I am often asked by “do-it-yourselfers" if I would share a playbook that is used by financial planners. I happily sell them a book that tells them exactly what to do.
The daunting amount of responsibilities a good financial planner has becomes apparent after reading that book—and many end up asking to be introduced to an excellent financial advisor.
Financial planning is about identifying the family purpose, segmenting this lofty goal into the successful execution of important life events, managing the risks that could delay or disrupt those events, minimizing the eroding effects of excessive taxation on each of these purpose-based accounts, and building an effective investment strategy that gives the family the best opportunity at success.
An example of a family purpose might be the creation of a strategy to fulfill the roles and responsibilities of multiple generations in a single-family business.
Another example could be more philanthropic, where each generation demonstrates a desire to contribute time and resources towards organizations that have meaning to them and the community at-large.
Sometimes, the family purpose is as simple as making sure there is funding for each child and grandchild to attend the college of their choice.
This philosophical conversation is always emotional and should involve as many family members as possible so that everyone understands their role in the successful execution of their unique family purpose.
The life events include paying down your mortgage, funding your children’s weddings, college tuition planning and a successful retirement. Each of these events carry different timelines and different strategies at the distribution date.
For example, a wedding event means the liquidation of the account when the wedding arrives. This one is easy.
Funding college tuition for our children requires a systematic distribution of those assets over a four-year period. Sometimes we have more than one child going to college at the same time. This starts to get a little more complex but is certainly easier if the accounts are separated.
Retirement is one of the more challenging distribution events because the length of retirement could easily be for thirty years or more. In an environment where interest rates are almost at 0%, this is a significant challenge!
Antiquated ‘Institutional Methods’
Financial planning has traditionally followed the “institutional” method. Most planning software follows this method as do most financial advisers in the major wirehouses. I am not a fan of this method for these important reasons:
- Institutions don’t get sick, hurt or fired from their jobs.
- Institutions don’t have children to put through college.
- Institutions often get rescued by governments or organizations during a crisis.
If these truths are so evident, why do so many planners still follow this flawed method?
A risk profile questionnaire is often the starting point for the institutional method. That makes sense because a board would usually have enough diversity of thought that an accurate risk assessment might be reached. However, a husband/wife team isn’t enough diversity of thought. Their answers to these questions will reflect how they feel in that moment, and nothing more.
Systematic rebalancing is often used to take advantage of underpriced securities, sell off overpriced securities, and remain consistent with the risk profile of the investor. If the risk profile was wrong to begin with, systematic rebalancing repeats the mistake. Add to this the stress felt during severe market downturns and the upcoming funding needs of the account in question, and this institutional method is doomed to deliver a panic reaction from the investor.
The New Era of The Aging Portfolios Method
I recommend a process called “aging” of portfolios instead. This process ignores the risk profile questionnaire and assigns the riskiest allocation to the purpose-based portfolio at the point farthest away from the distribution event. Each year, as the distribution date nears, allocations are moved gradually away from risk towards safer, more liquid securities. This prevents fear and panic by eliminating the presence of risk assets for purposes that are within a two-year period of the distribution date.
When addressing the risks humans face, we have to prepare for periods of illness, injury, or terminated employment. These challenges are real and deserve an emergency fund that is invested conservatively. These risks also bring up the discussion of outsourcing risk management to prevent disruptions to a financial plan during these periods.
For example, if a family is in accumulation phase and income is lost due to illness or injury, a disability income protection policy might be a good idea. Income that is lost due to premature death of the primary income earner can be devastating to the family purpose. A life insurance policy that is built to replace that lost income is an affordable method of outsourcing this risk management.
Most people who have sizable assets also have a high income. The tax challenges that come with this cannot be understated. Taxes on income distributed from corporate bonds are at the investor’s tax bracket. Taxes on treasury bonds avoid state income taxes, but not federal income taxes. Capital gains taxes can also erode wealth and can sneak up on investors at the most unusual times. Short-term capital gains taxes (these are capital gains that occurred from the sale of a security that was held for less than 12 months) are effectively at the tax bracket level, while long-term capital gains taxes are usually at 20% for higher income earners.
A good financial advisor will add value to the relationship by communicating regularly with the investor’s tax professional and will attempt to minimize these taxes using strategies like tax loss harvesting. Tax loss harvesting is when you sell a security that is down in value to realize that loss, but then use the loss to offset capital gains that occurred in another part of the portfolio. Some advisers will do this with ETFs (exchange-traded funds) and buy a similar ETF to replace it so the investor still has the opportunity to participate if the ETF goes up in value. A “wash sale” rule exists and prevents the investor from buying back the same security for a 30-day period.
I have always been a fan of tax harvesting of individual stocks, rather than an ETF. The primary reason is the ETF is a blend of securities that can minimize the downside (that is a good thing for risk management) through diversification, but that would also limit how much of a tax loss could be harvested due to the risk reduction qualities of the diversification inside the ETF. I often recommend replacing the security with another security that is in the same sector and of similar size. You can always go back to that sold security after the 30 days.
The market collapse at the beginning of the pandemic was a great example of an opportunity to realize tax losses that might be carried forward for years to come. If you had not tax harvested during that period of time, your opportunity has closed quite a bit due to the market rebound.
Liability Driven Investing
Most financial plans are generated by software programs and delivered in spreadsheet format and old-school bar graphs. This display method is boring and it does not incorporate a concept called liability driven investing. Liability driven investing calculates the unique future value need of each of life’s large funding purposes. This concept is useful because it eliminates the toxic conversations around beating benchmarks. That conversation often leads to poor investment decisions that are based on either fear or greed.
I am a fan of graphing the output of these purpose-based liability calculations against the assets (and projected future growth of those assets) in order to visualize the strategic shifts that need to be made in order to fulfill the family purpose.
This strategic understanding often leads to very successful relationships with good financial advisers. It is my hope that these new tools and methods can encourage more of the general public to seek the expertise of highly qualified advisers who can help Americans realize their potential in the arena of financial literacy.
Jeff Mount is president of Real Intelligence LLC. Jeff has been active in the financial services business for the last 25 years.
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