There are a number of things that need to be addressed in financial planning, including, but not limited to:

• Insurance & risk management
• Employee benefits
• Estate planning
• Retirement planning
• Portfolio allocation

Those items generally can be taken care of and forgotten about until you experience a life change of some sort (retirement or job change, marriage or divorce, new child, etc.) but there are a few maintenance items that are also important, but perhaps overlooked.  It is a best practice to do these things annually.  To remember, many people tie it to either their birthday, the new year, or when they file their taxes.

Credit Reports

We encourage our clients to request a copy of their credit reports for two reasons.  First, many people find inaccuracies on their reports.  While most of these are minor, occasionally there might be something significant enough to impair your credit.  The ideal time to discover this is not when you are trying to secure a new home or job.  Second, it will give you early warning of identity theft or fraud.  While many people are concerned with computer hackers stealing their identity, the more mundane methods are still the most prevalent.  A salesclerk stealing a credit card number or a relative stealing a check and forging the signature may not make headlines, but they are still classified as “identity theft.”  Periodically checking your credit report will ensure that you quickly become aware of irregularities in your accounts.

There are a few ways to monitor and protect your credit.  First, a number of services have sprung up that will notify you immediately if something looks suspicious.  While these may give some peace of mind, they probably are not worth the fees for most people since you can get copies of your credit report for free and monitor it yourself.  Similarly, you have no doubt seen many offers for credit protection insurance.  Many people don’t realize that consumers are only liable for the first $50 of fraudulent charges on their credit (not debit) cards (more details here).  Thus, if you are being charged five dollars per month for the insurance, there would have to be fraudulent charges more often than every ten months for this to make sense.

As an aside, many experts also recommend not putting outgoing mail (such as bills) containing checks in your mailbox.  Criminals do sometimes steal the checks and “wash” (using chemicals) the writing (except the signature) off of the check giving them a signed blank check.  It is recommended that outgoing mail with checks be placed in a mailbox that is only accessible with a key.

The easiest way to request your credit report is to go to annualcreditreport.com and follow the steps.  Be aware that you will have to get the report from each of the three services separately.  Also, to verify your identity, each of the services may ask you various questions (“What was your address in 1998?”, “Into which range does your current mortgage payment with ABC Bank fall?”).  If you do not have internet access, you may also request the reports by calling toll-free 1-877-322-8228.

Because there are three main credit reporting agencies and you can request one free report annually some overachievers request one every four months from a different agency.

If you want more information about your credit score (as opposed to your credit report), see here.

Social Security Statements

If you are still working, it is recommended that you get a copy of your Social Security statement each year.  (You may have noticed that as of 2011 you no longer automatically get these in the mail each year, but they were partially reinstated in 2014 so workers get one at ages 25, 30, 35, 40, 45, 50, 55 and 60.)  By reviewing your statement you can see estimates of your disability, future retirement, and survivors benefits (it assumes your current earnings level continues, which is probably correct for most people).  More importantly, since those estimates will change little from year to year, you can verify your earnings and Social Security and Medicare taxes were reported accurately.  This will let you know if someone else is using your Social Security number to report wages, if your employer hasn’t forwarded on the payroll taxes that were withheld, or if there is some other snafu.

To create an account, go to, www.ssa.gov/myaccount. To verify your identity you will have to answer some questions (just like with requesting your credit report) that only you are likely to know the answer to.

Statement of Net Worth

Arguably the best single metric of financial prudence and progress is tracking change in net worth over time.  If housing or investment values collapse (e.g. 2008) net worth will obviously decline, but in general, an increase in net worth year-over-year is a great measure of, as Ed Koch used to ask, “How’m I doin’?”

Net worth is simply adding up the fair market value of what you own (what everything would sell for currently) and subtracting what you owe.  For example, suppose in the last year you had the following changes:

• You contributed $18,000 to your 401(k)
• The principal on your mortgage was paid down (through regular monthly payments even) by $10,000
• You sold a car you no longer needed for $20,000
• Your portfolio declined by $15,000
• Your house appreciated by $10,000

Then your change in net worth is $23,000 for the year ($18,000 + $10,000 – $15,000 + $10,000 = $23,000).  The third item, the car, is irrelevant as one asset (the car) was merely swapped for another (cash) and didn’t change your net worth this year.  The sale of the car may improve it in subsequent years if the $20,000 is placed in something that increases in value rather than a depreciating vehicle.

Rather than the way I did it thought, you should actually make a list of all assets and liabilities and the dollar values each year and compare them to the previous years.

Conclusion

Each year I encourage you to practice good financial hygiene by checking your credit report, obtaining your Social Security Statement, and computing your net worth and comparing it to last year.

Financial advisors disagree vehemently about (at least) three topics:  fees vs. commissions, active vs. passive management, and the subject of this article:  permanent life insurance vs. taxable investments.

Assumptions & Observations

First, a few general comments before I discuss the specific factors impacting this decision:

• While both investment and insurance vehicles may have poor performance, excessive costs, etc., I see no reason to assume one to have consistently superior gross performance over the other. Too often the best products from one type are compared to the worst products of the other type biasing the outcome.  A fair comparison would be a very good, inexpensive life insurance policy versus a very good, inexpensive investment vehicle.

• Many people act as though they consider insurance proceeds to be free money. There is no printing press creating money in the insurance company’s basement.  In the long run, premiums are merely returned to the policyholders (unequally however) less a haircut for administrative expenses, commissions, profits, etc.  Remember the most fundamental general rule is TANSTAAFL (There Ain’t So Such Thing As A Free Lunch).  There are two possible exceptions to this with life insurance:  1) If you die prematurely, (earlier than the actuaries predicted) you “win.”  Of course, this benefit is offset by the reverse, if you live longer than expected, you lose.  2) There may be tax advantages from the insurance that make it superior.

• Estate taxes are frequently presented as the rationale for purchasing life insurance. To the extent the insurance is out of the estate (in an ILIT for example), the annual gifting could be made in cash to the beneficiaries directly.  The beneficiaries could then do this same analysis (taxable investment vs. insurance) to decide whether they should invest the gift (or any other funds for that matter) in an insurance vehicle.  While it is true that funds may be needed for liquidity at death, the gifts could be invested in a taxable account to accumulate that liquidity.  This brings us back to the “die early and win” versus the “die late and lose” issue mentioned previously.  If estate liquidity is needed in the short run, term insurance can be purchased and taxable investments used to accumulate the liquidity for the long run.

Factors

This brings us to the specific factors that impact this decision.  All of these don’t have to be true to make buying a permanent policy advisable, but the more that are true and the greater the extent to which they are true the more a permanent policy would be advantageous.

• Mortality – Because most people have a risk of lasting longer than their portfolio, compounding this risk would be irrational. Considering that insurance purchases are good if you die prematurely and suboptimal if you live a long time, purchasing permanent insurance as an investment (as opposed to for income replacement or other risk reduction) is generally irrational.  Thus, in regard to this factor, it would seem that permanent insurance should only be purchased by those with little or no risk of outliving their resources.

• Income Taxes – Higher tax brackets favor the life insurance policy unless the policy is lapsed. Then, the detrimental treatment of gains being taxed as ordinary income rather than capital gains tends to make the taxable investment more favored.  Additionally, using insurance removes the option of tax loss harvesting.  Note also that while insurance proceeds are income tax free so are capital gains if the investment is held until death for the step-up in basis.  While no taxable investment is perfectly tax efficient, equity index funds or ETFs would be very close.  If the investments in question are very tax inefficient (REITs, HY Bonds, or other fixed income – particularly in a high interest-rate environment) or have very high turnover, some sort of insurance wrapper (such as an annuity) may be appropriate if there are not enough assets in an IRA or similar vehicle to shelter those assets from current taxation. In addition, there is a risk that the tax code changes in the future causing the death benefit to be income taxable.  Thus, permanent insurance should only be purchased if there is a) a high degree of confidence that death benefits will continue to be income-tax-free in the future, b) tax-advantaged vehicles, such as a 401(k), deductible IRA, Roth, etc., have been fully utilized, and c) tax inefficient investments would otherwise be held in taxable accounts because retirement accounts are not large enough.

• Flexibility – Taxable accounts obviously have almost unlimited investment choices as well as the advantage of being able to cash out completely at any time without cost (other than taxes). Cashing out insurance policies in the early years frequently incurs very large losses as many expenses are front-loaded.  This can be thought of us the equivalent of an enormous contingent deferred sales charge (back-end load) that lasts, in many cases, for decades.  Also, cashing out in later years will incur ordinary income taxes rather than capital gains as mentioned previously.  Thus, permanent insurance should only be purchased if there is almost no chance an unforeseen contingency will cause the funds to be needed during the insured’s life.

• Insurance need – Life insurance is more favorable to the extent that it is needed anyway for risk reduction. Thus, permanent insurance is more advantageous when a term policy would otherwise be purchased anyway.

• Bad M&E effects – This is a little complicated. Essentially, in a variable permanent insurance contract, there are two components of the death benefit from the insurance company’s perspective:  1) The cash value of the policy and 2) the difference between the cash value and the death benefit – known as the “amount at risk.”  Each year, a Mortality and Expense charge (M&E) covers this second amount.  Essentially, the account is charged for one year term insurance.  This has pernicious effects.  If investment performance is good, the amount at risk decreases reducing the M&E charge and making the policy perform even better.  Conversely, if the investment performance is bad, risk increases, the M&E charge is higher, and the policy performs badly.  Thus, good results get better, and poor results get worse in the investment portion of the insurance.  Thus, permanent insurance policies must be monitored regularly and fully funded.

• Creditor Protection –  Life insurance is usually not subject to claims of creditors, but it depends on state law.  Thus, if there is significant worry about losing assets to creditors permanent life insurance may offer shelter.

Conclusion

The purpose of financial planning is to maximize your happiness across multiple contingencies.  The worst-case scenario or “perfect storm” for most people is living a long time and receiving poor investment returns simultaneously.  In this case, you may have to fund the insurance more than you want to (or can afford to), or if it is lapsed or cashed out, there may be taxes due at a higher rate (ordinary income vs. capital gains).  In that case, permanent insurance will be much worse than a taxable investment.  Conversely, in the event of premature death and/or very high investment returns, the insurance vehicle may well prove superior.  Making good outcomes better at the cost of making bad outcomes worse is generally not the correct approach because people are typically risk averse rather than risk seeking.

Rebalancing, according to Wikipedia, is “the action of bringing a portfolio of investments that has deviated away from one’s target asset allocation back into line.” How to do that optimally is the subject of this post. Below is a sample allocation to facilitate the following discussion of rebalancing. It should not be construed as a recommended portfolio in any way.

Asset Class	Target Allocation
U.S. Large Stocks	20%
U.S. Small Stocks	10%
Foreign Stocks	10%
REITS	10%
High Yield Bonds	10%
Investment Grade Fixed Income	40%

 

 

Following are the factors involved in rebalancing (in no particular order):

• Due to the momentum that exists in the markets, rebalancing should be done slightly less frequently than it would be otherwise. Allowing an asset class that has grown (decreased) through good (poor) performance to remain overweight (underweight) can add value. Even if momentum effects don’t add value net of costs as a trading strategy, not rebalancing is costless. Academic research has indicated that if rebalancing mechanically on a time schedule (monthly, quarterly, etc.) the optimal period is probably between one and two years.

• If cash flows are expected soon, it may be prudent to delay rebalancing. If a deposit into the portfolio is expected, those funds can be used to perform the rebalancing with trades that would have to be done anyway to invest those funds. Similarly, if cash will need to be distributed from the account soon but not immediately, it may be prudent to wait until that trade is required and use it to perform, at least to some extent, the rebalancing.

• If it is a taxable account, the recognition of capital gains should slow rebalancing while the recognition of losses should speed it. Note that I am not advocating that taxes should drive the asset allocation, but merely that at the margin, taxes should have some impact on whether and when an asset class is brought back into balance. Waiting until a holding becomes a long-term capital gain will almost always be appropriate. Also, in a taxable account where the owner’s life expectancy is not long, allowing asset classes that have grown “too large” to remain that way to capture a step-up in basis at death may be prudent. The trade-off between a “sure” gain (if anything in the tax code can be considered a sure thing) of 23.8% (or even more if there are state taxes) of the gains vs. slightly higher risk from not rebalancing must be weighed.

• The transaction costs are important as well. Generally this involves not just the commissions, but also the costs from overcoming the bid/ask spread and the market impact costs. These can be particularly large when the security is illiquid. Obviously, the lower the transaction costs, the more frequently rebalancing should occur.

• The magnitude of the discrepancy is a factor as well. For example, an asset class that is 10 basis points (0.10%) out of balance is almost certainly not worth “fixing.” On the other hand, one that is 1,000 basis points (10.00%) out of balance almost certainly is.

• The correlation of the asset classes that are out of balance matter as well. For example, suppose U.S. Large Stocks have grown to be 25% of our allocation, at the expense of Investment Grade Fixed Income which is now at 35% (versus the target allocation specified earlier). Given the dramatic differences between those two asset classes, rebalancing may well be prudent. Conversely, if U.S. Large Stocks have grown to be 25% at the expense of U.S. Small Stocks at 5%, the correlations and risk/return profiles are so similar that “fixing” it may be unnecessary.

• The size of the portfolio matters as well. If the U.S. Large has increased to 22% while the Investment Grade Fixed Income has decreased to 38%, that may or may not be worth fixing. If the total portfolio is valued at $100,000, the amount of the rebalancing trade is a mere $2,000 – probably not worth the transaction costs. On the other hand, if the portfolio is worth $10,000,000, the trade would be $200,000 which might make sense.

• If there is a better investment option available, rebalancing may be more attractive. Suppose our allocation to Investment Grade Fixed Income is slightly high with U.S. Large Stocks being low, but it hasn’t risen to the level that would normally trigger a trade. However, we have a slight preference for a different fixed income investment but not enough to warrant a trade. In conjunction with a slightly out-of-balance portfolio though it might make sense, fixing the out-of-balance condition would be two trades. Changing the fixed income allocation would also normally be two trades. But if we do both simultaneously it is only three trades: sell all the current fixed income and buy stocks and the replacement fixed income vehicle.

• The number of asset classes to fix will affect the decision to rebalance as well. For example, suppose that U.S. Large has 24% while U.S. Small has 6%. Doing two trades to fix that may make sense (depending on all the other factors we have discussed). But if U.S. Large Stocks has 24% while U.S. Small Stocks, International Stocks, High Yield bonds, and REITS each are at 9%, the number of transactions – and thus the transaction costs – may make it imprudent.

• The sensitivity of clients to trades may impact the decision as well. Clients in fee-based accounts are probably relatively insensitive to an additional trade, while a client in a commission-based account may be suspicious that the trade was done purely to generate another commission. This is a problem, and may lead to too little rebalancing in commission-based accounts to reduce this perception of over-trading (even if there isn’t any). So, oddly, a commission-based account can lead to too little trading from an objective standpoint, but it may still be optimal to maximize client happiness.

• Academic research in the field of behavioral finance shows humans in general, and men and professionals in particular, have a propensity to over-trade. This is probably related to over-confidence and a need to “do-something” even if it isn’t particularly helpful (see Congress for example). When in doubt, don’t trade is probably a good rule.

The complexity and inter-relatedness of these factors is why we don’t use an automated system to rebalance our client portfolios. Rather, at least quarterly, we review and evaluate all the portfolios manually in light of the above factors to determine what trades, if any, should be made.

I try (I really do) not to be the grammar police, but there are three terms routinely – and improperly – used by financial professionals. I can’t sit idly by when even Warren Buffet (who I greatly respect) is getting it wrong. Now, after you read this, in at least one aspect you can be smarter than Warren.

I think the reason some terms are used at all is that investment professionals try to adopt the veneer of the hard sciences to gain credibility, but it doesn’t help much when the appropriated terms aren’t even used correctly!

Our first term is Negative Feedback Loop. A negative feedback loop dampens itself. A positive feedback loop increases in magnitude because it feeds on itself. For example, as we saw in the mid-2000’s people bought houses causing prices to increase, causing people to want to buy houses to get in on the deal, causing prices to increase, etc. A negative feedback loop would be something like a thermostat. A temperature decrease closes the circuit in the thermostat causing the heat to come on and increase the temperature until the circuit opens again. This keeps the temperature at a relatively constant level. The 2008 Berkshire letter to shareholders is a good example of the misuse of this term:

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

The situation described is a positive feedback loop (or cycle) in a negative direction which is not at all the same thing as a negative feedback loop.

Reversion to the Mean is a second term often used incorrectly. Reversion to the mean is properly used to indicate that extreme occurrences are followed by less extreme occurrences. For example, suppose a husband and wife are each five inches taller than average. Their children will also be taller than average but not five inches taller than average. Their heights will tend to “revert” toward the population mean. If this were not true, people would routinely be ten feet tall after a few generations of the tall folks breeding. In the context of the market, when people say “reversion to the mean” they don’t generally mean because the market was up so much (say 20%) it will be above average again but not quite as much (say 15%), they mean it will be below average (like minus 10%) so that the average approaches the prior mean. The proper term for this is negative serial correlation not reversion to the mean.

The third term is Liquidity. Marketability means you can buy or sell something. Liquidity means the act of buying or selling quickly won’t change the price much. I have heard advisors say stocks aren’t liquid because they can go down in value, or you should keep five years of living expenses in cash for liquidity. Substantially all of most people’s portfolios are extremely liquid. All open-end mutual funds and all investments with trading volumes many times the size of the position you are trying to trade are extremely liquid. What people mean to say is that some investments are volatile (to which the appropriate response should be, “well, duh”). Volatility and liquidity are not the same thing, though illiquid investments are frequently volatile; volatile investments can be very liquid.

Finally, a bonus oddity – International. The investment industry for some inexplicable reason uses the term “international” when they mean “foreign” and are then are forced to use “global” when they mean “international.”

I now relinquish the post of grammarian…

What spending order is optimal for a retiree who is older than 59½ having three types of accounts: a taxable account, a Roth IRA, and a traditional IRA with no basis?

The default order is:

1. Taxable (preserves tax deferral in the other accounts)
2. IRA (no RMDs on the Roth, so this reduces future RMDs by taking the funds now)
3. Roth

In other words, the taxable account should be exhausted before drawing down the IRA which in turn should be exhausted before drawing upon the Roth. There are exceptions to the default order however:

1. To the extent the assets in the taxable account have a low basis and/or the owner’s life expectancy is short, it may be prudent to leave the assets untouched for a step-up in basis rather than sell them to live on.

2. After the taxable account is exhausted, if the tax bracket is abnormally high it may make sense to spend Roth funds ahead of IRA funds (or find some other way to get to next year and a more normal tax bracket such as tapping a HELOC temporarily).

Contrary to popular belief, if the tax bracket is abnormally low (or there is “room” in a moderate bracket) it is not optimal to withdraw extra funds.  Rather, (partial) Roth conversions to use those low brackets are a superior strategy.  (See this post for more on the analysis of Roth vs. IRA in general.)

The reason the Roth is last in the list is simply because, under current tax law, there are no RMDs on Roth IRAs (there are on Roth 401(k) accounts).  If all retirement accounts had RMDs (or no RMDs) they would all be equivalent (see this post for caveats though).

The real goal is to preserve tax deferral as long as possible (without triggering higher tax rates), so with that in mind, we can add a little complexity to the simple order above, this is a more complete ordering for a married couple who may also have inherited IRAs:

1. Taxable
2. IRA or Roth inherited by older spouse
3. IRA or Roth inherited by younger spouse
4. Older Spouse’s IRA
5. Younger Spouse’s IRA
6. Roth

This order assumes the spouses have similar ages.  It is possible that given a large enough age disparity options 3 & 4 could swap places temporarily.