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Wealth Management

The Wealth Management Process

It seems difficult these days to avoid hearing about financial matters. The sources of information have exploded as newspapers, magazines, internet, and financial news outlets such as CNBC, newsletters from legal and financial professionals, seminars, and even friends and family provide an almost countless source of information.

Over the years various phrases have been associated with financial matters including financial planning, estate planning, tax planning and many more. The most recent phraseology focuses on the term “wealth management”. There are four phases of the wealth management process – accumulation, utilization, preservation, and transfer. Wealth is a relative term, but the process is not solely for the wealthy. We all accumulate wealth. Once we have some measure of wealth we desire to protect it and utilize it. Since “we can’t take it with us”, we leave it to family, friends or charity.

Accumulating wealth is a simple concept – generate income in excess of expenses. Wealth accumulation flows from work and savings and sometimes the receipt of wealth from others.

Utilization of wealth is sometimes fun (taking vacations or buying “toys”) and sometimes a requirement (living expenses, education, medical, etc.).

Preserving wealth is taking steps to protect your wealth against, taxes, inflation, market fluctuations, and excess consumption. Concepts such as diversification, asset allocation, asset location and risk management are essential in this segment of the process.

Providing for the ultimate transfer of wealth at death is understandably uncomfortable for some. The inner gratification we feel from a receiving a raise or bonus, a gain from an investment, reaching retirement, giving to a charity or family members is not necessarily present when one has a Will or trust drafted that takes effect at death. Still, the transfer of wealth is vitally important (“Failing to plan is planning to fail.”)

In the coming months we will examine various topics in the financial world and how they relate to the wealth management concept. There is great potential for tax law revisions, and changes in retirement plan and investment rules. Market volatility is likely to continue. All of these will most likely impact your wealth management strategy in some fashion.

Wealth Accumulation

Wealth accumulation, in its simplest form, is the excess of income over expenses. The main sources of income are from work, previously invested savings and for some, the receipt of wealth from another person. Expenses include housing, utilities, transportation, living expenses, taxes, medical, education, expenses related to preserving wealth, not to mention “fun stuff”. While the concept of spending less than you receive is simple, many people do not really know where their money goes. They may only address the matter when facing the opportunity or the need to make a specific expenditure but find that the funds available come up short.

For many of us, income is generally received at regular intervals. Likewise, many expenses also arise on a regular basis. But some significant expenses can be unexpected or occasional. Thus, the first step for many should be to work out a budget that identifies income and expenses. The “wealth” that remains is available for saving. For those who work, there are several opportunities to amplify those savings using IRAs, profit sharing and 401(k) plans, and cafeteria benefit plans to name a few. These vehicles all have tax benefits and some may even enjoy a shared contribution by an employer.

We would like to utilize all the above savings vehicles to the greatest extent possible. However, that is not always viable for many. Some vehicles may not represent a usable benefit. For instance, child care expense plans will likely be used by younger married workers, as opposed single workers or empty nesters. Many tax favored savings vehicles result in limited availability of the funds once they are set aside. It is important to allocate savings to the appropriate account. Current law allows IRA (traditional or Roth) contributions of up to $5,000 per year. Also, the maximum elective 401(k) deferral amount is $16,500. Thus an individual can effectively save $21,500 for retirement. (For those over age 50 the limits are higher.)

IRAs and 401(k) plans each have benefits and limitations. For instance, a contribution to a traditional IRA may be tax deductible. However, a contribution to a Roth is not. Earnings in a traditional IRA are tax deferred, meaning no tax is paid until funds are withdrawn. Earnings in a Roth are permanently tax free. Deferring money in a 401(k) may generate a matching contribution by the employer. 401(k) plans may provide for purchase of employer stock. Employer stock received from a plan at retirement may be subject to favorable tax treatment.

Relatively new, but gaining popularity is the “Health Savings Account” or HSA. More and more employers are providing “high deductible health plans”. Participants in these plans may contribute to an HSA directly or through payroll withholding. In addition, employer contributions or employee salary deferrals to the HSA are not subject to FICA taxes. Earnings in the HSA are tax free if used for qualified medical expenses.

Not only are working and saving important, but where and how you save are important too!

Wealth Preservation - Investment Planning

Once one has accumulated some wealth, taking steps to preserve it is as important as acquiring it. Accumulated wealth can be eroded by investment expenses, taxes, market fluctuation, inflation, unexpected expenses, or major life event (job loss, divorce, or illness).

Fortunately, many strategies can mitigate the potential erosion. In designing an investment plan, many factors influence the choice of a strategy. No investment plan should be governed by a single factor. The major factors that go into the design of a plan are risk tolerance; liquidity needs both in time and amount, and current market conditions. These factors also indicate that investment planning is not a one time event, but rather an ongoing process.

The initial decision made in investment planning process is asset allocation. Asset allocation determines the amount and types of assets that are expected to provide the anticipated or required return consistent with the allowable risk tolerance. Asset allocation determines the amounts of various asset classes (stocks, bonds, CDs, real estate or other assets). Each asset class will be further allocated based on specific characteristics such as domestic or foreign stocks; market capitalization; credit quality and term; taxable, tax-exempt, or tax-favored; and specialty assets.

Asset “location” is also an important concept to consider. Because there are many saving and investing vehicles available today, a comprehensive investment plan should consider the location of the assets. For example, assume the investment plan for an individual recommends an equal asset allocation (50% / 50%) to stocks and bonds. If the individual has a regular investment account, an IRA and a 401(k) plan, the simple answer would be to apply that asset allocation in each account. But the simple answer is not always the best answer. Because IRA and 401(k) accounts are tax deferred, a well designed investment plan would treat the accounts as one large investment account instead of three separate ones. It may be advisable to “locate” the bonds most heavily in the IRA and/or 401(k), while locating most of stocks in the regular brokerage account. Asset location is increasingly important as more income sources come into play (Roth IRA, employer stock plans, inheritances, annuities, Social Security or other defined benefit).

Earlier in the discussion, we noted that investment planning is an ongoing process. That leads us to the concept of “rebalancing”. Rebalancing is important because most likely each individual investment will not have the same actual return performance. So in order to maintain the desired asset allocation it is likely that assets will need to be repositioned to maintain the target asset allocation. Rebalancing would be needed if the target asset allocation changes in the future.

Wealth Preservation - Dealing with Risk

When speaking of “risk” with respect to investment planning, we generally refer to circumstances or events that can cause a significant decline in the asset base such that the assets do not adequately provide for anticipated requirements. Specific risks include investment underperformance or decline, deflation or inflation, outliving your portfolio, family illness, death of an income provider, divorce, job loss or unexpected liability.

When speaking of risk tolerance, we refer to the ability to absorb a loss, without otherwise adversely impacting our normal routine. The level of risk tolerance for any one person is dependent on many different factors (age, health, current and future income sources, current or future monetary obligations, and even personality).

When speaking of risk management, we refer to the process of identifying specific risks, identifying the potential loss or financial impact, and taking steps to reduce the risk of loss or mitigate a loss that does occur.

It is important to note that it is nearly impossible to eliminate all risk. In some instances, reducing or eliminating a specific may increase a different risk. For example, an investor who wanted to construct a “risk-free” investment portfolio would likely choose assets such as U.S. Treasury obligations and insured bank certificates of deposit. While return of principal is practically assured, that investor faces risks nonetheless. If inflation occurs, the purchasing power of his income is reduced. He may be required to spend a portion of the underlying principal to supplement the income. As life expectancies increase, the effects of inflation are further intensified because the consumption of principal may occur over longer time.

To compensate, an investor could allocate a portion of the portfolio to equities. Assuming that equities grow over the long term, some of that growth could be reallocated into income producing investments in order to grow the income base. As you can see, risk is not eliminated. The investor takes on more market risk in the equities in order to address inflation and longevity risk.

Risk management also entails the use of insurance. Insurance is used to mitigate the impact of a loss. Insurance does not reduce risk, but rather replaces some or all of the loss. The cost of insurance is based on the level of risk one is willing to accept. Life, health, property and casualty, disability and long term care insurance coverage should be integral parts of your wealth management strategy. A periodic insurance review should not be overlooked. Our insurance consultants would be glad to discuss this with you.

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