1. Common Mistakes in Modeling Financial Strategies George K. Chamberlin, JD Vice President – Financial Strategies F I N A N C E W A R E ®

2. Common Mistakes in Modeling Financial Strategies ® Building PAGE 2 Modeling Financial Strategies Central to the advice process for our clients is the modeling of the financial strategies we create and recommend, as well as illustrating potential problems with clients’ existing financial strategies. However, our advice is only as good as the modeling that we do and such modeling depends a great deal on the inputs and framing the appropriate questions. We know that garbage in means garbage out and want to avoid wasted effort on meaningless modeling. Today, we will examine some of the most common modeling mistakes made by advisors and will talk about some ways to make your modeling more effective in the future. Then we will look at a few higher level techniques in modeling.

3. Common Mistakes in Modeling Financial Strategies ® Building PAGE 3 Common Questions and Issues Importance of Common Inputs » Ages, dates and life expectancy » Blended income tax rates » Retirement spending level Asset Allocation » Expense Ratio » Municipal Bonds Cash Flow Definitions » Required minimum distributions; 72t distributions » Section 529 plans » Insurance proceeds

4. Common Mistakes in Modeling Financial Strategies ® Building PAGE 4 Ages and Life Expectancy Using a realistic life span for each person is critical » Use appropriate time horizon based on actual life expectancy » Too short a time horizon risks running out of money before running out of life » Cutting off a scenario before last death may be problematic Ages associated with cash flows may have a huge impact » Event driven start and end dates » Retirement age variations » - Social security benefits » - Taxation of cash flows » - Inflation prior to beginning cash flow » First or second death

5. Common Mistakes in Modeling Financial Strategies ® Building PAGE 5 Retirement Triggered Items Retirement Spending Need » Client AND/OR Spouse? » Inflation is essential » Adjust for taxes Blended tax rates during retirement » Apply to cash flows such as Social Security, pensions, rental income » Do NOT apply to return on investments » Blended rate should never be set to zero

6. Common Mistakes in Modeling Financial Strategies ® Building PAGE 6 Asset Allocation Inputs Expense ratio may be essential since it allows the advisor to reflect fees associated with the management of client portfolios. Municipal bonds should be entered as the specific asset class as opposed to entry as a tax exempt item. The new asset allocation page offers numerous selections for the advisor.

7. Common Mistakes in Modeling Financial Strategies ® Building PAGE 7 Cash Flow Definitions – Qualified Plans One of the most common modeling problems experienced by advisors involves the distributions taken from qualified retirement plans (401(k), 403(b), IRA). Required Minimum Distributions Where an RMD is to be taken from a qualified retirement plan following the participant’s attainment of the required beginning date (age 70 ½), the RMD is automatically taken and applied to cash flows such as retirement income need. There is no need to enter the RMD as an item of retirement income. There is no need to enter a separate withdrawal for the RMD from the asset. Qualified plan distributions prior to the required beginning date – not RMDs – may not be effectively modeled since withdrawals are always taken from the most tax advantageous account and the target account may not be identified by the user. However, where the tax- advantaged accounts such as qualified retirement plans are the only assets, withdrawals as by way of a series of substantially equal periodic payments may be modeled.

8. Common Mistakes in Modeling Financial Strategies ® Building PAGE 8 Cash Flows – SOSEPP Where a client is taking section 72t distributions (SOSEPP) the best modeling technique is to omit the qualified plan from the holdings and to show the distributions as a taxable cash inflow. If the amount is an annuity, simply enter the annuity without any inflation. However, the cash inflow should be inflated to reflect both the anticipated growth of plan values AND the annual increase of distribution amounts where the distribution is based on life expectancy. If the distributions are not expected to reduce the value of the plan to zero, then a cash inflow of the appropriate remainder at the termination of the SOSEPP would be helpful. The suggested SOSEPP model is not an exact science when this approach is taken. However, it is a useful approximation of the impact of the SOSEPP and should not materially affect results.

9. Common Mistakes in Modeling Financial Strategies ® Building PAGE 9 Cash Flows – Education and Section 529 Education Planner Screen » Do NOT use this screen to enter Section 529 plans » This screen reflects need for education to be funded from the regular portfolio assets and cash flows Common Misconceptions about Section 529 Plans » Although the client funds a section 529 plan, the client DOES NOT own it » -The plan should NOT be included as a holding » -By law, the plan is not included in the donor’s taxable estate » By definition the section 529 plan is a gift to the named recipient » -There may be gift tax consequences for transfers » -The ability to designate different recipients is not the same as ownership » Though the donor MAY be able to take money out of a section 529 Plan, » -There will be income tax consequences including penalties » -Withdrawal defeats the purpose of the gift

10. Common Mistakes in Modeling Financial Strategies ® Building PAGE 10 Cash Flows – Life Insurance Proceeds Another common problem area involves the modeling of life insurance. The death benefit should be entered as an item of retirement income. This reflects the cash flow at the death event for the insured. It should not be adjusted for taxes since the proceeds are typically not taxed. The death benefit should NOT be entered as a tax-exempt contribution. The proceeds will almost never be paid into a Roth IRA account or its equivalent. More often, the proceeds are invested in the regular taxable portfolio or are used for specific expenses. The cash value should be entered as a Holding ONLY if the client plans to borrow against the cash value to fund retirement need or other goals. If it is available for these goals, then the death benefit modeled – if any – should be correspondingly reduced to reflect both the borrowing AND the cost of borrowing.

11. Common Mistakes in Modeling Financial Strategies ® Building PAGE 11 Advanced Modeling Issues There are innumerable strategies and techniques that may be employed in creating financial advice for our clients. Proper modeling helps us to help our clients assess the strategies and their needs. We will overview of several common modeling issues – more complete information is available on the site at User Resources for each of these topics. » Long Term Care insurance » Long Term Disability insurance » Pension Distribution Choices » Retirement spending level

12. Common Mistakes in Modeling Financial Strategies ® Building PAGE 12 Modeling Long Term Care Insurance Analysis Begin with the Base Scenario or current planning for the client » Copy the scenario and introduce a withdrawal to represent the anticipated need » The need may be worst case or average need – duration and amount » The result may show that there is a potential need for insurance » Copy the scenario illustrating need – this will show impact of adding insurance » Add the inflow of long term care insurance benefits to the scenario » Note that both duration and amount should be realistic » Add the outflow for the insurance premiums for the insurance » Obtain the amounts from an insurance agent if you don’t have them » The client can make an informed decision based on the information provided

13. Common Mistakes in Modeling Financial Strategies ® Building PAGE 13 Modeling Long Term Disability Insurance Analysis Begin with the Base Scenario or current planning for the client » Copy the scenario to illustrate potential consequences of a disability » The scenario should reflect termination of income for the disabled person » Contributions may cease for the disabled person » Show expenses of the disability such as medical costs » Set the duration of the disability » Note particularly the impact on the overall financial strategy » Copy the scenario illustrating disability so we may reflect impact of insurance » Add the inflow of long term disability insurance benefits to the scenario » Note that both duration and amount should be appropriate » Add the outflow for the insurance premiums for the disability insurance » An insurance quote – or your own insurance costs – may be helpful » Note the impact of adding insurance and fine tune to fit in with the other priorities the client has explained.

14. Common Mistakes in Modeling Financial Strategies ® Building PAGE 14 Modeling Pension Distribution Choices Clients often have a choice of different methods for receiving pension distributions and will wish to evaluate these methods before making a selection. Married clients typically have three choices: » Joint and survivor annuity which pays until the death of the second of them. Note that the amount received by the survivor may be lower » Single life annuity – based on the life of the pensioner – generally has higher payout but is limited to that person’s life » Lump sum – an immediate payout reflecting the present value of the stream of annuity payments available under the other options Model each choice in a different scenario and compare the results » Provides a powerful illustration for the clients – allows an informed decision » The employer typically provides the actual amounts expected under each choice making it easy to input the information for comparison » Each scenario will incorporate all the other goals and priorities the client has expressed

15. Common Mistakes in Modeling Financial Strategies ® Building PAGE 15 Determining Retirement Income Need One of the central aspects of any financial strategy is determining the amount that the client will need to spend during retirement in order to ensure the desired lifestyle. Modeling the different approaches helps to put the issue into focus and allows both advisor and client to think about the process. » Base the anticipated need on net income as adjusted by actual expenses » Remember that it is hard to predict expenses in future » Base the anticipated need on a budget established by the client » Again, it is hard to predict the future, particularly in terms of expenses » Base the anticipated need on actual pre-retirement income » Remember that expenses during retirement are usually much lower » Base the anticipated need on some percentage of pre-retirement income » How much is too little or too much?

16. Common Mistakes in Modeling Financial Strategies ® Building PAGE 16 We’ve looked at some common modeling issues. Are there any questions? Thank you, George Chamberlin gchamberlin@financeware.com (804) 644-4711 ext. 138