coverage amounts are generally written in what is called a split limit such as $200,000/$400,000/$100,000 meaning there is $200,000 in coverage for bodily injury per person with a maximum of $400,000 in coverage for bodily injury per occurrence, along with $100,000 in coverage for property damage. In practice, this is typically referred to as 200/400/100. It should be noted that it is possible for the insurance amount to be written as a single amount with an endorsement. This Combined Single Limit

(CSL) is applied to the property and bodily injury limit and there is no per person limit. Medical coverage (Part B) is frequently, but not always, included in the PAP. It pays without regard to fault and covers any medical, dental, and funeral expenses from an accident within a three-year period from the date of the accident. Uninsured/underinsured motorist coverage (Part C) is important because while many states require liability coverage, the reality is that not every driver follows the law. Should an insured person incur bodily injuries by a driver that is uninsured or underinsured, has an insolvent insurance company, or was involved in a hit-and-run, this coverage will pay for the expenses. Uninsured and underinsured motorist coverages are typically addressed in tandem. If coverage for physical damage to an individual’s own auto is desired, then Part D must be purchased. There are two coverages available; the first is loss in the event of collision and the second is other-than-collision loss. Each requires a deductible to be paid before the insurance company covers any amount. Collision loss covers losses to the insured’s car resulting from a collision. Other-than-collision loss will cover damages to the vehicle resulting from a tree branch falling on it, or hail damage. These coverages can be fairly expensive when compared to the cost of Parts A, B, and C. Financial planners need to work with their clients to determine if the cost of the insurance is worth it by determining the value of the insured vehicle and factoring in the client’s cash flow and other financial goals. It is important for the insured person to understand the obligations required by law and as part of their PAP when an accident or loss occurs. The PAP includes a section entitled duties after an accident or loss, known as Part E of the policy. If there are any injuries, or if the damage is fairly excessive, it is important to notify the police and paramedics. To add, while it is advisable to exchange insurance information with the other driver, it is important not to admit fault. Failure to comply may result in the insurance company not covering any losses. For these reasons, a financial planner should carefully review this section of their client’s PAP and help the client understand what they need to do should an accident or loss occur. While all parts of an automobile insurance policy are important, tremendous exposure can exist when a client does not have adequate liability insurance coverage. Planners need to carefully review and analyze clients’ coverage within their auto insurance policies. Failure to have enough liability coverage, through the auto or personal umbrella liability policy, is extremely risky and could jeopardize the clients’ overall financial plan. d. Explain the role of personal and business liability insurance in comprehensive financial planning and how personal umbrella liability policy (PUP) and business liability insurance interacts with other property and liability insurance products. A financial planner should be able to articulate the major characteristics of a PUP and to prescribe an appropriate liability limit for clients. A PUP provides coverage above and beyond the liability coverage amounts within an individual’s home and auto policies.

Typically, amounts range from $1 million to $5 million (but can be greater) and the premiums are typically very reasonable. Generally the PUP will come with what is known as a retention limit—an amount the insured must pay before the policy does—usually varying from $250 to $10,000. As with all other policies, the PUP does have exclusions. Typical exclusions include intentional losses, any liability that is covered under worker’s compensation, and any business pursuit liability. Planners should carefully review the PUP with the client and look over any other exclusions the policy may have. It is important to note any excluded losses that are the same across all policies, as the insured will not be covered for those. Moreover, common and often misunderstood exclusions on a PUP policy are uninsured/underinsured motorist coverage and business or professional activities. Fortunately, additional coverage for uninsured/underinsured motorists can be added to the PUP and separate business liability coverage can be purchased. Furthermore, a financial planner needs to integrate the PUP with the client’s other insurance policies (e.g., underlying coverage must meet the minimum PUP requirements) and assets (e.g., property address must specifically be listed on the PUP) in order for the PUP to be effective. Finally, a financial planner must be able to identify the need for business liability insurance and distinguish between the various types of business liability insurance available (e.g., Professional Liability, Product Liability, Commercial Property, Home-Based Business, General Business Liability, Worker’s Compensation, and Directors and Officers Insurance). The specific type of insurance needed will depend upon the nature of the client’s business and professional activities. A common insurance need that is often overlooked is the retention of an in-home employee, such as a nanny or a housekeeper. If the worker is considered an “employee,” then a worker’s compensation policy along with the appropriate income tax filings must be put in place. Additionally, as mentioned above, a PUP does not generally cover business and professional activities and therefore a separate liability policy must be established in order to cover these activities. A financial planner needs to assess a client’s personal and professional activities in order to recommend the appropriate blend of personal and business liability insurance. Table 30.1 Homeowner’s Insurance Types Form of Coverage HO-2 (Broad) HO-3 (Special) HO-4 (Contents Broad) Renter’s Insurance HO-5 (Comprehensive) HO-6 (Unit-Owners) HO-8 (Older Home)

Dwelling & Structures Coverage (Parts A&B) Named Perils Open Perils N/A

Personal Property Coverage (Part C) Named Perils Named Perils Named Perils

Open Perils Named Perils Named Perils

Open Perils Named Perils Named Perils

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Utilize class lecture to highlight important Property and Casualty Insurance concepts, including the common areas of coverage needs and the types of coverage offered by different home, auto, and liability insurance products. Invite a local property and casualty insurance agent to class.

Assign students to complete group projects on specific insurance coverage types. Have these groups make presentations to the class for a shared learning opportunity.

Lead a class discussion on how the liability components of home, auto, and umbrella insurances interact with each other. Provide students short descriptions of various small businesses. Have students work in small groups to evaluate insurance needs and lead a class discussion to synthesize student responses.

Provide students example auto and homeowner’s insurance contracts to review. Ask students to analyze the contracts to identify information that is pertinent to determining the adequacy of the insurance in meeting a client’s needs.

Lead an in-class activity that evaluates a client’s coverage needs based upon a set of facts. Bring current examples of situations where Property and Casualty Insurance products would be required. Have the class identify the types of coverage that would be needed. Provide small groups of students with scenarios of small business owners. Have them create a cohesive plan surrounding personal liability protection

Provide students a case study that outlines a client situation, their insurance needs, and their current coverage. Ask students to evaluate the adequacy of the coverage. Provide students a set of client facts and goals. Have students create a comprehensive property and casualty insurance plan.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Have students prepare questions for the guest speaker and evaluate their class participation.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner should be able to identify the different types of property and casualty insurance and describe the significance of this coverage in a comprehensive financial plan. An entry-level personal financial planner should be able to review client information to identify where additional property and casualty insurance is needed. Entry level planners should be able to review existing insurance contracts and identify potential areas of cost saving for a client. Competent: A competent financial planner can develop comprehensive personal property and casualty insurance approaches. A competent financial planner should be able to identify how small business ownership and entity selection relates to business property and casualty insurance needs. Expert: An expert financial planner will work closely with tax advisors to incorporate insurance needs into business entity planning. An expert financial planner can make optimal property and casualty insurance recommendations to clients that meet their needs at the lowest cost possible while integrating coverage across multiple policy types.

IN PRACTICE Cheyenne and Elijah Jayden, a financial planner with expertise in property and casualty insurance, met with her clients, Cheyenne and Elijah, to do a comprehensive review of their property and casualty insurance. They were concerned that their recent insurance coverage decisions still left them with too much risk. Cheyenne and Elijah had just purchased a new home appraised at $400,000. To help protect it, they purchased a HO-2 insurance policy that has a $300,000 dwelling coverage (Part A) limit. Additionally, they purchased personal auto policies from a different insurance company for both of their new vehicles. Both policies do not include collision and comprehensive (Part D) coverage. After reviewing and discussing the insurance policies, Jayden explains to Cheyenne and Elijah that they are not fully covered if something were to happen to their home, such as $40,000 of hailstorm damage to their roof. Since they have less than 80 percent of the replacement cost of their home, only $30,000 of the loss (less the deductible) would be covered. Furthermore, their HO-2 policy is a named perils policy and covers only sixteen specific losses. Jayden recommends that Cheyenne and Elijah purchase either a HO-3 or HO-5 policy that has a $400,000 dwelling coverage with inflation coverage to ensure they are fully covered as their home appreciates. Jayden explained that Cheyenne and Elijah may want to consider purchasing collision and comprehensive coverage for their vehicles. Currently, if either of them accidentally hit someone, their liability coverage will protect the other driver, but they would be responsible

for repair of their own car. Additionally, should a tree branch happen to fall on their car, or if the car is vandalized, they would not be covered as they do not have comprehensive coverage. For these reasons, and since the cars are fairly new, it would be prudent for Cheyenne and Elijah to purchase collision and comprehensive insurance within the personal auto policies. Lastly, Jayden recommends that Cheyenne and Elijah speak with both of their insurance companies and see what discounts are available for bundling their auto and home insurance policies together as well as adding a personal umbrella liability policy. They can also explore further savings through increasing the policy deductibles or potential home security system, or good driver or other discounts. By approaching both companies simultaneously, they can compare quotes, cost saving strategies, and the benefits of bundling the policies.

Chrysanthos Chrysanthos, age 45, is the sole proprietor of an executive placement business that he operates from his home office. Chrysanthos has had success in establishing reputable contacts with large and well-known companies and makes $200,000 per year, on average. Following his financial planner’s advice, Chrysanthos has adequate personal property and casualty insurance coverage in place, including auto, homeowners, and personal umbrella liability. Chrysanthos believes the liability risk to his business is low since clients do not come to his home and he thinks his personal umbrella liability policy would cover any potential claims arising from his business activities. Since his financial planner has not discussed business liability insurance with him, he hasn’t given the need for a separate business liability policy a second thought. In order to increase his social media presence, Chrysanthos has decided to start a blog and write about his experience working with clients and the challenges executives face when searching for executive level job opportunities. Chrysanthos chooses his newest client as a case study for his first blog post. While being careful to not include any specific personal information that would identify his client, the description of the client’s characteristics and current situation was detailed enough that several company contacts were able to identify her. His client is furious that her situation was utilized in Chrysanthos’s blog post and that several companies have identified her as the case study client. She believes her ability to get promoted has been harmed. Additionally, she feels the damage to her reputation will negatively impact her wage level over her remaining career. She decides to sue Chrysanthos to recover her expected future lost wages. Chrysanthos engages an attorney and discovers any liability resulting from his business activities are excluded from his personal umbrella liability policy. Therefore, his personal assets are exposed in this claim.

NOTE 1. George E. Rejda, Principles of Risk Management and Insurance (Upper Saddle River, NJ: Pearson Education, 2011), 149–176.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 31 Characteristics, Uses, and Taxation of Investment Vehicles Swarn Chatterjee, PhD University of Georgia Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

Investment is the vehicle used by a client to achieve mid- and long-term goals. Without investment of some sort, long-term goal achievement is difficult. Because of this fundamental

role that investment plays in a client’s overall financial plan, this chapter is connected to several areas of financial planning, particularly relating to long-term and short-term goal achievement, risk management, and cash flow. Specific topic areas include investment planning, income tax planning, retirement planning, estate planning, and education planning.

INTRODUCTION The financial markets are dynamic, volatile, and continually changing environments that present both opportunities and challenges to financial planners as they strive to manage their clients’ portfolios both effectively and efficiently. Therefore, the knowledge of various investment vehicles that are available, the applications of these vehicles in investment planning, and an understanding of the associated tax implications are essential for financial planning professionals as they endeavor to manage their clients’ portfolios by overcoming the existing challenges and taking advantage of the opportunities that are present in today’s securities markets. Knowledge of investment vehicles is especially important for portfolio construction and portfolio diversification decisions that financial planners are involved in during the investment planning process. Harry Markowitz’s work proved for the first time that the risk and return of the portfolio were different from the risk and return of the investment vehicles that were included in them, and the risk and return of the investment portfolio could be managed through the selection of the investment vehicles that comprised the portfolio.1 This finding changed the way investment portfolios were designed. The risk, return, and tax implications of the various investment vehicles are therefore important considerations that planners need to be aware of when preparing the investment portfolios of their clients.

LEARNING OBJECTIVES The student will be able to: a. Describe and compare the characteristics, including risk and return, of all asset classes including cash-equivalent securities, individual bonds and stocks, real estate, other tangible assets, all pooled asset categories, and derivatives. b. Select the appropriate use for each asset class and investment vehicle based upon its risk/return characteristics and expected cash flows. c. Advise clients on the tax implications of holding and disposing of each security type or asset class. Among the different types of investment vehicles that are available in the market today, some provide lower risks and generate lower but more certain returns, whereas other types of investment vehicles are more risky but offer the opportunity for a much higher potential return. Additionally, some investment vehicles are more capital intensive and require greater investment amounts, while other investment vehicles do not require a large cash investment.

Similarly, some investments require active management by professionals, while other investments are more passive in nature. The tax treatments on the investment income of these vehicles may also differ by the type of account in which these investments are held and by the type of investment vehicle that is being used by the financial planner. The tax treatment of various investment vehicles also affects the net returns on these investments on a tax-adjusted basis. Knowledge of investment vehicles is therefore important for financial planners to have so that they are able to make the appropriate investment selection and allocation decisions for their clients. Financial planners have at their disposal the choice of various types of investment vehicles with varying complexities. Some of the characteristics that make investment groups differ are potential growth in value (expected return); difficulty in predicting future value (risk); cash flow (income) generated (dividends, interest, or other cash flow); tax treatment; marketability; and market liquidity. Institutional differences exist as well, such as whether the investment class is generated in the primary markets (limited partnerships, initial public offerings [IPOs], and hedge funds) or the investments are seasoned investments from the secondary markets. The planners analyze these instruments and select the appropriate investment vehicles for their clients’ portfolios after taking into account the clients’ investment time horizons and their risk tolerances. Each investment vehicle has its own unique characteristics and tax treatment. Some investment vehicles have been designed to cater to specific types of investors. Financial planners need the knowledge to allocate their clients’ portfolios into the appropriate investment vehicles, the utility for which may vary by clients’ age, their risk tolerance, net worth, income, tax bracket, goals, and other considerations. These assets are held as either individual securities, mutual funds, exchange-traded funds (ETFs), or other similar pooled asset vehicles. An understanding of these investment vehicles, their applications in the portfolio construction process, and the taxation of these instruments is therefore essential for financial planners when they plan their clients’ investments. The knowledge of taxation of investment vehicles and awareness of the availability of various investment tax shelters are also very important for financial planners. The tax laws change periodically, and the economic and political factors affecting these changes add another dimension in the investment allocation and investment vehicle selection process. The tax laws associated with transactions of investment vehicles can be very complex. Certain investment vehicles produce ordinary income, such as interest income from bonds that is taxed at the taxpayer’s marginal tax rate, up to a maximum rate of 39.6 percent. Exceptions to this general rule apply, most notably that interest on municipal bonds is exempt from income taxation. However, this exemption is rescinded when the municipal bond is considered a private activity bond and the taxpayer’s tax liability is based on alternative minimum taxable income rules. Qualified dividends, under current law, are taxed differently from ordinary dividends and are subject only to the capital gains tax rate of 0 percent, 15 percent, or 20 percent, depending on the taxpayer’s marginal tax rate. In addition to how investment vehicles are taxed, certain account characteristics, such as Roth IRAs, will fundamentally change the way the income generated from underlying investment vehicles is taxed. If a taxpayer holds a portfolio of

investments within a Roth IRA and does not take distributions from the Roth IRA until the taxpayer has held the account for longer than five years and reached age 59½, then the distributions following that point in time will be tax free and all of the income earnings in the Roth IRA that had been deferred will then also become tax free. In contrast, distributions from a traditional IRA will always be subject to the taxpayer’s marginal tax rate, even if the earnings on the traditional IRA have resulted solely from long-term capital gains and qualified dividends. Higher income households will face additional taxes related to investment income. The Net Investment Income Tax (NIIT) is a 3.8 percent tax levied on net investment income in excess of certain thresholds determined by filing status. The NIIT covers a broad range of investment income sources, including but not limited to: Gains from the sale of stock, bonds, and mutual funds; capital gain distributions from mutual funds; gain from the sale of investment real estate; and gains from the sale of interests in partnerships and S corporations. Certain investment income that is excluded from taxation (i.e., a portion of the gain on the sale of a primary residence, qualified distributions from a Roth IRA account) is not subject to the NIIT of 3.8 percent. Financial planners must carefully review their client’s assets to determine which assets would trigger NIIT and under what circumstances the NIIT may be avoided. This chapter integrates the income and capital gains tax treatment with the description and application of investment vehicles in the portfolio selection and allocation decision-making process of financial planners for their clients. Knowledge of the various investment vehicles available in the market along with the knowledge of their tax implications will enable financial planners to develop strategies for optimizing the risk and return of their clients’ portfolios in a tax-efficient manner.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Utilize the lecture to integrate the application of the investment vehicles within a client’s portfolio, and discuss its tax implications when the investment vehicle is held for the short term and the long term.

Ask students to solve mini-case studies or situation-based questions that require knowledge of and test the application of the specific investment vehicles learned in class. For each mini-case, ask students to identify the risk/return and tax characteristics of the investment vehicle, the portfolio, and the holding account, and ask them to describe the net tax effect of gains and losses generated in the portfolio/account.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Arrange the wide range of investment vehicles into four broad categories based on their tax treatment and risk and return characteristics: (1) cash and cash-equivalent assets, (2) equities, (3) fixed income, and (4) alternative investments. Ask students to work in groups, with each group member focusing on one type of vehicle, and then provide the groups with an opportunity to present their findings to the class.

Given a client’s investment allocation and tax-related information and cash flows, use a mini-case or a related exercise that requires students to select different investment vehicles in a manner that is consistent with the required goals and objectives of the client’s tax situation and future goals.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Ask students to work in groups to recommend investment vehicles in portfolios across different life cycle stages. Ask them to compare and recognize the difference in asset allocation across the different life cycle stages. Provide students with cash flows and specific client objectives. Ask students to recommend specific investment vehicles based on the specific goals and objectives of the client situations. Discuss their recommendations and provide feedback.

Give students client net worth and cash flow statements. Provide situations where the portfolio allocation and savings strategies are not consistent with the client’s overall goals and objectives. Ask the students to review and analyze the client cash flows, identify the problems, and, based on client’s goals, recommend changes in the portfolio allocations to increase the client’s after-tax wealth over multiple time periods. Ask the students to communicate this to the client in a letter.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a

Provide the class with a client’s financial goals and a list of investment vehicles included in a client’s portfolio. Initiate a class discussion to identify the issues and develop recommendations focused on the selection of investment vehicles, with an emphasis on minimizing income tax consequences.

Provide client situations to students with a list of goals and asset information. Ask the student to identify the issues and opportunities for recommending various investment vehicles to allow clients to reach their goals in a rational, effective, and taxefficient manner.

new pattern or structure through generating, planning, or producing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: The entry-level personal financial planner should have a broad knowledge of the available investment vehicles, their appropriate application, and tax implications for investing in these vehicles over long-term and short-term holding periods. Competent: A competent personal financial planner can evaluate a client’s financial situation and goals, and can identify the opportunities to invest in the appropriate investment vehicles that are consistent with client goals and to withdraw from investment vehicles that are inconsistent with these goals in a manner that maximizes a client’s after-tax wealth. Expert: An expert personal financial planner can look at a client’s case more holistically and be able to identify both the problem areas and the opportunities, and recommend investment vehicles that meet a client’s specific needs in a way that is appropriate given the client’s longand short-term goals and that shows the planner’s ability to time the transactions and allocate the portfolio in a tax-efficient manner.

IN PRACTICE Rebecca Clyde, a financial planning practitioner, is preparing the investment plan for his client Rebecca. Clyde notices that Rebecca has allocated 90 percent of her assets to one mutual fund comprised of short-term government bonds. Rebecca has access to a defined contribution plan through her employer but seldom contributes to it; she currently holds the majority of her assets in a brokerage account. Rebecca is 42 and wants to retire at 67. She is single, has no dependents, is in the 28 percent marginal income tax bracket, and has moderate to high risk tolerance. Clyde finds that given Rebecca’s financial planning objectives and her retirement life expectancy, she will run out of money and will not be able to meet her postretirement expectations if she continues with her current asset allocation. Clyde decides to discuss this with Rebecca and offer her some recommendations regarding the investment vehicle selection and portfolio allocation. What does Clyde tell Rebecca? Clyde explains the risk and return of various investment vehicles to Rebecca and discusses with her the benefits of adding some equities to her portfolio. Adding stocks, stock-based ETFs, or mutual funds to the portfolio not only will increase Rebecca’s potential for greater

returns, but at the same time will provide her with a diversified portfolio that will have a lower risk than simply investing in a single stock, an ETF, or a mutual fund of one asset class, in her case short-term government bonds. Additionally, Clyde advises Rebecca to take the opportunity to participate in the 401(k) plan and encourages her to take advantage of other taxadvantaged accounts such as an IRA to further reduce the tax exposure to her portfolio. In this situation, a traditional IRA is likely superior to a Roth IRA given Rebecca’s age, marginal tax rate, limited retirement plan assets, and time horizon.

Mike Mike likes to trade stocks. He frequently reads information about stocks and financial markets through various blogs, media outlets, and popular publications. Mike thinks that he now has sufficient knowledge and is probably smarter than most other investors, and that he can therefore beat the market. Mike has been very successful in his logistics business. He is 29, single, and in the 39.6 percent marginal tax bracket. Mike really enjoys investing and is active with his brokerage account investments. As Mike’s financial planner, you note that Mike is subject to the 3.8 percent NIIT on all of his gains in the brokerage account. One way to avoid this would be to deposit money into a Roth IRA account or a qualified retirement plan with trading capabilities. Over time, contributions to these accounts would lead to substantial funds in the accounts that could be traded without concern for the NIIT.

NOTE 1. Harry Markowitz. “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 32 Types of Investment Risk Thomas Warschauer, PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

Although personal financial planners provide a multitude of services, one of the most common is matching investment selections to client goals and needs. Virtually every goal is funded by investments that take risk into account. Investment risk is a central factor that is directly reflected in education and retirement planning as well as other goals considered under “General Principles.” Investment risk is also associated with economic conditions, another “General Principle.” All decisions to accept, select, or resist investment risk are affected by

the client’s psychological risk tolerance and their objective risk-taking abilities. Finally, there are likely more regulatory issues related to “Professional Conduct” in investment risk than most other elements of financial planning practice.

INTRODUCTION Two common functions financial planners provide are: first, to help clients avoid investment risk they needn’t take and, second, to select the appropriate level of risk necessary to achieve client goals subject to their risk preferences. In order to accomplish these functions, planners need to understand each source of investment risk. That includes understanding what causes each type of risk, how it can be measured, and how it can be controlled. In addition to traditional measures of risk, planners should always be on the lookout to protect clients from low-probability, high-impact economic events (sometimes called “wild card” or “black swan” events).

LEARNING OBJECTIVES The student will be able to: a. Identify, measure, and differentiate between types of investment risks, including systematic, unsystematic risk, interest-rate risk, liquidity risk, credit risk, inflation risk, operating and financial risk, reinvestment-rate risk, exchange-rate risk, and political risk in a client’s portfolio. The most common way of looking at investment risk is a dichotomy, breaking total risk of a security or portfolio into two components, sometimes called market risk and non-market risk. This way of looking at security and portfolio returns is based on what is called the index model, which is derived from the capital asset pricing model (CAPM). There are a variety of similar risk measurement terms, which can be a bit confusing. Market risk is sometimes called undiversifiable risk because, in fact, it cannot be diversified against. It is also sometimes called systematic risk because it represents the co-movement of securities together. Non-market risk can be diversified away, at least partly, so it is sometimes called diversifiable risk. It is important to understand how we can quantify these risk measures based on our past experiences and how we can estimate risks in the future. Total risk is often measured historically by measuring the standard deviation of a security’s or portfolio’s returns. In order to estimate the measures of risk components for past returns using the index model, we regress market return premiums against security or portfolio return premiums (those are the holding period returns in excess of the risk-free rate). Graphically this is called the security characteristic line (SCL) which is also discussed in Chapter 33. Market risk can be measured for securities and for portfolios using a measure called beta, which measures how sensitive a security or portfolio is to market movements. Beta is the slope of the SCL. Non-market or unsystematic risk is usually measured by the standard

deviation of the error term around the security characteristic line. That is, the measure of the standard deviation of the difference between the security characteristic line and its return pairs is the measure of non-market risk. The process of security analysis includes evaluating these historically derived risk measures and evaluating how they may change in the future. Before the development of modern investment theory, the investments field emphasized the evaluation of risk through security analysis. Related risk measures are still used in that capacity. Business risk relates to the difficulty in projecting a firm’s operating income. It is caused by a number of factors, but primarily relates to the industry within which the firm operates, including operating leverage. Many firms use borrowed capital or leased equipment. The use of these can cause increased volatility of earnings through financial leverage and thus result in financial risk. Thus, business and financial risk make up most of the unsystematic risk and parts of the systematic risk of an equity investment. Modern investment theory (developed in the 1950s and 1960s) was based on these socalled two factor models. More “modern” work has included three- and multi-factor pricing models and planners should be aware of the implications of these models. The Fama-French model reflects additional factors of market capitalization and price-to-book ratios primarily as a proxy for market liquidity of the firm’s securities and their value/growth placement. Newer models have tried to include additional variables such as underlying earnings growth persistent in a manner that reflects market rewards and risks. Debt securities (bonds) also have their own measures of risk. Investors in such securities are always concerned with the possibility that higher interest rates will result in a diminished value of their investments. This is called interest rate risk. It is measured by a bond’s sensitivity to interest rate changes, which is measured by the bond’s duration. This represents the bond’s change in price for a given interest rate change. Reinvestment risk refers to the possibility that cash flow received from an investment cannot be invested at the same rate as expected. When an investment’s returns are measured by internal rate of return, that method assumes flows are reinvested at the same rate. The likelihood that this is not the case is reinvestment risk. Credit risk is a more general term and refers to the likelihood of repayment of a loan from a creditor’s point of view. For bonds, credit risk is typically measured by one of several coverage ratios. Two of the more popular of such ratios are the “times interest earned” ratio and the fixed-charge coverage ratio. Ratios measuring a firm’s liquid assets and levels of debt are also used in this regard. Liquidity risk refers to market liquidity (the term liquidity is also used in financial planning to refer to liquid—that is, safe—assets). Most securities trade in what are called the secondary market; that is, the market for already issued securities (for example, the New York Stock Exchange). When securities are traded, they may affect the market price of those securities. Liquidity risk is the risk that a client’s securities holdings, when sold, will generate less than the expected proceeds. This is not an issue for most clients with listed securities. However, it is an issue for lightly traded securities like bonds, municipal bonds,

smaller over-the-counter (OTC) stocks, limited partnerships, and collectibles. Inflation risk is the likelihood that currency will be worth less than expected in the future. Modest levels of inflation (1–3 percent) are often expected and are built into risk/return investment decisions. Obviously, investors are concerned with the purchasing power of their returns from investments at the time they are received in the future. If inflation exceeds expectations, then returns will be less valuable. Inflation also raises taxes and reduces returns further because capital gains taxes apply to nominal returns, not just real returns. Today, international investing is considered essential, because it is impossible to adequately diversify without it. However, additional risks are associated with international investing. These include exchange rate risk, associated with the likelihood that a foreign firm’s stock price or interest payments will be worth less because of an adverse movement in exchange rates, and political risk, which is the risk of expropriation of assets by political force. Another investment risk is important to financial planners but is not necessarily important to institutional portfolios. That risk is called “sequence risk.” The issue here is that, given a series of investment returns over a number of years, the sequence of returns matters, even if the average return is the same. And it matters differently to different clients. To the extent that most people have the largest investment base as they approach retirement, investment returns are most important immediately before and after retirement. To some planners this means reducing risk at this time of particular vulnerability. In any case, financial planners must consider sequence risk as being important to clients’ success. b. Explain the impact of low-probability economic events on clients’ welfare. One of the most difficult aspects of financial planning is dealing with events that are unlikely but, should they occur, would have a large effect on clients’ plans. Wars, huge economic dislocations such as a trade war, biological catastrophe, international events, unforeseen financial bubbles bursting, extreme weather, and many other things can have huge impacts on clients and their financial plans, particularly on the value of their portfolios. Assuming that most planners are not able to forecast these events, it is difficult to imagine how they can deal with them. Given the fact that most financial plans cover long time horizons, however, it is likely that something very serious may occur one or more times during the planning horizon. It is sometimes possible to envisage these events to a certain extent. When markets become unusually and measurably volatile, it is possible to temporarily hedge market risk. When it appears that monetary policy may result in extreme inflation, it is possible to include commodities such as precious metals in the portfolio. We sometimes can anticipate problems by watching derivative measures such as IVX. However, the most important thing is for planners to remain aware of world events and to try to anticipate the early warning signs. It is also important not to overreact to low-probability events, but rather to increase vigilance in times of great uncertainty. It is important to communicate your concerns to clients and explain what can be done to protect them. Finally, when the inevitable

unforeseen market breaks occur it is most important to encourage clients not to let that deter them from long-run market investments.

IN CLASS Level

Class Activity

In-class lecture illustrating how a client’s portfolio could be protected from each type of investment risk. Analyzing: Breaking material into In-class or online constituent parts, and determining how discussion categorizing the parts relate to one another and to an investment risk into overall structure or purpose through consistent groups. differentiating, organizing, and attributing Evaluating: Making judgments based on Lecture and in-class criteria and standards through checking discussion explaining how and critiquing a client may be affected by unexpected major events (e.g., a cutoff in oil supplies). Applying: Carrying out or using a procedure through executing or implementing

Student Assessment Avenue Ask students to explain what might result relative to a given context or case. Given a list of risk sources, ask students to develop nonoverlapping groupings relative to a given context or case. Using cases, ask students to explain how a client might be affected by a given major event.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can, using modern portfolio theory (MPT) investment characteristics, measure risk levels in current and proposed portfolios, but does not try to evaluate portfolio appropriateness at this level. Competent: A competent personal financial planner can find mechanisms for protecting clients from normal risk exposures. A competent personal financial planner can determine if the overall portfolio is appropriate for a specific goal. Expert: An expert personal financial planner can decide when and how to hedge against unusual risk events, such as currency changes, inflation, and interest rate changes or market failures. For example, an expert personal financial planner is familiar with hedging using foreign currency, interest rate, or market derivative instruments.

IN PRACTICE

Rosemary and James Rosemary and James Riccardo, both 67 years old, have only one goal: retirement. Their planner has concluded that the $1,200,000 they have in their single rollover traditional individual retirement account (IRA) (this was a rollover from Rosemary’s pension plan) is adequate to assure their retirement if it is invested prudently. They will receive pretax $25,000 per year from Social Security and desire another pretax $75,000 per year (in real dollars) from their investments. At this point, the only concern is risks. The risks that are of concern are normal investment risk, inflation risk, and low-probability, high-impact events that could substantially affect the success of their retirement portfolio. Their financial planner, Patricia Seals, has to figure out how much risk is appropriate for them to take. She estimates that the security market line displays an expected return of 8 percent (with a beta one portfolio) and that the current risk-free rate is 1 percent. The clients are normally risk averse, that is, about average among her clients. Patricia has concluded that the proper portfolio beta is 0.9 and therefore Rosemary and James’s portfolio return is going to be 8.2 percent [= 1 + 0.9(8 – 1)]. Patricia now needs to construct a fully diversified portfolio of that risk level. However, she is also concerned with the chance that the real portfolio return will be inadequate. So she ensures that 25 percent of the portfolio is made up of inflation-sensitive securities (Treasury Inflation-Protected Securities [TIPS], precious metals, real estate investment trusts [REITs], etc.), and minimizes the proportion in long-term non-inflationprotected bonds. As time passes, Patricia becomes wary of market conditions. The markets are extremely and measurably volatile (as measured by the Chicago Board Options Exchange Market Volatility Index [VIX]). She considers hedging market risk using market futures, on a temporary basis. Although she is aware this is like buying an insurance policy (that is, it is costly), she is very concerned that a market crash could destroy her clients’ retirement plans. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 33 Quantitative Investment Concepts Thomas Warschauer, PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

Almost all aspects of investment theory and practice have an element of quantitative analysis, and a basis in statistical methodology. Quantitative investment concepts are used throughout the investment considerations in retirement planning, with Chapter 53 devoted to “Types of Retirement Plans.” These statistical tools are commonly used in economic analysis (see Chapter 10). They are also sometimes related to time value computations (see Chapter 11). Statistical concepts, such as sensitivity analysis and Monte Carlo simulation, discussed in this

chapter, are utilized by all goal achievement methods, including retirement needs analysis (see Chapter 50), education planning (see Chapters 15–19), and insurance needs analysis (see Chapter 28).

INTRODUCTION Every competent financial planner should possess a comprehensive understanding of basic statistical methods. Nowhere in the profession is this more obvious than in the investments field. But as the connections diagram indicates, the use of these tools is more far-reaching than the investment area itself. The reason for the pervasive nature of statistics, particularly in investments, but also elsewhere in planning, is the stochastic nature of the real world planners are forced to contend with. As no one has a crystal ball, we must contend with uncertainty, and that means using statistics that describe not just the expectation of what might happen but also the range and distribution of possible outcomes.

LEARNING OBJECTIVES The student will be able to: a. Calculate and interpret statistical measures such as mean, standard deviation, Zstatistic, correlation, and r2 and interpret the meaning of skewness, and kurtosis. Most studies of statistics begin with a study of central tendency and dispersion. Measures of central tendency include means, medians, and modes. Further, there is a family of computations related to the mean, including both arithmetic and geometric averages. Each of these measures of central tendency has its use in the investments field. For example, given a series of historical returns, one might ask, “If the future is like the past, what return might I expect?” The best answer to that question would be the arithmetic average of the historical return sequence. A different question could be asked of the same data. One might ask, “My portfolio returned a certain amount. Is that more or less than the average return of an index?” To answer that question, we would need to compute the geometric return of the historical sequence, as this computation includes the effect of compounding. Another statistical concept essential in planning and particularly related to investments is the concept of dispersion. The assumption implicit in many financial models is that dispersion of past returns represents a measure of risk regarding future returns. Variance and standard deviation are prominent measures of dispersion and of total risk. One of the most fundamental investment strategies involves diversification. Portfolio selection criteria, whether approaching diversification using an asset allocation framework or using individual securities, require a portfolio manager to account for the relationships among securities or asset classes. Measures of these relationships are made using correlation coefficient or covariance measures. Sometimes we wish to measure how much

of the variance in one variable is associated with variance in another. For example, we may want to know what proportion of variation in a mutual fund’s returns are associated with variations in the market overall. R-squared (r2, the correlation coefficient squared) gives that proportion and is essential in the security selection process. It is also an important measure of portfolio diversification. Understanding the nature of past return frequency distributions provides a better understanding of what one might expect in the future. Normal distributions are fully described by mean and standard deviation measures. Although most planners are aware of the implications of normal distributions, few if any return distributions are in fact normal distributions. Additional characteristics of distributions include their left- or right-leaning nature (called skewness) and the peakedness of distributions (called kurtosis). Although understanding the nature of past return distribution may seem arcane, it can be an essential element in understanding risk. Often statisticians wish to measure whether a statistical property of a sample is statistically different from some underlying population. Statistical tests measure the likelihood of this. Common statistical tests include Z and t distributions. Planners should be familiar with using these statistical tests and understanding their results, which help to determine if differences in two distributions are likely to be associated with randomness or if they are likely to be statistically related. b. Estimate the expected risk and return using the capital asset pricing model for securities and portfolios. As described in the chapters on risk and return (see Chapters 35 and 37), the capital asset pricing model (CAPM) is the most accepted model in the investments field, even with its limiting assumptions. Those assumptions are that investors are risk takers, have one uniform holding period, use only traded investments, pay no taxes and encounter no transaction costs, are rational, and use both optimum and similar analytic techniques. According to CAPM, an individual securities return is described by:

An index model based on CAPM acknowledges that returns respond to factors other than market factors:

Given a portfolio of securities, a planner must be able to estimate the expected returns and risk level from those of the securities held.

and

where w represents the weight or proportion invested in security k. c. Calculate Modern Portfolio Theory statistics in the assessment of securities and portfolios. The basic nature of securities can be best determined graphically by the security characteristic line (SCL). The SCL is the plot of the excess returns of a stock or portfolio against the excess returns of the appropriate market index for a collection of holding period returns (HPRs). The actual SCL is the regression line best fitted to those points. The results of the SCL are the alpha, beta, r-squared, and the standard error of that regression line. These results can be determined for a portfolio or a single security. The interpretation of these parameters is also dependent on whether you view the market as price-efficient and whether you are referring to expected values or historical values. Regarding historical SCL values, a portfolio alpha (sometimes called Jensen’s alpha) represents the return to the manager’s selection, adjusted for risk, the beta measures the level of market risk in the portfolio, the r-squared measures the level of diversification within the portfolio, and the standard error describes the amount of residual or non-market risk. If these results were obtained for an individual security, the alpha represents a combination of the degree of new information regarding a security that was released during the observed period and the degree to which it was underpriced or overpriced to begin with. For a security, the r-squared represents the degree to which the company itself is diversified. Regarding anticipated values for these parameters, in an efficient market, alpha is always expected to be zero. In a less than efficient market, it represents the degree to which a security analyst believes a security is mispriced or that a portfolio contains mispriced securities. d. Explain the use of return distributions in portfolio structuring. The return distribution of historical data for a particular asset class demonstrates the nature of the variability of returns. If the distribution is normal, or lognormal, then we know quite a bit about the risk of that asset class. If the shape of that return distribution is skewed or has kurtosis, or even if it is shapeless or flat, that implies something quite different in terms of information needed to understand risk associated with that security or portfolio.

e. Identify the pros and cons of, and apply advanced analytic techniques such as forecasting, simulation, sensitivity analysis, and stochastic modeling. In the early years of financial planning, planners used deterministic present value models to assess savings needed to accomplish client goals. For example, for a retirement needs computation, planners would make point estimates of each data point: life expectancy, inflation, expected rate of return, and so on. However, it is common knowledge that the numbers are only estimates, and reality can vary substantially from these expectations. It is also clear that the timing of these deviations has a great effect on a client’s plan. The world is stochastic, and planners needed to deal with that reality. Two particularly important tools have been accepted into the practice of financial planning: sensitivity analysis and Monte Carlo simulation. Using these techniques, it is possible to determine not only how much a client may need to save for a particular goal, but the likelihood of that savings stream resulting in success (meeting the client’s specified goal).

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Provide students access to online databases containing historical return data for various investments, (Federal Reserve, Bloomberg, Wharton Data, Compustat). Ask them to translate return series into HPR data and compute the frequency distribution of returns. Finally, ask them to use descriptive statistics to evaluate the underlying distributions’ characteristics.**

Given a historical HPR sequence, ask students to calculate the different measures of central tendency and dispersion, as well as skewness and kurtosis.**

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Given the aforementioned, explain the implications of the HPR’s statistical characteristics to the nature of the investment itself.**

Provide students with data for several important asset classes (e.g., using the Morningstar/Ibbotson SBBI Classic Yearbook). Ask students to evaluate the future correlations between selected asset classes.**

Provide a specific client goal and ask students to evaluate the suitability of the aforementioned HPR stream for future investment, assuming similar future conditions to those in the sequence.**

Ask students to debate the use of that asset class for that particular goal.*

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Provide students a series of asset class HPR distributions and a series of goals with varying time horizons and importance. Ask students to match which HPR stream is most appropriate for each goal.**

Using the normal parameters for retirement computations, ask students to use Monte Carlo simulation or sensitivity analysis. In order to do that, they must specify the distribution characteristics for each asset class.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can determine the characteristics of a portfolio from historical data. Competent: A competent personal financial planner can match the portfolio’s characteristics with client risk aversion, time horizon, and importance of specific goals. Expert: An expert personal financial planner can calculate the likelihood of meeting a particular goal with a specified investment class’s characteristics using sensitivity analysis or Monte Carlo simulation.

IN PRACTICE Rodolfo and Henrietta Rodolfo and Henrietta Olvera are both very risk tolerant. Charles Cowan, their financial planner, has evaluated a series of asset classes and has estimated their expected returns, their risk levels, and their correlations among each of their pairs. Charles has built a portfolio with an expected return of 8 percent and a standard deviation of 12 percent. Charles agrees that inflation will average 3.5 percent throughout their lives, but that it is a normally distributed variable with a 4.3 percent standard deviation. The Olveras would like to retire on 80 percent of their current income in real dollars. They are both 50 years old and desire to retire when they are 70. They are both in good health. They expect to earn $36,000 (combined) Social Security retirement benefits. They currently earn gross salary of $65,000 per year and expect that their salary will increase at the rate of inflation plus or minus 1 percent. They have no retirement savings. Using Monte Carlo simulation, Charles develops a table showing what amount of their income they will need to save between now and then to be between 50 and 95 percent certain of reaching their retirement goal. Charles presents his findings to the Olveras, explaining the concept of sequence risk and how the Monte Carlo simulations allow planners to characterize the magnitude of this risk. He connects it to the fact that the Olveras are very risk tolerant by suggesting a specific threshold (e.g., a 70 percent success rate) that would be a good path for them to follow. Charles seeks the response of the clients now that they have a better understanding of the nature of risk and their likelihood of success. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 34 Measures of Investment Returns Thomas Warschauer, PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

Investment returns are inextricably linked to any financial goal-achievement planning function, including education and retirement goals. Understanding estimates of future returns is meaningless without understanding risks involved. The basis for investment returns rests on economic growth: that of the firm or specific project and that of the economy. Returns interact with time value calculations, valuation, portfolio, and allocation models. Returns encountered by clients are real after-tax returns, and so tax considerations are very important. Finally,

consumer protection laws sometimes prescribe how returns should be stated most fairly.

INTRODUCTION The concept of investment return is simple in nature but complex in implementation. Ex post (in the past), higher returns are always better than lower returns, no matter how they are calculated. But the investments field deals with the future (ex ante returns), not the past, and that is where it gets more complex. In the investment world, higher anticipated returns are usually accompanied by more uncertainty. What investors care about is return, sure enough. But they are interested in the spending power of what they actually get. Investors often must share their returns with the government through taxation. Returns are taken from investors in two ways: through direct taxation of returns by the state and federal government and through inflation. So investors care about returns after-tax, and they also care about the spending power of their future cash inflows from investments. That is, they desire higher real after-tax returns. There are a number of ways in which returns can be calculated. A planner needs to know when and how to use each. Because investors care mostly about future returns, and because future returns are uncertain, planners need to be able to compute and understand various risk-adjusted return measures.

LEARNING OBJECTIVES The student will be able to: a. Identify, measure, and interpret investment returns including after-tax, holding period return, effective annual rate, annual percentage rate, time- and dollar-weighted returns, and geometric and arithmetic returns. The simplest measure of rate of return is called the holding period return (HPR). It is computed for any given period of time as follows:

where PE = selling price, R = receipts during holding period, and PB = purchase price. The problem with HPR is that it does not account for the time value of money. Typically, HPRs are measured on an annual, quarterly, monthly, weekly, or daily basis. The most common use of HPR is to measure how volatile the return has been for a particular investment.

Another measure of return is the internal rate of return (IRR). It is described in the chapter on the time value of money (see Chapter 14). Internal rate of return is computed on either historical (ex post) cash flows or anticipated (ex ante) cash flows. It is usually computed using annual cash flows, although other periods are not unusual (monthly, quarterly, etc.). It is particularly useful for estimating returns from single-outflow investments with unequal inflows. One limitation of its use comes about when there are multiple outflows over the term of the investment. Also, this measure assumes that funds received during the investment period can be reinvested at the same rate as the IRR. So it is most useful when these limitations are not involved. One of the difficulties in using return measures is the issue of their comparability. This is particularly true when evaluating short-term investments where small differences in yield may make a big difference in which investment you select—for example, selecting shortterm Treasury bills or certificates of deposit. In this case, there is often an issue of compounding periods—that is, how often returns are added to principal to earn additional interest. Treasury bills are sold at discount and redeemed at par value. So, for example, suppose a one-year Treasury bill is sold at $97 and redeemed at $100. The return could be computed as:

However, what if that investment was a six-month T-bill? The planner might want to compute the effective annual rate (EAR). Then,

Notice that 3.093 times 2 does not equal 6.281%. In this case the exponent 2 is equal to 1 divided by the number of time periods per year. What if we wanted to know the EAR of an investment over a year? Say we bought a 10-year zero coupon bond for $400 (quoted as 40.00) that matures at par, $1,000 (quoted as 100).

But the EAR would be:

Another useful number is the annual percentage rate (APR). It does not contemplate withinyear compounding. That is, it uses simple (not compound) interest. One can transact between the EAR and APR as follows:

where p is the number of compounding periods per year. Given a fixed APR, the more frequent the compounding period, the higher the EAR will be. Investors are interested in real (not nominal) returns. After all, the whole point of adjusting for the time value of money is to equate purchasing power over time and adjusted for opportunity costs of funds not spent. It seems obvious that if we knew what the rate of inflation would be we could simply subtract the expected inflation rate from the expected rate of return:

However, that logic does not contemplate the compounding effect of inflation. The actual relationship is:

Another concern of investors is the taxes on the investment’s return. One source shows this relationship:1

where R = nominal rate, t = tax rate, r = real rate, and i = inflation rate. The sad, but true, fact of life is that it is not unusual to encounter real after-tax losses on many investments, even ones with positive real pretax returns. And even future returns are

sometimes expected to be negative after-tax and after inflation are considered. This is particularly true at the low-risk end of the investment spectrum. That is to say, investment returns frequently are insufficient to earn returns that keep pace with inflation and taxes. That is, with low risk/return investments, at times we can only hope to offset taxes and inflation as much as possible. Another issue related to return calculations is how one might average a number of holding period returns. Statistics classes review a number of measures of central tendency, including the arithmetic and geometric averages. Given a series of returns, a planner needs to know how to calculate these average returns and when each should be used. The arithmetic average is computed by:

where Xi = values to be averaged Σ = summation N = number of values to be averaged The geometric average is computed by:

When computing the geometric average of rates of return, we use:

When dealing with rates of return, the geometric average contemplates compounding whereas the arithmetic average does not. The smaller the variations in returns, the closer are the two averages. Given any variability in returns, the arithmetic average is always higher than the geometric average. When using average returns as a measure of expectations or guide for future returns, the arithmetic average is the best unbiased estimate. When making performance comparisons, the geometric average is the proper measure for comparison. A final issue when computing rates of return is the difference between time-weighted and dollar-weighted returns. Dollar-weighted returns are actually the internal rate of return (IRR) of a cash flow sequence as described in Chapter 14. Time-weighted returns are

actually the geometric average of the return sequence. Generally speaking, performance measurement contemplates the use of time-weighted returns because it eliminates the impact of cash flows over which the investment advisor/manager likely has no control, and so is a better measure of the investment strategy or policy. b. Calculate and interpret risk-adjusted performance measures such as the Sharpe, Jensen, and Treynor ratios. When comparing investment results, it is common to adjust those return results for risk. If one manager uses a high-risk strategy to earn a modest return and another earns the same return with a lower-risk strategy, obviously any risk-averse individual would prefer the latter. The most common way of adjusting for risk is to divide the risk premium (ri – rf ) by a measure of risk to get the unit of return per unit of risk measure. The Treynor index measures the risk premium per unit of market risk (beta), and the Sharpe measure assesses the risk premium per unit of total risk. Jensen’s alpha is also a return measure that adjusts for market risk. These measures are discussed in more detail in Chapter 40 (Portfolio Development and Analysis).

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Given a series of HPRs, compute the arithmetic and geometric average of returns. Compare time-weighted and dollar-weighted returns.**

Ask students to discuss when it is appropriate to use arithmetic averages of a return sequence and when it is appropriate to use geometric average returns.*

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Give the students a series of investment returns. Ask students to compute different return measures, such as HPR, EAR, and APR. Discuss when each could be used appropriately.**

Ask students to match various return computation results for each return method with situations for which each would be appropriate.**

Evaluating: Making judgments based on criteria and standards through checking and critiquing

The instructor and student role-play gathering data for a level of a client’s risk-aversion measure. They discuss different portfolio combinations that seem to satisfy the client. But then an adverse market causes losses. The role-playing student is asked whether the client wants to continue with the original target allocations or some safer choice.*

Given a case situation providing a range of investment alternatives, ask students to match investments with different client situations.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can compute each type of return discussed. That is, an entry-level planner, given actual data, can compute HPRs, APRs, IRRs, EARs, and geometric and arithmetic means. Competent: A competent personal financial planner can use each type of return computation in

the appropriate context. That is, given the numerical values indicated for entry-level planners, a competent planner knows when to use each. Expert: An expert personal financial planner can select investment alternatives from choices with ambiguous return results.

IN PRACTICE Robert and Mary Alberta has been a planner for several years. She is not accustomed to the low interest rate environment in which she finds herself. Her newest clients, Robert and Mary Piker, are very risk-averse. Their current checking account is paying what the bank claims is an EAR of 0.1 percent. The clients are in a 28 percent federal marginal tax bracket and in a 6 percent state marginal tax bracket. Alberta expects 2.8 percent inflation this year. She has found several CDs available with a desired 12-month maturity. One earns an APR of 1.8 percent with monthly compounding, and another earns 1.7 percent with quarterly compounding. She also has found that a 12-month Treasury bill is quoted as having a yield of 0.19 percent. Assuming these are all risk-less alternatives and assuming the clients are willing to tie up their funds for a year, Alberta needs to discover the best alternative for her clients and communicate the rationale.

NOTE 1. Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 9th ed. (New York: McGraw-Hill Irwin, 2011), 121. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 35 Asset Allocation and Portfolio Diversication Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Asset allocation and portfolio diversification is a fundamental element of the investment process (investment planning). Various asset allocation and diversification strategies will have different income tax considerations that must be accounted for depending on the tax status of the investor and/or the type of account that holds the assets (tax planning). Different asset allocation and diversification strategies may be indicated when investing for retirement (retirement savings and income planning). The professional delivery of investment advice is

regulated by state and federal agencies as well as self-regulatory organizations (professional conduct and regulation).

INTRODUCTION When advising clients on strategies to meet their financial goals, financial planners are often called upon to make recommendations regarding the deployment of client savings in pursuit of an investment return consistent with planning assumptions. In giving such advice, financial planners must have a thorough understanding of the primary factors that influence a portfolio’s risk and return, most especially asset allocation and diversification. Asset allocation refers to the process of selecting broad investment categories (e.g., cash, bonds, large-cap stocks, small-cap stocks, real estate securities) and the amounts that will be invested in them, a decision that has been shown to be the dominant factor in explaining the variability of returns among portfolios.1 Diversification, meanwhile, is the process by which one minimizes idiosyncratic risk in a portfolio by spreading investments across and within asset classes, national boundaries, and currencies. It is only since the 1952 publication of “Portfolio Selection” by Harry Markowitz2 that the correct way to measure the risk and return of a given portfolio allocation was established. The capital asset pricing model later built upon this work, offering a methodology for choosing the optimal combination of risky and risk-free assets via a linear combination of the tangent portfolio and the risk-free asset. The subsequent development of multifactor market models (e.g., the Fama-French three-factor model)3 offered further insights into those asset classes that seem to provide reasonable returns for the risks taken (i.e., are a “priced source of risk”). Although dual economic crises in the first decade of this century and the resultant rise in market volatility have caused some to question the validity of the preceding work, these remain the foundation for any evidence-based approach to assembling a client portfolio.

LEARNING OBJECTIVES The student will be able to: a. Construct an optimal client portfolio by the allocation of wealth amongst risky assets and risk-free security. While it is possible to solve the portfolio optimization problem using the calculus of constrained optimization with Lagrange multipliers, this technique becomes prohibitively difficult when dealing with more than three asset classes, and the vast majority of financial planners use some form of third-party software for this purpose. Nonetheless, such calculations are extremely sensitive to initial inputs, and the competent financial planner will have a more than rudimentary understanding of the underlying model. Among other things, the competent financial planner will be familiar with the Markowitz formulation for measuring portfolio variability, including the different approaches for developing inputs and the sensitivity of the model with respect to changes in those inputs.

The technique requires various estimates, including expected return and risk for each security, and a matrix of correlations for each pair of securities. The Markowitz model then uses a quadratic programming technique to develop what he called the “efficient frontier of risky securities”—that is, the portfolio with the highest possible return at any given level of risk. The results of the algorithm are to compute the proportion of each security or asset class to be held at any given level of client’s risk preference. William Sharpe also developed a similar model whose inputs (alpha, beta, and non-market risk for each security, as well as the expected return and risk of the market) generate similar results. It is important to mention that the asset allocation framework is a relatively new aspect of portfolio management. Previously, the Markowitz model was impractical because the large number of securities needed for the purpose of portfolio diversification required an equally large number of analyst estimates. However, by proposing to divide portfolio management into two stages—first, grouping similar securities into asset classes and, second, diversifying among asset classes instead of individual securities—the Markowitz model becomes much more practical. This is so because you are diversifying among a dozen asset classes instead of thousands of individual securities. It is also important to note that this method of portfolio management is very effective at using passive strategies and strategic management. b. Develop and communicate to a client a portfolio rebalancing strategy. To the degree that a given asset allocation is considered optimal based on a client’s objectives and risk tolerance, periodic rebalancing will be necessary to correct the tendency of different asset classes to drift away from allocation targets as a consequence of differences in realized returns. A variety of approaches to rebalancing have been proposed, focused variously on optimizing trading costs and capturing the assumed mean reversion of asset class returns. It could be pointed out that rebalancing is counterintuitive because it implies selling winners and buying losers. However, rebalancing is an important function that involves trading in a client portfolio on a calendar or boundary basis (i.e., opportunistic rebalancing),4 and it is important that clients understand the rationale and techniques to be employed in order to keep them committed to a consistent course of action. c. Recommend an asset allocation strategy consistent with a client’s risk tolerance. The best asset allocation strategy is one to which the client can remain committed over the long run. Significant factors in determining how steadfast a client will be are his or her risk tolerance and risk perception. While risk tolerance has been shown to be a relatively stable measure of the trade-offs an individual is willing to make between risk and reward, risk perception is highly unstable and represents an individual’s perception of the magnitude of those trade-offs at any given point in time. The financial planner has the dual responsibility of choosing a portfolio allocation that is objectively consistent with the client’s risk tolerance and also counseling and educating the client on an ongoing basis in order to minimize the instability inherent in the client’s risk perception.

IN CLASS Category

Class Activity

Applying: Carrying out or using a procedure through executing or implementing

Instructor lecture on portfolio optimization techniques, including a discussion of the Markowitz formula for portfolio variance.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Student Assessment Avenue

Assessment #1: Students are asked to build a spreadsheet optimizer in Excel based on the Markowitz formula and using Excel’s Solver function. Although one may also design such an optimizer using linear algebra (via the Array function), the virtue of using Solver is that it allows for a more intuitive application of each element of the formula. Instructor lecture on the Students write an integrative paper different approaches to discussing the different threads of research rebalancing a portfolio, related to the portfolio rebalancing with reference to the question, with specific reference to the different studies that have competing factors that must be balanced been conducted, their (e.g., tax cost, transaction cost, methodology, and momentum). 5 findings.

Student-led discussion on the three elements that go into client risk assessment: risk tolerance, risk perception, and risk capacity. Students can be given questions to guide their discussion, such as the following: What is the appropriate role for the financial planner in influencing risk perception? What role does the financial planning process play with respect to risk capacity? Does

Students are given a client profile and asked to assess the client’s relative risk tolerance, risk perception, and risk capacity. Students should explain how the three assessments interact and how they would classify the client based on the combined elements.

the client have any input into this part of the assessment? How does the financial planner weigh the three elements when choosing an appropriate portfolio allocation? Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Classroom role-play with the instructor playing the role of client and students interviewing the instructor in order to uncover goals, objectives, financial circumstances, risk tolerance, and risk perception.

Students take what they learned during the classroom role-play and develop recommendations for a diversified portfolio that is demonstrably connected to the client’s goals, objectives, financial circumstances, risk tolerance, risk perception, and risk capacity.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the elements that go into the Markowitz formula for calculating portfolio variance. This planner will also have a basic understanding of portfolio rebalancing techniques and can explain them in terms of diversification, transaction and tax costs, and momentum. Competent: In addition to the foregoing, a competent personal financial planner can develop portfolio allocation recommendations based on independently developed estimates of the optimization inputs (expected return, variance, and covariance) for which a detailed rationale can be provided (e.g., historical, forward-looking, blended, risk-premium-derived, etc.). Expert: In addition to the foregoing, an expert personal financial planner can develop asset allocation recommendations that take into account client goals, objectives, risk tolerance, risk perception, and financial circumstances, as well as economic and market conditions. This planner not only can weigh all of the foregoing factors in developing integrated recommendations, but can also clearly explain those recommendations to the client in a way that is demonstrably connected to client goals, values, and priorities.

IN PRACTICE Harry

Harry Bridges has just hired financial planner Holly Goemans to help him develop an investment plan for the cash lump sum that he is about to receive as a consequence of his recent retirement. This lump sum will represent the sum total of Harry’s investable assets and will need to be invested in a way that will support his spending needs in retirement. Holly begins by asking Harry a number of open-ended questions related to his vision for life in retirement. She then collects the information Harry brought based on the document checklist mailed to him prior to the meeting, including a risk tolerance questionnaire. In preparation for her next meeting with Harry, Holly uses the information gathered during their discovery meeting to assess Harry’s goals in light of his risk tolerance, risk perception, risk capacity, and other personal and financial circumstances. Balancing all of these factors, Holly chooses a portfolio allocation that she believes has a reasonable probability of sustaining Harry’s spending needs in retirement with the least amount of risk. Based on her assessment of Harry’s risk tolerance and perception, Holly knows that she will need to engage in extensive explanation and education to ensure that Harry will remain comfortable with the recommended portfolio over the long run.

Missy Missy Springsteen, a senior financial planner with the firm of Davidson & Potter, has been charged by the firm’s partners with reviewing and updating the firm’s model investment portfolios. She will be using portfolio optimization software that estimates the mean-variance efficient frontier based on user inputs. Having a thorough understanding of the mathematics at the heart of the optimizer, Missy knows how sensitive the optimizer’s output is to small changes in inputs, which consist of estimates of expected return, variance, and covariance among the candidate asset classes. Missy explores the results of various inputs, using historical estimates based on different time periods, and forward-looking estimates based on estimated risk premiums, ranked returns, and blended inputs. As she explores the results of different inputs, certain combinations tend to recur under multiple input scenarios, allowing Missy to select an optimal combination of risky asset classes. This core “risky asset” portfolio will then be converted into a series of portfolios with different risk profiles by leveraging it down the risk-reward spectrum through the incorporation of ever larger allocations to a high-quality, low-duration bond portfolio. In other words, all portfolios will be a linear combination of the optimal portfolio of risky assets and the low-risk bond allocation. Finally, Missy prepares a narrative describing the process by which she arrived at the model portfolios so that the firm’s advisers will understand and be able to explain the process and results to clients.

NOTES 1. Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal (May–June 1991): 40–48. 2. Harry Markowitz, “Portfolio Selection,” The Journal of Finance 7 (1952): 77–91. doi: 10.1111/j.1540-6261.1952.tb01525.x.

3. Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47, no. 2 (June 1992): 427–465. 4. Gobind Daryanani, “Opportunistic Rebalancing: A New Paradigm for Wealth Managers,” Journal of Financial Planning (January 2008): 48–61. 5. Ibid. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 36 Bond and Stock Valuation Concepts Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Factors that affect the valuation of stocks and bonds can have tax implications. For example, rising or falling interest rates can create premium and discount bonds, which have income tax implications (tax planning). Retirement planning depends on many assumptions related to capital market returns, which in turn depend on an understanding of how markets price bonds and stocks (retirement savings and income planning).

INTRODUCTION While financial planners assume many different roles with respect to client investment decisions, ranging from generalized advice to actual implementation and portfolio management, a thorough understanding of security valuation models is nonetheless essential knowledge for all planners. Even when a financial planner is not engaged in individual security analysis, understanding the models used by other market participants provides insights into how markets work and allows the planner to provide better investment advice, including the kind of clear explanations that keep clients committed to a consistent course of action. Stock and bond valuation techniques based on the concept of present value have been documented from the mid-nineteenth century, when actuarial techniques for valuing annuities were applied to stocks, a word that at the time was used interchangeably for both stocks and bonds. Bond valuation tables have been found dating to 1843, and stock valuation formulas based on fixed and growing annuity calculations have been documented as early as 1869, though these appear to be successors to even earlier versions.1 With the 1934 publication of Security Analysis by Columbia Business School professors Benjamin Graham and David Dodd, followed in 1938 by John Burr Williams’s The Theory of Investment Value, the idea of fundamental analysis began to come into its own. Building on the work of Williams, Myron J. Gordon later developed the constant-growth dividend discount model, commonly referred to as the Gordon model2 and still taught by every finance undergraduate program.

LEARNING OBJECTIVES The student will be able to: a. Value a bond using discounted cash flow and explain how interest rates affect bond values. The market price of a bond is the present value of all contractual interest payments plus the present value of the principal at maturity, discounted at a rate appropriate to the general level of interest rates for comparable securities. Formally, a bond is valued as follows:

where P = market price of bond i = market interest rate

C = periodic interest payment N = number of payments M = value at maturity (typically face value) As the market rate of interest rises, the rate at which each coupon payment and the final return of principal are discounted also rises, causing the present value of each to fall. This is why bond prices move inversely to interest rates, ceteris paribus. This is unequivocally the case with high-quality bonds like U.S. Treasuries, where there is little or no default risk, but may not be true with lower-quality bonds, where falling default risk may offset the impact of rising rates. A commonly used measure of the price sensitivity of a given bond to changes in yield is known as duration. In general, there are two forms of duration: Macaulay duration, which measures the weighted average maturity of all cash flows, and modified duration, which directly expresses a bond’s price sensitivity to changes in its yield. Macaulay duration is expressed in years and modified duration in percentages. When yield is continuously compounded, Macaulay duration and modified duration will be the same number, though expressed in different units. One of the investment strategies that investors employ to minimize interest rate risk is known as immunization, which involves matching a bond portfolio’s cash flows with the investor’s spending needs. b. Estimate the value of a stock using discounted cash flow, the CAPM, and price multiples. There are many types of equity valuation models used in finance. Balance sheet models are often used to evaluate liquidating or replacement values for companies to find a floor of value for the company or for a prospective buyout purchaser. But dividend discount models (DDMs) are by far the most used in fundamental analysis of a stock. The dividend discount model conceptualizes the intrinsic value of a stock as the present value of all future dividends, discounted using a required rate of return that reflects the riskiness of the stock. When dividends are assumed to be growing, the required rate of return is adjusted for the assumed growth rate and the model is known as the constant growth model or Gordon model. Formally, this model can be expressed as follows:

where V = intrinsic value of common stock D = dividend k = required rate of return on common stock

g = growth rate of dividends Sometimes intrinsic values are compared to market valuation by comparing the required rate of return of a stock to its market capitalization rate. The essential elements of DDMs are future growth and discount rates to be applied. Growth is related to the plowback ratio (b) (the proportion of earnings not paid out in dividends) and the firm’s return on equity (ROE) as:

The capital asset pricing model (CAPM) is often used to determine the required rate of return to use in the DDM. The CAPM provides a required return that is adjusted for a stock’s riskiness relative to the market as a whole and can be expressed as:

where Ri = required rate of return for individual security Rf = risk-free rate of return βi = beta of individual security E(RM) = expected return to the market as a whole This expression states that the expected (or required) return to an individual security equals the security’s beta times the expected market premium (i.e., the expected market return minus the risk-free rate of return). The DDM has several multi-period variants in which different growth rates are assumed over the different phases of a company’s life cycle. The logic here is that valuation techniques of finding value as the present value of future dividends are impractical (except for no-growth investments like preferred stock and mature growth investments valued by the Gordon model). Multi-period models divide the future dividend steam into rapidgrowth and perpetual slow-growth segments, thus making it possible to use present value methods on a perpetual stream. The financial markets have other valuation tools that are commonly used. These include relative price-earnings (P/E) multiples. The relationship of P/E to value is often expressed as:

Historically, stock valuation models have been used to identify companies whose shares were undervalued relative to the intrinsic value suggested by the model. Since, all other things being equal, dividend discount models favor stocks trading at a low price relative to earnings, it has been suggested that an investor could obtain similar results by simply buying low-P/E stocks.3 c. Differentiate between fundamental and technical analysis. Fundamental analysis involves an examination of the financial condition of a company, the development of forecasts related to earnings and profits, and the estimation of intrinsic value using a valuation model such as the dividend discount model. In other words, those using fundamental analysis attempt to gain insights into the fundamentals of a company’s business operations in order to select those that may be undervalued. By contrast, technical analysis involves security selection based entirely on patterns in a company’s stock price. Market technicians often use tools such as relative price movements tracked by moving averages or smoothing techniques. In recent years, market technicians have absorbed concepts from the field of behavioral finance, suggesting that the price patterns by which they trade are manifestations of the systematic cognitive errors that investors make, which have been identified by behavioral finance researchers.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Instructor lecture on time value of money concepts and the economic rationale for valuing assets with future cash flows using these techniques. Examples are presented for valuing a bond.

Students are provided with information related to the face value, coupon, and maturity of a bond, along with interest rates for comparable securities, and asked to calculate the appropriate price for the bond using a financial calculator.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Instructor lecture on the dividend discount model and its many variants, including the Gordon model and multistage dividend discount models. The economic rationale for using multistage models is also discussed. Examples of the DDM and its variants are presented.

Students are provided with data related to a series of real or fictional companies and asked to estimate earnings growth rate, payout ratios, beta, and intrinsic value at various points in time.

Guest lecturer from the Market Technicians Association (MTA) presents the positive case for technical analysis.

Students each write a paper comparing fundamental and technical analysis in which they take a position and marshal evidence in favor of one or the other approach. Creating: Putting Student-led discussion of the Students are provided with elements together to form current state of the economy and three stylized scenarios for a coherent or functional how different scenarios (rising changing macroeconomic whole; reorganizing interest and/or inflation rates, conditions and are asked to elements into a new falling rates, slowing growth, etc.) evaluate the expected impact pattern or structure would impact the values of stocks on a specified portfolio of through generating, and bonds. stocks and bonds. planning, or producing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner understands the basic relationship between interest rates and bond prices, as well as the basic techniques of fundamental analysis, including the use of dividend discount models. Competent: A competent personal financial planner understands how changing

macroeconomic variables—such as the general level of interest or inflation rates—can impact stock and bond valuations and the interaction effects that must be accounted for. A competent personal financial planner can explain, for example, how changing inflation expectations can impact interest rates through the mechanism of the bond markets. A competent planner can also explain these economic relationships to clients in a way that is both accurate and comprehensible to the client. Expert: An expert personal financial planner understands the strengths and weaknesses of both fundamental and technical analysis and will be able to cite (and argue) the evidence for and against each approach and/or combination of approaches. An expert planner can discuss approaches to security valuation that are grounded in a deep understanding of the economic context and rationale for each.

IN PRACTICE Georgette Georgette Dewan is visiting her financial planner, Allyson DeLoach, in order to discuss Allyson’s recommendation that Georgette sell the Treasury bond that she has just inherited. Georgette is confused by Allyson’s recommendation to sell a security that has an 8 percent coupon; surely there are few places where one can capture that high a guaranteed return! Allyson begins by explaining that, whatever the bond’s yield at issuance, a steep drop in interest rates and subsequent rise in the bond’s price have made the current yield much lower than 8 percent. Georgette counters that dividing the cash income by the current market price of the bond still suggests a yield of 5 percent. Illustrating her point on a legal pad, Allyson then explains that the nearly 50 percent premium in the bond’s price will disappear by the time the bond matures. It is the value of the original face amount of the bond that Georgette will receive, not the current market value. And it is the disappearing premium that causes the yield to maturity, which should be thought of as a total return to the bond, to be so much lower than it might at first appear. Gratified to understand a little bit more about the counterintuitive world of bonds, Georgette approves the recommended sale.

Tobe and Steve Financial planner Michiko Albert is meeting with her clients Tobe and Steve Stychfield to discuss their desire to obtain shares in the upcoming initial public offering (IPO) of BookFace Inc. The Stychfields are longtime users of BookFace’s services and are convinced that their positive personal experience with the company is a good basis for investing. Michiko has prepared an analysis based on the financials recently released by the company and begins with a discussion of how one might think about valuing a company like this. First, she explains, based on the company’s historical earnings growth rates and IPO price-earnings (P/E) ratio of 100, the initial offering price seems high. Michiko observes that the rate of growth in earnings implied by such a P/E is higher than what the company has reported for the past two fiscal years, and that, in any case, few companies sustain such a high rate of earnings growth over the

long run. She ends by quoting an opinion piece written by a famous economist at the end of the dot-com bubble in early 2000. The writer observed that a well-regarded technology firm currently sporting a triple-digit P/E would, if it produced a “modest” rate of return of 15 percent over the next 20 years, “suggest the improbable implication that the market capitalization of [the company] would become larger than the current gross domestic product [of the United States].”4 Within months, the share price of the company in question began a descent that within two and a half years took it from over $130 to below $9 per share. A decade later, the stock is still trading at less than $20 per share. Fundamentals matter, Michiko concludes; a company’s value cannot be divorced from reasonable assessments of its future earning potential. Tobe and Steve are convinced and agree not to pursue BookFace IPO shares.

NOTES 1. Robert M. Soldofsky, “A Note on the History of Bond Tables and Stock Valuation Models,” Journal of Finance 21, no. 1 (March 1966): 103–111. 2. Myron J. Gordon, “Dividends, Earnings and Stock Prices,” Review of Economics and Statistics 41, no. 2 (May 1959): 99–105. 3. Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 2nd ed. (New York: John Wiley & Sons, 2002). 4. Burton G. Malkiel, “Nasdaq: What Goes Up . . .,” Wall Street Journal, April 14, 2000. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 37 Portfolio Development and Analysis Thomas Warschauer PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

Building portfolios that meet client needs is an essential element in the financial planning process. Thus, it is a basic function provided by virtually all planners. Because most planners provide this function as representatives of registered investment advisers or through securities brokerages, it is important for them to be familiar with financial services regulations discussed in Chapter 6. The development and analysis of portfolios interrelate deeply with virtually all of the other investment topics, but particularly with investment strategies and asset allocation

discussed in the following two chapters. Investors are interested in the after-tax returns of their portfolios, and therefore planners must consider the tax implications of all portfolio decisions. As the needs of each individual goal are funded with differential characteristics, portfolio development must consider each goal’s timing and importance; thus the discussions of education and retirement needs have significant input to their portfolio design. Planners must contend with the personal and emotional aspects of their clients in the selection of portfolios; hence the discussion of client and planner attitudes is particularly relevant (see Chapter 72). Finally, portfolios must consider all elements whether in traditional investments or in insurance-based products including variable and fixed life insurance and annuities.

INTRODUCTION Portfolio development is somewhat different from a financial planning perspective than it would be for an asset manager because of two significant pieces of information that a planner possesses that an asset manager usually does not. Asset managers usually view the future as a single unspecified time period. In fact, this is a basic assumption of the capital asset pricing model. We call that assumption myopic, and it often results in suboptimal portfolio decisions. Financial planners, in contrast, know approximately what time horizons their clients are facing. Those time horizons are, of course, different for different goals. Planners also know how clients prioritize different goals. That information, along with the clients’ generalized risk aversion, allows planners to better specify the nature of the portfolios associated with each goal. While it is true that some planners do not take advantage of this information and instead develop a single portfolio regardless of goals, that is done because of institutional and practice limitations on their client accounts, not because it would result in superior performance. This chapter deals with the process of building and monitoring portfolios that best meet client needs.

LEARNING OBJECTIVES The student will be able to: a. Assist a client in identifying his/her investment objectives, time horizons, and risk tolerances. Clients often come to planners with only the most rudimentary concept of their goals. For many, their financial life is more about “getting past today” than achieving their financially related dreams. So planners shouldn’t merely ask clients what their goals and objectives might be. Clients often must be encouraged to openly dream about what it is they want to achieve that requires financial resources. Retirement and education goals are the easiest to imagine, but lengthy vacations or vacation homes, parental support, acquiring collections, and many other goals may be unspoken dreams of a client. It is not the planner’s job just to enumerate or rank these goals, but rather to elicit them. Evaluating each goal’s needed financial resources and timing is somewhat easier. If clients

know they want to achieve something, they may also have a good idea of the needed cash flow and its timing. Risk tolerance is a difficult consideration. Clearly a client who feels uncomfortable with uncertainty is going to feel uncomfortable with many investments. However, clients may not understand that there is also a cost to risk avoidance. That is, the safer their portfolio, the lower the expected return and therefore the higher the percentage of their income they need to set aside to achieve any objective. It is a planner’s responsibility to help a client understand this trade-off and evaluate the appropriate amount of risk for that particular goal. It is significant, though, that urging clients to take a risk at a level that makes them lose sleep is a very bad idea. So planners need to be aware of the various dimensions of risk aversion from an objective standpoint. Some goals may be fully funded. Others may be partly funded. That is, investments may already be associated with each goal. Those investments must take into account time horizon, priority, and risk aversion relative to those goals. This is institutionally easy to accomplish for retirement and education plans that are generally separate (such as 401(k) or IRA accounts and 529 plans or Education Savings Accounts). Other investment funds may be less associated with specific goals. b. Select an appropriate benchmark for assessing the value of portfolio management services. Planners often divide their clients’ portfolios in several ways, including by asset classes and by goals. Although it is possible to construct benchmarks for planners to compare and evaluate performance, it is difficult to do that for complex asset class portfolios. So benchmarks used for performance comparisons are usually an index of all investments in the specified asset class weighted by their respective values. Generally, portfolio performance must be measured in three distinct ways. First, was the asset allocation that was chosen by the planner and client optimal for the client’s goals? Second, was the performance in a particular period successful? And third, was the performance over time successful? The first issue is hardest to measure. It is truly asking, “Is this asset allocation optimal?” That is a difficult question to answer. The chapter on asset allocation (Chapter 35) deals with this issue. The second question is routinely evaluated by modern portfolio theory (MPT) measures (Sharpe and Treynor ratios, Jensen’s alpha, information/appraisal ratios, and M2 performance measures). The third issue relates to performance consistency. This is best measured graphically by looking at the monthly or quarterly performance of a portfolio relative to the quartile or quintile performance of its reference or benchmark group of funds. Although most financial planners do not use market-timing methods, those who do should evaluate their results independently of the aforementioned performance standards. Performance evaluation often includes style analysis for different asset classes. Finally, fixed income performance analysis is often based on a complex system of performance attribution that attempts to evaluate the source of success and failure of portfolio management’s various decisions.

c. Develop and communicate an appropriate investment policy statement (IPS) for a client. Investment policy statements (IPSs) are the best way to put the client’s and planner’s mutual understanding of their duties in writing. These statements are necessary because they explain planner responsibilities. They usually include the background situation of that particular client, investment objective(s), asset classes used (see Chapter 35), investment strategies used (see Chapter 38), constraints on the manager, income and risk level requirements, rebalancing processes, performance measurement standards, and responsibilities of the parties. Practice standards effectively require that these statements be mutually developed with the client. It is, at any rate, essential for the client to fully understand this document. It is as important to update investment policy statements as financial plans themselves. Inheritances, changes in assumptions or anything which could change time horizons of existing or new goals should cause the planner to revisit their IPS. Finally, as advancing age approaches, the plan should consider the risk aversion and goals of likely inheritors as well as the current owner. d. Apply duration and convexity in the construction of fixed income portfolios. One aspect of the financial planning process is the general awareness of each goal’s target time horizon. For fixed income portfolios, the best measure of market risk is the portfolio’s duration, as it measures the portfolio’s sensitivity to interest rate changes, the chief cause of market risk for bonds. The duration of the bond portfolio is simply the weighted average of the duration of the individual bonds it contains. The definition of risk-free changes from the single-period CAPM Treasury bill to the specified time horizon that matches the duration of a bond or bond portfolio to that time horizon. Stated in other words, if one matches the time horizon of a particular goal’s cash flows with the duration of its supporting bond portfolio, relatively low levels of interest rate risk exist. This is particularly important if the yield curve is normal (that is, upwardsloping). In that case, one earns a greater than T-bill rate with less risk. This process is called holding-period immunization. Planners often use zero coupon government bonds for this purpose. If a planner uses coupon bonds for immunization, he or she needs to be aware of the resulting shape of the price–yield relationship. This means that as interest rates change, the duration of the bond changes but will not change proportionately; thus complete immunization against interest rate risk is not possible in this case. e. Construct a tax-efficient, diversified portfolio meeting the goals, risk-preferences, and time horizon of a client. It is likely that an investor may have several portfolios held with different tax treatments. For example, an investor may have a portfolio held in her own name, a traditional 401(k) plan, a municipal bond portfolio, possibly a Roth IRA, a variable annuity, or variable life insurance. It is clear that the client’s global (overall) portfolio needs to be optimally

diversified. In other words, the sum total of all investment assets must result in a substantially diversified portfolio leaving only as much unique (unsystematic) risk as necessary to allow for active management where desired. However, the location of assets in the appropriate tax portfolio is very significant. It is obvious that a municipal bond or an insurance deferred annuity does not belong in a traditional IRA because the after-tax return would not be consistent with the risk taken. There are many other issues regarding the location of assets. For example, relative to corporate bonds, stocks have preferential tax treatment. That is, the tax rates of dividend and capital gains on stocks are currently lower than the ordinary income tax rates on corporate bond interest payments. So a planner may wish to locate the corporate bonds in a 401(k) or an IRA and locate the stocks in a taxable account. Various types of real estate may be held primarily for capital gain or for rental income generated. The income-oriented real estate may be best located in a tax-deferred account (not always easy to accomplish), whereas the capital-gain-oriented real estate may be located in a taxable account. This location issue is complicated by potential changes in tax treatment, as clients with different political worldviews want to treat return of the various types of capital differently. f. Measure and communicate a client’s portfolio performance using different risk and return measures. The measurement and the communication of performance are quite different entities. The reason is the former is quite technical, and the latter is difficult to explain to clients because it is not intuitive. The primary method of communicating performance is to display annual returns for the last quarter, prior year, and trailing multi-year periods. Despite its popularity with novice investors, this is of limited use because there is no adjustment for risk, and because one very good or bad performance period may be contained in multiple measures. Reviewing non-overlapping monthly or quarterly performance is superior because it at least gives the observer an indication of past volatility (i.e., risk). The field has devised several risk-adjusted risk measures, each with its own use. Jensen’s alpha. Alpha, as a portfolio measurement tool, is the percentage contribution to return earned by active management. It is devised by regressing recent returns to a portfolio against an appropriate market index. It is most easily understood by clients. Sharpe measure. The risk premium (portfolio return in excess of the average risk-free rate) divided by the standard deviation of the returns of the portfolio. This measure is used to measure overall performance, not simply performance of a single asset class. Treynor’s measure. The risk premium (portfolio return in excess of the average riskfree rate) divided by the portfolio’s beta. This measure is used to evaluate performance of a specific asset class or a segment of a diversified portfolio. Information ratio. The alpha of the portfolio divided by unsystematic (non-market) risk. It measures the manager’s performance percentage by the amount of unsystematic risk he or she took to earn it.

There are more sophisticated measures available for dissecting portfolio performance by its source or by its style. These tools are called performance attribution measures. For example, these methods divide performance into results by asset allocation decisions, timing decisions, and selection decisions. For fixed income securities management, for example, the methods may break down a portfolio manager’s results by his or her selection of duration, bond investment risk class, and selection of borrower type (industrial, utility, government, etc.).

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Ask students to use online investment sources such as Morningstar Mutual Funds to look up managers’ performances. Ask them to write a short essay on which manager was superior.**

On an exam, compute portfolio evaluation measure for a variety of situations such as overall portfolio performance, asset class performance, and client-friendly reporting measures from return and risk data provided.**

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Provide students with a short list of goals (with measures of time horizons and appropriate risk levels for each), and a list of asset classes (with expected returns and risk levels). Ask students to match the asset classes with goals.**

Provide students with investment results of specific managers’ funds using all performance measures. Ask students to explain in writing which measures should best be used in each situation.**

Ask students to bring investment reports from their employer’s 401(k) plans or family (they do not need to share them with others). Ask them to evaluate the performances of those funds using professional performance measures.* Creating: Putting Evaluate the riskiness of elements together to current markets and evaluate form a coherent or criteria to determine when it functional whole; is time to hedge market risk. reorganizing elements Facilitate a class discussion into a new pattern or as to whether the current structure through situation deserves such generating, planning, or treatment.* producing

Provide students with a short list of goals (with measures of appropriate risk levels for each) and a list of asset classes (with expected returns and risk levels). Explain to students that half of the funds are tax-deferred and half are not. Ask students to locate the asset classes within the two tax status portfolios.** Provide students with client goals and a current allocation. Ask them to evaluate the individual manager’s results, and reallocate the portfolio with different managers if necessary and different asset classes, taking tax efficiency into account.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES

Entry-Level: An entry-level personal financial planner can select an appropriate riskadjusted measure for the correct situation and explain its results to a client. Also, an entry-level planner should be aware of measures of tax efficiency in the selection of portfolio managers. Competent: A competent personal financial planner can determine appropriate asset classes or securities to include in a portfolio and determine the target proportion of those securities for a portfolio that properly reflects the client’s needs, financial status, and risk tolerance. Also, a competent planner can determine which portfolio decisions are tax-efficient and which are not. Expert: An expert personal financial planner can diagnose a manager’s performance as to which portfolio decisions were helpful to meeting client needs and which were not. Also, an expert planner can use derivative instruments to modify the risk level of client portfolios.

IN PRACTICE Robert and April Robert and April Foust have come to you with a portfolio of investments that seem to be a mixture of past advisers’ uncoordinated recommendations. One positive is that some of the funds seem to be doing well, another is that all the funds are in tax-deferred accounts held for specific purposes, and a third is that the Fousts seem to be able to meet their goals. So your function is not so much financial planning as investment planning. Table 37.1 contains data on what the clients have brought to you.

Table 37.1 Robert and April’s Portfolio Fund Class

Beta (to S&P) 1.1

Sharpe Ratio 0.773

Treynor Jensen’s Ratio Alpha 15.455 1.5%

Portfolio

0.8 0.6

0.625 0.667

18.75 16.667

0.3% –0.4%

401(k) 401(k)

3.6 years’ duration 1.0

nmf

nmf

5

U.S. bonds, mixed grade S&P 500 index

0.770

17.0

6

Equity income

0.8

1.06

21.25

+1% (to bonds Education Savings index) Account –0.10% Education Savings Account +3% Education Savings Account

1 2 3 4

Domestic growth Global growth Balanced

401(k)

nmf—no meaningful figure.

Robert and April have only two goals: the college education of their twins in six years and their retirement in 20 years. Ignore the amounts necessary to achieve their objectives. Assume that the allocation of their current funds is equal in each account. Also assume the amount in the Education Savings Account is enough to fund their education goal. Assume that their current savings rate plus their 401(k) is just sufficient to meet their retirement goal with a high level of confidence. Your assignment is to determine two allocations and make recommendations as to the viability and appropriateness of their current investments. First, determine if their overall portfolio is sufficiently diversified. Second, determine if the current investments should be kept. Finally, determine which funds should be in the retirement portfolio and which should be in the education portfolio. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 38 Investment Strategies Dave Yeske, DBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Various investment strategies will have different income tax considerations that must be accounted for depending on the tax status of the investor and/or the type of account that holds the assets (tax planning). Different investment strategies may be indicated when investing for retirement (retirement saving and income planning).

INTRODUCTION While financial planners will generally choose from a limited number of investment strategies when developing investment recommendations for clients, it is important that the planner possess an understanding of the full range of strategies that are available. The reasons that such breadth of understanding is important are twofold: First, a given client may possess unique circumstances that call for a specialized investment strategy, and second, clients may have questions regarding investment strategies not used or recommended by the planner, who in turn needs to be able to explain why such strategies are or are not appropriate for that client. An example of the former would be the client who holds a large, undiversified position in restricted employer stock, for whom the use of a derivatives-based strategy may be an appropriate way to mitigate downside risk, since traditional diversification techniques are not possible. An example of the latter would be the client who has previously been served by active managers who has now engaged a financial planner who uses a passive, index-fundbased approach (or vice versa). In order to keep this client committed to a consistent course of action, the financial planner will need to understand and be able to explain the rationales behind both active and passive investment strategies, compare and contrast the advantages and disadvantages of each approach, and explain why the recommended investment plan is the best fit for the client’s personal circumstances. Some investment strategies are straightforward applications of available investment instruments in order to achieve specific goals. Examples of this would include immunizing a bond portfolio to minimize interest rate risk or using options to minimize the downside risk of an undiversified stock position. Other investment strategies are based on one of several theoretical foundations for which there is not universal acceptance. For example, many investors believe in some form of the efficient market hypothesis (EMH) and conclude that active management strategies do not consistently add value. Such investors will usually adopt a passive approach to investing, relying on open-end index mutual funds, exchange-traded funds, and similar instruments when assembling a diversified portfolio. Beyond the choice of passive investment instruments, these investors will also typically employ a buy-and-hold strategy in which trading is minimized except for some form of systematic rebalancing or tax-loss harvesting. Other investors, meanwhile, reject the EMH and employ strategies meant to take advantage of systematic and identifiable mispricing of securities. These investors will use a variety of active strategies, including fundamental analysis, tactical allocation, sector rotation, market timing, and sometimes even technical analysis methods. Still other investors believe that market efficiency holds in some segments of the market but not in others. These investors may employ a blended approach such as the core and satellite strategy, in which the manager begins with a core of passive investments and then pursues active strategies with the satellite part of the portfolio.

LEARNING OBJECTIVES The student will be able to:

a. Explain and apply investment strategies such as buy-and-hold, immunization, core and satellite, and passive (indexed) and active management techniques such as tactical allocation, market timing, and sector rotation. Stock and bond investors have many strategies available to them when attempting to minimize risk or maximize return. Some of these strategies are focused more on one of those two priorities than the other, while other strategies are intended to serve both equally. Among those intended to minimize risk in a bond portfolio is a technique known as immunization. Immunization minimizes interest rate risk by matching a bond portfolio’s cash flows with the investor’s spending needs. Another strategy focused on risk minimization involves the use of options to minimize the risk of loss when an investor must hold a large, undiversified position in a particular security. This could involve buying puts or selling calls or a combination of both in a technique known as a collar. Investment strategies aimed at achieving some appropriate level of return or even superior returns generally fall under the headings of either active or passive. Among the former approaches is fundamental analysis using various forms of the dividend discount model (DDM). An example of such a model is the two- or three-period multistage DDM, which divides future growth periods into rapid and mature stages using the Gordon dividend valuation model to evaluate the long-term mature stage. Active strategies can also encompass outright market timing, wherein the investor moves into or out of the market based on technical or other indicators. One investment strategy that is commonly mentioned as a way to reduce risk is called dollar-cost averaging. The basic idea is that by investing a constant amount at regular intervals one buys more shares when prices are low and fewer shares when prices are high. This technique is said to reduce the average cost of shares below the average price. There is considerable disagreement over the effectiveness of this technique, though, and many planners and academics dispute its utility. Variations on this may include tactical allocation techniques that shift the relative weights of different asset classes based on macroeconomic or technical indicators and sector-rotation strategies that shift among industrial sectors based on similar inputs. Those pursuing so-called passive strategies will generally design and construct portfolios using open-end and exchange-traded index funds and similar securities. Just as passive strategists use index funds because they do not believe that financial analysts are capable of outsmarting the market with respect to individual security valuations, they likewise do not believe that one can accurately predict broad shifts in the markets; they therefore tend to embrace buy-and-hold policies. Having said that, passive investors will still employ opportunistic rebalancing strategies and taxloss harvesting strategies based on well-defined criteria and decision rules. Finally, some strategists embrace a blended philosophy as epitomized by the core and satellite approach, wherein a passive core portfolio is supplemented by a satellite that will be filled with active bets based on fundamental or technical indicators or the strategist’s independent judgment. b. Evaluate the use of options and futures for investment risk management purposes.

Options and futures are derivative securities (i.e., their value is dependent on changes in some primary security) that can be used for both speculative and risk management purposes. Since these securities shift in value in reaction to changes in an underlying security, they can be used to hedge the risks inherent in that underlying security. For example, an individual who holds a large, undiversified position in restricted employer stock can hedge away the idiosyncratic risk associated with that position by either buying puts or selling calls on the security in question. Investors will sometimes do both, using a strategy known as a collar, which involves buying puts to mitigate the risk of a price decline and partly or completely offsetting the cost by selling calls, thus trading away some portion of the stock’s upside potential. Portfolio insurance, meanwhile, may use index options or futures to protect entire portfolios from extreme market fluctuations. When considering the use of derivatives for risk management purposes, investment strategists need to consider the nature of the potential loss. For example, holding a concentrated position in a single security may encompass the possibility of irrevocable loss, while a broadly diversified portfolio may be subject to only the transient risks associated with cyclical economic and market downturns. The costs of insuring against the possibility of irrevocable loss may be deemed appropriate whereas the cost of insuring against a cyclical downturn may not.

IN CLASS Category

Class Activity

Student Assessment Avenue Applying: Instructor lecture on the use of derivatives for Students are given an Carrying out or risk management. This would include a exercise in which a using a discussion of techniques appropriate for concentrated stock position procedure mitigating the risk of concentrated holdings is specified and the students through executing and overall portfolio insurance. With respect are asked to calculate a or implementing to the former, this would include worked costless collar based on put examples of the use of collars. and call prices derived from a newspaper or appropriate online source. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure

Student-led discussion in which students are presented with different portfolios and asked to analyze the structure of the portfolio and then draw inferences as to the underlying philosophy or perspective represented. Is this a passive investor, an active one, or perhaps someone who blends both? Instructor-led discussion of targeted funding techniques, including such things as constructing an

Students are given a series of portfolios and work individually to analyze them in order to infer the underlying philosophy or perspective represented therein. Students are provided with a list of coupon bonds with

or purpose through differentiating, organizing, and attributing

immunized bond portfolio to fund a particular related information (coupon, price, maturity, duration) goal or series of goals (e.g., paying college tuition). and asked to construct an immunized portfolio in order to meet a specified goal (e.g., paying a series of increasing tuition payments over four years).

Students work in small groups to review client scenarios and determine (1) which risk management techniques are available in the given scenario, and (2) which techniques, if any, are appropriate based on the client’s overall circumstances. Creating: Students engage in a role- play with the Students take what was Putting elements instructor in which the instructor plays the learned during the role-play together to form a role of client. The students ask questions in and prepare coherent or order to uncover sufficient information about recommendations for one or functional whole; the client’s goals, values, and financial more investment strategies reorganizing circumstances to be able to recommend an that are appropriate to the elements into a appropriate mix of investment strategies. client’s goals and new pattern or circumstances. Students structure through must explain each strategy generating, in terms of how it relates to planning, or the client’s needs and how producing the strategies relate to each other. Evaluating: Making judgments based on criteria and standards through checking and critiquing

Instructor-led discussion in which different client scenarios are explored with reference to real and potential investment risks and the different approaches that might be employed to mitigate or eliminate that risk and the criteria by which one might choose one technique over another.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner understands the mechanics and rationales for different investment strategies, including passive, active, and blended strategies. Competent: A competent personal financial planner, in addition to the foregoing, understands the various ways in which derivatives may be used for purposes of risk management. Expert: In addition to all of the foregoing, an expert personal financial planner can make integrated recommendations that encompass multiple investment strategies that are demonstrably connected to the client’s particular goals, values, and circumstances. This

planner can weigh the advantages and disadvantages of each strategy and multiple strategies in combination and arrive at recommendations that balance those factors in terms of the client’s history, preferences, and values.

IN PRACTICE George Financial planner Marcelina Vasquez is meeting with her new client, George Plenary, for their first investment policy discussion. While Marcelina generally constructs passive portfolios composed primarily of index mutual funds, George’s prior adviser took a much more active approach to investing, including the use of actively managed mutual funds and separately managed accounts. Although George has hired Marcelina for a host of reasons, including her commitment to placing financial planning at the heart of the engagement, he still has questions about her investment approach. Marcelina begins with a description of the underlying theoretical justifications for active and passive approaches, along with a further explanation of the various strategies that arise from those two perspectives. She then lays out her reasons for choosing a passive approach, concluding with the statement that “Once you’ve assembled a broadly and appropriately diversified portfolio and put in place systems to monitor, rebalance, and report, you’ve achieved 90 percent of what’s achievable. Further time devoted to more active approaches is a ‘low-leverage’ activity and would be better devoted to financial planning analyses, a truly ‘high-leverage’ activity.” In other words, her final assessment is that active strategies fail her cost-benefit analysis when financial planning is competing for scarce planner time.

Kenneth Kenneth Smithers has arrived at the offices of his financial planner, Gerald Braverman, to discuss his concerns regarding the employer shares in his portfolio. Kenneth is an officer of a publicly traded company and holds a significant block of employer shares. Because he is considered an insider, Kenneth is restricted to when and under what circumstances he may sell his shares. Furthermore, there is an informal expectation in the executive ranks that each officer will hold company stock equal to at least twice his or her annual salary. This has left Kenneth with a substantial exposure to shares of a single company, and a recent rise in market volatility has him worried about the impact on his family’s financial well-being should his company fall out of favor with investors. Finally, the rise in market volatility also has Kenneth wondering whether something should be done to protect even his more diversified portfolio from downside risk. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 39 Alternative Investments L. Michael Ladd, CFA, CAIA, CMT, CFP®

CONNECTIONS DIAGRAM

The success of any investment planning program depends on a number of factors, including the accuracy of mean return forecasts, the closeness of fit between the time horizon of the investor’s goals and those of the investments utilized in the process, and the degree of variability between projected investment returns and true investment outcomes. A reduction in the average variability between the two can lead to an improved client experience. To that end, a comprehensive understanding of all of the investment options available to help achieve a client’s goals is paramount to a planner’s success in serving the client.

INTRODUCTION In the investment world, just as in the rest of the world, there is a trend towards ever greater complexity. A financial planner who possesses a strong foundation in the various disciplines of traditional investment analysis and who has a broad understanding of traditional investment classes and strategies is afforded an excellent point of reference from which to consider other, alternative investment concepts, assets, and strategies that do not fit neatly into the framework of traditional investment thinking. The greater and broader the knowledge base of the planner and the greater the number of corresponding investment options available to him or her, the higher is the likelihood that he or she will be able to deliver an excellent client experience and that the difference between return expectations and experience will be minimized. It is for this reason that planners need to widen their purviews to see investment alternatives that they otherwise might not have considered, if they expect to be successful in a complex investment world. This chapter conveys a framework for understanding how investment alternatives to traditional asset classes can be considered and interpreted.

LEARNING OBJECTIVE The student will be able to: a. Define and describe what qualifies as an alternative investment. 1. Explain asset class and describe the basic differences between the traditional asset classes and alternative asset classes. 2. Explain the primary rationale and uses for alternative asset classes. 3. Explain the primary differences between traditional investment strategies and alternative investment strategies including the potential advantages and disadvantages of utilizing alternative investment strategies. 4. Explain how the incorporation of alternative asset classes in a traditional asset portfolio structure can potentially improve both absolute and risk-adjusted portfolio returns. In the traditional capital markets that are composed primarily of stocks and bonds, improved capital efficiency is created by the matching of suppliers of funds with demanders of funds, thus creating newly issued securities purchased by the original securities investors (suppliers of funds). These original securities investors may secondarily exit their positions by exchanging them with other investors who were not included in the original mix. This type of secondary exchange has promoted the development of additional markets and market complexity, and has led to the creation of investment strategies and concepts that were perhaps not originally contemplated in the initial capital formation process. Here we are speaking of concepts such as absolute valuation based on an analysis of financial statements (think Graham and Dodd) and an understanding of legal, financial claims; technical and market analysis; a relative value-styled analysis based on a comparison (e.g., quantitative analysis) of known

investment metrics; MPT-related concepts (e.g., CAPM, EMH) based on the integration of statistical techniques and other constructs borrowed from the natural sciences leading to a new way to interpret the markets and the factors that drive them; and behavioral finance theories. Since these different approaches have different and competing things to say about the way the investment markets function, for all practical purposes, they truly should be considered mutually exclusive. For example, fundamental analysis and EMH could not coexist without an ad hoc redefinition of terms to make the coexistence tenable. This realization leaves the correct interpretation of the function and operation of investment markets subject to continued debate, allowing for the existence of many different investment strategies both “traditional” and “nontradtional” (or “alternative”). The equities, fixed income, and cash equivalents markets are considered the traditional capital asset classes, primarily because they share two important factors: (1) liquidity, and (2) susceptibility to discounted cash flow (DCF) valuation analysis. It is mostly because of these two factors that traditional capital asset classes are viable candidates for the types of disparate, analytic concepts mentioned previously. Asset classes that do not contain both of those two important factors are generally considered to be either “alternatives” or “hybrids,” with the word “hybrid” implying that the asset class in question possesses traditional attributes but is missing at least some element of the two named factors. In the interpretation of traditional, alternative and hybrid asset classes, it is clear that perspective is the key. History informs us that the interpretation of traditional versus alternative has nothing to do with “which came first.” For instance, both gold and silver can be found on the periodic table which means that they have been around even longer than real estate has been around, but they are also generally considered to be alternatives. Real estate may be considered as a hybrid because it is usually illiquid but, at the same time, is subject to DCF analysis. Examples of other asset classes that are considered alternatives include currencies (which have been around longer than stocks have been around), agricultural and energy commodities, nonprecious metals, less-liquid equity securities such as private equity (PE) and venture capital (a subset of PE), and some derivatives such as credit default swaps (CDS) and collateralized debt obligations (CDOs). This is by no means an all-inclusive list. The differentiating factors driving the returns of the alternative asset classes mentioned above are sundry and complex. It is important for the planner to segregate in his or her mind the concept of “alternative asset classes” from that of “alternative strategies” which themselves generally utilize the traditional asset classes (or some derivatives of them) in their execution. An alternative strategist will usually choose liquid instruments in the deployment of a non-traditional portfolio strategy because doing so allows him or her to reduce the number of risk factors affecting the outcome of the strategy, thus allowing for greater simplicity and the ability of the manager to more easily concentrate on what he or she does best. A simple example of an alternative strategy is the convergence trading method referred to as “arbitrage.” In pure arbitrage, a mispriced asset is both purchased (long) and sold (short) simultaneously in different markets so as to capture the profit made temporarily available by the pricing disparity. Arbitrage is rarely so pure, but the name provides a convenient label that reflects the general strategy type. Examples of arbitrage strategies include fixed-income arbitrage, statistical arbitrage, convertible arbitrage

and merger arbitrage. Arbitrage can be seen as an offshoot of traditional, relative value analysis (mentioned earlier) that incorporates non-traditional trading methods and sometimes leverage in order to enhance returns. Such strategies are focused and concentrated on specific ideas about believed market inefficiencies. The planner must also recognize certain descriptive characteristics that tend to differentiate traditional and alternative strategies. The application of leverage to enhance strategy returns or otherwise modulate the risk profile of an active strategy is a common characteristic of some alternative strategies, as is the flexibility of a strategy to concentrate its positioning on a small number of ideas or investment vehicles. For instance, a currency trader may focus his portfolio on a particular currency cross and, especially in the case of some low-volatility currencies, may also incorporate a significant leverage factor. The use of leverage is usually seen in the execution of managed futures strategies, which themselves tend to employ market trend analysis and trade in one or more markets, and may contain variable risk exposures that could make the strategy profitable in either up or down markets. Related in concept but yet more complex is a global macro strategy which may invest anywhere, go both long and short, concentrate or diversify, and use various forms and degrees of leverage. These types of strategies and others can be deployed via several different kinds of legal entities with the most well-known of these being the investment partnership structure of a hedge fund, which allows the manager of the fund to act as the general partner, with investors as limited partners. Very large firms executing highly complex investment strategies may combine both traditional and alternative asset classes and strategies. The potential complexity and sometimes opaque nature of many alternative investments has led, in recent years, to some new and more transparent avenues for planners to access areas of the alternative investment space via mutual funds and even ETFs, an alternative investment subset that may be collectively categorized as “liquid alternatives.” Interestingly enough, this expression circles our discussion back to one of the key characteristics of traditional asset classes: liquidity. The planner must recognize that there is usually a tradeoff between liquidity and return, which in fact explains why private equity is not considered by most to be part of the traditional, equities asset class, despite the fact that it is actually equity—the lower level of liquidity theoretically translates into the expectation of higher relative returns. For “liquid alternatives,” it would be only reasonable to conclude that their higher level of liquidity should correspond to lower relative returns. Another important difference between traditional and alternative investments for planners to consider is the plethora of the potential return distributions of alternatives. While a bell curve may express a rough approximation of the average historical returns of traditional asset classes, this simply is not the case for most alternatives that oftentimes have asymmetric payoff distributions bearing no resemblance to a bell curve. A planner must understand that enormous differences can exist between the return distributions and must also have some idea of how to mix the various strategies into a single portfolio that is logically constructed with the goal in mind of generating superior risk-adjusted returns. Some alternative investment-related firms have attempted to make the planner’s responsibility of this complex function delegable by creating single, alternative investment vehicles that are composed of some combination of

numerous complementary alternative assets and strategies, a type of investment solution loosely referred to as a “fund of funds.” From the discussion above, one can see the continuum of investment complexity extending from primary markets to secondary markets, from secondary markets to disparate concepts and theories about the way markets work, and from the realization that there is no unified and proven market theory to the search for and acceptance of the use of alternative strategies and extant alternative asset classes. A condensed overview of alternative asset classes and strategies (without reference to “hybrids”) can be found in Table 39.1.

Table 39.1 A Broad Sample of the Alternative Investment Space Alternative Asset Classes Private Equity

Alternative Investment Strategies Short Selling

Description of Strategy

Market Tinning

Moves back-and-forth from cash to equities; a pure beta strategy Invests both long and short across multiple markets in various ways Takes various market positions via futures; is usually systems trading-based Combines various alternatives into a single collective Uses arbitrage to profit from fixed income mispricings Uses arbitrage to profit from statistically based mispricings Uses arbitrage to profit from mispricings between similar securities Uses arbitrage to profit from mispricings between an issuer’s related securities Uses arbitrage to profit from mispricings corrected if a merger goes through Uses arbitrage to profit from mispriced volatility Attempts to capitalize on large reversals in an issuer’s financial fate

Takes on direct exposure that bets a stock will go down Credit Equity Long/Short Goes long and short different stocks; variable Derivatives market beta Volatility Futures Equity Market Neutral Goes long and short different stocks; sets market beta to zero Equity Derivatives Currencies

Global Macro

Precious Metals Managed Futures Non-Precious Metals Rare Art Thoroughbred Race Horses Agricultural Commodities Energy Commodities Timber Raw Land Private Real Estate

Fund of Funds Fixed Income Arbitrage Statistical Arbitrage Relative Value Arbitrage Convertible Bond Arbitrage Merger Arbitrage Volatility Arbitrage Distressed Securities

An advantage of utilizing alternative investments is the planner’s ability to choose from among a wider variety of investment options than would otherwise be the case. Traditional asset classes tend to have periods of “boom and bust” which, depending on a client’s starting and ending points in time, can wreak havoc on a planner’s ability to minimize the discrepancy between plan projections and client investment experience. It may be possible for a planner to circumvent such a large and adverse “bust” outcome by incorporating strategies or assets that

do not rely so heavily on the traditional markets’ correspondence to a plan’s average return projections. To fulfill this duty, the planner will have to decide which alternative assets or strategies to add, when to do so and to what degree the current portfolio allocation should be modified to include those new choices. As a part of that process, the planner must consider the differences in cost and transparency that will accrue to the portfolio if the changes are made. To help mitigate some of the risks related to the possibility of making unsatisfactory portfolio changes in the process, another option for the planner to consider is the delegation of the alternatives piece to someone with a greater degree of expertise in this area. Delegating this responsibility can reduce risk but may also mean higher costs and potentially lower net returns to the client, as is oftentimes the case with liquid alternatives. The planner must openly recognize that having a broader set of investment options does not mean the whole world of alternative investments is available to him. Some alternative strategies have very high minimums, lockups, or are even closed to new investors, thus limiting the number of true alternative options available for the planner to use. Acknowledging this limitation is important, particularly given that the returns on alternative investment strategies are more diverse than are the returns on traditional investment strategies. As the world steadily becomes more accustomed to new ideas, so clients may warm to the idea of efforts to reduce portfolio volatility by adding non-traditional assets or strategies to their existing, traditional asset class portfolios. The planner must find the right balance between the various considerations already mentioned, must consider the comfort and knowledge level of the client, and must make an honest self-assessment of his or her degree of understanding of any strategy considered for use. The planner must be able to explain how the incorporation of alternative strategies and assets can lower overall portfolio volatility, which can be made possible by a lower level of correlation between traditional investments and alternative investments. As the traditional capital markets are susceptible to boom and bust cycles, value-adding alternative strategy managers with strong skill sets may be able to take advantage of those cycles to generate excess returns. Mixing such alternative strategies together into a portfolio composed of traditional assets can help mitigate some of the downside risk and volatility associated with market cyclicality. Finally, the planner must recognize that alternative asset classes can themselves experience boom-bust cycles. There is no alternative investment panacea.

IN CLASS

Category

Class Activity

Student Assessment

Applying: Carrying out or using a procedure through executing or implementing

Instructor provides lecture on alternatives and asks students to later research a topic from a given list of alternatives.

Instructor has students or student teams give a short presentation on the researched topic.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Instructor assesses prior Instructor leads further student presentations. class discussions on the subject and provides feedback. Instructor creates hypothetical initial client interview, where client’s portfolio contains some existing alternatives.

Instructor asks student teams to come up with first comments about the portfolio and to make initial recommendations.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can discuss the differences in and compare the characteristics of alternative investments and traditional investments. Competent: A competent personal financial planner can describe various alternative asset classes and strategies, and can discuss when each option might best be added to a portfolio’s existing strategies. Expert: An expert personal financial planner can articulate the statistical differences in the return distributions of the sundry alternative investments and can assess qualitatively and quantitatively what may be an appropriate mix of traditional and alternative assets and strategies.

IN PRACTICE Sabrina and Evan Sabrina Lucias, a financial planner living in southern California, is playing golf one afternoon with a local resident who she has never before met, Evan Willberg. Mr. Willberg is an investor but is not one of Sabrina’s clients. However, he knows that she is a financial expert and so begins to chat with her and ask investment questions. As they are walking down the first fairway, Evan asks her, “What did you think of that move in the market today?” Sabrina believes that Mr. Willberg is probably referring to the stock market but she really just wants to play golf today, so she responds, “Yeah, I think a lot of people were surprised that SNB let the

floor on the euro go.” After a pregnant pause, Evan exclaims, “I meant the stock market!” Sabrina responds, “Oh, yeah.” As they walk further down the fairway, Sabrina begins to feel a little bit guilty about brushing him off and so she considers that he may actually need professional help. Wanting to understand his perspective a little bit better, she asks, “Well, Evan, what did you think?” Mr. Willberg then proceeds to share his ideas about the market, saying that the markets are rigged, too confusing, and that no one could ever understand them. He says that he invests in stocks and short-term bonds—mostly stocks—and that now he basically just rides the market up and down and he doesn’t know what else to do. From 2000 to 2002, he lost a lot of money but he made some back a couple of years later. From 2006 to 2008, he lost a lot of money again and decided to get out of the market altogether because he was sick of the ups and downs. He went back into stocks about a year ago but he is still frustrated because he missed most of the bull market. In addition, he thinks stocks may be too high and interest rates may be too low, but he is just not sure. As they are walking up to the first green, Evan asks Sabrina, “What else is there to do?” Sabrina doesn’t answer immediately because their other playing partners are putting. As the group is leaving the green and walking to the next tee box, Sabrina tells Evan that there are actually many other alternatives to “buy and hold” or whatever he calls his current strategy. She suggests that it might not be a bad idea to consider adding some of those other strategies or assets to his current portfolio, in order to give it more staying power and perhaps a more consistent return. Sabrina mentions equity market neutral and arbitrage as low-risk strategies. She suggests that, depending on his risk tolerance, he might consider broadening his investment horizons by adding macro-based themes to his portfolio; or, if he doesn’t want to make a significant overall strategy change, he could simply add some allocation to diversifying alternative assets such as currencies or precious metals. She tells Mr. Willberg that he should consider all of the investments options out there, rather than just a few of them. Finally, Sabrina tells Evan that the most important thing for him to do is to find an approach that best fits his needs and goals. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 40 Fundamental Tax Law Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTION DIAGRAM

While the primary focus of this topic is on tax planning, the concepts in this chapter apply directly to several other areas of financial planning. Retirement planning is directly affected by fundamental principles of income taxation, particularly when considering contributions to, earnings within, and distributions from tax-advantaged retirement plans. Cash flow management and financing strategies may also be directly impacted due to the after-tax cost of certain financing options relative to other financing strategies. Income tax planning should also

be incorporated into education planning, particularly what combination of education credits, deferred tax on earnings, and/or tax deductions on interest provide the greatest benefit to clients. The passage and implementation of the Affordable Care Act (also known as Obamacare) has further intertwined income tax planning and risk management and insurance planning. Increased taxes, such as the Medicare surtax of 0.9 percent, have increased higher-income households’ tax burden while middle income households have received greater access to refundable health insurance premium tax credits, if certain conditions are met. Additionally, changing income tax laws regarding capital gains rates and net investment income taxes have a direct impact on the after-tax rate of return realized on investment assets held outside of tax-advantaged retirement plans. Finally, estate planning, while separate and distinct from income tax planning, will also be influenced by a client’s current income tax situation.

INTRODUCTION An understanding of the fundamental structure of the United States Internal Revenue Code as it relates to individual income taxation is essential for every financial planning professional. Depending on the income level of the client, different aspects of the income tax laws will be more or less relevant. Various forms of wealth, such as human capital, investment capital, or physical capital, produce income, and how that income is recognized under the law will affect which planning alternatives provide superior outcomes for the client. Congress has made, and will continue to make, significant changes to various sections of the Internal Revenue Code. Amid this ever-changing environment, important consistencies in the general nature of the tax law have remained. A prominent theme of the U.S. income tax system is its progressive nature, which can be seen in many different ways. A notable trademark of this progressive income tax system is that the tax rates on personal income increase with earnings. The tax law also utilizes differing tax rate schedules based on filing status and personal and dependency exemptions, as well as refundable and non-refundable credits, phaseouts of deductions, and exclusions of certain income (and deduction) items to increase or decrease the progressivity of the income tax system. Since the ratification of the Sixteenth Amendment to the U.S. Constitution in 1913, tax law has considered the marital status and living arrangements of the taxpayer when assessing an income tax, and as early as 1917, dependents were also taken into consideration. In 2009, the impact of refundable tax credits based largely on earnings, marital status, and the presence of dependents resulted in about 30 percent of households receiving a net refund from the U.S. Treasury. Another 22 percent of households paid no income tax nor received a net refund, and 49 percent of households had a positive income tax liability. The distribution of income tax burden resulting from the United States’ progressive income tax system contrasts starkly with the tax burden distribution in countries that use other taxation systems like the flat tax, which is used in Russia and several other Eastern European countries, or a value-added tax system, which exists in several European and Asian countries.

In addition to understanding the progressive nature of the Internal Revenue Code, financial planners must also understand how federal economic, public, and social policies embedded in the Internal Revenue Code may affect their clients’ unique situations. Policy initiatives operationalized in the Internal Revenue Code substantially complicate the income tax law; however, they can also provide significant planning opportunities for eligible clients. Over the past two decades, the government has used changes to federal income tax laws to pursue social, public, and economic policy initiatives, including: Attempting to expand the number of individuals covered by health insurance, encouraging postsecondary education through tax credits, supporting employment through dependent care deductions and credits, encouraging retirement savings through expanded deductions and credits, and supporting businesses through accelerated write-off of capital investment. Various tax incentives, based on policy initiatives, may apply to a client during different stages of the client’s life; thus, effective tax planning anticipates and incorporates new tax planning strategies over the client’s life cycle to take advantage of current or changing circumstances that are unique to the client and that stage of their life. As financial planners make estimates and forecasts of income for current and future periods, it is essential that income taxation be considered. Many income tax planning strategies rely, in part, upon deferring or accelerating the recognition of income to a period when the marginal tax rate is lower; however, other planning purposes look at the overall tax burden faced by the client. It is necessary for the financial planner to carefully apply the appropriate marginal or average tax rate on income when estimating or forecasting current and future periods. The combination of a deep understanding of the client’s unique circumstances coupled with a solid understanding of U.S. income tax law fundamentals will enable the financial planner to work with the client’s tax adviser in developing and implementing the most tax-efficient financial planning options that will help the client reach his or her goals.

LEARNING OBJECTIVES The student will be able to: a. Compare and contrast the fundamental components of the income tax system including filing forms, filing status, income, exemptions, exclusions, deductions, adjustments, credits, and tax rates. Financial planners should have a working knowledge of the tax code and how various aspects of the federal income tax code affect their client’s tax situation. Life circumstances, such as marital status, age of children, and the age of the client all affect the client’s income tax liability. In addition, it is also important for financial planners to possess a functional understanding of the differences between deductions for adjusted gross income (AGI) and deductions from AGI and how the after-tax value of those deductions compares to tax credits. Financial planners must also recognize that a client’s gross income may be dramatically different from their taxable income, or tax base, due to exclusions, adjustments, and other exemptions that may be associated with the income. Thus, two

households with the same gross income may have dramatically different income tax bases, and thus may experience very different tax rates being applied to their income tax base. b. Explain how a progressive income tax system works and contrast it with other tax systems. As discussed in the introduction, the United States has one of the most progressive federal income tax rate systems in the world. Other countries, and even many states, have a relatively flat income tax rate structure, meaning that similar marginal tax rates are faced by moderate-income and high-income taxpayers alike. The progressive nature of the federal income tax system results in some taxpayers facing dissimilar marginal tax rates from year to year if their income is volatile, which in turn may require financial planners to advise their clients more frequently regarding current and future-period tax planning. c. Compute marginal and average tax brackets and explain the appropriate use of each. It is imperative that financial planners understand the difference between the marginal and average tax rates faced by their clients. Following an understanding of these different rates, financial planners must understand which rate is relevant when forecasting client needs into the future, or when determining the marginal effect additional (or reduced) taxable income will have on the client’s income tax liability.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Break students into small groups and have them properly classify common types of income into excluded income items and items that are included in gross income. Analyzing: Students work with a Breaking material partner to determine the into constituent equivalent value of parts, and deductions for AGI, determining how deductions from AGI, and the parts relate to tax credits given various one another and to marginal tax rates, and an overall structure determine which form of or purpose through tax-reduction method is differentiating, most advantageous given organizing, and client circumstances. attributing

Student Assessment Avenue Students will total the amount of taxable income.

Given a client’s tax return, use a matching exercise to connect how changes in deductions, income, or filing status affect other parts of the tax return (e.g., a change in income may result in multiple changes in the value of some deductions, credits, and taxes).

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Students work with classmates to develop a model for the typical family life cycle. Groups forecast when relatively high and low marginal tax rates will occur over the outlined family life cycle (internal factors). Groups also develop a model for alternative family life cycles and compare this life cycle pattern of marginal tax rates with the more typical life cycle pattern.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Give students three years of client tax returns that contain errors. Students review and analyze prior years’ tax returns. Ask them to identify errors and how to correct them. Also ask students to recommend changes in the structure of current and future-period transactions to increase the client’s after-tax wealth over multiple time periods based on the client’s goals. Ask students to communicate this to the client in a letter.

Students obtain information and commentary on the current economic cycle, historical tax rates, federal budget deficits and debt, as well as proposed tax strategies.

Prepare a comprehensive income tax plan over a multiyear time period, incorporating the client’s goals and internal and external environmental constraints, while addressing tax matters related to other areas of financial planning, including cash flow, education, investment, retirement, insurance and risk management, and estate planning. Students Students work in groups to should communicate this to the client in a develop what they think letter. future tax policy will look like.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: With respect to income tax law fundamentals, an entry-level personal financial planner can accurately prepare a standard Form 1040 tax return that would include itemized deductions (Schedule A), interest and dividends (Schedule B), and routine investment transactions (Schedule D). Competent: A competent financial planner can evaluate multiple years of prior Form 1040s and supporting documents to inform present tax planning decisions and identify planning opportunities and areas of concern for the current and future periods. The competent planner should be able to calculate the tax benefit of various investment decisions with the objective being to maximize after-tax wealth.

Expert: An expert personal financial planner can work closely with the client’s tax advisers to incorporate the client’s life stage, family goals, and current and anticipated internal and external environmental factors into comprehensive tax-planning strategies that utilize multiyear time horizons to help the client achieve his or her primary goals and objectives as efficiently as possible.

IN PRACTICE John and Susan John and Susan have been married for five years, and Susan is pregnant expecting their first child at the end of the year. John works as a physician’s assistant (PA). Susan is attending graduate school to work toward her Master’s degree. John paid Susan’s tuition and fees this year. However, John and Susan’s marriage was not going well and they decided to file for divorce. Susan moved in with her parents about halfway through the year. John paid for Susan’s tuition fall semester, but aside from the support that Susan received from her parents and John, she had no income. As the divorce proceedings progressed, John and Susan became increasingly distant and less cooperative. On December 1 of the current year, the divorce was finalized and on December 21 Susan gave birth to Jacob, a healthy boy. John was ordered to pay child support as part of the divorce agreement and will begin making payments in January of the following year. What are John and Susan’s filing statuses? At this point, John and Susan must file independently from one another. John will file as single, and Susan will also file as single, but as a dependent. Susan’s parents will likely claim Susan and Jacob as dependents. Because John’s filing status is now single, he will face smaller income tax brackets, a smaller standard deduction, and no dependency exemptions. In addition, John will not be able to claim the Lifetime Learning Credit on the tuition he paid for Susan because he is not filing with Susan, nor claiming her as a dependent. Depending on Susan’s parents’ incomes, they may be phased out of the child tax credit. The divorce would result in a substantial increase in John’s income tax liability relative to his previous filing status as married filing jointly. If John and Susan were to delay their divorce for just a few weeks, substantial savings would result that could potentially benefit both spouses. A financial planner who understands U.S. income tax law fundamentals should be able to identify this negative situation ahead of time and work with the clients to develop an alternative strategy, or at a minimum, prepare for the expected outcome. In addition, until Susan is able to finish her schooling, it may be difficult for her to find a highpaying job. In subsequent periods, her filing status will likely be head of household, because Jacob will be living with her and John will be paying her child support. Her modest income until her schooling is complete will increase the likelihood of her qualifying for the earned income credit, as well as the full child tax credit and/or the additional child tax credit, potentially creating a net refund for Susan at tax time. In subsequent periods, John may be continually phased out of the child tax credit and likely file as single. An understanding of these credits will help a financial planner offer advice when discussing the possible structure

of child support, property settlements, or who will claim the child as a dependent on an income tax return.

Jose and Alexandra Jose and Alexandra are married and are preparing for a future child and retirement. Both are working, and Jose currently earns $70,000 per year while Alexandra earns $90,000. They are planning to have a child in the next few years and are saving so that Alexandra will be able to reduce her hours until the child enters all-day school at age 4. During that time, Alexandra expects to earn about half her current wages. While they are determined to save for both the near term and the long-term future, they are not sure if they are contributing to the right type of retirement accounts. They are currently contributing the maximum amount to each of their own Roth IRA accounts, and they are contributing to Roth 401(k) plans through their employers. While several factors may affect an individual’s decision to save for retirement using taxadvantaged pretax strategies versus tax-advantaged after- tax strategies, a major determinant in this calculation is a comparison of Jose and Alexandra’s current marginal tax rate and their anticipated future marginal tax rate. Often financial planners look to external factors (e.g., Congress, current tax rates relative to historical tax rates, long-range economic forecasts). However, the internal environment of the client may be a more reliable predictor of future marginal tax rates. In this example, when Alexandra reduces her income to care for the new child and an additional dependency exemption is claimed, it is likely that Jose and Alexandra will have a much lower marginal tax rate once the baby arrives, making the current period’s marginal tax rate relatively high in comparison. In this situation, their after-tax accumulation strategy may be more efficient if they save in pretax vehicles such as traditional IRAs prior to the arrival of the baby, and save in after-tax savings vehicles such as Roth IRAs following the arrival of the child. If Jose and Alexandra were planning to withdraw the money in their retirement plan to support their standard of living while Alexandra stays home to be with the child, then Roth IRAs may be the best strategy since there is no penalty or tax on any principal that is withdrawn from the account. Additional children would significantly affect this decision. A financial planner must recognize both the internal environment and the external environment of the client and the associated tax implications when considering many aspects of financial planning.

Gloria Gloria has come to a financial planner seeking assistance managing her finances. She and Albert had been married for 42 years prior to Albert’s passing earlier this year. Albert had taken care of all of the financial decisions, ranging from investments to taxes, with only limited input from professionals. Albert enjoyed preparing his own tax returns by hand and did not use tax preparation software because he did not want to pay money for it. Their income consisted primarily of dividends, capital gains, and other investment income; required minimum distributions from employer-sponsored and individual retirement plans; a private pension; and

Social Security benefits. The financial planner agrees to work with Gloria, and as part of the initial client intake requests the past three years’ tax returns. As the personal financial planner reviews the tax returns, she notes several things. First, on the oldest tax return, Albert and Gloria claimed a long-term capital loss of $3,000, which suggests that their losses may have been larger than that. In subsequent years, though, only capital gains are reported. Second, she notes that one-fourth of Albert and Gloria’s income has come from qualified dividends, yet for all three tax years, their entire income has been taxed as ordinary income. Finally, she notes that Albert and Gloria have reported only half of their Social Security benefits as taxable, though their total taxable income substantially exceeds provisional income thresholds relating to the taxation of Social Security benefits. Other income, such as required minimum distributions and pension income, appear to be properly recognized. The financial planner should strongly encourage Gloria to also work with a certified public accountant (CPA) or other competent tax professional to amend her and Albert’s tax returns for the past three years. The practitioner provides Gloria with names of specific tax professionals who are qualified to assist Gloria and act with her best interests in mind. In order to help Gloria understand why it is important to amend Albert’s tax work, the financial planner reviews her findings with Gloria. First, in reviewing the supporting documents for the earliest tax return, she noted that the long-term capital loss was substantial and estimates that the resulting loss-carryover should have completely offset the subsequent years’ gains, resulting in additional recognition of the loss-carryover for the two most recent years. Second, she explains to Gloria that qualified dividends are taxed at a more favorable tax rate than other types of income, and by correctly applying this lower tax rate to that portion of their overall income, significant tax savings can be achieved. Third, she informs Gloria that more of their Social Security benefits should have been brought into taxable income. The practitioner explains to Gloria that the expected result of these three adjustments will be tax refunds for each of the three years, but that the final numbers will need to be calculated by the tax professional. The financial planner’s deep understanding of the federal income tax formula, along with an understanding of the supporting documents that contribute to that formula, helped Gloria claim a tax refund due to overpayment of taxes. Without such knowledge and review of past tax returns, these errors might not have been noticed prior to the statute of limitations expiring and disallowing Gloria from filing amended tax returns. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 41 Income Tax Fundamentals and Calculations Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

While the primary focus of this topic is on tax planning, concepts learned in this chapter apply directly to several other areas of financial planning. Many financial transactions, including purchasing insurance products, disposing of investment assets, and inheriting a qualified plan, affect the client’s income tax situation. A personal financial planner must understand how these various transactions affect the client’s current tax situation and be able to calculate and anticipate the change in tax liability. Most areas in financial planning, including retirement

planning, cash flow management, education planning, risk management and insurance planning, investment planning, and estate planning, are affected by income tax issues.

INTRODUCTION Form 1040 is the standard template for reporting and calculating individuals’ and married couples’ federal income and self-employment tax liabilities. While Form 1040 has gone through many revisions since its debut for the 1913 tax year, it has remained the primary reporting document required by the Internal Revenue Service (IRS) for individuals to report their tax related transactions. Obviously, many changes in the tax law, tax rates, and filing requirements have occurred since 1913. These ongoing changes necessitate annual revisions to Form 1040. Beginning in 1916, a new Form 1040 has been developed for each specific tax year. Form 1040 systematically walks tax filers through the complexities of the federal income tax calculation. Even with its step-by-step design, a financial planner must have a deep understanding of the reporting requirements, structure, and different types of income and applicable tax rates that may apply to income reported on Form 1040. Thus, a financial planner should understand the supporting documents, forms, and calculations used to generate the numbers reported on Form 1040. Typical supporting documents that a financial planner should be proficient in reading and understanding include: W-2 (Wage and Tax Statement) Form 1099 (i.e., 1099-INT, 1099-OID, 1099-DIV, 1099-MISC, 1099-R, 1099-Q, SSA 1099) Schedule A (Itemized Deductions) Schedule B (Interest and Ordinary Dividends) Schedule C (Profit or Loss from Business) Schedule D (Capital Gains and Losses) Schedule E (Supplemental Income and Loss) Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.) Schedule SE (Self-Employment Tax) Form 8615 (Tax for Certain Children Who Have Investment Income of More Than [annually revised limit]) Form 8814 (Parent’s Election to Report Child’s Interest and Dividends) Form 8889 (Health Savings Accounts) Form 8863 (Education Credits) Form 8949 (Sale and Disposition of Capital Assets, supports Schedule D)

Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts) This list is only introductory, and the specific forms used to aid in the calculation of the tax filer’s federal tax will vary based on their specific circumstances and will also vary from year to year due to changes in laws enacted by Congress. Information and calculations from these and other supporting documents may be transferred to Form 1040. Some calculations relating to exempt or excludable income may not need to be reported on Form 1040; however, it is always good to maintain supporting documents and calculations relating to that income in the event that the IRS has questions about the exempt transaction. Form 1040 follows the federal income tax formula: Gross Income – Deductions for Adjusted Gross Income = Adjusted Gross Income – Greater of Itemized Deductions or Standard Deduction – Personal Exemptions = Taxable Income × Tax Rate = Tax Liability – Tax Credits and Prepayments = Net Tax Due or Refund It is important to note that many deductions can be found embedded in the Gross Income section of Form 1040 due to the netting of income and expenses that result from similar activities, such as a sole proprietorship business or partnership. Netting of gains and losses also occurs with similar types of income, such as capital gains and losses being netted together. The netting of income and expenses (gains and losses) occurs on the supporting documents and forms, and generally only the final netted number is reported on Form 1040. In order to fully understand clients’ past and current tax situations, a financial planner must understand the supporting documents that resulted in the corresponding tax liability. When planning for clients, it is very important that the personal financial planner understand the clients’ Gross Income, Adjusted Gross Income, and Taxable Income. Two clients may have similar Gross Incomes but dramatically different Taxable Incomes because of differences in their life situations. It is also important for financial planners to recognize that consideration of a client’s marginal tax rate is often more important than the client’s effective, or average, tax rate when making financial planning decisions. Given the progressive nature of the income tax rate schedule, clients likely have marginal tax rates that are substantially higher than their average tax rate, and the marginal tax rate should be considered and used when calculating the after-tax value (cost) of additional deductions or income recognition.

Once a financial planner understands how these documents and calculations flow through to Form 1040, the financial planner can begin to engage in meaningful tax planning to structure income and expenses in ways that optimize tax efficiency given a client’s overall financial and personal goals. Because of the complexities of the Internal Revenue Code, coupled with the unique circumstances experienced by individual taxpayers, opportunities to identify and develop specifically tailored tax-saving strategies are abundant and should be carefully considered and discussed with the client’s CPA or tax professional. In addition to client-specific tax-planning opportunities, the U.S. Congress continues to embed tax-based financial incentives into the Internal Revenue Code. These incentives generally relate to long-term investment (retirement savings, small business development, favorable capital gains tax rates, etc.); human capital investment (education, training, health, employment-related expenses, etc.); and homeownership, to name just a few. These tax-saving strategies are generally designed to benefit broad segments of the population and should also be carefully considered. If a client is not taking advantage of tax incentives that are consistent with the client’s overall goals, the financial planner should discuss this with the client’s CPA or tax professional.

LEARNING OBJECTIVES The student will be able to: a. Complete a Form 1040, including the receipt of wages, retirement income, interest, dividends, capital gains, self-employment and rental income or losses; itemized deductions; credits; and estimated or carryover payments. Financial planners should possess a working knowledge of how income and deductions are reported on the federal income tax return and how the various income tax reporting schedules and forms flow together into Form 1040. Understanding how the forms interrelate will give the financial planner a much firmer grasp of how current and planned financial transactions may affect their clients’ income tax liabilities and corresponding cash flows. b. Recommend actions to minimize tax liability and maximize after-tax returns for clients and dependents consistent with IRS Code. This learning objective seeks to reemphasize to financial planners that the goal of tax planning is not to minimize current tax liability at all costs, but rather to maximize the clients’ potential for realizing goals by structuring clients’ financial affairs so as to achieve the greatest after-tax efficiency possible and realize the highest optimal amount of after-tax net worth possible. If the current-period tax liability is also minimized at the expense of future tax periods or, even worse, at the expense of a client’s long-term goals, then the overall goal of financial planning has been compromised.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Match the type of income, exemption, exclusion, deduction, adjustment, or credit with the corresponding income tax form, if there is one. Ask students to calculate the tax liability for a single tax filer and a married filing jointly tax filer with the same adjusted gross incomes. Students can discuss why their tax liabilities are different.

Develop a matching exercise that requires students to match specific information to the tax form that would contain that information. Give students a completed tax return and ask them to calculate the marginal tax savings of an additional deduction for AGI, deduction from AGI, and tax credit.

Ask students to determine the marginal tax rate and average tax rate for the two households. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing the material Evaluating: Making judgments based on criteria and standards through checking and critiquing

Ask students to rank-order a list of similar dollar-amount deductions for AGI, deductions from AGI, refundable tax credits, and non-refundable tax credits; students will rank them from highest to lowest tax savings value for taxpayers with marginal tax rates of 15, 25, and 35 percent.

Prepare a tax return with AGI near several key phaseout limits (i.e., earned income credit, education credit, etc.). Ask students to incorporate one additional deduction or income item and to prepare a short essay, with computations, explaining how many aspects of the tax return changed with the addition of one piece of information.

Ask students to work in groups to design a questionnaire that will gather all of the appropriate information from the client pertaining to each section of the tax return (i.e., income, deduction for AGI, selfemployment, etc.) in order to

Ask students to complete a basic Form 1040 tax return by properly classifying common types of income, exclusions, adjustments, and deductions, calculating taxable income, credits, tax liability, and net tax due or to be refunded.

complete the current-period tax return. Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Give students a short case about a client who is saving for a child’s college education. Divide the students into groups of three and ask them to develop savings strategies for the client. Ask the groups to exchange their strategies with each group listing the pros and cons for the other, looking at after-tax wealth of the strategy.

Ask students to prepare three viable college-funding scenarios for a client that maximize after-tax cash flows available for schooling expenses. Ask students to compare the three plans and provide recommendations on which plan best achieves the goal. Students then alter the fact pattern by increasing or decreasing the time until the child begins school and reassess their plans based on this change in time horizons. Students can communicate this to the client in a written letter.

Return the papers to the original groups and have them incorporate the best of both strategies into their recommendations.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner can calculate a client’s taxable income and net tax liability utilizing Form 1040, Schedule A, Schedule B, Schedule D, Form 8949, and Form W-2, as well as the following forms of 1099 income: R, INT, DIV, Q, and SSA. Competent: A competent financial planner should understand how the netting of income and expenses (gains and losses) affects clients’ current and future tax situations and where netting occurs. This is particularly important when considering the tax situations of clients who are self-employed or who have after-tax investment portfolios. The financial planner should be capable of using this knowledge to engage in meaningful tax planning over a multiple-year period, effectively minimizing the client’s tax burden across time, not just at certain points in time. Expert: An expert financial planner will work closely with the client’s CPA or tax attorney to identify and structure transactions that will minimize the client’s, and the family’s, tax burden across the client’s life cycle.

IN PRACTICE

Ed and Sylvia Ed and Sylvia have been married many years. They have three children: Maria, 26, Eduardo, 21, and Javier, 18. Maria has graduated college and is working out of state as an engineer. Eduardo is attending state university and has one year left until he graduates, and Javier will finish high school this year and start college. Ed is a manager at an industrial facility and Sylvia works for the local school district as a teacher. Through Ed’s connections at work, he has developed the capacity to have a fairly thriving side business doing specialty welding. Ed and Sylvia recently refinanced their home mortgage. Ed and Sylvia have decided to meet with Erika, a personal financial planner. They had an initial meeting during which Ed and Sylvia discussed some of their financial concerns and goals and they agreed to form a financial planning relationship with Erika. One of the things that was clear from the meeting is that Ed and Sylvia are very devout followers of their faith and expressed to Erika a desire to be able to give more to their church now, or sometime in the future. Ed and Sylvia also expressed some concern about how much they were paying in taxes since it seemed their friends were not paying nearly as much. Erika requested the last three years’ tax returns as well as other account information. Ed and Sylvia provided all of the information to Erika that she requested. As Erika reviewed the past tax returns she was first surprised by what she did not see based on her first discussion with Ed and Sylvia. The one thing she did not expect to see was the amount of taxes that Ed and Sylvia paid last year. The first thing that Erika found that was missing was a Schedule A. Erika knew that Ed and Sylvia have a reasonable-sized mortgage and pay property taxes, along with state taxes, that they would have received Form 1098-INT, and likely would have also received a statement from their church regarding any donations that they would have given; but there was no Schedule A. In fact Erika was surprised that they had just taken the standard deduction. The next thing Erika found surprising was that Schedule C also seemed to be missing. Erika knew that Ed had quite an active side business and that, based on their initial interview, would earn between $5,000 and $20,000 per year depending on the year. But there was no Schedule C. Erika did notice that Other Income of $8,000 had been reported on the first page of the 1040 with the word “Welding” typed in as a description. Erika noted that Eduardo and Javier had been claimed as dependents on the tax return, but again, there was no record of Form 8863 and no education credits had been claimed for Eduardo. Erika double checked the “For AGI” deductions section to make sure that Eduardo’s tuition expenses had not been deducted there. At the next meeting with Ed and Sylvia, Erika asked whether they had received certain tax forms in the mail, such as 1098-INT and 1098-T statements, as well as 1099-MISC forms, and a donations statement form from their church. Ed said that they had received several “tax things” but it seemed like too much paperwork to manage and maintain so they had not kept track of it. Sylvia chimed in and added that she kept last year’s forms, but they had thrown out all of the prior forms, they simply did not want the hassle of organizing all of the paperwork. Erika asked if Sylvia would bring in those additional tax forms that they had received.

As Erika looked over the additional forms that Sylvia brought she was able to recalculate some of the “From AGI” deductions and credits that Ed and Sylvia were able to claim. Erika quickly realized that by filing an amended tax return, Ed and Sylvia would be able to claim a refund of several thousand dollars. Erika met again with Ed and Sylvia and encouraged them to talk with a tax accountant to file an amended return to claim the deductions and credits that they were eligible for and that this could result in a tax refund worth several thousand dollars. She also informed them that they would need to claim Ed’s welding income as self-employment income on Schedule C rather than as Other Income on Form 1040. Along with managing the investments and other assets, Erika also helped Ed and Sylvia create an efficient record keeping system for all of their tax-related documents so that they could give those to the accountant at tax time. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 42 Characteristics and Income Taxation of Business Entities Webster Hewitt, CPA, CFP® University of Georgia Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

Business entity selection will directly affect the taxation of income associated with the business activity. However, equally important (if not more important) to the tax ramifications

of this decision is the need to properly manage business-related risks and opportunities by selecting the most appropriate business entity form that will mitigate risks posed by the business activity. Estate planning objectives may also be very important considerations when selecting among types of business entities to house certain income-producing activities.

INTRODUCTION This section is an introduction to the complexities and strategy behind business entity selection. The rules can be complex and may vary across individual states. Knowledge in this complex area is critically important to the personal financial planner, as self-employment (SE) continues to gain in popularity, including from within our own industry. All businesses choose a form of organization. Even a part-time business out of one’s own home is operating as an entity. Choosing the particular entity that best suits the business requires a thorough understanding of the nature of the business, relevant state and municipal law, federal income tax requirements, and the business owner’s future plans. Even with a wealth of knowledge in these areas, businesses evolve over time, so choice of entity is at best an exercise of professional judgment. This chapter offers a review of federal income tax requirements. However, no attempt has been made to discuss each state’s income and registration requirements. Generally, preparing the formation documents and monitoring the reporting requirements are beyond the scope of a personal financial planner’s expertise; these should be reserved for the client’s attorney or CPA. Financial planners, however, still play an important role in the formation and implementation stages. A planner’s unique knowledge of the client’s situation can play a key role in selecting the proper entity. Also, clients look to their planners for guidance on how this business will integrate into their overall plans. So it is imperative that financial planners can, at a minimum, identify major concerns and provide a clear overall perspective of what impact this has on other related disciplines such as retirement planning and employee benefits.

LEARNING OBJECTIVES The student will be able to: a. Differentiate between the organizational form and the tax treatment of income, expenses, payroll, and wage taxes for sole proprietorships, partnerships, LLPs, LLCs, S-corps, and C-corps. b. Compare the income and payroll tax effects of wage versus ownership income. c. Identify adjustments, deductions and exclusions that may be available to sole proprietors, partners, LLPs, LLCs, S-corp, and C-corp owners.

Overview of Most Common Types of Business Entities

The most simple and common form of ownership is a sole proprietorship. It is the default option for individuals unless another option is chosen. In short, a sole proprietorship is an unincorporated entity that is entirely owned and directed by one person, the owner. It does not exist outside of its owner, and all assets and liabilities belong to the owner personally. Sole proprietors are liable personally for all activities of the business. For federal income tax purposes, the owner must include Schedule C or C-EZ with the owner’s personal 1040 tax return. All income is taxed at the individual’s marginal tax rate. All profits of the business are subject to self-employment taxes calculated on Schedule SE of the 1040 (the SE tax). With a sole proprietor, the owner pays both the employer and employee portions. The Social Security tax in 2015 would be 12.4 percent total (combining the 6.2 percent by employer and 6.2 percent by employee) on the first $118,500. Medicare tax of 2.9 percent will be due on all profits (again combining 1.45 percent each by employer and employee). There are minimal other payroll requirements because the employer and employee are one and the same. A partnership consists of two or more people operating a business together. Profits and losses are typically divided as agreed upon by the partners. One type of partnership is a general partnership where partners are all considered co-owners of the business. For limited partnerships, there is at least one general partner and a number of limited partners. General partners are typically actively managing the affairs of the partnership, whereas the limited partners are considered investors only and have no authority to make managerial decisions. The limited partners have limited liability whereas general partners are jointly and severally liable, meaning they can be sued as a group or individually for the actions of anyone in the partnership. A limited liability partnership (LLP) is a specific type of partnership that provides protection to partners from the errors or omissions of other persons (except those under the control of the partner). Partnerships should have executed partnership agreements that spell out important information, such as admission of new partners, allocation of profits and losses, and termination of the partnership. Partnerships are regulated according to state law and are required to file a separate information tax return, specifically Form 1065, for federal income tax purposes. This 1065 return generates a Schedule K-1 for each partner showing their percentage allocation of income, losses, and deduction items to report on their individual returns. Generally, if you are a member of a partnership conducting a business, you must include your share of partnership income for SE tax. Limited partners not active in the business are typically exempt from SE tax. Corporations are separately organized entities from their owners. An owner can choose that the business be taxed as a C corporation or an S corporation. Both types operate the business under their corporate name (rather than the name of the owner). Creating a corporation requires registration and document filings with the state where they choose to incorporate stating the name and contact information of the corporation. Oftentimes a corporate charter and corporate bylaws are required. The owners typically contribute money or property in exchange for stock (income tax free). The owners continue the business until it is sold or liquidated. A key difference between S corporations and C corporations is how they are taxed. C corporations are taxed similar to individuals: income less deductible expenses to arrive at taxable income.

C corporations must file a separate tax return apart from their owner’s personal return—Form 1120 for federal income tax purposes. When a corporation distributes profits to shareholders, the payments are considered dividends. Dividends to the owners are not allowed a corporate deduction, and thus these monies are subject to a double tax: Profits are taxed first at the corporate level and then also at the owner level as dividend distributions. S corporations are corporations that make a special election for tax purposes. This election allows the corporation to pass through its income, losses, and deductions much like a partnership does. For federal income tax purposes, the appropriate form is Form 1120-S. Another key difference between these two types of corporations is that C corporations allow for multiple classes of stock, whereas only one class of stock is allowed for S corporations. Both types of corporations will require payroll record keeping. Only the amounts paid to employees as wages are subject to the SE tax (half is paid by corporation, and half is withheld from the employee’s salary). A limited liability company (LLC) operates as a hybrid option between a corporation and a partnership. It provides limited liability to the owners and the flexibility to be taxed as a corporation or a partnership as chosen by the “check the box” regulations. In some states, an LLC may be created even if there is only one owner and can elect to be disregarded for tax purposes (i.e., taxed as a sole proprietor). This election has implications for state and/or federal income and federal SE tax. The business must typically register to do business within the state and file articles of incorporation. While not always required, a business agreement is important to discuss the rules of the company.

Highlighting a Few Key Differences As discussed earlier, selection of entity form can lead to significant differences in taxation and registration purposes. Many start-up businesses select an LLC because setup costs are typically low and they can elect taxation. A common reason behind entity selection is to choose the form that minimizes taxes and registration costs. A thorough analysis of expected SE tax, federal and state income tax, and registration costs at the state and municipality level should be conducted. For example, a sole proprietor with $100,000 of business income would be subject to $15,300 of SE tax versus $11,500 for an S corporation that pays a salary of $75,000. Wages must be reasonable in amount and in conjunction with the services performed. There is currently no standard for how much should be paid as wages, but prudent judgment is warranted. For instance, a business owner earning $150,000 profit per year as the sole employee would be wise to take a salary of greater than $25,000. Selecting the proper home state can also save a significant amount in state taxes and registration fees. Keep in mind that maintaining a business presence in states other than where you are registered could subject you to their income taxes and registration fees for the income sourced within that state. Many small businesses generate little profit in their formative years. Oftentimes, astute owners will choose partnership or LLC at first so they can deduct any losses against other income sources. One of the greatest strengths of a corporation is that it allows the business to raise capital through selling shares of stock. C corporations allow for multiple classes of stock.

Creating voting and non-voting shares of stock is an important tool used to help facilitate the transfer of business interests to family members and key employees. Also to be considered is what type of retirement plan would be optimal. This will be discussed in further detail in Chapter 68. Business owners will also need to consider their options for health insurance, especially if they do not have the option to obtain coverage through their spouse’s employer. Business owners should consider purchasing insurance through professional or trade associations, if possible, as individual insurance policies can be expensive and difficult to obtain. The income tax treatment of health insurance premiums varies depending on the type of entity. Generally, Schedule C taxpayers, general partners, active participants inside an LLC, and employees who own more than 2 percent of an S corporation are eligible to deduct premiums on line 29 of the 1040.

IN CLASS Category

Class Activity

Student Assessment Avenue Applying: Carrying Ask students to match key characteristics of Give students a short out or using a each type of business entity with that type of fact pattern that procedure through entity. closely parallels executing or business entity implementing characteristics. Ask students to identify which business entity would be most appropriate given the fact pattern. Analyzing: Breaking Describe a fictitious case for the students to Students may prepare material into read. Ask them to write a summary of the key a short memo (one constituent parts, and pieces of information contained within the case, page) outlining the determining how the and describe the advantages and disadvantages situation and the parts relate to one of choosing between at least two options, important information another and to an providing figures where appropriate. that is missing to overall structure or make a determination. purpose through Alternatively, differentiating, multiple-choice organizing, and questions could be attributing created. Evaluating: Making Short cases for students to evaluate the Ask students to judgments based on advisability of a company’s choice in form of prepare a short writecriteria and standards entity. Typically, the case will have one or two up for each assigned

through checking and major issues to point out rather than a lengthy example. Specific issues that could be critiquing illustrated by the cases include potential for liability and mitigating risks, taxation of owners during start-up years and profitable years, need for capital, and desire for control in management decisions. Creating: Putting Ask students to create a fictitious business of elements together to their own (perhaps a financial planning form a coherent or business). Ask the students to outline their functional whole; recommended business entity and describe the reorganizing procedure for getting the business started. elements into a new pattern or structure through generating, planning, or producing

case study highlighting the advisability of the situation described in the case study.

Students write a report (two or three pages) that outlines what steps were necessary to start the business and why they chose the particular entity they did.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: With respect to business entities, an entry-level personal financial planner can identify the types of entities that are available, their distinguishing characteristics, and how each is created; review the organizing documents; and understand how they are taxed. Competent: A competent personal financial planner can ask appropriate questions to gain insight from the client with which to evaluate and identify planning opportunities and areas of concern for clients during business formation or ongoing. The goal is to help facilitate the client’s achieving an acceptable result by providing advice to the client and tax adviser who will implement. Expert: An expert personal financial planner can work very closely with the client’s tax advisers and likely possesses a strong background of experience in taxation. The expert planner can identify complex problems and proactively suggest strategies to minimize taxation, calculate the numerical savings by switching to a different entity, or spot flaws in organizational documents. The expert planner can identify the key factors on which to base a decision and clearly articulate a recommendation to the client.

IN PRACTICE Han Han is 40 years old and has enjoyed a very successful career as a pilot. He is very talented and has decided recently to start his own aviation business. During the course of meetings with his

financial planner, Han has mentioned that he will manage his business from his home, occasionally hiring help when needed. The gross receipts from the first year are expected to be $50,000. A personal financial planner should recognize that Han will be considered a sole proprietor until elected otherwise. If so, he would be personally liable for all activities of the business. Han will also need to track his business expenses for reporting purposes and tax deductibility, such as office supplies and business insurance. He will also be eligible to deduct a percentage of certain expenses that are related to the use of his home as his primary office. A personal financial planner should be familiar with Form 8829 and be able to inform Han that he will need to keep records substantiating the work expenses claimed on his tax return, such as real estate taxes, utilities, mortgage interest, and depreciating the home. If he chooses sole proprietorship, then all profits will be subject to SE tax (both employer and employee portions). Almost all profits will be subject to federal income tax as well (half of SE tax is an above-the-line deduction). If an S corporation or a C corporation is chosen, then only the wages Han pays himself would be subject to these self-employment taxes. If a C corporation is chosen, then profits could remain undistributed for future purchases. The personal financial planner and Han agree that an LLC would be optimal to give him flexibility to change his tax status depending on how the business performs. This decision turns out to be wise as, after a few years, Han lands a very lucrative job escorting royalty and decides to hire his former copilot Chu to help him manage the business.

William and Theodore William and Theodore enjoy their lifelong careers as teachers of history. In their free time, they enjoy writing and playing music. After mostly playing in their garage, they have been able to play in front of larger audiences and are hoping their career prospects will be brighter in the future. A personal financial planner should recognize that a general partnership would not provide William and Theodore with much protection should they be held liable for any lawsuits in connection with their band. A corporation may be an unnecessary complication given the minimal amount of compensation they have received from playing. However, an LLC electing to be taxed as a partnership could limit liability without creating excessive administrative requirements. The business may become very large someday so it is important to set up a basic operating agreement in writing to discuss how the business should operate, as well as how each homeowner’s interests are valued if one of the owners passes away. William and Theodore maintain careful records of their expenses and income to avoid the IRS classifying their band as a hobby in the initial years, which would not be eligible to deduct any losses.

Cal and Gillian Cal and Gillian have developed extensive experience working with government organizations. They have decided to leave their government jobs to start their own consulting firm, which they anticipate will be very successful.

Cal and Gillian will have to decide how much to pay themselves in wages. They will also be in need of health insurance and should look for coverage from any trade associations or their state exchange. Choosing the state in which to register is also important for state income tax purposes. Their travel (after deducting commuting miles), licenses, business insurance, and 50 percent of their meals will be deductible expenses against their income. Cal and Gillian are considering a corporate form. To maintain the integrity of the corporation, corporate bank accounts, phone, and a credit card should be obtained. Also, if a corporate form is chosen, Cal and Gillian will need to register to do business in any so-called foreign state (any state outside of their state of incorporation). A personal financial planner with expertise in the area who also knows the nature of the business is providing his expert advice, and points out that they may be subject to the personal services corporation (PSC) tax (at 35 percent) but that S corporations are not subject to the PSC tax. However, they decide on a C corporation. They end up working all across the United States doing short-term work, so the decision creates unnecessary regulatory costs and burdens, as Cal and Gillian had to register as a foreign corporation within each state where they do business. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 43 Income Taxation of Trusts and Estates Martin C. Seay, PhD, CFP® Kansas State University Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

While the primary focus of this topic is tax planning, concepts learned in this section apply directly to other areas of financial planning. The most direct connection is with estate planning, where an understanding of the income tax consequences of estates and trusts is critical in creating effective and efficient estate plans. Furthermore, the identification of property and

investments appropriate for transfer into a trust is greatly informed by understanding the income tax consequences of doing such a transfer.

INTRODUCTION An understanding of the fundamental structure of the United States Internal Revenue Code as it relates to taxation of trusts and estates is essential for financial planners. This knowledge base is especially critical at three points in the financial planning process: (1) when working with attorneys to create estate planning and trust documents; (2) when reviewing clients’ existing estate planning and trust documents; and (3) when working with a client who is actively engaged with an estate or trust. While the tax code can be rather complex for trusts and estates —making consultation with a CPA or an estate planning lawyer necessary—there are several guiding concepts and principles that a financial planner must understand. The current system for the taxation of estates and trusts can be traced back to the Revenue Act of 1916, which introduced a conduit structure of taxation. This system views trusts and estates as mechanisms to facilitate the transfer of wealth between individuals and delineates between the assignment of tax liability for income generated in a trust that is retained and income that is distributed.

LEARNING OBJECTIVES The student will be able to: a. Outline the basic income tax compliance rules for trusts and estates including when a return is required and how it is filed. b. Contrast the trust and estate income tax rules with personal income tax rules. c. Identify the income(s) that will pass-through to beneficiary/beneficiaries for tax purposes. d. Explain how a client will report income and appropriate deductions from a trust or estate on his or her income tax return. The concept of distributable net income (DNI) determines whether income generated within an estate or trust is taxable to the estate or trust or to a beneficiary. DNI is based on measuring the amount and character of income retained by the estate or trust and that which is distributed to beneficiaries. In general, income retained by the trust or estate is taxable to the estate, whereas income that is distributed is taxable to the beneficiary. A comprehensive understanding of this concept is crucial for financial planners when working with clients with complex trusts, especially those that have income beneficiaries. Overall, estates and trusts are viewed as separate taxable entities that come into existence at the death of an individual (in the case of an estate) or upon creation (in the case of a trust). Similarly to personal taxation, estates and trusts must report income annually. Trusts, with few

exceptions, must report income on a calendar-year basis. While fairly rigid, the inherent flexibility in determining when to establish a trust does provide for the implementation of income-tax-saving techniques. Estates, in contrast, have considerable flexibility in the selection of their tax year. An estate’s income tax year begins the day following its creation, but the executor has the discretion to choose its end date at any point in the subsequent 12 months. While this allows flexibility for an estate’s first tax year, all subsequent tax returns must be based on the selected year-end date. An understanding of tax year and filing requirements for estates and trusts is critical to a financial planner’s ability to maximize aftertax wealth for both the client and the beneficiary(ies). Taken as a whole, there are several income tax reasons for the creation of a trust. Foremost, the creation of a new tax entity allows for a separate tax return, and subsequently provides an opportunity to expose income to a lower effective tax rate as it climbs the trust tax rate schedule. However, personal exemptions are significantly reduced, and no exemption is allowed on an estate’s or a trust’s final income tax return. Consequently, even estates and trusts with relatively minimal amounts of income must file a tax return. Furthermore, income tax rates are severely accelerated, as compared to personal income taxation, causing any significant taxable income to be taxed at the highest income tax rate. In general, this makes significant income generation taxable to an estate or a trust undesirable. However, a properly constructed trust can allow a grantor to shift income from the trust’s tax return to that of a beneficiary. In order to achieve this benefit, the grantor must fully relinquish control of the property in the trust, triggering possible gift tax consequences. If improperly created, all income will be assigned back to the grantor regardless of whether it was distributed to a beneficiary, and the distributions may be subject to gift tax consequences. It should be noted that in the case of Intentionally Defective Grantor Trusts, income tax responsibility is intentionally maintained by the grantor to accelerate asset gifting. Given the more stringent income tax requirements for estates and trusts, a financial planner should be able to identify the types of assets that should be placed within a trust and recommend the necessary estate planning measures to maximize tax efficiency in accordance with client wishes. Income and/or deductions from a trust or an estate that are assigned to an individual taxpayer are reported through Form K-1, which is provided to the taxpayer by the trust or estate administrator. In function, a K-1 is very similar to a W-2 or 1099 in that it will provide the information necessary to complete a personal income tax return. However, this document often provides a much wider array of information, and care must be taken to ensure that all pertinent information is incorporated correctly. Any income or deductions received in this manner are subject to the same income tax treatment as income derived directly by the taxpayer.

IN CLASS Category

Class Activity

Applying: Carrying out Utilize lecture to highlight important

Student Assessment Avenue Ask students to complete a

or using a procedure through executing or implementing

estate and trust income tax concepts, which may include: (1) the role trusts play in transferring wealth, (2) the financial and non-financial benefits trusts provide for clients, and (3) how trusts can serve to lower effective tax rates for clients and increase wealth for beneficiaries.

personal income tax return with trust income.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Mediate a class discussion based on a list of the most common mistakes made by financial planners in working with estates and trusts. Ask students to identify the errors and their consequences.

Ask students to review example trust documents with corresponding asset information. Ask students to analyze the trust arrangement to identify tax issues.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Create an in-class assignment that details several example trust and estate arrangements. Ask students to identify both the income and estate tax implications created by these arrangements. Then, ask them to make recommendations to improve the arrangements.

Ask students to evaluate a case study that includes an improperly designed trust arrangement. Ask them to articulate the income-taxrelated issues and to provide viable alternatives that would have avoided these issues.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Provide the class with a list of a client’s assets. Mediate a class discussion to identify and create an estate plan, with an emphasis on minimizing income tax consequences.

Provide client scenarios to students with a list of goals and asset information.

These errors may include: (1) the inefficient selection of assets to place in a trust or estate, (2) the unintentional creation of a retained interest, and (3) incorrect utilization of a trust where cheaper effective options were available.

Ask students to prepare questions related to specific estate or trust income tax concepts.

Provide a list of estate assets to provide students with information. Ask students to identify the tax consequences of the individual assets.

Ask them to identify trust arrangements that effectively achieve client goals while minimizing tax consequences.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: With respect to taxation of estate and trust income, an entry-level personal financial planner can complete a personal income tax return that includes income from a trust or estate. Furthermore, an entry-level personal financial planner can review estate documents and identify red flags in terms of unexpected client income tax liability. Competent: A competent personal financial planner can evaluate estate and trust documentation and identify planning opportunities and areas of concern for the current and future periods. The planner can calculate the tax benefit of trust and estate arrangements with the objective being to maximize after-tax wealth for both the client and the beneficiary(ies). Expert: An expert personal financial planner can work closely with estate planning attorneys to identify comprehensive tax planning strategies that utilize multiyear time horizons. The planner can help clients achieve their primary goals and objectives as efficiently as possible in terms of tax savings and in planning costs. An expert personal financial planner can successfully identify and implement income tax strategies for estates and trusts.

IN PRACTICE Maria In her thirties, Maria Sanchez purchased a $2 million whole life insurance policy to protect against her premature death. Now in her seventies and with her husband having predeceased her, Maria is facing significant estate tax concerns. Over the years, the policy has accrued a cash surrender value of $475,000, and Maria has made total premiums payments of $225,000. If Maria surrenders her policy for cash value, she will be required to pay tax at ordinary income tax rates for any benefit received above the sum of premiums paid, in this case $250,000. Given that Maria does not need the value of the cash surrender value and wants to leave a sizable estate for her son Juan, her financial planner recommends the use of an Irrevocable Life Insurance Trust (ILIT). She recommends that the policy be transferred to the ILIT using her lifetime gift tax exemption. She recommends contributions equal to the gift tax exclusion be made annually to pay policy premiums. To allow these contributions to qualify as a present interest, she recommends the use of a Crummey provision. Assuming Maria lives an additional three years, the proceeds of the policy will be excluded from her estate and no income tax will be due related to the life insurance proceeds. However, if it is a participating policy, any dividend income retained in the trust will be subject to tax on the trust rate schedule.

Steve and Martha Steve and Martha Watkins have expressed a desire to begin gifting assets to their 21-year-old grandchild, Clark. However, they have expressed concerns about directly gifting money due to concerns about Clark’s ability to manage it. In addition to estate tax benefits, their financial

planner, Joe, also identified the possibility of income tax savings due to Clark’s limited income. Joe recommended that the Watkinses each contribute an amount equal to the annual gift tax exclusion from their taxable bond portfolio to a trust with Clark as the designated income beneficiary. He also recommended a Crummey provision within the trust documents to qualify the gifts as a present interest to avoid gift tax consequences. Last, he indicates that the Watkinses should place limitations on trust principal distribution contingent upon Clark reaching stated goals, whether educational or age-based. With this setup, Joe has successfully shifted income from the relatively high-income Steve and Martha to Clark, saving a considerable amount on taxes. A personal financial planner should be able to apply the knowledge of both estate planning and tax planning to create effective and efficient transfer arrangements. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 44 Alternative Minimum Tax (AMT) Webster Hewitt, CPA, CFP® University of Georgia Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

This chapter is primarily focused on taxation, but has some connection to investments and employee benefits (incentive stock options).

INTRODUCTION Congress has exercised its legislative power in numerous instances and used the tax system to encourage taxpayers to engage in various transactions that it deems economically or socially desirable. The result of these incentives is tax relief for participation in these provisions. As the number of such relief provisions grew through the years, Congress became increasingly aware that many taxpayers were carefully planning their affairs to take maximum advantage of these opportunities. As a result, a large number of individuals and corporations with large economic incomes were paying little or no tax. Instead of trying to reduce these incentives, legislators decided to impose an additional tax on those taxpayers Congress believed were overly taking advantage of tax relief provisions. Congress first enacted a tax in 1969 that was in addition to the regular income tax liability and was focused on certain preferences. However, this was overhauled in 1978 by a separate, parallel tax system with an alternative calculation of an additional tax liability that results in a minimum amount of tax the individual must pay. This system is called the alternative minimum tax (AMT) and is calculated for individuals on Internal Revenue Service (IRS) Form 6251.

LEARNING OBJECTIVES The student will be able to: a. Explain the alternative minimum tax. b. Identify taxpayer situations that are most likely to result in imposition of the AMT. c. Recommend strategies to avoid triggering the AMT. The term alternative is misleading, as this tax is a mandatory tax to be paid only if it exceeds regular tax liability. This parallel tax system also uses exemption amounts to recognize that some level of relief provisions should be allowed. However, these exemption amounts phase out at varying levels of tentative alternative minimum taxable income (AMTI), resulting in reduced or eliminated exemption amounts for taxpayers with large amounts of preference items. The AMT is calculated by applying a tax rate to a tax base. The tax base is called AMTI. The starting point for AMTI is regular taxable income. Two separate categories of modifications are then applied to regular taxable income in order to calculate AMTI. The first modification is for adjustments. The second modification is for preferences. Adjustments are made to items that are treated differently in the current period but that may reverse themselves in future periods through the credit for prior-year minimum tax (which is tracked on IRS Form 8801). Preferences are items that do not reverse over time. Preferences are add-backs in taking regular taxable income to AMTI. Once AMTI has been calculated, tax rates are multiplied to this base and a tentative minimum liability is reached. This amount is reduced by any allowable tax credits such as the foreign tax credit and individual non-refundable credits including child, adoption, higher education, and dependent care credits. This amount is labeled “tentative” because it must be compared to the regular income tax liability, and the AMT will

be the excess over the regular tax amount. The most common adjustments required of individuals are deductions from adjusted gross income that must be modified or are not allowed for AMT purposes. These add-back items are some excess medical expenses, state and local taxes, interest other than qualified housing and investment interest, miscellaneous itemized deductions subject to the 2 percent limitation, and personal and dependency exemption amounts deducted in arriving at taxable income. In addition, the standard deduction is not allowed and is added back by taxpayers who do not itemize. Many adjustments are not disallowed for AMT purposes, but are spread out (in the case of deductions) or accelerated (in the case of income items), with the difference in calculations being temporary, not permanent. This effect is best illustrated by depreciation. The AMT requires use of the alternative depreciation system (ADS) to compute depreciation, typically resulting in a straight-line, longer-life method than the modified accelerated cost recovery system (MACRS), which is mainly used in calculating regular income tax liability. Thus, AMT will be lower initially but in later years the ADS depreciation will exceed MACRS and the effect of the adjustment should reverse itself by utilizing the credit for prioryear minimum tax. Another common preference is the exercise of incentive stock options. AMTI includes the excess of the fair market value over the exercise price on the date of exercise. The most conventional preferences, which are always added back in the computation of AMTI, are private-activity bond interest, intangible drilling costs on oil and gas properties, percentage depletion deductions in excess of the basis of the property, and the exclusion of gain on qualified small business stock. There is a gap between the 28 percent maximum AMT individual tax rate and the 39.6 percent maximum tax rate for individuals. This gap makes it easy to trigger the AMT for high-income earners with large itemized deductions. Typically, the goal of tax planning is the maximization of wealth via the minimization of taxes. Too great a reduction in the regular tax may trigger AMT. Taxpayers subject to the AMT may be better off to accelerate income in the AMT year and defer deductions to a regular tax year, which runs counter to typical tax planning strategy. Taxpayers should also be aware of all adjustments and preference items that can trigger the AMT and consider them when evaluating investment opportunities. It is important to explore and plan for the AMT by running projected tax calculations under both the regular tax and the AMT system for the current year and for several years into the future. In some instances, a break-even point will arise where an individual’s regular tax and AMT are approximately equal. With diligent and thorough planning efforts, the effects of AMT can often be lessened. Taxpayers who may be subject to the AMT should consider tax planning opportunities available, weighing the effects in the current and future years: Bunch deductions in years with significant tax preferences items. Shift timing of state income tax payments and possibly deduct state sales taxes rather than income taxes on Schedule A. Dispose of investments in private-activity tax-exempt bonds.

Recognize capital losses if capital gains are causing the phaseout of the AMT exemption. Consider making shifts in your investment asset allocation. Accelerate income through individual retirement account (IRA) and/or pension distributions. Pay off home equity loans where the borrowed funds were not used to improve the residence. Consider intrafamily transactions.

IN CLASS

Category

Class Activity

Applying: Carrying out Ask students to review the basics of the AMT or using a procedure tax calculation. through executing or implementing

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Student Assessment Avenue Ask students to briefly write up several preference or adjustment items contrasting the treatment for AMT purposes versus regular tax.

Describe a fictitious case for the students to read that contains circumstances that will trigger AMT, such as high state and local tax deductions, high exemptions, and incentive stock options. Ask them to write a summary of the key pieces of information contained within the case and describe the effect on the AMT calculation.

Students may prepare a short memo (one page) outlining the situation and the pertinent information. Alternatively, multiple-choice questions could be created. Write three short cases describing the advice Students prepare a given to clients paying AMT. One case should short write-up for focus on incentive stock options, one on each assigned case property tax payments, and the other on the study highlighting timing of income. Ask students to evaluate the the advisability of advisability of the tax advice given. Typically, the situation the case will have one or two major issues to described in the case study. point out rather than a lengthy multiyear example.

Creating: Putting Ask the students to create a fictitious tax return Students write a elements together to for a client expected to fall into AMT. report (two or three form a coherent or pages) that outlines functional whole; what the situation reorganizing elements was and how taxes into a new pattern or due were structure through determined. generating, planning, or producing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: With respect to AMT, an entry-level personal financial planner can identify the major adjustments and preferences, and understand how the AMT tax is calculated. Competent: A competent personal financial planner can identify planning opportunities and spot clients paying AMT. The goal is to help facilitate the client achieving an acceptable result by providing advice to the client and tax adviser who will implement. Expert: An expert personal financial planner can work very closely with the client’s tax advisor and will likely possess a strong background of experience in taxation. The expert planner can identify planning opportunities and proactively suggest strategies to minimize AMT, calculating the numerical savings by running tax projections. The expert planner can identify the key factors to base a decision on and clearly articulate a recommendation to the client.

IN PRACTICE Tucker Tucker is currently self-employed with a good job in architecture. Tucker has had a very profitable year and realizes that he will owe a significant amount of income taxes. It is currently December and Tucker is trying to decide if he should make his final estimated state income tax payment before year end. In consultation with his personal financial planner and tax advisor, Tucker has realized that he will be in AMT this year. State income taxes are a preference item for AMT purposes so Tucker decides to delay the state income tax in hopes that the payment will be deductible next year (assuming he is back under the regular income tax regime).

Mandy Mandy is a tax consultant for several large clients. Her contract with her large clients lets her bill them for services monthly or quarterly, at her option. In reviewing her current-year tax situation, Mandy determines she will be subject to the AMT at the 28 percent rate. Mandy does not think she will be subject to the AMT next year, as she is retiring and likely in the 15 percent marginal tax bracket. If Mandy submits monthly bills for November to her large clients, she estimates she will receive $40,000 before the end of the year. What is her tax savings on the $40,000 in income if she submits monthly bills, as opposed to quarterly bills, assuming that clients pay upon receipt of the bill? Mandy is faced with an easy decision. In the current year, she can bill the clients, recognize the income, and have that income taxed at the higher AMT marginal tax rate. Also, if Mandy recognizes the income in the current year, she will pay the taxes a year earlier. If Mandy chooses to delay billing to next year (quarterly billing), then the income is effectively transferred to the next tax period, and a lower marginal tax rate will apply. In making this

decision, Mandy should consider not only the tax ramifications, but also the time value of money implications.

Janice On January 7, 2011, Janice received the right to acquire 500 shares of Smiles Corporation stock for $15 per share through an incentive stock option plan. Smiles Corporation quickly becomes one of the darlings of Wall Street and the stock price soared. The following year, Janice exercised her stock options and had a very large unrecognized gain for regular tax purposes. However, under AMT rules, Janice had a large AMT adjustment equal to the fair market value of the stock at the time of exercise less the strike price. Janice chose to hold the stock rather than make a disqualifying disposition and as a result incurred a substantial AMT liability that she paid with her income tax return. At the start of the following tax year, Janice heard that the Securities and Exchange Commission (SEC) was investigating Smiles Corporation for financial statement fraud. The stock price dropped dramatically on this news, but Janice believed that the company would bounce back. Smiles Corporation is vindicated and the stock begins to recover. In this scenario, Janice paid taxes, under AMT rules, on income that she had not yet realized; shortly after she paid these taxes, the underlying asset (Smiles Corporation stock) dropped significantly. In subsequent tax periods, Janice’s stock may recoup the excess taxes that she paid. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 45 Tax Reduction and Management Techniques Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

Congress, through the United States Internal Revenue Code (IRC), has implemented many social and economic policies through tax incentives or additional taxes. Given the underlying motivations of these incentives (i.e., social and other policy objectives), they are diverse and found throughout the IRC and can apply to many different areas of financial planning. These tax incentives often arise in retirement, investment, and education planning and can also be found in estate planning issues as well.

INTRODUCTION The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted. —U.S. Supreme Court, Gregory v. Helvering, 293 U.S. 465 (1935)

Embedded in the U.S. Internal Revenue Code (IRC) is a complex conglomeration of revenue, economic, and social policy measures. Congress has sought to incentivize, or reward, economically and socially desirable behaviors of taxpayers. Congress generally motivates such behavior by providing tax incentives in the form of permissible tax deductions or tax credits, or excluding some items from taxable income. As a result of these diverse policy goals being integrated into the tax code, meaningful opportunities exist for financial planners, in cooperation with tax professionals, to provide fruitful tax planning advice to clients. The end goal of tax planning for financial planners is maximizing the client’s after-tax wealth. Please note that the end goal of tax planning for financial planning professionals is not to minimize the amount of income taxes paid in the current year; rather it is to maximize after-tax wealth. As such, incorporating every tax-saving strategy available today into a client’s financial plan would likely be inconsistent with the financial planner’s fiduciary standard of care for the client, because such a strategy may adversely limit the client’s after-tax wealth accumulation across his or her life span, and thus materially affect their ability to reach stated goals. A continuing investment into understanding how the IRC operates relating to individuals can pay substantial dividends to financial planners and their clients as they seek to identify and implement tax planning strategies that are consistent with the clients’ overall financial objectives and that help to maximize the clients’ likelihood of achieving their short- and longterm financial goals. In many instances, financial planners who are proactive in looking for ways to optimize the tax efficiency of their clients’ financial plans may easily save their clients enough money over multiple tax periods to offset much of the planner’s fees, making for a very satisfied client.

LEARNING OBJECTIVES The student will be able to: a. Differentiate between tax avoidance and tax evasion. b. Identify income-shifting techniques (transfer and timing) and explain how income shifting benefits a taxpayer. c. Compare the cash flow impact of receiving tax-exempt or tax-sheltered income to taxable income. d. Explain how deduction clustering results in a lower tax liability. e. Calculate the advantage of using tax-preferenced retirement, education, and flexible

spending plans. f. Identify investment strategies that can be used to manage tax liability (e.g., tax loss harvesting, bond swaps, etc). As the opening quotation of this chapter notes, the U.S. Supreme Court recognizes the right of taxpayers to arrange their transactions in accordance with the law in such a manner as to avoid any unnecessary taxes. However, when transactions are arranged with the sole purpose of avoiding taxes that would otherwise be paid and such transactions have no other purpose to their structure or intent, then the courts have deemed that the taxpayer has acted outside the law, or the intent of Congress, and is obligated to pay the tax that otherwise would have been due. In such situations, the taxpayer has evaded taxes. In short, tax evasion occurs when taxpayers reduce their tax liability through dishonest or illegal activities, including non-reporting of income or overreporting of deductions, whereas tax avoidance strategies utilize legal and legitimate means of reducing the taxpayer’s tax liability. When prioritizing tax-efficient planning strategies, clearly some of the first strategies that should be considered are those that result in tax-exempt or tax-free income. Certain types of income, such as qualifying distributions from Roth individual retirement accounts (IRAs), or the capital gain on the sale of a primary residence (within limits and under certain conditions), are currently exempt from income taxation under the IRC. Similarly, interest on municipal bonds is also tax-exempt; however, in exchange for this tax-exempt treatment, investors typically receive a lower interest rate. For Roth IRAs, the benefit of potentially tax-exempt distributions is offset by the inability to deduct current-period contributions to Roth IRAs. Financial planners must understand the equivalent pretax and post-tax values of investments in order to prudently advise clients as to which strategy will assist them in reaching their goals most effectively. If tax-free income options are limited, paying tax at lower income rates is also a very desirable planning strategy. The progressive nature of the U.S. IRC allows a family the opportunity to reduce the household’s overall tax liability by shifting income to lower-income family or household members. However, in two precedent-setting instances, the Supreme Court has denied the assignment of income from earnings and property to individuals other than those who earned the wages or owned the property that produced the income: Lucas v. Earl, 281 U.S. 111 (1930); Helvering v. Horst, 311 U.S. 112 (1940). While denying the actions taken by the taxpayers involved in these cases, the Supreme Court did clarify how income could be shifted to other taxpayers. First, ownership of income-producing property must be transferred from the original taxpayer to another taxpayer or entity; in so doing, the income derived from the property will also be attributed to the new owner of the property. Second, wage earnings flow to those who labor for them; thus, many small business owners have found ordinary and necessary business tasks for which they can pay other family members. Shifting income to lower-income family members can lower the overall tax burden because more household-level income is tax-free due to standard deductions or lower marginal tax rates. Additionally, other family members with earned income can contribute to IRAs and other retirement plans, which can offset much of the earned income. Congress has acted to limit the tax benefits received by

transferring income-producing property from parents to children by expanding the “kiddie tax” restrictions. Shifting income into the future when the taxpayer may have a lower marginal tax rate may also be an effective tax management strategy. Two important environmental considerations should be made regarding this action: first, the taxpayer’s specific situation, and second, the external environment. Taxpayers enjoy greater certainty regarding their specific situations, which includes such things as their current earnings compared to anticipated future earnings, expected retirement income, the amount and expected duration of deductions, the number and duration of dependency exemptions and associated credits, current and expected filing status, and so forth. External factors, such as the economy and future tax policy, while important considerations, are much more difficult to anticipate. A careful consideration of the client’s internal and external environments will give the financial planner insight as to when, and for how long, incomeshifting strategies may be beneficial. When thinking of the external environment, it is wise to carefully consider the fact that what one Congress enacts, another Congress can limit or repeal, leaving the taxpayer and financial planner with great uncertainty regarding long-term tax planning. Just as income shifting may result in a higher after-tax wealth accumulation over multiple time periods, shifting deductions, or clustering deductions, may also prove to be beneficial to certain taxpayers. While taxpayers can choose to report income based on cash, accrual, or hybrid methods, most individual taxpayers choose the cash method. Because of this, taxpayers can manipulate the amount of their deductions based on when they pay those deductible expenses, within reason, and thereby have some control over their taxable income and resulting tax liability. As a general rule, deductions are often accelerated while income is typically deferred. Notable exceptions apply to this general rule, so financial planners serve their clients best by carefully analyzing the client’s current financial position, desired goals, and anticipated future financial position to determine whether income and deductions should be accelerated or deferred. Many clients face multiple choices when saving for future goals such as education and retirement. Financial planners can add clarity to these situations by conducting detailed analyses based on the client’s goals and circumstances and by recommending a tax-efficient strategy that achieves the desired outcome. Education funding can be done using tax-deferred accounts such as qualified tuition programs (i.e., 529 plans) and Coverdell Education Savings Accounts that allow tax-free distributions of earnings if used for qualifying educational expenses. However, qualifying educational expenses paid by using proceeds from such accounts cannot also be claimed as expenses for current education tax credits. For taxpayers in the 15 percent bracket, and potentially into the 25 percent bracket, the tax credits may be more valuable. Fortunately (and unfortunately), the definition of qualifying educational expense is not uniform across the tax-deferred educational savings accounts, education deductions, and educational tax credit programs. For many households, often the most ideal outcome is to use both tax-advantaged educational savings accounts and after-tax savings, or current income, to benefit both from tax-deferred/tax-free growth and the available tax credits (assuming Congress does not change the law—a rosy assumption indeed). A similarly perplexing

decision exists when considering saving using a Roth IRA or a traditional IRA. Over the taxpayer’s life course it is likely most beneficial to accumulate savings in both Roth and traditional IRAs. Financial planners must also be aware of tax-efficient strategies relating to portfolio management. Holding investment assets in a brokerage account allows financial planners and their clients to engage in tax-loss harvesting and bond swapping, and to enjoy lower long-term capital gains rates. Investment portfolios held in tax-advantaged accounts do not enjoy these same tax benefits, because the tax rules governing the account override the tax nature of the assets held in the account. Rather, assets held in tax-advantaged accounts receive a different set of tax benefits. Thus, financial planners should be judicious when making portfolio allocation decisions across tax-advantaged and non-tax-advantaged accounts.

IN CLASS Category Applying: Carrying out, executing, or implementing a procedure in a given situation

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and

Class Activity Ask students to break up into groups. Give each group three basic retirement savings scenarios comparing IRAs and Roth IRAs. In all scenarios, the taxpayer saves $5,000 per year (pretax amount) and earns a 10 percent rate of return over 30 years. Scenario 1 assumes that preretirement and postretirement marginal tax rates are equal. Scenario 2 assumes preretirement marginal tax rates are less than postretirement marginal rates. Scenario 3 assumes preretirement marginal rates are greater than postretirement marginal tax rates. Ask students to calculate the tax savings and after-tax wealth implications for an HMO health insurance plan provided by an employer, a preferred provider organization (PPO) plan with a flexible spending account, and a high-deductible plan with a health savings account. Use real premium rates if possible.

Student Assessment Avenue Give students various scenarios in which preretirement and postretirement tax rates differ, and ask them to identify when and how taxes should be deferred or not deferred for each situation.

Give students a college education savings scenario and client fact pattern. Ask students to determine, under current tax law, the best option to save for college. The options could be limited to qualified tuition programs, after-tax brokerage accounts in the parents’ names, or Uniform Transfers to Minors Act (UTMA) brokerage accounts. Ask students to support their answers with aftertax cost calculations.

attributing the material Evaluating: Making judgments based on criteria and standards through checking and critiquing Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

In class, present the students with a brokerage account containing a portfolio of investment assets. Show the basis, holding period, and market value for each asset in the portfolio. Go over the asset allocation of the portfolio and develop, with the students, a strategy for tax-efficient rebalancing of the portfolio.

Give students a brokerage portfolio, including basis, holding period, and market value for each asset. Give students a desired portfolio allocation that does not match the current allocation. Ask students to develop the most tax-efficient strategy to rebalance the portfolio.

Ask students to divide into groups. Give each group a different piece of information about the same client (i.e., one group would know she is a small business owner who would like to shift income to her children, another group may know that she would like to begin saving for her children’s education, and another group may find out that she would like to start saving for retirement more aggressively).

Give students a short case about a client who is a small business owner who would like to save for her children’s education and prepare for retirement.

Ask each group to create a recommendation based on the information that they received. Ask the students to discuss each group’s recommendation as a class and identify how and when recommendations were contradictory.

Ask students to prepare financial planning recommendations that demonstrate an integrated and functional knowledge in the areas of tax, retirement, and investment.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify different types of taxadvantaged accounts used for education, retirement, and health care savings and understand the pros and cons to each type of account. The entry-level planner should also understand the basic principles of income shifting, tax-exempt income, and income tax deferral. Competent: A competent personal financial planner can ask appropriate questions to gain insight from the client with which to evaluate and identify tax planning opportunities for clients who are seeking to achieve short- and long-term objectives. The financial planner can quantify the after-tax wealth benefits for different alternatives and recommend a comprehensive strategy that will help clients reach their goals effectively while minimizing income tax liability over

multiple periods. Expert: An expert personal financial planner can work very closely with the client’s tax advisers and likely possesses a strong background of experience in taxation. The expert planner can identify complex problems, proactively suggest strategies to minimize taxation over the client’s life cycle, and calculate the numerical savings of switching to a different strategy. The expert planner can identify the key factors on which to base a decision and clearly articulate a recommendation to the client.

IN PRACTICE Bartolo and Marissa Bartolo and Marissa have recently begun working with a financial planner in order to better prepare for retirement. Bartolo and Marissa have all of their investments in the form of mutual funds and exchange-traded funds (ETFs) held across brokerage accounts, Roth IRAs, and Marissa’s 401(k) plan. In total, about $800,000 is held equally across the three accounts. Bartolo and Marissa are in the 25 percent marginal tax bracket. Upon review of the portfolio, the financial planner notices that the portfolio has not been rebalanced for many years, and equities have appreciated much more than fixed income securities. As a result, the portfolio is much more aggressive than Bartolo and Marissa indicated. The financial planner notes that it is necessary to rebalance their portfolio and that some assets may no longer be the best fit for the portfolio going forward. The financial planner should take care not to immediately make substantial changes to the brokerage account because of the substantial unrealized capital gains in the account. Immediately rebalancing the tax-advantaged accounts will not trigger current tax liabilities. In this situation, the financial planner should carefully consider which investments should be sold and determine whether bond swaps or loss harvesting on other assets could offset the taxable gain on the appreciated assets being sold. If there are no losses with which to offset the capital gains, the financial planner may desire to implement rebalancing in the brokerage account over a multiyear period, depending on how well an optimal portfolio can be constructed, with most of the adjustments occurring in the tax-deferred accounts. The financial planner would also look at the equity and bond allocations for the entire portfolio, not each type of account. Tax deferred accounts are ideal locations to hold assets that produce ordinary income, such as bonds. Brokerage accounts are ideal for capital gain– producing assets such as stocks. Rather than rebalancing each account, the financial planner could rebalance the total portfolio so that equities in the tax deferred accounts are sold and replaced with bonds, thus eliminating, or minimizing the need to sell appreciated assets in the taxable account to rebalance the portfolio.

Frank and Jan Frank and Jan are preparing to send their three children to state university. They have

combined income subject to the 15 percent marginal tax rate. The children are all teenagers, with the oldest being 17. Frank and Jan are very savvy investors and have learned that they can find good investments over time that will result in good returns over the long run for their children. Frank and Jan have begun working with their new financial planner and have specifically asked for recommendations on preparing for their children’s college expenses. The financial planner recognizes that if Frank and Jan want substantial control over the investments in the accounts, then qualified tuition programs that offer the greatest tax-deferral benefits are not the best option. Also, Coverdell Education Savings Accounts have limited contribution caps and would likely not be sufficient for all three children. On the other hand, keeping such a portfolio in Frank and Jan’s names would not necessarily lead to higher potential taxes if assets are held for long-term periods and capital gains taxes can be avoided all together. Finally, if the assets are transferred and held in the children’s names, then the initial income on such a portfolio would be taxed at much lower marginal rates, but this benefit may max out quickly as the “kiddie tax” rules took effect. One alternative would be for the children to own ordinary income-producing assets in their name, and the parents could own capital assets for the purpose of the children’s education funding. However, once the children turn 18, they could use the assets held in their names for any purpose, not exclusively college. In this situation, the financial planner would likely recommend that a substantial portion of the couple’s college savings program be carried out using brokerage and savings accounts. This would provide the most tax-advantaged method because capital gains taxes could be controlled and minimized, and more importantly, since the money is coming from after tax accounts, Frank and Jan will preserve their ability to claim valuable education credits such as the American Opportunity Credit. By holding the assets in the parents’ names, the likelihood of the children qualifying for financial aid (scholarships, grants, and subsidized federal loans) will increase. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 46 Tax Consequences of Property Transactions Lance Palmer, PhD, CPA, CFP® University of Georgia Martin C. Seay, PhD, CFP® Kansas State University

CONNECTIONS DIAGRAM

Overall, the tax consequences of property transactions can materially impact income taxes, investment planning, estate planning, retirement planning, education planning, and risk management and insurance planning. An understanding of the tax implications of property transactions is critical when making investment decisions. Similarly, retirement planning and

education planning require personal financial planners to understand the tax consequences of property transactions when assets are held in standard investment accounts, as well as when they are held in tax advantaged accounts. In estate planning, the decision to sell property prior to death or retain it to bequest at the time of death can be partly motivated by current tax laws. Lastly, when property is involuntarily converted due to theft, damage, or full destruction, a portion of the insurance proceeds may be taxed under certain conditions.

INTRODUCTION When property is sold, or converted into cash or other property by some other means, the taxpayer must calculate the gain or loss on the sale or conversion of the property. Selling price, or fair market value at the time of conversion, less the basis of the asset, less any selling costs equals the gain or loss on the transaction. How long property was owned and whether the property is classified as a capital asset, an asset used in a trade or business, or as an ordinary income asset will determine how the gain or loss on the property transaction is taxed. Finally, some or all gains on certain types of property held by the taxpayer may be excluded from taxation, leaving the taxpayer with tax free income from the sale of the property. The market-based economy of the United States requires the free and efficient flow of capital to remain competitive and healthy. As new ideas, technologies, businesses, or uses of existing resources are developed, capital in a market-based economy should move efficiently from less productive ideas to more productive or higher-value ideas. Taxes, such as capital gains taxes, on capital that is reallocated from less efficient to more efficient uses create friction for the flow of capital through the economy. This friction may work against market efficiency and lead to constrained economic growth. Recognizing the essential lifeblood that free-flowing capital provides in a market-based economy, Congress has provided preferential tax treatment to investors in the form of reduced tax rates, or a reduced tax base, on certain capital gains transactions. This preferential treatment was observable as early as 1921 and has remained a feature of the Internal Revenue Code (IRC) since. Throughout the decades, the preferential treatment has taken many forms. However, a common element has been that the resulting tax on certain capital gains transactions yields a lower tax liability than what the tax liability would be if the gains were taxed as ordinary income. Another significant benefit of capital gains is that gains are not taxed until they are realized. Even when realized, certain capital gains may not be recognized immediately, or ever.

LEARNING OBJECTIVES The student will be able to: a. Differentiate between the taxation of capital gains and ordinary income, including the difference in applicable tax rates. b. Calculate the capital gain or loss on a property sale.

c. Explain the special rules regarding capital gains and losses on a principal residence. Certain requirements must be met in order for gains or losses from property transactions to be classified as capital gains or losses, as opposed to ordinary gains and losses. Capital assets, as discussed in IRC Section 1221, are defined by what they are not, rather than by what they are. Capital assets are not inventory, real or depreciable property used in a trade or business, copyrights or other creative works in the possession of the person who created or commissioned the work, accounts receivable, or government documents. Additional items also do not qualify as capital assets, but they are not listed here (see IRS Publication 544). It is important to note that the type of asset, its intended use, and who is in possession of the asset determine whether the asset is classified as a capital asset. Typically, capital assets are held for investment purposes rather than used in a trade or business. Unless an asset is explicitly defined as not being a capital asset, it is considered to be a capital asset. In order for gains on the disposition of capital assets to receive preferential tax treatment, the assets must be held for more than one year, which currently qualifies as a long-term holding period. The explicit tax rate on capital gains has varied over the years, and will likely continue to fluctuate as the desire and intent of Congress changes over time. However, despite the expected changes in the tax laws, it is still expected that the effective tax on long-term capital gains will continue to be lower than the respective taxpayer’s marginal tax rate, and will continue to provide meaningful planning opportunities. A lower effective tax on long-term capital gains can be achieved by either reducing the tax base or reducing the applicable tax rate. While generally lower tax rates apply to long-term capital gains, Congress has also allowed for a reduction in the tax base for certain long-term capital gains transactions. One example of this is the exclusion of up to $500,000 of long-term capital gains on the sale of a principal residence. Another example is Section 1202 qualifying small business stock. Higher-income households will face additional taxes related to investment income flowing from property transactions. The net investment income tax (NIIT) is a 3.8 percent tax levied on net investment income in excess of certain thresholds determined by filing status. The NIIT covers a broad range of investment income sources, including, but not limited to: gains from the sale of stocks, bonds, and mutual funds; capital gain distributions from mutual funds; gain from the sale of investment real estate; and gains from the sale of interests in partnerships and S corporations. Certain investment income that is excluded from taxation (i.e., a portion of the gain on the sale of a primary residence, qualified distributions from a Roth IRA account) is not subject to the NIIT of 3.8 percent. It is important to note that while long-term capital gains receive preferential tax treatment, long-term capital losses similarly receive reduced tax benefits because they are first applied against the preferential gains and then against other capital gains. Currently, only $3,000 of capital losses can be netted against ordinary income, with the remaining losses being carried forward indefinitely. Thus, while long-term capital gains are more desirable than ordinary gains, long-term capital losses are less desirable than ordinary losses, which are not restricted in their recognition.

It should be noted that, under some circumstances, property can be exchanged without immediate income tax consequences. Under Section 1031, exchanges of like-kind property that meet certain requirements may qualify for the deferral of gain recognition.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or Utilize lecture to discuss the using a procedure through theory behind the income executing or implementing taxation of property transactions.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Ask students to determine the income tax consequences using examples of the sale of stock and personal residences. Ask students to prepare questions related to the taxation of property transactions. Mediate a class discussion Ask students to review example based on a list of the most recommendations to a client common mistakes made by regarding the selection of assets financial planners related to to sell. Ask students to analyze income taxation in selling the recommendations and identify property. Ask them to identify the income tax liability associated the errors and their with the sale of each property. consequences. Create an in-class assignment Ask students to evaluate a case that includes a series of asset study that includes the sale of transactions. Ask students to assets resulting in unnecessarily calculate the tax liability high tax liability. Ask students to generated and evaluate the articulate the income-tax-related transactions in terms of issues and to provide viable maximizing clients’ after-tax alternatives that would have wealth. avoided these issues. Provide the class with a list of Provide client scenarios to a client’s assets. Mediate a students with a list of goals and class discussion to identify asset information. Ask students to and create a list of create a comprehensive strategy recommendations focused on to allow clients to reach their the disposition of assets, with goals through the disposition of an emphasis on minimizing assets as tax efficiently as income tax consequences. possible.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can determine whether an asset

qualifies as a capital asset and whether the required holding periods have been met to receive the preferential rate. An entry-level personal financial planner can also determine the applicable tax base for the capital asset and be able to apply the correct capital gains tax rate, given the applicable holding period and type of capital asset. Competent: A competent personal financial planner can develop comprehensive investment approaches that not only combine asset allocation models, but also incorporate asset location principles so that the long-term tax burden is minimized by recognizing some gains as longterm capital gains while deferring recognition of other gains by holding those assets in a taxdeferred account. Expert: An expert personal financial planner in this field will work closely with tax and legal advisors to plan the disposition of the client’s assets, including business, retirement, residential, and other assets, in the most tax-advantaged way possible. The planner will seek to maximize the benefit of recognizing capital losses while minimizing the recognition of ordinary gains across many tax periods, with the goal of minimizing the client’s tax burden across his or her life cycle as opposed to minimizing it in any given year.

IN PRACTICE Paula Paula really enjoys investing in real estate property in her local market. When Paula buys a property, she generally holds on to it for about two to three years before considering whether to sell it. While Paula owns the property she is always either: (1) making improvements to it, which either extend the useful life of the property (increase her basis in the property) or simply improve the aesthetic characteristics of the property, or (2) renting it out until she decides to sell it. Paula has a very good track record of selling the property for more than her purchase price plus renovations. Since Paula is single, she will often move into a property that she owns and live in it for a couple of years while she is making the renovations. Paula has just hired James as her personal financial planner. James recommends to Paula that she should sell her real estate holdings as soon as possible in order to diversify her risk and then reallocate her investment capital out of the local real estate market and into at least 90 percent of her investable assets using a brokerage account. The brokerage account will be invested based on a predetermined asset allocation model using well-diversified investments, such as exchangetraded funds (ETFs). James proposes that the remaining 10 percent of the portfolio can be invested at Paula’s discretion in real estate projects. While Paula understands James’s reasoning, she is uncertain of the urgency with which James is making his recommendation. Paula seeks a second opinion from her tax advisor and he suggests that Paula make a gradual transition out of her real estate holdings over the next several years so that she can minimize the taxes on the disposition of her properties. By doing this, Paula can take advantage of some exclusions to income available only to homeowners. While there will likely be some depreciation recapture if the property had been rented out while Paula owned it, some of the gain the property will likely be excluded from income if Paula is able to meet the ownership

and use tests for a given property. James’s recommendation was shortsighted in this situation. While well intentioned in order to help Paula diversify her assets, the urgency with which James suggested Paula dispose of the property could have resulted in substantial taxes on the gain from the sale of the property, taxes that could have otherwise been avoided with a little more deliberate and patient planning.

Francisco Given recent market turbulence, Francisco is very uncertain about the type of investments he should hold. Francisco hires Julia, a personal financial planner, to assist him with this decision. Julia recommends that a small portion of Francisco’s portfolio be invested in gold. Francisco has a friend who is a jeweler and offers to sell Francisco 10 ounces of pure gold at a 2 percent discount off of the current market price. Francisco agrees and purchases the gold. Later, he tells Julia that he has implemented her recommendation. Julia explains to Francisco that the gold that he has purchased will qualify as a capital asset; however, it will be deemed a collectible capital asset and will not receive the best tax rate available. In fact, the applicable tax rate may be as high as 28 percent compared to a maximum tax rate of 20 percent on investment grade gold coins. If Francisco wants to have physical possession of the gold, Julia recommends selling the gold he purchased before any significant gain or loss is realized on it and reinvesting the money into gold bullion that is minted by the U.S. Mint, which will currently qualify for the lowest available long-term capital gains tax rates. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 47 Passive Activity and At-Risk Rules Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

Planning relating to passive activity and at-risk rules should be conducted in conjunction with qualified CPAs or tax attorneys. A financial planner should take part in this planning process. Due to the focused nature of this topic, it generally only affects the income taxation of clients who choose to invest in various types of partnerships and limited liability companies and who do not participate directly in the routine management of the business. In situations like this, the investment may qualify as a passive activity, and financial planners should be aware of the

income tax implications of that activity.

INTRODUCTION Tax policy directly affects the economy. In some instances, effective tax policy may stimulate the economy, while in other instances tax policy may work against economic expansion. A good example of tax policy that worked against economic expansion was when investors sought unprofitable ventures over profitable ones due to the taxation of those ventures. Not too long ago, the Internal Revenue Code allowed investors in partnerships to take losses in excess of the amount of economic losses that an individual could accrue as a result of the investment. This led to an inefficient flow of capital in the country’s free market economy and capital investment was significantly distorted as investors sought returns on their investments through the deduction of investment losses rather than through the profitability of the investment. Highincome individuals would use the excessive losses, in excess of their investment and at-risk amount, from their partnership interest to shield other income. Thus, some investors intentionally sought unprofitable investments due to the potential tax savings from the deductions of excessive losses. As part of the Tax Reform Act of 1986, the U.S. Congress addressed this issue by introducing new loss limitations. These loss limitation rules are generally referred to as passive activity rules and at-risk rules. Both sets of rules limit the amount of losses investors can recognize. Passive activity rules apply to the individual’s participation in an activity. Collectively, the passive activity rules require an individual to materially participate in an activity in order for any losses from that activity to be recognized and taken against other active income or portfolio income. If an individual does not meet the requirements to be classified as materially participating in an activity, then the activity will be classified as a passive activity for that individual. Losses from one passive activity can offset income from another passive activity. However, losses from a passive activity cannot offset losses from active or portfolio income in the current year, but may be able to offset active and portfolio income when the passive activity is disposed of. For silent investors, partnerships and limited liability companies generally represent passive activities. Newly formed businesses often incur losses through the early years of operations. These losses, allocated to partners for whom the activity is considered passive, cannot be recognized unless that particular partner has other passive income against which the losses can be taken. The losses are referred to as suspended losses. Suspended passive activity losses carry forward indefinitely and can be recognized to the extent that the passive activity generates a profit, other passive income is generated, or the individual makes a qualifying disposition of an interest in the passive activity property. Financial planners must be able to effectively advise clients regarding the potential for suspended losses resulting from various investment alternatives and the timing of recognizing those losses. At-risk rules also seek to limit individuals’ abilities to deduct certain losses. The at-risk rules limit loss recognition to the taxpayer’s adjusted basis in the property plus any loans related to

the activity for which the taxpayer is personally liable, or loans for which the taxpayer has pledged property not used in the activity as collateral for the business activity loan. Nonrecourse financing for the business activity does not qualify as a loan under the at-risk rules because the taxpayer is not personally liable for debt. The amount at risk is also reduced by any previously allowed losses. Disallowed losses are suspended and can be carried forward indefinitely. However, they can only be recognized as the amount at risk in the activity increases, which could result from additional investment or net profit from the activity allocated to the taxpayer. It is important for the personal financial planner to recognize that passive activity rules and atrisk rules work simultaneously. Suspended losses under the at-risk rules may be allowed due to a subsequent increase in the amount at risk. However, the losses may still remain suspended under the passive activity rules if the taxpayer does not materially participate in the activity. Similarly, if the taxpayer is a material participant in the activity and the passive activity loss limitations do not apply, the taxpayer is still subject to the at-risk loss limitations rules, and therefore may still be required to suspend losses from the activity. The determination of at-risk amounts and loss limitations can be complicated. Determination of passive activities and at-risk loss limitations should be handled only by qualified and experienced tax professionals. The personal financial planner should work closely with the client’s tax attorney or CPA to understand the classification, aggregation, and net impact of these rules on the client’s tax situation and to ensure that the source of any suspended losses is clearly understood (i.e., passive activity loss limitation or at-risk loss limitation). By understanding the nature of any suspended losses, the financial planner is in a much better position to identify efficient ways in which the losses can be utilized.

LEARNING OBJECTIVE The student will be able to: a. Identify passive and at-risk activities and explain how taxation of such activities differ.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Ask students to break up into three groups (or if online, ask each student to prepare a five-minute presentation).

Ask students where passive activities will be reported on Form 1040 and how suspended losses will be reported and carried forward.

Ask one-third of the students to explain the determining characteristics of passive activities. Ask another third of students to explain the

difference between passive activity loss limits and at-risk loss limits. Ask the other third to explain how the loss limit rules work together and when and how losses can be recognized. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure

Give students a short fact pattern that contains both passive activity limitations and at-risk limitations.

or purpose through differentiating, organizing, and attributing

Students can then determine at what point suspended losses can be recognized.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Present a basic fact pattern to students of a client who has suspended passive activity losses. Provide some basic guidance on the business activity. Assign students to research planning strategies that would allow the client to recognize the losses while maximizing after-tax returns. Call on five students to report their recommendations during the following class period. Ask students to vote on the best recommendations.

Ask students to work in groups to identify which loss limitation rules are applicable, and when.

Call on three groups to present their conclusions, and have the rest of the class vote on which is most correct.

Give students a fact pattern regarding an activity. Using short-answer responses, students should identify whether the activity is a passive activity, how much money is at risk, whether there

are suspended losses, and whether those losses are suspended due to passive activity rules or at-risk rules.

Give students a short case containing circumstances relating to passive activity and at-risk rules. Ask students to evaluate the client’s situation and make recommendations in the form of a letter to the client outlining the situation, tax implications, and recommendations for current and future-period investments.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner can recognize passive activities and be able to communicate with the client’s CPA or tax advisor regarding passive activities in which the client is engaged. Competent: A competent financial planner will reach out to the client’s tax advisor and

discuss the nature of the passive activity. The financial planner will work closely with the client and tax advisor to explore ways in which after-tax wealth can be maximized over a multiple-year period. The personal financial planner will work with the tax advisor and client to determine whether the passive activity should be divested, coupled with other profitable passive activities, or engaged in actively. Expert: An expert financial planner will work closely with the client’s tax attorney or CPA regarding passive activity and at-risk rules that limit a client’s ability to recognize losses. Strategies are discussed and developed that are unique to the client’s circumstances and that seek to maximize after-tax wealth.

IN PRACTICE Javier Javier has been teaching math at the local high school for nearly 20 years. He enjoys teaching, but would also like to invest in a start-up business that may provide a larger payoff down the road. Javier has met Doug through a common acquaintance, Roberto, and the three of them decide to start a restaurant. Doug has all of the appropriate licensing and experience in managing restaurants. Javier and Roberto are primarily investors in the company. The company is formed as an LLC. Javier’s financial planner should work closely with Javier and Javier’s tax advisor to determine the likely treatment of this activity on Javier’s tax return. It is not uncommon for businesses to lose money the first year of operations. If Javier does not materially participate in the business, then his share of the loss from the first year would be suspended and he could not recognize it until the business generates a profit. Since Javier has summers off, he could potentially work on marketing the business all summer, as well as parttime during the year, and by doing so, satisfy the material participation standards. By being a material participant in the activity, Javier would then be able to recognize his share of the business losses against his wages that he receives as a high school math teacher. Javier has an important decision to make: participate materially in the business so that he can deduct the losses when they occur, or remain a “silent” investor and be subject to the passive activity loss limitation rules. Javier should also consider other tax consequences of material participation. If Javier participates materially in the business, then any income that he receives from the business will be subject to self-employment taxes. However, if he stays a silent investor, any income from the LLC allocated to him will not be subject to self-employment taxes because Javier is an investor. Fortunately for Javier, the determination of whether he participates materially in the business is determined each year and can change from year to year. Some careful planning of expected business revenues, time, and investment by Javier, his personal financial planner, and his tax advisor could provide Javier with significant tax savings in this first year of the business and in years to follow.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 48 Tax Implications of Special Circumstances Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

An individual client’s special tax situation may be related to a variety of different areas of financial planning. Most often, these situations relate to very important non-financial goals and objectives such as family and caregiving. These goals are particularly pronounced when a client is caring for an aging parent who is no longer able to live independently, or when an adult child is not able to live independently due to a physical or mental condition.

Sometimes these special tax circumstances are linked to family dissolution. Couples that have been married relatively long periods of time have likely accumulated many assets and liabilities over the course of their marriage, yet some of these assets may only be held in one spouse’s name, such as a retirement plan through a spouse’s employer. Divorce settlements may include the division of such assets between spouses, but financial planners need to understand how such transactions must be carried out in order to achieve the intended outcome. Because of the nature of these events, client communication is perhaps the most important content area to understand in relation to these situations. Estate planning, in relation to the client’s parents’ estate, is also an important consideration when providing care for elderly parents.

INTRODUCTION Societal trends continue to change the structure and look of households in the United States and throughout the world. Individuals are living longer, and a variety of housing and caregiving arrangements have been developed to accommodate their needs. Elderly parents are often living with or receiving financial assistance from adult children in order to maintain independence. These unique family circumstances often create useful tax planning opportunities as a result of favorable family-related provisions in the Internal Revenue Code. The Internal Revenue Code is generally slow to reflect societal trends. However, when the U.S. Congress has a desire to support or divert societal trends, it often does so in part through special tax law provisions. Some examples of this include: Providing a tax credit for parents who go to work or school and have to hire day care services for their young or disabled children or for their dependent elderly parents. Allowing children to claim dependency exemptions for parents who are not living in the children’s homes but are being supported financially by the children. Providing substantial tax benefits to offset the cost of tuition and other expenses to attend college. Making large tax credits available to families who adopt children, particularly children with special needs. Allowing children in foster care to be claimed as dependents. The U.S. Congress may seek to deter certain societal trends by disallowing deductions, tax credits, or certain filing statuses for tax filers engaged in activities that Congress does not support. In addition to the higher proportion of elderly citizens, changing trends in marriage continue to alter the traditional structure of households. Many young adults are also living in their parents’ homes longer after completing college, and young adults are attending college for more years. Congress is also seeking to incentivize, through the tax code, larger numbers of young adults to attend college and obtain postsecondary degrees. These tax-based incentives for higher

education are manifested through income exemptions (i.e., earnings from 529 plans, tuition scholarships, grants, and other tuition benefit plans); expanded deductions for higher education tuition, fees, and student loan interest; and various refundable and non-refundable credits relating to postsecondary education expenses. Tax benefits relating to postsecondary education can be complex and require thoughtful consideration of the client’s current and future financial situation when the children may be attending college. As noted, certain tax incentives are designed to encourage the accumulation of funds intended for college, such as 529 plans. However, if only these types of funds are used to pay for qualifying tuition and fees, then other tax incentives are forfeited, such as the American Opportunity refundable tax credit. A financial planner must be able to anticipate the client’s future tax situation at the time funds will be used to pay for tuition and other costs, and be able to determine the optimal balance between tax-advantaged funding sources (i.e., proceeds from 529 plans, tuition scholarships, grants, etc.) and non-tax-advantaged sources that will qualify for valuable tax credits (i.e., brokerage or savings accounts, current earnings, student loans, Uniform Transfers to Minors Act [UTMA] or Uniform Gifts to Minors Act [UGMA] funds, etc.). For certain tax filers, one type of funding source may dominate the planning alternatives. However, for most taxpayers, a combination of the two types of funding sources will produce the greatest after-tax benefit. Similarly, if taxpayers do not qualify for the American Opportunity credit but still choose to recognize qualifying tuition and fee expenses on their tax return, they can do so through an above-the-line deduction or by claiming the Lifetime Learning non-refundable credit. Whether the deduction or the credit is more valuable depends on the client’s marginal tax rate and state income tax rates. The task of planning for a child’s future college education requires that the financial planner have a working knowledge of both the savings and investment options available as well as all of the tax incentives associated with higher education expenses. While the U.S. Congress’s future intent is impossible to discern, long-standing provisions in the tax code will likely persist into the future. One other (sadly common) financially important family event is divorce. As part of a divorce, child support payments, property settlements (including qualified domestic relations orders), and alimony payments may be determined. Each of these types of payments has tax consequences and these differ due to the matching principle. The matching principle generally dictates that for every deduction from income, another taxpayer must recognize income. Stated differently, if no income is recognized by the receiving taxpayer, then the paying taxpayer is generally not able to deduct the payment. Child support, alimony, and property settlement payments can be substantial. Fiduciary standards require that the personal financial planner work in the best interest of the client, whoever that client may be. However, a deeper understanding of the tax ramifications of certain types of payments will help the financial planner understand each spouse’s tax incentives so that an optimal payment structure—if such a thing exists—can be negotiated. As can be seen in this brief list of examples, many family life cycle events and circumstances are reflected through special tax law provisions. Personal financial planners must be very

aware of both their clients’ situations and the features within the Internal Revenue Code that provide additional incentives, or disincentives, for those circumstances.

LEARNING OBJECTIVES The student will be able to: a. Explain the tax implications of supporting an elderly parent or adult child. Financial planners advising clients, either children or parents, should understand opportunities and pitfalls within the Internal Revenue Code pertaining to these types of situations. If certain transactions are sufficiently documented, the tax code allows for personal exemptions to be claimed, deductions associated with the claimed dependents, and other benefits that may reduce the taxpayer’s federal income tax liability. Specific rules relating to claiming dependency exemptions, income limitations, and claiming dependents when multiple individuals provide support, as well as others applicable in this area, should be understood by financial planners who are advising elderly clients or clients caring for their elderly parents. b. Recommend the appropriate credit/deduction to use for post-secondary education costs. Understanding the differences between excluded income (applies to some), deductions for adjusted gross income (AGI), deductions from AGI, and tax credits—and how to compute the equivalent value of these tax benefits—is essential when advising clients regarding the most tax-efficient ways to save for college. Specific rules defining qualifying higher education expenses differ depending on whether it is an income exclusion for scholarships, a deduction for AGI as part of a self-employed business expense, a distribution from a qualified tuition program (529 plan), an American Opportunity tax credit, a Lifetime Learning tax credit, or other deduction. Financial planners must navigate the combination of definitional restrictions and differing income tax benefits to find the most tax-efficient education savings strategy for their clients. c. Recommend income and asset transfers between divorcing spouses given the resulting tax effects. Divorce is generally very destructive to the financial plans of one or both spouses. The Internal Revenue Code allows for very efficient transfer of property between spouses during marriage and at the time of divorce. Alimony payments are treated as a deduction for one spouse and as income for the other spouse. Child support payments are neither deductible nor recognized for federal income tax purposes. Based on these and other rules, incentives exist to structure divorce settlements in certain ways. Financial planners should be able to explain clearly to both spouses involved the tax consequences of any divorce settlement structure and how those outcomes compare with other tax-efficient ways to structure the divorce settlement.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Students complete a short research project by discovering as many ways as possible for a taxpayer to qualify for head of household filing status.

Give students a brief fact pattern about a client’s family situation. Ask them to identify the following: the client’s filing status, number of dependency exemptions that can be claimed, the available standard deduction, and any tax credits that may be available.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Give the students a brief fact pattern regarding multiple individuals supporting one elderly individual. Students work in small groups to identify who is eligible to claim the elderly individual as a dependent and how that taxpayer should go about claiming the dependent.

Give students three years of tax returns, with each tax return showing changing life circumstances. Ask the students to describe what changes took place between each tax return and have them explain the resulting impact on the client’s tax liability.

Give students a fact pattern regarding family living arrangements, joint or sole custody of children, and the circumstances relating to extended family. In small groups, or on a discussion board, students explain who and why an individual may be claimed as either a qualifying child or a qualifying relative, and explain how this affects both filing status and the eligibility for certain credits.

Student assessments for this category could include calculating a client’s income tax liability, including self- employment income tax, under three different filing status scenarios. Students could also be assessed by calculating how much of a client’s Social Security benefits would be included in taxable income under three different income scenarios.

Randomly call on students to discuss this in class.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Present students with different types of income or tax items. Ask them to identify an associated deduction or alternate tax-advantaged income sources. Examples would be IRA (alternate income would be Roth IRA) or selfemployment tax (associated deduction to look for is business mileage, as well as many others).

Give students an open-ended case study incorporating several tax issues relating to a recently retired couple with selfemployment income, retirement distributions, and Social Security benefits. Have students prepare a tax return and also have them write a letter advising the clients on actions they can take to improve their future tax situation. Students write a letter to a client as if the client were 20 years younger, advising the client on actions he or she should be taking to improve his or her future (current) tax situation at retirement.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can determine whether a client is eligible for any tax benefits, such as claiming a dependency deduction or qualifying for a more favorable tax filing status, as a result of providing financial or living arrangement support to family members or friends. Competent: A competent personal financial planner can understand the trade-off between current and future tax benefits regarding various forms of exclusions, deductions, and credits that may arise over the family life cycle. Expert: An expert personal financial planner can identify and anticipate family life cycle events and circumstances that are likely to occur in the client’s life, and develop and implement financial plans that will maximize after-tax resources available to the client in order to successfully meet those events.

IN PRACTICE Jack and Deborah Jack and Deborah have just gotten back on their feet financially after a five-year stretch of difficult financial circumstances. Their son, John, is 15 years old and is planning to attend the state university. Due to Jack and Deborah’s recent financial difficulties, they have not set anything aside for John’s educational expenses. They have come to Julia, a personal financial planner, to determine how best to prepare for John’s college expenses.

Julia, aware of the tax implications of this decision, recommends that Jack and Deborah open a low-fee 529 plan sponsored by their state and contribute to the plan what they think John will need for housing costs. This will enable them to claim their state’s income tax deduction for 529 plan contributions. Because of the relatively short time horizon, Julia recognizes that the significant tax credits that Jack and Deborah will qualify for (their income is below the threshold) outweigh the tax savings from tax-free earnings in the 529 plan. Knowing the challenge that Jack and Deborah face in preparing for their own retirement and future financial goals, Julia recommends that Jack and Deborah discuss with John the importance of applying for scholarships to help cover the cost of tuition and books. John agrees and Jack and Deborah begin helping John to build a competitive and compelling scholarship application profile. Jack and Deborah also talk with John to let him know that they are planning to pay for his housing and food expenses, but that he will ultimately need to pay for his tuition expenses, either through scholarships, student loans, or savings and work. With clear expectations established, Jack and Deborah feel confident that they can support John throughout his schooling, and John is highly motivated to find his own funding for college. If John does take out student loans for tuition and books, Julia reminds Jack and Deborah that as long as they are claiming John, they are still eligible to receive the education credits associated with the payment of John’s tuition, assuming that it is not covered by scholarship money.

Donald and Victoria Donald and Victoria have decided to get a divorce. They will have joint custody of their three young children. However, the children will primarily live with Victoria, as Donald is often traveling for business for extended periods of time. It is likely that as a result of their divorce, some combination of child support, alimony, and property settlement payments will be made. Victoria has been a stay-at-home mother up until this point, but will begin working following the divorce. Her earnings will likely not be substantial in the foreseeable future. Ken is a financial planner that has been retained by Donald to provide guidance on the divorce settlement. While Donald is not intent on getting as much as he can in the divorce, he does want the separation of assets and the structure of ongoing support payments to Victoria to be financially efficient. Ken reviews the current assets and income of Donald and Victoria and also attempts to project the income that Victoria might be earning once she starts working. Ken notices the current and likely persistent gap in earnings between Donald’s wages and Victoria’s. As a result, Ken believes that the best thing for Donald will be to structure as much of the divorce settlement in the form of alimony as possible. This will allow Donald to deduct the alimony payments on his tax return (higher marginal tax bracket) and will require Victoria to report the alimony payments as income on her tax return (lower marginal tax bracket). As a benefit to Victoria for structuring the payments as alimony, Donald agrees to increase the payments slightly so that he can have the tax deduction. Personal financial planners may be called upon to provide guidance when divorce occurs. Given specific fact patterns, personal financial planners should be able to determine the

optimal structure of divorce-related payments that seek to maximize the after-tax value of the payments when considering both spouses. Financial planners should also clearly understand the best-case and worst-case tax scenarios for each spouse in regard to the structure of divorce payments. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 49 Charitable/Philanthropic Contributions and Deductions Webster Hewitt, CPA, CFP® University of Georgia Lance Palmer, PhD, CPA, CFP® University of Georgia

CONNECTIONS DIAGRAM

A comprehensive and integrated charitable giving plan for clients will require an understanding of the clients’ current and future income tax situations, their goals for the transfer of assets at their deaths, as well as an understanding of the nature of the property that they wish to give. Certain types of highly appreciated investment property provide personal financial

planners with significant planning opportunities for those clients who have expressed philanthropic aspirations or are currently engaged in charitable giving.

INTRODUCTION The United States has historically encouraged gifts to charity by allowing individuals and businesses to take tax deductions for contributions to such organizations. While Congress debates the future of income tax reform, including eliminating many itemized deductions or capping the amount of deductions for high-income taxpayers, it is likely that contributions to qualified charitable organizations will continue to be deductible for the foreseeable future, although adjustments to the current law are always possible. This chapter focuses on the current income tax rules at the individual level and identifies advantages and disadvantages of different assets. A personal financial planner should be able to recognize what gifts qualify for a charitable deduction and how the charitable deduction is calculated. Contributions to charity are generally not deductible unless the taxpayer itemizes deductions. The rules are very specific for whether a contribution is deductible and at what value. In general, a deduction is not allowed until actual possession of the property shifts from the donor to the organization. This can mean a taxpayer can write a check and postmark it on December 31 of a given year (or charge a credit card) and receive a deduction on the same year. However, a pledge is generally not considered deductible until it is actually delivered.

LEARNING OBJECTIVES The student will be able to: a. Identify qualified charitable contributions of cash, property, and appreciated assets and the advantages, disadvantages, and tax effects of such gifts. b. Calculate the maximum charitable contribution deduction allowed in a tax year. For a contribution to a charity to qualify as a charitable deduction, there generally must be a gift of some form (a transfer of something for no consideration in return). Receiving items in return for a gift reduces the donative intent and thus reduces, or limits, the deduction. The gift of money or property must be to a qualified charitable organization (gifts to individuals, political organizations, unions, and chambers of commerce are generally not deductible), and a complete list of qualifying charitable organizations can be found in IRS Publication 78. After determining whether a donation to a charitable organization is deductible, a taxpayer will need to know the amount of deduction one is entitled to take on one’s income tax return. Responsibility to value the gift is generally the donor’s and oftentimes requires a written receipt or appraisal report. For gifts of property other than money, the IRS will typically look to fair market value (the price at which the property would change hands between a willing buyer and a willing seller, neither under compulsion). The rules can be quite complex,

depending on the type of property. Any debts on the property will also affect the value of the property. IRS Form 8283 contains helpful guidance on determining the valuations of various asset types. The IRS typically limits the amount of charitable contribution deductions any taxpayer can take in a given year. The amount of the limit is generally a function of the taxpayer’s adjusted gross income (AGI) and the type of organization to which the donation was made. For example, donations to private operating foundations and certain pass-through private foundations are subject to more stringent deduction limits than are deductions for contributions made to public charities. Additionally, more restrictive deduction caps exist for non-cash contributions and non-public charities, and under no circumstances can a taxpayer claim charitable deductions in aggregate for more than 50 percent of the taxpayer’s AGI. If individuals are unable to take their full deduction because of the percentage limitations, they are allowed to carry over (use in following tax years) unused deductions for a maximum of five years. Financial planners without tax expertise may need to consult with a tax advisor to determine the tax treatment of a charitable contribution. Some taxpayers desire more control in sponsoring charitable activities. Private foundations can also be attractive charitable giving alternatives for high net worth clients desiring more specifically direct charitable activities. In this case, an individual or a family typically starts a private foundation. The IRS has allowed a great deal of flexibility for foundations to operate in accordance with the organization’s mission. A private foundation is typically best for individuals interested in investing time, effort, and raising the necessary financial donations. A private foundation offers a few advantages for wealthy families that public charities do not. For instance, a foundation can hire employees, leave a legacy in which future family members can participate, and offer the freedom to invest and give the assets away in accordance with the foundation’s stated desires. Private foundations require a separate tax return (990-PF) to be filed, and there are costs associated with setup and ongoing management. A personal financial planner with expertise should be familiar with several of the key Internal Revenue Code rules found in §§ 4940 to 4945. After acquiring a detailed knowledge of a client’s goals and objectives, a personal financial planner should be able to recognize what assets would be more advantageous to give to charity versus others. It is worth noting that donative intent is a prerequisite to charitable planning. Despite the income tax benefits, a donor will retain more wealth by holding on to financial assets than by giving them away.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Ask students to determine the value of a gift to a charity given that the gift comes in different forms: cash, personal property, appreciated stock, personal expertise, and time.

Give students a short fact pattern about two individuals with the same AGI, both of whom are giving the same amount of donations. One

gives some cash to a public charity and some cash to a private charity; the other taxpayer gives some appreciated stock to a public charity and some stock to a private charity. Ask students to determine the allowed charitable contribution for each taxpayer. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or

Write a fictitious case scenario for the students to read. The case should contain the following issues: AGI limitations, asset type restrictions, and type of charity limitations. Ask students to divide into groups of two or three to identify the key issues in the case and their effect on charitable deductions.

Given the previous case scenario and fact pattern, ask students to work individually on identifying the issues relating to charitable deductions. Have them write a short summary of their findings.

Short cases for students to evaluate the advisability of donating particular assets from a client’s balance sheet.

A short write-up for each assigned case study highlighting which assets might be best and why.

Discuss a new charitable organization that is being set up in the local community—an urban farming plot. Ask students to break into small groups. Assign each group the task of creating a donation pitch, including the tax benefits, to prospective donors based on specific asset needs of the charity (i.e., cash, land, machinery, plant starts, etc.). Students then discuss in class how each donor pitch and associated tax benefit would be different from the others.

Ask the students to create a fictitious case where a family is looking to gift assets to charity. Ask the students to adjust certain client facts and motives such that, when considered, they will alter how and where the client donates money and thus the tax consequences of such donations.

producing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: With respect to charitable contributions, an entry-level personal financial planner can identify the percentage limitations and the method of valuation for property donated. Competent: A competent personal financial planner can ask appropriate questions to gain insight from the client with which to evaluate and identify planning opportunities and areas of concern for clients while gifts are contemplated. The goal is to help the client achieve an acceptable result by providing advice to the client and the client’s tax advisor. Expert: An expert personal financial planner can work very closely with the client’s tax advisors and will likely possess a strong background of experience in taxation. The expert planner can identify complex problems and proactively suggest strategies to minimize taxation, calculate the numerical savings of using different strategies, and spot flaws (if any) in a charitable plan. The expert planner can identify the key factors on which to base a decision and clearly articulate a recommendation to the client.

IN PRACTICE Richard Richard is your client, and has become inspired by Victor, who leads a large non-profit organization providing food, clean water, and housing relief for women and children in troubled areas. Richard has decided he wants to give Victor some tangible property items (documents) worth a considerable sum. You have noticed that Richard is tired of operating his successful business and is considering selling after he decides what to do in retirement. Richard also owns a building used in the business. A personal financial planner should recognize that Richard could give the contributions to Victor’s charity instead of directly to him. If the item was tangible personal property of significant value, an appraisal would likely be required. A financial planner should also recognize that significant charitable gifts may require Richard to carry forward unused charitable contributions. If we know the documents and the business were valued at $200,000 and Richard’s AGI was $150,000, then his deduction would be limited to $75,000 this year with a $125,000 carryforward. A personal financial planner with expertise should understand the complexities of selling a business and consider the possibility of selling the stock in the business and contributing the building (which by now has been fully depreciated) to the charity with the deduction at its fair market value. If Richard chooses to give the documents to Victor directly and sell the business outright, he will receive no charitable deduction and would recognize long-term capital gains on the sale of the business. As a result, he would pay more taxes than is necessary, leaving less money for charitable purposes.

Thomas Thomas has enjoyed wonderful success in business ventures during his career. In his spare time, he has accumulated an extensive collection of artwork and valuables in his personal collection. Thomas also has been very philanthropic over his career, donating time and money to various causes. A personal financial planner should recognize that Thomas’s collection of art could be eligible for a charitable contribution of up to 50 percent of AGI and a carryforward of five years if he was willing to donate an entire or a partial interest of any pieces of artwork. Thomas should receive advice around structuring the agreement with the charity to ensure the artwork will be a related use and not sold. Also, a personal financial planner should be familiar with the importance of following the rules and regulations of obtaining a qualified appraisal to obtain the charitable deduction.

Monty Monty has recently hired you as his financial planner. He is in declining health and looking to give away a significant amount of his wealth to avoid estate taxes. After reviewing his situation, you notice he has been extremely generous giving money to many causes and business ventures. A personal financial planner should recognize that Monty may be better off gifting certain assets inter vivos versus through testamentary gifts. To the extent Monty wishes to give to charity during life, he could be best served from a tax perspective by giving shares of his highly appreciated stock, as he would then not have to recognize capital gains. The planner should also be able to advise Monty that selling the business interests that show unrealized losses and recognizing those capital losses against capital gains and ordinary income will be more valuable than passing the interests directly to a charity and thereby losing the ability to recognize the losses. A personal financial planner with expertise may be able to help guide Monty by explaining the costs, filing requirements, and potential benefits a private foundation could offer as opposed to a public charity or donor-advised fund. Also, if there was any desire for testamentary gifts, a personal financial planner should advise Monty the benefit of naming charity as the beneficiary of tax-deferred assets such as IRAs, 401(k)s and Non-Qualified Deferred Compensation Plans. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 50 Retirement Needs Analysis Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

Six factors are included in a thorough retirement needs analysis. These include income and expense needs, rates of inflation, returns on investments, taxes, number of years before retirement, and life expectancy after retirement. A planner who conducts a retirement analysis for a married couple must also understand estate planning and how the death of one partner affects the seven factors for the second-to-die spouse. Of course, insurance and risk

management will affect the cost of living as well as estate plans.

INTRODUCTION While seven factors are included in a mathematical analysis of retirement, a client’s satisfaction with retirement is most greatly correlated with meeting the personal objectives for retirement. These goals vary among clients. Some wish to travel extensively, whereas others want to relax at home. Hobbies such as golf can be more expensive than reading or watching a movie. Retirees who expect to live longer may experience greater health care expenses. A good retirement analysis begins with an honest examination of expected retirement lifestyle and estimated life expectancy. In addition, each of the retirement analysis factors should be explored in detail with the client. The lifestyle decision drives the retirement analysis, as it will often include parameters for income needs and retirement age. Age at retirement affects retirement benefits, especially those from Social Security and defined benefit pension payments, and number of years in retirement. Economic factors that can be estimated but not controlled by the client and planner also affect retirement satisfaction. Inflation erodes purchasing power, requiring more assets in order to fund retirement. While diversification and time can result in stabilizing rates of return, those that receive low rates of return early in retirement are hurt more than retirees who experience low rates of return later in their retirement years. In the United States, most retired individuals will receive a Social Security benefit. However, the likelihood that a retiree will receive a fixed monthly benefit from a pension plan is minimal due to companies’ continued migration from defined benefit to defined contribution plans. Clients will need to use withdrawals from private investments, defined contribution plans, or individual retirement arrangements (IRAs) to fund retirement expenses. Many retirees will either plan to earn some additional income through phased retirement part-time work or will, out of necessity, supplement retirement income with earned income. Additional savings (either private or through IRAs or corporate benefit plans) are required to fill the gap between the amount of funds needed for retirement and the current value of funds available. The amount of savings required to pay for retirement needs is dependent on the years until retirement, the value of current assets available for retirement, and the rate of return expected on retirement fund investments. Using tax-advantaged plans for retirement savings allows the worker to save for retirement with fewer out-of-pocket funds while achieving the retirement savings goal. It is imperative that clients understand that retirement savings decisions require trading off current consumption with future consumption. Planners are also well advised to explain the importance of using time (compounding) to their favor by employing savings plans as early as possible. Clients may find that they will not have enough funds available for retirement at their preferred retirement date. Understanding and explaining methods for mitigating this situation will build

trust and improve the probability that the clients will enjoy a satisfactory retirement. These methods include retiring later, supplementing retirement income with earned income from part-time or seasonal employment, decreasing retirement spending needs, or enjoying positive results from assuming increased investment risk. Of course, the latter method can never be assured, and genuine understanding and acceptance of the risks are needed. Several market products may be useful in minimizing the degree of longevity risk. These include using long-term care insurance for reducing expenses in the late stages of retirement, and annuities for stabilizing income streams. A thorough analysis of retirement funding needs is based on seven factors. No one knows with complete certainty one’s death date or the rates of inflation or investment returns over a very long period of time. Therefore, financial planners will also want to explore the probability that the assumptions used in the analysis will hold and that expected retirement outcomes will be achieved. A Monte Carlo analysis is the most useful tool for incorporating probabilities into the retirement needs analysis. The work versus retirement decision is often thought of as an all-or-nothing proposition. And in the past, it often was. Prior to 2006, workers could not receive any employer-provided retirement benefits if they were still working for that employer. However, in order to encourage retirements of older workers so younger individuals could enter the workforce, the government now permits employers to offer phased retirement. Phased retirement programs permit workers to reduce their work hours and receive qualified plan benefits while working part-time. Restrictions on these programs do apply. Workers can retire from one employer, receive benefits, and then also acquire a part- or fulltime position with another employer. Working after official retirement may allow retirees to maximize cash flow over the retirement life span by delaying withdrawals from retirement savings or postponing Social Security benefit receipt. Retirement cash flow varies with the timing of Social Security benefit receipt. Social Security payments increase 8 percent for every year after full retirement age that a retiree waits to claim benefits. A retiree who does not take early Social Security benefits may enjoy a benefit up to 30 percent greater than one who receives benefits at the earliest possible age.

LEARNING OBJECTIVES The student will be able to: a. Identify and evaluate the assumptions used in analyzing retirement needs including: age at retirement, cash inflows and outflows in various stages of retirement, goal priority and importance, longevity, rate of investment return, market volatility, and effects of inflation. b. Recognize the potential sources of income during retirement including Social Security, employer plan benefits, personal savings and investments, individual retirement plans,

and employment income. c. Calculate an appropriate savings plan to meet funding needs and communicate the importance of having a well-funded retirement plan. d. Recommend a plan for maximizing the probability of achieving the client’s goals and mitigating longevity risk. e. Use statistical and probability techniques in calculating retirement funding and income distribution plans. f. Explain various patterns of work-to-retirement transitions and phased retirement.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Draw a time line on the whiteboard. Outline the events that occur during a typical retirement, comparing those who retire early with those who don’t, and those with lesser and greater life expectancies. Then put a cost to these events and activities.

Student Assessment Avenue Students interview a relative or friend who is over 50 about their retirement expectations. Students should then map the interviewee’s time line and obtain costs of various aspects of the interviewee’s expectations (e.g., traveling four times a year to see grandchildren).

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Host a panel of three retirees in different retirement stages. Students question them about their preretirement hopes and dreams and their retirement realities. Include questions about greatest surprises, most difficult components, and what is making retirement good.

Ask students to research and explore one of several strategies for mitigating retirement underfunding or unplanned gaps. Students should explain to another student how his or her strategy can successfully mitigate retirement underfunding risks and the advantages and disadvantages of the strategy .

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Show how to conduct a financial needs analysis for retirement. Include a discussion of how to obtain reasonable assumed values for many of the factors and actual data for other factors.

Provide the students with four problems using different sets of assumptions. Ask students to calculate the retirement wage gap, amount of assets needed on the first day of retirement, and amount

needed to save between now and the first day of retirement. Ask students to compare and contrast the results based on age at retirement, life expectancy, and income-expense gap. Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

As a group, design an intake Given a case study, ask the sheet for a client regarding his or students to draft a retirement plan her retirement plans. and present the plan to their client. After presentation and Add components that are external questions, have them redraft the to the client, such as where rates analysis and plan of inflation and return on recommendations in writing. investments can be found and determined.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the retirement planning process to a client and gather intake data regarding a client’s expectations during retirement. The entry-level planner can accurately estimate retirement income and expenses and perform a retirement gap analysis using adequate assumptions. Competent: A competent personal financial planner can assist the client in determining a realistic retirement plan, including adapting to unexpected events during retirement. The competent planner can strategize about how the clients will be able to maximize retirement satisfaction with various income and asset distribution streams, income tax policy, and housing and investment choices. Expert: An expert personal financial planner can determine the probability of the retirement plan’s success and design complex strategies for meeting retirement goals.

IN PRACTICE Golden and Norwin Golden and Norwin, ages 61 and 63, live a great life. They travel and dance until the early hours of the morning. They enjoy a low-six-figure income. However, their savings are modest. Golden’s mother lived a long life, the past five years of which were in an assisted living and nursing facility. Their needs assessment leads you to advise them to begin doubling their savings and consider the purchase of long-term care insurance. This advice sends shudders through Golden and

Norwin, as the changes would require sacrificing some of their social life. Because their health is good and Golden’s profession allows for it, the financial planner then suggests they consider a phased retirement program beginning at age 68 and continuing until age 70 or 72 if their health allows. The phased retirement program will allow the clients to begin enjoying retirement activities while minimizing withdrawals from their modest savings.

Mary Jane Mary Jane has never married. She teaches Spanish at the local high school and fills her private time reading and knitting shawls for ladies in nursing homes. Every five years, she travels internationally on a two-week tour, costing about $6,000. At age 51, she spends just under 80 percent of her take-home income. Her take-home income is greatly reduced from her gross income, as she saves the maximum in the school district’s 403(b) plan. Mary Jane’s mortgage is 22 percent of her gross pay and her home will be paid off in two years. If she works until age 60, she will retire with a defined pension benefit of 67 percent of her current gross salary. Understanding her lifestyle and goals is fairly straightforward. Her monthly pension benefit will be enough to meet her cash flow needs. Her 403(b) savings should continue to grow, providing for any unexpected long-term medical needs. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 51 Social Security and Medicare Sarah D. Asebedo, MS, CFP® Virginia Tech Martin C. Seay, PhD, CFP® Kansas State University Thomas Warschauer, PhD, CFP® San Diego State University

CONNECTIONS DIAGRAM

Social Security and Medicare interact with many areas of financial planning. Social Security

Survivors benefits are an integral part of most life insurance needs analysis and Social Security disability payments are critical in evaluating clients’ disability insurance needs. For clients over age 65, Medicare is an integral part of health insurance planning. Because Social Security payments are fixed, forecastable, and generally dependable, they must be considered in determining investment strategy. Various Social Security payments interact with other taxable income in a way that ties these areas closely together. Lastly, Social Security retirement payments are an integral part of retirement income planning.

INTRODUCTION Social Security provides an important source, and possibly the only source, of inflationadjusted (real-dollar) retirement income for most retired Americans. It also is an important source of income for the families of deceased workers through survivors benefits. And finally, it provides an income for disabled workers and their families. The income tax treatment of Social Security benefits varies because taxability of benefits is based on the amount of other income. When analyzing an optimal Social Security benefit withdrawal strategy, a financial planner must integrate several client-specific factors, including the investment portfolio allocation and rate of return, risk tolerance, spending needs, inflation, income taxes, life expectancy, benefits payable to other beneficiaries, and survivor’s income needs. Medicare is the primary source of health insurance for Americans age 65 and over and is therefore an integral part of a client’s financial plan. Medicare is largely related to risk and insurance planning; however, the premiums for Medicare Part B and Part D increase based upon a client’s Modified Adjusted Gross Income (MAGI). Therefore, tax planning is important in managing the premium costs associated with Medicare. The Social Security system was created in 1935, and the first beneficiaries were awarded retirement and survivors benefits in 1940. The disability benefits provisions were added in 1956. The system was never conceived as a funded system. The idea was an intergenerational transfer of payments funded by a tax on workers and providing funds to beneficiaries. The trust fund established by the law was intended to accumulate excess receipts (that is, system-wide receipts in excess of benefit payments) and earn interest on those funds by investing the fund in special Treasury Department securities. The congressional record of debate indicated that the system was intended as a supplementary plan—that is, to provide a floor to retired workers and survivor families. In addition to retirement, survivors, and disability benefits, there is a very small death benefit intended to pay for minimal burial expenses. Medicare, a companion program to Social Security, was created through an Amendment to the Social Security Act in 1965. Previously, older individuals struggled to find affordable health insurance coverage and were often left to cover medical costs by themselves. Consequently, Medicare was created to provide easily accessible health insurance to individuals over the age of 65. Medicare was originally limited to Part A (Hospital Insurance) and Part B (Medical Insurance). However, the program was expanded in 1997 and 2006 to include Medicare Part C (Medicare Advantage Plan) and Medicare Part D (Prescription Drugs), respectively.

Additionally, Medigap plans, also known as Medicare Supplemental Plans, are available to supplement coverage offered by Medicare Parts A and B. Given the rising costs of healthcare and its impact on a retiree’s financial well-being, a financial planner should understand the Medicare program, its costs and benefits, and the role it plays in a retirement plan. Similarly, it is important that planners understand Social Security costs and benefits, and the role benefits play in insurance and retirement planning. Optimizing the benefits while reducing the tax consequences promotes financial well-being.

LEARNING OBJECTIVES The student will be able to: a. Provide an overview of the Social Security system. The payroll tax (FICA) that funds Old Age, Survivor, and Disability Insurance (OASDI) is shared by employers and employees. The current tax is 6.2 percent for each, although tax is only paid on wages up to an annual limit. Self-employed workers pay both halves but receive an adjustment for AGI (adjusted gross income) for the employer half of the tax paid. FICA taxes and Social Security benefits are based on the individual worker’s earnings, not family earnings. Generally, a beneficiary can receive benefits on only one worker’s account at a time. An exception would be a spouse who is under full retirement age (FRA) and is eligible for both their own worker’s benefit and a spousal benefit if the spousal benefit is higher. Under this scenario, the total amount received is not greater than the higher spousal benefit amount, however, the Social Security Administration (SSA) will pay the workers benefit first with the additional spousal benefit layered on top to equal the higher spousal benefit amount. SSA calls this a combination of benefits, which is effectively based upon two separate earning records.1 Social Security is set up as a pay-as-you go system. This means that current workers are paying Social Security taxes to provide benefits to current retirees. In the past, the number of workers far exceeded retirees, providing a net positive cash flow into the system. Consequently, there is a combined trust fund for retirement and survivors (OASI) benefits and a separate one for disability (DI) benefits. These trust funds are often referred to as “OASDI.” b. Advise clients in consideration of proposed program reforms. As the ratio of retirees to workers has increased, funding for Social Security through tax revenue has been growing less rapidly than expenses, and trust fund assets have begun to deplete. The primary cause of this drain is an increased life expectancy of beneficiaries. In addition, there has been an increase in survivors benefits unmatched by income increases. The funding needs of the Social Security system will increase over time as life expectancies continue to rise.

A number of steps have been proposed for solving the long-term fiscal problems of the system, including delaying full retirement benefits, increasing the tax rate, reducing the rate of benefit increases, and transitioning the program to a funded privatized system. Fiscal liberals argue that Social Security is a regressive tax because earnings above the wage base are not taxed. Fiscal conservatives see the benefits as regressive because of the lower rate of benefits for higher-earning individuals. A financial planner must be able to describe the issues facing the Social Security system and understand the potential implications from these issues into a client’s retirement plan. Some planners have taken the position that they cannot include the expectation of Social Security in retirement planning. Others believe that Social Security will remain in some form, with additional funding coming from general revenue or even increased deficit financing. It is a very expensive proposition (in the sense of increased client savings necessary) to assume benefits will not exist in the future. A financial planner must be able to communicate the current lifestyle tradeoffs associated with reducing or eliminating Social Security benefits in retirement planning projections. Additionally, the planning assumptions utilized need to align with the current and projected financial status of the Social Security system and each client’s unique vantage point. c. Explain how a client may qualify for Social Security benefits, given their payroll taxes and available benefits structure. There are several potential beneficiaries under the Social Security system and a financial planner should be able to identify when an individual may be eligible for benefits. Workers can be classified as uninsured, currently insured, or fully insured. That determination is made based on a computation that is a function of a worker’s Social Security earnings and how often the worker has paid taxes into the system. Some workers are not part of the Social Security system and are considered uninsured. Although many government workers are included, many are not (as the class of workers elected not to be). A worker’s insured status is based on the number of quarters of coverage warranted by the worker’s earnings record, which is an amount set by the Social Security Administration adjusted annually for inflation. To be currently insured, six quarters of coverage out of the preceding 13 calendar quarters is needed. To be fully insured, a worker needs 40 quarters (generally 10 years) of covered earnings, although they need not be consecutive. Generally, a worker needs to be fully insured and have earned at least 20 quarters of coverage during the last 10 years to collect disability benefits and fully insured to collect retirement benefits. Dependents of workers may be eligible for survivors benefits if the worker was at least currently insured at death. The level of coverage (uninsured, currently insured, and fully insured) is a distinct and separate computation from the amount of benefits that will be provided. In basic terms, a worker’s spouse may receive a retirement benefit equivalent to 50 percent of the benefits the worker has earned. For working couples, both may have Social Security accounts to

draw on. While under FRA, the worker’s benefit is paid first. For a married couple, if the worker’s benefit is less than 50 percent of their partner’s worker’s benefit, then an additional spousal benefit will be added to their own worker’s benefit (not to exceed the 50 percent level). Once FRA is attained, a worker can choose from which account they wish to receive benefits (spousal or own), regardless of which is higher.1 Other individuals may also be eligible to receive Social Security retirement, disability, or survivors benefits based upon a worker’s benefit, including: divorced spouses, a spouse at any age who is caring for a young child, a disabled spouse, a young unmarried child, a disabled child, and dependent parents. A financial planner must be able to distinguish between the various Social Security benefits available and the types of beneficiaries who may be eligible for those benefits. d. Explain the computation of the averaged indexed monthly earnings (AIME), the primary insurance amount (PIA), and disability, survivors, and maximum family benefits. There is a similar but distinct benefits structure for each of the major programs. In all cases, benefits are a function of income as taxed by Social Security. The computation of income is called the averaged indexed monthly earnings (AIME). AIME is computed based on the earnings record of the worker, which is available online. Note that any earnings above the Social Security Administration (SSA) annual wage base are not taxed and do not count in the AIME computation. The system computes AIME by indexing each worker’s earnings from the time he or she began working to two years prior to the first year of eligibility (e.g., indexed to age 60 for age 62 eligibility). The index used is the increase in the national average of all Social Security workers’ taxed earnings each year. The AIME is then computed as the monthly average of the highest 35 years of wage-indexed earnings. The base benefit is called the primary insurance amount (PIA), which is the worker’s retirement benefit if he or she retires at full retirement age (67 for those who were born in 1960 or later, 66 if born between 1943 and 1954, 65 if born in 1937 or earlier). The PIA is computed with a formula based solely on the worker’s AIME. The computation is based on so-called bend points, which change each year and are indexed to the average worker’s Social Security wages. The formula is steeply progressive; that is, workers get 90 cents for each dollar of earnings up to the first bend point, 32 cents for each dollar of earnings between the first and second bend points, and only 15 cents for each dollar of earnings above the second bend point. Generally, Social Security benefits are reduced from the PIA level based upon the age of the beneficiary upon commencement of benefits. The benefit reduction schedule varies depending upon the beneficiary category (e.g., retired worker, spouse, widow(er), disabled widow(er)).2 For a worker retiring five years prior to their Full Retirement Age (FRA), their benefit would be reduced by 6 percent per year, on average. The minimum age to receive benefits also varies.2 For example, retired workers and their spouses can receive benefits as early as age 62, where a surviving spouse can receive reduced widow(er) benefits as early as age 60, or age 50–59 if disabled. Workers who delay retirement receive increased benefits (called delayed retirement credits) for

each year they retire after their normal or full retirement year. The delayed retirement credits (DRCs) percentage depends upon the year of birth and ranges from 5.5 percent to 8 percent for years 1933 to 1943 and later.3 Another important aspect for financial planners is the amount of benefits a family is eligible for. As each dependent of the worker may draw benefits from a retired or deceased worker’s earnings record, there is a maximum family allowance computed from a worker’s PIA. Generally, divorced spouse benefits are not subject to the family maximum unless the divorced spouse qualifies for benefits as a caregiver for a young child of the worker.4 A financial planner must be able to describe the computation of benefits for a worker and their beneficiaries and to calculate age-based benefit reductions and increases as needed. e. Assist a client in selecting the optimal date to begin receiving Social Security retirement benefits and the impact of the earnings test. It would seem to be a simple decision to determine when a client should receive Social Security retirement benefits. However, there are a number of complicating issues. First, the healthier a client is and the more long-lived the person’s genetic pool, the more beneficial it is to defer benefits. This is particularly true for women, who have longer life expectancies than men. Another factor is the desire of a retired worker to continue to draw some employment income. After full retirement age (FRA) there is no earnings test. Before FRA, however, there is an earnings test that applies in the years leading up to FRA and a separate, more generous, earnings test that applies in the year a worker attains FRA. A financial planner must incorporate the earnings test into Social Security benefit strategies or a worker could suffer reduced or no benefits if they earn more than allowed. Moreover, a financial planner must be able to distinguish between income that is subject to the earnings test (e.g., wages), and income that is not (e.g., deferred compensation for work in previous years, or pension income). However, it is important to note that benefit reductions due to the earnings test are not permanent and are essentially credited back to the client upon attaining FRA. The tax treatment of Social Security retirement benefits is another confounding issue. If the only source of income is Social Security benefits, it is not federally taxed. If the beneficiary has other taxable income, one half of the Social Security income must be added to the other income to determine if it exceeds a threshold amount. If it does, then that half will be taxed at the taxpayer’s relevant rate. There is also an issue for married couples, particularly when their ages differ. It is necessary to compute the present value of expected benefits under alternative scenarios to help clients determine the optimal time for benefits to begin. Planning for spousal benefits can be complex and a financial planner must be able to navigate the various Social Security rules related to married couples in order to appropriately guide clients. There are two key strategies applicable to spousal benefits that a financial planner should integrate into analyzing a married couple’s benefit maximization strategy.

The first is known as file and suspend. Upon attainment of FRA (note, file and suspend is not possible before FRA), a worker can choose to file for their retirement benefit, but delay receipt of that benefit (i.e., “suspend”) and earn delayed retirement credits (DRCs). A worker must file for benefits and either receive those benefits or suspend them in order for a spouse to begin receiving spousal retirement benefits. Spousal benefits do not earn DRCs and therefore, this is an important strategy if the worker wishes to earn DRCs, but has a spouse at FRA who needs to file for a spousal retirement benefit. The second strategy is also available upon attainment of FRA; an individual has a choice to receive his or her own benefit or a spousal benefit regardless of which one is higher (under FRA, the benefit is the “greater of”). Therefore, for a married couple, one spouse can choose to claim a spousal benefit and delay their own benefit up to age 70 in order to earn DRCs. Either spouse can choose this option, but both cannot choose a spousal benefit simultaneously.4 A financial planner must be able to analyze the various factors affecting the optimal date to begin receipt of Social Security benefits, including age, early benefit reduction penalties, income taxes, investment rate of return and portfolio allocation, life expectancy, risk tolerance, spending needs, inflation, benefits payable to other beneficiaries, and survivor’s income needs. f. Explain the windfall elimination and the government pension offset on benefits. There are rules precluding workers who earned income from jobs that were not covered by Social Security from receiving some or all of their benefits whether on their own account or as a spouse. Further, there are rules preventing workers with few Social Security earnings from drawing full benefits. The windfall elimination provisions apply to those who had less than 30 years of “substantial” Social Security earnings. The Social Security Administration website provides a computation of the benefit reduction in this case.5 “If you receive a pension from a federal, state, or local government based on work where you did not pay Social Security taxes, your Social Security spouse’s or widow’s or widower’s benefits may be reduced.”6 That occurs because at some point in the past the workers of that government entity opted out of the Social Security program, often because they were offered a sufficient defined benefit retirement program. A financial planner must be able to identify when the windfall elimination and government pension offset provisions apply to a client’s anticipated Social Security benefit, as these provisions may affect the amount of Social Security benefits actually received. g. Describe the taxation of each type of Social Security benefits. The amount of federal income tax paid by Social Security recipients depends on their tax filing status (joint, single, etc.) and their other adjusted gross income. For lower-income people, Social Security benefits are not taxed. For higher-income people, 85 percent of their Social Security benefits are taxed. For people in between, 50 percent of their benefits

are included in their taxable income. The breakpoints between these amounts differ each year. But certainly a planner must take this into account in retirement planning.7 It is also important to be aware of the state income tax provisions for Social Security benefits, as some jurisdictions, even those with income taxes, do not tax these benefits, whereas others do. A financial planner must integrate the effect of income taxation on benefits into Social Security analysis and recommendations. h. Provide an overview of the Medicare program, including the payroll taxes and eligibility structure. Medicare is funded through income taxes, with recent legislative changes providing a tiered tax system. In general, Medicare taxes are 2.9 percent of earned income. For employed individuals, this tax is split with the employer and only 1.45 percent is deducted from their paycheck. However, self-employed individuals must pay the full 2.9 percent tax themselves, but receive an adjustment for AGI (adjusted gross income) for the employer portion of the tax. An additional tax of 0.9 percent must be paid by high income individuals with wages exceeding set thresholds, which vary by income tax filing status. Unlike Social Security, Medicare taxes must be paid on all earned income with no annual wage limit. Lastly, a Medicare tax of 3.8 percent is levied on the lesser of net investment income or modified adjusted gross income above a threshold amount, which also varies by income tax filing status. For most Americans, Medicare eligibility is tied to their 65th birthdays. The initial enrollment period begins three months before this date, with coverage commencing immediately upon turning 65 if enrollment is completed during this time period. An individual may wait until after their 65th birthday to enroll in Medicare without a penalty, as the initial enrollment period ends three months after this date. However, if an individual waits to enroll until after their birthday, coverage will be delayed as well. There are significant incentives to ensure enrollment within the seven-month initial enrollment period, as after this time insurance premium rates permanently increase 10 percent per year for Medicare Part B coverage. Individuals who are not eligible for premium-free Part A will also see increased premiums for late enrollment. Importantly, clients retiring before the age of 65 must seek health insurance coverage through other sources. If an individual, or their spouse, is employed and this employment provides coverage under a group health plan, a special enrollment period applies. This special enrollment period allows individuals to sign up for Medicare past the age of 65 at any point while employment and group coverage remain. Once employment and/or group coverage ends, an individual has eight months to enroll under the special enrollment period provision. Typically, the late enrollment penalty is waived if an individual properly enrolls during this special enrollment period, even if it is well past his or her 65th birthday. There are two scenarios that may make an individual under the age of 65 eligible for Medicare coverage. First, individuals receiving either Social Security disability benefits

or Railroad Retirement Board disability benefits are automatically enrolled in Medicare Parts A and B. Additionally, individuals experiencing permanent kidney failure, with renal disease and undergoing dialysis, or are on or waiting to be on a kidney transplant list, may be eligible for Medicare. In this scenario, individuals should contact the state’s Social Security office to verify eligibility. In both cases, premium payments for Medicare Part B will be required, although Part A, as usual, is typically free. A financial planner must be able to describe the initial and special enrollment periods, potential penalties, and special circumstances associated with Medicare enrollment in order to effectively guide clients in meeting the various enrollment dates and to mitigate potential penalties. i. Identify the four parts of Medicare coverage, the benefits provided by each, common out-of-pocket costs required for insured individuals, and alternative insurance options to cover the gaps associated with Medicare. Medicare is split into four parts: Part A (Hospital Insurance), Part B (Medical Insurance), Part C (Medical Advantage Plan), and Part D (Prescription Drugs). Medicare Parts A and B form the core coverage components, with all beneficiaries typically being eligible for both. While Medicare Part A is typically free, Part B requires recurring premium payments. As mentioned above, there is a penalty in the form of increased premium payments for delayed enrollment in Part B. Medicare Parts C and D were created as supplemental coverages and are available through private insurance companies, although the plans must meet certain requirements. Part C and D plans offer varying benefits, and consequently premium and out-of-pocket costs can vary significantly. However, if prescription drugs are not covered elsewhere there is an increased premium penalty for late enrollment or for a gap in coverage for Part D. Part A covers inpatient hospital stays, or consecutive stays, of up to 90 days. Individuals are required to make a single co-payment at the beginning of the first 60 days, and a copayment daily for each day afterwards. This coverage period will reset after an individual has 60 consecutive days with no Medicare payments. In addition, beneficiaries have a lifetime reserve of 60 days coverage beyond the recurring 90 days coverage period, although a significantly higher daily co-pay is required. Additionally, Part A can cover up to 100 days of rehabilitation services under certain circumstances. Similar to hospital coverage, the first 20 days are covered completely by Medicare, with the remainder requiring a daily co-pay. Lastly, Part A will cover hospice benefits for terminally ill individuals. While almost all Medicare beneficiaries are eligible for Part B, it is an optional coverage that requires monthly premium payments, typically deducted from Social Security benefits. While Part A is geared to hospital stays, Part B is focused on more routine medical visits. After meeting an annual deductible, Part B typically pays 80 percent of charges for approved services. Approved services include doctor visits, diagnostic tests, ambulance transportation, outpatient treatments, laboratory services, home health care expenses not covered by Part A, and a variety of other health services.

For individuals wanting additional medical coverage, two common alternatives are enrollment in a Medicare Advantage Plan or Medigap insurance. Medigap insurance, also known as Medicare Supplement Insurance, is sold as a supplement to Medicare Parts A and B. It helps cover some of the expenses, such as co-payments, co-insurance, and deductibles, not covered under these plans. Recipients of Medigap must be covered by Medicare Parts A and B, must not have a Medicare Advantage Plan, and pay premiums separately to a private insurance company. Similar to Medigap, a Medicare Advantage Plan (Part C) seeks to cover expenses not covered by Medicare Parts A and B alone. It is sponsored by Medicare but offered by private health insurance companies. By rule, a Medicare Advantage Plan must offer the same benefits as parts A and B, but also provide additional services. Plans vary and must be compared to understand different coverages and the value of the corresponding premium payments. Notably, Medicare Advantage Plans typically do not cover hospice care, although recipients can file for coverage directly through Medicare Part A. Medicare Part D is designed to offset the cost of prescription drugs. However, many individuals may have prescription drug coverage through a Medigap or Medicare Advantage Plan. Part D plans must be approved by Medicare but are offered through private insurance companies, and consequently policies must be compared in terms of benefits and premium amounts. j. Assist a client in selecting proper Medicare coverage and any supplemental coverage with careful attention to appropriate deadlines. Medicare elections are more straightforward than those related to Social Security, but still require time and attention. Planners should be careful to ensure clients follow enrollment requirements to avoid any penalties. They should understand how employment and group insurance coverage affects Medicare enrollment and how to work with clients transitioning into retirement. They should be aware of the effect of a client’s MAGI on Part B and Part D premium amounts and take advantage of any tax strategies that might provide savings. They should also talk with early retirees about the need for health insurance coverage before the age of 65 and work to devise efficient strategies to eliminate gaps in coverage.

IN CLASS Category

Class Activity

Student Assessment Avenue Applying: Determine if and when a client should draw Provide a short case Carrying out or retirement benefits. Given three scenarios for the describing client’s PIA, using a same person, ask students to calculate and compare life expectancy, health, procedure benefits. For example, the client has no other and other income. Ask through income and has a short-lived family history. How students to compute executing or does it change if the client has a long-lived family after-tax benefits and implementing history? How about if the client has substantial calculate the break-even

outside income? What if the client has a spouse and/or young children?**

age for each scenario. Have students complete a client letter explaining their recommendations.** Analyzing: Provide a panel of students with a client’s data Assign the following Breaking describing life expectancy, health, and other income problem: Given a material into and PIA. Ask students to analyze the situation and client’s PIA and his or constituent make recommendations. Then form the panel and her dependents’ ages parts, and ask them to try to isolate disagreements between and earnings, determine determining optimum retirement age recommendations.* the survivors benefits how the parts for a five-dependent relate to one family of a deceased another and to worker where the an overall surviving spouse works structure or and one of the dependent purpose children works.** through differentiating, organizing, and attributing Evaluating: Provide specific information about a client’s Ask the student to Making disability. Is it deemed permanent? Is it total? Ask prepare a disability plan judgments the student to determine if the client would qualify based on Social Security based on for disability under the rules. Additionally, ask the and Medicare benefits criteria and student to address health insurance costs and alone, along with a standards Medicare eligibility. How does Medicare budget.** through eligibility relate to qualification for Social Security checking and disability benefits?** critiquing Creating: In-class or online discussion: A young client family The client family needs Putting tells you to prepare a retirement plan. Given their to be educated to the elements young age, they are concerned with the health of the likelihood that they will together to Social Security system and that benefits will be receive benefits in the form a coherent there for them in the future. What are the pros and future and the pros and or functional cons to including or excluding benefits? What cons of excluding whole; client-specific factors need to be considered (e.g., benefits in their future reorganizing risk tolerance, perspectives, ability to adjust planning. Ask half the elements into a spending, etc.) How does excluding benefits from class to take the position new pattern or the plan impact the amount needed to be saved for that benefits should be structure retirement and their lifestyle today? Should they excluded in planning and exclude all benefits from the plan or only a the other half that through

generating, planning, or producing

percentage of the benefits?**

benefits should be included.

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner can explain to a client the “Your Social Security” statement from the Social Security Administration and can identify the basic PIA computation and eligible beneficiaries under the Social Security system. Competent: A competent financial planner can determine and explain when a client should optimally receive Social Security retirement benefits. Expert: An expert financial planner can maximize a family’s retirement income regardless of context.

IN PRACTICE John and Mary John and Mary are seeking guidance on when and how to take their Social Security benefits. Both are eligible for a Social Security retirement benefit based upon their individual earnings records. Mary is the higher earner; however, John’s individual benefit is still higher than 50 percent of Mary’s primary insurance amount (PIA). Mary is in excellent health and plans to continue working until she reaches her full retirement age (FRA). John, however, has health issues and does not have a family history of longevity. Therefore, John is ready to fully retire by age 62. They have planned ahead for John’s early retirement and do not need Social Security benefits to meet current living expenses. John and Mary want to understand how to maximize the potential economic value from their combined Social Security benefits while incorporating the implications of John’s compromised life expectancy. Planners must provide for the expected and protect against the unexpected. Social Security helps with both. As clients approach retirement, they can closely estimate their expected Social Security retirement benefits. A planner must be able to show how the income will contribute to their retirement plan and provide protection for the surviving spouse. First, John and Mary’s financial planner considers the options available to them before reaching full retirement age (FRA). With Mary’s high earned income and desire to continue working, her benefit would be reduced to $0 based on the earnings test if she were to draw benefits before her FRA. Therefore, Mary should at least delay her benefit until she has reached FRA when the earnings limit no longer applies. John has his own earnings record, which produces a benefit that is greater than 50 percent of Mary’s PIA. Since Social Security

automatically pays the “greater of” a spousal benefit or an individual’s benefit if you are under FRA, John is only eligible for his own benefit if he chooses to draw at age 62. Next, John and Mary’s planner considers the options available to them at FRA. John and Mary are eligible to earn annual delayed retirement credits (DRCs) on their individual benefits if they delay receipt of benefits beyond their FRA. Additionally, one spouse can choose to receive spousal benefits at FRA and delay their own benefit to receive DRCs. The choice to take a spousal benefit and delay an individual benefit at FRA is not restricted to the 50 percent spousal benefit amount. Therefore, either spouse (higher or lower earner) can elect a spousal benefit of 50 percent of the other spouse’s PIA amount; however, both spouses cannot simultaneously draw spousal benefits and delay their own. Furthermore, the person whose earnings record is providing the spousal benefit must either start drawing benefits or file and suspend their benefit for the spousal benefit to begin. Note that the file and suspend strategy is only possible at and beyond FRA. Finally, John and Mary’s financial planner must consider the impact of survivor benefits, especially given John’s compromised life expectancy and Mary’s longevity expectation. In a married couple, if one spouse passes away, then the higher of the spouse’s Social Security benefit continues for the surviving spouse. If the lower earner passes away first, then the higher earner continues drawing their own benefit. If the higher earner passes away first, then the lower earner picks up the higher benefit as a survivor. Therefore, regardless of who passes away first, the higher benefit will continue until the death of the second spouse. In order to maximize the survivor benefit, the higher earner will need to delay their benefit as long as possible. Based upon a break-even analysis and the above considerations, John and Mary’s financial planner has recommended the following: John should consider taking his worker’s benefit as early as possible at age 62. Since he will not have any earnings, the earnings test will not restrict his worker’s benefit. Moreover, his earnings record provides the lower benefit that will end upon the death of the first spouse. Given John’s compromised life expectancy and the financial planner’s calculated break-even age, he should consider taking his benefit as early as possible in order to maximize the number of years he has to receive his benefit. Mary’s earnings record provides the higher benefit and she should consider delaying as long as possible (age 70) in order to maximize the benefit payable to the surviving spouse. Further, since John will be drawing his worker’s benefit early, Mary will be eligible to draw a spousal benefit from John’s earnings record when she reaches FRA and continue to earn annual DRCs on her own delayed worker’s benefit. With a thorough understanding of Social Security retirement benefits and a break-even analysis incorporating financial characteristics (e.g., inflation, investment rate of return, and income taxes), John and Mary’s financial planner was able to derive an integrated Social Security retirement benefit strategy that is most likely to maximize this couple’s combined benefit over their joint life expectancy.

NOTES 1. U.S. Social Security Administration, “Retirement Planner: Benefits for You as a Spouse” (January 2015). Retrieved from www.ssa.gov/planners/retire/applying6.html. 2. U.S. Social Security Handbook, “Basic Reduction Formulas” (January 2015). Retrieved from www.socialsecurity.gov/OP_Home/handbook/handbook.07/handbook-0724.html. 3. U.S. Social Security Administration, “Retirement Planner: Delayed Retirement Credits” (January 2015). Retrieved from www.socialsecurity.gov/retire2/delayret.htm. 4. Clements, D. A. Guide to Social Security, 43rd ed. (Louisville, KY: Mercer, 2015). 5. U.S. Social Security Administration, “Retirement Planner: How the Windfall Elimination Provision Can Affect Your Social Security Benefit” (January 2015). Retrieved from www.socialsecurity.gov/retire2/wep-chart.htm. 6. U.S. Social Security Administration, “Government Pension Offset” (January 2015). Retrieved from www.socialsecurity.gov/pubs/EN-05-10007.pdf. 7. U.S. Social Security Administration, “Benefits Planner: Income Taxes and Your Social Security Benefits” (January 2015). Retrieved from www.socialsecurity.gov/planners/taxes.htm. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 52 Medicaid Katie Seay, CFP® The Trust Company Martin C. Seay, PhD, CFP® Kansas State University

CONNECTIONS DIAGRAM

Medicaid is a vital source of health care for low-income, elderly, and disabled individuals. Although partially funded by the federal government, programs are typically operated at the state level. This leads to significant variations in program eligibility and benefits across the country. Consequently, personal financial planners must be cognizant to understand the program

as it applies in the client’s state. Proper Medicaid planning requires an understanding of tax planning, retirement savings and income planning, and estate planning. Specifically, planners must understand program eligibility requirements, how different assets and asset vehicles will be treated, the benefits available to an eligible individual, the requirements to remain eligible, and the consequences of receiving benefits on an individual’s estate.

INTRODUCTION Signed into law in 1965, Medicaid is a health insurance program for low-income, lowresource individuals jointly funded by the federal and state governments.1 Medicaid programs serve low-income individuals, families, and children as well as seniors and adults with disabilities, and is a prevalent funding source for long-term care for low-income seniors and individuals with disabilities. Designed to be run at the state level, each state has discretion in determining program eligibility requirements and benefits offered, although certain federal standards must be met. Medicaid has continuously evolved, as both state and federal policies and regulations have changed over time. Most recently, the Affordable Care Act significantly altered the Medicaid landscape by providing additional federal funding to states whose Medicaid programs adopt a specified set of eligibility requirements. In most cases, these new eligibility requirements expand coverage beyond individuals that were previously covered. While not applicable to all clients, an understanding of Medicaid’s eligibility requirements and benefits structure is still of great importance to financial planners. While their clients may not be eligible, planners are often asked to make recommendations related to clients’ parents and loved ones who need guidance surrounding Medicaid. An understanding of Medicaid is also important when working with special needs clients, or clients that have special needs children. Additionally, a working knowledge of Medicaid is important if a personal financial planner’s firm has the ability to serve as a trustee. Under this circumstance a financial planner may administer a special needs or other irrevocable trust for the benefit of a Medicaid eligible individual.

LEARNING OBJECTIVES The student will be able to: a. Describe the Medicaid program structure and funding sources. Medicaid is jointly funded by the federal and state governments to provide health insurance for individuals meeting certain eligibility requirements. In general, Medicaid serves lowincome individuals and individuals lacking financial resources, but, depending on the state, covered individuals can vary significantly. Historically, the federal government has paid a set percentage of each program’s expenditures, with each state being responsible for funding the remainder. States use different procedures to procure their portion, although most often funding is allocated though legislative appropriations. The Affordable Care Act altered this funding formula, and provides for additional federal funding for states with

Medicaid programs that expand to cover individuals based upon new eligibility requirements. At a federal level, Medicaid is currently administered through the Centers for Medicare and Medicaid Services (CMS). b. Explain common eligibility requirements, how assets are treated in determining eligibility, and how asset transfers may be subject to a look back period. Despite the state-specific Medicaid program administration and eligibility requirements, all programs must meet certain federal guidelines. The guidelines are based on an individual’s household income, household size, disability status, and family status.2 Medicaid recipients must also be a U.S. citizen or meet certain immigration rules, be a resident of the state where the application is filed, and have a Social Security number.3 Financial resources are also typically used in determining Medicaid eligibility. Most states allow an applicant to retain $2,000 in countable assets, or $3,000 for a married couple. However, certain assets, including a primary residence, personal property and household furnishings, a vehicle, life insurance with face value less than $1,500, a burial plot for applicant and immediate family members, burial funds up to $1,500, and assets held in specific kinds of trusts, such as a special needs trust, are often excluded from this evaluation.4 Additionally, if one spouse lives in an institution or nursing facility, there are special spousal impoverishment provisions to help protect the resources of the community spouse. To limit asset sheltering, a five-year look-back period is employed from the date of application to identify any assets transferred at less than fair market value. Any gifts or transfers made within the look-back period are subject to penalty. A penalty, in the form of delayed eligibility, is calculated, typically by dividing the value of the transfer by the state’s average monthly nursing home cost. If a state elects to expand its Medicaid program based on new eligibility requirements set by the Affordable Care Act, the new eligibility requirements are based solely on income and household size. If a state has not expanded its Medicaid program, individuals may qualify for Medicaid coverage under the state’s existing rules. c. Differentiate between mandatory benefits and optional benefits that may apply depending on the state. Federal guidelines provide significant leeway for states to determine the benefits available for Medicaid recipients. However, certain mandatory benefits are required of all state programs. Mandatory benefits cover a variety of expenses, including those related to inpatient hospital services, outpatient hospital services, nursing facility services, home health services, physician services, laboratory and x-ray services, family planning services, ambulatory services, and certain costs related to care for pregnant women.5 Optional benefits vary significantly between each state, but common benefits include coverage for prescription drugs, clinic services, physical and occupational therapy, respiratory care services, podiatry services, optometry services, dental services, hospice, and prosthetics, among others.6 A financial planner should take care to understand the statespecific program benefits applicable to the client situation, as well as be able to identify

the individual’s recurring uncovered expenses. d. Identify planning strategies, in accordance with Medicaid regulations, to maximize client benefits and available resources. Planners should generally work in consultation with an experienced elder law attorney to ensure compliance with the rules and regulations surrounding Medicaid. However, within these guidelines, there are certain Medicaid planning opportunities. Typically, Medicaid planning seeks to preserve assets for other family members and provide for the healthy spouse. The use of a special needs trust, or some other type of irrevocable trust, is one such planning opportunity. Other strategies include advance planned gifting programs and turning countable assets into exempt assets. If a client expects to be a Medicaid recipient, he or she may consider prepaying their mortgage, making home improvements, prepaying burial expenses, or purchasing a car for the healthy spouse, among other strategies. Lookback periods, estate recovery, and other drawbacks or risks should be considered in Medicaid planning. e. Explain estate recovery implications for Medicaid recipients. Since 1993, state Medicaid programs are required to recover certain benefits paid on behalf of a deceased recipient.7 However, federal guidelines require states to recover Medicaid benefits paid for long-term care and related costs for individuals who were age 55 or older when Medicaid benefits were received or those who were permanently institutionalized, regardless of age.8 States may impose liens on property and assets to enforce estate recovery of all property and assets that pass to heirs through state probate law, although some states broaden the estate definition to include other assets. In certain situations, remaining trust assets must also be used to repay the Medicaid program. States have significant discretion in determining which Medicaid benefits to recover, if any. Estate recovery is prohibited if the deceased leaves a surviving spouse, a child under age 21, or a blind or disabled child.9

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Utilize class lecture to highlight important Medicaid concepts including program structure, funding sources, and eligibility requirements.

Assign students to complete group projects investigating specific states’ Medicaid programs. Have these groups make presentations to the class for a shared learning opportunity. Have students prepare questions for the guest speaker and evaluate their class participation.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Lead a class discussion on how planning strategies can be used in accordance with Medicaid regulations. Provide students short descriptions of various individuals or couples. Have students work in small groups to analyze if eligibility requirements are met and lead a class discussion to synthesize students’ responses.

Invite a local elder law attorney to class.

Provide students an example of a Medicaid eligible individual and the benefits this individual receives from Medicaid. Ask students to analyze the adequacy of these benefits in meeting required expenses.

Lead an in-class activity that Provide students a case study evaluates a client’s current Medicaid that outlines a situation of a plan based upon a set of facts. client who has an adult child with a disability. Ask students to evaluate the client’s current estate plan and its effect on the adult child’s Medicaid eligibility status. Creating: Putting Split students into small groups. Provide students a set of client elements together to Provide them with client scenarios facts and goals surrounding the form a coherent or and have them create a cohesive plan client’s parents. Assume the functional whole; surrounding Medicaid eligibility and parents are near the Medicaid reorganizing elements benefits. eligibility threshold and entering into a new pattern or a nursing home. Have students structure through create a comprehensive plan to generating, planning, address long-term care expenses or producing and any Medicaid planning needs.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner can describe their state’s specific Medicaid program eligibility requirements and benefits. Competent: A competent financial planner can determine a client’s Medicaid eligibility, how previous and future asset transfers will be treated, and the implications of the receipt of Medicaid benefits on an estate. Expert: An expert financial planner can work with an elder law attorney to determine the appropriate planning, as allowed by law, to maximize Medicaid benefits given a client’s specific situation and objectives.

IN PRACTICE Joanna and David Joanna and David have three adult children, Jim, Betsy, and Lydia. Lydia, their youngest child, has autism and currently qualifies for Medicaid benefits. Joanna and David are consulting with their financial planner, Roger, as a part of updating their estate plan. They are concerned that Lydia may lose her Medicaid benefits if she were to inherit assets at their deaths according to their current documents. They want to include Lydia in their planning and do not want to favor Jim or Betsy over her, but are seeking guidance on potential planning opportunities to preserve her Medicaid eligibility. In talking with Roger, Joanna discloses that Lydia has a deep appreciation and love for classical music. In fact, Joanna and David often take Lydia to local performances and would like for her to be able to attend shows after their deaths. Knowing that special needs trusts are typically considered an excluded asset for Medicaid eligibility purposes, Roger suggests that Joanna and David consult with their attorney to determine if a special needs trust for Lydia’s benefit might meet their listed objectives. With this arrangement, Joanna and David are able to specify in the special needs trust documents that, in addition to other supplemental needs Lydia may have, trust assets should be used to provide Lydia with cultural entertainment, including classical music performances. Their attorney agrees that, by naming the special needs trust as beneficiary of Lydia’s portion of Joanna and David’s estate, the couple would be able to maintain equity among their children while not affecting Lydia’s Medicaid eligibility.

NOTES 1. Centers for Medicare and Medicaid Services, “Brief Summaries of Medicare and Medicaid” (November 2007). Retrieved from www.cms.gov/Research-Statistics-Data-andSystems/Statistics-Trends-andReports/MedicareProgramRatesStats/downloads/MedicareMedicaidSummaries2007.pdf.

2. Centers for Medicare and Medicaid Services, “Medicaid and CHIP Coverage” (January 2015). Retrieved from www.healthcare.gov/medicaid-chip/. 3. U.S. Department of Health and Human Services, “Medicaid Eligibility” (January 2015). Retrieved from longtermcare.gov/medicare-medicaid-more/medicaid/medicaideligibility/general-medicaid-requirements/. 4. Centers for Medicare and Medicaid Services, “Medicaid Benefits” (January 2015). Retrieved from www.medicaid.gov/Medicaid-CHIP-Program- Information/ByTopics/Benefits/Medicaid-Benefits.html. 5. Ibid. 6. Ibid. 7. U.S. Department of Health and Human Services, “Medicaid Estate Recovery” (April 2005). Retrieved from http://aspe.hhs.gov/daltcp/reports/estaterec.htm. 8. Ibid. 9. Ibid. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 53 Types of Retirement Plans John E. Grable, PhD, CFP® University of Georgia

CONNECTIONS DIAGRAM

Retirement planning is interrelated with nearly every other element of the financial planning process, including cash flow and net worth, tax, investment, and estate planning. For example, it is important for financial planners to have a high level of competence in relation to tax code issues, investment selection criteria, and portfolio management techniques when making retirement plan recommendations to either a business owner or a client who requests retirement plan guidance. Additionally, the ability to estimate the manner in which a client’s

cash flow, net worth, and estate situation will likely change as a result of retirement plan decisions is one characteristic separating the best and brightest financial planners from others.

INTRODUCTION The first public pension arrangement in the United States was implemented by the state of Massachusetts during the seventeenth century.1 Colonists who were unable to work due to wounds received in battle received a pension, which was funded through public tax collections. It was not until the mid-nineteenth century that retirement plans, as public and private social benefits, began to take shape in a form recognizable in the twenty-first century. Retirement was a remote concept for most Americans prior to the Industrial Revolution. People tended to live in communities where elder care and old-age funding were provided by a person’s family and church. In 1875, the American Express Company, following a trend established in Germany and adopted throughout Europe, created the first private pension plan in the United States.2 Other large firms followed this movement by establishing defined benefit pension plans. It was not until the Great Depression of the 1930s that the U.S. government took steps to codify retirement plans within the tax code. It was also during this time period that President Franklin D. Roosevelt signed the 1935 Social Security Act, which established a normal retirement age of 65 for most Americans. Other milestones in the development of retirement plans in the United States included passage of the Employee Retirement Income Security Act (ERISA) in 1974, the introduction of individual retirement accounts (IRAs) during the same year, the 1978 Revenue Act that formed the basis of 401(k) and similar qualified retirement plans that entered the marketplace in 1981,3 Roth IRAs in 1997, and myRAs in 2014 (a plan that allows most working Americans to contribute after-tax dollars into government savings bonds and later pull funds out tax free at retirement). Retirement plans can be classified in a number of ways. The first distinguishing characteristic is whether a plan is a defined benefit or defined contribution type. A defined benefit plan provides benefits based on a standardized formula of contribution and/or distribution. Additionally, plans can be classified as being either qualified or non-qualified A qualified plan provides tax advantages for both plan sponsor and beneficiary. Table 53.1 illustrates common types of retirement plans by classification.

Table 53.1 Retirement Plan Types by Classification Qualified Defined Defined benefit Money purchase Target benefit Benefit/Pension Keogh money purchase Cash balance Plans Defined Contribution/ Profit Sharing Stock bonus ESOP 401(k) Roth 401(k) ThriftPlans savings* Keogh profit-sharing SIMPLE 401(k)

Non-Qualified Rabbi trust Secular trust Phantom stock plan 457 (quasi-qualified)** Roth 457**

*Governmental plans. **Non-profit plans.

LEARNING OBJECTIVES The student will be able to: a. Distinguish between qualified, government, non-qualified, and private tax-advantaged retirement plans. b. Describe the characteristics of the various types of defined benefit, defined contribution, and individual retirement accounts.

Rationale As suggested in these learning objectives, it is important to recognize that retirement planners often use four broad types of retirement plans when working with clients. Qualified plans are those that are specifically recognized in the Internal Revenue Code. A qualified plan allows for pretax employee contributions, the tax deferral of gains within the plan, and special tax benefits for employers that contribute to an employee’s plan. Government plans provide similar benefits as qualified plans, with the primary difference being the type of employee served. Non-qualified plans, as the name implies, generally do not provide for pretax employee contributions or immediate tax benefits for employers that make contributions; further, assets held in non-qualified plans often are subject to a firm’s creditors. Finally, private tax-advantaged plans may be available to some individuals. Examples include traditional individual retirement arrangements (IRAs) and Roth IRAs. While private plans generally provide tax advantages, the contribution limits and deferral opportunities tend to be limited. Financial planners should have a working knowledge of the funding characteristics and attribute features associated with common types of retirement plan vehicles used in the United States. While the dollar amounts change on a yearly basis, familiarity with the following eight plan characteristics is generally considered a minimal competency: 1. Maximum elective deferral limits.

2. Maximum annual addition limits. 3. Compensation limits for contributions. 4. Employer contribution requirements. 5. Use of plan forfeitures. 6. Availability of in-service withdrawals. 7. Vesting requirements. 8. Catch-up contribution provision limits.

IN CLASS Category Class Activity Applying: Carrying out or Illustrate plan similarities and using a procedure through differences via a plan chart.** executing or implementing

Student Assessment Avenue Assign students to explain, either orally or through a written assignment, the fundamental differences between qualified and nonqualified plans and defined benefit and defined contribution plans. They should specifically apply federal funding characteristic rules during their presentations.** Have students prepare a question for the guest lecturer before class.* Assign students to write a 5- to 10-page reaction paper to the business owner’s retirement plan needs.*

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Invite a small business owner to class. Prior to class, students should develop a set of questions to ask as a means for recommending a retirement plan that meets the business owner’s needs.*

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Develop a trivia-style retirement Assign students to read one or plan game; split students into more mini-case retirement teams and have them match plans plan narratives. with specific plan characteristics.* Ask students to recommend appropriate retirement plans that can be used to solve the

case issue(s).** Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

In class, visit the Department of Labor website to view Form 5500 —Annual Return/Report of Employee Plan(www.dol.gov/ebsa/pdf/20115500.pdf).

Assign students to develop a retirement plan for a small business interested in employee retention and maximization of owner retirement benefits. This, or a similar case, can be used to Use the form as a guide to developing a hypothetical plan for assess a student’s ability to a small business that is interested synthesize retirement plan data to match a client’s goals and in implementing a retirement objectives.** plan.**

*Appropriate for on-campus course. **Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify and differentiate between and among qualified and non-qualified plans and defined benefit and defined contribution plans. Further, an entry-level personal financial planner can identify plans used by for-profit, non-profit, and governmental organizations. Competent: A competent personal financial planner exhibits mastery of contribution limits, income restrictions, participation rules, catch-up provisions, and other technical details associated with the primary types of retirement plans. A competent personal financial planner can also match a retirement plan to both a consumer’s and a business owner’s financial needs and objectives. Expert: An expert personal financial planner can easily conceptualize and communicate aspects of a retirement plan for a business owner using a combination of qualified and nonqualified alternatives.

IN PRACTICE Small Business Owner There are two main reasons why retirement plans have developed over time. Some plans have been created in direct response to changes in legislative priorities (e.g., encouraging employers to offer tax-advantaged employee benefits) and/or shifts in the marketplace (e.g., large firms phasing out defined benefit plans). Other retirement plans have come into existence as a way to help business owners shelter income and increase their personal future asset and

income situation. Retirement plan descriptions, rules, and applications are typically introduced from a consumer point of view. That is, retirement plans are presented in the context of helping consumers save for retirement. This is certainly appropriate and helpful. Retirement plans, particularly qualified defined contribution plans, are among the few tax-advantaged tools available to help consumers proactively save for retirement income needs. However, it is sometimes more important to view such plans from an employer and governmental perspective. Imagine a small business owner in a college town. This person owns a restaurant and two bars. Her employees tend to be young and transient. As a business owner, it is reasonable to assume that she did not enter into these risky ventures with the intention to create jobs, provide employee benefits, or help employees save for retirement. Instead, she likely opened these businesses as a way to improve her household’s financial situation. If, in the pursuit of this activity, she also helps her employees achieve some degree of financial stability, this is, in her opinion, a positive outcome. It is not uncommon for this type of business owner to view her employees and conclude that their hourly wage is sufficient compensation. If left unfettered she would likely establish a retirement plan that maximizes her own current income tax deduction while ensuring maximum retirement income because she has no need to retain employees. Whether or not her employees participate would be inconsequential, and, in fact, employee participation could be deemed to hamper her personal goals by diverting resources away from her own pension maximization. While this thinking may be in line with a business owner’s goals, the outcomes associated with such self-interested benefit decisions have a wider economic impact. In this example, the employees would be forced to save for retirement using only after-tax savings vehicles or some form of tax-deductible individual retirement account. This is the primary reason so many different retirement plans exist. Many business owners, acting in their own interest, would readily discriminate against employees when allocating retirement benefit contributions. Today, this type of discrimination is only allowed through the use of non-qualified retirement plans. However, in order to enjoy the greatest level of current and future income tax benefit, laws have been enacted to encourage business owners to allow employees to participate in benefit decisions. The use of qualified plans not only benefits business owners, these plans help employees, and as a result, improve employee morale, retention, and satisfaction.

Kristy’s Client Kristy is a financial planner with a diverse clientele. Because she lives in a college town, she needs to have a working knowledge of many types of retirement plan alternatives. For example, she has been working with a 50-year-old client who is employed at a local university. Based on her knowledge of retirement plan rules and limitations, she was able to help her client save, on a pretax basis, $48,000 per year, which far exceeds the typical defined contribution limit. Here is how she did it: Under current rules, employees of colleges and universities and select other organizations may contribute fully to both a 403(b) plan and a 457 plan, assuming that both are provided by the employer. In 2015, this means that Kristy’s client was able to contribute $18,000 plus a $6,000 catch-up contribution to both a 403(b) plan and a 457 plan, for a maximum contribution of $48,000.

NOTES 1. Ryan G. Murphy, “The History of Retirement: 400 Years of Seeking Financial Security,” Investment Advisor (April 2006). Retrieved from www.advisorone.com/2006/04/01/thehistory-of-retirement. 2. P. W. Seburn, “Evolution of Employer-Provided Defined Benefit Pensions,” Monthly Labor Review 114, no. 12 (1991): 16–23. 3. Employee Benefit Research Institute, “History of 401(k) Plans: An Update,” Facts from EBRI (February 2005). Available online: www.ebri.org/pdf/publications/facts/0205fact.a.pdf. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 54 Qualied Plan Rules and Options Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

A large and important component of an individual’s employment compensation is the retirement plan benefit offered by an employer. Although an employer’s contribution to a retirement plan is not available for current consumption, it will produce an income stream at retirement. This transfer of income from the current earnings period to a later period is a fundamental retirement planning event and allows clients to even out their cash flows over time. One must

understand, however, the effect retirement benefits have on income taxes, now and in the future.

INTRODUCTION Employers use retirement plans as one component of a compensation package to attract and retain good employees. Because of the principle of compounding, retirement plans allow employers to lower their cost of labor while enhancing the income of their employees. A basic concept in income tax theory is that income is taxed during the period in which it is earned. In other words, if one earns a dollar today, one pays taxes on a dollar today. Tax theory also includes a matching concept—if income is taxed to one person, then the cost of providing the income is deductible to the payer in the same time period. Qualified pension plan rules, however, violate both these concepts. Why? Because the government hopes that encouraging the accumulation of retirement plan assets will reduce poverty or government dependence during retirement. An employer pension plan that meets the rules and requirements of two sets of law, the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA), is allowed special tax consideration. A plan that meets these rules is said to be “qualified” and the special IRC regulations apply. Employers’ contributions to qualified plans are not taxable to employees in the year in which the contributions were earned. However, the employer is allowed to take the value of contributions to a qualified plan as a business deduction on its tax return during the year in which the contributions were made or accrued. There are several basic ERISA rules that every financial planner should know. They address issues of eligibility, funding, coverage, vesting, and termination. Because the rules are detailed and complex, it’s important for financial planners to consult with qualified pension experts before designing or implementing a plan for a client. However, a basic understanding of the rules will permit a planner to assist clients in understanding their pension plan coverage, rights, and choices. An employer must fund its pension plan on an annual basis. Defined benefit plans require an actuarial assessment of the funding requirements. Unfunded plans may be assessed a penalty and are usually given a period of time during which the plan must be fully funded or it can lose its qualified status. Qualified plans cannot allow for in-service withdrawals (withdrawals from active employees). There is one exception to this rule. Employees over age 62 may continue to work for the employer on a part-time basis and still access plan benefits. Such phaseout plans allow employers to encourage the retirement of older employees who might otherwise continue working because they do not have access to full Social Security benefits or other income at their ages. Qualified plans must also limit the amount of life insurance and company stock held by the

plan. ERISA rules require certain employees to be included in a plan in order for it to be qualified. Generally, an employee over the age of 21 who works more than 1,000 hours per year and who has been employed by the company for at least one year may be a plan participant. Most companies desire to increase the long-term compensation of their leaders (executives and highly paid individuals) while minimizing the cost of their rank-and-file employees. And small business owners would like to take income out of the business in a way other than direct salaries. To minimize the possible discrimination against lower-paid, less skilled employees, ERISA uses non-discrimination rules. There are two methods by which this goal is accomplished. First, a plan is not allowed to have too many highly compensated individuals relative to the total number of plan-eligible participants. Second, the ratio of the plan benefits accruing to key employees (owners and management) compared to the entire benefits accruing to all employees in a plan must also be kept below a predetermined level. The benefit that a defined benefit plan can pay to a retiree is limited. The maximum benefit is predetermined and increases automatically with inflation. The amount of money that can be contributed to a defined contribution plan is also limited, and the limit amount is also predetermined and increases each year with inflation. All qualified pension plans, regardless of type, must give employees legal rights to their benefits according to certain schedules. This process is called vesting. Defined benefit plans and defined contribution plans have different vesting schedules. No vesting schedule permits an employee to have less than 100 percent ownership after seven years, and an employee’s own contributions to the plan are always 100 percent vested. Qualified pension plans may be terminated for a variety of reasons. Many employers choose to terminate a plan when it becomes too costly or too complex to administer. Plans may be terminated, but any rights and benefits accumulated before the date of termination must be guaranteed. Because a qualified pension plan is a right to future income or assets that have been earned in the past, it is imperative that those rights be protected. Employers or plan administrations have a fiduciary responsibility to manage the plan assets prudently. A fiduciary responsibility is one that requires the administrator to act in the best interests of the plan participants. Employers and employees gain great economic benefit from qualified pension plans. Qualified plans allow employers to attract and retain employees. They provide economic benefits to employees on a long-term basis. Because the plans are allowed tax advantages, laws are in place to protect the plan assets and beneficiaries.

LEARNING OBJECTIVES The student will be able to: a. Explain the tax implications of qualified plans to the employer and employee.

b. Explain the rules of qualified retirement plans including eligibility, coverage and discrimination, funding and contribution, distribution, vesting, and termination of plans. c. Explain the fiduciary responsibilities of employers with respect to the investments in their firm’s qualified plan under ERISA.

IN CLASS

Category

Class Activity

Applying: Carrying out or using a Review the procedure through executing or requirements of implementing qualified plans, including participation, vesting, and nondiscrimination rules.

Student Assessment Avenue Ask the student to determine if a client is eligible to participate in a qualified plan at her place of employment.

Using a W-2 form, ask the student to communicate to a client how much less income is taxable because a Using an example of qualified plan is in place. qualified and nonqualified plan contributions, illustrate the economic benefit to tax-advantaged saving.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Define highly compensated and key employee status. Discuss why this information is important.

Using a client/business owner’s company information, ask students to build a chart listing all employees; their ownership, management, and salary status; and maximum benefits or contributions allowed by law.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Demonstrate the calculations to determine if a plan is discriminatory.

Ask students to assist a business owner client in determining if his or her plan violates discrimination rules.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Working backward from a target contribution amount, illustrate how to set up a plan so that it is non-discriminatory.

Given information about a discriminatory plan, ask students to make changes in participation, benefits, and calculations that will bring the plan into compliance.

Using the chart, ask students to determine which employees are highly compensated or considered key employees.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain how qualified defined benefit and defined contribution plans work. The entry-level planner can advise the client on the current cost and tax benefits of saving through such plans. The entry-level planner can complete the plan application, investment form, and other management forms on behalf of the employee client. Competent: A competent personal financial planner can assist the client in determining how plan benefits coordinate with other income streams at retirement. In addition, the planner can analyze and recommend to the client the best use of qualified pension plan assets, including benefit, withdrawal, and assignment of benefits at death choices. Expert: An expert personal financial planner can coordinate plan selection and administration for a business owner with a professional pension plan provider/administrator. The expert planner will also be able to incorporate a client’s pension plan benefits into an employer or employee client’s complete financial plan.

IN PRACTICE JP and Max JP and Max have owned a farm equipment repair business for five years. They have 52 employees in four locations, and 36 of the employees have been with the firm less than two years. The owners would like to know if and when they must include the employees in the qualified defined benefit and defined contribution plans. There are several considerations in responding to their inquiry. First, the rules for defined benefit and defined contribution plans vary. Second, while those who have been with the firm for over one year must be included if over age 21 and working more than 1,000 hours each year, the owners may structure the vesting requirements to delay their rights to plan assets. Using longer vesting periods protects the owners if the employees leave after a short tenure, and provides an incentive for employees to remain with the company.

Emma Emma works for a large multinational company and makes $45,000 annually. The company puts 10 percent of her salary in a defined contribution 401(k) plan on her behalf. In addition, she may contribute up to $16,500 a year. The company will also match her voluntary contributions, up to 3 percent of her salary. Emma understands that her contributions are not taxed this year. She is confused, however, about whether the company’s 10 percent contribution is taxable each year. Her financial planner correctly tells her that the $4,500 company contribution is not taxable. He encourages her to “take the match,” noting that the additional $1,350 company contribution would also escape current taxes and would be taxed only when withdrawn.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 55 Other Tax-Advantaged Plans Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

Tax-advantaged retirement plans play a key role in the financial stability of aging individuals. The distribution rules allow tax-advantaged retirement plans to serve as a unique estateplanning tool. Contribution and distribution rules force a financial planner to consider the income tax implications of saving and withdrawing funds to meet retirement needs. Taxadvantaged plans may also be used to meet long-term estate planning distribution goals.

INTRODUCTION Since their introduction in 1974, individual retirement arrangements (IRAs) have played a pivotal role in the accumulation of assets for retirement. By the end of the third quarter of 2014, aggregate IRA assets stood at $7.3 trillion.1 A traditional IRA offers a worker or spouse of a worker a vehicle for retirement savings that enjoys tax benefits. Contributions to an IRA are tax deductible. The earnings on account assets (interest, dividends, capital gains) grow tax deferred. Contributions are limited, and the contribution limits are increased from time to time. A nonworking or underemployed spouse may contribute the same amount as a working spouse provided the couple’s total income is equal to or greater than the total contributions of the spouses. Added forms of IRAs make it more beneficial for self-employed individuals, employees of self-employed individuals, and spouses of workers to save for retirement. These forms include the simplified employee pension (SEP) and the savings incentive match plan for employees (SIMPLE). The contribution limits are greater for these plans than for traditional and Roth IRAs. The SIMPLE plan requires the employer to match a part of a contributing worker’s contribution. Only workers in the qualifying situation may contribute to these forms of IRAs. The Internal Revenue Code also permits qualified pension plan account owners to roll over the balances in these plans to IRAs. Roll-over account balances continue to enjoy tax-deferred growth and gain one important advantage over qualified plan assets. While IRA assets are subject to division upon divorce, they are not subject to court judgments, including bankruptcy. Rollover accounts accept assets in any form from other qualified and tax-advantaged plans. No tax or early withdrawal penalty (see later discussion) is due if the rollover was direct—from one account trustee to another. An account owner who withdraws cash and then attempts to contribute the funds to a rollover account would need to make up the 20 percent income tax withholding in order to avoid taxes and penalties on the rollover. While each IRA is subject to varying contribution limits, all IRA assets are unavailable for withdrawal until the account holder reaches age 59½. Because IRA assets were tax deferred upon contribution and growth, all withdrawals are subject to ordinary income tax rates. Early withdrawals are subject to a 10 percent excise tax penalty. Roth IRAs differ from the other IRAs in several important ways. First, contributions to the accounts are not tax deductible in the year of contributions. Second, all qualified withdrawals from Roth IRAs, and withdrawals of principal only, are non-taxable. In effect, this makes the earnings growth on Roth IRAs tax free, not simply tax deferred. Last, account balances are not subject to required minimum distribution (RMD) rules. This allows account balances to continue to grow past age 70½ for those who do not need the cash flow from account distributions to fund retirement needs. Clients may have a variety of tax-advantaged retirement plans that meet their needs, including

qualified employer pension plans and IRAs. It’s important that clients consider the difference between current income tax rates and expected future tax rates, their retirement savings needs, and funds available for saving. The legal advantages of using IRAs over qualified employer pension savings and the desire to continue to extend tax deferral past age 70½ should be assessed.

LEARNING OBJECTIVES The student will be able to: a. Differentiate between the various types of Individual Retirement Arrangements (IRAs) including traditional, rollover, Roth, SEP, and SIMPLE plans, including the tax treatment of contributions and distributions. b. Recommend an appropriate IRA for a client’s needs.

IN CLASS

Category

Class Activity

Applying: Carrying out or using In-class discussion a procedure through executing reviewing the or implementing contribution limits of IRAs, Roth IRAs, SEPs, and SIMPLE plans.

Student Assessment Avenue Provided basic information, students determine if an employer client is meeting the funding requirements of the SEP or SIMPLE he or she is using.

Instructor discusses and Review a client’s tax return for illustrates the SEP and compliance with contribution and SIMPLE model plan withdrawal rules. documents offered by plan trustees and preapproved by the IRS. Students are asked to build a chart comparing retirement savings options to use in explaining to clients how much they may contribute and the estimated annuity-type withdrawal amounts at retirement. Evaluating: Making judgments In-class or online Assist a business owner client in based on criteria and standards discussion of the criteria analyzing the appropriateness of through checking and critiquing to be used in evaluating using a SEP or a SIMPLE. the appropriateness of a plan for a client’s situation. Creating: Putting elements Instructor uses a decision Given a client’s retirement together to form a coherent or tree to assist students in savings budget, tax rates, and functional whole; reorganizing understanding the retirement savings needs, students elements into a new pattern or advantages and are asked to make a plan for structure through generating, disadvantages of each qualified and tax-advantaged plan planning, or producing plan and in creating a savings. retirement savings plan. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Instructor leads discussion calculating the net savings available for retirement using a traditional IRA and a Roth IRA.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner can explain how unqualified tax-advantaged plans differ from qualified employer pensions. The financial planner should also know the contribution limits and situations that give rise to early, normal, or late withdrawals from IRA assets. The planner should be able to complete the IRA application forms on behalf of the

client. Competent: A competent personal financial planner can assist clients in determining if they qualify for a deduction using a tax-advantaged plan, completing rollover transactions, and designing a basic withdrawal plan for IRA assets. Expert: An expert personal financial planner can design a plan for a business owner client, including communicating with other professionals to implement the plan. The expert planner will be able to design a comprehensive retirement savings plan using all available taxadvantaged plans to maximize savings, minimize tax liability, and meet retirement cash flow and estate planning needs.

IN PRACTICE Richard and Tammy Richard and Tammy have been married for 21 years. They own a small business with 23 employees. The business cannot afford a qualified defined benefit pension plan. However, employee retention is important. Richard and Tammy want to maximize their contribution to a plan and offer a plan that is easy to administer. A SEP or SIMPLE using the IRS’s model documents would be the simplest plan that would meet their needs. A financial planner can determine which of the two maximizes the owners’ contributions while still providing a retention-building incentive for employees.

Rachel Rachel is a 39-year-old artist employed by a small graphic arts firm and earning $47,500 each year. The firm does not offer a qualified benefit plan. She is deciding whether to save for retirement using a traditional IRA or a Roth IRA. Her planner initially thinks of recommending a traditional IRA because Rachel’s tax rate may be the same or lower at retirement. However, Rachel informs the planner that she is the only grandchild and heir of a rich grandfather (worth about $2.4 million). Because her financial planner now expects her to have significant cash flow and taxable income at retirement, she recommends that Rachel use a Roth IRA for her retirement savings funds.

NOTE 1. www.ici.org/research/stats/retirement/ret_14_q3, accessed February 6, 2015. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 56 Regulatory Considerations Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

INTRODUCTION Various government regulations and agencies require pension plan sponsors (employers) to protect workers’ retirement plan assets. Unfunded or underfunded pension plans place a large

risk on the long-term financial stability and security of their participants. A bankrupt fund will require a plan participant to significantly alter his or her cash flow plans leading up to and during retirement. Employers use retirement plans as one component of a compensation package to attract and retain good employees. Workers have come to rely on corporate plans to significantly increase their retirement income. One law and two government agencies are the primary sources of protection for these plans. The law that governs qualified pension plans is the Employee Retirement Income Security Act of 1974 (ERISA). The Department of Labor is responsible for regulating pension plans using the provisions of ERISA. In addition, a quasi-government agency, the Pension Benefit Guaranty Corporation (PBGC), provides insurance protection of plan assets. There are several basic ERISA rules that every financial planner should know. They address issues of eligibility, funding, coverage, vesting, and termination. Because the rules are detailed and complex, it is important for financial planners to consult with qualified pension experts before designing or implementing a plan for a client. However, a basic understanding of the rules will permit a planner to assist clients in understanding their pension plan coverage, rights, and choices. The Pension Benefit Guaranty Corporation is a quasi-government insurance agency. Pension plans pay annual premiums based on the number of plan participants and amount of unfunded liabilities. Should a qualified defined benefit plan suffer economic losses and not be able to pay benefits, the PBGC will provide funds. Plan participants who have a valid claim against a pension for lack of funding will receive a benefit directly from the PBGC. Of course, the plan participant will receive only a portion of the expected benefit. And the PBGC has a limit on the monthly benefit it will pay. Defined contribution plan assets are also regulated by ERISA. However, they do not enjoy PBGC insurance protection. Unlike non-qualified tax-advantaged retirement plans (e.g., individual retirement accounts [IRAs]), they enjoy protection from creditor claims and courtordered judgments.

LEARNING OBJECTIVE The student will be able to: a. Describe the plan protections provided by ERISA, the PBGC, Department of Labor policies, and other applicable regulations.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Review the basic protection provisions of ERISA and apply them to a hypothetical defined benefit plan and defined contribution corporate plan.

Match the provisions of ERISA and PBGC with a relevant list of provision descriptions.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Study a corporation’s summary plan description and identify explanations that directly relate to ERISA provisions.

Calculate the PBGC premium due from a small corporate plan.

Discuss a small business owner’s risk management strategy and the benefits of shifting assets to qualified retirement plans that benefit from creditor claim protection as a way to mitigate risk.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the basic protections provided by ERISA and the PBGC. Competent: A competent personal financial planner can calculate the PBGC premium for a corporate plan and determine the legal rights of a plan participant given vesting rights. The competent financial planner can also file a claim to the PBGC on behalf of a client. Expert: An expert personal financial planner can assist clients in ensuring that their business plans are in compliance with ERISA and PBGC regulations.

IN PRACTICE Jim Jim Sutton served his company as an engineer for 34 years. He recently retired, expecting to receive $2,300 per month in pension benefits. What a shock it was to learn that his employer’s plan was bankrupt and not able to pay benefits. Jim can claim a benefit from the Pension Benefit Guaranty Corporation. Because benefits will be determined based on a client’s

specific fact pattern, however, Jim will probably not receive 100 percent of expected benefits.

Georgeann Georgeann Doerkson is considering a career change. She has been a graphic artist for an advertising agency for three years. Her employer provides a defined contribution plan as part of her compensation package. Georgeann visits her financial planner to determine how she should handle her pension plan asset—should she roll the account to an IRA or leave it with her employer? Her financial planner has bad news to deliver. The plan uses a six-year vesting program. This means that Georgeann has a legal right to keep only 40 percent of her plan asset. Of course, any of Georgeann’s voluntary contributions to the plan would be immediately vested. In addition, non-qualified tax-advantaged retirement plans (e.g., IRAs) do not enjoy protection from creditors and court-ordered judgments. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 57 Key Factors Affecting Plan Selection for Businesses Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

Retirement plans play an important role in the operations of a business. First, they serve as a piece of the total compensation package for employees and owners. Second, tax law allows deferral of income taxation on these benefits, which allows owners to maximize cash flow over a period of time beyond the earnings years. Finally, because retirement benefits may be passed to heirs using special rules, an understanding of the integration of retirement benefits

with other assets is critical.

INTRODUCTION Retirement plans are a key component of any business’s total compensation package. The purpose of a good benefit program is not only to attract and retain qualified employees, but to also maximize the return on the owners’ investment and work efforts in the business. An owner’s needs may include income shifting, income and estate tax minimization, and estate plan management. Selecting the appropriate retirement plan can fulfill many of a business owner’s financial planning needs. Retirement plan benefits can be an expensive component of a business’s operations. The amount of cash available for funding benefits will be of great importance to owners. The cost of a plan includes not only the contributions that must be made on behalf of employees, but also the cost of administration, including preparing and filing annual reports with the Internal Revenue Service. Administrative costs include contribution and withdrawal or benefit accounting as well as investment management fees. Owners will also be interested in maximizing their personal benefits while complying with non-discrimination rules. If the plan favors the highly compensated or key employees, the plan may lose its qualified status and the accompanying tax benefits. Flexibility of contributions may be important to owners of businesses with uneven cash flow or those operating in industries with short business cycles. In addition to the costs of the plan, most plans are required to be administered in compliance with complicated federal laws. Owners will want to consider whether the company has qualified staff members to manage the plans or if it has access to external pension plan management specialists. Business owners may choose between qualified plans (defined contribution and defined benefit plans) and non-qualified plans that provide tax benefits as well (SIMPLEs, SEPs, and individual retirement arrangements [IRAs]). Non-qualified plans will offer lower administration costs and may be easier to manage, but often include reduced funding levels as well. Owners with cash available for plan funding who wish to maximize benefits to key employees while still maintaining compliance should consider a qualified defined benefit plan. Companies that need flexibility in funding but wish to fund a plan at a higher level might use qualified defined contribution plans. Employers desiring simplicity of administration or low funding levels will be most interested in the non-qualified plans such as SIMPLEs, SEPs, or payroll deduction IRAs.

LEARNING OBJECTIVES

The student will be able to: a. Identify the factors that will affect the selection of a retirement plan for a business. b. Recommend a qualified or non-qualified retirement plan given a business owner’s goals and objectives.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Class Activity Review a decision tree discussing each plan and why it sits where it does on the tree.

Student Assessment Avenue Give students a list of plan attributes and owner objectives. Ask them to match components of each list with components of the other. Discuss owners’ objectives and Provide the students with a list how the factors interact. Include of employees, their salaries, funding levels, administration and their job titles. Ask them to requirements, and return to calculate the funding required owners versus employees. using one of three plan options.

Review three companies’ plans and discuss what the objectives of the company might have been when designing the plan. Examine the invoice for administering the plan or create a to-do list for plan administration. Creating: Putting elements Design a spreadsheet for together to form a coherent calculating funding and benefit or functional whole; levels for different plan types reorganizing elements into a and employee profiles. new pattern or structure through generating, planning, or producing

Ask the students to determine if a company’s current plan meets the owners’ objectives. Ask students to write their analysis in 300 words or less. Have them record their analysis and explanation to the clients. Ask students to create a funding plan, given a particular plan and employee profile. Include estimated benefits to each employee upon retirement.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the basic components of

the various qualified and non-qualified pension plans available to a business owner. The entrylevel planner can identify an owner’s objectives and propose two alternatives that would meet those objectives. Competent: A competent personal financial planner can calculate the costs and benefits of using alternative plans and can provide a solid recommendation for which plan best meets owners’ objectives. Last, the competent planner can assist the owners in identifying and obtaining external plan administrative services. Expert: An expert personal financial planner can assist clients in ensuring compliance of plans with IRS and Department of Labor regulations. An expert financial planner can plan for and help clients understand how the plan under consideration affects their current and future cash flows as well as the estate planning outcomes of using a particular pension plan.

IN PRACTICE Eugene and Edmund Eugene and Edmund are a father-son corporate ownership team. Eugene is 40 and Edmund is 72 years old. Their company has been very successful in a stable business environment. Cash flows are great and steady. They would like to consider a plan that maximizes their personal benefits even if the regulations on such a plan are greater than those required of other choices. Most of their employees are lower-wage factory workers. While they have some employees aged 19 to 27, over 60 percent of their employees are over age 35. A defined benefit plan, while the most costly, may allow Eugene and Edmund to meet their goals. Such a plan will be a bit more expensive for them because their employee profile is older, requiring larger funding contributions, but it will provide them with the greatest personal benefit. In addition, the administrative and insurance costs for this type of plan are greater.

Charlita Charlita Thompson owns a small but successful online hat retail business. She has three employees. The hat business is variable depending upon the level of consumers’ discretionary income. She would like to implement a plan that allows for flexible funding at lower levels (say, 3 to 5 percent of earnings). Charlita should probably consider an SEP or SIMPLE plan, as administrative costs and funding requirements are lower. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 58 Distribution Rules and Taxation Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

The financial planner must be aware of distribution rules and tax consequences associated with various types of investments and accounts. While this issue predominantly pertains to retirement planning, one must be aware of the rules for other content areas as well. Education planning is one of these areas, as there are specific requirements, discussed elsewhere in this book, that pertain to education savings accounts such as the 529 plan or Coverdell. The rules

associated with both required and elective distributions from qualified retirement accounts have ramifications not only for the client’s tax bill, but for the retirement income plan as a whole. Finally, the impact that distribution rules and taxes have on legacy planning must not be ignored as a proper strategy can preserve wealth between generations.

INTRODUCTION Social Security benefits provide a base income for nearly all retired U.S. workers. The program was not designed to provide a majority, much less all, of a retiree’s income. To provide workers the opportunity to maintain their standard of living into retirement, the U.S. Internal Revenue Code (IRC) and Department of Labor regulations allow employers and workers to defer some of a worker’s income from working years to retirement years. Thus, workers can substantially increase their retirement income by utilizing an employer’s retirement plan in addition to relying on Social Security benefits. Employers may offer a variety of pension plans as an employee benefit. Historically, many of these were classified as defined benefit plans (the benefit formula was predetermined) and employees did not contribute directly to saving for these benefits. Defined benefit plans are expensive, however, and the number of employers offering defined benefit retirement plans has decreased during the past decade. As the number of employers offering defined benefit plans has decreased, the number of employers offering a defined contribution plan has increased. The benefit from a defined contribution plan is dependent upon the amount contributed (a formula determined by the employer) and investment returns on the contributions. Theoretically, the balance at retirement can be less than the value of the contributions if there are poor investment returns. In addition, many defined contribution plans accept voluntary contributions of deferred income by employees. The advantage of both defined benefit and defined contribution plans is the tax deferral of contributions to the plan. An employer receives an immediate business expense deduction for the value of contributions to a retirement plan. The employee, in turn, does not pay income tax on the employer’s contribution when the funds are contributed. The employee also avoids income taxes on the income that he or she voluntarily defers into a defined contribution plan during the year of contribution. Tax deferral does not mean tax exemption, however. The tax on contributions and investment earnings must be paid at the time of withdrawal (typically at retirement). Withdrawals are taxed at the taxpayer’s ordinary income tax rate in effect during the year of withdrawal. Because pension plan contributions and earnings receive preferential tax treatment, the Internal Revenue Code places some rules on the distribution of funds from qualified pension plans. Withdrawals made prior to a taxpayer reaching age 59½ are considered to be early withdrawals and are assessed a 10 percent excise tax penalty. These retirement plan assets can represent a substantial sum of money and a large percentage of the client’s overall wealth. Thus, understanding the rules associated with distributions from these accounts and the

methods available to minimize the taxation of these distributions can significantly influence whether clients attain their retirement goals. There are several exceptions to the early withdrawal penalty. Individuals who are divorcing may transfer pension funds between spouses via a qualified domestic relations order without incurring a penalty. Pension assets that are withdrawn because the owner died or became disabled are not subject to the 10 percent penalty. Taxpayers who retire early and agree to take withdrawals according to substantially equal periodic payment (SEPP) rules will not pay a penalty on the early withdrawal. Workers who are separated from service with their employer and over age 55 who receive distributions from their former employer’s qualified retirement plan will also avoid the penalty. For public safety employees separated from service, the age drops to 50 when distributions can be made penalty-free. Finally, withdrawals taken to pay medical expenses that exceed 10 percent of adjusted gross income (7.5 percent for taxpayers 65 and older, until 2017) are not charged the penalty. Taxpayers must begin taking distributions from pension plan assets by age 70½ according to a schedule set by the Internal Revenue Service (IRS). Required minimum distribution (RMD) amounts are based on the value of fund assets at the end of the prior year and a taxpayer’s age during the tax year. If less than the RMD amount is taken, a 50 percent excise tax penalty is assessed on the deficient amount. Workers who are older than age 70½ and own less than 5 percent of their employing company are allowed to delay withdrawals. Not all workers participate in employer plans. Some are self-employed or work for small businesses or self-employed business owners. Other workers simply choose to save for retirement in non-qualified plans. Several plans categorized as non-qualified act the same as qualified employer plans. These include individual retirement arrangements (IRAs), simplified employee pensions (SEPs), and savings incentive match plans for employees (SIMPLEs). The contribution limits on the non-qualified plans are different from the employer qualified plans, but there are many similarities in the distribution rules. In 1997, legislation was passed creating a new version of IRAs called Roth IRAs. The Roth provisions simply allow savers to contribute after-tax dollars into a Roth IRA and receive the earnings on the contributions tax-free at withdrawal. In addition, there is no required minimum distribution at age 70½. Of course, Roth provisions offer a great incentive to taxpayers who expect to be in higher tax brackets at retirement than during their working years. These plans are very advantageous to those who are many years away from withdrawing the savings, as the rule allows for tax-free growth in the plan assets. Roth provisions are now also available on 401(k) plans—a specific type of employer qualified defined contribution plan. With the advent of Roth provisions for certain plans, some taxpayers may find it beneficial to convert traditional qualified and non-qualified plan assets to Roth plans. The IRS does allow for assets to be transferred and converted from one type of plan to another. However, any assets that have not yet been taxed, such as assets in traditional IRAs and 401(k) plans, are

assessed a tax during the year of conversion at the taxpayer’s ordinary income tax rates. When the assets are taxed and converted to a Roth IRA plan, there is no penalty for early withdrawal of the converted funds (as technically they are only transferred, not withdrawn). Most retirees withdraw plan assets over a period of years—either on a periodic basis or in lump sums as they need cash for expenses. A few choose to withdraw 100 percent of their employer qualified pension, profit sharing, or stock bonus plan during one tax year—referred to as a lump-sum withdrawal. Taxpayers born before 1936 enjoy the option of paying a 20 percent capital gains tax on pre-1974 contributions and earnings. The remainder of the lumpsum distribution, or the entire distribution if nothing is taxed at the 20 percent capital gains rate, may be taxed at an average effective tax rate based on marginal tax rates in effect in 1986. Company stock is often included as one of the investment options in a voluntary deferral plan. Employees who hold employer company stock in a qualified employer retirement plan may choose to take a lump-sum distribution and pay a capital gains tax on any appreciation since the time of contribution in the employer stock when it is distributed from the plan, instead of the ordinary income tax rates that are normally assessed. To take advantage of this tax break, the employee must take a lump-sum withdrawal. The amount of the withdrawal that is attributed to capital gain on the company stock is taxed at current capital gains tax rates. The value of the remaining withdrawal is assessed a tax at ordinary income tax rates.

LEARNING OBJECTIVES The student will be able to: a. Explain the rules and penalties regarding retirement plan distributions. b. Describe the circumstances under which early distributions are allowed from taxadvantaged retirement plans without penalty including the Substantially Equal Periodic Payment and Qualified Domestic Relations Orders rules. c. Compare the taxation of normal distributions with Roth conversions, lump sums, and net unrealized appreciation withdrawals.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Show the students an example of an account with highly appreciated company stock in it. Ask the students to calculate the tax savings using the net unrealized appreciation (NUA) rule.

Provide the students with a client’s defined contribution pension plan statement. Ask them to calculate the income taxes due (1) if the client is withdrawing funds early, (2) if the client is over age 59½ and taking a lump-sum distribution, (3) if the client is rolling the entire account over to an IRA, (4) if the client is withdrawing the funds over a 15year period after age 59½, (5) if the client is converting the funds to a Roth IRA, and (6) during the first year of a required minimum distribution.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Review the retirement plans component of a client’s balance sheet, including the proportion of retirement plan values to total assets and net worth.

Students prepare a chart of all retirement plans, showing amount of fixed benefits or withdrawal amounts if voluntarily annuitized, and when distributions may and must begin. Note any opportunities for special treatments.

Discuss the impact of withdrawal selection on current and future income taxes, cash flow needs, and estate plans. Ask students to write brief explanations of Roth conversions and read these to the class. Students should critique the explanations for clarity and correctness.

Ask students to compare the cash flow for a client if she takes a lump-sum distribution from her retirement plans and then annuitizes the funds for her life expectancy or annuitizes her plan assets and makes periodic withdrawals of this amount from a qualified plan during her retirement.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Ask students to prepare a plan for withdrawing retirement plan assets considering the client’s cash flow needs and other income streams.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can classify a client’s pension plan holdings (qualified, non-qualified, other), and knows the rules regarding distribution of plan assets. Competent: A competent personal financial planner can identify opportunities for special tax treatment of plans, evaluate the client’s ability to meet exceptions to the early distribution penalty, calculate tax liabilities on withdrawals (including penalties), and calculate the required minimum distribution. Expert: An expert personal financial planner can calculate the taxes due on Roth conversions, net unrealized appreciation withdrawals, and substantially equal periodic payments. The planner can also make a withdrawal plan considering all retirement plan assets, and investment and estate planning needs.

IN PRACTICE LaTasha LaTasha Johnson, a single 63-year-old, is leaving her position as senior vice president for the local electric company. She will receive a monthly pension for life equal to 74 percent of her salary (current salary is $208,000) beginning next year. Sixty percent of her 401(k) plan is held in company stock—over 40 percent of the value is capital appreciation. She asks her financial planner to evaluate her 401(k) withdrawal options. Assuming her pension and Social Security benefit equal 100 percent of her preretirement income and she has no need for additional cash flow, it would be appropriate to consider a Roth conversion of her 401(k) assets. A Roth IRA eliminates the need for her to make withdrawals when she reaches age 70½ under the required minimum distribution rules. However, because she is in a high tax bracket and all converted assets are taxed at ordinary income tax rates, she may wish to delay taking her Social Security benefits and her defined benefit plan benefits for a year. Another advantage of Roth IRAs is the ability of heirs of the account to withdraw funds over a long period of time. Alternatively, LaTasha would be eligible for the net unrealized appreciation (NUA) rules on the company stock held in her 401(k). Her tax savings from using the NUA rules would equal the amount of the distribution multiplied by the difference between her ordinary income tax rate and the capital gains tax rate in the year of the withdrawal. Having the stock directly distributed to a non-pension-plan account would also allow her to continue to hold the stock for future appreciation at capital gains tax rates. LaTasha would need to have cash available from other sources in order to pay the tax due on the withdrawal.

Charles Charles Thompson is only 54 but retired unexpectedly when his wife became seriously ill and

he needed to care for her. Funds are relatively tight; the Thompsons are barely making ends meet. However, he has a sizable 401(k) through his former employer (worth $150,000). To access the retirement funds without penalty, Charles may consider transferring the 401(k) to an IRA via a direct transfer (no tax or penalty due). He can then begin withdrawals without penalty under the substantially equal periodic payment rules. It’s important to note that he would be required to take a distribution from his IRA for six years because the rules require distributions until the client reaches age 59½ or five years, whichever is later. Choosing to withdraw under SEPP rules will limit Charles’s options, as he will only be allowed to take an amount equal to the SEPP. If he later chose to take a larger withdrawal, all previous withdrawals would incur a tax penalty for early withdrawal. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 59 Retirement Income and Distribution Strategies Dave Yeske, DBA, CFP® Golden Gate University Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Retirement income and distribution strategies may involve the use of insurance products, including immediate and deferred annuities (risk management and insurance planning), investment strategies designed to preserve purchasing power throughout the length of retirement (investment planning), and tradeoffs between retirement income security and legacy

goals (estate planning).

INTRODUCTION One of the most common client goals addressed by financial planners is planning for a comfortable retirement. In addressing this goal, the planner must account for two distinct phases: the saving phase (planning for the accumulation of adequate retirement capital) and the distribution phase (planning to sustainably meet client spending needs throughout retirement). The saving or accumulation phase encompasses, in turn, many different domains within financial planning, including decisions about how much to save relative to retirement and other goals, as well as where to save, how to invest those savings, and how to protect the earnings over the life cycle. These in turn require decisions related to general financial planning (time value of money calculations), tax and estate planning, investment planning, and risk management. All of these same domains come into play when planning for the distribution phase, where the planner must consider and plan for safe-withdrawal policies, integration with and timing of Social Security benefits (if applicable), annuitized income, tax implications, required minimum distributions, Roth conversions, beneficiary designations, and investment policies. Thus, in addition to being one of the most common goals addressed by planners, retirement planning is also one of the most all-encompassing.

LEARNING OBJECTIVES The student will be able to: a. Select suitable investments for both funding and retirement distribution purposes, considering the time horizon and risk tolerance of plan owners and beneficiaries. b. Construct well-diversified, tax-efficient portfolios that minimize retirement income risk. There is always a dynamic tension between choosing an investment mix that might reasonably be expected to hold the return potential required to meet a client’s retirement goals and one that is also consistent with the client’s apparent or measured risk tolerance. While this tension is managed through an ongoing planner–client dialogue that encompasses education, explanation, and the exploration of trade-offs, it also demands a deep understanding of the economy, financial markets, and the nature of investment risk. This, in turn, requires the planner to possess a mastery of the concepts of diversification and asset allocation, tax-efficiency, liability-matching, and the insights of behavioral finance. Diversification involves appropriately spreading investment risk across asset categories (e.g., domestic large value stocks), and within categories, while tax-efficiency may include the choice of asset location (e.g., an IRA versus a taxable account) as well as income tax treatment of returns (e.g., capital gains and dividends versus interest income). c. Explain the use of life insurance products in retirement plan portfolios.

Life insurance products are often used in retirement planning and may include everything from the purchase of life insurance inside a pension plan to the use of immediate and deferred annuities. And while it is important for a financial planner to understand the technical application of these products as dictated by the tax code and other regulations, the planner must also be able to make choices that take into account a client’s risk tolerance and legacy goals (e.g., the tradeoff between annuitizing retirement assets as opposed to managing them by means of a safe-withdrawal strategy).

IN CLASS Category

Activity

Student Assessment Avenue

Applying

Instructor lecture on diversification and time horizon as they relate to the accumulation and decumulation of retirement savings.

Students are given a limited list of investment choices, such as might be found in a typical 401(k) plan (and including target-date funds), and asked to recommend a mix from among the available choices that most satisfies the demands of diversification and the time horizon for two different plan participants: a 32-year-old and a 64-year-old.

Instructor lecture on the use of insurance company products in retirement planning, including the use of immediate and deferred annuities.

Students write an integrative paper discussing the different threads of research related to the choice between annuitizing some or all retirement assets versus managing them for sustainable withdrawals over the course of retirement.

Carrying out or using a procedure through executing or implementing

Analyzing Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Student-led discussion on the Making judgments different approaches that have based on criteria been proposed for safely managing portfolio withdrawals and standards through checking during retirement. The pros and cons of fixed versus dynamic and critiquing Evaluating

Students are given several client profiles and asked to assess which approach for managing retirement income would be most appropriate for each based on the client’s age, risk tolerance, family structure, and

assets relative to spending need. (policy or decision-rule-based) withdrawal strategies should be addressed, including the reasoning behind and evidence for each. Creating Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Classroom role-play with the instructor playing the role of client and students interviewing the instructor in order to uncover retirement goals, financial and family circumstances, risk tolerance, and risk perception.

Students take what they learned during the classroom role-play and develop and present client-focused recommendations that illustrate the tradeoffs between taking a lump-sum distribution versus annuity income. The factors that must be accounted for include: the client’s family structure, risk tolerance, and legacy goals.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: The entry-level financial planner understands and can explain the different settlement options available to pension plan participants, including lump-sum and annuity income. This planner can explain the further choices that go with an annuity income election, including life-only and the various joint and survivor options. The entry-level planner can also explain the basics of portfolio diversification, including asset allocation and the measurement of portfolio risk. Competent: In addition to the aforementioned, the competent personal financial planner understands and can apply the various approaches to managing safe withdrawals in retirement. Expert: The expert financial planner conceptualizes retirement income choices at the highest strategic level and can analyze and clearly explain the tradeoffs that may exist between different income strategies. This might include scenarios involving the tradeoff between attaining a high degree of certainty by annuitizing retirement assets and achieving the legacy goal of maximizing the assets left to children or grandchildren.

IN PRACTICE Rich Rich McFarland, a 64-year-old physician, has decided he would like to retire and has asked his financial planner, Jen Hicksen, for help analyzing some of the choices he is now facing. Among them is the decision to elect lifetime income (annuity option) from his pension plan or

to take a lump-sum distribution, which would be rolled into the IRA that Jen manages for him. In her initial analysis, Jen is able to show Rich that, based on her firm’s capital market assumptions and the safe-withdrawal-rate system they employ, it would appear that the lifetime income and lump-sum options are very similar in terms of the amount of retirement spending each would support over Rich’s lifetime. Jen points out, however, that there are other factors to consider, including Rich’s strong desire to leave the largest possible legacy to his son and daughter. The lifetime-income option requires Rich to irrevocably surrender the underlying retirement assets, putting it at odds with his desire to maximize his children’s inheritance. Ultimately, Rich decides to elect lifetime-income but this now raises a further question: Should he choose the life-only or a joint-and-survivor option that would ensure either 50 percent or 100 percent continuing income for his wife, Sally, should he predecease her? Jen tells Rich that she normally recommends the 100 percent joint-and-survivor option. Rich objects, pointing out that the guaranteed monthly income becomes ever smaller as he chooses options that provide larger survivor benefits to his wife. Jen notes that Rich has a life insurance policy which, if it were kept in force during retirement, could provide capital to partially or fully replace the lost income to Sally, depending on when/if Rich predeceased her. She goes on to calculate the various ages that Rich must attain for each strategy to provide the most income for their joint lifetime, assuming that Sally survives to age 100 in all instances and taking into account the cost of the life insurance. Jen produces a graphical comparison of these trade-offs to help Rich better understand the underlying dynamic and schedules a follow-up meeting for the following week to finalize a decision. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 60 Business Succession Planning John E. Grable, PhD, CFP® University of Georgia Joseph W. Goetz, PhD University of Georgia Kevin Valentino, MS University of Georgia

CONNECTIONS DIAGRAM

One of the most important questions asked by an owner of a family business is how he or she can pass on their business to family members or new owners at the owner’s death. This issue

is both timely and important, as it is estimated that 80 to 90 percent of all business enterprises in North America are family-owned.1 Given that family businesses are generally privately owned companies that are not keen on sharing company information with outsiders, the question of business succession weighs heavily on many family business owners. It is quite common for business owners to reach out to financial planners for advice and counsel regarding whether family control of a business is a profit-maximizing business model. It is estimated that over 70 percent of family-owned businesses do not survive the transition from first to second generation.2 Interestingly, however, approximately 66 percent of business owners prefer to keep their business in the family.3 With such a large percentage of American businesses family-owned, the question of whether to pass a business down to family members or an outside party is a question financial planners should be able to effectively address. The answer is not always purely financial. A company may not only be the source of a family’s livelihood, but also the culmination of a lifetime of work, and therefore, the source of immense pride.4 It is reasonable to assume that current owners will likely first seek to have a family member succeed them. As such, financial planners should be able to help business owner clients create a business succession plan.

INTRODUCTION Business succession planning is complex and conceptually challenging because of information asymmetry. Information asymmetry occurs when the knowledge of one party in a contract is inferior to the knowledge of the other party in the contract. This imbalance of power in transactions can sometimes cause transactions to go awry and force prices of goods and services down. Asymmetry makes it difficult for buyers to distinguish between low-quality and high-quality businesses; sellers, in turn, lose incentive to focus on quality. Two mechanisms exist that can be used to reduce information asymmetry. One method is to use signaling, which is the active conveyance of information by the party with more knowledge. Another way to alleviate this problem is to make use of screening, which is a process whereby the uninformed party seeks additional information from the informed party.5 Financial planners can use the theory of information asymmetry when thinking about the business owner and the successor as two parties of a contract. For example, a business owner has inferior knowledge about the potential successor as compared to what the successor knows about his or her actual abilities and intentions. Although the successor may claim to be a smart and dependable businessperson who will continue the business for many years, the owner does not know if these claims are really true. The successor may, in fact, not disclose his or her real credentials and intentions. The business owner may make use of screening to reduce the informational asymmetry by asking the applicant to fill in missing information. The succession candidate will likely also have less information about the financial soundness of the firm, which represents an additional imbalance. It is possible for a financial planner to be hired by either the business owner or potential successor to help reduce information asymmetry, and in turn, increase the probability of a successful succession.

One reason business owners prefer to include family members in succession plans is that the business owner knows more about family members than outside successors, thus reducing information asymmetry. For example, assuming a healthy relationship between family members, the incumbent owner may be less likely to exclude negative information about the business to a family member. As such, it is often easier for financial planners to assist with business successions from one family member to another, as opposed to business owners who pass their business to an outside agent.

LEARNING OBJECTIVES The student will be able to: a. Describe why business succession planning is complex and challenging. b. Identify factors a business owner should consider when creating a succession plan, including the ability and motivation of a successor and the degree of idiosyncrasy in the business. c. Describe the purpose of a buy-sell agreement as a business succession planning tool. d. Illustrate how a buy-sell agreement can be designed and implemented.

Rationale There is an extensive amount of literature concerning business succession planning that can help financial planners as they advise their business-owning clients on how to best pass their business to its next owner. Overarching themes of this literature include the ability and motivation of the incumbent owner’s offspring, the degree of idiosyncrasy of the business, the incumbent’s inclination to familial or economic factors, an owner’s ability to choose among multiple family members as his or her successor, and in which generation the family business is currently operating. As reported by researchers on family businesses around the world, exiting family business owners generally wish to transfer their business to their offspring.6 Incumbent owners often feel this inclination to pass their business to offspring as a way to stay quasi-involved in the business and to continue or start a family legacy in the business. What often determines the best successor to a business, however, is the new owner’s abilities and motivation. Ignoring real factors, such as capabilities and inspiration, and instead relying on familial nepotism can fundamentally affect future firm performance. Family succession planning, while most comfortable for business owners, can be less advantageous to the firm post-succession. A business owner may be justified, however, in passing his or her firm down to less than qualified offspring when the firm is highly idiosyncratic. If a business owner’s offspring possesses human capital in the form of specific knowledge related to the family’s business, it may be advantageous to the firm to allow the son or daughter to take control of the business regardless of other abilities.7 The type of knowledge that is helpful to run a highly specialized

business is typically learned through experience, which can occur at a young age for many children of business owners. Such idiosyncratic knowledge includes important contacts and networks, innate rapport with firm employees, knowledge of the business environment, and knowledge of internal operations of the business. Business owners may reach out to financial planners to help quantify the value of this knowledge. Even accounting for the combination of technical and personal qualifications, the development of a succession plan can be shaped by other factors. With the amount of psychological stress that is put on a current business owner when considering whether he or she wants to keep the business in the family, she or he must believe that there is some benefit to passing down the business to a family member. If she or he does not perceive a benefit from passing the business to a family member, she or he will be more open to outside successors. Further, familial pressures to keep the business in the family have a large impact on whether an owner chooses an internal or external successor.8 Family members often believe that choosing an internal successor will allow the company’s beliefs to remain aligned with family principles and keep family members connected to the business in the future.9 Though family members can often be committed to the idea of the incumbent owner choosing a family member as his or her successor, the question of which family member is often less clear. Choosing which family member will cause a dilemma if the incumbent’s offspring satisfy familial and economic criteria to varying degrees. Creating significant lead time before the transition, for the purpose of selecting and training offspring, allows for more efficient succession plan implementation. The classic scenario occurs when one family member who has an exceptional understanding of the business lacks dedication to the family firm, while another member is highly loyal but possesses subpar business knowledge. Traditional corporate logic would suggest the incumbent owner choose the more able successor, though a family business mentality might pressure the owner to choose the more willing successor. As financial planners work with clients to help them choose the right successor, it is also important for the planner to advise his or her client to consider which generations are involved in the business succession. Research on the topic suggests that a transfer from first to second generation will negatively affect the company’s debt rate (i.e., the company will take on more debt), while successions in subsequent generations will have the opposite effect.10 Given that business succession is an important decision that impacts nearly every other aspect of a client’s financial plan, the decision should be carefully considered and designed. When helping clients work through succession planning issues, planners should consider the following factors: idiosyncrasy of the firm, funding mechanisms, and successor motivations, skills, and talents.

IN CLASS Category Applying: Carrying out or

Class Activity Present a lecture about buy-sell agreements by providing examples of

Student Assessment Avenue Provide the students with one or more sample buy-sell

using a procedure family transfers and transfers to nonthrough executing family members. One outcome of the or implementing presentation is to provide students with examples of buy-sell agreements, the process of transfer, and the advantages and disadvantages associated with each technique.

agreements. Templates can be found online.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Ask students to envision their own financial planning practice 20 or 30 years in the future. Ask each student to think about their “imaginary” family, retirement income needs, and future life goals. With this information, ask each student to develop a SWOT analysis (i.e., strengths, weaknesses, opportunities, and threats) that are related to transferring their business to a family member or another business employee.

Have students create and complete a buy-sell agreement rating rubric that can be used to help a client (in this case, the student) decide which business transfer alternative is the best solution. Examples of rubric items include:

Review three buy-sell agreements. These forms can be obtained from most small business development offices on college and university campuses. Ask students to evaluate the similarities and differences among the documents and provide a description of when each document would be most appropriate in practice.

As part of a standard examination, two or three buysell company scenarios can be presented. Students can then be asked to select the most appropriate buy-sell agreement from the ones discussed in class. This assessment requires students to make a judgment based on informed knowledge and a critique of company needs.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through

Ask a small business owner to attend class. Require students to develop a list of business succession planning questions to ask the guest speaker. Students should ask questions to guide them in the development of a buy-sell agreement plan; however, care should be taken on the part of the instructor to ensure that students do not get too personal in terms

Students should individually write a business succession plan that includes at least one buy-sell agreement recommendation. The plan should follow from the in-class interview with a small business owner. The plan should include the following elements:

Importance of future control Need for current income Desire for “legacy”

generating, planning, or producing

of family conflicts, net income generation, and other similar topics.

A review of the business owner’s goals Identification of key parties of interest in the business transfer (i.e., stakeholders) Recommendation for meeting the goal of the business owner in relation to family issues, income needs, and legacy hopes and dreams A specific implementation plan

Additional Assessment Strategies An engaging exercise for students is to ask them to project their “future selves” as a successful financial planning business owner. Ask students to imagine that they started a practice from the ground up, starting with just one client, not making much income early on, and finally achieving success after many years of hard work. Encourage each student to assume they have grown emotionally attached to the many families they serve; in addition to sustaining company profits into the future, the student is also interested in creating a personal legacy. At that point, provide the student with the following issue: (1) they now strongly desire to pass on the business to members of their own family, or (2) they want to pass the company on to someone they can really trust to take good care of their clients. Multiple scenarios can be developed in terms of the current characteristics of the company and children or other successors. For example, a student could assume that in the future one of his or her two children is highly skilled in financial planning and business management but is not very motivated to lead the business into the future, whereas the other child has less financial planning and business acumen but is extremely motivated to continue and lead the business. Have the students assume that in one scenario, they want the business to stay in the family, and in the other scenario, they do not. What factors would they consider in designing their own buy-sell agreements for both scenarios? Another activity is to review three buy-sell agreements (such as those available from a university or college small business development center). Students should describe the similarities and differences among all three agreements. Students should then research and develop a checklist of considerations for the development of buy-sell agreements.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level financial planner should be able to identify key factors

influencing a business owner’s succession plan, including the ability and motivation of the incumbent owner’s offspring, the degree of idiosyncrasy of the business, the incumbent’s inclination to familial or economic factors, the incumbent’s ability to choose among multiple family members as his or her successor, and in which generation the family business is currently operating. Competent: A competent financial planner should additionally be able to present multiple scenarios on how a buy-sell agreement could be designed and implemented with all key factors clearly defined. In addition, a proficient financial planner will be able to illustrate how different buy-sell agreements will affect the client’s probabilities of success within the context of their overall personal financial plan. Expert: An expert financial planner should additionally be familiar with recent research and literature regarding predictors of success and optimal models of business succession plans. The expert financial planner will have working knowledge of all key factors associated with business succession planning, and the communication skills to effectively address the interwoven complexity of psychological, relational, and financial factors and be able to work with affiliated professionals (e.g., accountant, attorney, and insurance professionals) in the development and implementation of a succession plan.

IN PRACTICE Tina A buy-sell agreement is a tool that is sometimes used to facilitate the transfer of a business to one or more additional owners. Consider the case of the Space Memorabilia Company. The company is currently owned by Tina Farnham and her two sons, Rob and Jay. Tina is considering retirement. She would like Rob and Jay to formally take control of the business; however, she has two concerns. The first involves her transition to retirement. She needs a formal agreement with Rob and Jay stating that they will purchase her majority share of the business. She is willing to take payments but she is also willing to cash out her position, but this would require the addition of debt to the company’s balance sheet. Tina’s second concern is what will happen to the company if either Rob or Jay should die or become disabled. Not only would her retirement income be in jeopardy, the continuation of the firm could be compromised. Essentially, Tina needs a plan that will reduce disruptions to business operations if either Rob or Jay should leave. The plan should also provide a level of protection against outsiders (i.e., non-family members) from gaining an ownership interest in the firm. Fortunately, Tina’s financial planner was able to assist her in developing a buy-sell agreement that met all of her requirements. The agreement provides the cash to pay off outstanding company debt, to purchase outstanding ownership interests, and maintain Tina’s retirement in the case of the death or disability of Rob or Jay. Tina’s planner recommended an entity purchase agreement. Using this succession planning tool, the company owns life insurance on each of the owners. The company pays all of the premiums and retains all cash value. In the

event of death or disability, the company uses proceeds from the insurance to purchase the business interests of the deceased or disabled business owner. In this case, if Tina were to die, the insurance proceeds would be used to pay off the debt related to her retirement. Before making the recommendation, the financial planner also reviewed two other possibilities. The first is a cross-purchase agreement. This is a plan where each owner buys life insurance on the life of the other business owners. As part of the agreement, proceeds from a policy will be used to buy the business interest of the deceased or disabled owner. Although less common, a second option is a wait and see buy-sell agreement. In this situation, the business has the right to buy the deceased owner’s interest first, but the company is not required to buy the interest. This agreement allows the remaining business owners to determine whether they wish to continue as owners and at what price they are willing to maintain ownership. There are many businesses that could benefit from a buy-sell agreement as part of a business succession plan, even when the business is very small. For example, imagine a client is a 5050 partner in a fairly established and profitable juice bar, wherein the client’s partner takes care of most day-to-day operations. Assume the client’s partner dies unexpectedly. Does the client still have a business? Who is the client’s new partner? Is it the partner’s wife or child? Does the client have the ability, the right, or the obligation to buy out the new owner(s), and if so, what are the terms? What if the client predeceased his partner? Who receives the 50 percent business interest and how is it valued? Based on this example, the importance of a buysell agreement cannot be overstated, particularly given the potential disputes and confusion that can be avoided as well as the threat to the business. Imagine a family business with six different owners, and one of the owners wants out of the business, or even worse, to sell his or her shares to a person of whom the other owners disapprove. A financial planner could assist a client by recommending a number of buy-sell agreements that could effectively address and even prevent many of these complex situations. For example, a cross-purchase buy-sell agreement automatically allows the client to buy the other partner’s share, whereas with a redemption-style agreement the business itself (through insurance or other means) would make the purchase, allowing the client to avoid having to use personal funds. Besides determining whether the agreement should be structured as a redemption or cross-purchase agreement, the financial planner can help the client address other considerations, such as: Does the agreement supersede all previous written and unwritten agreements? Should the agreement apply to all future owners or only current owners? Should an owner’s death trigger an automatic buyout option for other owners, or should the owner’s family retain ownership? How should the buyout price (i.e., valuation of business interest) or time for payout be addressed, or vary based on whether the owner resigns, is dismissed, or passes away? Should the buyout be funded through insurance, and if so, what type of insurance, and should it be held within a trust? Should the disability of an owner be addressed by a buyout? Under what circumstances?

Should there be periodic reviews of the agreement and a system for making changes (e.g., unanimous or majority vote)?

John Consider the succession planning challenge faced by John. He owns an aquarium store near his home. After the birth of his first grandson, his goals begin to change and he now desires to spend most of his time helping care for his grandson, as both of his grandson’s parents work very long hours and are under a lot of stress. John could create an agreement that allows for the gradual sale of the aquarium store. This is often a symbiotic agreement for both the seller and buyer. After transferring business ownership, John no longer has to spend time at the store or worry about operations, but at the same time he continues to receive monthly income from the gradual sale. This helps the buyer who may not be able to afford or finance the full purchase. Alternatively, John could lease the business for others to operate over a set period of time so that he could spend time with his grandson for a few years but then return to the store (because he did not give up any ownership). Giving up temporary rights to the business typically involves too much risk, but is another option that should be considered.

NOTES 1. Joseph H. Astrachan and Melissa Carey Shanker, “Family Businesses’ Contribution to the U.S. Economy: A Closer Look,” Family Business Review 16 (2003): 211–219. 2. Sebastian V. Grassi, Jr. and Julius H Giarmarco, “Practical Succession Planning for the Family-Owned Business,” Journal of Practical Estate Planning 10, no. 1 (2008): 27–60. 3. Brad Broberg, “Private Companies: Keeping a Family Business Alive Is Never Easy, and Tax Changes May Tempt Some to Cash Out,” Puget Sound Business Journal (June 15, 2002). Retrieved from www.bizjournals.com/seattle/print-edition/2012/06/15/privatecompanies-keeping-a-family.html?page=all. 4. John R. Wiktor, “The Family Business: Preserving and Maximizing an Investment in the Past, Present, and Future,” Journal of Taxation of Investments 31, no. 2 (2014): 65–73. 5. A. Michael Spence, Market Signaling: Informational Transfer in Hiring and Related Screening Processes (Cambridge, MA: Harvard University Press, 1974). 6. Melanie Maria Ganter, Nadine Kammerlander, and Thomas Markus Zellweger, “The Incumbent’s Dilemma When Exiting the Firm: Torn Between the Family and Corporate Logic,” Academy Of Management Annual Meeting Proceedings (2014): 965–971. 7. Khai Sheang Lee, Guan Hua Lim, and Wei Shi Lim, “Family Business Succession: Appropriation Risk and Choice of Successor,” Academy of Management Review 28, no. 4 (2003): 657–666.

8. J. Babicky, “Consulting to the Family Business,” Journal of Management Consulting 3, no. 4 (1987): 25–32. 9. Maryam Ahmadi Zahrani, Sahar Nikmaram, and Meisam Iatifi, “Impact of Family Business Characteristics on Succession Planning: A Case Study in Tehran Industrial Towns,” Iranian Journal of Management Studies 7, no. 2 (2014): 229–243. 10. Vincent Molly, Eddy Laveren, and Marc Deloof, “Family Business Succession and Its Impact on Financial Structure and Performance,” Family Business Review 23, no. 2 (2010): 131–147. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 61 Characteristics and Consequences of Property Titling Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

Property titling can affect many areas of the financial planning process. With respect to education planning, the titling of property may have financial aid consequences for the student. Care must be taken in insurance planning to ensure that the right property is covered and that the appropriate people are listed as beneficiaries depending on the type of contract involved. Certain property titling options carry with them ramifications for investment management,

especially when the investment is owned by more than one party. Property titling determines who is responsible for income and estate tax liabilities. Finally, property titling is a key element of the estate planning process as these decisions significantly impact the ability to manage assets during incapacity as well as how they are to be distributed at the death of the owner.

INTRODUCTION A property’s title indicates ownership. Ownership of a property implies income and distribution rights. Therefore, the title of a property affects how income is assigned and how a property may be distributed at death. Both of these factors will affect who enjoys the benefits of retirement and estate plans. Most countries allow individual residents to own property privately. In the United States, property ownership is so important that the government has to make a clear case in order to take one’s property for a public purpose. The way in which a property is titled guides the distribution of income from the property as well as the distribution of the property at the death of an owner. It also affects the severability right during life. There are five types of titles. The first four are actually a form of naming the owners of a real, personal, or financial asset. The fifth is a function of state law and is most important when property is divided subject to a divorce. The first, and simplest, form of title is sole ownership (also known as fee-simple ownership). An owner in fee retains all of the rights and responsibilities associated with the property titled in this manner. Joint tenancy with rights of survivorship (JTWROS) is a second form of ownership that implies three important concepts. Each owner owns an equal share of the property. Ownership allows any owner to act on behalf of all parties when managing the co-owned property. Upon the death of one owner, the other owners are automatic heirs, dividing the deceased owner’s share among themselves equally. However, for purposes of determining contribution, actual contribution rules apply unless the JTWROS is between spouses, and then each is considered to have contributed 50 percent of the value. Tenancy in common is a third, less restrictive form of ownership. The owners share the income and responsibilities according to the percentage of ownership they hold. One owner cannot presume to speak for the other owners. At the death of an owner, his or her share is transferred to heirs via a will, trust, or intestate succession. Tenants by the entirety, a fourth form of ownership, can be used only when a husband and wife own a property jointly. The owners hold the property with rights of survivorship as well. However, neither enjoys the right to dispose of the property without the other’s consent. In nine states in the United States, property held by a husband and wife that was acquired during marriage is automatically held as community property. This assumption takes precedence over any other form of property title if an owner is married. Gifts and inheritances,

regardless of when they were acquired, are exempted from the assumption of community property. Community property transfers outside of probate. It is important to note that ownership and assumption of debt are not necessarily one and the same. For example, it is possible that two individuals own a piece of property but only one holds the property as collateral for a loan. In that event, if the debtor gets in arrears, while the lender can put a lien on the real property, the other owner cannot be forced to repay the loan.

LEARNING OBJECTIVES The student will be able to: a. Compare and contrast the most common types of titling property (sole ownership, joint tenancy with rights of survivorship, tenants in common, tenants by the entirety, and community property). b. Recommend the appropriate property titling mechanism given the client’s lifetime and estate distribution objectives, and relevant state laws.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Present a lecture outlining each titling mechanism.

Student Assessment Avenue Prepare a matching game with client objectives on the left and titling mechanisms on the right. Ask students to match each objective with its most appropriate mechanism.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Provide examples of a balance sheet. Include financial statements and property titles.

Ask students to evaluate whether a mechanism used in a client scenario is appropriate for the objectives presented in the scenario. They must identify the scenario as estate planning, income tax, or retirement planning.

Add another column to the client’s Ask students to balance sheet and have students place a tell the P for those assets going through probate advantages and and a D for those assets being disadvantages transferred directly to the heirs by title of how each or designation. property is titled.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can determine which form of ownership applies to a property and the advantages and disadvantages of that ownership form. Competent: A competent personal financial planner can identify any duplicity in estate transfer if a property is held in a form contrary to other estate planning documents such as a will. The competent planner can also recommend a particular form of ownership to meet financial planning objectives for cash flow, tax, and estate planning purposes. Expert: An expert personal financial planner can assist estate planning attorneys and heirs in retitling and distributing the property of the deceased client according to the ownership form.

IN PRACTICE Shelley and Mark Shelley and Mark owned their home as tenants in the entirety. Shelley lived in the home prior to marriage and held a $25,000 mortgage on the $140,000 residence. The debt was never refinanced. Unfortunately, Shelley died five years into the marriage. At the time $3,400 was still owed on the mortgage. Mark will become the sole owner of the house because it was held as tenants by the entirety. Because most mortgages have “due on transfer” clauses, the lender can force the loan to be fully repaid when Mark attempts to transfer the house to his name as sole owner (he automatically inherited it). Shelley’s estate may repay the loan or Mark may repay the loan with cash or the proceeds of a new loan. If Mark allows the tenants in the entirety title to remain (not retitling to sole ownership) and does not make payments on the mortgage as scheduled, the lender has the right to foreclose on the property.

Margie Carol Halbick is moving in with her mother Margie in order to care for her as she ages. Margie is now in a position of requiring more comprehensive caregiving. Margie owns her home in fee and she would like to ensure that Carol receives her home at her death in return for providing care. To fulfill her wish without using a trust, she must either gift Carol the property now by retitling the property into a joint tenancy with rights of survivorship (JTWROS) or ensure that her house will transfer to her daughter via her last will and testament and probate. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 62 Gifting Strategies Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Gifting strategies require the strategic use of time value of money calculations. Many gifting strategies incorporate the use of insurance. The choice of assets, including investments, to be used in gifting strategies is crucial to maximizing a client’s potential lifetime benefit and goals of gifting. A financial planner must understand the income tax implications of any gifting strategy to be considered. The Unified Gift and Estate Tax laws require that all gifting strategies be coordinated with the ultimate estate tax ramifications. Gifting strategies are very

complex, requiring excellent communication skills on the part of the financial planner. Also, any gifting strategy analysis requires working alongside other professionals, especially estate planning attorneys but also often including tax preparers and insurance agents. Good interpersonal communication will facilitate the work of the group of advisers for the benefit of the client. And finally, as with every aspect of financial planning, the planner must adhere to standards of professional conduct and fiduciary responsibility.

INTRODUCTION The United States has a Unified Gift and Estate Tax system. The United States began to develop today’s Gift and Estate Tax system in 1916, just before joining World War I. Prior to this time, the federal government had employed estate taxes as only a temporary measure during times of national emergency, first in 1797 as a response to poor relations in France, then in 1862 during the Civil War, and last in 1898 during the Spanish-American War. None of these measures were permanent sources of funding, and all were removed immediately after the resolution of these conflicts. The 1916 estate tax was slightly different. In 1906 President Theodore Roosevelt proposed an estate tax that would break down large concentrations of wealth. Ten years later Congress passed the estate tax to raise revenues for World War I, but did not remove it at the end of the war. Legislative struggle ensued through the 1920s on the estate tax, with changes in the estate tax rate schedule, the estate tax exemption amount, and the gift tax, meant to stop estate tax avoidance through gifting during one’s lifetime. Hotly debated, the gift tax was introduced in 1924, then rescinded in 1926.1 During the Great Depression, Congress, faced with increased public spending, decided to raise revenue with the Revenue Act of 1932, hoping to limit the nation’s public borrowing. The Revenue Act of 1932 further increased the estate tax rate schedule, lowered the estate tax exemption amount, and reinstated the gift tax. For the first time, redistribution of wealth was an explicitly stated purpose of the estate tax. Changes after the Revenue Act of 1932 addressed additional topics, such as small businesses and spousal transfers, but changes to the structure of the transfer tax system did not occur until the 1970s.2 The Tax Reform Act of 1976 unified the estate and gift tax code with a single tax rate schedule, cumulative lifetime gifts, and marital deduction clarifications, among other landmarks, and created the system that is currently in place. Legal changes through the 1980s and 1990s addressed provisions on generation-skipping transfers, unified credit amounts, and the marginal tax rate schedule. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 made many changes as well, even briefly undoing the tax completely. However, these laws did not change the underlying structure of the Unified Gift and Estate Tax system. Due to this Unified Gift and Estate Tax system, gifting strategies have ramifications during life and at death. The ultimate tax goal of gifting is to reduce the Unified Gift and Estate Tax paid over a person’s lifetime, while also considering income tax costs. Needless to say, there are many other considerations in addition to total gift and estate taxes paid. Lifetime gifting strategies are an important part of estate tax planning and minimization. In addition to tax planning, lifetime gifting supports human dimension goals. The coordination of gifting

strategies with the client’s human dimension goals (in pursuit of the lowest gift and estate taxes possible) is a critical piece of the financial plan. It is necessary for the planner to have an understanding of the strategies available, their interrelation with estate tax minimization strategies, their risks and restrictions, the rules applicable in their implementation, and the context of the rest of the client’s financial plan. Attempting to reduce gift and estate taxes has complex ramifications. Funds gifted today generally become unavailable for use by the donor regardless of changing circumstances, including changing tax laws. But not availing oneself of gifting strategies can result in higher estate taxes than otherwise required. The tools and strategies available for gifting are varied and complex. Strategic and contextual thinking, as well as deep technical knowledge, are necessary to coordinate available gifting strategies with the rest of a client’s situation. This thinking can also enable a planner to minimize taxes while attempting to meet future needs and supporting the client’s values and other non-financial objectives. There is an added dimension to gifting strategies in that strategies, generally irrevocable, are implemented in an environment of changing rules, regulations, and client circumstances. Something implemented today may be subject to unforeseeable changes as tax laws and life circumstances change in the future. There are numerous gifting techniques available for consideration. There are present gifts and future gifts, and the tax treatment is different for each. There is an annual amount that one can give to almost anyone else that escapes any gift or estate tax treatment. The annual exclusion, which is indexed for inflation, stood at $10,000 per donee when indexing was introduced in 1997 and had risen to $14,000 by 2015, according to the Internal Revenue Service. Certain techniques reduce the value of the asset gifted, thereby creating less of a gift and utilizing less of the unified credit. Some techniques remove appreciation and other investment returns from the estate, while others reduce the estate by the gift and/or income taxes paid during the donee’s lifetime. Multiple benefits may be achieved through a given gifting strategy. Similarly, a given strategy may simultaneously result in a benefit and a cost. In addition to ultimate estate tax reduction, there are income tax ramifications to consider, including the consideration of the basis of the gift, any charitable deduction available, the tax bracket of the donor, and the tax bracket of the donee. Myriad other financial considerations also exist (e.g., the risk of the donee losing needs-based government benefits or scholarships) before any human dimension issues even come into play. Other variables that may affect the strategies considered are who the donee is, how old that person is, and what relationship the donee is to the donor. In addition to understanding and considering the gifting strategies available and how they fit into the estate tax system and lifetime plans, it is imperative that the client’s big picture human dimension goals be taken into consideration when developing a gifting plan. A plan that minimizes taxes over a client’s lifetime but facilitates situations that are not supported by the client’s value system is a bad plan. The financial planner can devise gifting strategies that help clients use their assets to support their heartfelt desires during their lifetimes while reducing gift and estate taxes paid in the long term. The successful financial plan will recommend gifting strategies that minimize taxes, maximize flexibility, consider future life and tax law changes, and meet the client’s human dimension

goals and objectives.

LEARNING OBJECTIVES The student will be able to: a. Describe the probate process, its advantages, disadvantages, and costs. b. Explain the characteristics and consequences of using alternative methods of transferring property at death, including named beneficiary, trusts (revocable and irrevocable), payable on death and transfer on death designations, probate, intestate succession, and direct transfer through titling. c. Select the most appropriate property transfer mechanism for a client’s situation.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Given a scenario and a solution, ask students to describe how the solution would and would not meet the needs of the client.

Student Assessment Avenue Provide a focused case situation with a solution. Students describe how the suggested solution meets the needs of the client. Ask the student to describe what needs would be unmet with the given solution. Alternatively, give students a list of needs that are applicable in the case situation and ask them if and how this particular need would be met. Analyzing: Breaking Given a wide range of Provide a broad case situation and a list material into variables (client fact pattern, of available gifting strategies. Ask constituent parts, and values, goals, and students to frame (describe in their own determining how the objectives), ask students to words) the relevant client needs and parts relate to one identify various solutions that then determine which strategy(ies) another and to an could work, explaining why should or should not be considered for overall structure or and how. the case situation, and why. purpose through differentiating, organizing, and attributing Evaluating: Making Given a wide range of Provide a broad case situation. Ask judgments based on variables (client fact pattern, students to analyze the outcome using different gifting strategies that they criteria and standards values, goals, and through checking and objectives), ask students to identify, comparing those outcomes to

critiquing

develop multiple scenarios illustrating tools that would work, and to compare the various alternatives and how they each fit into the broader client situation. Creating: Putting Given a wide range of elements together to variables (client fact pattern, form a coherent or values, goals, and functional whole; objectives), ask students to reorganizing elements develop and explain a into a new pattern or concrete set of structure through recommendations that generating, planning, incorporates aspects from all or producing areas of the financial planning situation.

the desired outcome the client has articulated. The student should identify all gifting strategies that might work in the given case situation and evaluate how well each one would work. Provide a broad and complex comprehensive financial planning case. Ask students to develop a comprehensive gifting strategy that is within the context of the entire financial plan fact pattern.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain each gifting strategy in language comprehensible to a non-specialist. An entry-level personal financial planner can apply a strategy and technical knowledge in a static example. Competent: A competent personal financial planner can evaluate various gifting strategies and select those that will work in a given client situation. A competent personal financial planner can issue recommendations for each gifting strategy that fits a client situation and can analyze and evaluate a given situation and how the various strategies and tools may work. Expert: An expert personal financial planner can creatively integrate sound gifting recommendations within the full context of the present and future situation as well as the rest of the client’s needs, including non-financial goals and objectives. An expert personal financial planner can create integrated strategies that fit into the overall context of the client situation.

IN PRACTICE The Smiths and the Joneses The Smiths are clients of Sam Jacobs, a personal financial planner who has been in practice for five years. The Smiths are very attached to their children and want to help them in any way they can. Sam listens intently to these desires and takes seriously his part in determining if what the Smiths want to do will fit within their financial goals. The question is whether the Smiths can afford to gift $50,000 to their daughter for a down payment on a home. After significant analysis, Sam determines that the Smiths’ financial situation can afford this

allocation of resources. He helps the Smiths structure their gift to be a joint gift that spans two years so as not to incur gift tax or even require the filing of a gift tax return. The Smiths make the gift. The Joneses are clients of Lisa Smart, a personal financial planner with 25 years of experience. The Joneses care deeply about their children as well and want to help them financially. Lisa listens to her clients’ desires and carefully contemplates her part in determining if what the Joneses want to do will fit within their financial goals. Are the Joneses able to afford a $50,000 gift to their daughter that will finance a down payment on their daughter’s new home? After significant analysis, Lisa determines that the Joneses can afford such a gift. Lisa then asks whether their daughter can afford the payments on this home on an ongoing basis. After some additional dialogue and analysis, it is determined that, in fact, their daughter would not be able to continue to make payments. Since the gift creates the probability of future gifts being necessary and that would not be sustainable for the Joneses, it is recommended they do not make the gift at this time.

Pat and Sam Pat and Sam are an unmarried couple in a fully committed relationship. Pat earns considerably more than Sam, has a much higher net worth, and is 15 years older. Pat and Sam live to the financial standard Pat’s income affords them. Pat and Sam each have nieces and nephews they love dearly and charities that mean a lot to them. Pat wants to make sure that Sam is provided for if Pat dies first. Pat and Sam both want to provide for their nieces and nephews and for their chosen charities, but not at the expense of each other. Their financial planner is challenged to design trusts and estate and gifting strategies that avoid gift tax on the expenses Pat covers and estate tax on the assets left for Sam’s use after Pat’s death. The strategies will also provide for their nieces, nephews, and charities after both Pat and Sam are gone, and, most importantly, provide for Sam for the potentially long time that Sam may live after Pat’s death. The planner recommends a series of gifts of future interests in trust for Sam, with nieces and nephews and charities as ultimate beneficiaries of the trusts. This serves to reduce the value of the gift to Sam, enabling Pat to use a significant portion of the gift tax exclusion amount. Their nieces and nephews and charities are provided for, but only after both Pat and Sam are dead. And it remains to be planned how to manage the current gifting issues inherent in their situation.

Mary and Rosa Mary Rodriguez, a widow of 17 years, has one daughter who takes wonderful care of her. Mary’s daughter, Rosa, is divorced and is raising two children, Rico, 11, and Susanne, 8. Rosa works hard at her job as a bookkeeper all day. She comes home to feed her children and help them with their homework. Two evenings a week and one day on the weekend, she goes over to Mary’s house to cook some meals and help Mary keep her home clean and organized. Rosa is doing an excellent job of providing for her family, but Mary feels she could help make Rosa’s life a bit easier and more enjoyable. Mary has asked her financial planner to help devise a plan whereby Rosa could move in with Mary (Rosa has indicated an interest in doing

so) and co-own Mary’s house (Mary believes this will make Rosa feel at home). Mary would also like to give Rosa some money on an ongoing basis to help her have some fun and great experiences with her kids. Mary has sufficient net worth to fund a significant portion of Rico’s and Susanne’s college educations as well. While Mary wants to be generous, she does not want to create a lot of complication and considers gift tax returns an example of such complication. She also does not want to create unnecessary income taxes. Mary’s planner recommends funding prepaid tuition plans for Rico and Susanne as well as gifting Rosa both rent (on Mary’s house in which Rosa and her children would be living) and additional funds within the annual gift exclusion.

NOTES 1. Joint Committee on Taxation, “History, Present Law, and Analysis of the Federal Wealth Transfer Tax System,” U.S. Congress, Washington, DC (November 13, 2007). 2. J. A. Cooper, “Lessons of 1932,” Estate Planning Studies (July 1, 2010). Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 63 Estate Planning Documents Andrew Head, MA, CFP® Western Kentucky University Sharon A. Burns, PhD, CPA (Inactive)

CONNECTIONS DIAGRAM

The primary estate planning documents are wills, trusts, general and health care powers of attorney, and advance medical directives. While the main purpose for obtaining these documents is to have a plan for the distribution or management of one’s estate in the event of death or incapacity, it is worth noting that an estate plan may encompass all areas of financial planning. It should also be pointed out that while insurance and retirement beneficiary forms

are not considered estate planning documents in the strictest sense, these documents certainly affect the distribution of insurance and retirement plan benefits upon death as well. A decedent’s property typically generates some income before it is distributed to heirs, and the financial planner must be knowledgeable about the income taxation of estates and trusts. Furthermore, it is important to be aware of what any estate, gift, or generation-skipping transfer tax implications might be for any of the aforementioned documents.

INTRODUCTION Every person, with few exceptions, owns property that will be distributed to survivors upon his or her death. Two legal documents are designed specifically for the purpose of affecting the transfer of property upon the death of an individual. These documents are a will and a trust. Wills and trusts may be used separately or in tandem to guide the distribution of a decedent’s property to heirs or beneficiaries. A will becomes effective upon the death of the writer of the will. The executor (or executrix) is the person who will manage the property being transferred via a will. Some states use the term personal representative in lieu of executor. An heir is a blood relative who, by terms of a will or by intestate succession, receives a decedent’s property or the proceeds of the sale of the property upon death. A legatee is a non-relative beneficiary named in a will. A decedent who has legal responsibility for another (usually a child or incompetent adult) may identify a guardian for this person in the will. The guardian may or may not also receive funds to use for the care and maintenance of the dependent. In some cases, a personal guardian and a financial guardian are named with respective duties. As legal documents, most wills contain the same clauses or terms. These include a statement as to the competency of the writer of the will at the time of execution and a statement revoking previous wills and codicils. The executor, guardian, and beneficiary/beneficiaries will be named. In addition, the desired distribution of the decedent’s property will be specified. A trust is a legal document that guides the management and distribution of property placed in trust by the donor. The donor may contribute property to the trust during life (inter vivos) or upon death (testamentary). The person who manages the trust property is called a trustee. The economic value of the property will be given to the beneficiary(ies) of the trust. A beneficiary is a person who receives financial value from the property held in trust. An income beneficiary receives the income generated from the investment of trust property. A remainder beneficiary receives either the property or proceeds of the sale of the property held in trust upon the death of the donor and/or the beneficiary. It is possible for the donor of a trust to also serve as trustee and beneficiary during the donor’s lifetime. Such trusts are commonly known as living trusts. Then, upon the death of the donor/trustee/beneficiary, other individuals become trustee and beneficiary. Trusts may be classified by the timing at which they become effective (inter vivos or

testamentary) or the purpose (e.g., spendthrift, generation-skipping, charitable). The main advantages of living trusts over wills is that the contents of a trust are private and property transfers do not need to be approved by the Probate Court. This latter advantage allows the time between death and transfer to be minimized and often saves money because attorneys are not necessary. The property of a person who dies without a will or trust will transfer via intestate succession. Intestate succession is the process of the state of residence for determining the heirs of a decedent’s estate and may differ from the wishes of the decedent. Two other documents are also considered to be components of estate planning even though in reality they are not. These two documents are the power of attorney (POA) and the health care power of attorney (HCPOA). A power of attorney is a legal document, executed by one person, giving another person the legal right to act on his or her behalf. Most POAs limit the powers by duties or other constraints. For example, a person may be able to pay bills on behalf of the other, but not buy and sell property. Or the POA may be able to act only when the other is out of the country or incapacitated in another respect. In all cases, a POA is valid only when the executor of the document is living. At this executor’s death, the executor of the estate or trustee of a trust then manages the property according to the terms of those documents. A health care power of attorney is a very limited power. It allows the POA to make health care decisions in the event the executor of such a document is unable to make his or her own health care decisions. The health care power of attorney is not the same as an advance directive. An advance directive provides guidance to medical personnel about what type and extent of care should be given in the event the executor of the document is unable to make those decisions for himself or herself. The common term for an advance directive is a living will. Wills and trusts must be executed before death. Some individuals employ only a will for estate planning. Others use a living trust that includes a successor trustee and remainder of successor beneficiaries for any property remaining at the donor’s death. A testamentary trust, however, is used in conjunction with a will. The trust is funded with property from the decedent’s estate (through the terms of a will or directly as a named beneficiary or transfer-on-death recipient). It is important to note that using a will does not negate the potential assessment of estate and inheritance taxes. The property in some trusts may, but not necessarily will, avoid estate taxation. Planners and clients will want to consider the effectiveness of all of these tools in effecting efficient transfers of property and reducing tax liabilities before finalizing estate plans.

LEARNING OBJECTIVES

The student will be able to: a. Identify and describe the components of estate planning documents, such as wills and trusts that are used to facilitate the transfer of one’s assets. b. Explain the roles of the parties used in estate planning including executor, trustee, power of attorney, beneficiary(ies), heirs, and guardians. c. Recommend appropriate estate planning tools to meet a client’s goals and objectives.

IN CLASS

Category

Class Activity

Applying: Carrying out or using Review a sample will a procedure through executing or and trust document, implementing identifying the various component clauses of each. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Interview medical personnel about the use of advance directives and health care powers of attorney in their professional settings and experiences.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Interview clients about their desires, and have students determine which legal documents are needed.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Student Assessment Avenue Ask students to use and compare “fill in the blank” will and trust documents found online to effect a client’s estate goals. Provide the students with a client’s estate planning documents and ask them to write an explanation to the clients about any redundancies or conflicts between the documents. Using the aforementioned documents, ask the students to explain to the beneficiaries and heirs their rights under the terms of such a plan. Do this via audio or video recordings.

Ask students to complete a written exercise comparing and contrasting the use of wills, living trusts, and testamentary trusts on criteria such as time, expertise needed to implement, and cost. Discuss the day-to-day Ask students to develop a operations of actively diagram or chart tracking the using a living trust to management of specific pieces of manage a client’s affairs. property over time (including the owner, trustee, POA, and executor) under the documents used by a client.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the basic principles and purposes of a will, living trust, or testamentary trust to a client. In addition, the entry-level planner can read a will or trust to identify the key components and parties to the documents. Competent: A competent personal financial planner can identify any duplicity in the estate planning documents, and can also make recommendations as to which techniques should be

used to achieve the client’s lifetime management and post-death distribution goals. Expert: An expert personal financial planner can assist estate planning attorneys and heirs in distributing the property of the deceased client in the most efficient and effective manner.

IN PRACTICE Angie and Ralph Angie and Ralph Anderson are 35 years old with three children under the age of 10. Ralph initially reached out to Braden Allen, a financial planner, looking for ideas about investment options for a piece of land he is planning to sell in another state. Mr. Allen assured Ralph that he would be happy to discuss investment options at a later date; though he was uncomfortable doing so until he learned more about the couple and their goals. During the discovery process, Mr. Allen finds that the couple does not have any estate planning documents in place. When meeting with the couple to present a financial plan, Mr. Allen points to this as a priority area to be addressed. Among some of the issues that are pointed out is the fact that in the event of the premature death of one of the parents, the children would, in most states, be entitled to at least 50 percent of the economic value of the probate estate, leaving the surviving spouse with the remainder. Furthermore, should both parents die, the probate court would have no direction regarding who the parents prefer to raise their children. The probate court would then have to decide who is best suited to rear the children, potentially causing a great deal of strife and expense to various family members who would want to do so. With each new scenario pictured, the couple’s anxiety increases. Mr. Allen points out that this is easily fixed and makes a couple of recommendations for local attorneys he trusts to draft all of the appropriate documents. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 64 Estate Tax Compliance and Tax Calculation Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Estate tax compliance and calculation requires the services of a qualified estate planning attorney and tax preparer. A financial planner must also understand the Unified Gift and Estate Tax calculations, as well as the process for calculating the estate and resulting tax and the methods of reducing estate taxes. With recent changes in the Unified Gift and Estate Tax laws, income tax ramifications became more critical to the estate planning process. Financial planners must utilize their interpersonal communication skills to clearly explain issues to the

clients and to work closely with the other professionals involved in the estate tax compliance and calculation process. Finally, as with every aspect of financial planning, the planner must adhere to standards of professional conduct and fiduciary responsibility.

INTRODUCTION The United States has a Unified Gift and Estate Tax system. At death, everything a person owns is accounted for, valued, reduced for outstanding debts (including burial and estate settlement costs), reduced by allowable deductions, and adjusted for lifetime gifts. The resulting tax is calculated, and available credits are applied to result in the estate tax liability. As complex as these prior two sentences may sound, they sorely underestimate the complexity of estate tax compliance and calculation. Because a financial planner is generally the most knowledgeable person about a decedent’s entire financial situation, he or she is well suited to assist the executor, trustees, and estate settlement attorneys in settling an estate. Equally important, however, is the financial planner’s ability to estimate the estate and resulting estate tax for living clients while preparing and monitoring a financial plan. The planner must then also evaluate the alternatives available after the death of a client—whether to use the Unified Credit or “port” it to a spouse, whether to gift assets to charity (depending on what is allowed by the estate), whether to value the estate at the date of death or at the alternate valuation date, whether to recommend the use of any available disclaimer provisions, and so on. The financial planner must know what is included in the gross estate and what is not. Generally, any asset in which the decedent held an incidence of ownership (in general, an interest or right that allows the person to change, modify, use, or benefit from an asset) at death will be includable in the estate. However, there are multiple scenarios in which it may appear that there is an incidence of ownership when in reality there is not (e.g., what appeared to be the ownership of a vacation home but was really only a life estate in the vacation home). There are also multiple scenarios in which it will appear there is no incidence of ownership when, in fact, there is (e.g., an asset ostensibly owned by someone else, such as a trust, but over which the decedent exercised a power of appointment through his or her will). Assets included in the estate may be transferred via provisions in a will; provisions in a trust; beneficiary designation or ownership designation, including various forms of joint ownership or ownership succession; or by law (such as by ERISA rules or in community property states). How an asset transfers will not often impact the gross estate, but it is important to include the distribution of the estate when considering estate tax compliance and calculation. It is also important for the planner to be able to identify and understand potential alternative valuation methods allowed by the IRS that may ultimately reduce the estate and resulting tax. These alternative valuation elections include the choice to value the estate six months after the date of death (versus on the date of death); the special-use real estate valuation, which allows the estate to value land used in a business (including farming) at its business use value versus its land value; or a combination of both alternative valuation elections. The financial planner must know what reductions are allowed in computing the adjusted gross estate. Allowable reductions include all debts of the decedent, including actual loans (e.g.,

mortgages and credit card balances); other liabilities that existed at death (e.g., unpaid expenses or carrying costs of assets held at death and incurred throughout the estate settlement process); and those that are incurred by the estate (e.g., burial costs, end-of-life costs, and estate administration expenses). It is important that the planner use his or her knowledge of a client’s situation to help ensure that all available estate reductions are taken. After calculating the adjusted gross estate, the planner should understand and be able to help gather the necessary information for all allowable deductions. Allowable deductions include charitable deductions (e.g., outstanding charitable pledges, assets left to charity, and gifts made by the estate); the marital deduction (and it is critical for the planner to understand when this deduction does and does not apply, as it does not apply, for example, to decedents married to non-U.S. citizens); and any state estate taxes paid. And the planner will need to have done sufficient discovery to know of past spouses, old and new portability amounts, and, of course, the basis of all assets in the estate and how that basis has changed with the client’s death (e.g., community property rules). The evaluation of the use of the exemption versus porting it, for surviving clients with estates that could grow to exceed the exemption amount, will require scenario planning analysis. A financial planner will know that this resulting taxable estate is actually not the final word on what is taxable but is rather a tentative calculation, and will know how to adjust the taxable estate for prior (post-1976) gifts made in order to calculate the tentative tax base. The planner will understand and be able to use existing estate tax rates to calculate the tentative tax, and will then know to reduce this tentative tax for prior gift taxes paid or deemed paid in order to calculate the estate tax before credits. Accurate treatment of prior gifts made and gift taxes paid requires a clear understanding of the interrelationship between gift and estate provisions. Understanding the impact of lifetime gifting on the client’s ultimate taxable estate and estate tax is integral to sound financial planning. Any amount gifted during life is not includable in the gross estate at death, although it is considered in calculations of the taxable estate and resulting estate tax (to ensure that lower tax brackets are not used more than once). Likewise, any earnings on and appreciation of a gifted item are out of the estate at death. Taxes paid on lifetime gifts also serve to reduce the ultimate estate (by virtue of the fact they have been spent) and are no longer a part of the estate in any way. The planner will know the existing estate tax law and available estate tax credits to reduce the calculated estate tax before credits in determining the estate tax liability that will be due. Finally, with respect to federal estate taxes, the planner will know when any special payment alternatives are available. There is an election for a one-year extension of time to pay estate taxes. There is also an estate tax installment election that allows an extension of up to 14 years to pay estate tax attributable to an estate’s interest in a closely held business. These provisions can provide much-needed relief to an estate. Some states impose an inheritance or estate tax (and some impose both), while some states have no such tax. Where there is such a tax, taxes are calculated differently by different states. Many states use the same federal calculation to get to the taxable estate, with the exception of allowing a deduction for state death taxes paid. Other states use other calculations. In addition,

allowable credits and applicable tax rates vary widely by state. Some states impose no tax unless there is a tax imposed at the federal level. The planner must be well versed in the state death tax rules for any state in which he or she has a client residing and be able to estimate state estate tax liability during the estate planning process. Estate tax compliance is crucial, particularly for larger estates, as audits are common and penalties (including return preparer penalties) can add up. While a fiduciary financial planner would never encourage or support any form of willful non-compliance, it is equally important that a planner help monitor the settlement of an estate to mitigate the possibility of negligent or accidental non-compliance. The estate attorney is ultimately responsible for the accurate and timely filing of an estate tax return and information regarding payment of taxes. However, the financial planner is often as aware (or more aware) of a decedent’s financial situation as those settling the estate. In terms of estate planning, the planner may not know as much about a client’s financial situation (although that will often be untrue) as the client, but will invariably know much more about gift and estate tax laws. There are filing deadlines that must be followed, including extensions. Some estates that are not required to file an estate tax return will still benefit from doing so in order to establish the inheritance value (and, therefore, basis and any appraised value) of the bequeathed assets. And the only way to qualify for portability of a spouse’s unified credit is for the deceased spouse’s estate to file an estate tax return. While the estate attorney will be responsible for meeting these deadlines, the financial planner can be instrumental in helping the estate file its return(s) on time. Use of assets (for paying expenses, for example) must be tracked carefully to ensure that deductible items are fully accounted for, but also to ensure that beneficiaries are treated fairly and within the law and the wishes of the decedent. It is also imperative that everything that is supposed to be accounted for in the estate tax calculation is, in fact, accounted for. Perhaps the most difficult risk to mitigate is that of valuing non-traded assets, such as businesses, antiques, collectibles, and the like. Multiple appraisals or valuations may be in order, and certainly the qualifications of the appraiser will matter in the event of an audit.

LEARNING OBJECTIVES The student will be able to: a. Calculate the gift tax consequences of lifetime transfers to individuals and charities and recommend when filing a gift tax return is necessary. b. Calculate the income tax consequences of lifetime transfers to individuals and charities. c. Calculate the estate tax consequences of lifetime transfers to individuals and charities.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Present the estate tax formula and describe what falls into each category and how the tax is calculated, including the treatment of prior gifts.

Provide short-answer and multiple-choice questions. Ask the students to use Excel and a calculator to calculate the estate tax. For each situation, ask the students to identify whether a return would have to be filed.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Ask students to work in Provide a case with a fact pattern groups to determine what of lifetime gifting and a taxable information in a estate. Ask the students to: provided fact pattern Prepare a statement that affects which parts of the indicates the gross and taxable estate tax return and estate at the time of death and resulting estate tax. the resulting estate tax. Resources: IRS Complete Form 706 for the publications—Form 706 year of death. and Instructions. Complete the state estate tax form for the year of death, if applicable. Guest lecture by a Students are given short cases and business or asked to calculate the estate taxes antiques/collectibles using available alternative appraiser about various valuation elections and to valuation techniques and recommend which election(s) the variability of make(s) sense in each given case. valuations given different situations. Guest lecture by a Ask students to calculate the estate financial planner or tax due if one or the other estate attorney outlining spouse/partner in their capstone non-compliance horror case were to die today. stories they have heard.

Evaluating: Making judgments based on criteria and standards through checking and critiquing

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify and calculate the gross estate, the adjusted gross estate, the taxable estate, the tentative tax base, the tentative tax, and

the estate tax liability. Competent: A competent personal financial planner can complete an estate tax return (both federal and state) and quantify the lifetime gifting impact on estate taxes. Expert: An expert personal financial planner can creatively analyze and design alternative strategies and be able to show how various scenarios would indicate different decisions and be able to do so both in a planning mode and in the case of settling an estate.

IN PRACTICE Todd Todd Andrews has come to meet with his planner, Scott Ryan, after the death of Todd’s father. Todd’s mother died some time ago, so Todd will be settling his dad’s estate. He has asked Scott for recommendations for a good estate attorney (Mr. Andrews Sr.’s attorney was in his home state of Colorado, but Mr. Andrews Sr. moved to Missouri to be closer to his son, so the estate will be settled there). Todd will hire an attorney before he takes any action, but he needs Scott’s help in two respects before doing so. First, Todd wants help sorting through the information he has and that he needs to gather together in preparation for his first meeting with the attorney he selects. Second, Todd is curious for an estimate of his father’s estate and any resulting projected estate taxes, and any alternatives available to the estate to reduce any taxes due. Scott examines the statements Todd has brought with him, and asks a number of questions about assets and liabilities that might exist but not be represented by the statements Todd has provided. He asks about insurance policies and other death benefits that might exist by virtue of other accounts or memberships in organizations. He asks about end-of-life and funeral expenses and other liabilities that may exist but not be reflected by the statements brought to the meeting. Scott then moves on to gathering information about charitable gifts and bequests that were made in the current year or are anticipated being made, and prior gifts that have been made in past years. He carefully reads Mr. Andrews Sr.’s estate documents, including beneficiary designations, to see how the estate will be distributed. With this information in hand, Scott can create an estimate (and itemized list) of Mr. Andrews Sr.’s gross estate as well as an estimate of the taxable estate and the resulting distributable estate. The final step in this analysis is for him to diagram who will inherit how much (and what, to the extent that is predetermined). Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 65 Sources for Estate Liquidity Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Analyzing sources of estate liquidity requires basic financial planning principles, such as creating and using financial statements. Insurance is a good source of estate liquidity in many circumstances. Consideration of which assets to use in which ways and how to plan for the financial needs of the heirs (e.g., carrying costs for a piece of real estate or a business) entail a thorough understanding of investments. Discussing sources of estate liquidity is not the most complex topic but still one that requires a lot of number crunching and, consequently, good

interpersonal communication skills for dealing with the estate fiduciaries and beneficiaries. The analysis of estate liquidity is generally completed in coordination with other professionals such as estate planning attorneys, tax preparers, and insurance agents. Good interpersonal communication will facilitate the work of the group of advisers for the benefit of the client. And finally, as with every aspect of financial planning, the planner must adhere to standards of professional conduct and fiduciary responsibility.

INTRODUCTION Estate liquidity is vital to financial stability of the estate. Lack of liquidity can result in negative outcomes (e.g., the inability to pay bills; to carry, sell, or distribute assets efficiently; and/or to support the beneficiaries who were previously dependent on the decedent). Estate liquidity is needed to cover a myriad of costs and other cash flow needs of an estate. These include the decedent’s final expenses; the carrying costs of the estate’s assets and liabilities; the living needs of the decedent’s dependents; the costs of settling the estate (e.g., selling the home, business, antiques, and collectibles, and hiring advisors); the distribution of assets from the estate to the beneficiaries; and the payment of income and estate taxes. Given current flexibility in estate tax laws, coupled with changes in the typical household composition (e.g., second marriages, stepchildren, etc.), it is difficult for the financial planner to accurately project estate liquidity needs once clients have changing household makeups, needs, and expenses, because asset values fluctuate and new assets and liabilities are incurred. Consequently, as with all financial planning strategies, the best estate liquidity strategies are those that provide for the greatest flexibility. Sources of estate liquidity include: Liquid assets held by the decedent prior to death (e.g., bank accounts). Marketable securities (though one must consider the market value fluctuations and the potential need for the estate to hold those securities without selling them in order to take advantage of postmortem planning needs, such as the alternative valuation date). Life insurance proceeds. Trusts outside of the estate that could purchase assets from the estate in an efficient way. Accounts receivable of the decedent (e.g., a final paycheck or deferred compensation). Liquidity can also be improved using available IRS estate tax payment deferral elections, if available. When planning for estate liquidity needs, an estimate of what the liquidity needs will be is required, even though estate liquidity needs can be difficult to project. Therefore, the best plan is one with flexibility. Once an estate exists, a calculation should be performed for the liquidity needs projected over the course of the settlement of the estate from the date of death until final distribution of assets. This will enable the executor to make timely decisions around the use, sale, liquidation, and distribution of assets.

LEARNING OBJECTIVES The student will be able to: a. Determine the need for estate liquidity. b. Develop a cash flow plan for maintaining a client’s estate from date of death to final distribution including the payment of tax liabilities.

IN CLASS

Category

Class Activity

Applying: Carrying out or Discuss a series of using a procedure through specific net worth and executing or implementing estate scenarios and, as a class, identify what liquidity needs the estate illustrates and what liquidity is available in the estate. Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing

Break the class into groups. Give each group a net worth and insurance scenario and have each group outline various strategies that would be available for meeting the estate liquidity needs.

Student Assessment Avenue Provide a net worth statement, including details about the assets and liabilities, and a list of insurance policies. The student will calculate the liquidity needs of the estate, given assumptions about the time to settlement. The student will identify the available liquidity in the estate. Provide an estate planning scenario. The student will calculate the liquidity needs and available liquidity and will identify strategies for using the available liquidity to meet the needs.

The group then presents the results to the class either in the classroom or in a synchronous or asynchronous online platform. Evaluating: Making judgments based on criteria and standards through checking and critiquing

Invite a guest lecturer to share stories of actual real-life cases where estate liquidity was particularly well covered and others where it was not, and what was done about it.

Provide a series of estate scenarios that summarize liquidity needs and available liquidity. The student will recommend and evaluate strategies that could have been put into place before death to solve the liquidity needs illustrated.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Discuss and demonstrate the development and presentation of a comprehensive financial plan.

Analyze liquidity needs for the purpose of the development and presentation of the comprehensive financial plan in the capstone course.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can calculate the liquidity needs of an estate and the available liquidity in the estate. Competent: A competent personal financial planner can analyze various estate liquidity planning needs and strategies and determine what works, what does not work, and why. Expert: An expert personal financial planner can creatively design alternative estate liquidity planning strategies with context, identifying trade-offs and benefits as well as making clear recommendations.

IN PRACTICE Anne and George Anne and George own 124 acres of land that have been passed down through Anne’s family for several generations. The land makes up 75 percent of their total net worth. They are very interested in passing the land on to their children and have asked their financial planner to help them figure out how to make that happen. Their planner has analyzed the need for liquid assets as if Anne and George were both to die now. She has calculated their final income tax bill, their estate tax bill, the settling costs of their estate (including paying off other liabilities), and the endowment amount necessary for the children to carry the land costs indefinitely. This total exceeds the balance of Anne and George’s remaining (non-land) net worth by $1 million. The planner recommends that they purchase a $1 million second-to-die life insurance policy inside an irrevocable life insurance trust. She further suggests that this policy has guaranteed increase options to provide for the potential appreciation of the land.

Robin and Allison Robin and Allison own a residence in their hometown and a beach house where they vacation in the summer. Both homes carry a mortgage. They have indicated that at the first spouse’s death, the survivor will sell both homes and move closer to their kids and grandkids. They want to sell each home for a fair price but they are worried about the ability of the survivor to carry the costs of two homes (the mortgages, property taxes, etc.) after the first spouse’s death in order to effect a fair market value sale. Their planner has advised them to ensure that liquid assets equal to 12 months of the carrying costs on both homes will be available to the survivor at the first spouse’s death. This will mean setting up a joint account for the additional amount that their life insurance proceeds would not cover after paying other debts and final expenses.

William As the executor of his father’s estate, William seeks his financial planner’s help in managing and settling the estate. His father had several bank accounts, some certificates of deposit (CDs), a brokerage account with mutual funds, a large individual retirement account (IRA), a

small life insurance policy, a home with a mortgage, an art collection, two cars, and the remainder of William’s late mother’s jewelry. William and his sister are the sole heirs to the estate. His sister could benefit from getting her share of the estate as soon as possible. William is very confused about how to manage the various assets. He does not know how much of the estate he should distribute now versus how much needs to be held back for expenses. He has told his financial planner that he believes he can get the house sold within six months. He then asks his planner to help him formulate an estate distribution plan that would accommodate his sister’s wishes. In response, the planner has calculated 12 months of carrying costs on the home (not six months, just in case), the income and estate taxes, the legal fees, the appraisal fees for the art collection and jewelry, and an additional significant amount for unforeseen expenses. He has given William a figure that would leave sufficient assets in the estate for all of those identified needs. William is going to be able to make his sister very happy by being able to distribute a moderate sum to her in the form of mutual funds right away. He will distribute the same amount to himself in order to balance the income tax impact of the distribution and to keep the record keeping clean. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 66 Types, Features, and Taxation of Trusts Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Trusts and their treatment are complex and connect with virtually every aspect of financial planning. Trusts can be used for risk management and often incorporate insurance policies. Trusts receive, purchase, and sell investments, making aspects of investment planning integral to using trusts. There are important income tax ramifications for the use of trusts. How the use of assets within trust planning impacts a client’s situation is important to understand within the client’s retirement planning as well as estate planning. The use of trusts is a complex topic,

requiring excellent communication skills on the part of the financial planner. Also, any strategic analysis of the use of trusts requires working alongside other professionals, such as estate planning attorneys, tax preparers, and insurance agents. Good interpersonal communication will facilitate the work of the group of advisors for the benefit of the client. And finally, as with every aspect of financial planning, the planner must adhere to standards of professional conduct and fiduciary responsibility.

INTRODUCTION A trust is a legal arrangement, created by a grantor (also called a trustor or settlor), to hold property for the benefit of one or more beneficiaries. The trust has a trustee, who is the fiduciary responsible for holding the property in accordance with the provisions of the trust. The trustee is the legal owner and has control of the property, but the beneficiary is the beneficial owner of the property. The trust document governs the management and operation of the trust. There is evidence of trust-like devices and trustee-like arrangements dating to Roman law, but more modern versions of the trust, legally separating ownership between the trustee’s legal ownership and the beneficiary’s beneficial ownership, date to the development of English common law in the thirteenth century. A strong body of trust law was established in England as a way to create more flexible arrangements for inheritance and property transfer than common law allowed. This tradition spread to British colonies and eventually to civil law countries, again as a means of dealing with everyday problems of inheritance, property transfer, and taxation with more flexibility than the legal system would otherwise allow.1 Previously determined by case law, where precedents rule, statutory law (or written law) is now widely used for trusts. As legislators across states have attempted to codify and unify trust laws throughout the twentieth and twenty-first centuries, the laws have addressed this need to empower the trustees, among other important thematic elements. The latest of these uniform efforts, the Uniform Trust Code, drafted by the Uniform Law Commission, became effective in 2000, and 24 states and the District of Columbia have adopted it as of mid-2012.2 Trusts are complex. They have many varied uses, and can create a multitude of planned and unplanned outcomes. Trusts can have significant income, gift, and estate tax ramifications. The reasons for creating trusts include: first, to protect and provide for beneficiaries; second, to provide for the management of assets; and, third, to reduce taxes. The appropriate use of trusts can enable grantors to: Provide for themselves (e.g., retaining an income interest or remainder interest in the property transferred to the trust). Provide for others (e.g., income and/or principal provisions for their beneficiaries or charities). Protect themselves (e.g., by establishing a successor trustee to manage the assets in the event of the grantor’s incapacity).

Protect others (e.g., through provisions designed to protect property for the benefit of the beneficiaries from foreseen or unforeseen risks such as illness or divorce). Reduce estate and gift taxes. Enforce their will after death. A personal financial planner should understand the two categories of trust characteristics: (1) living or testamentary and (2) revocable or irrevocable. These categories combine to create the types of trusts possible: revocable living, revocable testamentary (unusual to find, but not impossible to create), irrevocable living, and irrevocable testamentary. Trusts may be funded or unfunded. The income tax ramifications are important—including both the taxation of the trust (e.g., income, deductions, exemptions, credits, tax rates, and penalties for noncompliance) and the impact of distributions on that taxation for the trust and for the beneficiaries. The estate ramifications are also equally important and include both the impact on estate and gift taxes as well as the ultimate settlement of the estate. Equally important is a clear understanding of the various components of the asset being transferred to the trust when analyzing a client situation and making recommendations. The planner’s ability to analyze, clearly evaluate, and explain the various interests in the trust will enable the client’s trust to best suit his or her needs. Which beneficiaries get the income interest and which get the remainder interest, how and for how long, will determine the value of the transfer. This, in turn, will impact the tax deduction, estate reduction, or charitable gift. The change in estate tax law that created portability of the unified credit between spouses has caused a new type of trust to emerge—one where a surviving spouse has the power for a limited period of time after the death of their spouse to direct a chosen portion of the trust assets to a marital trust or to a credit shelter trust, depending on the projected/predicted best use of the unified credit, marital deduction, portability, and step-up in basis. The use of trusts for charitable purposes provides opportunities to benefit a favored charity, often while benefiting the grantor and/or the grantor’s heirs (through income tax provisions as well as income or principal provisions). Charitable trusts have the same characteristics as other trusts, but the value of any portion of the trust that goes to the charity creates a potential income tax deduction. A personal financial planner needs to know how to estimate the value of the charity’s part of the trust, although attorneys and valuation experts will determine the exact valuation. Certain assets transferred to a charitable trust can be sold without creating taxable income. It is important for a personal financial planner to understand the roles of the grantor(s), trustee(s), and beneficiary(ies) and to have clarity on the income, gift, and estate tax effects of assets transferred to the trust. For example, the planner will understand something as simple as whether a trust requires its own tax ID number or uses the tax ID number of the grantor or beneficiary and something as complex as how income is taxed within a trust and how trust distributions impact taxation for the trust and the recipient of the distribution. The planner will understand the rules governing the establishment and management of trusts, including trust distributions. The planner will understand what an income interest is and what a remainder interest is, and how those interests are valued. It is also imperative for a financial planner to

know the difference between having and using this knowledge versus practicing law without a license. While it is important for the financial planner to be able to read and interpret trust documents, the actual documents must be drafted by an attorney. The ability to understand and interpret the technical aspects of trusts and their use is important for the personal financial planner. It is equally important for a planner to understand the trust ramifications for a client’s situation both during the client’s life and after the client’s death. A revocable trust established during a grantor’s lifetime, and monitored well during that lifetime, can provide significant benefits while remaining completely flexible. That same trust, at the death of the grantor, reduces the flexibility of the trust to provisions incorporated by the grantor in the trust design. These trust provisions can provide for a great deal of post-grantor-death flexibility, but will be constrained both by design and by law (i.e., to meet certain legal, tax, and personal requirements) as the trust becomes irrevocable, with the provisions in place at the time of death. Simple will provisions can also create a testamentary trust. For each of these (and other) will and trust scenarios, income, estate, and gift taxes will be impacted and must be understood by the planner with the ability to explain the potential outcomes to the client. Perhaps more importantly, the outcomes for the trust grantor and beneficiary must be understood and evaluated in the context of the entire financial planning situation as well as the human dimension needs of the grantor and the beneficiaries.

LEARNING OBJECTIVES The student will be able to: a. Define and describe the uses of the four types of trusts including revocable, irrevocable, living, and testamentary trusts. b. Describe the basic components of charitable and non-charitable trusts including identifying the parties to a trust, and the operating terms of a trust. c. Identify the basic income tax consequences of a trust including deductions, exemptions, credits, tax rates, and penalties for non-compliance. d. Explain the income tax implications of trust income and distributions to beneficiaries.

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Illustrate trust similarities and differences via a chart that includes all four types of trusts (revocable living, irrevocable living, revocable testamentary, irrevocable testamentary) and lists the various provisions (e.g., income taxes, estate taxes, gift taxes, control over and use of assets) that apply to each combination.

Give the students a four-box grid (columns = revocable, irrevocable; rows = living, testamentary) and ask them to identify the types of trusts that fall within each box, as well as the provisions that apply to trusts within each box.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Invite an estate attorney to class to discuss his or her view on various types of trusts and how he or she analyzes a client’s needs and makes recommendations for a trust or trusts that would work to meet the client’s needs.

Before the class presentation, students develop a scenario about which to ask the estate attorney’s opinion.

Discuss various scenarios in which trusts could be used and what trust provisions would be most appropriate and beneficial in each scenario.

Students read a trust document and illustrate the income and estate tax impact and the distribution of the income and principal for the beneficiaries at various stages.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Work as a class to analyze and evaluate the use of various trusts and trust provisions within the context of a given case scenario that provides financial planning context (consider a case that has been used throughout the course).

Provide the students with a trust document and a fact pattern for the client in question. They will evaluate whether the trust met the needs of the client. Provide various what-if scenarios (alternative fact patterns for the same trust document) and ask the same question.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify the basic provisions and characteristics of trusts. Competent: A competent personal financial planner can clearly explain how a given trust works and its provisions, including all tax and distribution consequences. Expert: An expert personal financial planner can creatively craft the design (not the legal wording) of trusts for a given client situation.

IN PRACTICE Barat and Bavani Barat and Bavani are preparing to meet with their estate attorney to revise their estate documents, but have come in to meet with Jeanne, their financial planner, first. They currently have revocable living trusts. They have a friend who has money in a trust but cannot touch the money without asking the trustee, who often says no to the friend’s requests. Barat and Bavani are confused, as they are their own trustees and can access their money anytime they want. As they head into the meeting with their estate attorney, they want to understand how to avoid the sort of problem their friend is having with his trust. Jeanne explains that there are revocable trusts, such as theirs, and there are irrevocable trusts, which are generally created either at the death of the grantor or during the grantor’s life in order to take advantage of certain tax savings. Because Barat and Bavani want to maintain total control over their assets and they do not currently have a need or desire to reduce their estate taxes, Jeanne explains that they do not need to avail themselves of a more complex trust arrangement than the one they already have.

Latesha and Juan Latesha and Juan are in a dilemma. They have recently discovered that their son-in-law, Bill, is suffering from a gambling addiction. Apparently, he has had this problem for many years, but thought he had it conquered. Unfortunately, his addiction reoccurred recently and has resulted in some financial troubles for Bill and their daughter, Stella. The addiction does not appear to be threatening the marriage. However, Latesha and Juan are worried about the future, and what might happen if they leave money outright to Stella at their deaths. Their planner recommends that they leave Stella’s inheritance to her via an irrevocable trust, with a family friend (who knows the entire situation) as trustee, and a corporate trustee as successor trustee for backup and considering the long-term nature of this trust. The trust can be established to legally protect Stella’s inheritance for her benefit as well as the benefit of her children. As long as things remain safe, the income from the trust as well as any needed principal can be paid directly to Stella. But if the family-friend-trustee has any doubts, the trust income can be retained in the trust. This could result in higher income taxes but may not exacerbate Bill’s addiction and will ensure that Stella and her kids will have their inheritance available to them. The planner also suggests that the trust could be written to protect the assets even if Stella found herself liable

for some of her husband’s debts for some reason.

NOTES 1. Marius J. de Waal, “Trust Law,” Elgar Encyclopedia of Comparative Law, ed. Jan M. Smits (Cornwall: MPG Books, 2006). 2. “Legislative Fact Sheet—Trust Code,” Uniform Law Commission, 2012. Retrieved from http://uniformlaws.org/LegislativeFactSheet.aspx?title=Trust%20Code. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 67 Marital Deduction Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

The marital deduction is a key aspect of estate planning. Its beneficial use and the tactics to be implemented (e.g., titling of assets) must be explained clearly, making interpersonal communication important. Gift, estate, and income tax laws will impact the analysis and strategy incorporated by a financial planner. How insurance and investments are incorporated into a client’s financial situation will impact the marital deduction. Also, as with every aspect of financial planning, the planner must adhere to standards of professional conduct and

fiduciary responsibility.

INTRODUCTION Assets gifted or left (at death) to a spouse are generally estate and gift tax free due to the unlimited marital deduction. That sometimes means that leaving all of one’s assets to a spouse is the easiest and most cost-effective estate plan. However, this is not always the case. First, assets gifted or left to a non-U.S. spouse do not qualify for the unlimited marital deduction. (The solution to this dilemma is to establish a qualified domestic interest trust.) If the provisions of this trust comply with the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), there will be no taxes due at the death of the first spouse (leaving assets to the nonU.S. spouse). Taxes will be due, based on the estate tax laws in place at the time, at the death of the second spouse, just as would be the case in any situation. (All other references to “spouse” refer to U.S. resident spouses, unless otherwise noted.) Also, for couples with significant assets, leaving everything to each other could lead to a higher estate tax at the second death. Even with the portability of the unified credit, the use of that credit at the first death removes the appreciation on and income from those assets from the estate of the second to die. However, it also removes the step up in basis available at the second death if all assets are left to the spouse, utilizing the marital deduction and portability of the unified credit equivalent. The inability to predict the future makes this sort of planning particularly complex. The financial planner will point out that the successful estate plan will often utilize a bypass trust first before using the marital deduction where a reduction in estate taxes is relevant. The bypass trust uses the decedent’s unified credit to shelter that amount of estate from estate taxes, less any unified credit previously used for gifting purposes. The provisions of the bypass trust have the added benefit of allowing the decedent to control the ultimate disposition of assets while providing for a spouse during the spouse’s remaining lifetime. In addition, because nonU.S. residents do get the benefit of the unified credit, using a bypass trust will work in that situation as well. To the extent a family’s estate is too small to be concerned with estate taxes, leaving assets outright to spouses and using the unlimited marital deduction will generally be the best alternative. To the extent the estate is larger than the unified credit equivalent, the rest of the estate can be left to the surviving spouse using the unlimited marital deduction. If, in any circumstance, one spouse wants to control the disposition of assets at the death of the second spouse, but still wants to avail the first spouse’s estate of the unlimited marital deduction, the use of a qualified terminal interest property (QTIP) trust can be recommended.

LEARNING OBJECTIVES The student will be able to:

a. Describe the appropriate use of the marital deduction in estate planning including for both domestic and international spouses. b. Explain the relationship between the marital deduction and the qualified interest trust.

IN CLASS Category Applying: Carrying out or using a procedure through executing or implementing

Class Activity Lecture on the history of estate taxation with respect to the marital deduction.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Read and discuss the language used in a will or revocable living trust to define how much marital deduction an estate will take.

Creating: Putting elements together to form a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

Have a contest in class where the students work to be the fastest and most accurate in calculating how much marital deduction will be taken in a given fact pattern. Ask the class to create different situations from scratch and explain how the marital deduction might work. This can be done in small groups or done as a class.

Student Assessment Avenue Multiple choice exam: The student will calculate the marital deduction used given all the other figures for an estate tax calculation. The student will calculate the amount of a deceased spouse’s estate that would qualify for the unlimited marital deduction given the use of a bypass trust for a given set of estate values. Provide a series of financial planning scenarios with varying situations. The student will recommend how to use the marital deduction in each scenario. Students will incorporate the use and analysis of the marital deduction into their capstone financial planning case.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the marital deduction, including for the situation of one or two non-U.S. spouses. Competent: A competent personal financial planner can calculate the marital deduction that

will be taken in any given estate scenario. Expert: An expert personal financial planner can creatively and strategically include the use of the marital deduction in any estate analysis.

IN PRACTICE Bill and Beatrix Bill and Beatrix own their home and two cars, and have saved a little bit of money in their individual retirement accounts (IRAs). They hope to use this money to take some nice vacations during retirement. Bill’s pension will support them in their retirement, along with a small Social Security benefit Beatrix earned as a young adult. They have no other assets or liabilities. They want to set up their estate plan once and for all so that they do not have to worry about it at all during their retirement. They hire an hourly financial planner to help them figure out what they need to do. After she compliments them on having no debt whatsoever, even on their home, the planner explains that because the total value of their assets is lower than any potential estate tax hurdle, they do not need to worry about estate taxes. Bill’s pension disappears when the second of them dies, so there is no estate value to that very valuable income stream they have worked hard to achieve. Therefore, they can take advantage of the unlimited marital deduction to leave their assets to each other.

Tom and Jason Tom and Jason are upset. They just found out that despite being legally married in the state of Massachusetts, they will not qualify for the unlimited marital deduction for federal estate taxes at the first of their deaths, because they no longer live in Massachusetts, and the state in which they live does not recognize same-sex marriage and, consequently, in their situation, neither does the federal government. They consult their financial advisor, Steven Pike, about what options they have to share their assets, which are currently owned mostly by Jason (Jason has earned, and will almost certainly continue to earn, significantly more income than Tom), without incurring gift taxes (or estate taxes if Jason predeceases Tom without the assets having been equalized). Steven outlines various alternatives, noting that these are fairly extreme and that a legal agreement is highly recommended for the possible event of a dissolution of the relationship. One alternative is for Jason to gift assets to Tom, utilizing his current unified credit equivalent. Tom and Jason could then move to a community property state and register as domestic partners. In that way, all future earnings for each of them will be considered owned half each, so gift tax (or ultimate estate tax) will no longer be a problem. Additionally, to the extent half of Jason’s assets exceed the unified credit equivalent, he could gift his annual gift exclusion amount to Tom each year.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 68 Intra-Family and Other Business Transfer Techniques Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Intra-family and other business transfer is an extremely complex area of financial planning analysis. The successful financial planning analysis and resulting recommendations require an expertise in every topic area. The analysis of family financial statements and cash flow management, financing strategies, and time value of money concepts are all critical. There will often be insurance planning as well as risk management analysis required. The impact on and of the family’s investments is relevant. Often there will be a retirement planning component for

the generation transferring the business, and any strategies that could affect gift taxes, estate taxes, and income taxes will all need to be considered. Obviously, these transfer techniques are extremely complex, requiring excellent communication skills on the part of the financial planner. Business transfer planning and analysis require working alongside other professionals, such as estate planning attorneys, tax accountants, and insurance agents. Good interpersonal communication will facilitate the work of the group of advisors for the benefit of the client. And finally, as with every aspect of financial planning, the planner must adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION Clients with significant business and/or real estate assets will need a way to transfer those assets at or prior to their death. There are myriad objectives to be met with any such transfer, and the planner will first need to work with the client to unearth all of those objectives, the underlying reasons for them, and their relative priorities. Knowing the parties involved, whether family, employees, or co-business owners, and understanding the relationships, financial situations, and other factors about those parties will be crucial to developing an effective planning strategy for transferring the assets. To the extent there is a ready buyer for the asset, the legal terms of a future sale as well as the funding for the purchase can be planned in advance, during the client’s life. The terms of the sale will be outlined in a buy/sell agreement. Such an agreement can be between the owner and the company itself (a repurchase, or entity, agreement) or between two or more parties (a cross-purchase agreement). A cross-purchase agreement can involve a number of types of parties, including co-business owners, trusts, owners of unrelated businesses who agree to be each other’s buyout, or any parties willing to work together to provide for the orderly transfer of a business at the business owner’s death. A buy/sell agreement is often funded with insurance, specifically disability insurance and life insurance. The complexity of the amounts and types of insurance needed will depend on the complexity of the situation as well as attributes of the parties involved, including their health and finances. There are different tax ramifications depending on the buy/sell structure and funding chosen. For example, cross-purchase agreements increase the tax basis of the shares owned by the individual who purchases shares in the event of another owner’s death or disability. This increase in tax basis is determined by the amount paid for the deceased or disabled shareholder’s shares. However, cross-purchase agreements also increase the purchasing shareholder’s income taxation, because he or she must hold the insurance on the other shareholder and, to the extent that the company makes the insurance payment, which will have to be done through taxable income to the purchasing shareholder. The ultimately higher tax basis in the shares comes at the expense of income taxation for all the years the insurance is paid for. The entity purchase alternative does not create income taxation for the insurance premiums, but it does not provide a higher tax basis for the remaining shareholders, and any life insurance received by a C corporation could have a negative income tax impact at the corporate level. Clarity around income tax ramifications is crucial.

Generally, if clients are considering family transfers (other than buy/sell arrangements) that are not outright gifts, the clients will have an objective of reducing gift and estate taxes on any transfer of business or real estate assets without giving up total control of the assets. Clients who wish to reduce their ultimate estate taxes have access to many strategies. These strategies can reduce the potential estate taxes by reducing the value of the asset in the estate while allowing the client to maintain control of the asset during life. The asset value can be reduced by giving away the ultimate ownership of the asset while retaining an interest in that asset during life or for some predetermined length of time. The asset value can be reduced while retaining control by giving away only a portion of the asset, and this method can sometimes result in a discounted valuation due to lack of marketability or minority ownership. To the extent that an asset can be removed from the estate through gifting at a gift value that is less than the estate value, the total taxes have been reduced. These strategies also generally remove the appreciation on the entire asset or the gifted portion of it from the estate, further reducing the total taxes paid. Some of these tools allow the client to pay some of the expenses on the asset (such as the mortgage payment and taxes on a home placed in trust, or the taxes due on the income generated by the trust), thereby further reducing the client’s estate by the amount of those expenses paid. In addition, an asset can be sold in a way where the payment to the seller may be less than the value of the asset sold. The primary method for reducing an asset’s value in the estate is to transfer the asset during life by gifting or selling the asset for some amount that is less than the amount for which the asset would be valued at death. The use of a trust is helpful in this regard, generally through the use of a retained interest in the asset. The financial planner will need to analyze and recommend the appropriate use of trusts and their various forms of retained interest, including retained income in the form of an amount based on a dollar amount, an annuity amount, or a percentage of the asset value, and the use of an asset for life or for some specified period. The planner will need to calculate the value of an income interest and the resulting value of the remainder interest, which will represent the ultimate gift being made on which a gift tax will be calculated. The use of such a trust with a personal residence and the different provisions and benefits of a qualified personal residence trust versus a personal residence trust will need to be considered. In addition, it is helpful to be able to include in any analysis the tax implications and resulting effect on the ultimate estate of making a grantor trust intentionally defective. Another tool for transferring assets at a reduced value is the transfer of less than a full interest in an asset. The value of an unmarketable piece of an asset or a minority interest in something is less than its relative share of that asset due to the lack of control the minority owner has over the management or disposition of the asset. For this reason, a gift made of such an interest will be worth less than the value of that asset in the estate. Also, any appreciation on the gifted portion of the asset will be removed from the estate. If the lifetime gift exclusion has been used, the grantor can sell assets at a discount, thereby removing the amount of the discount as well as any appreciation on the asset from the ultimate estate. The tools to effect this type of transfer include trusts, family limited partnerships, and family limited liability companies (LLCs). A thorough understanding of each of these tools and how they can best be put to use is

critical to making informed recommendations in this regard. The owner of an asset can also sell the asset to the intended recipient. To the extent the payment in exchange for the sale has a possibility of returning less to the seller than the value of the asset, the seller’s estate has been reduced. This can happen by selling a discounted interest (due to lack of marketability and minority interest). An additional tool for receiving less for the asset than its value in the estate is through the use of a private annuity, whereby an asset is sold in exchange for a lifetime stream of income. To the extent the seller dies before receiving annuity payments equal to the asset value, the seller’s estate has been reduced. A successful financial planner will understand the use and effects of private annuities. A successful financial planner can coordinate estate liquidity needs with the rest of the business and real estate transfer goals and objectives within the overall financial planning context.

LEARNING OBJECTIVE The student will be able to: a. Recommend appropriate business and transfer techniques such as: 1. Buy/sell agreements a. Cross-purchase agreements b. Repurchase/Entity agreements 2. Grantor trust a. Retained Interest Trust GRITSs, GRATs, GRUTs PRT, QPRT b. Intentionally Defective Grantor Trusts 3. Family Limited Partnerships or Family LLCs 4. Private Annuity

IN CLASS

Category

Class Activity

Student Assessment Avenue

Applying: Carrying out or using a procedure through executing or implementing

Ask students to read a number of assigned Journal of Financial Planning and Financial Services Review articles on the topic of intra-family and business transfer techniques.

Ask students to write an essay on the use of one transfer technique (having read multiple articles on that technique).

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

In-class discussion analyzing various transfer tools and how they impact the distribution of the assets and the estate tax paid. Compare different strategies for the same fact pattern, and different fact patterns using the same strategies. Give the students various cases with strategies in place. Ask them to read and interpret those cases and then explain them to the rest of the class (as if they were explaining it to a client).

Ask students to diagram the distribution of business and real estate holdings and the taxes due from the estate for various scenarios.

Provide a series of case studies that include various financial planning scenarios. Students recommend strategies for meeting the client’s distribution goals for each scenario. Creating: Putting elements Work as a class to analyze and Students devise a business together to form a coherent evaluate complex business and and real estate transfer or functional whole; real estate transfer strategies and strategy to meet client reorganizing elements into a explain how they all work objectives (including new pattern or structure together within the context of a minimizing total taxes) over a through generating, full financial plan. several-generation situation, planning, or producing given a comprehensive financial planning case study.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can describe and explain each business and real estate transfer tool. Competent: A competent personal financial planner can evaluate various business and real estate transfer alternatives and explain how they work together as part of a larger strategy. A competent planner can recommend which alternatives work best and explain why. Expert: An expert personal financial planner can create a comprehensive business and real estate transfer plan within the larger financial planning context that meets all of the client’s

goals, including minimizing taxes, if applicable.

IN PRACTICE Ann Ann owns a home she purchased many decades ago just a few houses away from her childhood home. She also owns her childhood home, having purchased it from her parents via a family annuity prior to her father’s death. Ann’s daughter, Sharon, and Sharon’s two children live in “Momma and Daddy’s house” (Ann’s parents’ house), paying Ann close to fair market rent. Ann lives in her own home. Her son, Doug, was recently living there with her, but has moved out to live with friends. Ann would like Sharon to inherit Momma and Daddy’s house, and she would like Doug to inherit her house. Doug and Sharon are close and they like the idea of living near each other. Neither home has a mortgage. Ann intends to stay in her home for some time, but when she does decide to move to a retirement facility, Doug is prepared to move in and take over the home. Ann has asked her financial planner, David, to help her decide the best method for her children to inherit these two homes. Due to some other family land that may generate some significant income (from oil and gas royalty rights), Ann is concerned about her estate tax situation. David analyzes the potential income tax cost of losing the step-up in basis on either or both houses. He looks at the potential estate tax costs of retaining either or both houses in the estate. He determines that the ability to remove the homes from the estate outweighs the income tax ramifications, particularly since both Sharon and Doug intend to remain in the homes indefinitely. David considers a private annuity for each home, but neither Sharon nor Doug has the assets to make the payments, and Ann is too young to make such an annuity viable from a risk tolerance perspective (she may far outlive the age on which the annuity calculations are based, resulting in no savings to the estate in terms of estate taxes). David recommends each home be placed in a qualified personal residence trust (QPRT), with Sharon as the ultimate beneficiary of the QPRT holding Momma and Daddy’s house, and Doug as the ultimate beneficiary of the QPRT holding Ann’s house. The trusts will be written with a term that corresponds with Ann’s intention of entering a retirement facility in about 10 years. The gift tax return will reflect the resulting remainder interest in each QPRT as a gift to Sharon and Doug, respectively. Ann will continue to make the real estate tax payments on each property and pay for any necessary improvements. The use of funds in this way will further reduce her estate valuation. She will also receive the rental income from Sharon. However, because that property is rented, Ann will have to spend 37 days at Momma and Daddy’s house each year. This is easy, as she tends to visit at least one full day and night per week to stay with her grandchildren and give Sharon an opportunity to work late or have an evening out. As long as Ann outlives the length of the terms of the trust, both properties will be out of her estate at her death. They will each carry her tax basis. Additionally, Ann now has a clear picture of when she will move to a retirement facility—just after the two trusts terminate.

Donald Donald recently sold his business. Part of the sale entailed the buyer signing a long-term lease on the property the business inhabits, which Donald owns. The rent on this property is a nice stream of income, but fairly unnecessary for Donald and his wife, Mary, because their other assets more than support them. Donald and Mary have two sons, Alvin and Bob. Both sons are doing well in their chosen fields, but Donald and Mary fear the sons won’t be able to accumulate retirement assets sufficient for their needs. Donald and Mary’s other assets, including two high-value homes, create an estate tax problem for them. They gift their sons the full annual gift amount each year. Donald’s longtime attorney, Jimmy, has suggested something that sounds like an “idiot trust” (which makes sense to Donald to call it that, as apparently it is created to be intentionally defective) to enable Donald to move some of the rental income from the property into a trust to accumulate for his sons for their needs later in life. Jimmy explains that Donald can move 24.5 percent of the property into an intentionally defective grantor trust (IDGT) for each son. In this way, while 24.5 percent of the $2 million property seems like it would create a gift of $490,000, it will not—due to the fact that 24.5 percent is a minority interest with no bearing on any management or disposition decisions, the taxable gift will be closer to $350,000 for each son. The rent that goes along with that asset (about $50,000 per year per son) will go into the IDGT for them to accumulate for their later years. (Donald and Mary’s chosen trustee will determine when and how much income Alvin and Bob get from the trusts.) This strategy removes $1 million of estate value from Donald and Mary’s gross estate. It also removes the assets that would accumulate by virtue of the $100,000 of rental income to be received each year. In addition, the “intentionally defective” part of the trust means that any income taxes due (on the rental income, and ultimately on the investment income generated by investing the rental income) will be paid by Donald and Mary, further reducing their estate. It sounds very complex, but the estate tax savings are compelling enough to motivate them to implement the plan, particularly since it so well serves their desires for their sons.

Sherrell Sherrell is meeting with her planner to discuss her desire to bring some of her employees as partners into her small business. She has determined the buy-in strategy and valuation, and her attorney has drafted the ownership documents. Her employees are securing their financing, and it looks like sooner rather than later. However, they have asked her what will happen to their ownership if they die, and they want to know what will happen to them, as minority owners, if Sherrell dies. Sherrell understands the concept of a buy-sell agreement, and intends to put one in place, but she is unclear on how the purchasers (the survivors) would be able to pay for the buyout. Sherrell’s planner explains that generally the funding of a buy-sell agreement is provided through the purchase of insurance. Once the valuation and methodology for the buy-sell arrangement is established, insurance is purchased on each owner for the event of their death or permanent disability. If there are no concerns for the owners to get a step-up in tax basis for their purchase in the event the buy-sell arrangement is triggered, the company can own the

insurance (Sherrell’s company is an S corporation, not a C corporation, where this would be problematic) and purchase the shares of any deceased or disabled employee. However, it can make more sense from a tax standpoint to use a cross-purchase agreement (versus the entity purchase described earlier), whereby each remaining owner purchases his or her share of the deceased or disabled owner’s shares. This requires each owner to have insurance on each other owner, which can be done, but can also be fairly complex. Sherrell, after much consideration and very clear explanation from her advisor, decides that because the employees own a fairly small amount of stock, the tax basis issue is less relevant, so the company will own insurance on each of those employee owners (life and disability buyout) and will purchase those shares in the event of a death or disability. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 69 Postmortem Estate Planning Techniques Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Postmortem estate planning requires an overall view of the estate situation, including the basics of the general principles of financial planning. There is often insurance involved in an estate, and risk management can be an area of concern for the fiduciaries involved in settling the estate. The treatment and selection of assets in the management and distribution of the estate require a thorough understanding of investments and income taxes. A thorough understanding of all tax laws is crucial to ensuring poor decisions are not made by either inappropriately

implementing a postmortem technique or missing the opportunity to take advantage of such a technique. Postmortem estate planning is very complex, requiring excellent communication skills on the part of the financial planner. Also, postmortem planning will entail the planner working alongside other professionals, such as estate planning attorneys, tax accountants, and insurance agents. Good interpersonal communication will facilitate the work of the group of advisors for the benefit of the client. The planner must also adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION There are three scenarios where postmortem estate planning is important: (1) a mistake was made in the estate design, (2) circumstances changed after the estate was designed and no revision occurred, or (3) it is after the decedent’s death, or at some later time, that the situation is most clear to make a decision. The objectives for such planning can be to reduce taxes (income and/or estate), but may also be about meeting the needs of others such as the decedent’s heirs or chosen charities. Estate tax law specifically provides for some areas of flexibility, most notably the provision for disclaimer, the alternate estate valuation date, and powers of appointment. Other postmortem estate planning tools include election against a will, the ability of the executor or trustee to make postmortem gifts, and various methods of paying the estate tax. And a new and very important postmortem planning technique is the ability to determine the use of the marital deduction combined with portability of the unified credit equivalent versus utilizing a credit shelter trust. In order to have access to this postmortem planning, however, estate documents must have been written correctly before death. Without proper flexibility written into the documents, the surviving spouse may have little or no opportunity to make the best decision at the time. And of course, the best decision may be difficult to determine where, for example, it is unclear as to the relative merit of increased basis for the survivor versus removing appreciation from the survivor’s estate. Postmortem estate planning is a complex form of scenario planning. All relevant information (including asset values and prior basis; beneficiary wealth, needs, and desires; income and estate tax situations; and numerous other facts and figures) is necessary for the planner to analyze the various benefits and costs of different scenarios. A thorough understanding of the laws, even though the estate attorney will implement the strategies, is critical to a planner’s ability to benefit the client. Armed with this information, the planner can devise scenarios comparing the taxes paid and ultimate recipients of the estate as it stands with the expected outcomes of various postmortem planning techniques, including availing a surviving spouse of the portability alternative. The planner must understand and analyze the use of alternate valuation (the ability to value the entire estate six months after the date of death) and specialuse valuation (the ability to value certain farm and closely held business property at its farm or business use value rather than its fair market value), including their legal provisions and ramifications. For example, the planner must be able to apply the alternative valuation date rules, including determining the alternate valuation date, knowing to which assets (all) the

alternate valuation must apply, and knowing that the alternative valuation date may be used only when both the gross estate and the estate tax will be lowered by doing so. The ultimate impact on the basis of the inherited assets is also important to consider. The planner must help ensure that any postmortem planning techniques being considered remain viable by not allowing time to elapse or actions to be taken that would make a beneficial technique unavailable. Examples of this include allowing a beneficiary to receive a portion or benefit of an asset in a way that would eliminate the ability to affect a qualified disclaimer, or allowing a time period to pass or lapse, such as the nine-month time period within which a qualified disclaimer may be made. Various methods of paying estate taxes exist and are part of the postmortem planning process. Installment payment is an alternative for estates that include closely held businesses. Also available to estates that include closely held businesses is an IRC Section 303 stock redemption, whereby the estate can sell back shares of the corporation to the corporation at favorable capital gains rates in order to create liquidity for the payment of estate taxes. The rules around these payment methods are numerous and complex and must be well understood by the planner working to help settle such an estate.

LEARNING OBJECTIVES The student will be able to: a. Describe when an executor should elect to value estate assets using the alternative valuation date. b. Outline the rules that must be followed in order to use a qualified disclaimer estate planning strategy. c. Describe other forms of postmortem planning, including estate tax installment payments, stock redemptions for tax payments, special-use valuations, and elections against a will. d. Explain how and why QTIP property is a terminable-interest rule exception.

IN CLASS Category

Applying: Carrying out or using a procedure through executing or implementing

Class Activity

Student Assessment Avenue Read Part 3, Elections by the Executor, IRS Form Ask students 706 filing instructions to select one (www.irs.gov/instructions/i706/ch02.html#d0e673). postmortem planning technique and

write a brief essay on various situations in which that technique could be used. Analyzing: Breaking Facilitate an interactive class discussion of various Give students material into constituent estate scenarios and the available postmortem several case parts, determining how planning techniques available, including their costs scenarios, the parts relate to one and benefits. including another and to an overall recommended structure or purpose postmortem through differentiating, planning organizing, and techniques, attributing and ask them to calculate the financial impacts of these techniques, as well as write short essays about the impact on heirs. Evaluating: Making Break the class into teams. Give each team an estate Provide a judgments based on scenario and ask them to develop a postmortem series of criteria and standards estate plan and present it to the class. estate through checking and scenarios. critiquing Ask students to evaluate and recommend postmortem estate strategies that could or should be put into place. Creating: Putting Discuss and demonstrate the development and Require the

elements together to form presentation of a comprehensive financial plan. a coherent or functional whole; reorganizing elements into a new pattern or structure through generating, planning, or producing

students to include postmortem planning strategies in their final capstone case analysis and presentation.

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can identify and describe all available postmortem estate planning techniques. Competent: A competent personal financial planner can explain how each postmortem estate planning technique works, including all tax consequences, in contextual terms, given examples. Expert: An expert personal financial planner can incorporate postmortem estate planning strategies in a comprehensive financial plan.

IN PRACTICE Paul Mrs. Pritchett has passed away at the age of 89. She left the family farm, her pickup truck, and her wedding ring to her son, Paul, who has worked on the family farm for years. The farm is in a prime location and would sell to a developer for millions. However, Paul wants to keep the farm, continue to work it, and pass it on to his heirs. The farm will qualify for the special-use valuation whereby it can be valued as a farm versus at the land value. Even then, the farm value will create an estate tax in Mrs. Pritchett’s estate. Paul’s financial planner is working with his attorney to help him pursue an installment payment alternative, which would spread out the taxes over (up to) 14 years. This would enable Paul to keep the farm in the family. Paul’s financial planner has also suggested he consider disclaiming the farm, in which case it would pass to Paul’s children, escaping estate tax at Paul’s death. Paul does not like this idea, but he is very interested in anything that could help his children avoid the tax bill he is facing.

Lau Chun Lau Chun died on March 15 and left an estate worth $6 million. Since the value of the assets in Lau’s estate exceeds the unified credit, his estate will pay taxes on amounts above the unified credit. Lau’s assets will be valued as of the date he died, March 15. However, Lau held his entire investment portfolio in volatile stocks, and his assets fell to $4.2 million as of September 15. Lau’s executor chose to use the alternative valuation date on Lau’s estate tax

return in order to avoid paying any estate taxes. His heirs sold the stock that made up all of Lau’s estate on December 1, when the stock had gone back up and was now valued at $6 million. Lau’s heirs would owe capital gains tax on $1.8 million. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 70 Estate Planning for Non-Traditional Relationships Elissa Buie, MBA, CFP® Golden Gate University

CONNECTIONS DIAGRAM

Estate planning (including gift planning) for non-traditional couples encompasses the entire financial planning process and its component parts. General principles of financial planning, including financial statements, cash flow management, and other concepts, are necessary. Insurance planning and risk management are critical estate planning components for nontraditional couples. Income tax planning is relevant, as is retirement planning. The ability to share assets, protect each other, plan for combined retirements, and consider other

responsibilities (e.g., children from prior marriages or prior spouses) is often more complex. In addition to its inherent complexity, the discussion around issues relating to non-traditional couples may be sensitive. This necessitates excellent communication skills on the part of the financial planner. Also, any estate planning strategy requires working alongside other professionals, such as estate planning attorneys, tax accountants, or insurance agents. Good interpersonal communication will facilitate the work of the group of advisors for the benefit of the client. The planner must adhere to ethical standards of professional conduct and fiduciary responsibility.

INTRODUCTION For the purposes of this chapter, a non-traditional relationship is defined as any committed couple other than a couple consisting of one male and one female who are in their first legal marriage or, if previously married, have no ongoing ties to their prior spouse (i.e., no children, no shared property, no ongoing financial obligation). Legally married couples comprise fewer than half of all U.S. households (meaning, of course, that first marriages make up an even smaller proportion of households). The importance of the distinction between traditional and non-traditional relationships is that there are critical planning needs for unmarried couples and for legally married couples who have children from a prior marriage, have ties to a prior spouse, are legally married at the state level, or currently live in a non-recognition state. Planning needs fall into two broad categories. One category is divorced and divorced-remarried couples, who face special needs with respect to estate planning if they retain any ongoing legal or financial connection to their prior spouse and/or have children from that marriage. The other broad category includes couples who are not legally married or whose marriage is not recognized by the state in which they reside. The legalization of same-sex marriage in a growing number of jurisdictions has caused many same-sex unions to be treated the same as traditional marriages in all ways and by all federal agencies. However, there are still many situations in which this is not the case. Qualified domestic partnerships are not recognized as marriages at the federal level. And same-sex marriages for those residing in non-recognition states are only recognized by some federal agencies, not by all. Obviously, this is a complex topic and one where the planner will need to study the technical aspects for each state involved. And finally, because the unlimited marital deduction does not apply to persons married to spouses who are not U.S. citizens, much of the planning expertise for non-traditional couples will be helpful to planning for these couples as well. Fifty percent of first marriages end in divorce. If divorce happens early in the marriage, before significant assets and liabilities have been jointly created and before children, divorce can have limited financial and legal impact. But for most, a life has been built together that has to be untangled. This untangling requires consideration of gift and estate tax laws. Financial arrangements made through a legal proceeding can enable a divorced couple to exchange financial assets even after the marriage has ended without fear of incurring gift or estate taxes. Such planning can also create an ongoing legal obligation from one spouse to the other in the

form of spousal support (i.e., alimony) or shared entitlement to retirement assets or a pension. Planning needs become more complicated when a divorced person remarries. Financial obligations to a prior spouse must be protected after a remarriage. Complex planning needs may arise when attempting to provide for children of a prior marriage, complicated further if the new marriage also involves additional children. These planning needs can be met through asset titling, estate documents, and beneficiary designations. However, these must be designed and continually reviewed based on the obligations to the prior marriage, to the new marriage, and to any and all children involved, all while considering changing estate tax laws. The Williams Institute at the UCLA School of Law, a sexual orientation law and public policy think tank, estimates that 9 million (about 3.8 percent) of Americans identify as gay, lesbian, bisexual, or transgender.1 Based on the latest household numbers released in April 2012 by the U.S. Census Bureau, there were 646,464 same-sex couples in the United States in 2010. While same-sex marriage is recognized at the federal level, there are complications surrounding this recognition. Federal gift and estate tax laws are applicable to any legally married couple. However, Social Security benefits, as one example, are not available to the spouse in a samesex marriage unless that couple lives in a state that recognizes the couple’s marriage. This bifurcation of marriage recognition creates serious planning obstacles and opportunities for non-traditional couples. And, of course, some same-sex couples remain unable to marry, at least in the state in which they live. Legally recognized marriage bestows specific legal and financial rights on the couple and the individuals within the couple. Without marriage, or to the extent the marriage is not fully recognized due to the state of domicile, other tools are needed to create these legal rights, to the extent possible. The planner’s knowledge of all available gift and estate tax tools and the ramifications of each is critical. For example, an unmarried lesbian couple can draft a legal document outlining what happens to their assets if one of them dies. However, they cannot overcome the absence of the unlimited spousal exclusion by doing so. The gift tax ramifications of who pays for what in an unmarried relationship can be complex and costly. While government monitoring of gift taxes owed by unmarried couples appears to be minimal, this does not eliminate the need to plan accordingly. Where one member of a couple amasses or inherits assets and wishes to pass them on to the unmarried partner at death, there is no unlimited marital exemption, so any amount bequeathed over the then-applicable estate tax exemption will incur estate tax. Fortunately, the estate tax exemption has recently been significantly increased, but planning is generally still in order. An important issue that can be particularly challenging for unmarried couples is the management of health issues in the event of illness or incapacity of any kind. In the absence of strong legal documents, generally only spouses and blood relatives have rights surrounding an incapacitated person’s medical care and decisions, including end-of-life decisions. Unmarried couples must ensure that they have well-written, up-to-date health care powers of attorney, durable powers of attorney, and living wills (or similar documents as needed in each state). Planners must understand the requirements in all states in which they are advising and should help ensure that clients secure the services of an attorney specializing in working with nontraditional couples. The proactive planner will ensure that the location of valid copies of all current documents is known to all interested parties.

Every state has its own laws regarding marriage and domestic partnerships, and while most states do legally recognize same-sex relationships, some still do not. As of this writing, every state that previously allowed civil union or domestic partnership now also allows same-sex marriage. But there are presumably numerous couples who remain in a civil union or as domestic partners. Where this is the case, there is an effect on state-level income, gift, and estate taxes. There generally will not be an effect at the federal level. But there are exceptions here as well. In the state of California, for example, half of the income earned by a registered domestic partner is attributed to the non-earning partner, so there are no gift taxes or estate taxes due on accumulation of or expenses paid using that portion of the income. Financial planners should advise only in states where they are competent with regard to the applicable treatment of marriage alternatives and non-traditional relationships where there is no marriage or marriage alternative available. The successful planner will understand how to meet client goals and objectives, as well as legal requirements, using asset titling (including various forms of joint ownership), beneficiary designations, and collateral assignment of assets and life insurance policies. The planner will also have a full awareness of all tax ramifications of these techniques. The financial planning practitioner will also be able to describe the distribution effects of various estate distribution and gifting tools and titling, including trusts, limited liability companies (LLCs), family limited partnerships (FLPs), charitable gifting tools, and life estates. The planner should consider different planning strategies to achieve desired and legally required outcomes while serving as many of the client’s wishes as possible, including minimizing gift, estate, and income taxes. A clear understanding of and ability to explain the results of dying intestate is also needed. Under intestacy laws, while married partners are entitled to assets from their spouse, unmarried partners are not. Unmarried partners are only entitled to their own share of jointly held assets, those owned with rights of survivorship, or those for which they are the beneficiary. In some states, however, domestic partners do have rights to their partner’s assets after death (for example, community property assets located in California for registered domestic partners). The impact of state laws on federal taxes, while limited in many respects, must be understood and included in the analysis and recommendation of any estate planning tools and techniques.

LEARNING OBJECTIVES The student will be able to: a. Identify the impact of divorce and/or remarriage on an estate plan including asset titling and distribution, changes in beneficiary status, and selection of heirs. b. Recommend strategies that can be implemented to help ensure the appropriate management and transfer of assets to same-sex, non-traditional, and/or non-married partners.

IN CLASS Category

Class Activity

Student Assessment Avenue

Applying: Carrying Lecture by an estate planning attorney who out or using a specializes in working with same-sex couples. procedure through executing or implementing

Ask students to calculate potential gift and estate taxes given various scenarios for same-sex couples.

An interactive class discussion of various nontraditional couple scenarios and the planning tools available. (Examples would include couples who are registered domestic partners and those who are not, couples who have similar income and assets and those with disparate financial resources, couples with children from prior marriages and those without, couples married in and residing in states representing different marriage recognition, etc.)

Provide non-traditional couple scenarios, including recommended gift and estate planning techniques. Ask students to calculate the financial impacts of these techniques and write short essays about the impact on the partners in the relationship.

Analyzing: Breaking material into constituent parts, and determining how the parts relate to one another and to an overall structure or purpose through differentiating, organizing, and attributing Evaluating: Making judgments based on criteria and standards through checking and critiquing

Break the class into teams. Give each team an estate scenario that profiles a non-traditional couple, and ask the teams to develop an estate plan and present it to the class.

Provide non-traditional couple scenarios, including recommended gift and estate planning techniques. Ask students to evaluate the recommendations and suggest better or other ideas. Creating: Putting Address non-traditional couple estate planning The students include elements together in the context of a case the class has been using non-traditional couple to form a coherent for the semester. planning strategies in or functional their final capstone case whole; analysis and reorganizing presentation. elements into a new pattern or structure through generating, planning, or producing

PROFESSIONAL PRACTICE CAPABILITIES Entry-Level: An entry-level personal financial planner can explain the estate planning tools available to non-traditional couples and recognizes the different treatment of marriage alternatives and marriages performed in various states and how domicile can impact treatment at the federal level. Competent: A competent personal financial planner can analyze a non- traditional couple’s financial situation, whether married or not, with respect to estate and gift taxes and evaluate the tools currently in place or those being recommended. Expert: An expert personal financial planner can create a strategic estate plan for a nontraditional couple, whether married or not, and can incorporate non-traditional couple estate and gift planning strategies in a comprehensive financial plan.

IN PRACTICE Chris and Dave Chris and Dave are in a committed same-sex relationship. Chris is a litigation attorney and earns well over $500,000 per year. Dave is a social worker and earns around $50,000 per year. They are residents of California and many years ago they registered as domestic partners. They have not made plans to legally marry. They have worked closely with their financial planner, kept excellent records, and filed their income taxes correctly for their relationship. As such, most of their assets are legitimately community property, with the exception of a large individual retirement account (IRA) rolled over from a prior employer by Chris before he and Dave became registered domestic partners. The question they have now is how to handle an inheritance Dave is about to receive from an uncle who recently passed away. Chris and Dave would like to use this inheritance to purchase a long-desired vacation home in Lake Tahoe. They are unclear on the ramifications of purchasing this home, which they wish to own jointly, on their income, gift, and estate taxes. Their financial planner analyzes their current estate tax situation, including this pending inheritance, to determine the level of estate taxes that would be due at each death. She compares the current gift tax ramifications of Dave gifting one half of the Lake Tahoe home to Chris with the potential estate tax costs of Dave owning the property outright and leaving it to Chris in his estate. A final analysis is done contemplating how Chris’s large (non-community-property) IRA might be used in this situation.

Katie and Brandon Katie has married Brandon after being divorced from Tom for a number of years. Katie and Tom have a daughter, Susan, who is 13 years old. Brandon has six children from his previous marriage to Abbey. Katie and Brandon are committed to each other and want to provide for the surviving partner upon the death of the other. However, they also want to ensure that their respective children inherit their assets (i.e., Katie wants Susan to inherit her assets and Brandon wants his six children to inherit his assets). They have kept all assets separate other

than their home, which they pay for 50–50, and the bank account out of which they pay household expenses, which is also funded 50–50. In addition to the financial issues, there are a number of human dimension issues to consider in this situation. Katie and Brandon enjoy relationships with each other’s children and do not want to risk those relationships in the event of one of their deaths. Katie and Tom had a relatively amicable divorce, but Katie would not want Tom to get access to any of her assets left to Susan. Brandon has a good relationship with his ex-wife Abbey, but feels the same way. Katie and Brandon’s financial planner summarizes their assets as a starting place for the dialogue. He clarifies the couple’s wishes to ensure a complete understanding of the desired outcomes and the objectives and values inherent in them. He then provides three different alternatives for Katie and Brandon to review. The first leaves each partner’s assets outright to that person’s children (in trust, but with no provision for the surviving spouse). While this does not appear to meet the couple’s goals, it does give them a starting place that allows them to evaluate the need (without denying the desire) to financially provide for each other. The second alternative leaves the assets outright to each other, with the understanding that the surviving spouse would keep assets separate and would use the decedent spouse’s assets as needed, but would leave the remainder of the assets to that spouse’s children. Again, this does not meet the couple’s goals, but it does show them the other end of the spectrum with respect to alternatives, and allows a candid discussion of the benefits and risks of leaving all decisions to the surviving spouse. The third and final alternative illustrates leaving all assets to trusts, with the surviving spouse as the income beneficiary and the children as the remainder beneficiaries, with provisions for providing for the children’s needs as the trustee sees fit during the life of the surviving spouse. Reviewing this alternative allows a dialogue around the complications that could arise at the death of the first spouse if all assets are left into trust with limited access for the children. The need for support for the children, the children’s emotional reactions to receiving no inheritance, their potential fears over the treatment and use of those assets during their stepparent’s life, and other costs and benefits are discussed. The review of these three different scenarios allows Katie and Brandon, with the help of their planner, to develop an estate plan that is a hybrid of all three of these alternatives and best suits their various needs. Reviewing the pros and cons of these three options allows Katie and Brandon to make an educated decision about the combination of benefits they want and the trade-offs they are willing to make.

NOTE 1. G. J. Gates, “How Many People Are Lesbian, Gay, Bisexual and Transgender?” Los Angeles: The Williams Institute, UCLA School of Law (April 2011). Retrieved from http://williamsinstitute.law.ucla.edu/wp-content/uploads/Gates-How-Many-People-LGBTApr-2011.pdf.

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CFP BOARD’S CODE OF ETHICS AND PROFESSIONAL RESPONSIBILITY CFP Board’s Code of Ethics and Professional Responsibility (“Code of Ethics”) is an important component of CFP Board’s Standards of Professional Conduct (“Standards”). The Code of Ethics sets forth seven principles that express the ethical and professional ideals certificants are expected to display in their professional activities. These principles, which are aspirational in character and provide a source of guidance for certificants, form the basis of CFP Board’s Rules of Conduct, Financial Planning Practice Standards, and Disciplinary Rules and Procedures. Collectively, these documents reflect CFP Board’s recognition of certificants’ responsibilities to the public, clients, colleagues, and employers. The seven principles set forth in the Code of Ethics are as follows: Principle 1—Integrity: Provide professional services with integrity. Integrity demands honesty and candor, which must not be subordinated to personal gain and advantage. Certificants are placed in positions of trust by clients, and the ultimate source of that trust is the certificant’s personal integrity. Allowance can be made for innocent error and legitimate differences of opinion, but integrity cannot coexist with deceit or subordination of one’s principles. Principle 2—Objectivity: Provide professional services objectively. Objectivity requires intellectual honesty and impartiality. Regardless of the particular service rendered or the capacity in which a certificant functions, certificants should protect the integrity of their work, maintain objectivity, and avoid subordination of their judgment. Principle 3—Competence: Maintain the knowledge and skill necessary to provide professional services competently. Competence means attaining and maintaining an adequate level of knowledge and skill, and application of that knowledge and skill in providing services to clients. Competence also includes the wisdom to recognize the limitations of that knowledge and when consultation with other professionals is appropriate or referral to other professionals necessary. Certificants make a continuing commitment to learning and professional improvement. Principle 4—Fairness: Be fair and reasonable in all professional relationships. Disclose conflicts of interest. Fairness requires impartiality, intellectual honesty, and

disclosure of material conflicts of interest. It involves a subordination of one’s own feelings, prejudices, and desires so as to achieve a proper balance of conflicting interests. Fairness is treating others in the same fashion that you would want to be treated. Principle 5—Confidentiality: Protect the confidentiality of all client information. Confidentiality means ensuring that information is accessible only to those authorized to have access. A relationship of trust and confidence with the client can only be built upon the understanding that the client’s information will remain confidential. Principle 6—Professionalism: Act in a manner that demonstrates exemplary professional conduct. Professionalism requires behaving with dignity and courtesy to clients, fellow professionals, and others in business-related activities. Certificants cooperate with fellow certificants to enhance and maintain the profession’s public image and improve the quality of services. Principle 7—Diligence: Provide professional services diligently. Diligence is the provision of services in a reasonably prompt and thorough manner, including the proper planning for, and supervision of, the rendering of professional services. CFP Board applies its professional standards—including its Code of Ethics—early in the CFP® certification process, and conditions CFP® professionals’ use of the certification marks on their agreement to abide by certain terms and conditions, including the Standards. For example, everyone who seeks CFP® certification is subject to a background check, and those whose past conduct falls short of CFP Board’s ethical and practice standards can be barred from becoming certified. After attaining certification, a CFP® professional who violates CFP Board’s ethical and practice standards becomes subject to disciplinary action up to the permanent revocation of certification. CFP Board’s active enforcement of its Standards is one of the key elements that distinguishes the CFP® certification from other designations in the financial services industry. CFP Board has adopted Disciplinary Rules and Procedures that set forth the investigative and disciplinary process that applies to CFP® professionals. CFP Board is committed to maintaining a disciplinary process that is fair to the certificants whose conduct comes under scrutiny and one that is credible to the public. For more information about CFP Board’s Standards of Professional Conduct, including its Code of Ethics and Professional Responsibility, Rules of Conduct, Financial Planning Practice Standards, and Disciplinary Rules and Procedures, see www.cfp.net/for-cfp-professionals/professional-standards-enforcement/standards-ofprofessional-conduct.

PART Two Introduction Charles R. Chaffin, EdD CFP Board Thomas Warschauer, PhD, CFP® San Diego State University Part Two focuses on the practice of financial planning. Specifically, it describes what financial planners actually do in their work; that is, the processes they follow. Part Two is based upon the six steps that denote the financial planning process “which typically includes, but is not limited to, some or all of these six steps: Establishing and defining the client-planner relationship, Gathering client data including goals, Analyzing and evaluating the client's current financial status, Developing and presenting recommendations and/or alternatives, Implementing the recommendations, and Monitoring the recommendations.”1 Because the two parts of the fourth step (developing and presenting recommendations) are inherently different from each other in the planning process, they are discussed here in two separate chapters. Each of the chapters in Part Two begins by defining what is involved within each step of the financial planning process and exploring the rationale and some related techniques involved in achieving the completion of this step in the financial planning process. The chapter then focuses on the “In Practice” section, which illustrates each step of the financial planning process through the use of one case that runs throughout the entire section of this book. This approach helps to illustrate the many facets of this case as well as how each step of the financial planning process affects many of the variables involved with this particular family.

THE JAMESON FAMILY In order to understand these applications, it is necessary to introduce the Jameson family. Our clients are Rick and Maria Jameson. Maria's mother is Rose, her father is deceased, and she has two brothers. Rick's parents are Billy and Joann. The Jamesons have three children. It is a second marriage for each of them. Maria has a son, Carlos, from a previous marriage. Carlos is married to Christina. They have two one-year-old children, twins. Rick also had a previous child, Mackenzie, who has a daughter of her own, named Megan, now two. Maria and Rick also have a third child, Sophia, age ten. Mackenzie and her daughter live with the Jamesons. To summarize their situation, the following points need to be understood: The Jamesons are a prototype “sandwich generation” family, with the need to help Rick's parents, support their own children, and provide for retirement. Rick's daughter Mackenzie has a child, now two. Mackenzie is in college, and lives with

Rick and Maria. The clients want to help her on her road to independence. Rick's parents live on Social Security and Rick and Maria want to help them. They need to plan for Sophia's college education in eight years. Maria's mother is well off, though they do not want to include her large estate in their plans. The Jamesons want to retire and travel. The clients are a bit overwhelmed by their competing goals, needs, and confused priorities. The following family tree may be helpful in following the case throughout Part Two.

NOTE 1. CFP Board of Standards, Inc., Standards of Professional Conduct, Terminology, http://www.cfp.net/for-cfp-professionals/professional-standards-enforcement/standards-ofprofessional-conduct/terminology.

CHAPTER 71 Establishing and Dening the Client-Planner Relationship Elissa Buie, MBA, CFP® Golden Gate University Dave Yeske, DBA, CFP® Golden Gate University

DEFINITION The proverb “well begun is half done,” whether one prefers to attribute it to Aristotle or to Mary Poppins, is as true for a financial planning engagement as for any other human endeavor. And for financial planning, “well begun” means the establishment of a clear understanding of the needs and concerns of the client, the capabilities and conflicts of the financial planner, and all the facts and circumstances that will determine whether the planner and client are well matched in their needs and capabilities. Especially for the financial planner, Stephen Covey captured well the focus of this first stage in the planning process: “Seek first to understand, then to be understood.”1

PURPOSE Seek first to understand: The first order of business for the financial planner is to be clear who the client will be in any engagement. Among other things, the focus of any advice and the duty of loyalty will be determined by the identity of the client. If the individual is a business owner, for example, the planner must determine whether the client will be the individual, the individual’s business, or both. This will be determined by the specific needs expressed. For example, if the planner is being hired to advise on the structure and funding of a company retirement plan, the client is clearly the business, and the planner will have a fiduciary obligation under the Employee Retirement Income Security Act (ERISA) not just to the business’s owner but to all the retirement plan’s participants. In other instances, the planner may be engaged by an individual in his or her capacity as trustee, bringing the trust’s beneficiaries into the orbit of any advice to be given. The number and identity of those who will be clients in any engagement must be clearly spelled out and unambiguous if the planner is to fulfill all of his or her obligations. After determining the identity of the client, the financial planner must next uncover the client’s needs and expectations. Among other things, it is only with a clear and complete understanding of these needs and expectations that planners can make a good-faith assessment of how well their skills and experience are matched to the demands of the engagement. It also allows the

financial planner to assess the client’s understanding of the benefits and limitations of the financial planning process itself, preparatory to explaining the process to the client. Setting appropriate expectations is crucial to a successful financial planning engagement, and this can be accomplished only if the planner understands the expectations the client holds at the outset. Then to be understood: It is an unfortunate fact that the nature of the financial planning process is widely misunderstood, making it essential for the financial planner to explain the process to the client in a clear and comprehensive fashion. Unless clients fully comprehend the nature of the financial planning process, they may very well resist revealing the personal and financial details so essential to its success. Beyond the nature of the process itself, it is also important for the financial planner to explain the scope of services offered by the planner and the planner’s firm. There is a great deal of diversity among financial planners and planning firms with respect to service offerings, and this will help determine how well the planner can meet the client’s needs and expectations. A client seeking specialized tax advice, for example, would tend to favor a planner or firm that specializes in this area. Ultimately, the planner must make an honest assessment of how well his or her particular capabilities, or those of the firm, match the client’s needs and expectations, and then clearly communicate this to the client. Identifying a mismatch between skills and needs does not necessarily mean the engagement cannot go forward, however, as the planner may be able to mobilize resources outside of the firm in order to fill the gap. If, for example, the client is in need of specialized tax advice beyond the skill and training of the planner, the planner may suggest bringing in a tax attorney or accountant to deal with the tax issue, while personally addressing the client’s remaining needs. When practicing as a fiduciary, the financial planner must also identify, communicate, and attempt to resolve any real or potential conflicts of interest between planner and client. In explaining any apparent conflicts, the planner must make it clear to the client how this could potentially impact the advice and the client’s welfare. For example, a financial planner who is licensed to sell insurance would need to reveal that she might receive additional income if the client implemented risk management advice through the planner in her role as insurance agent. The fact that the types and amounts of insurance that the planner recommends will directly impact potential income from insurance sales is a tangible conflict. Simple disclosure of the conflict may be a sufficient resolution if the client is comfortable with this solution. Alternatively, the client may decide that implementing all insurance recommendations with an outside insurance agent is the only way to resolve the conflict. Ultimately, there is no one resolution to conflicts of interest, only the necessity that any conflicts be resolved by the mutual consent of the planner and the client. A successful financial planning engagement depends on more than the skill and diligence of the financial planner; it also requires active engagement by clients. To achieve this, the planner must clearly explain to clients their roles and responsibilities in the financial planning process. Clients must understand, for example, that they will be expected to reveal personal and financial information and to take certain actions to implement recommendations in order to maximize the probability of achieving their goals. Clients cannot fully enter into a financial

planning engagement without a full understanding of their role in the process. Once the client’s needs and expectations have been explored and the planner’s ability to meet them discussed, the scope of the engagement must finally be documented. This might take the form of a letter of understanding or contract and may be printed or electronic. Likewise, real or potential conflicts of interest having been revealed and resolved, these must also be documented, along with all compensation arrangements. In many instances, such documentation will be covered by disclosure forms mandated by a government regulator holding authority over the activities of the financial planner. Whatever form it takes, the process of documenting the scope of the engagement, conflicts of interest, and compensation arrangements is intended to minimize the possibility of future misunderstandings arising between client and planner.

TECHNIQUES There are a number of techniques commonly used by financial planners when establishing and defining the client-planner relationship. As with all interactions between clients and planners, dialogue is the starting point. This will often take the form of simple, open-ended questions or appreciative inquiry,2 but at times questions may be directed toward more specific topical areas. Many planners use a variety of more formal instruments, surveys in which clients can check off life transitions they are experiencing or expect to experience or indicate their level of satisfaction with different aspects of their financial life. Such instruments allow the planner to quickly identify areas of dissatisfaction or impending life transitions that have planning implications and can ensure that the planner asks appropriate questions in order to flesh out the issues. Additionally, the use of a written instrument to define the roles and responsibilities of both the planner and the client is generally recommended. All of this will help to determine and define the scope of the planning engagement. It has been shown that clients place a high value on their financial planner having a systematic process for uncovering personal goals, values, and expectations, and the use of formal instruments, such as forms and checklists, can go a long way in assuring clients that they are engaged in such a structured process.3 Such formal approaches have also been shown to be associated with higher levels of client trust and relationship commitment, two variables that exert a powerful impact on the planning relationship. Sharma and Patterson note that higher levels of trust and relationship commitment are associated with a higher propensity to reveal personal and financial information and to implement recommendations.4 It is also highly associated with “functional conflict,” the ability to resolve conflicts quickly and effectively when they arise. When explaining the financial planning process, planners will often use visual representations, finding that graphical forms help to illustrate the interconnected and process-oriented nature of financial planning. As Tufte has observed, “Only a picture can carry such a volume of data in such a small space.”5 Beckes also recommends the use of “engagement standards,” which take the form of written documentation explaining how the planner practices, what the client can expect, and the role

and responsibility of the client in the process. As Veres puts it, “Engagement standards are like an instruction manual, letting the client know how to get the best of what the planner has to offer.”6 Finally, advisory agreements that clearly spell out the services to be delivered, the methodology to be employed, and the means of compensation are important tools for establishing the advisory relationship.

IN PRACTICE Maria and Rick Jameson have arrived at the offices of Lopez and Jenkins for an initial interview with Colleen Jenkins. Because a good friend referred Rick and Maria to Colleen, they think it likely that they will hire her. Nonetheless Rick and Maria are not certain that their circumstances are identical to the referring friend’s and therefore feel the need to learn much more about how Colleen works with her clients before making a final decision. For her part, Colleen is always very careful to uncover the needs and expectations of prospective clients to ensure that she will be well suited to meet those needs. As she likes to say, “Life is too short to take on a client for whom I am a poor fit, as this inevitably leads to frustration for both of us.” Prior to this meeting, Colleen’s assistant sent Rick and Maria a package that included the firm’s disclosure document outlining how they get paid and potential conflicts of interest, a copy of the firm’s brochure, a sample of Lopez and Jenkins’s client advisory agreement, a document illustrating the roles and responsibilities of the firm and the client, and two checklists, one devoted to “financial satisfaction” and the other to “life transitions.” Rick and Maria were asked to complete the two checklists and either return them to the firm or bring them to the first meeting. Rick and Maria chose to complete the forms and fax them back to Lopez and Jenkins a few days before their first meeting. As a consequence, Colleen has already noted that Rick and Maria have low satisfaction with their financial record keeping and management, their ability to financially help family members, and their readiness for retirement. Colleen also noted from the “life transitions” checklist that Rick and Maria were expecting an inheritance long term, educating kids now and in the intermediate term, helping aging parents in the short-term, and were anticipating retirement in the intermediate term. Colleen begins the meeting by simply saying to Rick and Maria, “Tell me what brings you here.” After a brief pause, Rick and Maria reply that Maria has reached her 20-year anniversary of working in her school district, and it has caused them to begin to think about when they might be able to retire. Colleen nods and leans forward, saying, “That’s certainly a question we can help you answer. If you don’t mind, though, I have another question: I see from the surveys you returned that you’re not happy with your ability to financially help family members. Can you tell me more about that?” This time without hesitation, Rick also leans forward, saying: “Yes, both of my parents are alive, and they have worked hard all their lives, but they live primarily on their Social Security. And now my mom, who has been caring for my ailing father, is aging to the point she can no longer readily care for him. They need help or to move to a retirement home, but they

really can’t afford to do so. At the same time as we are thinking of how we can help them, our eldest daughter has moved back into our home with her two-year-old, and we have a 10-yearold daughter who is very smart and will certainly go to college and we want to help her do so when the time comes.” This time Colleen sits silently for a full minute before saying, “Tell me more about your family.” Rick and Maria explain that they each have a child from a prior marriage. Maria’s son, Carlos, is married with twin one-year-olds, and, while successful, is married to a woman they just aren’t “sure about.” Rick’s daughter, MacKenzie, was in a bad relationship. She had a baby and had to move back in with Rick and Maria while she finishes her college degree and then finds a job. Maria and Rick also have a daughter together. Sophia is 10 and in fifth grade. They want to help their children as needed, help Rick’s parents, and make sure their own finances won’t ever cause them to be a burden on their children. Basically, they feel overwhelmed at their place as the sandwich generation. Colleen then asks, “Is there anything else I should know?” After a pause, Rick and Maria say, “No, that is what we are wrestling with right now.” Colleen, contemplating Rick and Maria’s circumstances and the issues they’re dealing with, decides that there is probably a good fit between Rick and Maria’s needs and her own skills and experience. Colleen has worked with many clients in the sandwich generation, and has been successful in helping them weigh the consequences of their various choices and arrive at decisions that best balanced their needs, circumstances, and values. As part of her internal assessment, Colleen noted Rick and Maria’s low satisfaction with their financial record keeping and management and is confident that the tools she has employed successfully in the past to help clients manage their cash flows will be effective with Rick and Maria as well. Having decided there is a good fit, Colleen moves on to explain how she might help Rick and Maria. “I think I can help you,” Colleen begins. “Let me tell you how.” She then proceeds to frame the trade-offs that she believes Rick and Maria are facing, noting that there are many options available to them that she will be able to describe to them after she has gathered the necessary information and done some analysis. She points out that this analysis will be best done by being very comprehensive, covering virtually all aspects of their financial situation and needs. She shows them an outline of the financial plan she will prepare and a checklist of the documents she will need from them in order to have sufficient information on their finances. She further points out that she will work with their tax preparer and attorney, or refer them to such, but she will not prepare taxes or legal documents. Colleen places a diagram of the financial planning process on the table between them and explains how they would work together. Next to a bubble labeled “Initial Interview,” which she points out is this meeting, the second bubble in Colleen’s flowchart is marked “Discovery Meeting,” and Colleen explains that this would be her opportunity to learn more about Rick and Maria, about their personal history, their family, and the beliefs and values that guide them. As Colleen explains, there are often many paths to a destination and it is important that Colleen be recommending only those that are suited to Rick and Maria’s personal situation,

preferences, and values. The Discovery Meeting would help ensure that this would be the case. Next, she points out on the flow chart, comes the “Planning Meeting.” It is here, she says, that they will have a chance to explore the trade-offs that Rick and Maria face, where the choices and consequences are made explicit and Rick and Maria will learn what is possible. This stage may repeat, Colleen observes, as new alternatives emerge from their dialogue and exploration. Next comes “Implementation,” where concrete action steps are established that will move Rick and Maria toward their goals. It is at this point that Colleen explains the potential conflicts of interest that could arise during implementation. These conflicts are outlined in the disclosure document as well, she points out. The flowchart they are studying is circular, and Colleen points out that financial planning works because it proceeds as a continuously unfolding process, which has no beginning and no end but provides ongoing guidance in the face of emerging reality. Colleen finishes by reviewing with Rick and Maria the written document that outlines the roles and responsibilities of both her, the planner, and of Rick and Maria. By now, Rick and Maria have decided that they will engage Colleen to be their financial planner. Colleen’s listening skills and her systematic approach to learning about Rick and Maria’s needs have given them great trust and confidence in Colleen and in the financial planning process. They indicate as much to Colleen. At this point, Colleen mentions the disclosure document that had been sent to Rick and Maria, as well as the advisory agreement, asking if Rick and Maria have read them. Rick and Maria indicate that they have read both of them and are comfortable with what they found there. Colleen then clarifies that Rick and Maria understand what the financial planning engagement will cost and asks them to sign the advisory agreement, pulling up her calendar on the conference room computer and suggesting several meeting dates for their Discovery Meeting. A date is chosen, and Rick and Maria leave the office feeling relieved. They don’t yet know what possibilities their financial situation may provide, but they feel confident that Colleen and the financial planning process will help them understand them in the end.

NOTES 1. Stephen R. Covey, The 7 Habits of Highly Effective People: Powerful Lessons in Personal Change (New York: Simon & Schuster, 2004). 2. Ed Jacobson, Appreciative Moments: Stories and Practices for Living and Working Appreciatively (Bloomington, IN: iUniverse, 2008). 3. Carol Anderson and Deanna L. Sharpe, “The Efficacy of Life Planning Communication Tasks in Developing Successful Planner-Client Relationships,” Journal of Financial Planning 21 no. 6 (2008): 66–77. 4. Neeru Sharma and Paul G. Patterson, “The Impact of Communication Effectiveness and Service Quality on Relationship Commitment in Consumer, Professional Services,” Journal

of Services Marketing 13, no. 2 (1999). 5. Edward R. Tufte, The Visual Display of Quantitative Information (Cheshire, CT: Graphics Press, 2001). 6. B. Veres, “Life Planning 101: Here’s How to Get Started in Life Planning—and in the Process Create an Outrageous, Effortless Practice for Yourself,” Inside Information (2002): 6–9. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 72 Gathering Information Necessary to Fulfill the Engagement Elissa Buie, MBA, CFP® Golden Gate University Dave Yeske, DBA, CFP® Golden Gate University

DEFINITION This step in the financial planning process refers to the systematic collection of client information that will form the basis for the planner’s subsequent analysis and recommendations. It encompasses both qualitative and quantitative information that is unique to the client. Qualitative information will generally include the client’s life history, financial experience, personal values, preferences, and goals. Qualitative information may also include the client’s learning style, heuristics, and cognitive biases. Quantitative information will include such data as the client’s income and expenses, assets and liabilities, insurance coverage, employment benefits, estate arrangements, and other similar information.

PURPOSE In order to prepare a financial plan that is demonstrably connected to a client’s needs, values, and goals, the financial planner must start with information that is unique to that client. There is an old saying that to a workman whose only tool is a hammer, everything begins to look like a nail. While true in much of the financial services world, it is the antithesis of true financial planning. Beyond the need to develop financial planning strategies that are suited to a client’s financial circumstances, the planner must also choose from among the set of technically feasible solutions those that are best matched to the client’s personal values, heuristics, and cognitive biases. This will maximize the probability that the client will embrace and act on the planner’s recommendations.

TECHNIQUES The identification of clients’ values and attitudes, as well as the itemization of their relevant financial data, is achieved through the discovery process. The techniques used to elicit client information may include, inter alia, some or all of the following:

Open-ended questions. Structured interviews. Appreciative inquiry. Mind-mapping. Data forms and document checklists. Risk tolerance surveys. Or other assessments. It is critical that the planner use open-ended questions that allow clients freedom to fully express their personal values and tangible goals. It is important to be careful not to ask questions in such a way as to lead the client to a particular answer or to reveal or embody the planner’s personal values or biases. There is evidence that clients value the use of a systematic discovery process and that this is correlated with higher levels of client trust and relationship commitment.1 The discovery process should match both the planner’s methodology and personality. Complex, analytical financial plans will generally require more raw data than plans prepared in a more macro-level or big-picture fashion. Of course, the financial planning process will have been discussed with the client during the establishment of the relationship. Before the financial data related to the client’s situation can be used in a meaningful way, the client’s values and attitudes must be understood. This information enables the planner to integrate the factual data about the client’s financial situation with what really matters to the client and his or her life goals. A thorough understanding of the client’s interior finance aspects (e.g., family money history, religious beliefs, value system, etc.) will help the planner develop and communicate recommendations that will meet the client’s needs, will be understood by the client, and will maximize the probability of the client taking action. The discovery process can take many forms, but generally will include an exploration of the client’s personal life (upbringing, family, education, culture, etc.). The planner will use learned communication skills to probe for additional information as needed. In order to improve communication with the client, the planner needs to be sensitive to non-verbal signals provided by the client and be aware of the planner’s own physical and non-verbal cues. The discovery process may include the use of structured interviews, which can help the planner to better understand much of the following about the client: Who matters to the client and why. What matters to the client and why. What the client’s life and worldview are. What money means to the client and why. What goals, dreams, and aspirations the client has, including time horizons as applicable. What fears and concerns the client has.

What financial knowledge and experience the client has. What the client knows and does (human capital). What obstacles, risk exposures, and risk capacity the client has (including health issues). What the client’s risk tolerance is. Exploration of a client’s interior financial information is a critical part of the financial planning process. The answers to questions about a person’s family values or money history do not lend themselves to being tracked on a data gathering form. Different planners will approach this aspect of the financial planning process in different ways. But critical for all planners during the discovery process is the ability to listen in an engaged and active way. Listening skills can be learned, and ultimately come from a deep desire to know the client well in order to provide the best financial plan possible. While personal information allows the planner to tailor a plan to a particular client, quantitative data—such as account types and balances—are needed to determine if reaching client goals is possible. The purpose for seeking a particular data point should guide the information request. The financial planner has a variety of sources for obtaining quantitative data. The most obvious source, of course, is the client. Many clients are able to complete lists of property owned and liabilities owed, as well as how they spend their income. However, clients are often not aware of the technical differences between types of account titles, and may not remember the beneficiaries on an account. And a planner may be quite surprised to find that clients often cannot state the dollar value of a property or an account with acceptable accuracy. It is the planner’s responsibility to verify, to the extent possible, the information provided by the client. This requires the planner to gather, or the client to provide at the planner’s request, recent account statements, income tax returns, financial account applications, and employer and government benefit program information. For each asset, liability, or legal document (for example, life insurance policies, estate planning documents, employment contracts, and benefit statements) the following information should be gathered. Account or document name (such as checking account or trust). Name of titled owners. Date account created. Value of account (including debts). Income or expense created by account. Name of beneficiary. Contract terms that may limit owner’s decisions. In order to conduct technical analyses, economic information from external sources may also

be required. Most often, this information drives the assumptions made in technical analyses. Information in this category may include historical interest rates, inflation rates, historical and expected rates of return on capital assets, and relevant tax rates. Each financial planner and firm will need to develop and implement policies regarding the use of the external information just discussed. For example, are planners to use the 10-year rate of return of the Standard & Poor’s S&P 500 index or the five-year rate of return of the Dow Jones Industrial Average in technical analyses? Regardless of the policy, it will be imperative that all planners in a firm follow the policy closely. And written policies may protect planners in mitigating operational risks. Ultimately, criteria such as accuracy, client convenience, and business considerations will determine how data and information gathering is performed. A thorough, formal discovery process will be focused on learning about the client in a deep and meaningful way. Through this process, the client enjoys the opportunity to build trust in the planner early in the relationship. The greater the trust the client has in the planner, the more readily the client will hear, believe, and implement the plan recommendations. Clients, therefore, will be more likely to share information and keep the planner informed of life changes, which is critical to the financial planning process being successful. Unfortunately, an untrustworthy planner can use the discovery process to build a false sense of trust with the client. Clients need to work with their planners with their eyes wide open, and the financial planning profession needs to remain diligent in educating consumers and policing those practicing financial planning. The tools and techniques used in the discovery process are as numerous as the planners who use them. There are tools available from third-party vendors (e.g., full discovery systems with questionnaires, risk tolerance tests, etc.) and techniques that may be learned from books and articles on the subject (e.g., mind mapping as a way of tracking the answers to various discovery questions). Many planners have developed their own tools and techniques through years of experience and trial and error. The planner’s personality is likely to drive which methods are used in data gathering. A savvy planner will also consider the client’s personality and situation when determining the mix of data gathering techniques to be employed. In addition, the type of information to be collected will also impact the selected methodology. For example, an older client may feel more comfortable providing all information in person. A sophisticated computer user will be able to provide factual data in an online format. As with establishing and defining the client relationship, research suggests that a formal discovery process with written tools is valued by clients, and such a process leads to higher levels of client trust and commitment.2 At this point in time, the discovery process has not been adequately researched to offer a definitive set of best practices, leaving planners to decide for themselves what works best for their firm and their clients.

IN PRACTICE

Maria and Rick were seated comfortably in their financial planner’s conference room ready to participate in the discovery process. They had previously supplied a series of documents that had been requested on a document checklist and were curious about what would happen during their office meeting. After some niceties, their financial planner, Colleen Jenkins, asked Maria to “tell me about you, tell me your life story.” Maria sat back and said, “Well, I was born on July 14, 1962, in Seattle, Washington. My first job as a special education teacher was at the Smithson Academy. After I’d been there for five years, Smithson lost its funding for my particular program. After searching for six months, I found my current position at Littleton High School, and started working there in 1993.” Colleen listened intently, and when Maria was done, began gently asking open-ended questions and probing for more information: “Tell me about growing up in Seattle.” “Oh, you have two brothers—tell me about them.” “What did your parents do for a living?” “Who managed the money in your house when you were growing up? Tell me more.” Colleen continued her questions until she felt that she had a good sense of Maria’s upbringing, family, culture, and value system. She then turned to Rick and began her inquiry again, using her natural curiosity and a series of open-ended and appreciative questions to bring out the details of Rick’s personal history and values. Among the many things that Colleen learned from this first part of the discovery meeting was that, while Maria was the one who tended to worry most about financial issues, it was understood between them that Rick would take the initiative whenever action was required. Colleen also learned that Maria’s widowed mother, Rose Rodriguez, was more than well off financially but that Maria and Rick did not wish to count on her for lifetime financial help or inheritance when planning their family’s finances. It was quite the opposite situation with Rick’s parents, Billy and Joann, who were scraping by on Social Security and very little else. One of the things that Maria and Rick were struggling with—and hoping the financial planning process could illuminate—was how to balance their sense of obligation to provide some support for Rick’s parents with their desire to help their children and grandchildren financially. The couple shared with Colleen that, while they loved each other’s children and had no desire to treat them differently, they knew that their estate plan lacked the safeguards to ensure this outcome and it made them nervous. Related to this, Maria and Rick opened up enough to also reveal their unhappiness with their daughter-in-law Christina, saying that they wanted to be sure that under no circumstances would she gain access or control to any of their assets if something happened to them. Next, Colleen introduced Maria and Rick to the concept of mind-mapping, wherein they would visually represent their answers to her next question on a blank sheet of paper, using boxes, circles, and lines to connect related ideas. Colleen asked them to individually illustrate their ideal life, one in which money was “no object.” “Please include all those things you would have, do, or be,” Colleen continued, “make this richly representative of who you are.” After a moment of contemplation, Maria and Rick both went to work, covering their respective sheets of paper with bubbles filled with words representing activities, achievements, and material goods. After 10 minutes of this, the couple sat back and Colleen asked each of them in turn to describe what they’d drawn. There was significant, though far from complete, overlap between the two drawings. From the descriptions, Colleen learned that among their top priorities,

Maria and Rick were anxious to help MacKenzie finish her education, find a good job, and reestablish herself. Colleen also learned that finding a way to visit Rick’s parents in Kansas City more often was a priority (Rose already made frequent trips to visit with Maria, Rick, and the kids and grandkids). Providing for Sophia’s college education was likewise a high priority and another area where Maria and Rick didn’t feel comfortable assuming that Rose would be helping financially. Retirement loomed large as an issue, both as a source of longing for the freedom and expanded travel opportunities it represented and as a source of great anxiety over their ability to ever achieve that state. From the two parts of the discovery process, Colleen now felt that she had a good sense of Maria and Rick’s primary goals and priorities, as well as the mental maps, biases, and personal values that would determine which strategies the couple were most likely to adopt, embrace, and implement. Maria and Rick and been extremely diligent about collecting all of the documents enumerated on the checklist that Colleen had provided them. Contemplating the stack of bank and brokerage statements, tax returns, employee benefit booklets, insurance declaration pages, and estate documents, Colleen felt confident that she had the quantitative data necessary to thoroughly assess Maria and Rick’s goals in light of their available resources.

NOTES 1. Carol Anderson and Deanna L. Sharpe, “The Efficacy of Life Planning Communication Tasks in Developing Successful Planner-Client Relationships,” Journal of Financial Planning 21, no. 6 (2008): 66–77. 2. Ibid. Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

CHAPTER 73 Analyzing and Evaluating the Client’s Current Financial Status Thomas Warschauer, PhD, CFP® San Diego State University Vickie Hampton, PhD, CFP® Texas Tech University Andrew Head, MA, CFP® Western Kentucky University After defining the scope of the engagement and collecting both quantitative and qualitative data, the financial planner is prepared to evaluate and document the strengths and vulnerabilities of the client’s current financial situation. The quality of this analysis is dependent on the planner’s success in building a trusting relationship with the client that results in sufficient and accurate data.

DEFINITION Clients come to the planner for a specific reason. Sometimes it is to achieve a particular goal such as educating children, planning for retirement, or determining what to do with a windfall such as an inheritance, and sometimes it is to solve a problem such as excessive taxation or too much debt. Occasionally, clients come to planners for the purpose of a comprehensive plan. Regardless of the client’s motivation for arriving at the planner’s office, the planner needs to evaluate the strengths and vulnerabilities of the client’s current situation. In the words of CFP Board’s Standards of Professional Conduct, “A financial planning practitioner shall analyze the information to gain an understanding of the client’s financial situation and then evaluate to what extent the client’s goals, needs, and priorities can be met by the client’s resources and current course of action.”1 In other words, the practitioner thoroughly analyzes the qualitative and quantitative information gathered from clients to see if they can meet their goals doing what they are currently doing. In the process, the practitioner also may discover areas where the clients are vulnerable. For example, a lack of liquidity or appropriate insurance coverage may leave them exposed to risks that could jeopardize their ability to meet goals. Although the early financial plans written in the 1970s were lengthy documents prepared using calculators and legal pads, today’s analysis tends to be more concise and employs a number of more sophisticated tools. These range from relatively inexpensive financial calculators to expensive software packages. They also include some services that can be outsourced, such as data input and back-office operations. These tools and services have increased the efficiency

and accuracy of the numerical calculations; however, financial planning practitioners still provide needed expertise to discover the client’s strengths and vulnerabilities. One has to know what to do with the data in addition to having the knowledge and wisdom to interpret the analysis. As discussed in Chapter 72, the second domain of the financial planning process is gathering the information necessary to fulfill the engagement. In order to review this information, a planner needs to organize, analyze, and evaluate this information even before beginning to develop recommendations, which are the procedures discussed in this chapter.

PURPOSE Clients typically do not come to the financial planner just to get an evaluation of their current financial condition. However, this analysis is a critical part of the financial planning process. Not only does it assess the likelihood of the clients reaching their financial objectives by continuing along their current path, but the analysis also is important in identifying other areas that should be addressed. For example, clients may come to a financial planner with a stated goal of providing a college education for their children, but an analysis of their strengths and challenges uncovers the need for insurance to protect the income stream of the breadwinner(s) against death and disability. Identification of these issues may require amending the scope of the engagement, which could require additional data collection. The objective analysis and evaluation of the client’s financial situation forms the foundation for the recommendations that a planner will ultimately make. Just as we would not want a physician recommending a surgery without first giving the patient a thorough physical examination, it is dangerous for a financial planner to make recommendations prior to completing a thorough analysis of the client’s current financial condition. Value is added when the client is informed of his or her strengths and vulnerabilities, and this service should help build trust in the relationship in addition to leading the financial planner to sound recommendations that facilitate goal achievement. Thorough analysis of the client’s current financial condition also serves the planner in several ways. It increases the efficiency and accuracy of recommendations and should provide increased conformity across clients and planners in an office for both accuracy and compliance concerns. Objective analysis and evaluation also help protect the practitioner from future liability issues.

TECHNIQUES In developing and documenting a client’s strengths and vulnerabilities, a planner must attend to many areas. Any financial plan is based on a series of assumptions, both exogenous/economic and endogenous/personal. It is important to recognize that planners are not themselves economic forecasters. However, the success of their role as planners is partly dependent upon their estimation of future levels of interest rates, market returns, levels of economic growth,

and inflation. Economists regularly disagree as to the specifics of these key variables, so it is necessary for planners to know how to find and evaluate consensus levels of those variables or to decide to deviate from them for specific reasons. Also, a planner must evaluate the likely growth in the client’s income and the client’s longevity. Again, planners are not economic forecasters or public health experts, but reasonable assumptions need to be made regarding income growth and mortality, and to that end planners should be familiar with occupationbased income growth and with gender-and health-based mortality tables. The CFP Board Financial Planning Practice Standards attest to this need. They state: The practitioner will utilize client-specified, mutually agreed-upon, and/or other reasonable assumptions. Both personal and economic assumptions must be considered in this step of the process. These assumptions may include, but are not limited to, the following: Personal assumptions, such as: retirement age(s), life expectancy(ies), income needs, risk factors, time horizon and special needs; and Economic assumptions, such as: inflation rates, tax rates, and investment returns.2 Financial planners often prepare lists of strengths and vulnerabilities for their clients and for themselves. These lists are not always the same, as their purpose is different for the client and the planner. The purpose of such a list is for clients to indicate where planners may be going with their recommendations at an early stage. It also serves to let the clients know that they have, in fact, done some things well. The purpose of the list for the planners may be to remind them not to omit a particular consideration in developing the recommendations at a later phase. To provide some examples of a possible list of strengths and vulnerabilities, we provide the following table. Examples of Determining Strengths and Vulnerabilities of Clients Review Statement of Financial Position and Cash Flow Is the client making normal progress in building an investment portfolio? Is the client making use of the retirement and/or education tax deferrals? Is an inappropriate amount of assets tied up in the client’s business or employer?

Insurance

Debt

Does the client have auto and homeowners insurance with adequate limits and provisions?

Does the client have any loans with excessive interest rates or any loans that could be financed at a lower rate?

Is flood or earthquake insurance indicated? If so, does the client have adequate coverage?

Is a disproportionate amount of income spent on debt payments? Are investment funds available to prepay loans?

Is property and casualty Retirement Planning (P&C) insurance Does the client have employerreplacement cost based retirement plans? covered? Is the client covered by Social Does the client have or Security? need umbrella insurance?

Does the client have substantial unmarketable assets? Is the client portfolio excessively concentrated in particular investments? Is the client’s annual savings rate reasonable? Is the client’s marginal tax bracket appropriate? Liquidity

Does the client have or need life insurance? Is the type of life insurance appropriate? Does the client have disability insurance? Is long-term care insurance appropriate? Does the client have nursing home insurance? Is there a plan for postretirement health insurance?

Has the client built additional retirement savings? Estate Planning Does the client have a will (or trusts if indicated)? Does the client have estate tax or probate issues? Does the client have living wills, health care powers of attorney, or durable powers of attorney?

Does the client have adequate liquid assets? Has the client arranged adequate secured or unsecured lines of credit? Education Planning Does the client have dependents for whom he or she plans to pay educational costs? Has there been an attempt to fund these costs? Copyright © 2012 by Thomas Warschauer.

One of the responsibilities of financial planners, whether they develop a comprehensive financial plan or a plan targeted to a specific goal, is to ensure that unforeseen circumstances do not interfere with their plan, at least to the extent that is practical. Three areas that are necessary to review, regardless of clients’ stated objectives, are their emergency fund adequacy, their use of debt, and their protection against insurable loss. Failure to do so may inhibit their ability to reach even their most mundane of goals. The first step after reviewing assumptions behind the plan is often to evaluate the financial status of the client. The purpose of creating and evaluating financial statements is to measure the extent to which a given client compares with income and asset peers. A planner should

review the financial status of the client to ensure that the client has an adequate emergency fund held in liquid assets and that the level and type of debt the client has used are appropriate in the particular circumstances. The CFP Board Financial Planning Practice Standards state: Prior to making recommendations to a client, it is necessary for the financial planning practitioner to assess the client’s financial situation and to determine the likelihood of reaching the stated objectives by continuing present activities.3 There are innumerable risks clients face as they work to achieve their objectives, some of which can be ameliorated with the use of insurance. Planners need to evaluate each insurable peril and decide the extent to which the client wishes to retain or insure against it. Many goals stipulated in the second domain, “Gathering Information Necessary to Fulfill the Engagement” (Chapter 72), have future cash flow needs; most obvious among them are retirement and education goals, but others may be relevant, such as the purchase of a vacation home, travel expenses, life insurance needs computations, and many others. For each goal, a capital needs analysis must be conducted. Tools in these areas often include spreadsheet analysis using sensitivity analysis and/or financial planning software using Monte Carlo analysis. In developing the recommendations (Chapter 74) these different needs must be ranked and coordinated, and a comprehensive plan must be developed that integrates all recommendations into a consistent interrelated set of recommendations. In order to evaluate both the retirement and risk management goals, the data collected regarding employee benefits are important. Employers sometimes provide a plethora of benefits, including health, life, and disability insurance and a variety of retirement plans. It is important for the financial planner to obtain actual plan documents, as it is not uncommon for a client to have significant misinformation or gaps in knowledge about the specifics of their coverage and benefits. Investment analysis at this stage of the financial planning process usually consists of an overview of asset allocation. Also, a planner must determine if the allocation to asset classes provides adequate diversification, if the client holds any poorly performing assets, and if the strategies used in the past were appropriate or appear to be so for the future. The intersection with the fourth domain of the financial planning process, “Developing the Recommendations” (Chapter 74), requires a systematic coordination of the investment plan with the goals, to assure the optimal chance of success. Virtually all financial planners are, or should be, prepared to provide planning services for all of the aforementioned functions. However, there are three sets of considerations in which various planners may be expert or may choose to work with other experts. These areas are taxation, estate planning, and business planning. Of course, basic levels of analysis must be performed in these areas and should not be ignored. In many instances, the financial planner is the professional most intimately acquainted with the details of a client’s financial affairs and can be a valuable partner to the other professionals working for the client. The financial planner is necessary not only as a partner for the other professionals, but also as a partner to

the client in order to ensure that goals are met. For example, the tax professional serves chiefly to minimize the tax burden on the client; however, it is possible that an action taken to minimize the tax burden will end up preventing the client from reaching his or her goals. The financial planner serves as the informed buffer to assist both parties in making better decisions for the client. The financial planner is educated in taxation and certainly must review a client’s tax bracket to determine if the client has a reasonable tax rate relative to the circumstances. Awareness of deductions, credits, and income-inclusion items that may pertain to the client’s specific situation should be identified to assist the tax professional. They certainly should consider and when appropriate recommend the use of tax-incentivized retirement tools such as 401(k)s and individual retirement accounts (IRAs), and education savings tools such as Coverdell Education Saving Accounts and 529 plans. The planner should help clients decide whether they may be better off with Roth or Traditional retirement savings arrangements. The planner certainly should help clients decide when to accept Social Security retirement benefits. However, many clients have complex tax problems to which a tax specialist should attend. Certainly this vulnerability should be expressed to those clients. Unless the planner is a CPA, enrolled agent, or tax preparer, the planner may not actually prepare tax filings for clients, even with the assistance of tax software. Similarly, the financial planner is educated as to the needs of estate planning. This, too, is a volatile area with estate law constantly changing. A planner is probably well-suited to review estate documents to ensure they exist, are up-to-date, and say what the client thinks they say. The financial planner should make suggestions for reducing probate costs using the various tools available, if such costs are anticipated to be onerous. The planner should ensure that the title to property is appropriate and will allow its transfer in death with the minimum of cost and inconvenience. The planner should feel comfortable recommending gifting strategies where appropriate and should ensure that beneficiary designations are proper on life insurance, retirement plans, and elsewhere. As with tax and business planning, planners should be aware of their limitations in this area if they are less than expert and should arrange to work with estate planning experts when necessary. Unless CFP® professionals are also estate planning attorneys, they should not engage in writing or creating any estate documents. Business planning is a third specialization in which the financial planner may be less than expert. Although licensing is not an issue, the ethics code makes practice outside of your knowledge base unacceptable. Business valuation and succession are as much an art as a science, and expertise gained here is very valuable. The lack of expertise could easily lead the client to suboptimal results.

IN PRACTICE Now that financial planner has established and defined the client relationship with Rick and Maria Jameson and built a deep understanding of their financial status, their goals, needs and priorities, values, and dreams, she needs to evaluate where they are headed and what strengths

and weaknesses exist in their current situation. It is common for the planner at this stage to address some recommendations associated with addressing limitations discovered. The first step in evaluating their financial condition is generally the preparation of a statement of financial condition and a cash-flow statement and applying ratio analysis to those statements. The ratios applied to these statements yield these results:4 Ratio Liquidity Savings Asset Allocation Debt Burden Inflation Tax Burden Housing Expenses

Computation Liquid assets/monthly expenses Savings/gross income Net investment assets/net worth Total debt payments/ after-tax income % change in net assets/rate of inflation Payroll and property taxes/gross income Homeowners expenses/gross income

Jameson’s 3.5 6% 55% 30% 1.3 33% 30%

Standard >2.50 >10% >50% 2