Tags: inflation | retirement plans

Although the rate of consumer price inflation (as measured by the Consumer Price Index) is running at a subdued 1.7% year-over-year, the risks are increasing for higher inflation down the road. The Federal Reserve recently said it will continue to pump money into the financial system by buying billions of dollars worth of mortgage securities every month. This, combined with the trillions they have already pumped into the system, has potential to ignite much higher inflation over the coming decade.

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Most people understand that inflation can be the worst enemy of those living on a fixed income. It erodes the purchasing power of any investments that don’t go up with inflation and the portion of investments that actually do rise with inflation are taxed, further reducing the investor’s purchasing power. Because gains due to inflation are generally taxed, even those not on fixed incomes and fully invested in stocks or commodities take a hit.

Although many do understand how insidious inflation can be when it comes to their investments, they have no way of quantifying how much of an impact an increase (or a decrease) in the inflation rate will have. So it’s useful to run scenarios where we can actually see the impact of rising prices on a person’s overall wealth and retirement situation.

Using our Retirement Planner, I started out by looking at a couple that is 40-years-old and is invested 50% in equities and 50% in bonds. They have $300,000 saved and plan on retiring when they are both 62. They will also have $40,000 in recurring expenses in retirement. Inflation is assumed to be 2% per year, equities return 6% per year, and bonds return 1% per year. Under this scenario, taking into account social security payments they will receive and all taxes, this couple will not run out of money in retirement until they are 101 years old.

But what happens if the rate of inflation rises by just two percentage points to 4%? To make the scenario more realistic, I also had all annual returns increase by two percentage points as well. With inflation of 4% rather than 2%, this couple will run out of money when they are 96. Because gains due to inflation are taxed, yet expenses rise by the full amount of inflation, this couple will see their first shortfall in retirement a full five years earlier.

Now let’s look at a couple that is closer to retirement and is 55 years old. They have $300,000 in relatively safe short-term treasuries, will have $40,000 in recurring expenses in retirement, and will see their first shortfall in retirement occur at age 95. In a situation like today, inflation can be much higher than the yield on short-term bonds. So I ran a scenario where the return on their short-term bond holdings is only 0.5% and inflation again rose from 2% to 4%. Under this outcome, this couple will see their money run out not at age 95, but at age 82. With inflation rising by two percentage point, this couple just saw 13 years knocked off of their nest egg!

What these scenarios show is that inflation can severely diminish a person’s hard-earned wealth. But it is especially damaging to those on a fixed income when short-term rates are being held near zero while prices continue to rise. Not only are expenses rising as prices increase, but those on a fixed income watch their already paltry yield reduced by their full marginal income tax rate, not the lower capital gains tax rates that equity investors usually see.

So what can be done in this situation? The first thing nearly every investor should be doing is sheltering as much of their wealth from taxes as they can in tax-deferred accounts such as 401(k) plans and IRAs. That way any gains due to inflation will not be taxed right away.

One of the best hedges against inflation that works well in a tax-deferred account is Treasury Inflation Protected Securities (TIPS). The principal balance of these securities moves in tandem with the Consumer Price Index (CPI). However, it is important to keep in mind that interest and any gains due to changes in the CPI are taxed as ordinary income. That is why these securities should normally be held in a tax-deferred account, if possible. TIPS can be bought as physical securities or through ETFs such as TIP or through mutual funds such as VIPSX.

At a recent webinar on A4A, I spoke about how I’ve been using mind maps to successfully launch my RIA, grow AUM, and benefit from stronger relationships with clients based on transparency. Here are answers to some of the questions posed by advisors attending the session:

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Q: When using a mind map, what do you do if clients don't understand it? Is there a way to make it simpler for these clients so they do understand?

If you think about it, how can an advisor manage a client’s assets without writing an Investment Policy Statement?  Taking it a step further, how can an advisor write an Investment Policy Statement without having a full understanding of a client?  The mind mapping process allows us to gain a better understanding of the client’s needs.  Assets typically follow once we’ve laid a solid foundation by way of the mind map.

Tags: 529 plans | college planning | CSS PROFILE | FAFSA | financial aid | Sallie Mae

It’s college time, and parents of high school seniors across the country – myself included – are scurrying to figure out a good many things, such as how to fill out the FAFSA, Common Application, and CSS PROFILE. They are also trying to figure out how to title accounts earmarked for college costs. And the list goes on.

Financial advisors, however, are somewhat ill-equipped to help clients with some of the finer details of applying to college and helping their clients get financial aid. “College financial consulting is a very specialized field, in my opinion, and many advisors don’t realize the number of financial variables involved and how these variables impact the affordability of college,” says David Emery, CFP, CDFA, CCPS of the Marshall Financial Group.

“I don't think most advisors are very good at the FAFSA and other government aid forms,” says Christopher Olsen, CFP, of Olsen and Associates, a financial advisory practice of Ameriprise Financial Services, Inc.

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Then again, there’s a good reason for that say financial advisors. “In my experience, both personally and professionally, most of the people we deal with don't qualify for aid,” says Olsen.

But that point of view could be a mistake according to a recent SmartMoney.com report. “Nearly 30% of high-income families didn't fill out the FAFSA last academic year, according to a recent Sallie Mae survey. But that's usually a big mistake, Alex Bickford, a senior manager of college finance at College Coach and a former financial-aid officer at Southern New Hampshire University, is quoted as saying in the report. That’s because affluent families may qualify for at least some aid, Bickford says.

In the main, advisors acknowledge that they are more expert in helping clients save and invest for college than figuring out financial aid forms and the like.

“I think planners in general are aware of the issues and can, at the very least, raise awareness of the consequences of each type of account on the financial aid calculations via the FAFSA.  However, college planning is one more area that specialization pays the most benefits,” says Michael Clancy, CFP, CLU, the director of financial planning at Drexel University’s College of Medicine.

Indeed, some planners might consider making it a core competency and specialty given it’s importance to many families. “Paying for college routinely comes up as the number two most important financial goal for families, behind paying for retirement,” says Clancy.

For her part, Paula Nangle, CFP of the Marshall Financial Group says she completed the National Institute of Certified College Planners to earn her Certified College Planning Specialist designation, but she hasn’t maintained it. “There is an awful lot to know about college planning,” she says, noting, as did Olsen, that most her clients will not qualify for financial aid and have considerable wage income. “I would say my expertise and experience (with FAFSA and filling out other government aid forms) is limited.”

But even though Nangle’s experience is limited, her firm does have a college planning expert at her firm with whom she consults. “College planning is a pain point for many clients and it is an area where planners can add a lot of value,” says Nangle, who notes that one of the advisors in her firm – Emery – specializes in college planning and that she often consults with him.”

Personal Experience Plays A Role

On a personal note, Nangle says that she will become much more familiar with the college application process as her daughter is now a junior in high school. Others have become familiar with the college application through personal on-the-job training too.

“There is nothing in our formal training that addresses these issues,” says Tim Knotts, CFP of the Hogan-Knotts Financial Group. “However, continuing education, and life experiences can give us the background we need.”

As an example, Knotts says he has four children, two of whom are out of college and two of whom are still in college. “I have some serious expertise right now in all of these areas,” Knotts says. “However, I can see this becoming rusty in 10 years or so unless I make a conscious effort to keep up on it.”

What Advisors Need To Know

Advisors have the best background to bring the knowledge of various account types as well as the client’s other goals into play for a more comprehensive solution, says Clancy.

But Clancy acknowledges that things get complex given that clients might need to complete FAFSA forms for some colleges, the CSS PROFILE for others, and still other forms for another college.

“Profile schools add some complexity to the financial aid calculations that do not get covered in general financial planning education,” says Clancy. 

How insurance and annuities play a role too can be clouded by the planners own views on those products – pro and con, says Clancy. “If a planner’s compensation model does not allow for selling those products then their utilization in addressing financial aid ‘may’ be overlooked,” say Clancy.  “Vice versa is also true in that many pitches to parents regarding increasing financial aid are designed to market more insurance-based products vs. other investment vehicles. “

Comparing aid “packages” from one school to the next or even steering parents and the student towards schools that fill more of the cost of attendance with grants vs. loans needs to be brought into the conversation well before a student matriculates, says Clancy.  “If a planner doesn’t have these conversations routinely then they should partner up with experts for the benefit of their client base that could use this information,” Clancy says.

As for financial aid calculations, Clancy says there’s more than just one year involved.  “While account types are important for that first calculation, when funds are withdrawn - to pay for school or not - can impact the next year’s calculation negatively too,” he says.

And then there’s the issue of taxes. “How familiar a planner is with personal income tax preparation should also be brought into the conversation,” says Clancy.  “If the parent is a business owner or landlord not only makes the tax situation more complex but opens up other opportunities for how to pay for college.”

Planners also need to discuss using life insurance as a way for clients to pay for college costs. “Not only for goal completion, in case a parent pre-deceases the child, but also when co-signing for a loan,” says Clancy.  “How is the debt going to be repaid and potential loan forgiveness programs or scholarship searches are areas a planner can expand on their service offerings.”

Where Advisors Make Mistakes

For his part, Emery says the following are among the more common mistakes that trip up advisors who do college planning.

1.    Not all 529 withdrawals for college costs are tax free.  Many times advisors set up 529 savings accounts, manage the growth of these funds, but when it comes to liquidate those funds, sometimes they trigger a taxable event.  I have seen this happen if a client has a financial aid package or if they are also utilizing tax credits.

2.    Not understanding which assets need to be reported on FAFSA or CSS Profile forms.  When assets are valued, which assets need to be reported, and the correct value of reportable assets are extremely important in accurately reporting a family’s ability to pay for college.  Also, which entity reports the asset is also important.  If a client has a student going to some of the more expensive private schools, that family may have to file three different financial aid forms (FAFSA, Profile, and the school’s own form). I have seen mistakes with all of these areas.

3.    Many advisors don’t realize that their current planning for the family may impact future years college costs (both good and bad).  To do good college financial consulting, the planner really needs to consider all the years the family has kids attending college, which can span as many as 10-plus years.

A Chance To Learn More About Incorporating College Planning Into Your Practice

In the interest of full and fair disclosure, I am presently a full-pay client of Strategies for College. But even if I wasn’t, I’d still want to tell you more about a webinar the company are hosting for advisors and others in financial services industry who would like to offer college planning services - at some level - to clients and prospects. Learn more about the free ProPlan PLUS: A Business Development Program For Financial Services Professionals webinar that will take place on 9/25/2012 from 7 pm ET to 8 pm ET.

Share Your Story Below

Are you in a position to help your clients complete financial aid forms, or do you mostly specialize in helping them save and invest for college? Share your story with your peers in the comment field below.

R. Brian Fechtel is a life insurance agent, a Chartered Financial Analyst, and the founder of Breadwinners’ Insurance. In an article in the September issue of the Journal of Financial Planning (“Bringing Real Clarity of Cash Value Life Insurance to the Marketplace”), Fechtel makes these good points:

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- Current life insurance illustrations are an inadequate tool for understanding and comparing cash value life insurance policies.

- State insurance regulators have been ineffective in providing useful information to consumers.

- When you review the past performance of a policy, it is useful to determine the sources of variance between illustrated and actual values.

- A comparison of term and cash value life insurance should take into account the product costs as well as the income tax treatment.

A few observations:

- Fechtel does what every buyer in the life settlement industry does: he reverse-engineers illustrations to break out the charges and credits, although with less precision than the life settlement industry would accept. Life settlement buyers deconstruct illustrations to estimate the minimum premiums that must be paid to keep a policy in force. Fechtel does it to create “informative illustrations.”

One person’s informative illustration is another person’s waste of time. Two of the eight columns in his illustration show guaranteed amounts. In an earlier post (“Life Insurance Guaranteed Values Are a Big Fat Idiot”), I explained the near-zero information content of guaranteed values.

The three annual cost columns in the illustration will take some effort for advisors to understand and explain to clients, with no advantage over a rate-of-return perspective that fits naturally with how advisors approach other investments.

And how can an informative illustration fail to indicate whether the numbers in each column are beginning-of-year or end-of-year?

- An article that claims to correct the shortcomings of a century of work on life insurance cost disclosure should contain more than a skimpy literature review. Fechtel mentions four contributors to this literature but leaves out many others. And the limited review contains a factual error: Fechtel says that M. Albert Linton developed his method in the 1960s, but in fact he began presenting it in the 1920s (see, for example, “The Material Return from Life Insurance as an Investment,”Life Association News, November 1927).

[Historical digression: Miles Menander Dawson, a consulting actuary for the New York State legislature’s landmark investigation of the life insurance industry, presented a crude version of “buy term and invest the difference” in his 1905 book, The Business of Life Insurance. The rates of return in such comparisons are now called Linton yields. S.H. Nerlove (“The Investment Element in Life-Insurance Contracts”) and Linton debated methodology in the pages of the Journal of Business in 1928.]

- Fechtel claims that an insurer’s statutory financial statements contain useful information to understand a policy’s past performance (and possibly to predict future performance), but he offers no empirical evidence. He states: “..this policy’s actual financial performance, along with that of all the insurer’s other policies, can be reconciled with the insurer’s actual financial performance as reported in its annual statement filed with regulators. Admittedly, sufficiently precise reconciliations can be tediously challenging data collection and analysis projects, but, in contrast to some practitioners’ mistaken beliefs, they are hardly impossible.”

As one of those practitioners with mistaken beliefs, I would applaud any credible research on the correlation between companywide statutory accounting information and product-specific pricing factors. This is, in fact, a frontier of life insurance product due diligence.

Fechtel has published an impressively detailed analysis of an insurer’s financial statements on BreadwinnersInsurance.com, so one part of this project is already done. Now someone just has to break into insurers’ home offices and steal the profit tests. As I explained in an earlier post about the Veralytic Report, profit tests are indispensable for understanding the risks that you are taking when you buy life insurance policies with nonguaranteed values.

- Fechtel is unjustifiably dismissive of options analysis. He ignores the most important option that consumers have: the option to wait. And he complains that “practitioners who advocate viewing cash value policies as packages of options…have then either failed to provide the costs of such bundled products or have erroneously confused analysis of an illustration for analysis of a policy.” I have found that options analysis leads to useful insights despite the difficulty of quantification. However, a recent example of research that might meet Fechtel’s high standards is  Nils Rüfenacht, Implicit Embedded Options in Life Insurance Contracts: A Market Consistent Valuation Framework, Physica-Verlag, 2012.

- Where is the evidence that Fechtel’s analytical approach leads to better outcomes for consumers? It is not enough to declare, as he does repeatedly, that his way of looking at life insurance improves consumer decision-making. Declarations are not evidence. He has been promoting his preferred disclosures for at least 19 years (see “Fairer Product Comparisons,” Best’s Review, February 1993), so he has had a lot of time to assemble a robust database of results showing the power of his method. Does it do nothing more than guide advisors to ask a few of the many questions that should be on any comprehensive checklist?

One unintended lesson from this article is that financial advisors have been badly served by their educational curriculum. Instead of a detailed explanation of how life insurance policies are actually priced, provided by actuaries who do the pricing, they have to settle for one superficial description after another.

9-22-2012 update

Regarding the relationship between statutory accounting information and policy performance, here’s a research paper that I overlooked: James M. Carson and Randy E. Dumm, “Insurance Company-Level Determinants of Life Insurance Product Performance,” Journal of Insurance Regulation, Vol. 18, No. 2 (Winter 1999). A related article also appeared in the September 2000 issue of the Journal of Financial Service Professionals.

The authors looked at data compiled by A.M. Best for 73 universal life policies issued in 1985 to 45-year-old male nonsmokers. The face amount was $100,000, and the annual premium was $1,500. They examined the relationship between actual policy performance, measured by 10-year cash surrender value, and selected company-level information, mostly based on insurers’ statutory annual statements. Their regression analysis showed that three company-level data items were significantly related to policy performance: lapse rate (statistically significant at the 0.01 level) and general expenses and investment yield (significant at the 0.10 level). Variables that showed no significant relationship included company size, organizational form (mutual vs. stock), A.M. Best’s financial strength rating, net gain as a percentage of total income, and change in product mix.

It makes sense that lapse rates should have the strongest relationship; that data item is for life insurance only, whereas other items are aggregates for all lines of business.

11-3-12 update

You can read Brian Fechtel's reply at http://www.glenndaily.com/glenndailyblog26.htm