Creating a Plan for Effective Wealth Transfer
Investors often concentrate on accumulating assets, but how much time and energy is spent on preserving those hard-earned assets for future generations? Not nearly enough. Have you considered any of the following strategies to help pass along more of your estate to your heirs?
Nuts and Bolts of Estate Planning
Many people don’t begin thinking about transferring their assets until retirement. In reality, effective estate planning is an ongoing process — often best begun at a much younger age. At the very least, you should have a will to ensure that your final wishes are known. If you have dependent children, also consider naming a suitable guardian for them. After determining the value of real estate, cash-value life insurance policies, and assets held in retirement and investment accounts, a more encompassing plan may also be necessary.
Giving Less to the Tax Man
What can you do to avoid drastically reducing your estate to meet tax obligations? Life insurance may be a tax-efficient way of transferring accumulated wealth. Some types of policies offer current tax benefits and also reduce or eliminate taxes for beneficiaries. And life insurance may also increase the amount passed on to your heirs. Plus, it may also help owners of highly appreciated property or small businesses retain their assets, rather than be forced to sell those assets to pay Uncle Sam.
Trusts may also be appropriate, and there are many types from which to choose. A grantor retained annuity trust (GRAT), for example, allows you to transfer assets to an irrevocable trust and then receive a yearly annuity for a specific number of years. Once the GRAT is dissolved, the remaining assets pass to the beneficiaries, usually free of estate and gift taxes. Charitable remainder trusts are also popular. They can be arranged so that you — and, if you desire, a named beneficiary — receive tax benefits and, in some cases, income during life. What’s more, the trust also benefits a charity of your choice. If appropriate, trusts are a key part of the estate planning process.
This article just scratches the surface of effective wealth transfer. Contact your financial advisor or lawyer about these and other suggestions to make the most of your assets — for both you and your heirs.
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© 2011 McGraw-Hill Financial Communications. All rights reserved.
April 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Dan Federman, CFP®, a local member of FPA.
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Slow and Steady Wins the Race
For illustrative purposes only, this shows the risk of seeking high return investments compared to owning investments that provide steadier, lower volatility returns. “Hot” investments often are accompanied with wild volatility. Because no one can consistently predict the future, a prudent way to invest is like the “tortoise” instead of the “hare.” A widely accepted method to achieve lower volatility is by including a wide mix of assets in a long-term investment portfolio. Avoid making massive bets on “hot” stocks, “hot” fund managers, or “hot” asset classes. To read more about risk and standard deviation read “What Did Risk Say to Return?”
For more information about Ariba or to call about a portfolio review visit www.aribaasset.com or call 1-800-808-7488 x101 or x104.
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What Did Risk Say to Return?
by Dan Federman, CFP®
“No Pain, No Gain!”
In order to achieve investment returns that outpace inflation and taxes (two of the biggest hurdles to accumulating lifetime wealth), investors must assume risk. This does not mean investors must roll the dice with their money. It just means they need to include “risky assets” in their diversified portfolio. Risky assets are simply investments with returns that are not guaranteed. For example, a stock is considered riskier than a corporate bond. US Government bonds are about the only type of asset considered “riskless.”
To measure the true risk of your mutual fund or investment portfolio check its “standard deviation,” which is the amount of fluctuation in performance that an investment can be expected to have from year to year, compared to its average return. A high standard deviation means greater volatility (and greater risk). A low standard deviation means lower volatility (and lower risk).
To demonstrate the concept of standard deviation, below is a bell shaped curve (Figure 1) showing a hypothetical “normal distribution” of investment results. Based on 84-years of actual risk and return data for the S&P 500 Index (1925-2009), the average return was 10.4%, with a standard deviation of 19.2%. Statistically, this means there is a 68.2% probability that returns will fall within one standard deviation of the average, and a 95% probability that returns will fall within two standard deviations. Thus, 68.2% of the time the S&P 500 earned between -8.8% and 29.6%, and 95% of the time the S&P 500 earned between -28% and 48.8%. Talk about a roller-coaster ride. Generally, an investment will typically earn returns above or below its average, and very rarely will it achieve its “average” return any given year. To see a comparison of returns and risk for seven asset classes, see Figure 2 below.
Investors who ignore standard deviation often place too much money in risky investments, leading to wild gyrations in their portfolio. On the opposite end of the spectrum are investors who place too much money in CDs, money markets, and other “safe” investments that earn very little in returns. There actually is a method to the madness when it comes to successful portfolio management. The method involves blending negatively correlated assets (such as stocks and bonds) to smooth out volatility. Just like chocolate and peanut butter, two negatively correlated assets go well together. The blended portfolio of two negatively correlated assets has lower volatility than either individual asset.
Since stocks are riskier than bonds, one can reasonably expect stocks to provide higher returns than bonds in the long run. So why include bonds in a portfolio? The two main reasons are emotional risk tolerance and age. Investors who do not have the stomach for the roller coaster ride will avoid some of the pain associated with a bear market in stocks if they allocate a portion of their portfolio to bonds. Also, a retiree who is no longer earning an income and withdrawing from his portfolio to meet monthly expenses cannot afford to experience wild gyrations in his portfolio, and will therefore want to include bonds in his portfolio.
So, the next time someone touts the average performance of a particular mutual fund or manager, ask him what’s the standard deviation?
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Figure 1: Standard Deviation Demonstrated
Figure 2: Risk and Return of Asset Classes Over Specific Time Periods
To request information about Ariba call 1-800-808-7488 x101 or x104, or contact us at http://aribaasset.com/contact.html
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How Much Income Can I Expect to Receive from My Investments in Retirement?
by Dan Federman, CFP®
This is a simple, yet dangerous question. The reason I say that is because it IS possible to create an investment portfolio of stocks, bonds, and mutual funds with a starting yield of 7% to 14%. A novice investor would see those eye-popping yields and think this is a great thing. In fact, why wouldn’t EVERYONE invest in this stock or bond portfolio providing a double-digit income return? Unfortunately, there is a very good reason these securities are paying such high yields. The reason is called RISK, which comes in many different flavors: interest rate risk, inflation risk, default risk, event risk, business risk, political risk, credit risk, currency risk, liquidity risk, and market risk, among others. Of these risks, market risk is the only type of risk that cannot be eliminated through a diversified portfolio*.
Getting back to the income question, the answer lies not in the investments, but in the investor’s personal financial circumstances. The proper way to plan for income during retirement is to start by assessing your estimated monthly expenses, which is often a function of lifestyle and family responsibilities such as taking care of aging parents. Next, add up your estimated income sources (ex. Social Security, pensions, etc.). If there is a shortfall between estimated income and expenses, or if your income sources do not adjust for inflation, then it’s time to review your investment portfolio to determine a) how much income you need (or would like) and b) how long do you need this income to last?
If, based on your analysis, you or your advisor determines that you need to earn 7% income from your portfolio, do NOT make the common mistake of seeking securities yielding 7% or more. This can unintentionally lead to an unsuitable, improperly diversified portfolio exposed to a number of the aforementioned risks.
A more prudent way to approach this topic is by focusing on “withdrawal rates” from your portfolio to meet your income needs. In fact, a common term thrown about in financial planning journals is “safe withdrawal rate,” of which there have been a number of studies concluding a 4% withdrawal rate can provide a reasonable amount of income that will enable your diversified portfolio of stocks, bonds, cash, and alternative asset classes such as real estate, precious metals, oil & gas,etc. to continue growing for a 30+ year time horizon. After all, a retiree’s worst nightmare is outliving his or her money. Now, if the expected time horizon (based on life expectancy tables) is 15 years or less, then a higher withdrawal rate of 7 to 8% may be considered. But let’s be honest, who wants to look at a life expectancy table and see that they’re only going to be around for another 15 years or less? For this and other reasons, such as desire to keep the portfolio growing to pass on to heirs or charities, we prefer the 4% withdrawal rate as a guideline when working with retirees. For each person the situation is different.
*A diversified portfolio investing in a variety of asset classes has been shown to reduce volatility associated with market risk.
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Safe withdrawal rate
Defined: The quantity of money, expressed as a percentage of the initial investment, which can be withdrawn per year for a given quantity of time, including adjustments for inflation, and not lead to portfolio failure; failure being defined as a 95% probability of depletion to zero at any time within the specified period.
Usage: Typically, SWR is utilized as an approximation of the probability that a given portfolio can support a given annual spending component for a required period, with a reasonable confidence. To do this, variables such as the allocation of assets within a model portfolio, the beginning balance, and/or the number of years expected in retirement are varied, a model is applied, and results of these alterations in the variables are observed and compared, in order to optimize for the maximum.
Controversy: Unfortunately, the term “Safe Withdrawal Rate” is necessarily an ambiguous term. This is because initial methods utilized historical data to statically determine what would have been safe given the actual results that past portfolios would have generated with the variables given. The next logical step, of course, was to use that information to predict future SWRs. Either use is technically correct, but one should always be sure to be clear whether the use is in reference to past or projected SWRs, so that unnecessary argument can be prevented.
Source: http://www.bogleheads.org/wiki/Safe_Withdrawal_Rates
To request information or a complimentary portfolio review, please contact 1-800-808-7488 x101 or visit http://aribaasset.com/contact.html.
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