Transcript CERTIFIED FINANCIAL PLANNER™ CERTIFICATION …

CERTIFIED FINANCIAL PLANNER CERTIFICATION
PROFESSIONAL EDUCATION PROGRAM
Financial Plan Development Course
Session 8
Investment Planning
©2015, College for Financial Planning, all rights reserved.
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8-2
Investments: The Basics
Financial Planner’s Job
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Clear understanding of portfolio characteristics needed to achieve client goals and
timelines
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Knowledge of portfolio risk, both short- and long-term
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Consideration and incorporation of tax strategies and consequences
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Helping client understand how these fit together
in their lives and avoiding inappropriate reactions
(This one is the hardest!)
Familiarity with specific strategies: risk reduction, income generation, growth, etc.
Ability to evaluate individual investments and how they fit in portfolio and/or
evaluate third party managers
Understanding and proactive planning for consequences of economic trends
Methods of managing and integrating multiple accounts by multiple providers
including qualified plans
8-3
The Investment Process
Step 1: Gather Information
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Most facts are easy, simple-to-get documents.
Cash flow requirements, timelines, and goals are more difficult because many clients don’t think
past this quarter.
Knowledge about the client is hardest and the most important; it requires good listening skills.
It defines the success or failure of your client relationship.
Knowledge about facts
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investments
basis
tax situation
risk capacity
timelines and goals
liabilities
resources and liabilities that
don’t show on official balance
sheet
• cash flow requirements
Knowledge about client
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attitudes
past experience and behaviors
risk tolerance
portfolio expectations
engagement
expectations
8-4
Step 2: Analyze
Required portfolio characteristics
Uncommon issues and impacts
• Time frames
• Unique assets
• Cash flow requirements
• Concentrated positions
• Risk capacity
• Asset retitling/gifting plans
• Risk measurement
• Business ownership with cash flow
and disposition plans
• Vehicle structure(s)
• Tax issues – income and cap gains
• Estate planning coordination
Client expectation management
• Management of special assets,
impact on insurance needs, etc.
Overlay economic conditions
• Mental accounting
• Volatility/risk tolerance
• Return expectations
• Investment management services
expectations
• Sophistication level
8-5
Define Risk Parameters
Risk
Tolerance
Risk Capacity
how much volatility will a client be willing to accept before
withdrawing their money when the market is down to
achieve a higher overall return
measures the amount of financial cushion or safety net
available to a client before and after an investment decision
has been implemented (maximum amount that could be lost
or minimum floor for accounts)
Time
Horizons
when and how much will the client withdraw to meet
specific goals
Required
Rate of
Return
measures what return a client needs to earn to achieve their
goals with the resources and anticipated contributions
Don’t force your own risk tolerance on the clients—bad things
could happen.
8-6
Clients
Considerations
Dudellas
Dowlers
Time frames
Outflow: next 4 yrs. for
college, 5 yrs. for car, 20
yrs. to retirement, 31
yrs. planned distribution
13 yrs. to first planned
withdrawal, 20 yrs. to
retirement, 31 yrs.
planned distribution
Cash flow requirements
Risk that may need to
tap due to lack of
reserves
None anticipated for 13
yrs.; partial risk until
emergency reserves
funded
Risk capacity
Maximum loss between
$20,000–$40,000 if
implement risk plans
Maximum loss between
$50,000–$100,000 if
implement risk plans
Risk tolerance
Below average, but
investment choices/
portfolio do not match
risk tolerance
Average risk but
portfolios and risk
tolerance do not match
8-7
Clients
Considerations
Dudellas
Dowlers
Vehicle structure
Nonqualified assets
depleted. Do not qualify
for deductible IRA,
qualify for Roth IRA,
employer match not
captured, have access to
stock purchase plan and
other employer plans
next year.
Currently have mixture.
Do not qualify for
deductible IRA, qualify
for Roth IRAs, have room
in qualified plans but
capturing all matches.
No options/restricted
stock, etc.
Tax issues
25% federal, 4.63%
state, no tax carry
forwards, underwithholding, education
tax credit options.
25% federal, 4.63%
state, no tax carry
forwards, state gives tax
deduction for 529 plan,
child tax credit phaseout
issue.
Estate tax planning
concerns
No special
considerations.
No special
considerations.
8-8
Clients
Considerations
Dudellas
Dowlers
Mental accounting
Education first so
everything wide open for
that goal.
$22,000 of municipal
funds for college.
Volatility/risk tolerance
High concern, reduce risk Past strong response to
until reserves built and
market downturns,
risk plans in place.
disparity between stated
risk and current portfolio.
Return expectations
5.5% with 2.5% inflation
was acceptable and
allows client to achieve
goals. Client seemed to
understand discussion.
5.5% with 2.5% inflation
was acceptable and
allows client to achieve
goals. Client seemed to
understand discussion.
Sophistication level
Moderate to high on
taxes and employer
benefit, low on
investment
characteristics.
Moderate: less sure of
asset classes, theory,
fees, risk and return
measures, used to
mutual funds & ETFs.
8-9
Impact of Client Expectation Management
Sophisticated Client
• Asset allocation for entire
portfolio across multiple
accounts
• Matching of vehicles and
specific investment types
• Diversification of vehicle
types and management styles
• Combined cash flow duration
with complex cash flow plan
• Statistical analysis and
quarterly reports
Unsophisticated Client
• Account for each goal
• Asset allocation in each
account or combo
• Durations matched to
individual goals
• Passive management with
few changes
• Semiannual or annual high
level investment review
related to goal achievement
8-10
Assessing Risk Tolerance
In setting risk tolerance:
• Give more than one risk
tolerance questionnaire
• Get client to review gains
and losses in current
portfolio for different time
periods
• Look at worst case and goal
achievement
• Discuss your assessment of
their risk capacity
• Get client to consciously
choose and verbalize
risk/return so you know
they understand!
When actual risk vs. profile
risk don’t match, find out why:
• Unaware of current risk due
to lack of knowledge
• Doesn’t believe risk really
applies to them
• Hears risk questions and
magnifies risk implied (10%
loss becomes 25% in their
mind)
• Investment choices were
presented in terms of gain,
not loss
• Discuss choice satisfaction
and history to understand
how they got there
8-11
Determining Risk
Consider Time Horizon & Risk Tolerance
Time Frame
High Risk Tolerance
Moderate Risk
Tolerance
10+ years
Aggressive
Moderately Aggressive
Moderate
7 to 10 years
Moderately Aggressive
Moderate
Moderate
3 to 7 years
Moderate
Moderately Conservative
Moderately Conservative
1 to 3 years
Moderately Conservative
Moderately Conservative
Conservative
Less than one year
Conservative
Conservative
Conservative
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Low Risk Tolerance
When you add in RISK CAPACITY it can change the mix based on size of portfolio.
Client sets risk capacity floor at $500,000, 10+ time horizon, and high risk
tolerance:
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Investments are worth $2,000,000: Aggressive portfolio
Investments are worth $550,000: Moderate
The time frame and risk capacity should shift portfolio chosen after portfolio
indicated.
8-12
Clients
Uncommon Issues
Dudellas
Dowlers
Unique assets
Stock purchase plan
None
Concentrations
Potential in future
None
Asset retitle or gifting
Willing to consider
shifting assets for
education
Willing to consider
shifting assets for
education, also using
charitable gifting
strategy within current
gifts
Business implications
None
None
Impact on insurance
needs
None*
None
*concentration in future could impact
8-13
Unusual Situations
What would you do with…
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Timberland investments in Alaska with special tax treatment?
Partial venture capital ownership of fishing vessel?
Private annuity with family member?
Two businesses owned in different countries with
currency, tax, and ownership issues by divorcing couple?
• Fake investments?
• Business cash flows hidden from the IRS?
• Unusual nonqualified restricted stock plans based on
relationship of market return to stock return?
TIP: If you uncover something that is unfamiliar, ask for
documentation and permission to call client or other advisors
for additional information.
• Then research/find expert to assist before completing analysis.
• What you don’t know can hurt you and the client.
• How would these assets impact other parts of plan, like
life insurance?
8-14
Clients
Uncommon Issues
Dudellas
Dowlers
Investment management Creation of investment
services expectations
policy statement and
adherence to it.
Semi-annual meetings:
one focused on cash flow
and taxes, one on
returns compared to IPS
and goals.
Creation of investment
policy statement and
adherence to it.
Quarterly reviews
compared to IPS and
goals.
Annual return discussions
of 3% real return goal.
Annual return discussions Willingness to take some
of 3% goals and updated loss to protect downside.
financial projection.
Your constraints
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?
8-15
Investment “Vehicles”
Vehicles + Asset Allocation + Specific Investments
= Portfolio Designed to Meet Client Needs.
• Tax-advantaged plans – IRAs, Roth, 401(k), 403(b), etc.
• 529, Coverdell, Series EE bonds
• Nonqualified investment accounts, brokerage, managed,
pooled, self-directed, set portfolios, customized
management, multiple managers
• Trusts
• Annuities – immediate, deferred, variable, fixed
• Life insurance – variable, fixed
• Mutual funds, lifestyle funds, ETFs, individual stocks and
bonds
8-16
Considerations for Vehicles/Structure
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Size of portfolio that would be in vehicle
Income and estate tax situation of owner(s)
Owner desire to be engaged in active management
Active vs. passive management
Expenses
Liquidity characteristics
Your investment management capabilities defined by time
management/profitability and firm constraints
8-17
Which Vehicles?
Dudellas
Municipal money market for most reserves
Roth IRA for additional reserves and
accumulation with tax diversification –
creditor protected
Dowlers
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Why?
Employer plan to capture match and
reduce taxes
529 Plan? To transfer money?
Stock purchase plan?
8-18
Impact of Vehicle Choice
Traditional IRA
Roth IRA
Impact of shifting $4,000 per year from traditional to Roth for 58-year-old until age 62.
8-19
What do you know about Roth IRAs?
8-20
Roth IRAs
Recommendation: Fully fund Roth IRAs starting in year 2015.
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Clear, actionable recommendation
Advantages
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Contributions can be withdrawn without taxes or penalties at any time.
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Not required to ever make withdrawals.
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If held at least from years from initial contribution, can withdraw earnings without tax or penalty.
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Creditor protection up to $1,000,000 from bankruptcy but not lawsuits; based on state.
Earnings accumulate tax-free.
Great for accumulating large chunks of money to pull out for goals after 59½ to avoid spikes in
tax bracket.
Great to use for accumulating medical retirement reserves (average couple age 65 will spend
$240,000 for medical expenses during retirement).
No tax or penalty if withdrawn after 59½, in case of disability, first home purchase, medical
premiums while unemployed, qualified higher education expenses, unreimbursed medical
expenses in excess of 10% of AGI.
May use substantially equal payments to avoid taxes and penalty .
Allows management of taxes in retirement by balancing income from qualified plans and nontaxable distributions from Roths along with other sources like Social Security and after-tax
investments.
8-21
Roth IRAs
Disadvantages
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No tax deduction compared to IRAs or 401(k)s.
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Earnings withdrawals that do not meet those listed above are subject to
tax plus 10% penalty.
May be phased out due to income restrictions in the future.
Limited to $5,500 per person as long as earned income meets it.
Additional catch up of $1,000 when over age 50.
Alternative: Continue accumulating in taxable accounts for any goals you
believe they may need prior to age 50 (no tax advantage, however) or put
more in qualified plans. If withdrawing the money from qualified plans for
lump sum like cabin, may offset value of tax deduction.
8-22
When Writing Vehicle Recommendations
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If there are tax rules, be
specific and complete.
Give the client enough
information so they can make
informed decision.
Protect yourself by writing the
details in and checking your
sources so you are
knowledgeable and don’t make
errors in your explanations of
penalties and rules.
Once you have them written,
they are easy to copy and paste
into many client reports.
8-23
Vehicle & Construction Recommendations
Move your largest old 401(k) plan into an IRA. The other
is being transferred to your qualified plan to allow a loan.
Advantages
• Asset allocation is more easily managed with wider choice of
options and quicker response time
• Internal investment fees may be lower than old 401(k)
• Asset allocation being monitored by a professional
• No tax consequence for moving
Disadvantages
• Loses some but not all protections from creditors based on your
state of domicile
• Loses pension guarantee protection from federal government
• Paperwork and time
8-24
After Analysis
Define current and proposed asset allocation characteristics
(qualified, nonqualified, total portfolio, per account or per bucket)
Create Investment Policy Statement
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Draft
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Review and agree with client
Craft Transition Plan
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Map existing investments to new plan
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Identify asset class shifts to accomplish new targets
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Craft plan and share with client and advisors
Identify underperforming assets within asset class
Determine tax consequences of total shift and transition strategy
Evaluate and select recommended investments
Explore impact on other areas or
tax efficient method of transitioning
8-25
Common Client Asset Allocation
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Buy one of everything in every account
o Difficult to figure out asset allocation or risk
o Ends up with eight different small-cap funds or worse,
eight different lifestyle target funds with $500 each
Don’t know what to do so put all in cash or all in one stock
fund
o End up with concentration
Never rebalance:
o Results in concentration
o Results in assuming either
more or less risk than
anticipated
8-26
Dowlers’ Current Portfolio
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What is the mix between stocks and bonds?
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How efficient is portfolio?
What is standard deviation and
return?
Will it meet their goals?
What can you tell about their prior decision making?
How do Jim and Anne differ?
Anne's
401(k)
Cash & Equiv.
Short-Term Bonds
Int. Term Bonds
Long-Term Bonds
Large-Cap Value Stocks
Large-Cap Growth Stocks
Anne's
Fixed
Annuity
Anne's
IRA
Jim's
401(k)
Jim's
Trad.
IRA
Joint
Large Cap
Growth
Joint Muni
Bonds
Joint Small
Cap Growth
$32,889
$15,073
$9,762
$9,762
$83,924
$67,444
$7,537
$7,537
$26,987
$18,341
Mid-Cap Stocks
$
$32,889
$108,759
$77,206
$7,537
$34,524
$18,341
$40,467
Small-Cap Stocks
$40,467
$
Int. Dev. Stocks
$165,071
Int. Emerging Stocks
Total
Total
$30,147
$19,524
$83,924
$183,412
$165,071
$32,889
$26,987
$67,444
$40,467
$484,794
8-27
Performance Measurement
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Alpha (Jensen Index)
Treynor Index
Sharpe Index
Information Measure
8-28
The Jensen Index (Alpha)
a  rp  rf  rm  rf β
• Measures whether the actual return exceeds the
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return that should have been earned based on
the CAPM
An absolute measure of return
8-29
Treynor Index
• A relative measure, used
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for comparison: the
higher the better
Beta needs to be reliable
Formula is provided on
test
8-30
The Treynor Index
Standardizes the return in excess of the risk-free
return by the portfolio’s beta
Ti 
rp  rf
β
8-31
Treynor Calculation
You have to choose between the following two
funds; the current risk-free rate is 5%.
• Fund A: 18% return, beta of 1.3
• Fund B: 14% return, beta of 0.85
Fund A
18 – 5 = 10
1.3
Fund B
14 – 5 = 10.59
0.85
Answer: Fund B with the higher Treynor ratio
8-32
Sharpe Index
• Can be used when beta is
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not reliable
Calculation is similar to
Treynor; Sharpe uses
standard deviation in the
denominator, Treynor
uses beta
Relative measure used for
comparison; the higher
the better
Formula provided
8-33
Sharpe: Used for Reliability
Sharpe standardizes the return in excess of the
risk-free rate by the portfolio’s standard deviation.
Sp 
rp  rf
σp
8-34
What would you rather have?
Mnemonic you won’t forget:
Testing portfolios for diseases:
SD
or
Sharpe divides by
Deviation
TB
Treynor divides by
Beta
8-35
Plan Development: Sharpe Ratio Formula
Return – Risk Free (2.5%)
Standard Deviation
What does this tell us about the efficiency of their
portfolio compared to these?
What would the efficient frontier look like with these
portfolios?
8-36
Explaining Risk/Reward
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How do you explain concepts to clients?
o What is risk? How do we measure it? What can clients
use to “get a handle” on risk.
o What is return? What measurements are important?
What should clients look for?
o Why is the relationship between risk and return
important? How can clients gain confidence
that they are making the right decision?
Try saying and writing an explanation.
Ask peers and others how
understandable you are.
8-37
Next Class
Prior to next class
Investment II
Finish reading
Investment section
Complete Plan
Development
boxes 14,15 & 16
Reviewing
potential portfolios
and impact on
plan
Tax consequences
8-38
CERTIFIED FINANCIAL PLANNER CERTIFICATION
PROFESSIONAL EDUCATION PROGRAM
Financial Plan Development Course
Session 8
End of Slides
©2015, College for Financial Planning, all rights reserved.