Asset Allocation – Who Are You Investing For?
It’s been widely publicized that a principal determining factor in the volatility and return of an investment portfolio is the portfolio’s asset allocation. The Financial Industry Regulatory Authority (FINR A) defines “asset allocation” as follows:
“Dividing your assets on a percentage basis among different broad categories of investments, including stocks, bonds, and cash. Asset allocation is a strategy for reducing the risk associated with investing. Since your portfolio is spread among different asset classes, it’s less likely that they will all perform badly at the same time. Finding the right mix of assets depends on your age, your assets, your financial objectives and your risk tolerance.”
Financial advisors often cite the results from a study published in 1986 “Determinants of Policy Performance,” by Brinson, Hood and Beebower, which concluded that 93.6 percent of the variation of returns is explained by a portfolio’s asset allocation policy. While the findings of this study have been debated, specifically the actual degree to which asset allocation drives an investment portfolio’s outcome, there’s agreement that, regardless of the actual percentage, asset allocation plays an essential role in determining an investment portfolio’s return.
This definition refers to a number of factors that should be taken into consideration when choosing an appropriate allocation. These include:
• Risk Tolerance
• Financial Objectives
• Current Assets (need to diversify)
• Age (time frame assets will be invested)
There are, however, a number of additional factors that should be considered:
• Taxation
• Liquidity
• Beneficiary
Most people recognize the first six factors listed above. The higher risk one is willing to take, the higher the potential return will be. The appropriate mix of stocks, bonds, and cash will depend on other assets you currently own. Some investments may be appropriate for short-term goals, while others are better suited for long-term financial goals. Some investments create income that’s taxable at ordinary income tax rates, some create long-term capital gains which may be taxed at lower capital gains rates, and some investments produce tax-free returns. And finally, there are investments that restrict access or are difficult to liquidate, while others are highly liquid.
However, the final factor—who will benefit from your investment success or suffer from your investment losses—is often overlooked. Considering whom you are investing for is an important element in determining how to position your discretionary financial resources. If these funds are going to be used to pay for a child’s college education, you’re investing for the benefit of the child. If the funds are meant to provide income when you and your spouse retire, you’re investing for the benefit of yourself and your spouse. If you have established a private foundation, the funds you have contributed will eventually benefit charitable organizations and/or individuals in need.
The FINRA definition refers to three broad categories of investments—stocks, bonds and cash. The characteristics of a cash position include very low investment risk levels, high accessibility, and relatively low returns. Examples of cash investments include bank accounts, money market funds, and certificates of deposit. Bonds are characterized by low risk of principal (depending on the grade of the bond issued), higher expected returns than cash and income that may be tax-free (depending on bond type).
There is, however, another asset that combines the advantages of cash investments and bonds, provides a number of other unique advantages and is particularly well suited when the funds are being invested for the benefit of future generations (children, grandchildren, etc.) life insurance. Advantages of a cash value life insurance policy include:
• Builds cash surrender values which are readily accessible
• Cash values grow on a tax-deferred basis and, when properly designed, may be distributed tax-free
• If structured correctly the death benefits are received income and estate tax free
• Potential for higher growth rates than cash positions
• Low risk to principal
• Death benefits may be easily split up between heirs
• In many states, life insurance cash values and death benefits are protected from creditors by statute
• Beneficiaries receive a highly liquid asset (cash)
• Provides financial protection from the premature death of the investor—protects the individual(s) the investments are intended to benefit.
When the intended benefactors of your investment decisions are your children or grandchildren, it’s important to consider the issues that may arise out of the particular assets that make up your estate will consist. Consider the following:
ASSET | POTENTIAL ISSUES |
Family-Owned Business |
• Some children involved in business, some are not, family strife almost always results when children who are not involved in the business receive ownership. • It is a difficult asset to value • If the children not involved in business the death of the owner may cause a fire sale at substantially discounted price. |
Commercial Real Estate |
• One child may need cash and wants properties sold, while other child understands it may be a bad time to sell • Downturns in the real estate market are a risk • Heirs are responsible for maintenance, insurance costs and real estate taxes until property sold • Heirs subject to legal risks as property owners. |
Marketable Securities |
• During your life, they are subject to market risk. • Marketable securities are a liquid asset and potential target for creditors. |
Second Residence |
• One child may want to retain the property, another child may want to sell it. • The property may hold sentimental value. • Heirs are responsible for maintenance, insurance costs, and real estate taxes until sold. • Heirs subject to legal risks as property owners. |
Farm / Ranch Land |
• Land valuable on paper, but doesn’t generate sufficient income for upkeep. • Maintenance costs and real estate taxes may be substantial. • Land may be more valuable if developed, but heirs may disagree about whether to maintain it as ranch land or to receive the highest price. |
Qualified Retirement Plans / IRAs |
• These are subject to both estate taxes and income taxes upon the death of participant, depleting the asset by as much as 60 percent to 70 percent. |
Life insurance may be used as a wealth transfer tool to accomplish many goals—protecting your children from mismanaging their inheritance, avoiding family strife after your death, avoiding probate and protecting the inheritance from creditors. It also provides the perfect asset (cash) at your death, should your heirs need liquidity. Life insurance ensures that your heirs receive exactly the amount you want them to receive, when you want them to receive it. It provides an asset that avoids the family strife that often arises out of receiving property, such as commercial real estate, vacation homes, personal residences and closely held businesses.
This article originally appeared on mainstreetpractitioner.nsacct.org
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