©2015, College for Financial Planning, all rights reserved.

Session 8Investment Planning

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMFinancial Plan Development Course

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8-2

Investments: The Basics

Financial Planner’s Job

• Clear understanding of portfolio characteristics needed to achieve client goals and timelines

• Knowledge of portfolio risk, both short- and long-term

• Familiarity with specific strategies: risk reduction, income generation, growth, etc.

• Ability to evaluate individual investments and how they fit in portfolio and/or evaluate third party managers

• Consideration and incorporation of tax strategies and consequences

• Understanding and proactive planning for consequences of economic trends

• Methods of managing and integrating multiple accounts by multiple providers including qualified plans

• Helping client understand how these fit together in their lives and avoiding inappropriate reactions (This one is the hardest!)

8-3

The Investment Process

Step 1: Gather Information

• Most facts are easy, simple-to-get documents. • Cash flow requirements, timelines, and goals are more difficult because many

clients don’t think past this quarter.• Knowledge about the client is hardest and the most important; it requires good

listening skills.• It defines the success or failure of your client relationship.

8-4

Step 2: Analyze Required portfolio

characteristics• Time frames

• Cash flow requirements

• Risk capacity

• Risk measurement

• Vehicle structure(s)

• Tax issues – income and cap gains

• Estate planning coordination

Client expectation management • Mental accounting

• Volatility/risk tolerance

• Return expectations

• Investment management services expectations

• Sophistication level

Uncommon issues and impacts• Unique assets

• Concentrated positions

• Asset retitling/gifting plans

• Business ownership with cash flow and disposition plans

• Management of special assets, impact on insurance needs, etc.

Overlay economic conditions

8-5

Don’t force your own risk tolerance on the clients—bad things could happen.

Define Risk Parameters

8-6

Clients

Considerations Dudellas Dowlers

Time frames Outflow: next 4 yrs. for college, 5 yrs. for car, 20 yrs. to retirement, 31 yrs. planned distribution

13 yrs. to first planned withdrawal, 20 yrs. to retirement, 31 yrs. planned distribution

Cash flow requirements

Risk that may need to tap due to lack of reserves

None anticipated for 13 yrs.; partial risk until emergency reserves funded

Risk capacity Maximum loss between $20,000–$40,000 if implement risk plans

Maximum loss between $50,000–$100,000 if implement risk plans

Risk tolerance Below average, but investment choices/ portfolio do not match risk tolerance

Average risk but portfolios and risk tolerance do not match

8-7

Clients

Considerations Dudellas Dowlers

Vehicle structure Nonqualified assets depleted. Do not qualify for deductible IRA, qualify for Roth IRA, employer match not captured, have access to stock purchase plan and other employer plans next year.

Currently have mixture. Do not qualify for deductible IRA, qualify for Roth IRAs, have room in qualified plans but capturing all matches.No options/restricted stock, etc.

Tax issues 25% federal, 4.63% state, no tax carry forwards, under-withholding, education tax credit options.

25% federal, 4.63% state, no tax carry forwards, state gives tax deduction for 529 plan, child tax credit phaseout issue.

Estate tax planning concerns

No special considerations.

No special considerations.

8-8

Clients

Considerations Dudellas Dowlers

Mental accounting Education first so everything wide open for that goal.

$22,000 of municipal funds for college.

Volatility/risk tolerance

High concern, reduce risk until reserves built and risk plans in place.

Past strong response to market downturns, disparity between stated risk and current portfolio.

Return expectations 5.5% with 2.5% inflation was acceptable and allows client to achieve goals. Client seemed to understand discussion.

5.5% with 2.5% inflation was acceptable and allows client to achieve goals. Client seemed to understand discussion.

Sophistication level Moderate to high on taxes and employer benefit, low on investment characteristics.

Moderate: less sure of asset classes, theory, fees, risk and return measures, used to mutual funds & ETFs.

8-9

Impact of Client Expectation Management

8-10

Assessing Risk Tolerance

8-11

Determining Risk

Consider Time Horizon & Risk Tolerance

•When you add in RISK CAPACITY it can change the mix based on size of portfolio.

•Client sets risk capacity floor at $500,000, 10+ time horizon, and high risk tolerance:

• Investments are worth $2,000,000: Aggressive portfolio• Investments are worth $550,000: Moderate • The time frame and risk capacity should shift portfolio chosen after portfolio

indicated.

Time Frame High Risk ToleranceModerate Risk Tolerance Low Risk Tolerance

10+ years Aggressive Moderately Aggressive

Moderate

7 to 10 years Moderately Aggressive

Moderate Moderate

3 to 7 years Moderate Moderately Conservative

Moderately Conservative

1 to 3 years Moderately Conservative

Moderately Conservative

Conservative

Less than one year

Conservative Conservative Conservative

8-12

Clients

Uncommon Issues Dudellas Dowlers

Unique assets Stock purchase plan None

Concentrations Potential in future None

Asset retitle or gifting Willing to consider shifting assets for education

Willing to consider shifting assets for education, also using charitable gifting strategy within current gifts

Business implications None None

Impact on insurance needs

None* None

*concentration in future could impact

8-13

Unusual Situations

What would you do with…

• Timberland investments in Alaska with special tax treatment?

• Partial venture capital ownership of fishing vessel?

• Private annuity with family member?

• Two businesses owned in different countries with currency, tax, and ownership issues by divorcing couple?

• Fake investments?

• Business cash flows hidden from the IRS?

• Unusual nonqualified restricted stock plans based on relationship of market return to stock return?

TIP: If you uncover something that is unfamiliar, ask for documentation and permission to call client or other advisors for additional information. • Then research/find expert to assist before completing analysis.

• What you don’t know can hurt you and the client.

• How would these assets impact other parts of plan, like life insurance?

8-14

Clients

Uncommon Issues Dudellas Dowlers

Investment management services expectations

Creation of investment policy statement and adherence to it.

Semi-annual meetings: one focused on cash flow and taxes, one on returns compared to IPS and goals.

Annual return discussions of 3% goals and updated financial projection.

Creation of investment policy statement and adherence to it.

Quarterly reviews compared to IPS and goals.

Annual return discussions of 3% real return goal.

Willingness to take some loss to protect downside.

Your constraints ? ?

8-15

Investment “Vehicles”

Vehicles + Asset Allocation + Specific Investments

= Portfolio Designed to Meet Client Needs.

• Tax-advantaged plans – IRAs, Roth, 401(k), 403(b), etc.

• 529, Coverdell, Series EE bonds

• Nonqualified investment accounts, brokerage, managed, pooled, self-directed, set portfolios, customized management, multiple managers

• Trusts

• Annuities – immediate, deferred, variable, fixed

• Life insurance – variable, fixed

• Mutual funds, lifestyle funds, ETFs, individual stocks and bonds

8-16

Considerations for Vehicles/Structure

• Size of portfolio that would be in vehicle

• Income and estate tax situation of owner(s)

• Owner desire to be engaged in active management

• Active vs. passive management

• Expenses

• Liquidity characteristics

• Your investment management capabilities defined by time management/profitability and firm constraints

8-17

Which Vehicles?

Dudellas Dowlers

Municipal money market for most reserves

?

Roth IRA for additional reserves and accumulation with tax diversification – creditor protected

Why?

Employer plan to capture match and reduce taxes

529 Plan? To transfer money?

Stock purchase plan?

8-18

Impact of Vehicle ChoiceTraditional IRA Roth IRA

Impact of shifting $4,000 per year from traditional to Roth for 58-year-old until age 62.

8-19

What do you know about Roth IRAs?

8-20

Roth IRAsRecommendation: Fully fund Roth IRAs starting in year 2015. • Clear, actionable recommendation

Advantages

• Contributions can be withdrawn without taxes or penalties at any time.

• Earnings accumulate tax-free.

• Great for accumulating large chunks of money to pull out for goals after 59½ to avoid spikes in tax bracket.

• Not required to ever make withdrawals.

• Great to use for accumulating medical retirement reserves (average couple age 65 will spend $240,000 for medical expenses during retirement).

• If held at least from years from initial contribution, can withdraw earnings without tax or penalty.

• No tax or penalty if withdrawn after 59½, in case of disability, first home purchase, medical premiums while unemployed, qualified higher education expenses, unreimbursed medical expenses in excess of 10% of AGI.

• Creditor protection up to $1,000,000 from bankruptcy but not lawsuits; based on state.

• May use substantially equal payments to avoid taxes and penalty .

• Allows management of taxes in retirement by balancing income from qualified plans and non-taxable distributions from Roths along with other sources like Social Security and after-tax investments.

8-21

Roth IRAs

Disadvantages• No tax deduction compared to IRAs or 401(k)s.

• May be phased out due to income restrictions in the future.

• Limited to $5,500 per person as long as earned income meets it. Additional catch up of $1,000 when over age 50.

• Earnings withdrawals that do not meet those listed above are subject to tax plus 10% penalty.

Alternative: Continue accumulating in taxable accounts for any goals you believe they may need prior to age 50 (no tax advantage, however) or put more in qualified plans. If withdrawing the money from qualified plans for lump sum like cabin, may offset value of tax deduction.

8-22

When Writing Vehicle Recommendations

• If there are tax rules, be specific and complete.

• Give the client enough information so they can make informed decision.

• Protect yourself by writing the details in and checking your sources so you are knowledgeable and don’t make errors in your explanations of penalties and rules.

• Once you have them written, they are easy to copy and paste into many client reports.

8-23

Vehicle & Construction Recommendations

Move your largest old 401(k) plan into an IRA. The other is being transferred to your qualified plan to allow a loan.

Advantages

• Asset allocation is more easily managed with wider choice of options and quicker response time

• Internal investment fees may be lower than old 401(k)

• Asset allocation being monitored by a professional

• No tax consequence for moving

Disadvantages

• Loses some but not all protections from creditors based on your state of domicile

• Loses pension guarantee protection from federal government

• Paperwork and time

8-24

After Analysis

Define current and proposed asset allocation characteristics(qualified, nonqualified, total portfolio, per account or per bucket)

Create Investment Policy Statement• Draft

• Review and agree with client

Craft Transition Plan• Map existing investments to new plan

• Identify asset class shifts to accomplish new targets

• Identify underperforming assets within asset class

• Determine tax consequences of total shift and transition strategy

• Evaluate and select recommended investments

• Explore impact on other areas or tax efficient method of transitioning

• Craft plan and share with client and advisors

8-25

Common Client Asset Allocation

• Buy one of everything in every accounto Difficult to figure out asset allocation or risko Ends up with eight different small-cap funds or

worse, eight different lifestyle target funds with $500 each

• Don’t know what to do so put all in cash or all in one stock fundo End up with concentration

• Never rebalance:o Results in concentration o Results in assuming either

more or less risk than anticipated

8-26

Dowlers’ Current Portfolio

• What is the mix between stocks and bonds?

• What is standard deviation and return?

• How efficient is portfolio?

• Will it meet their goals?

• What can you tell about their prior decision making?

• How do Jim and Anne differ?

Anne's

401(k)

Anne's

Fixed

Annuit

y

Anne's

IRA

Jim's

401(k)

Jim's

Trad.

IRA

Joint

Large

Cap

Growth

Joint

Muni

Bonds

Joint

Small Cap

Growth Total

Cash & Equiv.                 $

Short-Term Bonds         $32,889       $32,889

Int. Term Bonds $15,073

$9,762 $83,924

        $108,759

Long-Term Bonds   $9,762         $67,444   $77,206

Large-Cap Value Stocks $7,537               $7,537

Large-Cap Growth

Stocks

$7,537         $26,987     $34,524

Mid-Cap Stocks       $18,341         $18,341

Small-Cap Stocks               $40,467 $40,467

Int. Dev. Stocks                 $

Int. Emerging Stocks       $165,071

        $165,071

Total $30,147

$19,524

$83,924

$183,412

$32,889 $26,987 $67,444 $40,467 $484,794

8-27

Performance Measurement

• Alpha (Jensen Index) • Treynor Index• Sharpe Index• Information Measure

8-28

The Jensen Index (Alpha)

• Measures whether the actual return exceeds the return that should have been earned based on the CAPM

• An absolute measure of return

βrrrra fmfp

8-29

Treynor Index

• A relative measure, used for comparison: the higher the better

• Beta needs to be reliable

• Formula is provided on test

8-30

The Treynor Index

Standardizes the return in excess of the risk-free return by the portfolio’s beta

β

rrT fp

i

8-31

Treynor Calculation

You have to choose between the following two funds; the current risk-free rate is 5%.• Fund A: 18% return, beta of 1.3• Fund B: 14% return, beta of 0.85

Fund A Fund B18 – 5 = 10 14 – 5 = 10.59 1.3 0.85

Answer: Fund B with the higher Treynor ratio

8-32

Sharpe Index• Can be used when

beta is not reliable• Calculation is similar

to Treynor; Sharpe uses standard deviation in the denominator, Treynor uses beta

• Relative measure used for comparison; the higher the better

• Formula provided8-33

Sharpe: Used for Reliability

Sharpe standardizes the return in excess of the risk-free rate by the portfolio’s standard deviation.

p

fp

σ

r r Sp

8-34

What would you rather have?

Mnemonic you won’t forget:

Testing portfolios for diseases: SD or TB

Sharpe divides by Treynor divides by

Deviation Beta

8-35

Plan Development: Sharpe Ratio Formula

Return – Risk Free (2.5%)Standard Deviation

What does this tell us about the efficiency of their portfolio compared to these?

What would the efficient frontier look like with these portfolios?

8-36

Explaining Risk/Reward

• How do you explain concepts to clients?o What is risk? How do we measure it? What can

clients use to “get a handle” on risk.o What is return? What measurements are

important? What should clients look for?o Why is the relationship between risk and return

important? How can clients gain confidence that they are making the right decision?

• Try saying and writing an explanation.Ask peers and others how understandable you are.

8-37

Next Class

8-38

©2015, College for Financial Planning, all rights reserved.

Session 8End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMFinancial Plan Development Course