General & Misc. Planning: February 2006 Archives

I am profoundly lucky in that I read "I Will Fear No Evil" in high school. Not an assignment, I just like to read, and Robert A. Heinlein has always been one of my favorite authors.



A very few pages into the book, he has one of his characters toss off two famtastically good pieces of advice in quick succession, viewed from the point of view of thirty years later and multiple licenses in financial planning. He has one character, a lawyer no less, deal effectively and beyond challenge with two financial problems in quick succession. The first had to do with a very ill old gentleman with a will of longstanding effect, who doesn't want the existing provisions upset, as often happens to people who die with a new will. This extremely wealthy man has decided he wants to leave his secretary a million dollars.



The solution? A single-pay policy of life insurance. Problem solved. But once he's out of the room, the secretary protests, saying she'd just waste the money, or even get in trouble with it. She wants it given to charity.



Solution? Write it so she got an income off of it every week - essentially turn the lump sum into an income generating asset, with the additional advantage of a donation to charity when she shuffles off the mortal coil. She tells the lawyer she would never have thought of that solution.



His answer? "That's because most people think of money as something to pay the rent. They don't think of money in terms of what it can do."



Okay, I always was a math geek, but this concept was something I understood immediately, and it made a huge difference in the way I thought about money forever afterwards. Money wasn't just something to buy stuff with. Money could do things. Money could make more money. Money was potential, potential that got bigger all on its own if you only let it.



Now from a much later viewpoint, I see the flaws in Mr. Heinlein's plan. If you don't want your estate plan messed with, a living trust beats a will on every point. Furthermore, the interest rate imputed in the return of the life insurance proceeds was only a simple compounding at less than four percent - I can almost certainly do that much above inflation if I invest reasonably. Nonetheless, Mr. Heinlein grasped some very powerful concepts very well, and he was able to show the application to a teenager of no particular qualification. This is better than the vast majority of supposedly more sophisticated writers of serious "litracha" can usually do, and he did in almost in passing - no preaching, no grandstanding, just one heck of an effective example, twice in the space of a hundred words or so that were completely aside of the main plot.



These days, I still love reading fiction where the writers show they really understand economics and finance. They're hard to find. I happened to be volunteering as an event coordinator at a con a couple years ago, and ended up assigned to a reading with an author who made a mistake so elementary it showed that he had done no research because it impacted a benefit that literally everyone gets - he just didn't know about it. It really was critical to the plot, and if he had made one phone call when writing the story, any professional he called would have corrected the error. I very tactfully (for me, anyway) informed him of this gap, and I recently ran across the story in print. He hadn't fixed the error. I'm not planning on buying any more of his stuff. Another highly hyped novel said that the author understood economics and finance. What the author understood was that illegal drugs were a highly profitable trade if there's no real possibility of getting caught. Well, duh. He blew it, otherwise, not even considering the constraints of the problem he had set up. Despite the fact that I really enjoyed most of his writing, I may not buy the sequel just because what he missed was so painfully obvious to me that it really destroyed the rest of the story. As long time friends have heard me say many times, "I'm willing to suspend disbelief, but not hang it by the neck until dead!" This stuff is more constant than even the laws of physics, unless you postulate that you're dealing with a non-human psychology, and even then they're still there. Don't even get me started on the stuff supposedly written for everyday, mundane situations.



Still, some do get it right. S.M. Stirling in his Island In the Sea of Time stories, and to a lesser extent in Conquistador. Poul Anderson must have gone back through merchant records in the early Age of Sail, or known someone who did, for some of his Polesotechnic League stories, because he more than once cites some of the same sort of brutally coldblooded logic that was present then. Many of his other stories bear this same kind of mark. I was pleasantly surprised about a year ago by a side plot in a stand-alone novel from Michael P. Kube-McDowell - although he always seems to do solid research.



Got some suggestions? I'd love to hear about more such authors, who manage to teach, or at least stay in touch with economic realities while they entertain. Those authors who do a good job of this perform a real public service, while those who ignore it so that they can tell their story unencumbered by mere facts often earn their work a ceremonial throwing - twice across the room.



Caveat Emptor.

what happen when 401K leave blank on beneficiary

Nothing unless you die, and it's not covered in your will or other documents. Then the state's intestate code takes effect. Each state has a law for how the estates of those who die intestate will be divvied up. These laws were typically made generations ago, and the societal assumptions that they make are no longer valid. Furthermore, by failing to name a beneficiary, you are passing up on the chance to avoid probate, the legal process by which your estate is gotten to your heirs. Everybody has a probate, and fees are levied on the basis of the value of the assets that are in probate. For many assets, such as bank accounts and investment accounts, avoiding probate is as easy as naming someone a beneficiary, and any accounts where you have names someone a beneficiary go to them immediately upon proof of your death, outside of probate.

This is important because your heirs do not have access to those assets until probate is settled. This is a minimum of nine months, and in large complex cases can be a couple of decades. Probate fees are about seven percent per year, and until probate is settled, they might get to live in the house you left - but they can't sell the house if they need to move, or if, for instance, all of your assets are tied up in probate and they can't make the payments on the loan.

Most people do not understand the naming of beneficiaries, and never give it a second thought. Many times this translates to the first spouse still being the beneficiary of a policy of life insurance, when you divorced without children fifteen years ago, and now your second spouse has two young children to bring up without you, and without your life insurance proceeds. Even if the first spouse is generous enough to disclaim the money, since you obviously did not name your second spouse as a beneficiary, the money now has to go through probate.

Contingent beneficiaries are also important. Primary beneficiaries sometimes predecease you, or perish in the same accident. One common (and often worthwhile) tactic is to name spouses as primary beneficiaries, children as contingent beneficiaries. Many accounts allow the naming of secondary contingent beneficiaries as well. One approach is to name them individually, another to name them as a class ("all natural and adopted children of John and Jane Smith"), and two ways of accounting for their as yet unknown numbers of people who may be born later, "per stirpes" which is by branch, and "per capita" which is by head.

Every time you have a major life event, such as marriage, divorce, birth of a child, or the death of someone who is one of your beneficiaries, you should make a habit of going through all of your accounts and making certain the beneficiary designations are up to date with the new developments. Of course, if you have trusts and the like, this is also an ongoing requirement for them, and trusts are even better for avoiding unnecessary estate complications.

Caveat Emptor

If you've been around the financial planning business any length of time, you've likely run into the saying "The biggest risk is not taking one."



It is endemic to all financial instruments, indeed, all investments, that return is the reward for risk. It is axiomatic that the entity that takes risks gets the rewards.



Generic stock market returns are between ten and thirteen percent per year, depending upon who you ask and how you frame the question. Contrast this with the five or six percent that insurance companies will guarantee. You invest, you get five to six percent guaranteed. They use your money, they get the difference.



If you invest $100 per month at 5.5% from the time you are 25 until the time you are 65, the insurance company has guaranteed you about $174,000. If you annuitize that in a fixed annuity on a "Life with ten years certain" basis, you'd get somewhere between $1000 and $1100 per month if you're male. Ladies and gentlemen, that won't buy very much now, much less forty years from now with average inflation. Matter of fact, it's only about a 1.67 times overall return net of inflation.



Now $100 per month is a lot less than people should be investing for their own future, but it's indicative of the problem. Even if you contributed $1000 per month, which is more than most people can commit, between however many tax-deferred investments it takes, it's $1.74 Million, which goes to a payout of $10,000 or so per month if you annuitize at 65. Sounds like a lot of money today, right? But you're spending those dollars all in an environment where, at 3.5 percent inflation, $10,000 per month is about the equivalent of our $2500 per month now - and every year that passes in retirement, your money buys less.



Suppose, instead, you were to invest $500 per month - half what you had to come up with in the previous example - and invested it in the broader market, earning a 9 percent return, well below historical average market returns, and then in the final year you lost forty percent of your money due to a market crash? Think you'd be better off, or worse?



Slightly worse off, in raw numbers. $1.40 million ($2.34 million before the crash). For half the effort to save. This despite a major investing disaster at the worst possible time. But then let's say you manage to retain your intestinal fortitude, and instead of annuitizing on a fixed basis, you simply withdraw the same $10,000 per month we had in the previous example, while leaving it invested and generally earning 9%. Your money keeps increasing, and if you live to age 95, you leave 2.23 million dollars to your heirs, a sum that, if not so great as it sounds, will still buy a decent house in most areas of the country sixty years from now under our assumptions.



Now let's say that you want to live the same lifestyle, equal to $2500 per month now, that you have at retirement, so your monthly withdrawals increase by 3.5 percent per year. You didn't even have this option in the fixed rate examples. Your money lasts 19 years 3 months (plus a few thousand left over). Once again, for half the effort to save.



This is not wild risk taking. This is simply doing exactly what the insurance companies are doing, and assuming the investment risk yourself. Do not think for a minute that banks and insurance companies are insulated from failure if the market conditions go sour enough. They aren't getting the money to pay you from some kind of transdimensional vortex. If their investment results are bad enough so that they can't pay you, they won't. Government bailouts are also limited, and the government's guarantee programs are likely to undergo severe modification in the next forty years, as they deal with problems such as social security and medicare payouts that are much larger than what their pay ins will be. States, which generally stand behind insurance company guarantees, will not likely be in a stronger position than the federal government. Not to mention the kind of impact this sort of financial crisis will have upon government budgets.



Speaking of the banks, let us consider a hypothetical four percent CD, on a "taxed as you go" rather than tax deferred basis. Assume 28 percent federal tax rate, and 7 percent state and local. $1000 per month invested, every month for 40 years. How much does it turn into?



$842,800. As opposed to $1,044,600 just to break even with inflation at 3.5 percent per year and being able to buy the same stuff. I'd snark that you might as well bury it in a mattress, but in point of fact, that would only get you $480,000.



The point I'm trying to make here is that the so-called traditional "conservative" investments are anything but. If you aren't putting your money into investments where there is some market risk, then the only guarantee you have is the guarantee that it won't succeed, the guarantee that you will be living in poverty.



So in financial planning, the biggest risk is in not accepting some.



Caveat Emptor.

UPDATED here

It shouldn't surprise anyone that there are things you should do before you make your first investment. The SEC, NASD and all of the various other financial planning organizations all explicitly list three things that should be in place in most cases prior to making your first investment in anything.



The first of these is an operating reserve. This is a fund of ready cash outside of any investment account, that you can use for emergencies. The minimum is three months of your normal expenditures, but six months is better. People lose jobs, have accidents, have health problems, things come up - you get the idea. Unless your job is rock steady, your cash flow predictable, and you can live on less than fifty percent of your take home pay, you really want to have living expenses for six months saved up, and for some self employed situations where your cash flow is uneven (like say, financial planner or real estate), twelve months is better. Having this much cash on hand gives you a certain security, and you likely won't have to cash in your investment for some minor emergency.



The second of these is a life insurance policy. This isn't from any deep-seated desire to sell you a life insurance policy. Investment professionals have only been getting insurance licenses since about 1980, and this recommendation is far older than that. Almost everyone is going to need a life insurance policy at some point in their life, and it is cheaper and more effective to purchase while you are young. and especially before health problems are likely to develop. As I've found out, sometimes things happen to you that prevent you from obtaining life insurance (as in no company will issue you a policy, or will only do so on prohibitive terms), and if you want a family eventually, it is wise to take care of this now. Furthermore, certain life insurance policies are among the very best investments you can make, and more effective the sooner you start them. This is not to say that life insurance is for everyone. I have a client who's older, has no dependents and never will, has plenty of assets to cover final expenses, and those assets are titled so that they will pass immediately and correctly to his heirs. A life insurance policy would still be of benefit if he had certain goals, but he doesn't. So we've decided it's not for him.



The third of these is estate planning. This is actually in the requirements as a will, but there are other elements such as durable power of attorney for health care, living trusts, and so on. These do cost a certain amount of money, but it's money well spent. If something happens to you without doing this planning, every state in the US has a different law as to what happens to your assets, your minor children, your pets, etcetera. These are all cookie cutter approaches, and that cookie cutter was likely enacted a long time ago, to where the societal assumptions that the legislature made at that time are no longer valid for any large proportion of the population. The majority of your assets should not be transferred by a will, anyway - wills can be and are challenged successfully every day. Trusts are far better.



If the person you work with is any kind of financial planner, they should add two additional concerns to the list. They are disability income insurance and long term care insurance. The need for both goes away as you become more affluent. Remember, that insurance companies exist to make a profit and if you can afford the risk of losing what they insure, you shouldn't buy a policy. So if you've got a couple million somewhere, and if you never made another penny you would be comfortable, there is no need for disability insurance. The same applies to Long Term Care, albeit probably requiring more affluence. Average base per diem cost in California is $180, with another $60 or so in supplemental charges. So when you can afford $240 per day (between $85,000 and $90,000 per year) for a period of several years in addition to what ever else you may need for your family to live, you are not a good candidate for long term care insurance. On the other hand, long term care facility prices keep rising, and as medical capabilities for keeping you alive get better, you can expect to spend longer in such a facility.



(For all the money and research we throw at prolonging lives, you'd think we could spend more on making it a robust life, or allocate more of what we already spend towards that end. More and more, we are statistically tending towards living longer in an increasingly frail, helpless and joyless condition. As long as people are enjoying life, more power to them. When it becomes a miserable painful existence, as I have seen too much of, I just don't see the point. When I see what so many people put themselves or their loved ones through, I'm making certain I'll always have a "check out" option under my own control, and if I don't have control to exercise, my wife and I are agreed that neither one of us wants to hang around).



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Caveat Emptor

I have never liked or favored the estate tax, and yet I am very much of two minds about actually abolishing it. I'm glad of the benefits to the individuals involved, and yet it is only one of the issues involved in planning for what happens to all of us eventually, and abolishing it removes the most obvious motivation for handling the rest.



The benefit of abolishing the estate tax is obvious: people don't get taxed, so their heirs get what they earned rather than the government. This is a good thing, and I favor it for that reason.



On the other hand, there were so many mechanisms varying from outright gifting to 529 accounts to life insurance to trusts, each of which except the first can be used to retain control and benefits of assets while avoiding estate tax liability, that estate tax is and always has been essentially voluntary. You have to just not plan in order to pay estate tax, and some of the mechanisms available actually increase your available estate over what would have been its original gross value otherwise. Since we know that death is something each of us is going to have to face, there can be no reason except stupidity for not undertaking to plan for it. Estate tax was a voluntarily paid tax on stupidity.



Furthermore, there are other estate and contingency planning options that people need to take care of, and fewer people are doing so as estate tax was one of the primary levers that moved people to do it. All of this planning is just as necessary as estate tax planning, and usually taken care of at the same time.



Here are just a few of the other issues:



Will: The will probably should not be used for financial purposes, but resolves other functions such as who gets custody of minor children. Please note that a will is not necessarily binding upon the states where your will is probated, and can be challenged. Many wills are challenged, a large portion of them successfully, and even if your estate wins the battle it will be diminished in the process.



Durable Power of Attorney for Health Care: if you can't make health care decisions, this tells who you delegate that power to. If there's a court case brought, it's going to be very short and abrupt. Case closed.



Trusts, revocable and irrevocable. I'm not certain it's possible to successfully challenge a well-constructed trust where the assets that are actually transferred to it are concerned. You didn't own them. The trust does, and the trust didn't die. The instructions live on, like a corporation. The named successor trustee also usually gets the ability to manage the trust's assets if you are alive but incapable. Assets in a trust can avoid not only estate tax, but probate as well. If you want to be certain of the disposition of what you leave, particularly in a speedy manner, this is probably the way to go. Many estates are not finished with probates for years, and until they are, your heirs don't get control of the assets. Nor are we certain that estate tax is going away forever. Probate is also expensive, time consuming, and lucrative for attorneys. Seven percent of probated assets seems to be about the minimum cost, and it can easily top thirty percent. I haven't investigated, but I suspect the trial lawyers would be solidly behind banishing estate tax for this reason.



Business operations: many small to medium sized businesses have no plan to keep them going in the event the owner-operator dies or becomes disabled. Certainly nobody else working there has the knowledge, the experience, and often the necessary licenses. If the business closes because the proprietor isn't there, it's worthless. If there's a plan of succession to keep it open and operating, however, you or your family can likely sell it as a going concern with consistent profit.



Retirement plans: If you have certain types of tax deferred retirement plans, they can be expensive to convert to assets in your heirs' possession, even without estate tax. Better to draw these down and keep other accounts available.



Life Insurance: There are going to be expenses when you go. These vary from taking care of the body you leave behind to probate to keeping your business running if you have one. The people doing these things want cash. Life insurance is usually the cheapest way to pay them. Your family is also likely to need something to replace your income in many cases. Life insurance is about the only choice.



One hopes you begin to get the idea. Consult an attorney and financial professional in your area to find out how it works, but all of this needs to be taken care of, or your family will wish you had.



Caveat Emptor.



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