1. ©2015 College for Financial Planning, all rights reserved. Session 9 Investment Planning II CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Financial Plan Development Course

2. Start Recording This class is being recorded so you may review it at a future time. 9-2

3. Devil is in the Details of Asset Allocation Software Constraints Asset Class Returns & Risks What indexes are used? What time frames are used? What constraints are placed on asset classes? Forward looking or back testing? Correlation Coefficients Are the same indexes and time frames used? Your Design Constraints Standard or custom portfolio construction? Purchasing realities – limits, fees, timing? Firm Constraints Tracking and management? Personal constraints? 9-3

4. How does software create efficient frontier & asset allocation portfolios? Some portfolio teams determine assumptions about inflation, risk, returns, and correlations They define how much asset classes can vary Input portfolio models into program Maps current investments to asset classes Uses proxy index to determine returns and correlation coefficients Illustrate given portfolios on efficient frontier Using risk tolerance as guide, picks closest portfolio 9-4

5. Standard Asset Classes If you change asset classes and returns, assume responsibility for always updating the software. Most firms handle their own projections of returns and updates. How do they arrive at their assumptions? This is using 2.5% inflation compared to historical 4.38%. What relationship does this have with projected return and impact on projecting success of achieving goals? Note: There are no alternative investments but mid-cap stocks. Unclassified has no returns so assets are ignored in standard plan. You or your firm have to map assets that don’t match based on some characteristics. 9-5

6. Understanding Proxies and Time Frames If you were building your own portfolios, what time frames would you use for historical returns? Notice what happens when index wasn’t around for the time frame. How much will adding one year or changing the time frame make to projections? What difference would it make if you used 10 years vs. 40 years? 9-6

7. Asset Classes ≠ Real Portfolio Where do I put real estate? What about hedge funds? What about lifestyle/target funds? When you get a statement showing asset allocation, it doesn’t mean the clients are really invested there! It just means that assets are mapped there! 9-7

8. What about asset categories not listed? Here is how MGP maps asset classes. Other companies map differently. 9-8

9. Classification of Assets Some are easy to see why not allocatedOther unclassified may be not so easy to understand In any case, YOU have to decide where to put them based on return based on risk based on correlation based on coefficient of determination (R²) OR Create your own asset classes and mapping. Most large firms will provide this to users. Small and independent advisors must take more responsibility. 9-9

10. Asset Class Correlations (changes quarterly) Notice the difference between historical and projected. Who is doing the projection? What criteria are they using? How much faith do you have that it is right? What alternative do you have? What about asset classes not listed? 9-10

11. Creating the Efficient Frontier If you create custom portfolios, sometimes software changes the efficient frontier. Moved the efficient frontier so that now all company portfolios are inefficient! 9-11

12. Understanding Software Implications 1. Assumptions about projected returns, risk, and correlation are the basis for the efficient frontier and results. 2. The myriad investment choices must be directed into an asset class even if they typically vary based on risk or return characteristics. 3. Minimum and maximum constraints are usually added to program to minimize large swings, so not fully open model. 4. Every time the underlying projections are changed, it causes EVERY client’s portfolio allocation to change (even if it was done just yesterday; typically can’t recall the old allocation). 5. It’s a starting point. It incorporates important concepts and allows us to provide consistent advice, incorporating economic conditions and risk management. 9-12

13. Potential Model Portfolios 9-13

14. Portfolio Impact Can you explain why the confidence increases but then decreases? What do you think would happen if you decreased risk in retirement? Balanced I Balanced II Total Return II This is assuming Balanced I in retirement for all portfolios. Below is projected value remaining in current dollars at end of plan under average and bad timing. Note straight line results vs. Monte Carlo. 9-14

15. Tax Consequences When is it worth shifting to new portfolio? When will it break even? With $10k cap gains, takes 8 years to break even With just $5k cap gains, it takes 4 years, to break even with the increased return 9-15

16. Let’s Calculate Taxes How much in taxable accounts needs to be moved to comply with portfolio? (Annuity addressed next.) 1. Which accounts will have tax consequences if moved? Long-Term Bonds (Muni’s) and Small Cap Growth 2. Determine amount needed to sell to match new asset class: Long-Term Bonds = 0, so sell all. Small Growth Stocks would be pared down to $24,240, so sell $16,227. 3. Calculate tax consequences. o Determine taxable gain for component being moved by multiplying gain percentage times amount being moved. Long-Term Bonds (Muni’s) $67,444 * 3.62% gain = $2441 taxed. Small Cap Growth sell = $11,279 * 25.87% gain = $2917.87. o Determine rate: 15% long-term or 25% (+ 4.63% state) for short term or ordinary income by looking at chart: Muni’s short-term gain, Small Cap Growth long-term gain o Calculate tax consequence by multiplying rate by taxable amount. $2,441 *.2963 = $732.27 for Muni. What will tax be for Small Cap? 9-16

17. Addressing the Annuity Options? Cash in fixed annuity and pay ordinary income tax rates plus 10% penalty if before 59½. Gain of $4,524 would have tax of $1,340.38 plus penalty of $452.37 = $1,792.75. Keep, and be out of compliance with model or use to replace some municipal bond portfolio. 1035 exchange into variable annuity 1035 exchange into long-term care now or later NOT subject to surrender period now. If 1035 into variable contract, surrender period starts over for five years and fees will be.5 high 9-17

18. Impact of Taxes Tax impact without annuity ranges from around $1,300 to $1,550 If you sell, the annuity sale generates tax of $1,340 plus penalty of $452 for total of $1,793 Must carry the cost of shifting into the cash flow for the financial plan so full resources continue to be invested Can use gifting of $4,000 per year to offset planned gains and reduce cost of rebalancing (covered next week). 9-18

19. How are you structuring? DudellasDowlers One portfolio: Because everything else will come from cash flow not investments No ability to do asset class tax planning because of emergency funds or qualified money for now You choose: One overall asset allocation with plan for shifting assets to match duration for college or Two asset allocations: one for retirement, one for education Strategy for annuity Strategy for asset class placement and types of account 9-19

20. In Your Executive Summary Explain risk return concept Define which portfolio(s) you are recommending and why Use the tax cost in the disadvantages Address the annuity in a separate recommendation: keep, sell, or 1035 exchange Explain that the next step will be creation of Investment Policy Statement and selection of specific investments, which could create a different tax situation When you get to retirement, education, and cabin accumulations, define the VEHICLES! 9-20

21. Any questions? 9-21

22. Crafting Define current and proposed asset allocation characteristics (qualified, nonqualified, total portfolio, per account or per bucket) X Create Investment Policy Statement Craft Transition Plan Map existing investments to new plan Identify asset class shifts to accomplish new targets X Identify underperforming assets within asset class X Determine tax consequences of total shift and transition strategy X Evaluate and select recommended investments X Explore impact on other areas or tax efficient method of transitioning X Craft plan and share with client and advisors 9-22

23. Next Class Tax Planning Read Chapter 4 Complete Plan Development boxes #17, #18, & #19 Tax Projections Tax Opportunities and Concerns Flexible Spending Accounts Gifting Appreciated Stock 9-23

24. ©2015 College for Financial Planning, all rights reserved. Session 9 End of slides CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Financial Plan Development Course