Vol12 issue1

Journal of

Personal Finance Financial Planning Implications of the American Taxpayer Relief Act Michael E. Kitces, Pinnacle Advisory Group

How Much Is Your 401(k) Worth?

David Blanchett, Morningstar Investment Management

A Macro-View of the New Definition of Fiduciary Under ERISA Proposed Sec. 3(21) Richard D. Landsberg Director – Advanced Consulting Group, Nationwide Financial Services

Direct Investing in Bonds during Retirement Stephen J. Huxley, University of San Francisco Manuel Tarrazo, University of San Francisco

A Digital Asset Balance Sheet: A New Tool for Financial Planners John E. Grable, University of Georgia Nolan D. McClure, University of Georgia Kimberly Broddie, University of Georgia Stefen Kutzman, University of Georgia Brad Watkins, University of Georgia

Tools, Techniques, Strategies & Research to Aid Consumers, Educators & Professional Advisors Volume 12 Issue 1

2013

Journal of Personal Finance

Volume 12, Issue 1 2013

The Official Journal of the International Association of Registered Financial Consultants

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CONTENTS Editor’s Notes...................................................................................................... 8 Financial Planning Implications of the American Taxpayer Relief Act of 2012 ................................................................................................................ 10 Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC Income and estate tax planning has been remarkably difficult for the past decade, inhibited by an ongoing series of temporary rules and important tax planning provisions that are perpetually scheduled to lapse or about to sunset. Due to the never-certain-for-long environment, many clients (and even their planners) have struggled to engage in effective long-term income and estate tax planning. In this article, we look in depth at the new income and estate tax rules that will apply in 2013, and their financial planning implications, from the old laws that were extended and made permanent, to some extensions that are still temporary, to a few entirely new rules that were introduced.

How Much Is Your 401(k) Worth? ................................................................. 46 David Blanchett, CFA, CFP®, Morningstar Investment Management How much is your 401(k) or IRA worth? In this paper we discuss three different methods that can be used to estimate the relative value of a tax-advantaged account within a financial planning context. The Balance approach is based simply on the value of the account, the TaxAdjusted approach adjusts this value to take taxes into account, and the Benefit Equivalent approach determines the value of the 401(k) or IRA relative to the amount of income it can generate over the lifetime of the account when compared to a taxable account. Through simulations, we find that for a 401(k) the Benefit Equivalent effective value of a stock portfolio may be worth approximately 100% of a taxable account and approximately 110% of a taxable account for bonds. For a Roth IRA we find that the Benefit Equivalent effective value of a stock portfolio may be worth approximately 130% of a taxable account and approximately 140% of a taxable account for bonds.

A Macro-View of the New Definition of Fiduciary Under ERISA Proposed Sec. 3(21) ........................................................................................... 71 Richard D. Landsberg, JD, LLM, MA, CLU, CPM, ChFC, RFC, AIF Director – Advanced Consulting Group, Nationwide Financial Services

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Journal of Personal Finance This article seeks to examine the Sec. 3(21) definition of fiduciary under the Employee Retirement Income Security Act of 1974, as amended (ERISA) with particular emphasis on the regulatory proposal that has been offered and is due to become final later this year. It offers perspectives on the general duties of fiduciary contact with the larger, more overarching matters that have been proposed. The paper should increase fiduciary awareness and execution of fiduciary responsibility as it relates to ERISA qualified retirement plans. It seeks to integrate prudent investment process and procedure with the new proposal.

Direct Investing in Bonds during Retirement ................................................ 98 Stephen J. Huxley, Ph.D. (corresponding author), University of San Francisco Manuel Tarrazo, Ph.D., University of San Francisco Direct bond purchases can address major issues confronting retirees better than alternative investments such as providing retirement income, moving to a retirement homes, leaving a legacy, etc. It is best to concentrate on cash flows and conceptualize “risk” as failing to meet unavoidable payments, rather than on returns and return volatility as a proxy for risk. Our research shows that direct bond investing – especially with the assistance of a professional financial planner offers many advantages to moderately sophisticated small investors.

A Digital Asset Balance Sheet: A New Tool for Financial Planners ........... 134 John E. Grable, Ph.D., CFP® (corresponding author), University of Georgia Nolan D. McClure, University of Georgia Kimberly Broddie, University of Georgia Stefen Kutzman, University of Georgia Brad Watkins, University of Georgia Financial planners are increasingly encouraged to discuss digital asset planning issues with clientele. Typically, these discussions involve prompting clients to identify and maintain records regarding online accounts, computer files, domain names, social media information, and important passwords. This paper adds to the tools financial planners can use when working with clients by presenting a digital asset balance sheet. The sheet is intended to provide a structure to help clients document which digital assets are owned, how much these assets may be worth, and whether ongoing liabilities may be associated with the ownership or possession of such assets. This paper also provides information about the ownership characteristics of some digital consumer assets. ©2013, IARFC. All rights of reproduction in any form reserved.

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CALL FOR PAPERS JOURNAL OF PERSONAL FINANCE (www.JournalofPersonalFinance.com) OVERVIEW

The Journal of Personal Finance is seeking high quality manuscripts in topics related to household financial decision making. The journal is committed to providing high quality article reviews in a single-reviewer format within 45 days of submission. JFP encourages submission of manuscripts that advance the emerging literature in personal finance on topics that include: -

Household portfolio choice Retirement planning and income distribution Individual financial decision making Household risk management Life cycle consumption and asset allocation Investment research relevant to individual portfolios Household credit use Professional financial advice and its regulation Behavioral factors related to financial decisions Financial education and literacy

EDITORIAL BOARD The journal is also seeking editorial board members.

Please send a current CV and sample review to the editor. JPF is committed to providing timely, high quality reviews in a single reviewer format.

CONTACT

Michael Finke, Editor Email: jpfeditor@gmail.com www.JournalofPersonalFinance.com

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JOURNAL OF PERSONAL FINANCE VOLUME 13, ISSUE 1 2013 EDITOR Michael S. Finke, Texas Tech University ASSOCIATE EDITOR Wade Pfau, National Graduate Institute for Policy Studies (GRIPS) EDITORIAL ASSISTANT Carey Yeary, Texas Tech University EDITORIAL BOARD

Steve Bailey, HB Financial Resources Joyce Cantrell, Kansas State University Dale Domian, York University Monroe Friedman, Eastern Michigan University Joseph Goetz, University of Georgia Clinton Gudmunson, Iowa State University Sherman Hanna, The Ohio State University George Haynes, Montana State University Douglas Hershey, Oklahoma State University Karen Eilers Lahey, University of Akron Doug Lambin, University of Maryland, Baltimore County Rich Landsberg, Advanced Consulting Group Jean Lown, Utah State University

Mailing Address:

Angela Lyons, University of Illinois Ruth Lytton, Virginia Tech University Lewis Mandell, University of Washington and Aspen Institute Yoko Mimura, University of Georgia Robert Moreschi, Virginia Military Institute Edwin P. Morrow, Financial Planning Consultants David Nanigian, The American College Barbara O’Neill, Rutgers Cooperative Extension Cliff Rob, University of Alabama Jing Xiao, University of Rhode Island Rui Yao, University of Missouri Tansel Yilmazer, University of Missouri Yoonkyung Yuh, Ewha Womans University

IARFC Journal of Personal Finance The Financial Planning Building 2507 North Verity Parkway Middletown, OH 45042-0506

© Copyright 2013. International Association of Registered Financial Consultants. (ISSN 1540-6717) ©2013, IARFC. All rights of reproduction in any form reserved.

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Postmaster: Send address changes to IARFC, Journal of Personal Finance, The Financial Planning Building, 2507 North Verity Parkway, Middletown, OH 45042-0506 Permissions: Requests for permission to make copies or to obtain copyright permissions should be directed to the Editor.

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Disclaimer: The Journal of Personal Finance is intended to present timely, accurate, and authoritative information. The editorial staff of the Journal is not engaged in providing investment, legal, accounting, financial, retirement, or other financial planning advice or service. Before implementing any recommendation presented in this Journal readers are encouraged to consult with a competent professional. While the information, data analysis methodology, and author recommendations have been reviewed through a peer evaluation process, some material presented in the Journal may be affected by changes in tax laws, court findings, or future interpretations of rules and regulations. As such, the accuracy and completeness of information, data, and opinions provided in the Journal are in no way guaranteed. The Editor, Editorial Advisory Board, the Institute of Personal Financial Planning, and the Board of the International Association of Registered Financial Consultants specifically disclaim any personal, joint, or corporate (profit or nonprofit) liability for loss or risk incurred as a consequence of the content of the Journal.

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EDITOR’S NOTES This issue contains articles that emphasize practical issues of interest to financial advisors. I am grateful to the contributors for their high quality submissions Author Michael Kitces provides an in-depth overview of the significant new tax law changes following the American Taxpayer Relief Act of 2012. Kitces has been a leader in providing timely, well researched information for the financial advising community. His extensive review of salient tax changes provides insight into many income and estate tax issues and gives useful examples for practitioners.

The next three articles provide important information related to retirement. In the first, David Blanchett estimates the sheltering benefit of various retirement accounts to give a more accurate estimate of the after-tax retirement income stream from a dollar of savings. His examples provide unique insight into how sheltering affects asset allocation and income planning. The second article by Richard Landsberg delves into the responsibility of plan sponsors and administrators under ERISA. The article lays out how fiduciary standards relate to investment management within retirement accounts and provides some much needed clarity for those who make recommendations and select investments options. The third article by Stephen Huxley and Manuel Tarrazo provides an important analysis of low-risk portfolio investments in retirement by reviewing direct bond investing strategies. Most retirement investment analyses assume safe assets are invested Š2013, IARFC. All rights of reproduction in any form reserved.

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in short term risk-free securities, but this article lays out how a practitioner might go about investing in a bond strategy to achieve retirement income objectives.

The final article provides a guide to an important new field of estate planning. Most of us navigate financial markets through electronic resources without thinking about how our many accounts will be accessed after our death. John Grable and his co-authors explain the importance of having a plan for electronic assets, or a digital asset balance sheet. The issue of electronic resources is one that is likely to grow in importance and affects every aspect of financial planning. I look forward to future research that investigates how this transition to online decision making impacts the behavior of individuals.

~Michael Finke

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FINANCIAL PLANNING IMPLICATIONS OF THE AMERICAN TAXPAYER RELIEF ACT OF 2012 Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC

Pinnacle Advisory Group

Income and estate tax planning has been remarkably difficult for the past decade, inhibited by an ongoing series of temporary rules and important tax planning provisions that are perpetually scheduled to lapse or about to sunset. Due to the never-certain-forlong environment, many clients (and even their planners) have struggled to engage in effective long-term income and estate tax planning.

In this article, we look in depth at the new income and estate tax rules that will apply in 2013, and their financial planning implications, from the old laws that were extended and made permanent, to some extensions that are still temporary, to a few entirely new rules that were introduced.

Š2013, IARFC. All rights of reproduction in any form reserved.

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Introduction Income and estate tax planning has been remarkably difficult for the past decade, inhibited by an ongoing series of temporary rules and important tax planning provisions that are perpetually scheduled to lapse or about to sunset. Due to the never-certain-for-long environment, many clients (and even their planners) have struggled to engage in effective long-term income and estate tax planning.

This uncertainty culminated in the so-called “fiscal cliff” at the end of 2012, where an incredibly wide swath of tax laws were scheduled to lapse back to their old 2001 levels.

Ultimately, Congress averted the Fiscal Cliff with H.R. 8 – the American Taxpayer Relief Act of 2012 – but what’s most notable about the new legislation is not just that it avoided a lapse back to 2001 rules, but that the new provisions of the law are mostly permanent, providing some certainty in tax planning again for the first time in nearly a decade.

In this article, we look in depth at the new income and estate tax rules that will apply in 2013, and their financial planning implications, from the old laws that were extended and made permanent, to some extensions that are still temporary, to a few entirely new rules that were introduced.

Tax Brackets Technical Rules For the past several years, individuals have been subject to a six tax bracket system, with 10%, 15%, 25%, 28%, 33%, and 35% tax rates. Without the American Taxpayer Relief Act of 2012 (ATRA), the tax brackets would have lapsed back to

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the old rates that applied when President Clinton left office, which were 15%, 28%, 33%, 36%, and 39.6%.

Under the American Taxpayer Relief Act (ATRA), the existing six tax brackets remain and are made permanent, with their existing (annually indexed for inflation) income thresholds. In addition, a seventh tax bracket was added: income in excess of $400,000 for individuals, and $450,000 for married couples (a compromise from higher and lower amounts proposed by Republicans and Democrats, respectively) will now be subject to a top tax rate of 39.6%, effectively lapsing high income individuals back to the “old” top tax bracket. The new 7-bracket system, and the associated thresholds, are shown in Figure 1.

The $400,000 / $450,000 income thresholds for the new 39.6% tax bracket are indexed for inflation (as are all the income tax bracket thresholds).

Planning Implications There are several important planning implications to the new tax rate structure under ATRA. The first is simply to acknowledge that there is now a new top tax bracket – 39.6% – that affluent clients must contend with; as always, higher tax rates make it slightly more appealing to engage in tax deferral and tax management and minimization strategies. Given some states that now have top state (and local) tax rates that exceed 10% (as high as 13% in California under their “Prop 30” legislation), the reality is that the combined top tax bracket for many clients may exceed 50%... and that’s before accounting for the impact of the phaseout of itemized deductions and personal exemptions ©2013, IARFC. All rights of reproduction in any form reserved.

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(discussed later), and the onset of the new Medicare taxes on earned and unearned income that separately took effect in 2013 as a result of the Patient Protection and Affordable Care Act of 2010 (also known as “Obamacare” or PPACA).

In addition, it’s notable that because of the additional Figure 1. Tax Brackets for 2013.

Individuals Taxable Income Up to $8,925 Over $8,925 but less than $36,250 Over $36,250 but less than $87,850 Over $87,850 but less than $183,250 Over $183,250 but less than $398,350 Over $398,350 but less than $400,000 More than $400,000

Tax Liability 10% of taxable income $892.50 + 15% of excess over $8,925 $4,991.25 + 25% of excess over $36,250 $17,891.25 + 28% of excess over $87,850 $44,603.25 + 33% of excess over $183,250 $115,586.25 + 35% of excess over $398,350 $116,163.75 + 39.6% of excess above $400,000

Married Couples (Filing Jointly) Taxable Income Up to $17,850 Over $17,850 but less than $72,500 Over $72,500 but less than $146,400 Over $146,400 but less than $223,050 Over $223,050 but less than $398,350 Over $398,350 but less than $450,000 More than $450,000

Tax Liability 10% of taxable income $1,785 + 15% of excess over $17,850 $9,982.50 + 25% of excess over $72,500 $28,457.50 + 28% of excess over $146,400 $49,919.50 + 33% of excess over $223,050 $107,768 + 35% of excess over $398,50 $125,846 + 39.6% of excess above $450,000

Tax bracket thresholds are estimates based on projected inflation adjustments.

Medicare taxes and high income phaseouts that now apply – each with their own income thresholds – using “just” the tax brackets to determine a client’s marginal tax rate is actually less relevant than ever, at least for clients above $200,000 of income (where the new taxes and phaseouts begin to apply).

Instead, it will be necessary to look at the impact of all of these factors when evaluating a client’s true marginal tax rate (in

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addition to determining whether the income is earned income, unearned income, interest, dividends, capital gains, etc., as different income types have different rules and rates that apply).

It’s also important to note that with the new rules, some tax brackets are much wider than others. For instance, because the existing threshold for the 35% tax bracket was already scheduled to go to $398,350 in 2013 (for both individuals and married couples), the 35% tax bracket is now a very narrow tax bracket (especially for individuals!), as shown earlier in Figure 1.

Marriage Penalty (Relief) A long-standing issue under the tax code is the socalled “Marriage Penalty” – the fact that most of the tax bracket income thresholds for married couples are only slightly higher than (or in some cases, the same as) they are for singles, which means a dual earner married couple may owe more in taxes than the same two people would if they were single and each filed separate individual tax returns.

For example, imagine a couple where husband and wife each have $400,000 of taxable income after deductions in 2013. If they filed their own tax returns individually, the income for each would fill the current six tax brackets, end just short of the 39.6% tax bracket, and the tax liability (per Figure 1) would be $116,163.75 each (or $232,327.50 total).

However, as a married couple, their income “stacks” to a total of $800,000 of taxable income. As a result, one spouse’s income fills the bottom six tax brackets, and the other spouse’s income falls entirely in the 35% bracket (from $400,000 to $450,000 of income) and 39.6% for the remainder (the last $350,000). The total tax liability for the married couple would be $264,446, for a total “marriage penalty” of $32,118.50. (Notably, the rather unfavorable provisions that apply to the Married Filing Separately status are designed to prevent couples from just filing separately to avoid this “marriage penalty” result.)

In the original 2001 tax legislation, a partial “marriage penalty relief” provision was included, which made the 10% and 15% tax brackets for married couples twice the size of the individual bracket – and fortunately, after being scheduled to sunset, ATRA instead has made that permanent.

However, the marriage penalty still remains in effect to varying degrees for the remaining tax brackets, and while a $450,000 threshold for the 39.6% bracket for married couples (compared to $400,000 for individuals) provides a small amount of relief, the marriage penalty still substantively remains for all those who exceed the 15% tax bracket.

©2013, IARFC. All rights of reproduction in any form reserved.

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By contrast, the 33% bracket is far wider; it runs from $183,250 to $398,350 for individuals, and from $223,050 to $398,350 for married couples. As a result, climbing from $250,000 to $350,000 of income doesn’t even change a client’s 33% tax bracket, but rising further from $350,000 to $450,000 results in a 6.6% jump in tax rates (from 33% to 39.6%).

Expect to see many clients and planning strategies focused on keeping income below the $400,000 / $450,000 threshold (especially given its further impact on long-term capital gains rates and qualified dividends, as discussed in a later section).

Overall, the primary impact of the new rules is simply that our income tax system is now more “progressive” (meaning higher tax rates on higher incomes), which at the margin will make tax deferral strategies more and more appealing as income rises. This may increase interest for higher income clients in the use of tax-deferred annuities (especially the new lower-cost options starting to be released by a few companies), life insurance strategies (although be careful not to let the tax tail wag the investment dog), qualified retirement plans and deferred compensation, as well as the value of taxfree-growth savings options like Section 529 college savings plans.

Higher tax rates also increases the relevance and potential impact of proactive year-to-year tax planning (especially if income is volatile at all, and there may be income/deduction timing opportunities).

Phaseout of Itemized Deductions and Personal Exemptions Technical Rules

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Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (the first of President Bush’s two major pieces of tax legislation), high-income taxpayers were subject to a phaseout of their personal exemptions and itemized deductions as income increased. To the extent that AGI income exceeded specified thresholds, taxpayers would lose: - 2% of their personal exemption amounts for each $2,500 (or partial amount thereof) beyond the threshold; notably, this phased out 2% times the total number of exemptions simultaneously (for however many family members there were), until 100% of all exemptions were phased out; and - Itemized deductions were reduced by 3% of the amount that AGI exceeded the threshold.

These phaseouts continued to apply until a maximum of 100% of personal exemptions and 80% of itemized deductions were phased out.

Under the 2001 tax legislation, these phaseouts were themselves phased out from 2006 to 2009; by 2010 they were eliminated entirely, which meant that all individuals kept all of their personal exemptions and itemized deductions, regardless of income level. However, the phaseouts were scheduled to return in 2013 with the fiscal cliff, and under ATRA they were in fact allowed to return (and were made permanent), albeit with new income thresholds.

Under the new rules, the “Pease limitation” (the phaseout of itemized deductions, named after the Congressman who originated the rule) and the PEP (Personal Exemption Phaseout) both apply beginning at $250,000 of AGI for ©2013, IARFC. All rights of reproduction in any form reserved.

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individuals, and $300,000 of AGI for married couples (higher than the approximately $180,000 AGI thresholds that would have otherwise applied if the prior rules had simply been reinstated without change).

Notably, because personal exemptions are fully phased out over an income range of $122,501, at an income level of $372,501 for individuals, and $422,501 for married couples, the impact of the personal exemption phaseout ceases. The itemized deduction phaseout continues to apply regardless of how high income rises, though, until/unless the phaseout reaches its maximum impact (no more than 80% of total itemized deductions can be phased out).

Planning Implications To the extent that itemized deductions and personal exemptions are being phased out again starting in 2013, the net impact is a higher marginal tax rate once income reaches the phaseout thresholds, as the phaseout of both the personal exemptions and itemized deductions push up the 33% and higher tax brackets.

Example 1a. In 2013, a married couple is just above the $300,000 AGI threshold, which means they will likely be in the 33% tax bracket after deductions. If the couple earned another $2,500 of income, this would phase out another 3% x $2,500 = $75 of itemized deductions, resulting in a total taxable income increase of $2,575. At a 33% tax rate, this leads to another $849.75 of taxes, which is the equivalent of a $849.75 / $2,500 = 33.99% marginal tax rate. Thus, the net effect of the itemized deduction phaseout is to increase the marginal tax rate by 3%

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(phaseout) x 33% (tax bracket) = 0.99%. Notably, if the couple was subject to the 39.6% tax bracket, the net impact would be 3% x 39.6% = ~1.2% increase in the marginal tax rate, instead of just ~1%.

Example 1b. Continuing the prior example, the additional income would also phase out another 2% of personal exemptions. If each personal exemption is worth $3,900 (in 2013), then the additional income would eliminate $78 of each personal exemption, which would result in an additional 33% x $78 = $25.74 of taxes. Relative to an income increase of $2,500, this results in an increase in the marginal tax rate of $25.74 / $2,500 = ~1%. Notably, as a married couple, the total impact would be twice this amount (approximately 2 percentage point increase in marginal tax rate), as each of the couple’s personal exemptions phase out simultaneously.

In the end, the net impact of the phaseout of itemized deductions and personal exemptions is an increase in the client’s marginal tax rate as income rises; the itemized deduction phaseout adds approximately 1% to 1.2% to the tax rate, and the personal exemption phaseout adds another 1% to 1.2% per exemption (e.g., multiplied across a family of 5, the net impact would be a 5% to 6% increase in the marginal tax rate).

As noted earlier, though, the impact of the personal exemption phaseout ends once income reaches the upper thresholds ($372,501 for individuals, or $422,501 for married couples). In point of fact, this means the marginal impact for individuals will typically be contained entirely within the 33% tax bracket (which starts below the $250,000 PEP threshold and ends above the $372,501 maximum phaseout threshold); for married couples, the impact is spread across the 33% and ©2013, IARFC. All rights of reproduction in any form reserved.

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35% tax brackets (but since the impact ends at $422,501 of AGI, it never reaches the 39.6% tax bracket for married couples). Although the PEP never impacts the 39.6% tax bracket, the impact can still be quite significant; for a family of five, the personal exemption phaseout essentially creates an extra “bubble” in the marginal tax rate, boosting it by more than 5% across the income range from $300,000 to $422,501 of AGI. As a result, the impact of the PEP for a family of five boosts the 35% tax bracket to a marginal rate near 40%, even though the couple is still shy of the 39.6% marginal tax bracket threshold.

Determining which tax bracket applies during the personal exemption phaseout is also complicated by the fact that while tax brackets are based on taxable income (after deductions), the personal exemption phaseout is based on AGI (as is the itemized deduction phaseout); as a result, the impact may be less for a client with high deductions, whose AGI is high enough to trigger the phaseout even though income after deductions is low enough to fall in the 28% tax bracket.

It’s also notable that because the phaseout of personal exemptions is 2% of the exemptions for each $2,500 of AGI or partial amount thereof, the marginal tax rate on small amounts of income is very erratic.

Example 2. A individual client has AGI of $325,000.

Adding another $1 of income – which is a partial amount of the next $2,500 – results in a phaseout of 2% of his/her personal exemption, resulting in $78 of lost deductions and another $25.74 of taxes; in other words, adding $1 of income resulted in a whopping $25.74 of taxes, or a nearly 2,500% marginal tax rate! On the other hand, if the additional income had been

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$1,000 instead, the same $25.74 of taxes would result, which is a marginal tax rate of only 2.57%; if the additional income had been $2,000, the same tax impact would have resulted in a marginal tax rate of only 1.33%; and if the additional income was $2,500, the impact is only about 1.0%. Although these increments are likely sliced too narrowly for much tax planning, it may become relevant in scenarios like deciding whether or how much of a Roth conversion to recharacterize to optimize the associated tax liability (which is sometimes analyzed and planned down to the last $1).

On the other hand, while the impact of personal exemption phaseouts occurs only at the 33% and 35% tax brackets, the phaseout of itemized deductions can span the 33%, 35%, and 39.6% brackets, as it continues to apply until/unless the maximum phaseout cap is reached. In practice, though, the cap rarely is reached, as higher income tends to result in additional itemized deductions (such as state and local income tax liabilities that have to be paid), and when deductions are phased out at “only” 3% of income, even a client with $1,000,000 of AGI only phases out $700,000 x 3% = $21,000 of deductions (and in practice, most individuals with $1,000,000 of AGI often have far more than “just” $21,000 of deductions). Notably, for those who live in a state with a state income tax rate higher than 2.4% (80% of 3%), the itemized deduction phaseout will typically never be reached, as higher income creates new deductions at the same rate that deductions are being phased out.

Due to the passive nature of these phaseouts of itemized deductions and personal exemption - they either apply, or they don't, based on income - little planning can be done to directly mitigate or avoid them. Instead, the net impact is simply that it ©2013, IARFC. All rights of reproduction in any form reserved.

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makes tax planning all the more valuable, as tax rates for higher income individuals are even higher once accounting for the impact of phaseouts. For instance, most income in the 33% bracket is already subject to a true marginal tax rate of 35% (or 36% for married couples, rising higher with larger families), and married couples in the 35% bracket may already be taxed at 38% or higher (including the phaseout of itemized deductions and at least two personal exemptions). The 39.6% bracket is closer to 40.8% for most clients as itemized deductions continue to phase out.

However, it’s also crucial to note that in the case of the itemized deduction phaseout in particular, because it is calculated based on income, not the amount of deductions, it’s still worthwhile to pursue tax deduction strategies. In other words, the presence of the itemized deduction phaseout generally does not make it less valuable to engage in strategies like charitable giving that produce deductions. After all, if a client has $1,000,000 of AGI and $100,000 of itemized deductions, then $21,000 of itemized deductions are phased out, and the net deductions are $79,000; if charitable contributions are then added to that (or any other deduction), the tax benefit of that charitable deduction is unaffected by the already-phased-out $21,000 of deductions. The charitable contribution will still produce tax savings at the marginal tax rate. Viewed another way, the effective result of how the itemized deduction phaseout is calculated is that the phaseout impacts the first deduction(s) taken, while marginal planning is based on the last deduction(s) being taken (which rarely overlap). Thus, the phaseout of itemized deductions should be viewed for most clients as an increase to the marginal tax rates that applies to additional income (unless the phaseout cap is

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actually being reached), not as a reason to avoid/minimize/reduce deductions.

Long-Term Capital Gains and Qualified Dividends Technical Rules Prior to the Bush tax cuts, the long-term capital gains tax rate was 10% for those in the lowest ordinary income tax bracket, and 20% for those in the remaining four tax brackets.

These capital gains rates were reduced to 5% (for those in the bottom two ordinary income tax brackets) and 15% for the upper brackets under the Jobs Growth and Tax Relief Reconciliation Act of 2003 (JGTRRA), and the 5% rate was subsequently reduced to 0% (beginning in 2008). The 0% and 15% capital gains tax rates continued through the end of 2012, and were scheduled to lapse back to 10% and 20% in 2013.

In addition, JGTRRA also created the so-called “qualified dividend” treatment, which allowed investors to have dividends taxed at the favorable long-term capital gains rates if they met certain requirements, including a 60-day holding period requirement (90-days for preferred stocks) and that the business was a domestic C corporation (or certain foreign companies traded on US exchanges).

Under ATRA, the 0% and 15% long-term capital gains rates were made permanent for most, but allowed to lapse for high-income individuals, creating a new 20% long-term capital gains rate for those subject to the new top 39.6% tax bracket (for taxable income in excess of $400,000 for individuals or $450,000 for married couples).

Thus, in 2013 and going forward, there are now three tiers of long-term capital gains tax rates: ©2013, IARFC. All rights of reproduction in any form reserved.

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- 0% (for those in the 10% and 15% ordinary income tax brackets); - 15% (for those in the 25%, 28%, 33%, and 35% ordinary income tax brackets); and - 20% (for those in the 39.6% tax bracket) In addition, under ATRA the rules for qualified dividends are also made permanent, albeit still tied to the longterm capital gains tax rate, which means qualified dividends for high-income individuals will also be subject to the new 20% rate.

Planning Implications As with the increase in ordinary income tax brackets, the most immediate impact of the new long-term capital gains rates is simply that high income clients must now contend with a higher tax rate, and that overall the taxation of both long-term capital gains and qualified dividends is now more progressive (meaning higher tax rates on higher income individuals).

However, in the context of long-term capital gains and qualified dividends in particular, it’s important to remember that 2013 also marks the onset of the new 3.8% Medicare tax on net investment income, which applies to individuals with more than $200,000 of AGI (and married couples over $250,000 of AGI).

As a result, the reality is that clients won’t actually face a 20% long-term capital gains rate at $400,000 of income.

Instead, the long-term capital gains and qualified dividend rates will rise from 15% to 18.8% (including the 3.8% surtax) at the $200,000 and $250,000 AGI thresholds, and will then rise to

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23.8% (i.e., 20% capital gains + 3.8% Medicare surtax) once taxable income crosses the $400,000 and $450,000 thresholds.

In essence, this means there are actually four long-term capital gains tax rates: 0%, 15%, 18.8%, and 23.8%, although notably the 18.8% threshold is based on AGI (before itemized deductions and exemptions) while the rest are based on taxable income (after all deductions). In addition, the reality is that the top long-term capital gains and qualified dividend tax rate is actually even higher than 23.8%, once accounting for the marginal impact of itemized deduction and/or personal exemption phaseouts.

Notwithstanding these varying thresholds, it’s important to note as well that the various capital gains rates only apply to gains that fall within the applicable income thresholds. Thus, for example, if a married couple had precisely $0 of taxable income and then began to sell investments to generate long-term capital gains, the first ~$72,500 of gains (up to the upper threshold for the 15% ordinary income bracket) would be taxed at 0%, subsequent gains would be taxed at 15% (which would continue until AGI rose high enough to reach $250,000), then capital gains would be taxed at 18.8% (and that rate would continue until taxable income reached $400,000), and any remaining long-term gains (and qualified dividends) would then be taxed at 23.8%. This means a client with $401,000 of taxable income only has the last $1,000 of capital gains actually taxed at 23.8%, while the remainder is taxed at a blend of 0%, 15%, and 18.8% rates.

The Value Of Tax Deferral Ultimately, the net result of these tax rate increases is to increase in turn the value of tax deferral, although notably even at a top 23.8% tax rate, the benefits of long-term capital gains Š2013, IARFC. All rights of reproduction in any form reserved.

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deferral are still quite limited unless the deferral time period is significant.

25 Figure 2. Economic Value of 1 Year of Tax Deferral for Various Tax Rates & Gains

Embedded Gain 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

15% tax rate 0.109% 0.200% 0.277% 0.343% 0.400% 0.450% 0.494% 0.533% 0.568% 0.600%

18.8% tax rate 0.137% 0.251% 0.347% 0.430% 0.501% 0.564% 0.619% 0.668% 0.712% 0.752%

23.8% tax rate 0.173% 0.317% 0.439% 0.544% 0.635% 0.714% 0.784% 0.846% 0.902% 0.952%

For instance, imagine an investment that was purchased for $300,000 and is now worth $400,000, representing a healthy (and probably multi-year) gain of $100,000, or 33% on the original investment. The reality is that the tax liability on $100,000 of capital gains will have to be paid someday (unless the value declines and the money is lost, or the client dies, neither of which is an improvement!). Thus, the value opportunity of tax deferral is to keep the current tax liability, which may be as high as $23,800 (at a top 23.8% rate), invested on the client’s behalf.

At a moderate 8%/year growth rate, this means keeping the last $23,800 of future-tax-dollars invested allows for an additional return of $23,800 x 8% = $1,904/year. This amount represents the true economic value of tax deferral: an extra $1,904 of growth that could be earned and put in the client’s pocket, on the $23,800 of tax dollars available to keep invested before they’re turned over to Uncle Sam. However, the reality is that $1,904 isn’t really a great deal of economic value on a $400,000 investment; the “benefit” of tax deferral is a mere 0.48%/year – which for many investments could be gained or

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lost in months, weeks, days, hours, minutes, or even mere seconds of market volatility.

Of course, the caveat is that this benefit compounds for each year that capital gains taxes are deferred; which means while just a year or two of deferral isn’t very impactful (relative to market volatility), a decade or more of tax deferral certainly can be. On the other hand, the value of tax deferral is also not even this high for clients in lower tax brackets; Figure 2 indicates the value of one year of tax deferral, assuming an 8% annual appreciation rate, varying levels of capital gains, and varying levels of already-embedded gains.

In terms of dividends, the primary impact of higher qualified dividend tax rates is simply to force investors to look a little more carefully at whether the after-tax yield of higherdividend stocks is still worthwhile at those higher rates. On the other hand, the reality is that qualified dividends still represent a significant tax break relative to non-qualified dividends, or the taxation of ordinary income (e.g., bond interest); as a result, investors who found dividend-paying stocks appealing before will not likely be dissuaded by the change in the qualified dividend tax rate.

Alternative Minimum Tax Relief Technical Rules The Alternative Minimum Tax (AMT) represents an "alternative" secondary tax system to which all individual taxpayers are subject. Technically, the process requires an individual's tax liability to be calculated twice - once under the "regular" tax system, and again under the (AMT) system,

Š2013, IARFC. All rights of reproduction in any form reserved.

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which has different tax rates and also fewer deductions - and the total amount of taxes actually owed is the higher of the two.

In exchange for a relatively limited number of deductions and exclusions from income, the AMT system does allow a large flat exemption amount to all taxpayers, which is phased out at higher income levels. The purpose of the exemption is to ensure that a large portion of lower and middle income taxpayers are not subject to the AMT (because the single large deduction is sufficient to ensure that their AMT liability will be lower than their regular tax liability, causing them to pay taxes under the "normal" regular system and not the AMT system).

However, if the AMT exemption is "too" small of an amount, it does not sufficiently limit exposure to the AMT, which has been especially problematic since 2001 as regular income tax brackets have declined with legislation and the tax bracket thresholds have continually adjusted for inflation, resulting in an ongoing “AMT creep� with more and more taxpayers becoming subjected to the tax each year. To try to mitigate this, Congress over the past decade has temporarily "patched" the AMT exemption to a higher amount several times to keep the AMT from affecting more and more taxpayers, with the latest AMT patch expiring back on December 31, 2011.

Fortunately, with ATRA the ongoing series of temporary AMT patches comes to an end. The provisions of ATRA retroactively patched the AMT exemption for 2012, at $78,750 for married couples and $50,600 for individuals (these are essentially the 2011 amounts adjusted for inflation). In addition, the legislation permanently adjusted the AMT

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exemption amount to these levels going forward, with an automatic inflation adjustment to the AMT exemption amount each year in the future, along with the threshold for the top 28% AMT tax rate, and also the threshold for the phaseout of the AMT exemption.

In a separate but related provision, the rules that allow nonrefundable tax credits to be used for both regular and AMT purposes (subject to some restrictions) is also retroactively patched for 2012 and made permanent going forward, which simply means the typical tax credits that clients claim will continue to apply, regardless of whether the client is subject to the AMT or not.

Planning Implications In reality, the AMT “fix” was one of the most significant tax planning changes under ATRA. The new rules kept the scope of the AMT from widening to an estimated nearly 30 million taxpayers who would have been affected in 2012 without a patch (from only about 5 million impacted in 2011). In practice, the lapse of the AMT patch would have resulted in AMT becoming “the norm” and only clients whose income was very low (e.g., less than $60k) or very high (e.g., $600k+) would have escaped its grasp. In other words, for most financial planners, clients subject to AMT would have been the standard scenario, and the exception would have been clients who were actually subject to the normal tax system.

Because of the wide scope of the AMT, though, the cost of this permanent patch to the AMT was significant; the Congressional Budget Office estimates indicate that nearly 45% of the entire $4T fiscal impact of the legislation over the next 10 years was attributable to this AMT resolution. ©2013, IARFC. All rights of reproduction in any form reserved.

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Notwithstanding the cost, though, the reality is that AMT is still not off the table for clients entirely; the ATRA “fix” was not repeal, but merely a patch of the AMT at 2011 levels with future inflation adjustments. Fortunately, this should largely eliminate the AMT creep problem; however, to the extent that approximately 5 million taxpayers were subject to the AMT in 2011, so too will a roughly comparable number continue to be exposed to the AMT going forward. In other words, thanks to the new AMT exemption amount and inflation adjustments, those who avoid the AMT should continue to avoid it, but those who are subject to it should continue to be subject to it, unless there is a significant change in income or deductions.

Evaluating AMT Exposure for Clients So which clients are at greatest risk for AMT exposure? In general, individuals from $200,000 to $350,000 of income and married couples from $250,000 to $475,000 of income; the new 39.6% tax bracket will make it “easier” for clients to begin to escape the grasp of the AMT above $400,000 of income by racking up a regular tax liability at a faster rate. Common AMT triggers that typically increase exposure for clients in this category include: - Being married. Both due to the fact that the AMT exemption for married couples is not twice the amount it is for single individuals, and also because of the two personal exemptions claimed for a husband and wife. On the other hand, the width of the lower tax brackets for married couples and the fact that it requires more income for their AMT exemption to phase out means the worst exposure for married couples begins

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at a higher income level than for single individuals (although it also extends to a higher level).

- Having a family. Because personal exemptions are not allowed under the AMT system, a larger family (dependent children, or even dependent {grand}parents) means more personal exemption deductions lost for AMT purposes, and therefore a greater AMT exposure. Notably, though, this is primarily an issue for those with approximately $100,000 to $300,000 of AGI; income lower than this range is mostly covered by the Figure 3. Estimating Potential AMT Exposure new AMT Taxable Income MFJ Individual exemption, and $56,154 $34,314 $50,000 income higher $46,539 $33,352 $75,000 than this range $45,576 $29,534 $100,000 is less impacted $40,692 $26,072 $125,000 due to the fact $35,255 $22,611 $150,000 that the personal $31,794 $19,149 $175,000 $28,332 $17,247 $200,000 exemptions will $24,059 $15,819 $225,000 be phasing out $22,630 $14,390 $250,000 under the $21,201 $12,961 $275,000 regular tax $19,773 $11,533 $300,000 system, too. $18,344 $13,855 $325,000 - High state income tax liability. Since state and local income taxes paid are an AMT adjustment, the higher a state’s

$16,916 $18,320 $350,000 $15,487 $22,784 $375,000 $14,153 $27,366 $400,000 $14,153 $37,723 $425,000 $14,153 $48,080 $450,000 $22,298 $58,438 $475,000 $32,655 $68,795 $500,000 Note: Chart does not include impact of itemized deduction phaseouts, which may alter thresholds slightly depending on the particular type of deductions claimed.

Š2013, IARFC. All rights of reproduction in any form reserved.

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income tax rate, the more taxes are paid, the greater the deduction for regular tax purposes, and the greater the AMT adjustment (and potential exposure) for AMT purposes. In states like California, New York, Hawaii, Iowa, Oregon, Vermont, Maryland, and DC – where the top combined state and local tax rate is about 9% or higher – it will be difficult to avoid the scope of the AMT unless income is very high or very low. Even clients in “mid-taxation states” (where the rates are approximately 4% to 7%) may find it difficult to avoid the AMT if the client is exposed to several factors on this list simultaneously.

- High property tax liability. As with state and local income taxes paid, any property taxes paid are a deduction for regular tax purposes, an AMT adjustment item, and therefore leads to greater exposure to the AMT. In some states and counties, a high property tax liability may be unavoidable due to a high local property tax rate (e.g., 2%+). In other states and counties, the property tax rate may be more modest, but if the real estate itself is very expensive (e.g., many metropolitan areas on the east and west coasts), then a large property tax bill (and a large AMT adjustment) may be unavoidable even at “reasonable” rates.

- Large miscellaneous itemized deductions. Any type of deduction claimed as a “miscellaneous itemized deduction subject to the 2%-of-AGI floor” is not available for AMT purposes, and consequently large miscellaneous itemized deductions can end up being an AMT trigger. Notably, for many advisory firms, the investment advisory fees that clients pay (and seek to deduct) fall into this category, and consequently may trigger AMT exposure.

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It’s important to note that while the list of deductions above are AMT triggers, this is only true to the extent that the deductions are lost for AMT purposes. It never helps to deliberately avoid or not claim such deductions; to the extent not claiming the deduction would reduce AMT exposure, it happens only by increasing the client’s tax liability under the regular tax system by an equivalent amount in the first place.

Thus, the fundamental point is not that such deductions should be avoided, but simply that having a large amount of these deductions increase the likelihood that not all of them will be able to be utilized due to the AMT. Figure 3 can be used to estimate a client’s AMT exposure in 2013. The column on the left indicates the client’s taxable income (after all deductions). If the deductions the client claimed includes AMT adjustments (such as the ones just listed) that add up to at least the amount indicated in the chart (or any greater amount), the client will likely be subject to the AMT in 2013.

It’s notable, though, that for many clients being subject to the AMT is not necessarily bad for tax planning at the margin. While being exposed to the AMT means, by definition, that the client will pay a higher total tax liability, the top tax bracket for the AMT is only 28%, compared to 39.6% under the regular tax system. As a result, clients subject to the AMT may actually wish to accelerate more income into an AMT year to take advantage of what is only a 28% marginal rate as long as the AMT continues to apply, at least until income rises so high the client crosses back into the regular tax system.

On the other hand, the phaseout of the AMT exemption causes the client’s true marginal tax rate to rise from 26% 28%, up to 32.5% - 35%, while the AMT exemption is being ©2013, IARFC. All rights of reproduction in any form reserved.

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phased out. The impact ends when the exemption is fully phased out, which will occur at Alternative Minimum Taxable Income (AMTI) levels of approximately $323,000 of income for individuals, and $473,000 for married couples (in 2013). As a result, planning for and around preserving the AMT exemption amount from year to year, in addition to avoiding the higher marginal tax rates as the AMT exemption phases out, becomes a significant AMT planning strategy.

Miscellaneous Extensions – Temporary and Permanent In addition to the preceding major changes to ordinary income tax brackets, long-term capital gains, qualified dividends, and the Alternative Minimum Tax, ATRA included a long list of “miscellaneous” changes. In some cases, rules that had expired in 2011 were (retroactively) reinstated for 2012, and often extended into 2013 as well. In other cases, the extensions run for 5 years (through 2017) instead of just one year. In addition, a number of rules that were scheduled to lapse at the end of 2012 were not only extended, but actually made permanent (by entirely eliminating the sunset that would have lapsed them).

The guidance below is not an exhaustive list of every extension that occurred, but highlights the ones most likely to be relevant to planners and their clients.

5-year extensions A number of the most popular “middle class” tax credits that were scheduled to lapse (either entirely, or back to lower limits) at the end of 2012 were extended for 5 years, through the end of 2017. These include more favorable refundability thresholds for the Child Tax Credit (which overall

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is also made permanent at the $1,000 per child level; see later section below), and the Earned Income Tax Credit for lower income individuals.

Most significant for planners in the 5-year extension category is the American Opportunity Tax Credit for college expenses (which had replaced the Hope Scholarship credit in 2009 as the primary tax credit used for college education expenses).

1-year extensions Most of the items in the “1-year extension” category are technically 2-year extensions – reinstated retroactively for 2012, and then extended again into the upcoming 2013 tax year. Most of these items will only have a limited impact on clients – who will either be eligible to claim them, or not – and don’t necessarily require additional planning, although a few have additional planning implications, as noted.

The list of the most popular items, all of which will expire again at the end of 2013, include: - Deduction for up to $250 expenses for elementary and secondary school teachers - Exclusion from income of discharged mortgage debt (necessary to prevent a short sale from triggering income tax consequences for the amount of debt that was/is discharged) - Deduction of mortgage insurance premiums as qualified residence interest

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- Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, useful in states that have little or no income taxes) - Above-the-line deduction for up to $4,000 of highereducation-related expenses (although in practice, this deduction is rarely used due to the availability of the American Opportunity Tax Credit, which was also extended and provides far more favorable tax benefits for those eligible) - Business provisions, including increased Section 179 expense deductions for small businesses (up to $500,000 expensing limit and phasing out at $2 million of eligible property purchased), and 50% bonus depreciation for all businesses.

- Exclusion from income for Qualified Charitable Distributions from an IRA to a charity (still with the age 70 1/2 requirement and the $100,000-per-taxpayer-per-year limitation). Notably, a special rule allowed qualified charitable distributions made by February 1, 2013 to be counted retroactively for the 2012 tax year, for those who wanted to take advantage of the rule for 2012 and 2013. (See sidebar for further discussion of the efficacy of qualified charitable distribution strategies.)

Permanent Extensions A number of tax rules were extended and made permanent under ATRA, due to the fact that they were previously scheduled to sunset at the end of 2012, but ATRA entirely removed the sunset provisions of President Bush’s 2001 and 2003 tax acts.

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As a result, the following provisions are now permanent law: - The $2,000 contribution limit on Coverdell Education Savings Accounts, and the rules allowing qualified distributions to be used for eligible elementary and secondary school (i.e., K-12) expenses - The higher credit amount and income phaseout limits for the adoption tax credit - Above-the-line deduction for student loan interest - Exclusion for employer-provided education assistance - Increased dependent care credit - Increased/expanded child care tax credit - Marriage penalty relief, which made the 10% and 15% tax brackets, and the standard deduction, twice the size for married couples as it is for single individuals Notably, the existing phaseout thresholds that apply to many of the aforementioned deductions and credits are also made permanent.

Other Notable Provisions Intra-Plan Roth conversions An entirely new rule created under ATRA – intended to raise enough revenue to pay for half of the 2-month delay on certain spending cuts (also known as sequestration) – will now allow individuals to convert their existing traditional 401(k) account to a Roth 401(k), if the employer offers designated Roth accounts under the plan, regardless of whether the ©2013, IARFC. All rights of reproduction in any form reserved.

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individual is allowed or eligible to take a distribution out of the plan in the first place. The transaction will be taxed in a similar manner to any other Roth conversion. Notably, though, such conversions will not be eligible for recharacterization (e.g., if the client changes his/her mind, or the account has dropped in value), until/unless Congress further changes the rules to allow recharacterizations in the future. In addition, the client will still need available dollars to pay the tax liability associated with the conversion, especially since the money converted itself will not be available (as it’s still inside the plan and only eligible for a loan, not a distribution).

Qualified Charitable Distributions (QCDs) from IRAs A popular tax planning provision that has been enacted, lapsed, reinstated, and relapsed repeatedly for years, the rules for Qualified Charitable Distributions (QCDs) from IRAs allow retirement account owners to make a distribution directly from an IRA to a public charity (but not a private foundation, supporting organization, or donor-advised fund).

The donation is not eligible for a separate charitable deduction, but is not counted as a taxable distribution, either; the money simply goes directly, on a pre-tax basis, from the IRA to the charity. However, the maximum QCD for any individual in a single year is only $100,000 (a married couple can do $100,000 each from their own respective IRAs), and QCDs can only be done if the IRA owner is over the age of 70 ½. On the other hand, QCDs also satisfy an individual’s Required Minimum Distribution (RMD) requirements, allowing the IRA owner to kill two birds with one stone (making a charitable contribution, and satisfy his/her RMD requirements), while not incurring taxes on the distribution.

Of course, reinstating QCDs for 2012 was of limited benefit, given that the law isn’t even being enacted until 2013. To provide some flexibility, two special rules were added: the first allows QCDs from an IRA to charity made by February 1 st, 2013, to be applied retroactively for the 2012 tax year; and the second allows any IRA withdrawals that occurred in December of 2012 to be treated as a QCD if the amounts are donated as cash to a charity by February 1st, 2013. In practice, though, these special rules for January 2013 were likely to be of limited use.

Beyond the lookback provisions, the caveat to all QCDs remains that ultimately contributing appreciated securities directly to a charity is still more tax efficient than using QCDs in most circumstances. As a result, taking advantage of QCDs in 2013 (and the retroactive-to-2012 special rule) will primarily be useful for clients who either: 1) were going to make cash contributions anyway; 2) are expected to exceed the charitable deduction thresholds (and anticipate not being able to use the charitable deduction in a carryforward year, either); or 3) have a material difference in state income tax treatment.

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The reason this new intra-plan Roth conversion rule is notable is that, under prior law, a client could only convert a 401(k) plan if he/she was eligible to take a distribution from the plan (whether it's going to a Roth 401(k) or Roth IRA), which generally meant the client had to be 59 1/2, deceased, disabled, or separated from service, unless the plan allowed inservice withdrawals. The new ATRA provision will allow an intra-plan Roth conversion, regardless of whether the client is eligible for a distribution out of the plan (although being eligible for a distribution is still required to convert the money to a Roth IRA). Notably, the rules allow the new intra-plan Roth conversions for 401(k)’s, and also 403(b) and 457 plans.

The plan does have to be amended to allow such conversions, although such amendments should not be difficult to implement.

The essence of the new rule simply means clients can now do intra-plan 401(k) (or 403(b) or 457 plan) conversions from traditional to Roth in the same manner they can do so for IRAs. But clients still can't go FROM a 401(k) (or other employer retirement plan) TO the IRA unless they are otherwise eligible for a distribution from the retirement plan. In theory, the increased flexibility for Roth conversions means more (current) workers will convert their existing 401(k) and other employer retirement plans, which provides a short-term revenue increase for the Federal government (thus, this new rule was actually scored as a "revenue raiser" in measuring the fiscal impact of the legislation).

Of course, whether completing a Roth conversion (inside a 401(k) or with an IRA) is a good deal or not depends on several individual-specific factors, most notably whether the client’s tax rate is anticipated to be higher in the future than it Š2013, IARFC. All rights of reproduction in any form reserved.

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is now. In point of fact, the scope of the provision is likely to be limited, as those with the largest account balances (workers in peak earnings years) are also the least desirable Roth conversion candidates (due to peak income tax rates).

Conversely, those who would benefit most from conversion, such as those with temporary income decreases due to unemployment or younger workers who still have modest income may have difficulty utilizing the new rules, either because they lack the liquidity to pay the taxes on a Roth conversion, have relatively small pre-tax 401(k) account balances in the first place (due to limited income and savings, or because they’ve already been contributing to Roth accounts), or have already separated from service and therefore don’t need the new rules anyway (because a Roth IRA conversion would be available at that point).

National LTC Commission The Community Living Assistance Services and Supports Act (the “CLASS Act”) was created under PPACA, and was intended to establish a national, government-run longterm care insurance program. The coverage would be purchased directly by consumers and would be guaranteed issue (i.e., without underwriting). It was expected to offer modest but useful-sized policies, hopefully with premiums that could still be affordable to most consumers, and participation would have been voluntary.

Unfortunately, though, the CLASS Act and its national LTC coverage program was determined to not be economically viable by the Department of Health and Human Services in 2011, which put the program on indefinite administrative hold.

Notably, the primary concern regarding the CLASS Act was

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that since coverage was optional, it was unclear whether the insurance could sustain reasonable pricing and actuarial integrity given the likely adverse selection issues.

Under ATRA, the CLASS Act is formally repealed, but is replaced with the establishment of a new “Commission on Long-Term Care” that is intended to provide a fresh look at national needs for long-term care, and try to come up with workable plan for “the establishment, implementation, and financing of a comprehensive, coordinated, and high-quality system” for long-term care services. The Commission will be bi-partisan, and has a relatively short timeline (6 months) to provide initial recommendations.

Although it remains to be seen whether the Commission’s work will bear any fruit, expect to hear more discussion later in 2013 regarding potential options for a more nationally coordinated long-term care services system (in addition to a means to finance it). Proposals may even include an alternative to the CLASS Act for government-run long-term care insurance coverage, integrated with Medicare, and/or another form of mandatory health coverage to reduce adverse selection.

Estate Taxes After years of variability and uncertainty, another significant change under ATRA was that the estate tax laws now have permanence. The new rules continue the current $5 million (annually adjusted for inflation) gift and estate tax exemption, but make these amounts permanent going forward (including the annual inflation adjustments). This means the estate tax exemption for 2013 will rise to approximately $5.25 million (from $5.12 million in 2012). ©2013, IARFC. All rights of reproduction in any form reserved.

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The top estate (and gift, and GST) tax rate is increased to 40% (from the prior 35%), although this too is a permanent change and not subject to lapse or sunset.

In addition, the rules for portability of a deceased spouse’s unused gift and estate tax exemption amount (but not Generation-Skipping Tax amount) are made permanent. This means the surviving spouse of any individuals who passed away since January 1st, 2011, have the deceased spouse’s unused estate tax exemption available to use (assuming the required Form 706 estate tax return was timely filed), and that portability is available going forward as well, both to use a deceased spouse’s exemption, and for a currently living client to leave an unused exemption to a surviving spouse at the first death.

Ultimately, the permanence of portability will have a very significant impact on estate planning for most clients, as it reduces the need to use bypass trusts for all but the wealthiest of families or those with other non-tax-related reasons to use trusts. On the other hand, for many clients, bypass trusts may remain relevant for several more years to come, not to plan for Federal estate taxes, but to manage state estate taxes, as most states that do still have an estate tax do not allow portability. In fact, the reality is that planning for estate taxes may shift heavily from a Federal to state-by-state focus in the coming years.

The provisions in ATRA also make permanent the state estate tax deduction, which replaced the state estate tax credit last decade. This is significant, to the extent that states which did not “decouple” from the Federal system can no longer hope that a sunset law will reinstate the old state estate tax credit

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system. Thus, to the extent that states want to generate their own estate or inheritance taxes, they will need to create and apply their own state-level taxes (for which the decedent’s estate will receive a Federal estate tax deduction), especially since many states do not have a gift tax and can no longer rely on the Federal gift tax exemption to backstop their state estate tax laws.

What Didn’t Get Extended?

Given all the discussion of what was extended under ATRA, it raises the question of what was not extended.

The most significant provision that was not extended was the 2% reduction in the payroll tax rate that has been in effect for the past two years. By allowing the payroll tax cut to lapse, all clients with earned income (whether as wages or via self employment) will see their payroll tax obligation rise by 2 percentage points in 2013 up to the $113,700 wage base. The net result will be a reduction in take-home pay of up to $2,274, which will be implemented for employees via an increase in withholdings and a smaller paycheck going forward from here.

Given that the scope of the payroll tax system actually affects more Americans than the income tax system, this is the primary driver for the Tax Policy Center’s estimate that the compromise agreement under ATRA would “still result in a tax increase on 77% of American households.”

Beyond this, the primary parts of the fiscal cliff that were not extended are the unlimited 35% tax bracket (which lapsed back to 39.6%) and the 15% long-term capital gains rate (which lapsed back to 20%), and also applies to qualified dividends; both of these lapses, as noted earlier, only apply to ©2013, IARFC. All rights of reproduction in any form reserved.

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taxpayers with taxable income in excess of $400,000 for individuals and $450,000 for married couples.

Bringing It All Together Ultimately, there are two overriding themes to the planning implications of the fiscal cliff tax legislation.

The first is that the overwhelming majority of the significant changes to the law are permanent changes. The decade-long struggle of engaging in tax planning with clients, where it was difficult to know what to do each year because of the looming expiration of current tax brackets, or capital gains rates, or qualified dividend treatment, or the AMT exemption amount, is no longer an issue. Once again, planning can occur with some sense of permanence to the strategies.

Of course, the caveat to all of this is that even “permanent” tax laws are only permanent until Congress enacts a new law to change them again. Nonetheless, the reality is that Congress rarely enacts adverse tax changes retroactively, which means if ultimately there will be significant changes in the future that would materially alter the tax landscape, at least there’s a high likelihood that we’ll have advance notice and opportunity to plan for them. And with the extent of current Congress gridlock, it’s not clear that much significant tax legislation will be forthcoming anytime soon, especially since the only major legislation in recent years has been driven by the sunset provisions themselves, which no longer exist. In the meantime, though, the fact remains that we have a permanent tax environment in which to plan for the foreseeable future.

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The second theme of the fiscal cliff tax legislation is, as President Obama has advocated, the tax system is now more progressive – higher tax rates on higher income individuals – and this progressivity extends to not just ordinary income tax brackets, but also long-term capital gains and qualified dividends as well. In addition, the introduction in 2013 of the two new Medicare taxes on unearned income makes the system even more progressive for higher income individuals, with both the 0.9% Medicare surtax on earned income and the 3.8% Medicare tax on net investment income.

As a result of the interplay between the ordinary income tax rates, payroll taxes, and the new Medicare taxes, most clients are now effectively subject to far more incremental tax brackets than realized. Ordinary income is subject to 7 tax brackets now (or more for investment income subject to ordinary income rates); long-term capital gains and qualified dividends are subject to four brackets (0%, 15%, 18.8%, and 23.8%); earned income is subject to rising and falling payroll tax rates depending on whether the individual is below the Social Security wage base, above the 0.9% Medicare surtax threshold, or somewhere in between. Indirectly, additional brackets apply as itemized deductions and personal exemptions phase out as well.

Conclusion In the end, the fiscal cliff legislation will likely be viewed positively by most advisors, at least to the extent that it provides the permanence necessary for productive income and estate tax planning, without sunsets and scheduled lapses of key foundational portions of the tax law. However, the American Taxpayer Relief Act of 2012 will not mark the end of ongoing fiscal deficit and spending debates, and additional ©2013, IARFC. All rights of reproduction in any form reserved.

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tax law changes may also be on the table with further legislative battles. Fortunately, though, it will at least require a new, proactive piece of legislation from Congress to change the tax laws as they are now written, and the permanence of the new law arguably removes some of the pressure and impetus for additional significant individual income tax legislation in the near term.

At the same time, the increased progressivity of the tax system will likely make many clients more interested in proactive tax planning, especially at higher income levels where the combined impact of all the tax law changes can result in significantly higher tax rates than in the past. In addition, permanence of the estate tax system may finally provide some impetus – or at least, remove some hindrance – for clients to finally get underway with estate planning that they may have been putting off for years.

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HOW MUCH IS YOUR 401(K)WORTH? David Blanchett, CFA, CFP® Morningstar Investment Management How much is your 401(k) or IRA worth? Like many questions, the answer is it depends. In this paper we discuss three different methods that can be used to estimate the relative value of a taxadvantaged account within a financial planning context (or the “effective” value): the Balance approach, the Tax-Adjusted approach, and Benefit Equivalent approach. The Balance approach is based simply on the value of the account and the Tax-Adjusted approach adjusts this value to take taxes into account. The Benefit Equivalent approach determines the value of the 401(k) or IRA relative to the amount of income it can generate over the lifetime of the account when compared to a taxable account. This is the most complex approach, but potentially the most viable within a financial planning context.

While each of the three different approaches provides a different insight into the effective value of a 401(k) or IRA, the Benefit Equivalent approach may be the most relevant for investors who are using these tax-advantaged accounts for their intended purpose: to create income during retirement. Through simulations, we found that for a 401(k) the Benefit Equivalent effective value of a stock portfolio may be worth approximately 100% of a taxable account and approximately 110% of a taxable account for bonds.

For a Roth IRA we found that the Benefit Equivalent effective value of a stock portfolio may be worth approximately 130% of a taxable account and approximately 140% of a taxable account for bonds.

The author thanks Alexa Auerbach and Bill Reichenstein for helpful edits and comments.

©2013, IARFC. All rights of reproduction in any form reserved.

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Introduction How much is your 401(k) or IRA worth? This is an important question that has implications in a variety of financial planning contexts, such as determining a client’s net worth or achieving a target asset allocation across different account types. In this paper we discuss three different methods that can be used to estimate the relative value of a taxadvantaged account within a financial planning context (or the “effective” value): the Balance approach, the Tax-Adjusted approach, and the Benefit Equivalent approach.

Under the Balance approach the effective value of the 401(k) or IRA is just the unadjusted value of the account (i.e., the balance). Under the Tax-Adjusted approach the effective value is determined by taking into account some type of tax adjustment (generally a discount). The Benefit Equivalent approach determines the balance in a taxable account required to create the same amount of lifetime income as a taxadvantaged account (e.g., 401(k) or IRA) in question. The Benefit Equivalent approach is the most complex of the three, but is potentially the most useful when determining the relative value of different accounts in a financial planning context, especially as it relates to achieving a retirement income goal for a retiree.

We find that the effective value of an 401(k) or IRA can vary materially based on account type (Traditional versus Roth) as well as other factors such as the lengths of the accumulation and distribution periods, tax rates, and how the portfolio is going to be invested. Using a Tax-Adjusted approach (with a liquidation focus) the value of a Traditional IRA or 401(k) might only be worth half its existing balance,

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while using a Benefit Equivalent approach the value of a Roth 401(k) or IRA invested in bonds could be worth double its existing balance.

Literature Review Horan (2007) provides a relatively thorough literature review on the topic of valuing different account types.

Correctly framing the value of different accounts is an important exercise, since account types with different tax benefits are not going to be economically equivalent. The majority of research on the topic focuses on two main themes: determining the overall value of the account, and the value to use within any type of portfolio optimization.

Sibley (2002) develops a model to calculate taxable equivalent values (TEVs) that make balances in non-taxable accounts comparable with taxable accounts. This is very similar to the “Benefit Equivalent” approach used for this paper. Sibley uses a model, however, that assumes the account is liquidated as a single cash flow at some future time, which is inconsistent with how these accounts tend to be used by retirees. Horan (2002) expands Sibley’s approach to include annuitized cash flows and a broader array of taxation schemes, where returns can be attributed as ordinary or capital gains, as well as realized and unrealized.

Reichenstein (2007) contends that the after-tax values (ATVs) must be used when assessing portfolio risk and asset allocation, which is the Tax-Adjusted model within the framework of this paper. This is based on a “risk-sharing” model, where the government, by taxing annual returns or terminal withdrawals, shares investment risk as well as investment returns with the account holder (and is therefore a ©2013, IARFC. All rights of reproduction in any form reserved.

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part owner in the account). Reichenstein (2007) derives the value of a tax-deferred investment based on the premise that investors bear all the investment risk and contends that Sibley’s and Horan’s taxable equivalent models are wrong because the discount rate in their models does not reflect the fact that investors bear all the risk of investment returns in TDAs and Roth IRAs. Reichenstein’s model implies an investor would be indifferent between a taxable account and a Roth IRA. This is despite the fact that a Roth IRA has a greater relative value, especially over longer time periods and when investing in relatively inefficient portfolios due to its entirely tax-free status, while future taxes will be due on gains in the taxable account. Dammon, Spatt, and Zhang (2004) characterize this concept best when they note that wealth in the tax-deferred account is more valuable than wealth in the taxable account because of the ability of the tax-deferred account to earn pretax returns.

Defining Value Valuing a 401(k) or IRA initially does not seem like a difficult exercise. Unlike assets such as paintings, homes, or cars, 401(k)s and IRAs are typically expressed as some dollar value (e.g., your IRA is worth $62,549.23). Using this dollar value to define the value of the account is an approach we call the “Balance” method. This is the most common technique used to value IRAs and 401(k)s within a financial planning context. This simplistic approach, though, overlooks some important differences in the different types of accounts. For

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example, a 401(k) (or Traditional IRA1) is an account that has not yet been subject to taxes, while the owner of a Roth 401(k) has already paid tax on the contributions. Therefore it stands to reason that a Roth IRA should be worth more than a Traditional 401(k).

The second approach we use to define the value of a tax-advantaged account is the Tax-Adjusted approach. Under this approach the balance is adjusted to incorporate taxes. For example, if an investor owns a 401(k) worth $100,000, assuming a 25% tax rate, the effective value of the account would be $75,000 ($100,000 * (1 - 25%) = $75,000).

Reichenstein, Horan, and Jennings (2012) use a Tax-Adjusted approach and give an example of an investor (Janet) who has $1 million in a tax-deferred account in bonds and $1 million in a tax-exempt account in stocks and that in retirement she will be in the 28% tax bracket. They noted that while she currently has 50% allocated to stocks and 50% allocated to bonds, her tax-deferred account is only worth $720,000 after taxes, thereby changing the effective asset allocation to 58% stocks and 42% bonds.

There are a number of different tax rates that could be used in the Tax-Adjusted approach: a liquidation tax rate, a current marginal tax rate, a retirement tax rate, or combinations of the three. The liquidation tax rate would be the total tax paid if the account were liquidated. This is likely going to imply largest potential reduction from the unadjusted value, since it would be based on the marginal tax rates at the federal, state, and local level and would also (potentially) include the 72(t) 10% distribution penalty tax for nonqualified 1

In the context of this analysis these terms can generally be used interchangeably but 401(k) will be the term used going forward to minimize redundancy Š2013, IARFC. All rights of reproduction in any form reserved.

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distributions and could exceed 50% for some investors. The current tax rate would just be the current tax rate that would apply to the monies, ignoring any potential penalties.

The retirement tax rate is the tax rate that the investor expects to pay on the monies when they are distributed during retirement. Estimating future tax rates, however, is a difficult exercise especially since an investor would need to forecast future tax rates. While tax-advantaged accounts benefit investors by allowing all potential gains (in a Traditional IRA) to be deferred until distributions, the potential benefit can be greatly reduced if the future tax rate exceeds the tax rate at the time the contributions are made. Gokhale and Kotlikoff (2003) note that some investors will likely end up being taxed at a lower tax rate than they would have paid to make the taxadvantaged contribution, limiting the potential value of the account.

The Benefit Equivalent approach recognizes that taxadvantaged accounts convey additional tax benefits for the holder that should be considered when determining the relative value of the account. The key concept behind the Benefit Equivalent approach is that the lifespan of a tax-advantaged account could exceed 60 years for some investors (e.g., for someone who is 25 years old) and therefore the potential benefits of a tax-advantaged account would be realized over an extended period.

Benefit Equivalence The Balance and Tax-Adjusted approaches are absolute measures of the effective value of a 401(k), not relative measures, since they assign a value to the account in isolation.

While these approaches offer a simple way to determine the

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effective value, they are incomplete since they do not consider the relative ability of these accounts to create retirement income when compared to a tax-advantaged account. Investors save money to achieve a goal, for example retirement, therefore the relative value of an account should be determined using a framework describing how the account helps that investor achieve his or her goal.

The Benefit Equivalent approach determines the value a 401(k) would need to have in order to create the same level of benefits as a taxable account. For example, assume you start out with $100,000 in a 401(k) with an annual rate of return of 5%. There are no cash flows during the first five years, but an annual $28,075 withdrawal starting at year six. At the end of year 10 the account is depleted. If we assume a 25% tax rate, the $28,075 withdrawal would result in a $21,056 after-tax withdrawal. This is shown in Panel A of Table 1.

Table 1: Benefit Equivalence Panel A: 401 (k) Year 1 2 3 4 5 6 7 8 9 10

Beginning $100,000 $105,000 $110,250 $115,763 $121,551 $127,628 $104,531 $80,278 $54,813 $28,075

Pre-tax CF After-tax CF 0 0 0 0 0 0 0 0 0 0 -$28,075 -$21,056 -$28,075 -$21,056 -$28,075 -$21,056 -$28,075 -$21,056 -$28,075 -$21,056

End $105,000 $110,250 $115,763 $121,551 $127,628 $104,531 $80,278 $54,813 $28,075 $0

Š2013, IARFC. All rights of reproduction in any form reserved.

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Panel B: Taxable Account Year 1 2 3 4 5 6 7 8 9 10

Begin $78,530 $81,475 $84,530 $87,700 $90,989 $94,401 $76,885 $58,712 $39,857 $20,295

Cash Flow $0 $0 $0 $0 $0 -$21,056 -$21,056 -$21,056 -$21,056 -$21,056

Growth $3,927 $4,074 $4,227 $4,385 $4,549 $4,720 $3,844 $2,936 $1,993 $1,015

Taxes $982 $1,018 $1,057 $1,096 $1,137 $1,180 $961 $734 $498 $254

End $81,475 $84,530 $87,700 $90,989 $94,401 $76,885 $58,712 $39,857 $20,295 $0

In order to determine the effective value of the 401(k) to a taxable account for this investor (or really this scenario) we need to determine the value of the taxable account that would yield the same after-tax cash flow of $21,056 in years six through 10. We will assume that the taxable account has a basis equal to its initial value and that the entire 5% annual return (gain) is realized each year (i.e., the account is invested in bonds) and that all gains are taxed at 25%. If we “solve� for the initial balance, we determine the taxable account would need an initial balance of $78,530 to create the same amount of after-tax income as the 401(k). This is shown in Panel B of Table 1.

For this scenario we determined that a $100,000 401(k) balance creates an equivalent amount of benefits as a $78,530 taxable account balance. Therefore, the $100,000 401(k) is only worth 78.5% of the $100,000 taxable account from a Benefit Equivalent perspective, i.e., 21.5% less, since the taxable account is able to produce the same income with a lower initial balance. While it should not surprise the reader that the 401(k) is worth less than the taxable account, it is

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important to note that the 21.5% reduction is less than the assumed tax rate of 25%. This is because the 401(k) is more tax efficient than the taxable account, and this tax efficiency increases the effective value of the 401(k).

The Tax Efficiency Spectrum In the previous section we explored a simple example, but the relative value of a 401(k) account is going to depend on a variety of factors, such as the relative tax rates, the length of the investing period, and the tax efficiency of the respective investments.

The relative tax efficiency of investments can be thought of in terms of a spectrum. The least efficient investments from a tax perspective are investments where all gains are realized each year and where the realized gains are taxed at ordinary income tax rates. For the purpose of this section we will call these investments “bonds” since bonds tend to have these attributes, especially if you were to purchase a bond directly from an issuer.

On the opposite end of the tax-efficiency spectrum would be an investment where gains are only realized when money is withdrawn from the account and all gains are taxed at capital gains rates. This type of growth and taxation would be possible for an individual stock that pays no dividends. We will therefore call these investments “stocks” for this section.

While holding stocks can be more tax efficient than holding bonds, this is not always the case. The relative efficiency of holding stocks can vary at a much greater level than holding bonds based on the types of stocks held and turnover. A mutual fund manager who frequently trades the ©2013, IARFC. All rights of reproduction in any form reserved.

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portfolio, thereby causing the mutual fund shareholders to realize gains regularly, can dramatically reduce the relative efficiency of holding stocks. At the extreme, if a portfolio manager causes an investor to realize all gains in a given year based on securities that are held for less than a year, holding stocks could be even more inefficient than holding bonds if the returns exceed those of bonds. This concept will be explored in greater detail in the next section.

For now, let us assume that bonds are perfectly inefficient tax investments and stocks are perfectly efficient tax investments. This means the returns on bonds are realized every year and taxed at ordinary income tax rates while the gains for stocks are only realized when the stock is sold to generate income (during retirement). We assume that the annual return on bonds is 4.0%, the annual return on stocks is 8.0%, and inflation is 2.5%. For the analysis we assume that the accounts will grow over a period of time between one to 40 years (the accumulation period), after which distributions will be taken from the account (the retirement period).

The portfolio distribution amount (during retirement) is based on the value of the portfolio when the distribution period starts. The initial distribution amount is simply the percentage return for the account, which is 4.0% for bonds and 8.0% for stocks. The initial withdrawal amount is assumed to increase annually by inflation (2.5%) until the account is depleted. This approach can ensure that the distribution period lasts a reasonable period (between 20 and 25 years) and that the account is exhausted at some point.

We conduct four different simulations, for two different investment types (stocks and bonds) and for two different

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account types (401(k)s and Roth IRAs). Within each simulation we vary the ordinary income tax rate and the length of the accumulation period. All gains for the taxable stock account are assumed to be long-term capital gains, which we assume is taxable at the 15% rate. All bond income is taxed at the ordinary income tax rate, which varies by simulation. The basis of the taxable accounts is equal to the initial balance.

For the analysis we test accumulation periods from one to 40 years (in one-year increments) and ordinary income tax rates from 15% to 45% (in 1% increments). An investor with a 40-year accumulation time horizon could be someone currently 25 years old planning to retire when he or she turns 65. While the highest tax rate (45%) is above the highest current top federal ordinary income tax rate (at least at the time this paper is being written), an investor could potentially be taxed at a rate greater than 45% when considering state and local taxes. Tax rates could also increase in the future.

Results Figure 1 includes the results for the 401(k) analysis for stocks and bonds. As a reminder, the percentage values in Panels A and B are the effective values a 401(k) would need to have in order to create the same level of income as a taxable account. In the first example on Benefit Equivalence (Table 1) the 401(k) was worth 78.5% of the taxable account. We use the same general approach in this section, although we conduct considerably more simulations.

For bonds (Panel A in Figure 1) the relative value of the 401(k) depends a great deal on the length of the accumulation period and the tax rate, where the effective value of the 401(k) ranges from 88% to 173%. The minimum effective value Š2013, IARFC. All rights of reproduction in any form reserved.

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(88%) is higher than the first example (which had an effective value of 78%) because the total period is longer. The first example had a period of only 10 years (five accumulation years and five distribution years), while even in the one-year accumulation example the total period is 26 years since the retirement period is assumed to last 25 years.

Longer accumulation periods and higher tax rates increase the relative value of the 401(k). As a reminder, the tax rate on the 401(k) distributions is assumed to be the same as the tax rate paid for the realized income from the bond returns, the difference is that the taxable account realizes the gains annually (and pays taxes on them) while the 401(k) only pays taxes when distributions are taken from the account.

The interesting takeaway from Panel A for bonds in 401(k)s is that for investors who have at least 10 years for accumulation, the 401(k) is worth more than a taxable account (i.e., has a higher effective value). This is despite the fact that taxes have yet to be paid on the 401(k) and the only gains paid on the taxable account are gains on the returns. For a bond investor with an accumulation period of 10 years (and approximate distribution of 25 years) the simulations show a 401(k) is going to be worth at least as much, if not more, than a taxable account from a Benefit Equivalence perspective. We approximate the effective value at 110% of the taxable account.

The effective value of a 401(k) for stock investors is always less than a taxable account, averaging approximately 85%. This should not surprise the reader, since the perfectly efficient stocks have no realized gains and taxes are only paid at long-term capital gains rates (15%) when the stock is sold to

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create income for the retiree. Taxes are also not due on the basis, thereby creating tax-free income for the retiree.

Figure 1: Relative Value of a Traditional 401(k) versus Taxable Account

Accumulation Period (Years)

Panel A: Invested in Bonds 15% 95% 97% 100% 103% 106% 109% 113% 116% 119%

1 5 10 15 20 25 30 35 40

Ordinary Income Tax Rate 20% 25% 30% 35% 40% 94% 93% 91% 90% 89% 97% 96% 95% 95% 95% 100% 101% 101% 101% 102% 104% 106% 107% 108% 110% 108% 111% 113% 115% 119% 112% 116% 119% 123% 128% 116% 121% 126% 132% 138% 121% 127% 134% 141% 149% 125% 133% 141% 150% 161%

45% 88% 94% 102% 111% 121% 132% 144% 157% 171%

Panel B: Invested in Stocks

Accumulation Period (Years)

Ordinary Income Tax Rate 15%

20% 25% 30% 35% 40% 45%

1

92%

89% 85% 82% 79% 76% 73%

5

93%

90% 87% 83% 80% 77% 74%

10

95%

92% 88% 85% 82% 79% 76%

15

96%

93% 89% 86% 83% 80% 77%

20

98%

94% 91% 87% 84% 81% 78%

25

99%

96% 92% 88% 85% 82% 79%

30

99%

96% 92% 88% 85% 82% 79%

35

100%

96% 92% 89% 85% 82% 79%

40

100%

96% 92% 89% 85% 82% 79%

Š2013, IARFC. All rights of reproduction in any form reserved.

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The next analysis looks at the relative value of a Roth IRA versus a taxable account. Roth IRAs are similar to taxable accounts in that taxes have already been paid on the accounts; therefore, the value of a Roth IRA would likely be the same using a Tax-Adjusted effective value measure. Roth IRAs have an advantage over taxable accounts, though: all future gains are tax free while a taxable account realizes gains annually. This has a material impact on the relative attractiveness of the accounts, especially for a bond investor, as can be noted in Panel A of Figure 2.

Figure 2: Relative Value of a Roth 401(k) versus a Taxable Account Panel A: Invested in Bonds

Accumulation Period (Years)

Ordinary Income Tax Rate 1

15% 20% 25% 30% 35% 40% 45% 109% 112% 114% 117% 119% 124% 126%

5

112% 115% 119% 122% 126% 131% 134%

10

115% 119% 124% 130% 134% 142% 146%

15

119% 124% 130% 137% 143% 153% 159%

20

122% 128% 137% 145% 153% 165% 174%

25

126% 133% 143% 153% 164% 178% 189%

30

129% 138% 150% 162% 175% 192% 206%

35

133% 143% 157% 171% 187% 207% 224%

40

137% 149% 164% 181% 199% 223% 244%

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Panel B: Invested in Stocks

Accumulation Period (Years)

Ordinary Income Tax Rate 1

15% 20% 25% 30% 35% 40% 45% 105% 105% 105% 105% 105% 105% 105%

5

107% 107% 107% 107% 107% 107% 106%

10

109% 109% 109% 109% 109% 109% 108%

15

111% 111% 110% 110% 110% 110% 110%

20

112% 112% 112% 112% 111% 111% 111%

25

114% 114% 113% 113% 113% 113% 113%

30

114% 114% 113% 113% 113% 113% 113%

35

114% 114% 114% 113% 113% 113% 112%

40

114% 114% 114% 113% 113% 113% 112%

The simulations show the effective value of a Roth IRA is always worth more than a taxable account—considerably more in some scenarios for a bond investor. In Panel A of Figure 2 we see the effective range is between 109% and 250%. The effective value differences are similar to Panel A of Figure 1 (for 401(k)s) but the Roth IRA is worth more (not surprisingly) because the monies are already after tax. For a bond investor with an accumulation period of 10 years (and approximate distribution of 25 years), the simulations show a 401(k) is worth at least as much if not more than a taxable account from a Benefit Equivalence perspective. We approximate the effective value at 140% of the taxable account.

Less Efficient Stocks The previous analysis made assumptions regarding the relative efficiency of bond and stock investments, where bonds were assumed to be perfectly inefficient and stocks assumed to Š2013, IARFC. All rights of reproduction in any form reserved.

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be perfectly efficient. Bond investments are almost by definition going to be perfectly inefficient, since the holder of the bond will receive the coupon payments and those coupon payments will be taxed at ordinary income rates. Even if an investor were to purchase a zero coupon bond (which does not have coupon payments) tax is due on the imputed interest that accrues each year. Therefore, assuming bonds are perfectly inefficient is a reasonable assumption; however, assuming stocks are perfectly efficient is subject to greater scrutiny.

In order for stocks to be perfectly efficient over a long time period (e.g., 30 years), an investor would have to purchase a single individual stock that pays no dividends for the entire period. It is unlikely many (if any) investors would invest in this fashion. In reality investors purchase diversified investment vehicles, such as mutual funds that vary considerably with respect to tax efficiency. At a minimum many stocks pay dividends, which reduce their overall tax efficiency.

One metric that can be used to gauge the relative tax efficiency of a mutual fund is the turnover rate. The turnover rate is the percentage of a fund’s holdings that has changed over a year. The rate is calculated by dividing the lesser of purchases or sales (excluding those of short-term assets) in a fund’s portfolio scaled by average net assets. In the 2012 Factbook, the Investment Company Institute (ICI) noted that in 2011 the average asset-weighted annual turnover rate experienced by equity fund investors was 52%. This was slightly below the average turnover rate over the past 38 years, as noted in Figure 3.

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Figure 3: Turnover Rate Experienced by Equity Mutual Fund Investors 100%

Turnover

80% 60% 40% 20% 0% 1974 Source: ICI

1980

1986

1992 Year Asset-weighted average

1998

2004 Average

The frequency that a mutual fund manager turns over a portfolio has important implications for the after-tax returns achieved by investors. Morningstar, Inc. has a metric called the Tax Cost Ratio that measures how much a fund’s annualized return would be reduced by the taxes investors pay on distributions. This metric provides the user with an indication of how trading activities of the portfolio manager would affect the shareholder’s returns net of taxes. For example, if the portfolio manager is interested in selling a security that has a sizeable gain but has held it for almost a year, he or she could either choose to go ahead and sell the stock (whereby the gain would taxed at ordinary income tax rates because the holding period was less than a year) or hold the stock and sell it to ensure the shareholders would incur long-term capital gains.

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In order to determine how the effective value of a Traditional 401(k) and Roth IRA changes for a stock investor some additional simulations are conducted where the relative tax efficiency of the stock (or really stock portfolio) being held varies. The two main variables that are adjusted are the percentage of gains realized in a given year (5%, 25%, 50%, and 100%) and the percentage of gains realized that are longterm capital gains (i.e., taxed at 15% versus the ordinary income tax rate). The most efficient stock simulation would be one where no gains are realized each year (gains are only realized when the stock is sold to fund retirement) and where all gains are long-term capital gains. Changing these variables therefore changes how tax efficient the stock investor actually is with respect to his or her portfolio.

For this analysis we run simulations for 20%, 30%, and 40% ordinary income tax rates and for 5, 15, and 25 year accumulation periods. The results for the 401(k) are included in Table 2 and the results for the Roth IRA are included in Table 3.

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5 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 83% 87% 93% 108% 25% 83% 86% 90% 102% 50% 82% 86% 89% 98% 75% 82% 84% 86% 93% 100% 82% 83% 84% 88%

40% Ordinary Income Tax Rate 15 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 87% 96% 109% 146% 25% 86% 94% 104% 132% 50% 86% 91% 99% 120% 75% 85% 89% 94% 109% 100% 85% 87% 90% 99%

% of Gain LT % of Gain LT

% of Gain LT

30% Ordinary Income Tax Rate 15 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 93% 99% 108% 135% 25% 92% 98% 106% 127% 50% 92% 96% 103% 120% 75% 92% 95% 99% 113% 100% 91% 94% 97% 106%

% of Gain LT

5 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 89% 92% 97% 108% 25% 89% 92% 95% 104% 50% 89% 91% 93% 102% 75% 88% 90% 93% 99% 100% 88% 89% 91% 95%

20% Ordinary Income Tax Rate 15 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 100% 103% 109% 125% 25% 99% 103% 108% 123% 50% 99% 102% 107% 120% 75% 99% 102% 106% 118% 100% 99% 102% 105% 115%

% of Gain LT

5 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 96% 98% 101% 108% 25% 96% 98% 100% 107% 50% 96% 97% 100% 106% 75% 96% 97% 99% 104% 100% 96% 97% 98% 103%

% of Gain LT

% of Gain LT

% of Gain LT

% of Gain LT

Table 2: Relative Value of a Traditional 401(k) versus a Taxable Account Invested in Stocks for Various Efficiency Scenarios 25 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 103% 109% 118% 145% 25% 102% 108% 116% 141% 50% 102% 107% 114% 137% 75% 102% 106% 114% 133% 100% 102% 105% 112% 129%

25 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 96% 107% 122% 169% 25% 95% 104% 118% 155% 50% 95% 102% 112% 142% 75% 95% 99% 107% 130% 100% 94% 97% 103% 119%

25 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 89% 104% 128% 198% 25% 89% 100% 118% 170% 50% 89% 97% 111% 148% 75% 88% 94% 102% 128% 100% 87% 90% 96% 110%

Not surprisingly the simulations show that the effective value (or relative value) of a 401(k) invested in stocks varies significantly across different holding periods, tax rates, and levels of stock tax efficiency. 401(k)s invested in stock are most valuable when all the gains in the stock portfolio are realized every year as ordinary income (i.e., they are perfectly inefficient, like bonds) and are least valuable when ordinary tax rates are highest for very efficient stock investments. The simulations show, however, that the minimum effective value Š2013, IARFC. All rights of reproduction in any form reserved.

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of a 401(k) invested in stocks was only 82% of the actual value while the maximum effective value was 198%.

If we assume a turnover rate (or % Gain Realization in Figure 2) of 35%, which is the approximate median for equity funds in 2011 according to ICI, and that 75% of the gains realized by stock investors (or really mutual fund investors) are long-term capital gains, the simulations show that a Traditional 401(k) invested in stocks is worth approximately the same (100%) as a taxable account from a Benefit Equivalent perspective.

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5 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 115% 121% 129% 151% 25% 114% 118% 124% 141% 50% 114% 120% 123% 135% 75% 113% 117% 118% 129% 100% 113% 114% 117% 122%

40% Ordinary Income Tax Rate 15 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 120% 135% 152% 204% 25% 119% 131% 143% 181% 50% 118% 126% 139% 166% 75% 118% 122% 130% 151% 100% 117% 122% 125% 136%

% of Gain LT % of Gain LT

% of Gain LT

30% Ordinary Income Tax Rate 15 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 119% 129% 139% 175% 25% 119% 126% 137% 163% 50% 118% 124% 132% 155% 75% 118% 121% 127% 147% 100% 118% 122% 126% 137%

% of Gain LT

5 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 115% 118% 126% 140% 25% 114% 119% 123% 134% 50% 114% 118% 120% 131% 75% 114% 116% 120% 128% 100% 114% 115% 117% 123%

20% Ordinary Income Tax Rate 15 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 119% 123% 130% 149% 25% 119% 122% 128% 147% 50% 118% 121% 129% 144% 75% 118% 123% 127% 141% 100% 118% 122% 126% 138%

% of Gain LT

5 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 114% 117% 121% 128% 25% 114% 117% 120% 128% 50% 114% 116% 119% 127% 75% 114% 116% 118% 125% 100% 114% 115% 118% 123%

% of Gain LT

% of Gain LT

% of Gain LT

% of Gain LT

Table 3: Relative Value of a Roth IRA versus a Taxable Account Invested in Stocks for Various Efficiency Scenarios 25 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 123% 130% 141% 173% 25% 123% 129% 138% 170% 50% 123% 128% 136% 164% 75% 122% 127% 136% 159% 100% 122% 126% 134% 154%

25 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 125% 139% 156% 219% 25% 124% 135% 153% 198% 50% 123% 132% 145% 184% 75% 123% 128% 138% 169% 100% 122% 125% 134% 153%

25 Year Accumulation Period % of Gain Realized 5% 25% 50% 100% 0% 122% 143% 178% 275% 25% 125% 137% 163% 233% 50% 124% 136% 155% 203% 75% 123% 130% 142% 177% 100% 122% 124% 134% 152%

Roth IRAs were worth more than taxable accounts for each of the different tax scenarios in Table 3. This is not surprising since while both the taxable account and the Roth IRA are after-tax vehicles, any future gains are taxed in the taxable account while all future gains are tax-free in the Roth IRA account. The minimum effective value was 113% of the taxable account and the maximum value was 275% of the taxable account. If we assume a turnover rate (or % Gain Realization rate) of 35% and that 75% of the gains are longŠ2013, IARFC. All rights of reproduction in any form reserved.

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term capital gains, the simulations show a Roth IRA invested in stocks is worth approximately 130% as a taxable account from a Benefit Equivalent perspective.

Implications Up to this point we have noted three different approaches that can be used to estimate the effective value of an IRA or 401(k): the Balance approach, the Tax-Adjusted approach, and Benefit Equivalent approach, focusing primarily on the later. Under the Balance approach a 401(k) or Roth IRA would have the same effective value as a taxable account of the same value. Under the Tax-Adjusted approach the value of the account would vary depending on the assumptions regarding when the distributions would take place and any additional penalties that may be assessed to access the money. For simplicity purposes we will assume the tax rate for the TaxAdjusted approach is 25%, leading to an effective value of 75% of balance of a 401(k) and an effective value of 100% for a Roth IRA (since Roth monies are already post-tax).

Through these simulations we found that for a 401(k), the Benefit Equivalent effective value of a stock portfolio is worth approximately 100% of a taxable account and approximately 110% of a taxable account for bonds assuming the account is held for at least 20 years in accumulation and 20 years in retirement. For a Roth IRA we found that the Benefit Equivalent effective value of a stock portfolio is worth approximately 130% of a taxable account and approximately 140% of a taxable account for bonds. However, the actual effective value for the Benefit Equivalent approach would differ materially by the tax efficiency of the investor’s portfolio.

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Therefore, across the three approaches we have values for 401(k)s that range between 75% to 110% (on the conservative side) and values for Roth IRAs that range between 100% to 140% (on the conservative side). Which is the right number to use for a financial plan? If an investor has at least 15 years until retirement and plans to hold the account until then, the value of the 401(k) is likely worth at least the current nominal balance. However, if an investor has limited taxable holdings and may need to access the 401(k) at some point to fund his or her lifestyle before retirement, a discount is likely in order.

Conclusion How much is your 401(k) or IRA worth? Like many questions, the answer is it depends. In this paper we discussed three different methods that can be used to estimate the relative value of a tax-advantaged account within a financial planning context (or the “effective� value) - the Balance approach, the Tax-Adjusted approach, and Benefit Equivalent approach. The Balance approach is based simply on the value of the account and the Tax-Adjusted approach adjusts this value to take taxes into account. The Benefit Equivalent approach determines the value of the 401(k) or IRA relative to the amount of income it can generate over the lifetime of the account when compared to a taxable account. This is the most complex approach, but potentially the most viable within a financial planning context.

While each of the three different approaches provides a different insight into the effective value of a 401(k) or IRA, the Benefit Equivalent approach may be the most relevant for investors who are using these tax-advantaged accounts for their intended purpose: to create income during retirement. Through simulations we found that for a 401(k), the Benefit Equivalent Š2013, IARFC. All rights of reproduction in any form reserved.

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effective value of a stock portfolio may be worth approximately 100% of a taxable account and approximately 110% of a taxable account for bonds. For a Roth IRA we found that the Benefit Equivalent effective value of a stock portfolio may be worth approximately 130% of a taxable account and approximately 140% of a taxable account for bonds.

References Dammon, Robert M., Chester S. Spatt, & Harold H. Zhang. 2004. “Optimal asset location and allocation with taxable and tax-deferred investing.”

Journal of Finance, vol. 59, no. 3 (June): 999–1037.

Gokhale, Jagadeesh, and Laurence Kotlikoff. 2003. “Who Gets Paid to Save?” Tax Policy and the Economy, vol. 17: 111–40. Cambridge: MIT Press, 2003.

Horan, Stephen M. 2002. “After-tax Valuation of Tax Sheltered Assets.”

Financial Services Review, vol. 11, 253–276.

Horan, Stephen M. 2007. “An Alternative Approach to After-tax Valuation.” Financial Services Review, vol. 16: 167–182.

Reichenstein, William. 2007. “Implications of Principal, Risk, and Returns Sharing across Savings Vehicles.” Financial Services Review, vol. 16, 1–17.

Reichenstein, William, William W. Jennings, and Stephen Horan . 2012.

“Perspectives: Two Key Concepts for Wealth Management and Beyond.” Financial Analysts Journal, vol. 68, no. 1: 14-22.

Sibley, Mike. 2002. “On the Valuation of Tax-advantaged Retirement Accounts.” Financial Services Review, vol. 11: 233–251.

Important Disclosures The research team within the Morningstar Investment Management division pioneers new investment theories, establishes best practices in investing, and develops new methodologies to enhance a suite of investment services. Published in some of the most respected peer-reviewed academic journals, the team’s award-winning and patented research is used throughout the industry and is the foundation of each client solution. Its commitment to ongoing research helps maintain its core competencies in asset allocation, manager research, and portfolio construction. Rooted in a mission to help individual investors reach their financial goals, its services

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contribute to solutions made available to approximately 24.3 million plan participants through 201,000 plans and 25 plan providers.

The Morningstar Investment Management division creates custom investment solutions that combine its award-winning research and global resources together with the proprietary data of its parent company. This division of Morningstar includes Morningstar Associates, Ibbotson Associates, and Morningstar Investment Services, which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. With approximately $195 billion in assets under advisement and management, the division provides comprehensive retirement, investment advisory, portfolio management, and index services for financial institutions, plan sponsors, and advisors around the world. For more information, please visit http://global.morningstar.com/mim.

Data as of September 30, 2012. Includes Morningstar Associates, Ibbotson Associates, Morningstar Investment Services, OBSR Advisory Services, and Ibbotson Australia.

The above commentary is for informational purposes only and should not be viewed as an offer to buy or sell a particular security. The data and/or information noted are from what we believe to be reliable sources, however Morningstar Associates has no control over the means or methods used to collect the data/information and therefore cannot guarantee their accuracy or completeness. The opinions and estimates noted herein are accurate as of a certain date and are subject to change. The indexes referenced are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. The charts and graphs within are for illustrative purposes only.

Monte Carlo is an analytical method used to simulate random returns of uncertain variables to obtain a range of possible outcomes. Such probabilistic simulation does not analyze specific security holdings, but instead analyzes the identified asset classes. The simulation generated is not a guarantee or projection of future results, but rather, a tool to identify a range of potential outcomes that could potentially be realized. The Monte Carlo simulation is hypothetical in nature and for illustrative purposes only.

Results noted may vary with each use and over time.

The results from the simulations described within are hypothetical in nature and not actual investment results or guarantees of future results. Š2013, IARFC. All rights of reproduction in any form reserved.

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This should not be considered tax or financial planning advice.

Please consult a tax and/or financial professional for advice specific to your individual circumstances.

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A MACRO-VIEW OF THE NEW DEFINITION OF FIDUCIARY UNDER ERISA PROPOSED SEC. 3(21)

Richard D. Landsberg, JD, LLM, MA, CLU, CPM, ChFC, RFC, AIF Nationwide Financial Services This article seeks to examine the Sec. 3(21) definition of fiduciary under the Employee Retirement Income Security Act of 1974, as amended (ERISA) with particular emphasis on the regulatory proposal that has been offered and is due to become final later this year. It offers perspectives on the general duties of fiduciary contact with the larger, more overarching matters that have been proposed. The paper should increase fiduciary awareness and execution of fiduciary responsibility as it relates to ERISA qualified retirement plans. It seeks to integrate prudent investment process and procedure with the new proposal.

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“Hell is empty, the devils are with us.”

William Shakespeare The Tempest Act 1, Scene 2 Where We’ve Been – ERISA Procedural Process ERISA is an umbrella of governance standards.

Specifically, ERISA never has, doesn’t now, and never will differentiate between large qualified retirement plans and small ones. ERISA holds all plans to the same level of fiduciary responsibility. ERISA does not exculpate small plans that cannot afford expertise from large plans presumed to be able to obtain fiduciary expertise. Granted, it may be problematic for the smaller plan to find high quality, cost effective services – but the capability to find and the existence of such services exists. Since the Department of Labor (DOL) emphasizes procedural prudence much more than actual portfolio performance, the courts have found liability when ‘imprudent risks’ were taken because of deficient documentation regarding the rationale behind the investment decisions or the lack of process.2

2

Trone, Donald B., Albright, William R., Madden, William B. “Procedural Prudence” (SEI Management, 1991) at 6. Sandoval v. Simmons, 622 F. Supp. 1174 (D.C. Ill. 1985); Withers v.

Teacher’s Retirement System of the City of New York, 447 F. Supp. 1248 (S.D. NY 1978); Freund v. Marshall & Isley Bank, 485 F. Supp. 629 (W.D. Wisc. 1979); Palino v. Casey, 664 F.2d 854 (Mass Ct. App. 1981); Donovan v. Bierwirth, 538 F. Supp 463 (E.D. NY 1981); Donovan v.

Cunningham, 716 F.2d 1455 (5th Cir. 1983), at 1467. Marshall v. Glass/Metal Assocs. & Glaziers & Glassworkers Pension Plan, 507 F. Supp. 378 (D. Haw. 1980) at 384.

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ERISA was passed in 1974 to protect the retirement plan assets of participants. The statute does not exist to protect plan sponsors. Congressional history is crystal clear that the passage of ERISA was a statutory mandate of codified trust law principles with applicability to the uniqueness of employee benefit plans.3 The procedural standards that named fiduciaries must adhere to are outlined in conceptual form under ERISA. In summary, the prudent expert standard applies4; assets of the plan should be diversified5; asset performance must be monitored6; an investment policy must be established and best practices demands that it is in writing7; investment expenses must be controlled8 and prohibited transactions must be avoided.9 DOL auditors and investigators regularly examine qualified retirement plans for compliance. When a problem or violation is detected, correction is sought and in the alternative enforcement action can be brought against the fiduciaries of the plan. Remedies may be sought and fashioned for infractions and can include restitution to the plan10; equitable or injunctive relief11 or penalties may be applied.12 3 Serota, Susan P. & Brodie, Frederick A. “ERISA Fiduciary Law” (BNA Books, Washington, D.C. 2nd Edition) at 3-5. See also, ERISA Sec. 2, 29 U.S.C. Sec. 1001 for the Congressional findings supporting ERISA’s enactment in 1974; Trone et. al. at 2.

4 ERISA, Title I, Part 4, Sec. 404(a)(1)(B) 5 ERISA Title I, Part 4, Sec. 404(a)(1)(C) 6 ERISA Title I, Part 4, Sec. 405(a) 7 ERISA Title I, Part 4, Secs. 402(a)(1), 402(b)(1)-(2), 404(A)(1)(D) 8 ERISA Title I, Part 4, Secs. 404(a); 9 ERISA Title I, Part 4, Sec. 406 10 ERISA Title I, Part 4, Sec. 409(a); Donovan v. Bierwirth, supra; Leigh v. Engle 727 F.2d. 113 (7th Cir. 1984); Lowen v. Tower Asset Management, Inc., 829 F.2d. 1209 (2d. Cir. 1987); GIW v. Trevor, Stewart, Burton & Jacobson, 895 F.2d. 729 (11th Cir. 1990) 11 ERISA Title I, Part 5, Sec. 502(a)(3); Brock v. Robbins, 830 F.2d 640 (7th Cir. 1986); Marshall v.

Teamsters Local 282 Pension Trust Fund, 458 F. Supp. 986 (E.D. NY 1978); Fink v. National Savings & Trust Co., 772 F.2d 951 (D.C. Cir. 1985)

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General Fiduciary Duties ERISA is far more complex than the conventional definition of a trustee found in the Restatement of the Law of Trusts (Third, 2003). When a trust provides for co-trustees they perform their trust functions jointly…ERISA by contrast envisions multiple fiduciary service providers and the complexity responds to the dispersion of fiduciary functions that ERISA permits. Therefore, ERISA provides for “fractionated” fiduciaries under Sections 3(21), 3(38), 402(a), 403(a), 405(a).13 Trust fiduciary law derives from two grand principles under common law, the trustee’s duties of loyalty and of prudence. ERISA fiduciary law carries both forward. ERISA Sec. 404(a) establishes four general duties governing the conduct of all fiduciaries. The legislative history of ERISA Sec. 404 indicates that Congress intended Sec. 404 to codify the principles of fiduciary conduct developed under the common law of trusts, but with the fractionated modifications appropriate for employee benefit plans.14 ERISA fiduciary duties can be divided into specific and general duties. The specific duties require the trustee under ERISA Sec. 403(a) to administer and make all investment 12

ERISA Title I, Part 5, Sec. 502(l) Landsberg, Richard D.“The Intricate World of the Plan Administrator as Plan Fiduciary” Journal of Pension Planning & Compliance (Vol. 38, No. 5, Spring 2013) at 12; Langbein, John H.; Stabile, Susan J.; Wolk, Bruce A. Pension and Employee Benefit Law (Foundation Press, Thomson West Publishing, 4th Ed., 2006, New York, New York) 13

14

Landsberg, Id at 13.; ERISA Sec. 3(21)(A); Medill, Colleen. “The Law of Directed Trustees Under ERISA: a Proposed Blueprint for the Federal Courts” Missouri Law Review (Vol. 61, No. 4, Fall 1996) at 832; HR. Rep. No. 93-533 (1973); S. Rep. No. 93-127 (1973); H.R. Conf. Rep. No. 93-1280 (1973); Langbein, John H.; Stabile, Susan J.; Wolk, Bruce A. Pension and Employee Benefit Law (Foundation Press, Thomson West Publishing, 4th Ed., 2006, New York, New York) at 556

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decisions regarding the plan, to follow the terms of the plan document (so long as that is consistent with the requirements of ERISA or state law, as applicable) and to provide diverse investment choices so as to minimize the risk of large losses.

The fractionated fiduciaries have specific duties delineated in ERISA Secs. 3(21), 3(38) related to investment advising or management. Secs. 402(a) named fiduciary and 3(16) plan administrator relate to plan operations.15 The general duties are more broadly defined and relate to any fiduciary conduct, across the board, regardless of whether the fiduciary is a 3(16); 3(21); 3(38); 402(a); 403(b) or 405(a) not only the carrying out of plan responsibility. General duties introduce us to the idea of procedural diligence. General duties are found in ERISA Sec. 404(a):16 

 



15 16

Duty of Loyalty: Sec. 404(a) (1) (A) requires a fiduciary to discharge all duties to the plan “solely in the interest” of the participants and beneficiaries and for the “exclusive purpose” of providing benefits and defraying reasonable expenses.

Duty of Care: Sec. 404(a) (1) (B) requires the discharge of duties as a prudent expert would act.

Duty to Diversify: Sec. 404(a) (1) (C) requires the fiduciary to diversify the investments of the plan prudently in order to minimize the risk of large losses, unless it would be imprudent to do so.

Duty to Follow the Documents: Sec. 404(a) (1) (D) requires the fiduciary to discharge duties in accordance with the documents governing the plan. This duty requires a fiduciary to NOT follow the documents if in

Landsberg, Id. Medill, Id.

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doing so it would be inconsistent or contrary with ERISA. The plain statutory language and broad fiduciary duties of ERISA Sec. 404(a)(1) are applicable to and are reconciled with the investment advisor under ERISA Sec. 3(21).

Prudent Procedural Process – The Investment Policy Statement ERISA Sec. 402(b)(1) states that, “Every employee benefit plan shall provide a procedure for establishing and carrying out a funding policy in a method consistent with the objectives of the plan…” Part and parcel to the idea of a funding policy is the outline of investment strategy, often referred to as the ‘investment policy statement.’ It has been argued that this ‘funding policy’ and ‘investment policy statement’ is only applicable to defined benefit plans.17 This author finds fault with that argument because as the plan sponsor has fiduciary responsibility for either type of plan, it becomes necessary to make use of the investment policy statement in a prudent plan process regardless of whether the plan is defined benefit or defined contribution in design.18 The investment policy statement is based upon the ‘funding’ assumptions utilized and becomes the very foundation upon which all investment decisions are made.19 If an investment policy statement has been properly formulated and memorialized, all prudent procedures covered will be addressed and presented in the document itself. This is predicated upon the fact that liability usually occurs when the

17

See, Serota & Brodie, at 193.

29 C.F.R. Sec. 2509.94-2 (DOL Interpretive Bulletin) at 7-11.

19 Serota & Brodie, supra, at 194; Trone et. al. at 7 18

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fiduciary has failed to act with prudence as opposed to making a bad decision.20 For a defined benefit plan, a ‘funding policy’ encompasses the detailed assumptions presented by the plan actuary and plan administrator as they pertain to the ability of the plan to provide benefits in the form of the future value of an annuity due. Any funding policy functionally deals with funds moving in and out of the plan. With a defined benefit arrangement, an investment policy statement will support the asset flows that sustain the financial health of the arrangement.

Ergo, an integral part of the funding policy is the plan’s investment strategy.

Investment policy for a defined contribution plan isn’t concerned with assets necessary to provide a stream of income but instead its primary goal is with the accumulation of account balances. The guiding principle for a named fiduciary and prudent expert is diversification;21 that is, achieving the maximum expected return for any given level of risk exposure.

Therefore investment selection will be dependent upon risk tolerance, consistency of returns, portfolio volatility, portfolio monitoring and benchmarking and reasonable expenses among other considerations. As anyone can see, both plans are taxexempt but defined benefit arrangements have unique features that can lead employers to pursue investment policies that differ radically from defined contribution plans.

20

Trone, et. al.; Marshall v. Glass/Metal Association, supra; Donovan v. Cunningham, supra; Katsaros v. Cody 744 F.2d 270 (2d. Cir. 1984); Donovan v. Mazzola, 716 F.2d 1226 (9th Cir. 1983) 21 ERISA Title I, Part 4, Sec. 404(a)(1)(C)

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The investment policy statement in finished form requires specificity for the plan that it governs. The investment policy statement is an ERISA document and therefore it should be carefully drafted and reviewed by all advisors and consultants involved with the plan’s administration and maintenance. Input should be freely solicited. Finance and treasury, accounting, human resources, legal and third-party service providers are some of the parties who should be consulted.22 Items that affect the plan and should be taken into consideration are time horizon of commitment to investment alternatives, asset classes, investment management, monitoring investment alternatives and similar details.23 Finally, the statement should be signed by the appropriate parties in conformity with the plan documents. Some documents may require that management execute the investment policy statement as a directive to the trustees of the plan. Other plan documents may require the owner(s) of a business to execute the investment policy statement. As a practical matter, it is a good business practice to at least have the parties acknowledge the existence and terms of the statement.24

22

Trone, et. al. at 7-11 Trone, Id. 24 Trone, Id. 23

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It should be noted that the continued adherence to the investment policy statement is most difficult when market dislocations take place and uncertainty is prevalent in the financial markets. It is critical that the plan sponsor obtain unbiased, impartial and objective guidance and recommendations from appropriate advisors. It is also critical that the plan sponsor document resulting decisions with an appropriate paper trail which shows that the decisions reached were issue oriented and process driven in conclusion, i.e. prudent plan operation or prudent investment process.25 Prudent Procedural Process – Diversification of Plan Assets It can be argued that paramount to prudent investment procedures is the diversification of plan assets. ERISA directs that plan participants will/may not benefit from an investment strategy or menu that has all of its “eggs in one basket.” The lack of diversification has been an easy challenge for litigation for two reasons. First, lack of diversification is easier to prove than specific imprudence.26 Second, once a party proves lack of diversification, the burden shifts to the fiduciary to demonstrate that nondiversification was prudent under the circumstances.27

25 26 27

Trone, et. al. at 8 Trone, et. al. at 13 Trone, et. al., Id.; H.R. Rep. No. 1280, 93rd Cong., 2d Sess. 302 at 304 (1973)

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In the 39 years since ERISA was enacted, innovation of the investment marketplace has elevated “asset allocation” as part of the diversification discussion. A number of studies have concluded that asset allocation decisions have the greatest impact on the overall long-term performance of a portfolio.

Practically speaking, 92% of a portfolio’s performance variance can be attributed to asset allocation decisions, 2% to timing the portfolio positions and 3% to actual security selection. 3% of a portfolio’s variance is pure luck.28 Asset allocation is, in the opinion of this author, the natural evolution of Markowitz’ efficient frontier. Asset allocation is based on the principle that individual asset classes have different investment characteristics and that asset classes can be combined to optimize the objectives of the investment policy statement. For any given expected rate of return, an optimal mix of asset classes can be determined that will yield the expected rate of return with the least amount of volatility or risk.29 Equally, for any given level of assumed risk, a higher expected return may be obtained by mixing different asset classes than by investing in a single asset class. Necessary to implementing an efficient frontier portfolio30, there are five variables that must be taken into consideration for every asset allocation decision.

28

Brinson, Gary P., Hood, L., Beebower, Gilbert L. “Determinants of Portfolio Performance” Financial Analysts Journal (July-August 1986); Brinson, Beebower and Singer. “Determinants of Portfolio Variability II: An Update” Financial Analysts Journal (May/June 1991) 29 Markowitz, Harry. “Portfolio Selection” The Journal of Finance (Vol. 7, No. 1. Mar., 1952), at 77-91 30 Markowitz, at 79;

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Time Horizon. It is understood almost universally that “time” is an investor’s greatest ally. However, some investors lack the patience to let time drive the return. For purely emotional reasons, investors get caught up in the hyperbole of financial news and short-term direction of the financial markets while ignoring the long-term benefit of patience. Historical research has consistently shown that the longer a portfolio can remain invested, the more “aggressively” a portfolio can be diversified without compromising the investors’ assumed risk tolerance.31 Assumed Risk Tolerance. Investment risk is defined as the probability or likelihood of not attaining one’s investment objectives within a given time period. Fiduciaries can be prone to avoiding risk by seeking the safety of cash and fixed income securities. For instance, while the use of cash and bonds may be suitable for short-term investing it probably will be inappropriate for long-term investment portfolios. Why? Over an extended period of time, inflation can deteriorate the real return of a fixed income portfolio. Considering the definition of risk, an investment policy statement that sets an expected return objective “at least” exceeding the rate of inflation will be susceptible to a claim of imprudence for exposing a portfolio to unacceptable risks by investing only in long-term bonds and cash.32

31 32

Markowitz, at 78-79; Trone, et. al. at 15-17 Markowitz, at 82; Trone, et. al. at 17

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Expected Rate of Return. For fiduciaries of defined benefit plans, funding objectives will dictate a baseline return that the plan must achieve in order to meet projected payment streams of income. For defined contribution plans, the future is not fixed, but the current contribution is fixed. Therefore, the fiduciary should set a realistic expected return that, at the very least, will ensure growth of assets over inflation.

The selection of realistic expected returns can be difficult because of purported “returns� for investments that are displayed in financial marketing material and/or press releases.

Specifically, investors seem to have grown accustomed to the secular bull market of the last 30 years and the long-term increase in equity indices. Setting high, unrealistic return expectations for funds or managers can create never-ending problems as plan investment strategies and funding policies are implemented.33 Selection of Asset Classes. There are many asset classes. They can be as simple as a certificate of deposit and as complicated as a bond swap fund. An asset class is a broad investing category. The main asset classes are stocks, bonds, real estate, cash and money market funds, gold and precious metals, commodities and collectibles. Each of the main asset classes covers a very broad set of investing options. In fact, with the advent of over-the-counter derivatives the number of asset classes can expand geometrically to cover the synthetics of the actual asset classes enumerated. Fiduciaries should be concerned with diversifying and rebalancing a portfolio or providing participants with the opportunity to do so. The asset classes listed above could be considered a first step towards achieving the benefits of asset allocation.

33

Markowitz, at 77; Trone, et. al. at 17-19

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The first step in selecting appropriate asset classes is to determine if the plan documents restrict the use of certain asset classes or investments.34 Most often a patrician approach by a plan sponsor will have restrictions on or against particular investments. Also, the concept of ‘social investing’ can be considered a restriction. The second step in the selection of asset classes is to make sure that the investments selected do not move lockstep with one another as the financial markets change.35 In stochastic portfolio theory, this implies a low correlation coefficient. Of primary importance in asset allocation is to select asset classes that exhibit low correlations with one another. By way of example - do foreign equities exhibit similar risk and return characteristics as domestic equities? If they do, then there is a high correlation between foreign and domestic equities. If a conclusion is reached that foreign and domestic equities do not always move in tandem, the use of both asset classes might (along with other considerations) provide investors with the benefits of diversification.

Once an asset allocation has been set, and before the investment policy statement is implemented, consideration must be given as to when a portfolio or a fund investment should be rebalanced. A necessary provision to any investment policy statement is to rebalance the portfolio anytime the current asset allocation differs from the stated policy allocation by more than a specified percentage.

34 35

Trone, et. al. at 19 Trone, et. al., Id.

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Prudent Procedural Process – Monitoring Investment Performance A fiduciary’s duties do not end with the development of an investment policy statement and the selection of appropriate investment advisers or a fund lineup to implement the policy.

The fiduciary must ensure that those persons charged with investment responsibility comply with the provisions of the plan’s investment policy statement.36 It is not enough for a plan sponsor or named fiduciary to give a cursory review of investment reports and claim that such activity is “monitoring.” Properly discharging the fiduciary duty in a prudent manner demands that a fiduciary’s analysis of investment performance include a review of investment performance by one familiar with such undertakings, i.e. the ‘prudent expert.’ Two guiding and overriding principles loom large for fiduciary consideration in monitoring investment performance Does the plan achieve its expected return and investment objectives? This is the most critical question the fiduciary must answer. Unresolved, the plan sponsor can be faced with unhappy participants who question the fiduciary’s prudent handling of the invested assets. In any event, a fiduciary should determine whether a lack of performance was the result of underexposure of asset classes offering greater returns, market upheaval, manager performance, high administrative expenses or a combination of factors.37

36 37

Trone, et. al. at 37 Trone, et. al. at 37-38

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Is the investment manager still abiding by the plan’s investment policy statement? Specifically, this asks whether asset allocations are being adhered to. This is the one point in the supervisory process where the fiduciary should review whether the portfolio, fund or lineup should be rebalanced to remain aligned with the allocation agreed upon in the investment policy statement.38 Of course, there are times when firing an investment adviser is the prudent thing to do, de facto. One reason would be a change in the investment adviser’s strategy or style drift.

No fiduciary should entrust assets to an untested strategy.

Another reason would be because the manager or fund has drifted away from its previous investment objective(s). Any untested or unagreed-to methodology puts the portfolio or fund taking upon unwarranted volatility as does a drifting style.39 Monitoring and benchmarking investment adviser performance extends beyond a mathematical analysis of manager performance figures. Changes in an investment adviser’s style, staff changes and plan objectives may necessitate the replacement of an investment adviser or a fund in the lineup. Investment policy statements are not static documents. They did not come down off a mountain etched in stone tablets. Change is certain and as circumstances change, a change in asset classes, funds or investment managers all occur over time.

38 39

Trone, et. al. at 38 Trone, et. al., at 40

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Prudent Procedural Process – Controlling Investment Expenses The ERISA fiduciary should always be aware of all costs involved with the management of an investment portfolio or fund. Costs are incurred whether the fiduciary has employed the services of a bank, insurance company or investment advisory firm. There is wide disparity between the total costs charged by various firms and high fees may significantly affect the overall performance of the portfolio.40 While not exhaustive there are three main categories of expense that a fiduciary must be concerned with.

Trading Costs. Trading costs are concerned with the execution of buying and selling transactions that make up the investments in a given portfolio. Trading costs are made up of two elements – commissions and execution costs. Commission costs are fully and freely negotiable and have been declining over the last several decades.41 Execution costs represent the realized cents per share difference between the executed price of a stock and the fair market price, recognizing market impact effects. The market impact of a security is determined by monitoring the after-trade behavior of a stock. By way of example, if a share’s price falls after the trade is put on, it is assumed that the trade was made under pressure and that conditions were unfavorable for buying.42

40

Trone, et. al., at 43 Trone, et. al., Id. 42 Trone, et. al., Id. 41

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Trading costs in funds may be even more opaque than with a managed portfolio. Nevertheless, the costs can be calculated within reason upon request. Most fund companies should have this data readily available for different types and styles of funds.

Custodial Fees. Custodial costs are incurred as a result of the need to have an institution serve as a custodian or “processor” of the investment portfolio’s securities and transactions. Custody fees are often a flat percentage of assets within the portfolio. Custodians will charge fees-pertransaction that take place within an investment portfolio as well.43 Why would something as simple as custodial charges be important? While more transparent than other costs, the fiduciary must be aware of the potential for lost opportunity costs. Not all custodians are the same. Delays in sweeping cash to money market, settling trades, receiving dividends or interest payments can all have a detrimental effect on the performance of a portfolio.

Money Management Fees. As with all costs, fees can vary significantly by the portfolio size and type of securities held. Equity managers handling smaller accounts may charge more than equity managers handling larger portfolios. It is also likely that some fixed income managers will charge less than equity managers to manage the same size portfolio.44 Management fees, advisory fees, sub-advisor fees, expense ratios, 12b-1 charges et. al. all go into the category of ‘money management fees.’

43 44

Trone, et. al., at 44 Trone, et. al., at 44-46

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The plan sponsor or named fiduciary should at least annually re-evaluate the expenses of the plan. This is particularly important as plan assets grow in size. The larger the plan assets, the better the negotiating ability the fiduciary has to reduce costs of the plan. However, cost reduction shouldn’t become an obsession at the expense of investment performance or value.

New Definition of Fiduciary Under ERISA 3(21) ERISA Section 3(21)(A)(ii) requires only that a person render investment advice for a fee, direct or indirect, with respect to plan assets for such person to be accorded fiduciary status.The key regulatory definition of when a person who provides “investment advice” to a plan becomes an ERISA fiduciary dates to 1975.45 ERISA Section 3(21)(A)(ii) describes the circumstances under which the rendering of investment advice gives rise to fiduciary status. In 1975, the Department of Labor issued a regulation interpreting the statutory provision.

The regulation created a 5‐ part test, all parts of which must be satisfied for a person to become a fiduciary through the provision of investment advice to a plan.

45

29 C.F.R. 2510.3-21(c), 40 FR 50842 (Oct. 31, 1975); Advisory Opinion 76-65A (June 7, 1976)

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On October 22, 2010, the DOL announced that, due to the changes in the financial markets and in the terms of benefit plans, it was proposing a revised definition of when an individual becomes a fiduciary by providing a plan with investment advice. The implications of the DOL’s decision are far more consequential and far reaching today than they would have been 39 years ago, as more than three decades of reliance on the current standards form the basis of service provider relationships and payment structures applicable to literally trillions of dollars of ERISA plan and IRA assets. The proposal, which affects not only ERISA plans but also IRAs and other retirement vehicles subject to the Internal Revenue Code’s prohibited transaction rules, would effectively prohibit common payment arrangements that include variable compensation, require significant changes in the business operations of some service providers, increase costs for plans and participants, and potentially impose new restrictions and limitations on service providers engaging in cross‐ selling and plan rollovers.46 Of consequence is that the liberalizing nature of who and what can be covered under the proposal creates issues regarding the activities of financial professionals. It is thought that the proposal’s broad language can create fiduciaries under the proposal who are rarely fiduciaries under current law.

46

Campbell, Bradford P. “American Bar Association Commentary on DOL’s Proposed New Definition of Fiduciary” (SAC 441,865,970v1, November 11, 2010)

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The DOL contends in justifying the costs attendant to expanding the definition of a fiduciary advisor, that difficulty has arisen in conducting effective enforcement against nonfiduciary advisors with undisclosed conflicts. However, the DOL does not mention in its proposal that such undisclosed third‐ party compensation is already prohibited by the final regulation amending the 408(b)(2) prohibited transaction exemption for “reasonable” arrangements.47 The Proposed Regulation Under the proposed regulation, a person who provides the following types of advice and recommendations to a plan fiduciary or participant may result in the person’s being a fiduciary under ERISA: (i) advice, appraisals or fairness opinions concerning the value of securities or other property; (ii) recommendations as to the advisability of investing in, purchasing, holding or selling securities or other property; or (iii) advice or recommendations as to the management of securities or other property. It is (ii) and (iii) that this article is limited to.48 Under the proposed regulations, at least one of the following alternative conditions must also be met by a person described above in order for the person to be an ERISA fiduciary. These conditions are that (i) the person represents or acknowledges in writing or orally that the person is acting as a fiduciary; (ii) the person exercises any discretionary authority or discretionary control with respect to management of the plan, exercises any authority or control with respect to management or disposition of its assets, or has any 47 48

Campbell, Id. Prop. Reg. Sec. 2510.3-21(c)(1)(i)(A)(1),(2) and (3), FR Vol. 75, No. 204 (October 22, 2010)

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discretionary authority or discretionary responsibility in the administration of the plan; (iii) the person is an “investment adviser” under the Investment Advisers Act of 1940; or (iv) the person meets the basics of the Five-Part Test (removing the elements that require advice on a “regular basis” and a “mutual understanding” that the advice will be the primary basis for investment decisions).49 Satisfaction of any one of these alternative conditions under (c)(1) of the proposed regulation may result in the person being an ERISA fiduciary if that person is also providing investment advice for direct or indirect compensation.

Providing investment advice for a fee or other compensation, direct or indirect, means any fee or compensation for the advice received by the person providing the advice (or by an affiliate of the person) from any source and any fee or compensation incident to the transaction in which the investment advice has been rendered or will be rendered.50 The term “fee or other compensation” includes, but is not limited to, brokerage, mutual fund sales and insurance sales commissions, and also includes fees and commissions based on multiple transactions involving different parties.51 The proposed regulation sets forth certain investment advice that may be given without the person giving the advice being an ERISA fiduciary. Specifically, a person will not be a fiduciary with respect to the provision of investment advice or recommendations if the person can demonstrate that the recipient of the advice knows or, under the circumstances reasonably should know, that the person is providing the advice or making the recommendation to the recipient in the capacity 49 50 51

Prop. Reg. Sec. 2510.3-21(c)(1)(ii)(A),(B),(C) and (D), FR Vol. 75, No. 204 (October 22, 2010) Prop. Reg. Sec. 2510.3-21(c)(3), FR Vol. 75, No. 204 (October 22, 2010) Id.

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of a purchaser or seller of a security or other property, or as an agent of or an appraiser for a purchaser or seller, whose interests are adverse to the interests of the plan or its participants, and that the person is not undertaking to provide impartial investment advice.52 In addition, if the person merely furnishes any of four specific types of information and materials – (i) plan information (including general reports on the value of investments or legal compliance)53, (ii) general financial and investment information54, (iii) asset allocation models55, and (iv) interactive materials56– the person will not be an ERISA fiduciary. Additionally, a person will not be a fiduciary if the person merely markets or makes available securities or other property (e.g., on a platform), without regard to the individualized needs of the plan or its participants, from which a plan fiduciary may designate investment alternatives into which participants may direct their accounts, provided the person discloses in writing that the person is not undertaking to provide impartial investment advice.57

52

Prop. Reg. Sec. 2510.3-21(c)(2), FR Vol. 75, No. 204 (October 22, 2010) Prop. Reg. Sec. 2510.3-21(c)(2)(ii), FR Vol. 75, No. 204 (October 22, 2010), referencing 29 C.F.R 2509.96-1 (“IB 96-1”) 54 Id. 55 Prop. Reg. Sec. 2510.3-21(c)(2)(ii)(A), FR Vol. 75, No. 204 (October 22, 2010) 56 Id. 57 Prop. Reg. Sec. 2510.3-21(c)(2)(ii)(B), FR Vol. 75, No. 204 (October 22, 2010) 53

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Perspectives on the Proposed Regulation In essence, what the DOL’s new proposal means is that it intends to expand both the types of advice and the types of advisors subject to ERISA fiduciary status. Particularly bothersome is the language found in Prop. Reg. Sec. 2510.321(c)(1)(i)(A)(3) referencing recommendations “as to the management of securities or other property.” How broad is the term “management” intended to be? The DOL notes in the preamble to the proposal that the term would include recommendations relating to proxy voting and the selection of investment managers while referencing the special concerns of plans with employer stock.58 This begs the question of “why not just spell it out?” Therefore, to the critical eye it seems a distinct possibility that other consulting services might be captured by the use of the innocuous term ‘management’.

The conditions presented by the proposal generally relate to the degree of authority, control, responsibility or influence that is possessed, directly or indirectly, by the person rendering the advice, and the reasonable expectations of the persons receiving the advice.59 Satisfaction of any of these conditions may result in a person being deemed to be a fiduciary for ERISA purposes if that person is also providing investment advice for a fee. Under the proposed regulation, this will be true even if the person providing the investment advice does not provide that advice on a “regular basis” or does not intend for the advice to be a “primary basis” for making an investment decision.60

58 59 60

Preamble to Prop. Reg. Sec. 2510.3-21(c), B(a), FR Vol. 75, No. 204 (October 22, 2010) Thompson Hine. “Investment Management Update” (Cincinnati, November 2010) Id.

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This is because the proposed regulations eliminate the requirement that the investment advice be provided on a “regular basis” pursuant to a “mutual understanding” that the advice will serve as a “primary basis” for investment decisions (key components of the Five-Part Test under the current regulations).61 It is also worth noting that the fact that a person may be excluded from the definition of an investment adviser for purposes of the Advisers Act is not determinative of whether or not such a person would be deemed to be a fiduciary under ERISA. By way of illustration, a broker or dealer who otherwise may be excluded from the definition of an investment adviser under Section 202(a)(11)(C) of the Investment Advisers Act of 1940 still may be deemed to be a fiduciary under the proposed regulations if the advice or services provided by such person otherwise satisfies the expanded definition. Like the existing rule, the proposed regulations indicate that a person must provide advice for compensation (whether direct or indirect) to become a fiduciary for purposes of ERISA. 62 Conclusion In summary, the old five‐ part test is eliminated with the result that investment advice no longer must be provided on a regular basis (one‐ time advice will be sufficient), and the parties no longer need a mutual understanding that the advice will serve as the primary basis for a plan investment decision.

Consequently, certain actions are specifically stated to constitute investment advice.

61 62

Id. Id.

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It is important to note that if a provider of investment advice or recommendations represents itself to be an ERISA fiduciary then, “it walks like a duck, quacks like a duck” and fiduciary status will attach because “it’s a duck.” It will be important for advisers to diligently monitor to what extent the DOL might define the provision of investment advice to encompass recommendations related to taking a plan distribution.

Since the proposed regulation by its very nature is nonexclusionary and intentionally vague in places, there are many, many situations in application that advisors need to be made aware of. Finally, the proposed rule would make it clear that acknowledging fiduciary status, orally or in writing, when providing investment advice for a fee is sufficient to result in fiduciary status. This seems squarely directed against service providers who have attempted to deny fiduciary status even though they have expressly agreed to such status in their agreements with a plan. Counsel for plans will want to negotiate that much harder for the acknowledgments of fiduciary status that they have always sought.

Clearly, the new proposed regulation of a 3(21) fiduciary necessitates not only compliance with the new rule, but its integration with the consistent operative machinery of a prudent procedure for plan investments. It is very apparent now that prudent investment process will be the watchtower for compliance with Prop. Reg. Sec. 2510.3-21.

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Consequently the pipeline of procedural investment prudence that existed in a vacuum until the last 20 years is now in the foreground. A strict adherence to all of the principles discussed herein will go a long way toward proving that in fact a procedure and prudent machinery for decision-making has been undertaken. This will be necessary for advisors and professionals in the future since the nets of Sec. 3(21) have been cast wide upon the qualified plan waters.

In the end, road mapping with an investment policy statement, adherence to diversification principles of modern portfolio theory, investment selection process, monitoring performance, expense management, and understanding the pitfalls that arise from conflicts of interest go hand in hand with undertaking fiduciary duties.

It seems only natural that procedural prudence goes hand in hand with the new definition of fiduciary. Those that understand it, embrace it and meld the two together will be very much in demand.

Important Disclosures Federal income tax laws are complex and subject to change. The information in this memorandum is based on current interpretations of the law and is not guaranteed.

Neither Nationwide, its employees, its agents, brokers or registered representatives gives legal or tax advice. You should consult an attorney or competent tax professional for answers to specific tax questions as they apply to your situation.

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Nationwide and the Nationwide framemark are registered service marks of Nationwide Mutual Insurance Company©. Nationwide Financial Services, Inc. All rights reserved.

Nationwide Investment Services Corporation, Columbus, Ohio, member FINRA. The Nationwide® Group Retirement Series includes unregistered group fixed and variable annuities and trust programs. The unregistered group fixed and variable annuities are issued by Nationwide Life Insurance Company. Trust programs and trust services are offered by Nationwide Trust Company, FSB a division of Nationwide Bank®. Nationwide Investment Services Corporation, member FINRA. In MI only: Nationwide Investment Svcs. Corporation. Nationwide Mutual Insurance Company and Affiliated Companies, Home Office: Columbus, OH 43215-2220.

NFM-11431AO (2/13)

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DIRECT INVESTING IN BONDS DURING RETIREMENT

Stephen J. Huxley, Ph.D. University of San Francisco Manuel Tarrazo, Ph.D. University of San Francisco Direct bond purchases can address major issues confronting retirees better than alternative investments such as providing retirement income, moving to a retirement homes, leaving a legacy, etc. It is best to concentrate on cash flows and conceptualize “risk� as failing to meet unavoidable payments, rather than on returns and return volatility as a proxy for risk. Our research shows that direct bond investing - especially with the assistance of a professional financial planner - offers many advantages to moderately sophisticated small investors.

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Introduction Our times require wise management of whatever savings retirees accumulate and, very particularly, that they make the most from their funds, assets, and pensions. At the moment of this writing, the crisis that became obvious during the summer of 2008 continues to generate deep structural changes all over the world that directly affect everyone. The effects are well known. Sustained unemployment rates are at levels rarely seen in the past (reaching even higher levels among young people - up to 50% among 18-24 year-olds), sluggish growth of economies, aging populations in developed countries, stressed public assistance systems despite enormous public expenditures, and deficits that only seem to get worse.

The good news is that, for the first time ever, individual small investors need to make no more than six clicks on their browsers to buy bonds directly, as illustrated later in this study.

This opens doors that had in the past been open only to dealers and institutional investors who dominated the fixed income market and should attract household investors who, by themselves or with the help of financial planners, can enhance their investing options by buying bonds directly. The aforementioned economic trends and deficits suggest that bonds will not be in short supply anytime in the foreseeable future.

It is therefore timely to explore the following: a) the state of the art in terms of extant knowledge shared by individuals and their financial advisers about fixed income; b) what would be the best way to address one of the major financial problems requiring the fixed income feature that bonds provide; and, c) how to evaluate alternatives to buying Š2013, IARFC. All rights of reproduction in any form reserved.

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bonds (insurance annuities, bond mutual funds, reverse mortgages, and so on).

In the first part of this paper, we concentrate on developing a given size and pattern of cash flows. Providing predictable cash flows is one of the most attractive features of direct bond purchases. In this part we choose not to inquire about what those cash flows are for, because we want to highlight the importance of studying self-directed investors with enough sophistication to be aware of the properties of bonds and what they offer. These investors, in turn, set the bar for a particular type of practitioner, one who must be able to add demonstrable value to discerning clients. Within this expository strategy we analyze first what this type of relatively sophisticated investor can do by him/herself. We then bring in a professional financial adviser. Finally, we provide a brief assessment of how the existing literature meets the needs of both the assumed hypothetical investor and the practitioner.

While there is enough theoretical support to guide direct bond buying by individuals, the support is somewhat disjointed and we believe even savvy investors would have problems piecing it together. One of the obstacles to overcome is the overwhelming pervasiveness of “return-based� works (modern portfolio theory, duration-based immunization, emphasis of bond mutual funds) at the expense of cash-flow based approaches, which are what most retirees and other individual investors actually face - well-known, expected payments.

The paper’s second part considers the alternatives available to the investor who needs cash flow. The starting list of alternative ways to build fixed income is rather open ended, for example staying in cash, buying insurance annuities, signing for a reverse mortgage, engaging in buying real estate

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and renting it, investing in high-yield dividend stocks, etc. To avoid shallow comparisons and bad decisions while comparing alternative investments, we need ways to integrate information of different kinds (qualitative and quantitative), and to develop a consistent approach to do so reliably – that is, we need a methodology. We will evaluate certain tools that can be employed to formalize comparisons of alternative investments, which fills an important gap between actual decision-making by households and the literature. The tools we put together build from early suitability analyses, complemented and extended with modern developments from information and computer sciences.

The conclusion from our effort is quite encouraging.

Direct bond investing, especially when coupled with the assistance of a professional financial planner, can be very helpful to moderately sophisticated small investors in or close to retirement age.

The Cash Flow Funding Problem This is the most straightforward application of purchases of bonds because it takes advantage of their distinctive feature - providing cash flows which are perfectly predictable at the time the securities are purchased. Not only are the coupon payments known but so is the maturity value of the bond (the face value). This predictability is actually quite rare in the world we live in and represents one of the unique qualities of individual bonds. We focus on bonds of the highest quality. We want to emphasize first what investors can do for themselves, then clarify how financial advisers can add value. Brief notes concerning support from the literature close the section. Š2013, IARFC. All rights of reproduction in any form reserved.

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The Self-directed or “Do-it-yourself” Approach to Cash Flow Funding As an example, suppose our investor is concerned about funding an expense of approximately $15,000 dollars per year, for 18 years, and has about $200,000 to allocate for bonds.

The $15,000 may be needed for full or partial payments to an assisted living facility for a spouse or relative over his or her remaining life expectancy. We assume our investor has a nonnegligible degree of financial sophistication (someone who knows the difference between a bond and a stock).

The availability of direct purchases of individual bonds has increased remarkably over the past 15 years. The investor might first seek bond quotes from his or her custodian.

Schwab, Fidelity, TD Ameritrade, etc. all offer real time bond buying opportunities that can completed online. Or the investor might access the finance.yahoo.com website, then navigate to the “investing” page, and select “bonds.” From there, our investor would access the “bond screener” to see information about real bonds that are available for purchase at that precise moment. A more specialized screener is available from the TRACE (Trade Reporting and Compliance Engine) system that the National Association of Security Dealers (NASD) introduced in July 2002 in an effort to increase price transparency in the U.S. corporate debt market. TRACE provides all over-the-counter market activity in TRACEeligible securities (investment grade, high yield and convertible corporate debt). And, as they write in their “compliance” site, “If you are an individual investor and would like to view realtime price and volume information for individual bonds, please refer to www.finra.org/marketdata.” The U.S. Treasury Department offers a full-fledged access portal to treasuries at

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http://www.treasurydirect.gov/ . We assume the investor is interested in high quality corporate bonds because they typically pay a higher yield than US Treasuries (the spread can be confirmed by the data on the term structure available at the bond screener access on yahoo.com). Our savvy investor needs only to copy information on a particular bond and proceed to see how such investment can satisfy his/her needs.

Exhibit I presents a straightforward cash flow analysis that would allow our investor to assess the bond purchase. The numbers have been calculated assuming the investor used one of the screening services to obtain information about bonds (this example is based on an analysis done in 2011). Assume our investor selected a suitable-looking bond with the following characteristics: Issuer, FEDERAL HOME LOAN BANKS; price, 108.15; coupon, 5%; maturity, 28-Sep-29; noncallable; Fitch ratings, AAA; yield to maturity, 4.352%; and current yield, 4.623%. Although the bond frequency is semiannual, we will be using annual coupon payments to facilitate the exposition.

The first column of the table in Exhibit I shows the year, and the second one shows the present value of the bond, which is calculated at the time of the purchase using annual figures (nper, 18; fv, 1000; pmt, 50; pv, -1081.5; rate = ytm, 4.3384%). The block labeled “Bond holdings” shows the bonds the investor holds under three scenarios: 1) 0% decapitalization, in which all bonds are held until maturity, 2) 50%, decapitalization, in which the investor sells a few bonds each period so that the final holdings are 50% of the original amount, and 3) 100% decapitalization where all the bonds are sold through the investing period. The block of columns labeled “Bond revenues” shows cash flows that include the ©2013, IARFC. All rights of reproduction in any form reserved.

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initial purchases in 2011, the flow of coupons, and corresponding bond sales during each of the remaining periods.

Exhibit I: Do-It-Yourself Investing.

Bond holdings Year

PV bond

Bond revenues

0%

50%

100%

0%

50%

100%

2011 $1,081

184

184

184

($198,996)

($198,996)

($198,996)

2012 $1,078

184

179

174

$9,200

$14,342

$19,484

2013 $1,075

184

174

164

$9,200

$14,076

$18,952

2014 $1,072

184

169

154

$9,200

$13,809

$18,419

2015 $1,068

184

164

144

$9,200

$13,542

$17,884

2016 $1,065

184

159

134

$9,200

$13,274

$17,347

2017 $1,061

184

154

124

$9,200

$13,004

$16,809

2018 $1,057

184

149

114

$9,200

$12,735

$16,269

2019 $1,053

184

144

104

$9,200

$12,464

$15,728

2020 $1,048

184

139

94

$9,200

$12,192

$15,184

2021 $1,044

184

134

84

$9,200

$11,920

$14,639

2022 $1,039

184

129

74

$9,200

$11,646

$14,092

2023 $1,034

184

124

64

$9,200

$11,372

$13,543

2024 $1,029

184

119

54

$9,200

$11,096

$12,992

2025 $1,024

184

114

44

$9,200

$10,819

$12,438

2026 $1,018

184

109

34

$9,200

$10,541

$11,882

2027 $1,012

184

104

24

$9,200

$10,262

$11,324

2028 $1,006

184

99

14

$9,200

$9,982

$10,763

2029 $1,000

184

99

14

$193,200

$103,950

$14,700

The most straightforward case is when all the bonds are held until maturity (i.e. “full preservation� of capital), depending on the purchase par value. The $200,000 capital

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allows the purchase of 184 bonds at $1081.50 each (integer part of dividing the capital by the bond price) at a cost of $198,996. The investor receives $9,200 in coupons each period (184 times $50 per bond) except for the last, where he gets $193,200, that is, $184,000 in face values (184 times $1,000) plus the last round of coupon payments for $9,200. In the 100% decapitalization case, the investor calculates how many bonds he would sell each period so that the portfolio depletes entirely. The corresponding calculation is easy; liquidating 184 bonds during 18 periods requires selling 10 bonds each period (the integer part of 184/18 = 10.22) until the last, when the final 14 bonds would mature. The 50% and 100% decapitalization cases are approximations, since interest rate changes would alter the exact value of the bonds when they are actually sold. For each 1% change in rates, the market value would change by approximately the current duration of the bonds sold. Over time, these changes may be up or down.Note that our investor is sophisticated enough to know that some flexibility may be needed in both setting expectations concerning cash flow matching, and also with respect to the overall investment plan. The investor is planning to allocate $200,000 and to see if a planned expense of $15,000 can be met. Clearly, holding all bonds to maturity provides the highest preservation of capital, which may be important if one of the spouses in the household survives the other, but it fails to provide the desired $15,000 because only the coupons are received.

Selling the bonds over the time horizon has its limitations as well. First, it is surprising that the difference in yearly revenues for the 50% and the 100% decapitalization strategies is not larger. In one case we are selling 10 bonds per year, and in the other only five. There are two items to Š2013, IARFC. All rights of reproduction in any form reserved.

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consider. Selling more bonds provides extra revenues but decreases coupon revenues significantly. That is why the total revenues during the last few periods nearly converge. More importantly, the investor is likely to wonder whether the difference in yearly cash flows between the 50% and 100% decapitalization strategies compensates for the very large difference in ending value ($103,950 for the 50%, and $14,700 for the 100% decapitalization). A similar reasoning strengthens the case for the no decapitalization strategy, whose yearly revenues come close to those of the other strategies during the last years, while providing an ending value nearly equal to the initial investment.

Another interesting result is that a single corporate bond of the highest quality may suffice to meet the needs of our investor. Buying more than one bond does not seem to offer additional benefits, at least in our simplified “do-it-yourself� investment setting. The investor may reasonably expect that ups and downs in bond prices will more or less cancel each other.

Finally, what these computations do show is how misleading it would have been for the investor to even look at the yield to maturity calculations for each of the strategies. As a matter of curiosity, the rates of returns for each strategy can be easily approximated in EXCEL with the internal rate of return formula =IRR(‌) on each of the revenue columns (4.34%, 4.18%, and 3.92% for the 0%, 50%, and 100% decapitalization strategies respectively). Note how atrociously wrong it would be for any investor to judge the cash flow profiles by these indicators. The differences among rates may seem small. However, they mask nearly $100,000 of actual

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differences in terminal value, which surely are very significant and valuable for the investor.

At this point, our investor has done a considerable amount of work and contacts a financial adviser. The investor does not provide much information about his/her financial situation, which could have forced the adviser to focus exclusively on the cash flow matching issue. In order to do conscientious work, the adviser tries to see the numbers provided by the investor as part of a more comprehensive perspective.

The Financial Adviser Assisted Way The cash flow funding problem is well known to financial advisers. Retirees often come to them seeking a secure income stream to replace the steady income they give up upon retirement. To pay living expenses, they will now begin drawing down their lifetime savings to augment whatever they anticipate receiving from Social Security or other sources.

Retirees must attempt to balance the twin problems of spending too much or too little. Because their retirement portfolio is a finite sum that may run out, spending too much is likely to be considered the worse error. Note that there is a certain asymmetry at play here. Spending too little means a life of needless frugality and worry - still bad but not quite as bad as ending up a ward of the state (or a ward of their progeny). One of the common tasks of financial planners is to help clients avoid these extremes and identify an income stream from the portfolio that will last over some defined

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period of time, usually 30 years.1 Once this income stream is specified, the next problem is to determine how best to fund it.

The retirement income problem is actually the wellknown “cash matching” problem that appears in most finance texts and was the original motivation for research into dedicated portfolios.2 A dedicated bond portfolio of customized individual bonds can be constructed whose cash flows from coupon payments and redemptions will match any desired income stream over any desired time horizon, as we saw in our first example of a $15,000 per year income stream over 18 years.

Most advisers use software (such as Money Guide Pro, Naviplan, Money Tree, etc.) that projects annual cash flow needs as part of their standard retirement planning analysis.

The traditional approach to funding is to construct a “conservative” portfolio with a 40 to 60 percent allocation to fixed income investments, the balance in equities. The retiree then withdraws cash every year from the best performing asset, and the portfolio is rebalanced back to the original allocations.

The idea behind the heavy allocation to bonds is to reduce the volatility of the portfolio, which is the way – regrettably, the only way – risk is measured by Modern Portfolio Theory, the dominant model used in personal as well as institutional financial planning. In practice, we have to take into account longevity risk, sequence risk, and other types of risk that 1

Personal finance research suggests that an initial withdrawal rate of about 4 percent of the retirement portfolio’s value in the first year, with the same dollar value increased annually by the prior year’s inflation rate, will last at least 30 years 95 percent of the time according to past U.S. returns. Higher withdrawal rates of 5 percent have equivalent probabilities of success if higher allocations to equities are permitted.

2 See Dedicated Portfolio Theory, www.wikipedia.com.

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retirees tend to worry about more than volatility. (One wonders how much they would be concerned about volatility if no one ever told them that it was “risk!”) Let us suppose, however, that the fixed income allocation will remain at 40 percent but this allocation will now be held as individual bonds rather than as bond funds. By simply holding the individual bonds that match the needed cash flows to maturity, the retiree actually wrings double duty from the same fixed income allocation, volatility is still dampened and a secure income stream is produced. It is a “free lunch” in the same sense that portfolio diversification is a free lunch when it produces the same returns with lower volatility from uncorrelated assets.

Matching cash flows to income is the class cashmatching problem found in most finance textbooks. It is solved by using dedicated bond portfolios. They can provide an elegant and effective solution for retirement income utilizing individual bonds, as explained in the following examples.

The easiest example is zero coupon bonds. Simply match the face values of the bonds maturing in each year to the cash flow needs for that year. Investment grade zeros or US Treasuries strips minimize or eliminate risk of default., But zero coupon bonds do carry some disadvantages.

Their returns are sometimes lower than coupon bonds. But a worse problem is that if the portfolio is held in a taxable account, taxes must be paid on the increase in value as each year passes and interest accrues even though it is not actually received. Thus, taxes must be paid from other sources.

Coupon bonds, on the other hand, do not have the tax problem because the coupon interest payments provide the money to pay the taxes. But coupon bonds present a different ©2013, IARFC. All rights of reproduction in any form reserved.

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problem, namely more complex calculations to solve the cashmatching problem. Cash flows in the early years of the time horizon much factor in the interest that will be received from bonds maturing in later years. If the cash flows are the same every year or even rising at a steady rate, the problem can still be solved with fairly straightforward mathematics, though the calculations would likely be challenging even for sophisticated investors. But in more complicated cases, such as cash flows following an uneven, lumpy pattern, a higher level of mathematics involving nonlinear programming is required, meaning some degree of financial engineering and its technical mechanics are needed.

To demonstrate the dedicated portfolio approach, we examine two cases. The first consists of a smooth income stream that rises steadily at three percent per year over 5 years (this is arbitrary - it could be longer or shorter). The second will be a lumpy income stream, identical to the first but with an extra $10,000 needed in Year 2 and an extra $11,000 in Year 3.

Case 1: A Smooth, Steadily Rising Income Stream Suppose our investor has just retired with a portfolio of $1,000,000, all in a qualified IRA account. He projects living expenses at $50,000 per year. He expects $17,000 from Social Security and an effective tax rate of about 25%, including federal and state taxes. This means the entire Social Security receipts will have to be used for taxes, but he will be left with a net, after-tax income of about $50,000. Withdrawing $50,000 means the initial withdrawal rate will be 5 percent of the initial portfolio value and will pay living expenses for the first year (Year 0).

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Now assume the investor wishes to set up a protected income stream for the following five years, increasing at the rate of three percent per year to account for inflation. Because this portion of the portfolio will be used only for retirement income (call this portion the “Income Portfolio”), it will be ultra conservative and use only US Treasury bonds. Table 1 (Exhibit II) lists the target income stream.

Table 2 (Exhibit II) shows the cost of meeting the income stream with US Treasuries, based on quotes from early March, 2012. The total cost of this income portfolio would be $269,711. It would produce cash flows of $273,958.

Exhibit II. Cash Dedication Examples Table 1. Target Income Stream Year

Withdrawal

0

$50,000

1

$51,500

2

$53,045

3

$54,636

4

$56,275

5

$57,964

Total

$273,420

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Table 2. Meeting Cash Flows with Coupon Bonds Total Cash Flow

Target

Excess

Year

Bond

Coupon

Matures

YTM

Number

Cost

Cum. Int.

1

USTreas

4.25%

8/15/2013

0.271%

43

$45,353

$8,323

$51,323

$51,500

($178)

2

USTreas

0.50%

8/15/2014

0.416%

47

$47,094

$6,495

$53,495

$53,045

$450

3

USTreas

4.25%

8/15/2015

0.608%

48

$53,838

$6,260

$54,260

$54,636

($376)

4

USTreas

3.00%

8/31/2016

0.877%

52

$56,773

$4,220

$56,220

$56,275

($55)

5

USTreas

4.75%

8/15/2017

1.098%

56

$66,653

$2,660

$58,660

$57,964

$696

Total

$269,711

$273,958

$273,420

$537

This does not quite match the total income stream needed ($273,420). The match cannot be perfect because bonds must be purchased in $1,000 increments. But the correlation with the desired income stream is over 99 percent and the differences each year are trivial. So long as each bond is held to maturity, the income stream is secure, protected from the market fluctuations. Note that although the market value of the bonds is not immunized, the cash flows themselves are.

The effects of volatility have been nullified where it counts.

Note that the asset allocation to fixed income is now based on a very intuitive foundation: the level of income stream wanted and the number of years desired for that income stream to be protected. All other money can be invested for growth, presumably equities (or other types that promise higher returns than bonds), which will provide the funds needed to extend the income portfolio each year as the bonds mature. In this case, the allocation will be about 5 percent to cash, 27 percent to bonds, and 68 percent to equities. If the investor

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asks “Why do I have 27 percent in bonds?” the answer will be “Because you wanted to protect your income for five years.”

Very intuitive.

Case 2: Lumpy Income Stream Assume our retiree wishes to take a vacation every other year that will cost $10,000 in Year 2, $11,000 in Year 4.

This leads to the target income stream shown in Table 3 (Exhibit II, Continuation).

Exhibit II. Cash Dedication Examples (Continuation).

Table 3. Target Income Stream with Lumpy Cash Flows Year

Living Expenses

0

$50,000

$50,000

1

$51,500

$51,500

2

$53,045

3

$54,636

4

$56,275

5

$57,964

Total

$273,420

Vacations

$10,000

Total Withdrawals

$63,045 $54,636

$11,000

$67,275 $57,964

$21,000

$294,420

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Table 4. Meeting Cash Flows with Coupon Bonds Cum. Int.

Total Cash Flow

Target

Excess

$45,353

$8,650

$51,650

$51,500

$150

56

$56,111

$6,823

$62,823

$63,045

($223)

0.608%

48

$53,838

$6,543

$54,543

$54,636

($94)

3.00% 8/31/2016

0.877%

63

$68,783

$4,503

$67,503

$67,275

$227

4.75% 8/15/2017

1.098%

55

$65,463

$2,613

$57,613

$57,964

($351)

Year

Bond

Coupon Matures

YTM

Number

1

USTreas

4.25% 8/15/2013

0.271%

43

2

USTreas

0.50% 8/15/2014

0.416%

3

USTreas

4.25% 8/15/2015

4

USTreas

5

USTreas

Total

Cost

$289,548

$294,130

$294,420 ($290)

Table 4 (Exhibit II, Continuation) lists the bonds needed to supply this cash flow. This example is small enough that it can be solved by hand, but a problem with a longer horizon or even more lumpy cash flow might require the use of integer programming to select the bonds which met the cash flows at minimum cost.

By following the dedicated portfolio strategy with individual bonds, the retiree maintains control over all assets, can ignore market fluctuations for over five years, and sleep at night knowing the money will flow into the account like an annual paycheck. Furthermore, the classic risks of holding fixed income have been reduced or entirely eliminated.

Default risk has been eliminated by using Treasuries. Market risk has been eliminated because the bonds are held to maturity. Reinvestment risk has been eliminated because the funds are consumed for living expenses rather than reinvested.

Inflation risk has not been eliminated but has been reduced by adding three percent each year to the cash flows.

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Compare these results to the same allocation invested in a bond fund. A bond fund would dampen volatility as much as the individual bonds and would also mitigate default risk by holding a large number of bonds. But the other classic risks remain, with market risk the most worrisome in the current interest rate environment of historically low yields.

Unfortunately, most retirees cannot afford to set up a dedicated bond portfolio to cover 30 years because they do not have sufficient funds (sufficient, at least, to support their existing or desired life style). They must set it up for a much shorter span, typically 5 to 10 years, and replenish it over time.

Thus, one year after the initial portfolio is set up, the first bond will mature and the decision must be made whether or not to roll the portfolio forward by selling off enough equities to extend the time horizon back out to its original length. This dynamic element is often overlooked even in the textbooks that cover dedicated portfolios. Yet it is the reality that must be dealt with to put the theory into practice. Techniques are available to do this but the methodology is proprietary and not widely known (see www.assetdedication.com).

Perhaps the most important results of this exchange are that the adviser can clearly add value and the more sophisticated the investor the more these services are likely to be appreciated. The added net value is created by 1) setting and analyzing the decision in the more comprehensive manner, 2) being able to find better bonds, 3) providing position management services (buying/selling), and 4) by including key elements in the decisions that were non-existent in the do-ityourself approach – most notably, inflation protection, taxation, insurance considerations, integration with real-estate holdings, bequest motives, etc. More about this later. Š2013, IARFC. All rights of reproduction in any form reserved.

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Risk, Customization, and Cash Flows The cash-flow matching examples above made no explicit reference to theory or sophisticated models, especially on the part of the individual investor. What is the state of the theoretical support to optimize this decision, and where is it to be found?

The usual procedure in textbooks is to dedicate a few pages to bond basics, then go straight into duration-based immunization (DBI), complemented with more or less deep analysis of the term structure of interest rates. The discussion is invariably oriented towards: a) returns-based institutional investing; b) improving our understanding of fixed income markets and the structure of interest rates; and c) contributing to the research on valuations, expectations (in required rates of return), fair prices, and market efficiency.

As noted earlier, cash matching does appear in most finance texts. The material, however, is pitched to pension funds and therefore not directly applicable to our small, individual investor or retiree – see, for example, the chapters “Liability Funding Strategies” (Fabozzi, 2004) and especially “Dedicated Bond Portfolios” (Fabozzi, 2001). A related concept, dedicated portfolio theory receives scant attention these days in academic literature. Most textbooks treat it in one or two pages (see Bodie, Kane, and Marcus, 2010; Jordan and Miller, 2008; Sharpe, Alexander, and Bailey, 1998). One of the lone exceptions is the extensive treatment of dedicated portfolio theory in Fabozzi’s book on the collected works of Martin Leibowitz (1992), and the references in the previous paragraph.

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It seems fair to conclude that we currently cannot find readily available material on how an individual investor may use bonds to match expected payments. An exception is Huxley and Burns (2005), who adapt the concepts of cash flows matching to the needs of individual investors, as part of a comprehensive financial planning program.

Modern portfolio theory (MPT) is another area where investors and advisers may look for guidance and support, and it was the source of the percentages split in asset allocation. We mentioned earlier that the traditional approach is to set a mixed stock-bond portfolio, where bonds provide the necessary dampening effect on volatility. Regardless of the percentages used, this approach has severe problems for individual investors’ interest in a given level of cash flows. First, it reduces “risk” to nothing more than volatility of returns, which ignores longevity risk, sequence risk, and other types of risk that retirees must face. Second, it is fixated on using mutual funds.

MPT assumes the only purpose of the fixed income allocation is to dampen volatility. Any sort of fixed income investment will do. That is, according to MPT it does not matter whether the fixed income allocation is held as individual bonds or bond funds because both will accomplish the same goal. As a result, most individual investors (and perhaps too many financial planners) do not distinguish between individual bonds and bond funds. They regard them as equivalent.

But bonds and bond funds actually differ in very fundamental ways. Individual bonds are, in fact, legal contracts. They have specified coupon interest payments that must be made on predetermined dates. They have specified maturity dates known in advance. They may have call features ©2013, IARFC. All rights of reproduction in any form reserved.

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or be non-callable. Such unique characteristics differentiate them from nearly all other financial securities. Individual bonds (and Certificates of Deposit, which are really bonds with government-backed guarantees) represent one of the few cases where the future can be forecast with accuracy.

Bond funds, on the other hand, do not have these unique characteristics. Bond fund managers hold hundreds or thousands of bonds which they typically trade on a daily basis.

They buy and sell bonds in much the same way that equity fund managers buy and sell stocks. Bond funds have no specified coupon interest payments and no specified maturity dates. The ability to forecast their cash flows with certainty is lost. They behave like and are used as sluggish stock funds.

There is one exception. In 2011, a new type of bond fund was introduced that behaves like an individual bond.

Guggenheim now offer “bulletshare” ETFs that consist of a collection of 75 to 100 investment grade corporate bonds all maturing near the end of the same year (BSCD 2013, BSCE 2014, …BSCK 2021). Coupon payments are distributed out to investors who buy the shares and, when the final year is reached, the fund is terminated and all redemption proceeds are distributed to the shareholders. These ETFs thus behave almost as individual bonds. Guggenheim also offers a similar corporate junk bond ETF, Barclays Ishares offers the same type of ETF consisting of investment grade munis, and Fidelity has recently begun to offer such investments.

In sum, the specialized (academic research) fixed income literature and textbooks seem to focus predominantly on the analysis of returns in the context of (large) bond fund positions. With respect to guidance provided by portfolio

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theory, its contribution is severely limited because of its conceptualization of risk and its reliance on mutual funds. It is unfortunate that investors are so thoroughly inundated with an unrelenting MPT view of return volatility as the only way to measure risk. Otherwise they would likely have attained a more balanced view of the other types of risks and how important they are to proper retirement planning. Most advisers realize that most bond funds cannot be used to lock up the income stream that retirees seek with certainty. Only a collection of individual bonds or the new ETFs purchased in the right quantities with the right coupon payments and right maturity dates can deliver certainty when it comes to providing secure cash flows that will match the liabilities that retirees’ future living expenses represent.

These observations imply that much of the literature fails to serve individual investors considering bond purchases for cash flow purposes because the characterization of risk does not reflect the customization required in real investing cases. Given that 76 million baby boomers are expected to retire in the next 20 years, there is a clear and definite need for more literature support in this area.

Return-based approaches ignore period-by-period cash flow needs, which also bypass the client customization required by small investors and retirees. The consequence is a misrepresentation of risk for this class of investors because, as noted by Smidt (1978), “(T)he risk of an asset or of a portfolio cannot be determined without knowing something about the characteristics of the investor” (1978, p. 18). This is especially so for retirees. Moreover, risk must be defined in terms of the consequences of not having expected incomes, as has been eloquently and effectively noted by Jeffrey (1984): ©2013, IARFC. All rights of reproduction in any form reserved.

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“The problem with equating portfolio risk solely to the volatility of portfolio returns is simply that the proposition says nothing about what is being risked as a result of the volatility. … Volatility per se, be it related to weather, portfolio returns, or the timing of one’s morning newspaper delivery, is simply a benign statistical probability factor that tells us nothing about risk until coupled with a consequence. … The determining question in structuring a portfolio is the consequence of a loss; this is far more important than the chance of a loss. … RISK [capitalized in the original] IS THE PROBABILITY OF NOT HAVING SUFFICIENT CASH WITH WHICH TO BUY SOMETHING IMPORTANT,” (1984, p. 34).

When risk is properly conceptualized, appropriate customization follows. In addition to customization and cash flows, a third element must be added: an enhanced perception of what liquidity is and what it represents for investors. These three elements should integrate naturally in the framework of consumption smoothing suggested by the life cycle financial planning.

The life-cycle hypothesis is a common staple in economics books and courses, especially in the coverage of consumption hypothesis. It builds on various contributions by Fisher and Harrod, but was set in its present form by Ando and Modigliani (1957). The basic idea is that the consumption pattern throughout the course of our lives changes less that our pattern of revenues; therefore, individuals and households consuming over their revenues have either to borrow against future earnings or exhaust previous savings and investments.

Early studies of the life-cycle hypothesis focused on the marginal propensities to consume of different groups.

Currently, the hypothesis provides a solid and practical

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economic foundation for financial planning by individuals, often under the heading of “consumption smoothing” (see, for example, Kotlikoff (2007)). In the case of the life-cycle idea, in Exhibit III Figure 1, the image is indeed worth more than a thousand words; it shows at what stages of our lives we are likely to need either borrowing (formative, early career), or to use up accumulated resources (e.g., retirement). It is also easy to understand what investment characteristics are needed at each stage of our lives and, in turn, which types of securities are suitable for providing them: liquidity, throughout our lives for transactions and safety; stocks, appreciation; bonds, income. The retirement segment in this chart is “curiously” longer than it is usually depicted –the reader will know why and its important implications for financial planning.

Exhibit III. Life-cycle, Consumption Smoothing, and Liquidity Management.

Figure 1. Consumption Smoothing Over Time (Life-Cycle Hypothesis)

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Figure 2. Consumption Smoothing, Investing, and Liquidity Management

Consumption smoothing must be used with caution: “Given that economists have primarily been having internal conversations about optimal financial decisions, it’s not surprising that the practice of financial planning has developed with little regard to the dictates of consumption smoothing. Conventional planning’s targeted liability approach has some surface similarities to consumption smoothing. But the method used to find retirement and survivor spending targets is virtually guaranteed to disrupt, rather than smooth, a household’s living standard as it ages. Moreover, even very small targeting mistakes will suffice to produce major consumption disruption for the simple reason that the wrong targets are being set for all years of retirement and potential survivorship,” Kotlikoff (2007, p. 1).

Nonetheless, one would expect investing textbooks to take advantage of the handy lead provided by economics and offer some segments on how households, and especially

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retirees, can implement consumption smoothing using direct purchases of bonds. Unfortunately, this is not the case.

Figure 2 of the same exhibit shows that liquidity is more than cash residuals, and should be thought of as the way to integrate financial asset transactions throughout the life of the investor. The (consumption) payments are the counterpart to the asset-cash flows sought after by the investor. For our investors, as in the corporate finance setting, cash flows are wider, more comprehensive and complex, than mere “cash.”

“Cash flows” represent entire chains of “cash-assets-cash” sequences that integrate life-cycle decisions and the corresponding asset-cash decisions. Lack of an appropriate conceptualization for “liquidity” has hampered progress in portfolio theory, whose static, one-period, “cash as residual” approach is not practical. Warschauer and Guerin (1987) isolated the problem: “Many elements of the personal financial planning process lack a theoretical basis and so are troubling to both academics and committed professionals in the field. One of the most perplexing questions facing scholars and practitioners alike relates also to the matter of personal liquidity. What is the optimal amount of liquid assets to be held by an individual?

This question must be answered in every financial plan. The answer however, is not simple. Consequently, far too often this important subject is dismissed during the planning process through the expedient of applying ‘rules of thumb’ that have little, if any, basis in theory,” Warschauer and Guerin (1987, p.

355).

How to customize appropriate risk considerations, apply life-cycle reasoning, and match expenses to cash flows (in and out) with an enhanced understanding of liquidity is ©2013, IARFC. All rights of reproduction in any form reserved.

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what is needed to develop and implement state-of-the-art financial plans - solid, common sense, and powerful. These elements are, for instance, present in the integrated model for financial planning suggested by Chieffe & Rakes (1999).

We must add two items to close this section. With respect to the literature, Tarrazo (2005) analyzes duration and immunization, which are shown to be rather faulty concepts even for institutional investing – e.g., in the typical application of duration-based immunization the textbook model ends up selecting only two securities. Tarrazo and Murray (2004) show the shortcomings of asset allocation advice when carelessly derived from ill-specified mean-variance models. Tarrazo (2008) examined all major financial models with financial planning potential and formalized a linear-expenditure-statepreference model, which brings closer the extant models to practical financial planning. The linear expenditure formulation separates necessary from discretionary expenses for a number of periods ahead, and the state-preference part allocates earnings to security purchases (stocks and bonds). In this manner, unavoidable expenses (carrying Jeffrey’s risk of not having the money to buy something important) have a direct influence in investing behavior.

The perfect analytical model is yet to come. Much practical progress can be made with the tools identified up to this point. Still, there is something major missing which is revealed – full force - when the investor asks a simple question: What can I do other than buying bonds?

The answer to that question depends on the specific problem we are trying to address with the fixed income funding. Bonds and the alternative to bonds offer different

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advantages and disadvantages depending on the problem being considered and the type of investor/consumer/household.

Direct investing in bonds appears to be an appropriate and straightforward way to solve the cash flow needs problem but it is not the only way. As the reader may anticipate, a discussion with practical value would go well beyond the allowable limits of any study. Our presentation, therefore, will try to stress the qualitative components and how they must be integrated with the numerical funding (cash flows), while preserving practical value. Our aim is not to provide a pre-fab solution/answer but to set the analysis on the most favorable ground for everyone involved.

Alternatives to Direct Bond Investing, Qualitative Matters Exhibits IV and V list alternative ways to finance moving into a retirement home, these are evaluated using two familiar approaches. In both cases, the tabular representation provides an automatic tool for comparisons. These tables speak mostly for themselves.

The first one (Exhibit IV) selects certain key, desired characteristics/properties and evaluates how each alternative fares in terms of each characteristic. In addition to building upon factual data, the properties resemble tips of icebergs, each one pointing to deep concerns of the investor. These concerns include the ability to meet dollar needs, longevity, the degree of comfort with the technique used (“We are not good with paperwork”), capture of all risks involved (“Kids, what happens if I do not like to be at the retirement home?” “What happens if we set this up and one of us passes away, say five years from now?”), behavioral matters (“Mom, you are underestimating the cost of the retirement home because you think you need less assistance than you actually do”), family ©2013, IARFC. All rights of reproduction in any form reserved.

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matters (“Jane is expecting and they may need/rent our home down the road. They cannot possibly afford to get a mortgage at the moment.”); and preference matters as well (“No rentals been there, done that.”).

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Exhibit IV. Qualitative Analysis: Desired Properties Approach.

Assisted bond investing (ABI) Meeting cash-flows

Risk of not meeting payments

Investment cost

Ongoing management cost & effort

Bequest motive

Flexibility

Reverse mortgage

Annuity

OK

OK

Lowest if coupons plus sales are properly calculated

Eliminated if the investor buys a sufficiently large annuity and we ignore possible insurance company bankruptcies and low returns

Minimal

Larger than in bonds to get same cash flows because yields are usually lower than bonds

Minimal

Minimal

Full capital preservation if bonds are bought at par and held to maturity

Some annuities offer survivorship rights but increase the cost to the investor

Quite large due to liquidity of securities

None - very punitive surrender charges if plans change

Rental unit

OK

OK

Eliminated if house equity is large enough but returns are usually low

Units may not rent; tenants may not pay; units may need costly repairs

Larger than in ABI

Larger than in bonds, especially if management costs are inputed and unit does not appreciate

Considerable if the investor may need to liquidate the reverse mortgage

Considerable costs in management.

(Ten hours of "material involvement" per unit and per week required by the IRS)

Typically no bequest

Inheritors may end up with a good or bad investment and a rental activity which they may or may not want

Investor may be required to live in his/her home for the duration of the contract.

Less than in ABI

Subject to significant market risk if liquidation becomes necessary

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Exhibit V employs another common device - listing pros and cons. It seems less systematic but it can be brutally direct and economize much time and effort. Rather than engaging in lengthy explanations we will let the reader, who may already be familiar with the issues involved, peruse the exhibits. We all have to deal with these matters in our personal lives because of our parents, in-laws, or ourselves. Everyone must face these issues.

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Exhibit V. Qualitative Analysis: “Pros and Cons” Approach

Pros

Cons

Assisted bond investing

Annuity

Reverse mortgage

Rental unit

Predictable income from bonds held to maturity

Easy to acquire

Easy to acquire

Positive cash flows provide income

Liquidity of financial securities

Provides lifetime income

Converts home equity into income for those who cannot borrow otherwise

Additional security if property appreciates

Provides a selfannuity

Provides cash flow

Provides cash flow

Owner can add "sweat equity"

May require expertise to set up

High surrender charges

Low returns

Risk of bad tenants

Consumes home equity normally bequeathed.

Bonds must be replenished as they mature

Low returns

Few people can afford 30 years from 100% bond portfolio

Inflation protection often not available

Climate may be bad for banks to enter into these deals May prove cumbersome if there are strings attached, or if the owner must sell

Ongoing maintenance and management responsibilities

Declining home values can wipe out equity and legacy value

©2013, IARFC. All rights of reproduction in any form reserved.

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Given the unavoidable nature of including qualitative matters into the analysis, it is appropriate to indicate that other approaches are available in the literature. One of these is the “demand for characteristics approach” first proposed by Lancaster (1966), who tried to improve upon the fullinformation, static, and objective approach of the traditional demand theory.

Lancaster assumes that consumers need certain characteristics that goods provide, singly or in a combination.

In the case of our securities (bonds, immediate annuities, reverse mortgages, and rental units), they all offer the characteristic of generating cash flows, but this characteristic is bundled with others the buyer also receives. Switch “good” for “financing option” and Lancaster’s own descriptions could not fit any better to our problem: “1) The good, per se, does not give utility to the consumer; it possesses characteristics, and these characteristics give rise to utility. 2) In general, a good will possesses more than one characteristic, and many characteristics will be shared by more than one good. 3) Goods in combination may possess characteristics different from those pertaining to goods separately,” (ibid., p. 134). Auld (1972), however, noticed that imperfect knowledge could deform the perception of characteristics and, while feeling him/herself satisfied, optimality was out of the question – e.g., an investor that does not know about bonds. Tarrazo (1999, 1997) extends Lancaster’s (1966) approach using fuzzy sets.

Finally, the “pros and cons” approach could be implemented using binary comparisons because in some cases it may not pay to face some of the trade-offs, see Hogarth and Karelaia (2005). It is also likely that there are other potentially useful decision-making techniques (e.g., heuristics) among the

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many recent developments in this area, see for instance Smith and Winterfeldt (2004).

Concluding Comments This study demonstrates potential uses of bonds by small investors and households in practice, which requires integration of the efforts of investors, practitioner-advisers, and researchers. Best outcomes are likely when discerning investors work with capable and conscientious advisers on an important problem where bonds satisfy a clearly identified cash flow need. In the first section, we considered a possible exchange between an investor/consumer/household of certain financial sophistication trying to obtain a predictable stream of cash flows from bond purchases and their potential adviser.

Such exchange was contrasted with some of the available literature and we indicated that an essential chain of related matters needs to be better addressed in the literature.

In the problems where bonds can help individual investors the most, the essential relationship is between risk, customization, and cash flows that are needed to make unavoidable payments. This is also the essential relation implied in the life-cycle financial planning model. In contrast, much of the literature is dominated by a setting in which 1) standardized advice using asset classes that do not map directly into cash flows like bonds do; 2) risk is understood as volatility of returns; and 3) households are left to their luck in matching investing cash flows to required payments. There is little doubt that direct bond investing – especially with the assistance of a financial planner - offers many advantages to moderately sophisticated small investors in order to properly address, if not solve, major problems arising during retirement. Š2013, IARFC. All rights of reproduction in any form reserved.

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References

Ando, A., & Modigliani, F. (1957). The life cycle hypothesis of saving: aggregate implications and tests. American Economic Review, 53, 55– 84.

Auld, Douglas A. L. (1972). Imperfect Knowledge and the New Theory of Demand. Journal of Political Economy. Vol. 80, No. 6 (Nov.- Dec.), 1287-1294.

Bodie, Z., Kane, A., & Marcus, A. Investments. 9th Edition. MacGrawHill, New York, 2010.

Chieffe, N., and Rakes, G. (1999). An integrated model for financial planning. Financial Services Review, 8, 261–268.

Dus, I., Maurer, R., & Mitchell, O. (2005). Betting on death and Capital markets in retirement: a Shortfall Risk Analysis of Life Annuities Versus Phased Withdrawal Plans. Financial Services Review, 14, 169196.

Fabozzi, F. (2004). Bond Markets, Analysis and Strategies. 5th ed. Pearson Education Prentice-Hall, Inc, Upper Saddle River, New Jersey.

Fabozzi, F. (2001). The Handbook of Fixed Income Securities. 6th ed.

McGraw-Hill, New York.

Huxley, S., & Burns, B. Asset Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation. McGraw-Hill, New York.

Jeffrey, R. (1984). A New Paradigm for Portfolio Risk. The Journal of Portfolio Management, 1984, Vol. 1, No. 1 (Fall), 33-40.

Jordan, B, & Miller, T. (2008). Fundamentals of Investments. 5th. Ed. Mcgraw-Hill, New York.

Kotlikoff, L. (2008). Economics Approach to Financial Planning. Journal of Financial Planning, Vol. 28, no. 3 (March): 42-52. Also available at: http://www.esplanner.com/learn/economics-approach-financialplanning Lancaster, K. (1971). Consumer demand-A new approach. Columbia University Press, New York.

Lancaster. K. (1966). A New Approach to Consumer Theory. Journal of Political Economy. Vol. 74, No. 2 (Apr6), 132-157.

Leibowitz, M. L. (1992). Investing: The Collected Works of Martin L. Leibowitz. Frank J. Fabozzi (Editor). An Institutional Investor Publication. Probus Professional Pub. Rosen, H., & Wu, S. (2004). Portfolio Choice and Health Status. Journal of Financial Economics, Vol. 72, No. 3, 457- 484.

Sharpe, W., Alexander, G., Bailey, J. (1998). Investments. 6th ed. PrenticeHall.Upper Saddle River, New Jersey.

Smidt, S. (1978). Investment Horizons and Performance Measurement. The Journal of Portfolio Management, Vol. 4, No. 2, Winter, 18-22.

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Tarrazo, M. (2008). A Quantitative Individual Financial Planning Model with Practical Implications. International Journal of Applied Decision Sciences, Vol. 1, No. 2, , 212-244.

Tarrazo, M. (2005). Full Dimensional Immunization. Applied Business and Economics, Vol. 5, No. 1, 30-49.

Tarrazo, M. (1999). Fuzzy Sets and the Investment Decision. Journal of Investing-Financial Technology. June, 37-47.

Tarrazo, M. (1997). An Application of Fuzzy Set Theory to the Individual Investor Problem. Financial Services Review, Vol. 6, No. 2, 97–107.

Tarrazo, M., & Murray, W. (2004). Teaching What We Know about Asset Allocation. Advances in Financial Education, Spring, Vol. 2, 77-103.

Waggle, D., & Johnson, Don. The Impact of the Single-Family Home on Portfolio Decisions. Financial Services Review (2003), Vol. 12, No. 3, 201-217.

Warschauer, T., and Guerin, A. (1987). Optimal Liquidity in Personal Financial Planning. The Financial Review, Vol. 22, No. 4 (November), 355-367.

Š2013, IARFC. All rights of reproduction in any form reserved.

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A DIGITAL ASSET BALANCE SHEET: A NEW TOOL FOR FINANCIAL PLANNERS John E. Grable, Ph.D., CFP速 Nolan D. McClure Kimberly Broddie Stefen Kutzman Brad Watkins University of Georgia

Financial planners are increasingly encouraged to discuss digital asset planning issues with clientele. Typically, these discussions involve prompting clients to identify and maintain records regarding online accounts, computer files, domain names, social media information, and important passwords. This paper adds to the tools financial planners can use when working with clients by presenting a digital asset balance sheet. The sheet is intended to provide a structure to help clients document which digital assets are owned, how much these assets may be worth, and whether ongoing liabilities may be associated with the ownership or possession of such assets. This paper also provides information about the ownership characteristics of some digital consumer assets.

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Introduction The concept of digital legacy planning has recently gained recognition as an important financial planning topic.

Articles on preserving digital assets after death have appeared in diverse publications, including The Wall Street Journal (Greene, 2012), the American Airlines magazine— AmericanWay (Dobrow, 2012), and The Journal of Financial Planning (Hopson & Hopson, 2012). In order to fully appreciate the interest in digital asset protection within the context of estate planning, it is first important to have a clear definition of a digital asset. According to Beyer and Cahn (2012), digital assets include (a) online accounts, (b) files stored on computers, (c) files stored online, (d) files stored in the “cloud”, (e) domain names, (f) online business assets, (g) social media sites, and (h) sometimes hardware (e.g., flash and external hard drives). As new technologies evolve, this list is likely to increase.

A review of the existing literature surrounding the issue of digital asset planning indicates the following: financial advisors should be actively engaged in helping their clients identify, through a formal inventory, all digital property owned or controlled. Further, some have indicated a need to also inventory liabilities associated with digital asset ownership. For example, owning a domain name typically requires an ongoing registration fee which is a contractual obligation. If the fee is not paid, the client’s ownership in a domain name may be forfeited.

There are many reasons why digital asset planning is important. Beyer and Cahn (2012) and Hopson and Hopson (2012) identified some of the most consequential reasons clients should engage in a digital asset inventory process. Of ©2013, IARFC. All rights of reproduction in any form reserved.

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primary importance is the issue of respecting a client’s wishes at death. It is probable that a client will want some of his or her online presence to last as a legacy, with other assets disappearing at death. If these wishes are not described in detail implementation becomes problematic. Also of importance is the need to minimize online identity theft risks. It is essential that a person’s executor or estate administrator has access to key login information as a way to gain and secure access to online assets. This can only be done, efficiently, through the use of a formalized inventory system.

Some may conclude, after reading about digital asset planning, that much of the concern surrounding the disposition of these assets can be handled either through a person’s will or through a power of attorney. In reality, neither of these estate planning tools is sufficient either to protect a client’s privacy or to dispose of assets with the least hassle. Beyer and Cahn (2012), for example, noted that few financial institutions allow someone holding a power of attorney to gain access to an incapacitated or deceased person’s accounts. The disposition of digital assets through a will is also somewhat problematic.

Because assets named in a will become public record, this method of transference defeats a key reason for digital asset protraction; namely, minimization of identity theft threats.

Assuming that a complete inventory exists, this, with a letter of last digital asset distribution instructions, could instead accompany a client’s will. Alternatively, some clients, especially those with high value digital assets, might consider establishing a digital trust to hold assets.

Consider what could happen when a client fails to account appropriately for their digital assets. To begin with, the burden to track down accounts, passwords, and key

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documentation will fall on family members and/or the client’s executor, thus increasing time and expenses associated with estate settlement. It is entirely possible that some accounts will be overlooked or undetected. Equally likely is the possibility that valuable assets will be unaccounted for in the gross estate and transferred to persons or entities counter to the client’s wishes or at below market valuations. For example, Greene (2012) reported on the travails of a spouse whose husband did not fully account for his own and their joint digital assets. The spouse was unable to quickly or efficiently access important websites, take control over her husband’s email accounts, or download important family documents. This example illustrates the need for a digital asset inventory for use by a client, his or her family, the family attorney, and the appointed estate executor.

What might a digital asset inventory or “balance sheet” look like? Table 1 provides a simple template to help financial advisors as they work with clients to develop such a document.

As shown in the table, assets can be categorized in a number of ways (e.g., intellectual versus business property). To be useful, such a table should show the location of each asset. This might be a website address or, in the case of hard assets, the physical location. If a username and password are required to access the asset, these should be listed and updated on a regular basis.1 Similarly, if a special identification number and/or answers to security questions are required to access an account these should be provided as well.

©2013, IARFC. All rights of reproduction in any form reserved.

Articles

List serve(s)

Books

Intellectual Property

Password

Username

Location

Digital Assets

Identification Number(s)

Table 1. Digital Asset Balance Sheet

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Fair Market Value (FMV)

Security Question Answers

Save

Maintain

Instructions

139

Delete

Sell

Probate

Will/

Trust

Distribution

Other

Property Obtained

Purchased Virtual Property

Video Game Property:

Video

Music

Historical Albums

Photographs

Digital Media

Other Social Media

Twitter®

Facebook®

Blogs

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©2013, IARFC. All rights of reproduction in any form reserved.

Journal of Personal Finance

Flexible Spending

Health Savings Account

Retirement Account

Brokerage Account

Protected Password Accounts:

Online Accounts

Other

Gambling Interests

Fantasy League

Avatar (e.g., SecondLife速)

through Talent

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Email Account(s)

Other Online Business

EBay Business

Website(s)

Domain Name(s)

Online Business Interests

Other

Other Loyalty Programs

Frequent Flier Account

Subscription(s)

Savings/Checking Account

Account

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Š2013, IARFC. All rights of reproduction in any form reserved.

Journal of Personal Finance

Website Hosting

Domain Hosting Contract(s)

Digital Liabilities

Other

External Digital Storage

External Hard Drive

Transferrable Licenses

Hardware

Software

Online Backup Data

Domain Name(s)

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Est. Present Value of Liability

Payment Instructions

143

Digital Net Worth

Liabilities

Value of Assets

Other

Ongoing Online Business Interests

Ongoing Online Account Maintenance

Ongoing Digital Media Costs

Ongoing Intellectual Property Obligations

Contract(s)

144

Š2013, IARFC. All rights of reproduction in any form reserved.

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Also shown in the table is a column prompting a client to indicate the fair market value of the asset. It is important to note that not all digital assets have a market value, although all have at least some personal or family value. For the purposes of the inventory, only the fair market value should be listed.

Unfortunately, this is not easy to calculate in most cases. In fact, quite a bit of confusion exists related to the valuation of digital assets. Some of this confusion arises from whether a financial advisor’s client actually owns what is listed in the inventory.

Consider the ownership of music records, CDs, and cassettes. For several decades, consumers have been protected under what is known as the first sale doctrine. Section 109 of the U.S. Copyright Law makes provision for the purchase and resale of “phonorecords.” Phonorecords are “records in which sounds, other than those accompanying a motion picture or audiovisual work, are fixed by any method now known or later developed, and from which the sounds can be received, reproduced or otherwise communicated, either directly or with the aid of a machine or device.”i The term “phonorecords” includes the material objects in which the sounds are first fixed. Does the current definition of a phonorecord include digitally downloaded music and movies? Unlike owning a music CD collection, which would be listed as an asset on a client’s balance sheet (i.e., the client owns the property and may resell it at market value), the determination of whether to list MP3s or similar products can only be answered by understanding where the online data was obtained. It does not appear that Section 109 of the U.S. copyright law fully applies to most clients in the 21st century. Table 2 provides a summary of the ownership characteristics of some of the most popular consumer sites on the Internet.

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As mentioned above, valuing digital assets can be quite challenging. Financial planners can play an important role in helping clients place a price on both intellectual and intangible assets by adopting valuation methods commonly used at the corporate level. Matsuura (2004) identified four common valuation models: (a) cost-based, (b) options-based, (c) income-based, and (d) market-based. The cost-based approach provides an estimation of replacement value by focusing on the costs to obtain, manage, and maintain an intangible asset.

Several limitations are associated with this procedure. Of primary importance is the notion that what a client has invested may simply be a sunk cost; that is, the true value of the asset may be much less than what was spent developing the asset.

Second, a cost-based approach fails to take into account the future value of an asset.

The option-based approach to asset valuation typically is used when intellectual property has the ability to be licensed.

Because this is rarely the case with personally-owned digital assets, this method of price estimation is seldom used by financial planners. Occasionally, income-based valuation models are used to estimate asset values. As the name implies, the asset must provide some source of current income. For example, a digital book that generates royalties can be valued using an income-based model. Basically, this approach discounts royalty revenue to obtain a present value for the asset.

The most widely used approach to digital asset valuation is the market-based method. When possible, the value of an asset can be determined by estimating how much the asset has or might trade for in the secondary markets, or by obtaining valuation estimates of similar assets. Clients who Š2013, IARFC. All rights of reproduction in any form reserved.

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own a domain name may find domain name valuation sites of interest. For example, valuate.com® provides an appraisal of domain names. Of course, this approach assumes that a market exists for an asset in order for an appraisal to work. Rather than assuming limited marketability, financial planners and their clients may be surprised to learn that robust markets exist on the Internet for online gaming and other digital assets. For example, massive multiplayer online role-playing games (MMORPG)—games that allow players to assume the role of a fictitious character—are quite large and active. Secondary markets for characters provide some liquidity for those who own these types of assets. MMORPGs, such as World of Warcraft®, often have more than 10 million players at any one time. According to Stephens (2002), “Players themselves earn money by selling in-game objects, such as magical swords, deeds to virtual pieces of land, and even characters, to other players desiring to advance more quickly in the game” (p.

1515). Active marketplaces, including gamewar.com®, allow players to buy, sell, or trade digital gaming assets,ii although it is important to note that like any traded commodity, the spread between bid and ask prices can be quite large. Markets for other digital assets also exist. For example, internet domain names can be purchased, sold, and auctioned through domain name listing sites, such as auctions.godaddy.com® and domaining.com®. While not every digital asset can be valued using market price data, it behooves financial planners and their clients to explore asset valuations through this process.

Also shown as a component of the inventory (Table 1) are spaces for a client’s distribution instructions and preferred method of distribution. A check mark indicating whether an asset is to be saved or maintained, either as a business or legacy asset, or deleted or sold, will help to ensure that the

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client’s wishes are completely implemented. Further, if a client has a strong desire to make public his or her distribution wishes, this should be indicted by marking the use of a will through the probate system. Typically clients will prefer that digital asset planning remain confidential. In these situations, the client should be clear when indicating this preference.

The concept of defining and managing a client's digital legacy will likely grow in importance in the future. This paper provides one framework for helping clients identify, categorize, and value their digital assets. Financial advisors are encouraged to adapt Table 1 to meet the needs of their clients.

In the future, this digital balance sheet may look significantly different as new products and services enter the marketplace, but for now this form provides a starting point in client-planner discussions regarding digital legacies. A special note about Table 2 is warranted. While every attempt was made by the authors to validate the information in the table, it is important for readers to note that company policies change on a regular basis. Before implementing any recommendations or altering a client implementation strategy based on the table, additional due diligence on the part of the reader/advisor is required. The information, in other words, is presented for information purposes only, not as a definitive source of any company's policy.

Š2013, IARFC. All rights of reproduction in any form reserved.

Is Asset Owned by Client?

No

No

Internet Site

Amazon

Apple: iTunes

Duration of Ownership

n.a.

n.a.

Is Asset a License?

Yes

Yes

Duration of License

149

Lifetime

Lifetime Very Limited

Restricted

Customers are not allowed any resale or commercial use of an Amazon service.

Users are not allowed to download or copy account information for another merchant or data gathering tools. iTunes restricts usage of downloads to personal, noncommercial use on up to five computers, except for film rentals. Products can also be stored on up to five different accounts on compatible mobile devices. Free content provided by iTunes has an unlimited use. Audio playlists can be burned to CDs up to seven times.

Copied CDs have the same usage rules as CDs purchased from the store. Product licenses for both music and movies are for personal use only, which means clients are not allowed to burn products for any reason other than their own personal use.

Film rentals have more restrictions than music; these can only be viewed on one device at a time and must be watched within 30 days of downloading, and finished watching within 48 hours. Technically, a decedent could leave a user identification and password to his or her beneficiaries, but this would be in violation of the iTunes user agreement.

User Agreement Policies

Table 2. Examples of Ownership Characteristics of Consumer Digital Assets on the Internet

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Ease of Asset Transferability?

Yes

No

Yes

No

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Blogger

Ebay

Facebook

Google

Instagram

LinkedIn

Posterous

Squarspace

Tumblr

Twitter

Webbly

150

Lifetime

Limited

Lifetime

Lifetime

Lifetime

Lifetime

Lifetime

n.a.

Lifetime

n.a.

Lifetime

No

No

No

No

No

No

No

No

Yes

No

Yes

n.a.

Broad

Broad

Limited

Broad

Limited

Broad

Limited

Broad

Restricted

No

Limited

Twitter has an inactivity policy where it will monitor account activity and delete any account that shows signs of inactivity for more than six (6) months. Twitter will only delete an account of a deceased person by request of an immediate family member or someone authorized to act on behalf of the deceased's estate, with appropriate documentation. Account login information will not be provided to anyone, regardless of their relationship to the deceased.

A "verification of death" form may be used to notify LinkedIn that a user has passed away, in which case the account will be terminated.

Facebook’s licensing and usage of personal content is subject to each client’s privacy and application settings. The license ends as soon as the property is deleted. Facebook has an option to “memorialize” accounts. The firm prefers to memorialize an account when a person dies, thus protecting the information in the account and restricting access to anyone. Confirmed immediate family members may choose to have the information deleted.

Restrictions specify that account information must be kept confidential and that others are restricted from using a client’s account information. Google has the right to disable an account, although it does not state under what exact conditions this will happen. Users are prevented from sharing content based on copyright protection laws. Under the Rights and Restrictions section of the Terms of Service, users are prohibited from sharing or lending any service with any person or institution except with express permission and enabled by Google. Google uses digital rights management software and watermarking to prevent content sharing.

The buy/sell contract will be voided at the client’s death.

©2013, IARFC. All rights of reproduction in any form reserved.

n.a.

n.a.

n.a.

n.a.

n.a.

n.a.

n.a.

Lifetime

n.a.

Contract Period

Journal of Personal Finance

Yes

Xanga

Lifetime

Lifetime

Notes: n.a. = not applicable

Yes

WordPress

Volume 12, Issue 1

No

No n.a.

n.a.

Broad

Broad

151

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Nearly all firms that provide access to digital assets prohibit impersonation of another person. Technically, controlling a deceased person's account would likely be classified as "impersonating" someone else; however, the table above assumes each social media service would not allow someone to control a deceased person's account.

References Beyer, G. W., & Cahn, N. (2012). When you pass on, don’t leave the passwords behind. Probate & Property, 26(1), 40-43.

Dobrow, L. (2012, April). E-state planning. AmericanWay, 34 & 39-40.

Greene, K. (2012, September 1-2). Passing down digital assets. The Wall Street Journal, B8. Accessed February 7, 2013: http://online.wsj.com/article/SB10001424127887323644904578272352 355489198.html?mod=WSJ_PersonalFinance_PF4#articleTabs%3Dart icle Hopson, J. F., & Hopson, P. D. (2012). Planning for clients’ digital assets.

Journal of Financial Planning. Accessed January 29, 2013: http://www.fpanet.org/journal/PlanningforClientsDigitalAssets/ Matsuura, J. H. (2004). An overview of intellectual property and intangible asset valuation models. Research Management Review, 14(1), 1-10.

Stephens, M. (2002, May). Sales of in-game assets: An illustration of the continuing failure of intellectual property law to protect digital-content creators. Texas Law Review, 80, 1513-1535. Accessed February 7, 2013: https://litigationessentials.lexisnexis.com/webcd/app?action=DocumentDisplay&crawli d=1&doctype=cite&docid=80+Tex.+L.+Rev.+1513&srctype=smi&srci d=3B15&key=f0d1fe58b71b126290f676816d19a6e5

i

As an alternative, those who are computer savvy may wish to explore the use of password manager software; password manager software allows clients to access password information through a single user-defined password, which then provides access to password information using any ©2013, IARFC. All rights of reproduction in any form reserved.

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web browser. If this approach is taken, it is still important to share the master password with a spouse, children, or attorney. i http://www.law.cornell.edu/uscode/text/17/109 ii Valuation of MMORPG assets can range from a few to several thousand dollars.

IARFC Financial Plan Competition 2014

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The International Association of Registered Financial Consultants invites your school and your financial students to participate in the Financial Plan Competition scheduled for next school year. As we are judged the finalists of the 2013 contest, we have built on the success of that event and hope that you will join us for another, even more rewarding competition. Now is the time to complete a Participation Agreement for your school.

For the 2014 competition we are announcing that the finalists and their faculty advisor will enjoy a 3 day, 2 night trip in May 2014 to Las Vegas, NV where they will present their comprehensive financial plan to a team of judges.

Here are highlights of the Plan Competition and some of the benefits your school and your students may earn:  Students will prepare a comprehensive personal financial plan based on uniform data furnished by the IARFC. 

For consistent and objective judging, the students will all be required to use the same financial planning software.



The IARFC will contribute (at no cost) comprehensive planning software, Plan Builder Financial, to the school for the use of students and faculty members.



Faculty members may use the plans and the process as part of their particular course curriculum, if desired.



Students must submit completed plans to the IARFC (postmarked or shipped) before January 31, 2014.



Students may enter plans individually or they may join in teams of up to three students working together on one plan submission.



The IARFC will judge all the submitted plans and select two plans as finalists.



These two winning finalists or teams will personally present their plans to a panel of RFC judges in Las Vegas as the final judging criteria. ©2013, IARFC. All rights of reproduction in any form reserved.

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

The judges will announce the winner on or before June 1, 2014.



Each participating school that submits a plan will receive a plaque recognizing the school and the department.



Each student who submits a plan will receive a certificate of completion.



Each of the finalist students will receive a certificate and wall plaque. As sponsors join the program, the IARFC may award additional prizes for the finalists and winners.



The IARFC will provide national media releases on the Plan Competition and name the participating schools. The Association will distribute these media releases during and after the competition.

The IARFC is a non-profit professional association and the Plan Competition Committee includes educators and experienced financial service practitioners. Your school and department may consider the Plan Builder Financial Software a donation from the IARFC. The software will be licensed for use through the competition and by request, the individual student licenses can be extended at no cost to the end of 2014.

Do you wish to participate? If so, please designate the appropriate faculty member through whom we will coordinate all the information, distribution and communications. Complete the Participation Agreement for online submission at www.IARFC.org\ParticipationForm We will begin the process of distribution of the sample case data and the software for student use after we receive this form. The deadline for registration is October 31, 2013.

Need more information? We have posted the rules and forms on the website: www.IARFC.org. Select Financial Plan Competition from within the blue box on the home page. (www.iarfc.org/FinancialPlanCompetition ) Alternatively, for specific

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questions not addressed by the information on the website, send an e-mail to info@IARFC.org.

Cordially,

Edwin P. Morrow, CLU, ChFC, RFC® Chairman & CEO

©2013, IARFC. All rights of reproduction in any form reserved.

Find a Member at: www.IARFC.org International Association of Registered Financial Consultants

How can you be sure a financial consultant is among the finest? Just visit with a Registered Financial Consultant速.

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