Pasadena Financial Planner -- Pasadena, California

8 - Insurance Risk Management

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Step 8 of 10 Personal Financial Planning Steps in the Right Direction

This is one of the “10 Steps in the Right Direction” that make up The Pasadena Financial Planner’s personal financial planning and personal investment management process. For a summary of these ten steps, see Your Family Financial Planning. To find an in-depth article for each step, just click the Sitemap link at the top of this page. Also, you can reach us by using the contact form below, and you can subscribe to our Objective Family Financial Planning Blogs by clicking the orange RSS icon to the left. Please enjoy reading this article. Thank you!

Set an insurance budget as part of your personal financial planning for non-investment risks

While value, affordability, risk exposure, and risk tolerance should affect insurance purchase decisions, insurance is often sold and purchased emotionally. Yet, insurance premium payments reduce personal funds that might otherwise be available for additional investments and/or consumption. Many people could spend all their net savings on insurance premiums and have nothing left to invest and to build an investment portfolio. The issue is where to set a rational rather than emotional balance between expected risk and return.

The reality is that individuals and their families must intelligently and rationally budget for those insurance coverages that might ameliorate most effectively the risks that could do most damage their lifetime financial prospects. There simply are too many risks and too many types of insurance that cost too much. Given the required premiums for the broad range of insurance coverages, a majority or even a large minority of the US population simply can not afford adequate coverage for most of these insurance risks. Furthermore, they cannot find jobs that help to provide adequate coverage in some of these risk areas.

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At the outset, let me be very clear about the role of insurance in personal financial planning. Certain types of cost effective and carefully selected insurance coverages from reliable insurance companies are vital and very important to protect your family’s long term financial interests. Determining which insurance coverages would be most beneficial to you requires 1) knowledge of your needs, 2) an appreciation for uncertainty, 3) an understanding of the best product alternatives, and 4) complete objectivity in the decision process. Unfortunately, putting all four of these factors together when buying insurance is a very tall order.

Given the unpredictability of life and the attendant risks, fears, and emotions, a primary point of this article is to urge you to shift your personal insurance decision making process toward as much rationality as is possible. When you find yourself in an insurance sales process, where subtle or overt appeals to your emotions have begun to predominate, stop and step outside the sales process for a breath of fresh air. Your emotions may be willing to pay any price for safety, but your rational mind should be asking about the tradeoffs. Do your homework BEFORE the ink is drying on the contract.

Tradeoffs between personal financial and investing strategies and insurance risk management are inevitable

Living is risky and unpredictable. For the price of their premiums, insurance companies promise to eliminate or reduce many of these risks for you. When you have coverage in force, you experience an insured event, and your insurance company steps up to meet its obligations, the real virtues of insurance are obvious. At other times, you must operate in a very broad realm of uncertainty about a) what might happen to you and your family, b) whether the insurance that you happened to purchase will actually cover the risks that actually materialize, and c) whether your insurance company will deliver on its promises.

To remind you of the extent of the various risks to which you might be exposed, these are many of the insurance coverages that you could buy, depending upon your needs:

Insurance is never free and you should never expect it to be “profitable” to you. Unless an insurance company is poorly managed and makes excessive benefits commitments, you can never make a “profit” from an insurance company on the premiums you pay. From a strict financial standpoint, you should always expect to get less money out of insurance than you pay in insurance premiums.

In general, you are paying to participate in a risk sharing pool. That is all insurance really is. If, somehow, you find an insurance contract that seems to provide excessive benefits relative to its costs, then you better be toward the front of the claimant line, because the insurance fund will be exhausted before those at the back of the line get served. A better approach would be not to enter into any insurance contract that seems too good to be true.

Insurance is even more expensive, because it not just a redistribution of paid in premiums and the pooled financial assets of policy holders. Insurance premiums include very substantial sales and marketing costs, administrative expenses, and insurance company profit requirements. For some forms of insurance, less than 50 cents of each dollar taken in gets paid out in benefits. Insurance is like a lottery. Insurance premiums and lottery tickets are both prices of participation. Yet, with insurance there inevitably is less joy in the payout, because something rather nasty needs to happen to become a “winner” with insurance.

Risk and return tradeoffs between insurance and investments

Insurance affordability inevitably dictates that most people will bear some insurable risks without insurance coverage. Individuals may be more or less comfortable with this situation. Having a good understanding of one’s risk exposure and risk tolerance is one place to begin.

Given that people are exposed to many, if not most, of the risks that could potentially be reduced by the insurance coverages listed above, where do you set the balance? A good start is to have a better understanding of the potential impact of certain risks, through financial planning and cash flow modeling across your lifetime. To judge the value of insurance, you need to have a better understanding of the inevitable reduction of consumption, savings, and investments that accompanies higher insurance premium payments.

In general, individuals can significantly lower insurance premium costs by focusing on buying catastrophic risk coverage and using self-insurance for more minor risks. For the insurance that you must have, shop around and choose high deductibles to reduce premium payments. Carefully evaluate the scope of insurance coverage to assure that the policy has good quality catastrophic coverage. Then, invest the premium savings achieved through higher deductibles, rather than spending those savings. Over time, these premium savings and investment returns on them will build up your self-insurance asset pool.

Catastrophic personal events can drain assets and destroy the best of investment plans.

Property, liability, life, disability, and other types of insurance may be rational purchases, because of risk pooling with other risk adverse people. However, these types of insurance are not investments in and of themselves. Instead, they limit the financial impact of potential, but relatively unlikely, negative future events. The question comes down to finding good quality insurance at a competitive price and determining the tradeoff between money spent on premiums versus money retained and invested.

Optimal investment planning focuses on enhancing expected risk-adjusted portfolio performance. An optimal investment plan assumes that the necessary labor-based net income will be earned over time to build up your investment assets. By adopting optimal investment practices, individuals increase the chances of financial success that can be attributed to investment returns. However, other risks are inherent in life planning, and there are no guarantees. Personal financial and investment plans may fall short of goals due to a long list of non-investment risks. These risks include inadequate savings, personal tragedy, and family misfortunes.

Combined insurance and investment products confuse personal financial planning decisions

In recent years, insurance firms have expanded their products and services from offering only pure insurance to selling hybrid products that combine insurance and investment characteristics. Long ago, the insurance industry also garnered certain tax treatments that can make their products more seem more appealing to persons with particular tax situations. The mixing of these tax advantages into hybrid insurance and investment products makes evaluation even more confusing.

Unfortunately, many hybrid insurance/investment products are characterized by inferior returns, very high costs, significant insured risk limitations, and other problems. Ultimately, the issue that the potential buyer must sort through is whether the purchase of a separate insurance-only product and a separate investment-only product would yield better insurance risk reduction and superior risk-adjusted investment performance. Very often, buying separate low cost insurance and separate low cost investments is a much better alternative.

Insurance-based annuity income guarantees are not investments

Investment risk cannot be insured or avoided. Without the risk of loss of capital, you simply cannot be investing. If you think that you can pay someone else to take away your investment risk through some insurance guarantee and still have the chance of earning an investment risk premium, you are simply mistaken. No insurance company will take on your investment risk, unless they can do so profitably for the capital that they must put at risk.

Many investors rationally seek retirement income guarantees through annuities insurance products. When they purchase such insurance with their labor income and/or investment assets, they change the complexion of their portfolios. When they shift investment risk bearing to an insurance company providing a guarantee, they cease to be investors for that portion of their assets.

For example, fixed or immediate annuities are not a investment. Instead, you transfer your assets to an insurance company and you pool your longevity risk across all annuity participants. Your expected total return is likely to be inferior to holding onto your assets and continuing to be exposed to the investment risks. However, unless you have far more financial assets than you are likely ever to need, you cannot self-insure against longevity risk.

Longevity risk is when you live far longer than expected and you exhaust your financial assets somewhere along the way. The value of an annuity is realized, when you live a long life, and of course, the insurance company also stays around to meet its commitments. When your lifespan is shorter, you just happen to be the part of the annuity participant pool that provides valuable financial assets to fund the remaining lives of the other participants. From six feet under, presumably, you will not be concerned about your altruism toward these other longer lived annuity participants.

Finally, there is one insurance risk that individuals must retain and cannot shift, when they trade their financial assets and investment risk to an insurance company for an annuity. This risk concerns whether the asset pool of the guaranteeing insurance company will be adequate to fulfill its future annuity obligations. The sad, yet still ongoing saga of the 1991 collapse of Executive Life Insurance Company is a reminder of nontransferable risk when dealing with insurance companies.

Do your homework about the insurance company from which you intend to buy an annuity or any other insurance product. Looking into the resources and ratings of insurance companies can reduce the risk of non-fulfillment. Do not expect that a commissioned insurance agent or insurance broker will do this, as carefully as you should do this assessment. Insurance agents and insurance brokers will get paid at the front end, whereas you want to get paid all the way to the back end!

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See Step 9 — Efficiency of Personal Investing Strategies >>>

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Start a conversation today — Just scroll down to the contact form below and send a message to the Pasadena Financial Planner

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Larry Russell, Managing Director

MBA — Stanford University, MA — Brandeis University, and BS — M.I.T.

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Lawrence Russell and Company Pasadena, California 91103

A California Registered Investment Adviser — Certificate 133101

KNOWLEDGE — OBJECTIVITY — HONESTY — CONFIDENTIALITY — DILIGENCE — EFFICIENCY — SATISFACTION

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Asset Allocation, Investment Asset Tax Location, and Emergency Cash Management

This article discusses personal investment portfolio asset allocation and some considerations about where to hold different classes of financial assets from the standpoint of more optimal taxation.

As you move your cash, bond, and stock financial assets into lower cost, more broadly diversified investment mutual funds and/or ETFs, you should also consider how to “locate” your investment asset allocation with respect to more optimal taxation. This article will also discuss some ideas about where and how to hold your cash assets and how to make emergency cash available.

First, we presume that you have already properly assessed your investment risk tolerance. Using knowledge of your investment risk tolerance, we also presume that you have decided upon an appropriate asset allocation across the primary cash, bond, and stock asset classes. Then, the next question is how you will split your cash assets, fixed income assets, and equity assets between your taxable retirement investment accounts and your tax-advantaged retirement investment accounts, including traditional IRAs, Roth IRAs, traditional 401ks, Roth 401ks, and other such tax-advantaged retirement accounts.

Deciding which investment assets to hold in various types of taxable investment accounts versus tax-advantaged or tax-deferred retirement accounts is known as the “asset location” decision.

There can be substantial confusion on the part of individual investors and many investment advisors as to the best location for assets from the standpoint of taxation over the long-term. Simply put, in deciding on your investment asset location, the question is whether you should hold your stocks, bonds, and/or cash in taxable and/or tax-advantaged retirement accounts. To summarize the investment research literature, the academic consensus is that you should prefer to hold your stock or equity assets in your taxable accounts and you should prefer to hold your cash and fixed income assets in your tax-advantaged accounts.

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The primary reason for this is that long-term federal capital gains tax rates historically have been substantially lower than short-term capital gains tax rates and ordinary income tax rates. Even though stocks tend to appreciate more quickly than bonds, taxation on equities can often be deferred for a very long time. In addition, when capital gains taxes must be recognized on equity asset transactions, very often these gains will be subject to lower federal long-term capital gains tax rates.

[Note, of course, we also hope that you intend to lower your investment fees and investment taxes significantly, if you have not done so already. You can invest your equity, bond, and cash assets in very broadly diversified, passively managed index mutual funds and index ETFs with very low costs, very low turnover, and very low taxes, as well.]

Fixed income / bond assets and cash money assets usually yield income that must be recognized regularly and must be paid at generally higher ordinary income tax rates.

Including inflation which has averaged 3% annually, stocks have returned about 10% per year over the past 80 years. Alternatively, expressed in real dollars or constant purchasing power dollars without inflation included, this means that stocks have yielded about 7% annually over the long-term. For these many decades, high grade longer duration corporate bonds have yielded about 5.5% to 6% including inflation and about 2.5% to 3% without inflation. Cash has yielded somewhat short of 4% with inflation and somewhat less than 1% in real terms without inflation. (For more information about long-term financial asset returns, see these Investment Returns and Securities Market Risk Premiums Articles published on our sister website, The Skilled Investor.)

For bonds, only a small part, if any, of longer duration fixed income yields are in the form of capital gains, which could be subject to more favorable long term capital gains tax rates. Cash does not generate favorable long-term capital gains at all. Despite the lower yields of bonds and cash, their income is usually continuous and taxable in the short-term. Particularly if you have a relatively high combined state and federal marginal income tax rate, you can lose a substantial part of your bond and cash income to taxation without the tax shelter provided by tax-advantaged retirement plans.

In contrast, even though equities have substantially higher yields, a substantial proportion of these returns can be deferred, which avoids near term taxation. Furthermore, if properly managed, most often these taxable equity returns can be taxed at lower federal long-term capital gains tax rates, when needed.

Combined, these factors mean you can net more after taxes by holding your equities investment assets in taxable accounts and by holding you bond and cash assets in tax deferred retirement accounts.

In the research studies that were mentioned above, investigators analyzed a wide range of portfolios with different asset allocations and different asset tax locations. The objective of these studies was to determine what is optimal from a tax location standpoint, and uniformly they reached the general conclusion to put equity assets subject to long-term capital gains into taxable accounts and bond or fixed income assets into tax-advantaged accounts.

Cash and cash equivalents, which tend to earn less than bonds are “located” in the middle from a tax location or tax optimization standpoint. If your particular asset allocation would me that any cash or bond assets would be held in your taxable accounts, the assets should be cash assets, because their taxable yields are usually lower than bonds. (See the related section below about cash holding entitled “Emergency cash management and your allocation of cash assets to tax-advantaged retirement accounts.”)

Your asset allocation and the total amount of assets you have in taxable versus tax-advantaged accounts combined with your asset allocation will determine whether some of your cash, bond, and/or equity assets end up being held “less optimally” from a taxation standpoint in taxable or tax-advantaged accounts.

To be clear, however, the research demonstrates that the asset allocation decision dominates the tax location decision. This means that you do not change your asset allocation decision, because of tax considerations. Instead, you hold to your asset allocation despite tax considerations. (Note, however, there may be alternative investment vehicles that address particular needs. For example, persons with very high federal, state, and local marginal income tax rates and a relatively high allocation toward bonds may find that their bonds would fill their tax-advantaged accounts and overflows into their taxable accounts. When this happens, they might benefit from holding municipal bonds rather than taxable bonds.)

Obviously, over time your assets in taxable versus tax-advantaged accounts may grow at differential rates. In addition, over time you might decide to change your asset allocation between asset classes. However, asset allocations tend to be relatively stable because they are tied to your relative investment risk tolerance, which tends to be more stable. Therefore you preferred asset allocation percentages do not have to change over time, although they may.

As time goes on, you may need to make rebalancing adjustments to maintain your asset allocation within the percentages and tolerances that you wish to maintain. This might cause some shifts in the which asset classes are held in accounts with different taxability. Nevertheless, your asset allocation decision still would drive everything.

An example of how the personal asset allocation and asset location decisions are combined

Your asset allocation decisions and your asset location decisions can be mapped onto a line that goes from 0% to 100%. First, total the cash, bond, and stock financial assets that you hold in your taxable and tax advantaged accounts, and then determine the proportions that are in taxable accounts or tax-advantaged retirement accounts.

In this example, assume that you presently hold 60% of your total cash, bond, and stock financial assets in taxable accounts. In addition, assume that 30% of your total assets are held in traditional tax-advantaged accounts, and that 10% of your total assets are held in Roth tax-advantaged accounts.

Using the 0% to 100% line illustrated in the graphic below, mark the range from 0% to 60% as your taxable assets. Mark 60% to 70% as your Roth tax-advantaged retirement assets. Finally, mark 70% to 100% as your traditional tax-deferred retirement assets. (Below, we will discuss why we have chosen to place your Roth retirement assets before your traditional tax-deferred retirement assets, as you move up this line.)

Next, on this same line we will overlay your asset allocation. Let us assume that you have chosen an overall asset allocation of 70% to stocks and equity assets, 20% to bonds and fixed income assets, and 10% to cash and cash equivalents. Along this 0% to 100% line, your individual stocks, equity mutual funds, and stock ETF assets would be assigned to the left hand side of this line or from 0% to up 70%.

Because bonds tend to be higher yielding than your cash, you would always assign your fixed income assets to the right hand side of this line. Since you have decided that you want to have a 20% bond asset allocation, then your bonds would fill in the range from 80% to 100%. Finally, your cash would fill in the space in the middle that remains between equities and bonds. In this case, you cash would be “located” from 70% to 80% along this line.

Now, what is the result? Of your 70% allocation to equities, 60 percentage points would fill up your taxable accounts entirely and the remaining 10 percentage points would overflow into your tax-advantaged retirement accounts. In particular, your 10 percentage point overflow of equities would be invested in your Roth retirement accounts. Therefore, in this example, all of your Roth account assets would be equities, since 10% of your total assets currently are equities.

For the remaining 30% of your total assets, which are traditional tax-advantaged assets in the 70% to 100% range of this line, these would be where you put your bonds and cash. Therefore, your 20% fixed income asset allocation and your 10% cash asset allocation would be held in your traditional tax-advantaged retirement accounts.

Why would equities be allocated into Roth retirement accounts versus into traditional tax-advantaged retirement accounts.

If your equity asset allocation is sufficiently high that some of your equity assets would be held in tax-advantaged accounts, then they would be invested in Roth accounts, if you have Roth account assets. Because equity assets historically have appreciated more quickly than bonds or cash, it is preferable for your stock assets to be in Roth accounts, which would not be subject to future taxation. Since traditional tax-advantaged accounts eventually would be taxed at ordinary income tax rates, you would prefer that these accounts would grow more slowly, while you would prefer that your Roth accounts would grow more quickly in relative terms.

Also, note one caveat about the example presented above. If your asset allocation and/or taxable versus retirement asset proportions were different and your equities do not entirely fill your Roth accounts, then you would fill the remainder of your Roth accounts with your bond assets rather than your cash assets. This is simply because you would prefer to have higher growth fixed income financial assets in your Roth accounts versus slower growing cash assets.

In addition to normal differences in investment asset class growth rates, there are some other personal estate planning reasons that could favor placing higher growth assets into Roth retirement accounts.

Roth retirement accounts have some very significant advantages over traditional tax-advantaged accounts for estate planning purposes. If a family’s financial model indicates that there is a good possibility that they will still have some tax-advantaged account assets at death, then those should be Roth tax-advantaged account assets, whenever possible.

US tax laws and IRS regulations require mandatory withdrawals from traditional retirement accounts after age 70 and 1/2. These mandatory withdrawals might be adequate to meet your expense needs in retirement without having to touch your Roth retirement account assets. During your retirement, your Roth accounts would not have mandatory withdrawal requirements. (Obviously, in retirement you would still have the option to withdraw either traditional retirement account assets and/or Roth retirement assets.)

Furthermore, your Roth accounts could be inherited by your children, and these inherited Roth assets could also grow tax free within the inherited Roth account over the expected life of the child. During your child’s life there would be certain mandatory withdrawal requirements that apply to them and taxes would apply to these mandatory withdrawals. This means, for example, that a child inheriting a Roth account at age 40 could perhaps enjoy another 50 years of tax-free investment growth with an income stream along the way from the mandatory taxable withdrawals. Traditional tax-advantaged retirement accounts do not provide these very significant estate planning benefits.

Emergency cash management and your allocation of cash assets to tax-advantaged retirement accounts.

Some people become concerned, if their combined asset allocation decision and asset location decision means that all their cash would be held more optimally from a tax standpoint in their tax-advantaged retirement accounts versus in their taxable accounts. Furthermore, some people also may be concerned about how much cash to hold in a taxable account for “emergency” purposes, despite whether such taxable cash holdings are less optimal from a tax location standpoint.

Often these emergency cash and tax issues are of lesser importance than they would seem at first. A decision can be made simply to keep “X” expense months of cash in a taxable account and to pay the taxes, even though this allocation might less than optimal from a tax savings standpoint. In addition, real estate lines of credit or other unused and available debt lines can be taken into consideration, which perhaps might reduce the amount of emergency cash that one desires to hold in taxable accounts.

By way of example, if your monthly expenses were $6,000, you might want to hold 6 months cash or $36,000 in a taxable savings account. Assuming that you could earn the average historical pre-tax return of 4% annual interest rate on these $36,000 dollars, your taxable savings account would yield $1,440 in additional taxable income. If your total marginal federal income tax rate and state income tax rate was 26%, then you would pay about $375 more in federal and state income taxes annually to hold this cash in a taxable account versus in a tax-deferred retirement account.

To optimize your asset tax location, you could invest your cash in a tax deferred retirement accounts and use off-setting transactions to raise cash money for emergencies.

If you did happen to have a major financial emergency, you could make some offsetting transactions to free up the needed emergency cash from your retirement accounts. In effect, cash can be “moved” out of your tax-deferred accounts when needed by selling taxable equity assets for the cash that was required and then “replacing” those assets in your retirement accounts. You would replace the assets that you sold in you taxable accounts by buying similar assets in tax-advantaged retirement accounts using the cash that you held in your tax-advantaged accounts.

Of course, these offsetting transactions could trigger capital gains tax recognition related to your equity asset sales from your taxable account sales. Over the long-term, the affects usually are quite small particularly since true emergencies consuming significant amounts of cash are relatively rare. Of course, you also might need to make overall adjustments to your asset allocation, given the emergency use of the cash. Furthermore, be aware of IRS wash sale tax rules that might apply, if you buy substantially identical investments in tax-advantaged retirement accounts, when you also sell them in taxable accounts.

Finally, concerning a smaller cash emergency fund, you still might chose to hold some amount of cash in a taxable account for ready access — perhaps a few thousand dollars or more. There could be other benefits to doing this. You may find a bank that will arrange for your savings account cash (earning reasonable interest we hope) to act as over-draft protection to your linked checking account. With such an arrangement the higher taxes associated with holding a small amount of emergency cash in taxable accounts might be offset sometimes by preventing those nasty overdraft events, when you make a mistake and bank charges mount rapidly.

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See — Personal Investment Strategy >>>

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Start a conversation today — Just scroll down to the contact form below and send a message to the Pasadena Financial Planner

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Larry Russell, Managing Director

MBA — Stanford University, MA — Brandeis University, and BS — M.I.T.

.

Lawrence Russell and Company Pasadena, California 91103

A California Registered Investment Adviser — Certificate 133101

KNOWLEDGE — OBJECTIVITY — HONESTY — CONFIDENTIALITY — DILIGENCE — EFFICIENCY — SATISFACTION

.

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