Aging gracefully―a blueprint for your future

If you could peek into the future and the final 10-20 years of your life, what would that look like? Do you see yourself traveling, healthy, energetic and excited about experiencing new challenges? Or do you have visions of illness, body pains, lethargy, disengagement and a lonely life?

What if you could manage that trajectory to a more positive future with fewer deficits and more joy? Research is churning out reports on how we can slow down the negative parts of aging and enhance the joyful aspects of our lives.

Throughout my life, I’ve met many people on both sides of aging. It is clear that our attitude drives this journey. It can turn us into victims or champions over our lives. Often it begins with our attitude each day―do we resign ourselves to a self-defeating diagnosis and settle for dissatisfaction? Or do we take daily challenges as an opportunity to remain engaged and positive? Experts in aging are in agreement that we will be much happier as we age if we are comfortable in our chosen lifestyle (that is to say, we are in the habit of doing things that give meaning and value to us) and that we don’t let our “illness” or age-related challenges define our daily lives.

As technology continues its exponential growth, the key to managing and thriving in this ever-faster moving era is our ability to adapt and remain true to ourselves. I believe equally important is to allow ourselves time to unwind and gain perspective. Unfortunately, most of us would likely skip ‘self-time’ (time for meditation or reflection) in pursuit of getting more accomplished.

Though it doesn’t take a financial windfall to have a healthy retirement, it does help tremendously not to have financial worries. Financial plans and conscious financial choices will help minimize financial anxiety and create an opportunity for a healthy retirement. Beyond this opportunity, it is up to us to build lifestyles (and needed financial resources) that give us joy today and throughout our later lives.

Research on aging recommends that we include the following:

  1. Though we are all different and choose different lifestyles, we all benefit from activities that provide us with at least a minimal level of social interactions. It is social engagement, according to these experts, that can add years and quality to our lives. In addition, volunteering has been shown to reduce pain as well as increase endorphins. Even when homebound, it is essential to be active and motivated.
  2. It is no surprise that a graceful happy retired life must also include regular and vigorous mental engagement. Your financial plan should be your guide to attain your goals, but it will be your consistent financial behaviors that will keep you mentally engaged with your money later in life. We are all aware that as we age we have a higher risk of memory loss, dementia and even Alzheimer’s. We can’t control inherited diseases (50% of those over 85 are affected with a dementia-like Alzheimer’s disease but that also means, 50% are not!) but we can rise to the challenge and keep our brains mentally active.
  3. Improving your quality of life includes addressing your physical health and diet. It is recommended that we exercise regularly, including at least 45 minutes of aerobic activity. A diet with reduced portions and elimination of processed foods appears to also be connected with healthier happier lives.
  4. Though sometimes difficult, it is essential that we be able to ‘let go’ of hate, resentment and regret that reinforces negative emotions. Though it’s never easy, experts say that ideally you’ll forgive or ‘walk away’ to attain a healthier life. I find that smiling every day makes me happier and has the added bonus that it makes others smile too.
  5. Finally, stay true to your lifestyle and decision process throughout your life. If you are comfortable in your core values and habits then even the worst challenges will be manageable.

In short, a successful blueprint for a long and rewarding life entails the intentional effort to remain active, engaged and positive.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cost effective implementation of Long Term Care insurance

Long Term Care (LTC) decisions form a critical part of all retirement plans. That said, we can’t properly address individual LTC needs until a retirement plan is designed and participants are able to quantify the aspect of Long Term Care they will fund. If LTC insurance is part of their ideal LTC plan then we must identify the best policy and the most cost effective way to pay for it. This article is intended to review LTC and layout how a business can help pay for LTC insurance in a cost effective manner.

(1) Long Term Care – a review
Long-term care (https://longtermcare.acl.gov) is a range of services and supports needed to meet personal care which is not included in healthcare. About 2/3 of the population will need LTC after age 65 (and 1/3 before 65). Of those reaching age 65, 70% will need LTC or assistance with activities important to life. LTC includes everything from social services, physical and emotional support, finances, housing, a myriad of legal decisions, family interaction and social dynamics. LTC should include all assistance with tasks that will allow for productive, engaged and enthusiastic daily life. It should include assistance with routine tasks such as housework, money management, taking medication, shopping, traveling, caring for pets, responding to emergencies (these are known as Instrumental ADLs) and NOT just the “basic” Activities of Daily Living (ADLs, such as assistance with bathing or eating).

Currently, 80% of all LTC needs provided in the home are supported by unpaid family, friends or neighbors. The average support needed in the home is about 20 hours per week. Fortunately, as services develop, we find an increase in community support services. These include adult care services, transportation services, and home care that is round the clock or as needed.

If you require or prefer the use of LTC services provided by an institution or facility you will need to investigate Assisted Living, board and care homes, or Continuing Care retirement communities, not just nursing homes.

(2) What is LTC insurance?
LTC insurance is a contract to pay premiums every year for care you may need in the future. It will pay out an agreed daily amount for your care only if you are unable to do a certain number of Activities of Daily Living (ADLs). These are the basic ADLs (includes bathing, eating and dressing). LTC insurance is not usually available if there are pre-existing conditions. Benefits are provided for a set number of years of care based on a daily dollar amount dependent on local costs and total maximum benefits (these are usually capped at around $350K). But how many years of LTC will be needed is unique to the individual, though we have past indications that males need at least 2 and females 4 years. Three years is the standard, but we know that 20% of those over 65 years will need ADL assistance for longer than 5 years. For these reasons we recommend this insurance purchase be made based on your retirement plan.

Naturally, LTC insurance premiums are less expensive for the young (and healthy) but starting early will cost more over time and is not advisable if your personal cash flow can’t support this expense throughout your life.

(3) Best ways to pay for LTC insurance
How do we pay for LTC insurance if we think it fits within our retirement plan? It should be clear that healthcare or Medicare (except for very short periods of time and only in specific emergency situations) do not cover LTC costs. On the other hand, Medicaid does cover LTC but has very strict requirements to qualify. If you are fortunate to qualify, LTC coverage is provided by the Older American Act (OAA) and Department of Veteran Affairs.

The most common way to pay for basic LTC needs is through insurance or out of the personal or family budget. Other ways include a reverse mortgage, annuities, other assets, and income from a dedicated source (such as rental income).

LTC insurance premium costs are based on your age, your location, your wishes for level and amount of care. The premiums are not usually a burden on a yearly basis but they take a toll over time. These premiums must remain in effect for life. Additionally, policy premiums today can increase by more than inflation (over the last year we’ve seen 18% to 90%[!] increases in premiums for existing policies).

Long Term Care Purchasing Options

There are at least 2 ways to pay for a new LTC insurance policy – as an individual or as a business. The advantage of an individual LTC insurance policy is that it is based on your needs and can be tailored to you. The advantage of a business LTC insurance plan is that it can be paid by the business and therefore tax deductible. If you are the business owner it can also be tailored to your wishes (see the chart below assembled by Aikapa).

LTC insurance premiums are supposed to be deductible but we find that most of our clients with high AGI (Adjusted Gross Income) and low medical expenses are not able to deduct their premiums on their annual IRS tax filings (Schedule A has a 10% AGI floor). In addition, the deduction is also limited to age specific maximums (see table below) regardless of actual cost for the purchased LTC insurance policy. To help you understand the implications I’ll outline at LTC insurance for three separate age scenarios (ages 55, 61, and 71):

Currently a basic 3-year policy with $150 benefit per day would have an annual premium of around $2,100 at age 55, $2,900 at age 61, and $6,900 at age 71 (quotes may differ given different assumptions and are likely to be lower for males and couples but may be higher or not available based on health history).

Long Term Care Deductible Limits

To help understand how tax deductions actually work if buying this insurance individually, I’ll use the three LTC examples outlined above: To allow for this comparison, I’ve assumed that the cost of the above three policies are the only tax deductible medical expense. This is important because the deductibility is dependent on exceeding a 10% floor based on AGI. Anyone with an AGI (i.e. number at the bottom of the first page of your 1040 IRS filing) of more than $60K would not be able to deduct their LTC premium under any of these scenarios unless there were other deductible medical expenses. Most of our clients that purchase an individual policy are not able to deduct premiums. In retirement deductible medical expenses rise and then some of these premiums are tax-deductible.

On the other hand, the same insurance policy purchased by a business provides tax deduction of LTC insurance premiums up to age limits and may even cover the entire premium (see below for details).

Sole Proprietors, Partnerships, S Corporations, and LLCs can provide owners and spouses with LTC premium tax-deductions that are only limited by age specific maximums (see above table – which shows that at a business can pay up to $1,530 for an owner’s (aged 51-60) LTC premium tax-free). If we look at the same three examples AND purchase the policy using one of these firms the tax deduction in 2017 for the 55 year old would be $1,530 (less than the cost for a base policy of $2,100), the 61 year old would have their premium fully paid tax-free (since their premium of $2,900 is less than the maximum limit of $4,090 for her age group), and the 71 year-old would pay no tax on $5,110 (though premium total was $6,900).

C Corporation and non-profits may cover LTC insurance premiums  for owners or members tax-free (without age limits mentioned above).

Using the same three examples AND having the C Corporation or the nonprofit pay for the premiums, then the entire LTC insurance premium for all age groups would be tax-free.

In summary, Long Term Care planning involves much more than just buying a LTC insurance policy. It encompasses consideration of a myriad of integrated services and support that should be aligned with your wishes both early and later in life. LTC insurance is one way to cover basic ADLs. Before making a purchase of LTC insurance you must have calculated what you wish to cover yourself and what will be paid for by insurance benefits. It is more cost effective if LTC insurance is provided by an employer (with no cost to you) and even better if you are the employer. As the employer you can design a policy that best fits your plan and offers tax-free premiums.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Two common estate planning failures

(1) Failing to plan for incapacity:

Only 33% of Americans have executed a medical directive (as found by the American Bar Association). AARP (American Association for Retired Persons) reports that 45% of Americans over the age of 50 have a durable power of attorney.

Legal documents to plan for incapacity include a power of attorney, a medical directive and a trust. Even though it is a good first step, a comprehensive estate plan requires these documents and more.

Media mogul Sumner Redstone had an estate estimated to be over $42B, but late in his life a series of conflicts began over his competence and the control of his estate. According to the granddaughter, “the aunt and other family members succeeded in reversing decades of my grandfather’s careful estate planning and poised themselves to seize control of Viacom and CBS.”

Naturally, we all have some expectation of what our life’s work will amount to. The legal system has documents that can be used to support our wishes if we are unable to make decisions, but who decides when we are not able to make them? As difficult and challenging as it is, we might want to consider what indicators we wish to use to trigger assistance. Otherwise, you could find yourself making a good many mistakes before anyone deploys these legal estate documents.

In one case, the California Court of Appeals ruled: “Appellant produced evidence of forgetfulness, erratic, unstable and emotional behavior, and of suspicion, probably delusional at times, on the part of the testatrix. This is of no avail unless it were shown, as it was not, that it had direct influence on the testamentary act.” In essence, the court is saying that the individual displaying these disturbing signs is still capable of making their own financial decisions. After all, we are all entitled to make poor decisions.

In a perfect world we would never have to deal with diminishing faculties or the thought that, at some point, someone else will have to make decisions for us. The truth is, most of us struggle with the timing and triggers that have to do with relinquishing our ability to self-direct or make our own decisions.

Estate planning begins with the basic documents, but effectively planning for incapacity entails much more.

(2) Dying without a will:

Dying without a will doesn’t impact the deceased, but signing a will does make it easier on those left behind. And yet, people who ought to know a whole lot better continue to die intestate (without a will). Famous examples include Abraham Lincoln. Lincoln was a successful and skilled attorney and yet he left an estate of $110,297 without a will. In more recent times, the entertainer, Prince, died without a will, leaving an estate of $300M. Though Prince’s sister and five half-siblings appear now to be the instate heirs, this would have turned out differently if not for DNA testing. Carlin Q claimed to be the “love child” of Prince and would have inherited the entire estate (!) had DNA testing not proven that he was not a biological offspring of Prince.

It is shocking that over 64% of Americans do not have a will. Yet a will is simple to create. Dying without a will means the estate will be handled by attorneys in front of a probate court. Dying intestate results in delays, higher fees and possible litigation. It surprises many that intestacy can create other messy dispositions based upon the order of death or age of those inheriting assets.

In many states, each child and the surviving spouse will inherit an equal percentage. If a trust is not established, a minor child may be entitled to receive inherited assets by age 18. Ex-spouses may have control of the inheritance until the child reaches adulthood.
In some states, if a married couple with no descendants (children) and no wills are injured in the same accident and one spouse dies prior to the other even by a few minutes the outcome will be that only one spouse’s descendants will inherit the couple’s joint estate and the other spouse’s family will receive no assets. In California, Alaska, Kentucky, Texas, and Wisconsin the state requires that the spouse must outlive the other by more than 120 hours, not just a few minutes, for the assets to pass to the ‘surviving spouse’ and skip the first-to-die family.

Some famous examples include musician, songwriter and poet,  Kurt Cobain, who left a detailed suicide note but didn’t sign a will. As it happened, his wife and daughter were his only heirs and the estate was split in half. Martin Luther King Jr. died without a will leaving his children in a long fight over the estate.

So how does the state decide who manages the assets for under-age children when there is no will? Current state statutes set an order of appointment with the surviving spouse normally being the first person, followed by the closest BLOOD family members. This is determined by relationship, not competence. Think about it. Do you really want anyone to manage the estate for your loved ones just because they are your closest blood relative?

Prince’s estate is an example of how much of his legacy will be wasted as six different heirs without knowledge or competence in the music field are now fighting over how to handle his vast music empire and unreleased songs. Of course, he is gone so at least he doesn’t have to worry about it, BUT his fans will be affected.

Finally, the wishes of the deceased may not be respected without a will. NFL player Steve McNair purchased a million dollar home for his mother to live in, but he retained title to the home. On his death, his wife demanded that the mother pay rent and when she couldn’t, she had to move out! It would have been so simple for McNair to provide a written will stating that his mother could keep the home when he was gone.

Estate planning is a significant part of your overall financial picture. We’ve reserved the month of June to review beneficiaries on your accounts and to encourage you to review your wishes for your estate plan. Our priority in estate planning is to ensure that you are comfortable with the basic estate planning documents (DPOA, will and trust) that will protect you and your family to a very large degree in the event of your incapacity or death.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

‘Burn rate’ should be key to retirement savings

People often talk about “saving for retirement.” Few question the need to put aside adequate savings to ensure the successful funding of their retirement plan. The operative word though is “adequate.” How much in the way of savings is “adequate”? Of course, it differs from individual to individual, but you will most likely find that spending is the common variable that shapes the limits of what constitutes adequate savings. With few exceptions, our spending needs in retirement will exceed the amount provided by our inflation adjusted social security benefit. Everything else being equal, the success or failure of any effort to fund retirement is above all dependent on lifestyle and spending habits or ‘burn rate’.

To help you visualize “the power of spending” and its impact on a retirement portfolio, I’ve created four basic retirement funding scenarios. These scenarios assume the same retirement period (beginning 2017 and ending 28 years later), an annual social security benefit of $40K (adjusted for inflation), and a $1M diversified portfolio with a rate of return of 5.5%. The only varying parameter between scenarios is the amount of spending each year with associated tax liability. Each scenario was created using 500 cycles of Monte Carlo probability simulations that modify every parameter except length of retirement to address a range of economic variables and unexpected expenses. The charts include only four (out of 500) projection lines from “best case” to “worst case”.

For the first scenario, our hypothetical client spends $50K/year (before tax), having accumulated $1M at the point that she is ready to retire in 2017. As the chart demonstrates, for the best possible outcome the $50K annual spending client actually grows her nest egg to $1.4M over 28 years (this is the blue line or highest line at year 2045) ― leaving, I should add, a sizable chunk of change for a life beyond 28 years, long term care needs, or for her legacy (be it a favorite charity or her grandchildren). If all economic variables are worse than expected and things don’t quite pan out, she can still expect $250K in assets (see the gray line or lowest line at 2045) after enjoying 28 years in retirement. Not too shabby!

But what if our hypothetical client was in the habit of spending about $75K/year (before tax) instead of $50K? (again, assuming she starts her retirement in 2017 with a $1M portfolio). In this situation, assuming everything goes better than expected the Monte Carlo simulations show a surplus of over $1M after 28 years, BUT in a worst-case scenario the portfolio is depleted after 20 years (around 2037) ― enough to make a financial planner seek ways to protect against the worst-case scenario.

Approaching the Bay Area experience is a hypothetical client who spends $100K/year (before tax). What then? The $1M portfolio would not last her beyond 21 years (2038) even in the best scenario. Unfortunately, there is a higher probability that it will be gone after 15 years (2031). While the worst-case simulation shows that the portfolio could be depleted in as little as 10 or 11 years (2028).

Though there are many other possible spending targets (and also more parameters to consider than those in these scenarios), our final hypothetical client spends $150K/year (before tax) to maintain her lifestyle. In which case, the $1M portfolio would last 9 years tops (2026) and could well be depleted within 5 years (2022).

The story told by the 4 charts is very clear. Saving and spending levels must be aligned for a successful retirement strategy. Clearly, accumulated assets alone are not in and of themselves indicative of success over the long-haul. On the other hand, spending habits and your ability to adhere to a budget are very useful indicators. They can provide a realistic view of your retirement “burn rate” and better align your savings today with future need.

Think of it this way, your approach to spending and your connection to buying are formed throughout your life. It becomes an unshakable habit. For this reason, spending seldom decreases in retirement except with a great deal of stress, anxiety, and depression. To avoid this unhappy outcome, the smartest and healthiest action is to establish a realistic budget for the lifestyle that you seek, then plan your savings around the cost to sustain that lifestyle. The goal of your retirement savings would be to build enough wealth to support your lifestyle.

Though planning for retirement includes more than your burn rate and savings rate they are critical beginnings. What I like best is that these are aspects of retirement planning that we can control.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Death and sepulcher – facing the inevitable

Benjamin Franklin famously wrote, “in this world nothing can be said to be certain, except death and taxes.” In all the years that I’ve worked with clients to create a financial path for their long-term wishes in life and after they are gone, I’ve covered a huge spectrum of topics. Until now, I’ve never asked clients about their “right of sepulcher” (the right of sepulcher means the right to choose and control the burial, cremation, or other final disposition of a deceased person). I recognize that, for some, this topic may seem a tad morbid. The cautionary tales of contentious and messy celebrity funerals that follow (suggested by Amy F. Altman, an associate at Meltzer, Lippe, Goldstein and Breitstone) may provide you with some perspective and may help you consider how you and your loved ones feel about your right of sepulcher.

  • Litigation surrounding the 2007 death of actor, model and TV personality Anna Nicole Smith made headline news for weeks as her mother and the guardian of her infant daughter battled for the right of sepulcher. Ultimately, the daughter’s guardian prevailed and Anna was buried in the Bahamas next to her late (and recently deceased) son.
  • Boston Red Sox Hall of Famer Ted Williams’ death in 2002 resulted in a spectacular rift between his children over the disposition of his remains. His eldest daughter argued that Williams’ will clearly stipulated cremation, BUT his son had been given power of attorney and his father’s health proxy and he wanted his father cryogenically preserved. Eventually, the son won out, largely because the daughter could not afford the cost of litigation.
  • Legendary actor Mickey Rooney died in 2014. His estranged wife wanted him buried in a shared plot purchased before they had separated. Rooney’s conservator (court appointed guardian) had other ideas and a costly tug-of-war ensued. In the end, his wife capitulated, recognizing that burial in a Hollywood cemetery befitting Rooney’s status was appropriate.

These cases, regardless of age, underscore the importance and value of discussing with loved ones your preferences for disposition. The laws regarding rights of sepulcher vary widely by state. If permitted under state law, completing a “disposition of remains form” together with advanced directives seems an appropriate start. This will create clarity with respect to the sensitive issues surrounding burial.

As with all legal documents you need to first understand what it is that you really want, which can take a long time to fully grasp and may require delicate discussions with loved ones and personal introspection. Leaving aside what I consider the more important question regarding life support for now, you can first deal with the question, do you want to be cremated, or perhaps cryogenically preserved? Do you want to be an organ donor? Would you like your funeral to take place at home or at a funeral parlor? Do you want a formal service or commemorative event? Though you’ll be gone, these are all options that may well prove to be important (and costly if mishandled) to those you leave behind.

At times, I think that there is so much to do while we are alive that taking time to consider what will happen after we’re gone seems inconsequential and entirely unimportant, but this may not be the case for loved ones. Let me offer an example.

Recently, a client shared that over the course of a dinner conversation with his parents they casually revealed their preference to be cremated. This came as an enormous shock. “Never in a million years,” he said, “would I have predicted that this was my parents actual wish.” This is a man who has made every effort to ensure he is in touch with the real wishes of his aging parents. “I would have got it wrong,” he said, adding “a split second’s worth of conversation set me straight.” He felt like a huge weight was lifted from his shoulders.

The person to whom you give the right of sepulcher may gain much by having even a short conversation about your wishes, regardless of your age.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Your Credit History – wealth and identity

Our recorded credit history is tracked by the three national credit bureaus (Equifax, TransUnion, and Experian) and each calculates a credit score. Though the credit score is a required component for loans it is NOT based on our entire financial history and it may not represent us correctly. It is up to us to ensure that it does. Why is this important? For your wealth and your identity.

Each credit bureau uses an algorithm (model) to generate a number (FICO score) based on your recorded credit history that is, imperfectly, a measure of the risk the system associates to someone with your recorded history. Lenders who depend on credit bureau reports for assessing whether or not to lend, use this score as one measure of your “credit worthiness”. Those with no financial history or less than sterling repayment records are likely to face higher cost loans IF they are able to obtain a loan at all. It is true that loans are available for those with lower credit scores but additional requirements will be imposed, including a low debt-to-income ratio. Even then, the loan will be at a higher rate.

Couples can sometimes be surprised when one partner lowers the expected family credit score. These couples may be effectively managing their financial life and yet obtain a low combined credit score that will raise their cost of borrowing. In most cases, the partner with the higher credit score applies for the loan singly to obtain the best rates (‘excellent’ rates are generally available with a FICO of 780 or higher), while the other partner must rebuild their history.

As time goes on, more and more of our interactions are managed electronically. Hand-in-glove with electronic transactions come ways for us to be identified and verified electronically. It is now more common for our financial identity to be confirmed by using facts found in one of our three credit bureau history records. It is crucial that you know and can recognize all information in each of these reports.

Once you have checked your history thoroughly, you’ll find an annual check-up to be quick and sufficient. Obtaining your credit history and checking it for errors can be completed on your own or with our assistance. If you need to make corrections, let us know or contact the specific credit bureau directly.

Finally, when you are getting ready to take out a loan for a large purchase be sure to first check your credit history (more than three months ahead) – you don’t want surprises.

So how might you be able to improve or maintain your credit score? Here are a few essentials to keep in mind:

  • don’t miss payment due dates – set up automatic minimum payments even if you pay your accounts in full (this will protect against the unexpected)
  • monitor your cash flow – don’t over extend yourself – try not to use more than 30% (better at less than 10%) of available credit (credit used compared to total credit available is called the ‘utilization rate’)
  • don’t apply for a lot of credit from different sources all at once – it can set off major alarm bells and may impede new financial loans for several months
  • if consolidation is indicated, try to keep your total credit the same and never close your oldest credit card
  • installment loans (i.e. car, mortgage) can have a positive impact on your score – be sure your lender actually reports to at least one bureau (some don’t)
  • your credit history can include a lot more than just a car loan or credit card – utility, cable, rent, and cell phone payment history can all be tracked and used either to boost the score or knock it down
  • if retirement is on the horizon, make extra effort while you are still earning to maximize all aspects of your credit history and bolster your credit score
  • if retired, disabled or unemployed restrain your credit card purchases and instead find ways to reduce expenses – it is more difficult to recover from credit card debt when income is limited
  • verify your credit history on a regular basis and correct errors promptly

Credit history is not a statement about you personally but a less than perfect measure to determine ‘credit worthiness’. It is best to capitalize on the rules to obtain the best score possible. Moreover, since credit history is now used to verify identity, it is incumbent on us to ensure the records have captured our information accurately.

Feel free to give us a call if you need help with the process.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

A business owner quandary: cash or accrual?

Financial statements are one of the most powerful and least utilized business tools. Small business owners need to master financial statements if they hope to work not just in their business, but on their business. And yet, I see all too often just how little time business owners spend exploring them. In my experience the bookkeeping burden doesn’t excite us into spending time on financials beyond tax preparation. In this discussion, basic features of cash and accrual financial accounting are presented with the goal of demystifying them and providing an opportunity for exploration.

One of the first decisions when starting a business is to determine the most appropriate accounting method for the business and for tax filings (the two most common are cash and accrual).

The cash method accounts for revenue when the money is received and for expenses when the money is paid out. It is useful for tracking monthly cash flow since it works just like a checkbook and the balance sheet appears like a checkbook register. Unfortunately, it can convey the wrong message regarding the long-term well-being of a company.

The accrual method of accounting provides a better picture of company profits during an accounting period by recording revenues when they are earned and expenses when incurred but it is not intuitive since the financials do not represent day-to-day accounts. Accrual accounting instead provides a view on long-term financial well-being.

So, what does the IRS require?

The IRS in 2001 relaxed prior requirements that forced many small businesses to use accrual accounting. To reduce the accounting burden on small businesses the current rules allow firms with under $5M in revenue to use cash basis accounting, unless they are an inventory based business.

For tax purposes, the accounting method is locked-in with the first business tax filing. After the initial year, a business uses the same accounting method unless it receives prior approval from the IRS.

It has been my experience that cash and accrual accounting are often misunderstood. It is important that small business owners address with their accountant, bookkeeper, and tax preparer how these two accounting methods will be implemented. The key is to be consistent in applying the rules.

What are some of the problems that may surprise you?

To cite an unusual example, a client sent you a check (on December 30, 2016) for interior decorating services you provided to her and you received the check on January 2, 2017.  Small businesses using cash accounting might be surprised that the IRS expects you to apply this check as income received in 2016. Strictly speaking, the rules require you to observe ‘constructive receipt’. Meaning, the money is available to you and under your control, whether or not you have taken actual possession of it. The fact that you haven’t deposited the check is strictly speaking a moot point as far as the IRS is concerned. Adhering to this ideal is a burden on small businesses. It’s our observation that accountants for small businesses operating on a cash basis consequently define constructive receipt as earnings and expenses in the register by December 31.

Constructive receipt argues against some commonly employed practices, such as delaying the deposit of income or the acceleration of expenses for the sole purpose of avoiding taxes. On the other hand, delaying invoicing does seem to be a more acceptable practice. It is generally more common for cash basis businesses to delay invoicing rather than delay cashing a check received so as not to run “afoul” of the constructive receipt rule.

To be clear, there is a large difference between the unintended receipt of a delayed payment (typically due to a tardy customer payment or a receivable that is in the mail) and deliberate manipulation. Here’s an example of a practice that is clearly not allowed. A small business owner is entitled to receive $20,000 on a contract completed in 2016. The owner contacts the client requesting that the payment not be made until January 2017. That’s not acceptable per published IRS rules.

On the other hand, IRS rules can sometimes be too onerous for a small business. For example, if you pay $2,000 in 2016 for an insurance policy effective for one year beginning July 1, you should deduct $1,000 in 2016 and $1,000 in 2017. It is my experience that this is seldom the practice for small business owners who without intending to avoid payment of tax, will register payment in the year paid without an evaluation of when the benefit will be derived.

Though few use the accrual method of accounting, its purpose is to match income and expenses in the same year. It is therefore critical to choose the year well – when there is any doubt on which year to choose, the decision is made on when ‘economic benefit’ was attained. This can be burdensome to small business owners since the assessment of ‘economic benefit’ is sometimes quite difficult to ascertain.

Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. As an example, you sold a computer on December 28, 2016 and billed the customer the first week of January 2017, but did not receive payment until February 2017. Using the accrual method, you must include the amount received for the computer with your 2016 income because ‘economic benefit’ was obtained when the computer was sold. Obviously, tracking and attribution requires a lot more work on the part of the small business owner using the accrual accounting method.

As part of learning to work on your business, not just in your business, it is important that you first develop confidence that your financial statements (Profit & Loss, Balance Sheet, and Cash Flow statements) accurately represent your financial activity. It can take time to develop a reliable and consistent system. Once you have confidence in your financial statements you should address deriving more from them than just how to handle business tax liability.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

 

Understanding Longevity Risk and Your Retirement

The oldest person alive today is Emma Morano of Vercelli, Italy who turned 117 this November. She was born in 1899! Queen Victoria was still on the throne of England and William McKinley was president of the United States. If you’d asked Emma in 1917 if she could imagine living long enough to see 2017, would she have imagined such a long life? Most Americans do not live as long as Emma, but in general we are living longer and healthier lives. The number of centenarians is on the rise. Longevity – long life – can have obvious perks, but also poses a conundrum in terms of finances. To help us plan for longevity we use “longevity risk” to measure the likelihood that you’ll run out of wealth before you’ll run out of life. In our planning we like to ensure that we mindfully set longevity at the right level for each person.

Few, if any of us, have advance knowledge of precisely when our time will come, so questions like this often boil down to statistics. You’ll sometimes hear that the average life expectancy for females is age 83 and age 81 for males, BUT are these appropriate target-end dates for your retirement plan? The truly important challenge is coming up with the best end-dates for retirement that will allow you to enjoy your wealth early while leaving enough assets to comfortably support you later in life.

In retirement planning, the variation in life expectancy can range quite dramatically and yet we find that client expectations generally fall into two categories, (1) those who want to make absolutely sure they don’t outlive their wealth, and (2) those who have a definite expiration date in mind, say 80 years of age, and believe that planning for life beyond that age is simply not relevant or realistic. The latter are often operating on some assumption based on, for example, both parents dying in their late 70s or not long after retirement.

At the risk of sounding morbid, but with the goal of having your retirement plan more fully represent your expected end of life target date, I want you to consider three facts that most often cause people to underestimate their longevity (in turn, this may help you understand why we sometimes encourage you to increase your target-end date):

Life expectancies that are often quoted may not be relevant since they are often calculated at birth. Life expectancy on reaching age 60 or 65 should be much higher than those quoted at birth since some will die before they reach this age. In fact, life expectancy for a 65-year-old, non-smoker is much higher. As an example, a 65-year-old female of average health has a 50% chance of reaching age 88 (see the table below) but once she reaches age 88 she has a much higher chance of reaching age 95.

longetvity_table

  1. Life expectancy is often calculated using mortality rates from a fixed year instead of projected to future expected mortality rates. Social Security Administration (SSA)’s period life tables are based on real mortalities in any given year. Though valuable, since they are real, they underestimate the observed trend for increased survival. As mentioned above, we perceive our survival based on our own anecdotal experiences. The question to ask ourselves, is this correct or is this an underestimation?
  2. Finally, we find that the population on which longevity risk calculations are based may not be appropriate. If we work with an aggregate US population life expectancy (as does the SSA period life tables) we must include a correction for socioeconomic and other factors that are known to impact mortality rates and could underestimate our lifespans. To-date there is evidence to indicate a positive link between income, education, long-term planning, and health. Yes, someone who plans and prepares appears (statistically) to live longer.

In case it is still not clear – let me explain. When planning retirement projections, the length of retirement greatly impacts planning choices (planning for 20 versus 45 years may require different strategies given the same wealth). Considering your specific longevity risk necessitates that we prepare for the contingencies that apply to you. There may be good reasons to target a lower longevity, but for most we will likely need to include, at the very least, a reasonable adjustment for expected increased longevity. This often means distribution of existing assets and thinking about end-of-life questions (a topic most prefer not to address too closely). If you are expecting a longer life, consider accumulating a pool of longevity assets (like some are doing to cover for potential Long-Term Care contingency) or purchasing a longevity annuity (this asset would only be used if you live past a certain age and, therefore, accumulate what are called mortality credits that can provide a good income late in life, but would be lost if you wind up passing sooner).

Obviously, estimations are just that, estimations. Still, a thoughtful scientific approach ought to be the foundation for retirement projections, never speculation or conjecture. Like Emma, some of us will be blessed with a long life, even inadvertently. One way or the other, I want all of us to feel that we’ve had a life well spent, and that will depend largely on how well we’ve planned for possible contingencies in your life.

This educational piece was drawn from my work with clients, www.longevityillustrator.org, the Social Security Administration period life tables, and a recent academic publication by Wade D. Pfau, Ph.D., published in The Journal of Financial Planning, November 2016, vol 29, issue 11, pp 40.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

2016 Presidential Election and the Markets

No matter the results, this is certainly turning out to be an “interesting” election. One of the things I find intriguing, is the willingness of financial “experts” and pundits to make predictions about the economic and financial ramifications of electing either candidate. Predicting the markets is fraught with difficulties at the best of times. Predicting lasting market behavior based on campaign promises and fluid party platforms is impossible.

The summary of pundit prognostications below does NOT reflect my views, but it does reflect the sort of noise I hear daily from market timers and day traders (a high proportion traditionally lean toward the Republican Party).

On a Clinton Victory
What reaction can we expect: Mild relief, to include a rally in stocks and bonds, but nothing particularly bullish though we expect to regain at least our September 30th gains. Expect little change in oil/gold and, similarly, little change in the value of the US dollar by year-end.

Perceived winners: Hospitals (no Obamacare repeal or replacement, maybe some small tweaks); small businesses (new tax breaks); alternative energy (continued investment in alternative energy programs).

Perceived losers: Biotech/pharma (fears of regulation/price ceilings); energy & coal (increased environmental regulation reducing coal and fossil fuel production); private prisons (Clinton wants to shut them down).

On a Trump Victory
What reaction can we expect: Stocks: a selloff lasting into the New Year. Bonds: Treasuries lower in the near term, but not a large change. Dollar: lower as markets take in the cancellation or renegotiation of major trade deals. Gold/Oil: both up on uncertainty.

Perceived winners: Coal (anticipating reduced regulation on coal production and sales); overall energy sector (in a relaxed regulatory environment); pharma/biotech (little or no risk of price controls or ceilings); banks (potentially higher rates, rollback of certain Dodd-Frank regulations).

Perceived losers: Hospitals (changes to healthcare law, including repeal of Obamacare); alternative energy (less funding and support for alternative programs and a return to energy reliance on oil/coal).

For what it’s worth, at the time this goes to press [October 31] online betting sites show a 70% probability that the Democrats will win the Senate and Hillary Clinton a 75% chance of winning the presidency. The media, on the other hand, suggests that there are ways for Donald Trump to garner enough Electoral College votes for an upset victory. This additional uncertainty will have potential market consequences until the end of election day.

As investors, as Americans simply trying to decide how to manage our finances, what do we surmise from all this prognostication? Basically, don’t lose perspective. Our thinking should change very little since our long-term goals have not changed. In 2012, the S&P 500 dropped 7% ahead of and after the election. The level of fear so far indicates that in 2016 we may see a similar drop which will provide another buying opportunity. Personally, though I understand why these predictions are being made I do not believe it is possible to predict market direction in the long-term. Storms come and go and staying the course is safest until the facts are in. Throughout, we remain true to our goals – rebalance as necessary and stick to a well-diversified portfolio.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Retirement Income Planning – Spend early or make it last?

During our working years we plan for retirement or financial independence in part by saving maximally and investing in assets that are likely to appreciate.  While we are working and saving for retirement we are in the accumulation phase. As we approach retirement (within about 5 years) we continue accumulating assets and begin the process of distributing those assets to sustain our chosen lifestyle throughout retirement. When we use an income stream from our assets we have entered the distribution phase.

During the accumulation phase we all focus on portfolio returns and tolerate some volatility. We can weather market fluctuations and lack of liquidity since we are not dependent on the portfolio and have our earnings to support our lifestyle. The main objective is to pay required taxes, support our lifestyle, save, and establish a life that encourages us to flourish.

As we approach the time when our assets alone will be used to support our lives, it becomes essential that we address the nuances of how the assets will be deployed – this is termed Retirement Income Planning.

Retirement Income Planning addresses in a pro-active manner how to create a stream of income for our remaining days (using accumulated assets) once our income from work no longer fully supports our lifestyle. Since the retirement time horizon is unknown, we must marry wishes for early retirement or plans for having larger income distributions with having assets last through an unknowable lifespan.

Running out of money is never an option in retirement but leaving money behind is also not acceptable, if it limits your lifestyle. This balance becomes a challenge as lifespans extend and health preservation becomes more successful and expensive. The latest survey shows that couples aged 65 have more than half probability (56%) of at least one spouse living to age 92. Despite these findings many feel they will not live past 80 and yet, if healthy and productive, they might feel very differently once they reach 90. Planning effectively for longevity is essential and must be weighed against the benefits of early spending.

For Retirement Income Planning, we also need to manage tax liability since we want to be sure that assets last as long as possible, particularly tax-deferred assets that are taxed at ordinary tax rates on withdrawal.

A market downturn can more greatly impact a portfolio early in retirement or just before the distribution phase. In retirement, unlike in the accumulation phase, it is much more difficult for the portfolio to recover from a market downturn. A robust retirement income plan must include ways to deliver the needed income regardless of market behavior.

The new reverse mortgages are income distribution tools that retirees can use to access home equity as part of a retirement income plan. For some, they provide at least three advantages early in retirement: reduced tax liability, longer investment time for the portfolio, and enjoyment of their home until retirees are ready to downsize.

For all retirees preserving their purchasing power (not just preserving the dollar amount) is an essential part of an income plan. Failure to include inflation protection is evident when retirees hold little to no significant equity portfolio and the consequences are dire. Though annuity and pensions are useful income distribution tools they fail unless combined with a strategy that protects against inflation. Sustaining purchasing power is even more significant when considering healthcare expenses. Keep in mind that healthcare costs grow due to inflation and also as a percent of annual spending as we age.

Scenarios that use all available tools to address how to best deploy retirement income will provide each retiring person with confidence to spend early and throughout retirement without fear of outlasting their assets.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com