Executive Summary

To be credible, any form of wealth planning must be capable of addressing the following issues:

• Real wealth involves sustainable Cash Flow, and most people are more concerned with running out of money than any other financial issue.
• An effective wealth planning program must have the capacity to:
  1. Gauge the financial impact on long-range Net Worth of a client’s specific, year-by-year, required after tax Cash Flow (including a factor for inflation);
  2. Calculate the most efficient distribution from liquid assets to produce the required Cash Flow;
  3. Convert illiquid assets to liquid assets at any time a shortfall of required Cash Flow exists;
  4. Calculate Net Worth using realistic asset-by-asset client assumptions (after accounting for required Cash Flow);
  5. Illustrate revisions to the asset mix to improve Cash Flow and maximize Net Worth;
  6. Include special gifting strategies for clients wanting to support charitable institutions;
  7. Maximize Wealth to Heirs in coordination with the most efficient pre-death Net Worth;
  8. Illustrate varying levels of death taxes due to the unstable nature of federal estate taxes;
  9. Analyze all planning variations in “do-it-versus-don’t-do-it” graphical comparisons;
  10. Provide year-by-year numerical backup for every aspect of the analysis so that professional advisers can easily audit any aspect of it.

There are many narrow gauge issues addressed by specialty programs (retirement planning, pension analysis, asset allocation, estate taxes, and charitable giving, to name just a few), and these programs retain their importance; however, effective wealth planning only takes place when the recommendations from these focused programs are integrated into an overall analysis containing the features noted above. This is because the key determinant of the effectiveness of any analysis must always be don’t run out of money before you run out of time, and it is impossible to measure the impact of a narrowly focused recommendation on Cash Flow and Net Worth without integrating it into an overall plan.

For the client reading this Summary: Most advisers do not offer this type of analysis, but every single-issue financial strategy you consider must be looked at in this manner because you don’t want to run out of money before you run out of time. Once you establish your initial Wealthy and Wise base line, it will be simple to “test drive” any new financial consideration through the model to gauge its impact on your Cash Flow, Net Worth, Wealth to Heirs, and in many cases, Wealth to Charity.

For the marketing and compliance officers of financial institutions: The suitability of recommendations is not complete unless they are evaluated within the context of a Wealthy and Wise analysis.

For the planning specialist reading this Summary: If you are not using Wealthy and Wise logic, pray your competition isn’t either.

The Logic of Wealthy and Wise^®

Detailed Analysis

Real wealth involves sustainable Cash Flow, and most people are more concerned with running out of money than any other financial issue: Net Worth certainly has value, but the amount of sustainable after tax Cash Flow that can be produced from Net Worth is the real measure of wealth. Also keep in mind that the invasion of Net Worth to provide an unrealistic level of Cash Flow is bound to end up producing no Cash Flow at all. How are people to know? A Wealthy and Wise analysis tells the story as shown in the following graphic.

Male 65; Female 60

$3,000,000 in Liquid Assets Available to Provide Retirement Cash Flow

Annual After Tax Cash Flow:

Strategy 1: $100,000

Strategy 2: $150,000

Strategy 3: $200,000

As you can see from the Strategy 3 flag pointing to zero, $200,000 in Cash Flow produces a mid-range disaster as the liquid assets producing Cash Flow disappear at ages 85/80. Strategy 2 hangs on longer, but it eventually dissipates as well. Strategy 1 more than supports its level of Cash Flow and also provides for a substantial inheritance for heirs.

This analysis also calculates that Strategy 1 can support $29,000 in additional annual Cash Flow with Liquid Assets never dropping below their starting point of $3,000,000. The $29,000 can be used for: 1) additional retirement Cash Flow; 2) gifts to heirs; 3) funding deductible gifts to charity in the amount of $42,000 (31% tax bracket assumed); or 4) a combination thereof.

Every individual contemplating retirement (or any other scenario that requires Cash Flow) must be certain to determine the sustainable level of Cash Flow that a given level of liquid assets will provide. In addition, a valid analysis must also illustrate the conversion of some or all illiquid assets (if present) to liquid assets whenever a shortfall of Cash Flow occurs.

Only a Wealthy and Wise analysis has the capacity to illustrate these critical scenarios.

Distribution logic is critically important: Matthew and Catherine Fox, age 65 and 60, have the following liquid assets available for retirement income:

$     600,000 Certificate of Deposit -- assumed yield: 4.00%
$     833,333 Muni Bond Fund -- assumed yield: 3.50% (mgt. fee of 0.35%)
$  2,250,000 Mutual Funds -- assumed yield: 7.00% growth; 1% dividend
                                                    (mgt. fee of 0.80%) (cost basis: $750,000)
$    750,000 Matthew’s IRA -- assumed yield: 8.00% (mgt. fee of 0.80%)
$    900,000 Catherine’s IRA -- assumed yield: 8.00% (mgt. fee of 0.80%)
$ 5,333,333 Total

Matthew and Catherine want $200,000 a year in after tax retirement cash flow compounding by 3.00% for inflation. Imagine it is the first day of the first month of retirement. They need $16,667 (200,000/12) for the first month. From which account should they take it -- and does it make any difference?

It makes a significant difference. The order in which liquid assets are accessed for cash flow should be prioritized in order to produce the highest possible long-range Net Worth. This is generally the most overlooked aspect of wealth planning. Let’s provide the desired cash flow but compare the least efficient withdrawal order (“Bad Logic”) to the most efficient (“Good Logic”).

Comparing the two strategies, below are the Net Worth results for Matthew and Catherine. We’ll refer to the most efficient Good Logic as “Strategy 1” and the least efficient Bad Logic as “Strategy 2”.

In this example, there is a 49% increase in long-range Net Worth using the most efficient distributions. It is clearly a major component of effective wealth planning.

Informed decisions require a comparative analysis: The reason many well-intentioned, single-issue recommendations are never implemented is because the planner or adviser neglects to include the impact of the recommendation on a coordinated evaluation of Cash Flow, Net Worth, and Wealth to Heirs.

Take the example of John and Fran Sandor, age 65 and 60. Their financial adviser has recommended they acquire Long-Term Care policies. Should the Sandors purchase the policy or is their Net Worth sufficient to self-insure the potential risk? They have current Net Worth of $3.5 million and after tax cash flow requirements of $80,000 a year plus a 3% inflation assumption.

Where does the money come from to purchase such policies? The typical presentation assumes the funding source is the Sandors’ current Cash Flow; however, this affects the Sandors’ lifestyle in uncomfortable ways. The sensible approach is to access assets that make up the Sandors’ Net Worth.

While this may make sense from a Cash Flow perspective, won’t a reduction in assets produce a corresponding reduction in Cash Flow? And won’t a reduction in assets increase the possibility of running out of money before running out of time? These are all valid issues, and they can only be addressed with a Wealthy and Wise analysis.

Here are the assumptions for the evaluation:

• Assume a claim for one of the Sandors occurs in 8 years that lasts for 6 (until death).
• Assume the total daily benefits for the claim on a monthly basis will be $6,000 in today’s dollars -- and medical inflation averages 5% a year.
• Assume the annual premium for a Long-Term Care policy covering both John and Fran is $12,000 -- reducing to $6,000 during and after the claim period. Assume an inflation rider is included in the premium which increases total monthly benefits by 5% (compounded) a year.
• Assume retirement cash flow needs decline by 25% during and after the claim period.

The following graphic represents the results of this analysis for the Sandors comparing Strategy 1: No Claims; No Premiums; Strategy 2: Self-Insure LTC, and Strategy 3: Insure LTC.

Why is buying the LTC insurance the most efficient option?

Remember this assumption? “Assume retirement cash flow needs decline by 25% during and after the claim period.” It’s simple mathematics -- the reduction in retirement cash flow more than offsets the cost of the premiums for the Long-Term Care policies -- including time value of money. (The reduction in retirement cash flow during and after the claim has also been included in the self-insured option.) This may be a surprise result, but you can’t tell until you test each assumption!

Maximizing Net Worth: Different income-producing assets produce Cash Flow in various forms and yields. A methodology is needed to determine the most efficient use of various assets in order to produce the required after tax Cash Flow while simultaneously maximizing Net Worth.

For example, concern often exists about the quality of the tax deferred funds contained in an IRA, 401(k), or Keogh. Tax deferral is great, but the death tax can be staggering since it can combine income and estate tax. This often causes these accounts to be the target of what many call “pension predators” who recommend various financial alternatives funded by withdrawals from tax deferred funds.

Let’s review this in some detail.

Harry and Angela Dorsey are age 55 and 50 and intend to retire in five years. They have $800,000 in an IRA as part of their current liquid assets of $4,000,000. Assume they want $100,000 in today’s dollars in after tax retirement Cash Flow indexed for annual inflation at 4%.

Examine the following graphic:

Strategy 1 illustrates the withdrawal of money from the IRA first to support their required after tax Cash Flow, and it reflects incredibly poor advice -- yet “IRA first” is a common planning recommendation.

Strategy 2 illustrates the withdrawal of required minimum distributions only from the IRA and, compared to Strategy 1, this procedure enhances their long-range Net Worth by more than $6,000,000.

Only Wealthy and Wise evaluates and compares these two alternatives within the context of Net Worth.

The poor results of Strategy 1 are also carried over to the Dorseys’ heirs as you can see below. The planner who makes the “IRA first” recommendation to the Dorseys is, through bad advice, confiscating over $2,300,000 in long-range Wealth to Heirs.

Note: Due to consistent long-range inaction in Washington, no one knows what the level of estate taxes will be after 2012. We believe there are four possible outcomes:

1. Exemption of $5,000,000 per person with a top rate of 35% through 2012; then revert to 2001 rules of $1,000,000 per person with a top rate of 55%. (Current law.)
2. Exemption of $5,000,000 per person with a top rate of 35% through 2012; then permanent repeal.
3. Exemption of $5,000,000 per person with a top rate of 35% through 2012 and all years thereafter.
4. Exemption of $5,000,000 per person with a top rate of 45% through 2012; then per person reduced to $3,500,000 with an increase in the top rate to 45%. (This is President Obama’s recommendation.)

Note: The Wealth to Heirs graphic above assumes Option 4 although Wealthy and Wise can illustrate any of the four options.

The current instability of estate taxes causes many clients to postpone important planning decisions, and access to an analysis that can consider alternative estate tax scenarios is valuable.

Adjusting Net Worth in favor of a charitable cause without penalizing Wealth to Heirs: Continuing with the Dorsey analysis, an IRA (and any other tax deferred account, e.g. 401(k), Keogh, tax deferred annuity) is heavily taxed at death -- in some cases, as high as 80% counting both income and estate taxes.

As a result, many charitable commentators recommend leaving an IRA to a charity at death so no such taxes are imposed -- and replacing the value of the tax deferred asset to heirs with tax free life insurance owned by a wealth replacement irrevocable trust (formed on behalf of heirs). The proceeds of life insurance funded in this manner are not subject to income or estate taxes.

If the Dorseys change the beneficiary of the IRA to their favorite charity to take effect only after they both die, 100% of the residual value of the IRA is preserved for a favorite charitable cause. Prior to death, the asset remains an accessible liquid asset available to the Dorseys. (Incidentally, they can further change the beneficiary of the IRA at any time prior to death.)

Strategy 3 (a so-called “Charitable IRA”) produces the comparative results shown below. A $2,000,000 life insurance policy with an increasing death benefit has been injected into Strategy 3 with the wealth replacement irrevocable trust as policy owner and beneficiary. Gifts to the trust to fund the policy’s annual premium of $18,000 have been added to the Cash Flow requirements of Strategy 3.

Strategy 3 produces a significant long-range gift to charity in excess of $2,500,000 with a considerable improvement in Wealth to Heirs in all years.

For the arrangement to be acceptable, the Dorseys must have a strong charitable motivation and must also be able to tolerate the reduction of their long-range Net Worth (caused by the additional Cash Flow required for the gifts to the trust).

Without a Wealthy and Wise analysis, the Dorseys would have great difficulty in gauging the impact of this particular approach in the context of their overall Cash Flow, Net Worth, Wealth to Heirs, and Wealth to Charity.

Below is another way to look at the results -- dollars to the IRS or dollars to a favorite charity?

Note: The tax of $1,241,513 associated with Strategy 2 (IRA Last) is income tax caused by salvaging so much of the IRAs values by keeping it intact for as long as possible. This is what causes the Wealth to Heirs in Strategy 2 to be so much better than Strategy 1. Wealthy and Wise also has the capacity to reflect the so-called “stretch-out” option which provides that the residual values of an IRA can be inherited by the next generation with its income tax deferred status intact until heirs make the required withdrawals. A Charitable IRA in conjunction with a wealth replacement irrevocable trust is generally a preferred approach since, in addition the benefit to charity, heirs inherit a tax free capital account rather than an account on which income taxes are still due.

Conclusion: With the growing commoditization of financial products, some financial advisers increasingly tend to recommend products and strategies in a vacuum instead of integrating them into an overall plan. The analytical process described in this report is the only mechanism that allows a client to evaluate a recommendation in the comparative context of its overall impact on Cash Flow, Net Worth, Wealth to Heirs and, if part of the consideration, Wealth to Charity. Acting on any financial recommendation that is not integrated in this fashion should be delayed until such an evaluation occurs and satisfactory conclusions are reached. Wealthy and Wise is not necessarily designed to replace other financial software programs; however, once any program generates a recommendation, planning is not complete until that recommendation becomes part of a Wealthy and Wise analysis.

Other Wealthy and Wise Concepts Using a Comparative Analysis

Currently available:

Annuity rescue
Arbitrage using of a Single Premium Immediate Annuity
Downsize or upsize home (or Refinance)
Reverse mortgage
Charitable remainder trust (CRT)
Family Limited partnership (FLP)
Loan-based private split dollar
Private limited collateral assignment split dollar
Premium financing

Coming soon:

Deferred income annuity (with guaranteed minimum withdrawal benefit)
Inherited IRAs
Roth IRAs
Inherited Roth IRAs

Planned for 2013:

Grantor retained annuity trust (GRAT)
Charitable lead trust (CLT)
Intentionally defective irrevocable trust (IDIT)
Installment sale to an intentionally defective grantor trust
Dynasty trust
Self-cancelling installment note (SCIN)
Private Annuity

Wealthy and Wise is published by InsMark, Inc., San Ramon, CA. For more information or to license the software, go to http://www.insmark.com/products/wealthy-and-wise-system or call an Account Executive at 1-888-InsMark (467-6275). For information about corporate accounts, call David A. Grant, Senior Vice President - Sales, at 1-925-543-0513.

Note: Information in this report is educational, and comparative data is hypothetical. Examples and case studies are for illustration purposes, and actual results may vary. Legal and tax information is for general use only and may not be applicable to specific circumstances. Clients should consult their own legal, tax and accounting advisors to assist in the evaluation of any potential transaction or strategy.

IRS Circular 230 Disclosure

In order to comply with requirements imposed by the IRS which may apply to this document (including any attachments, enclosures, or referred material) as distributed or as re-circulated, please be advised that the material contained herein is not intended or written to be used, and it cannot be used, by anyone for the purposes of avoiding any penalty that may be imposed by the Internal Revenue Service under the Internal Revenue Code. In the event that this document (including any attachments, enclosures, or referred material) is also considered to be a “marketed opinion” within the meaning of the IRS guidance, then, as required by the IRS, be further advised that the material contained herein is written to support the promotions or marketing of the transactions or matters addressed by the material contained herein, and, based on the particular circumstances, you should seek advice from an independent tax advisor.

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