Rick Ray

How to Look Behind the Numbers of Mutual Fund Performance

If you are a mutual fund investor, it’s hard to resist peeking at those performance reviews published every year, listing top-performing funds. Of course, you may hope your fund will be among them, or you may be seeking new investment ideas. In either case, mutual fund performance statistics can be useful.

But do you know how to look “behind the numbers” to see the true story of mutual fund performance? That story is more intricate than the simple rate of return numbers most performance reviews offer. When you see the whole story, you are in the best position to answer important questions involved in selecting funds, such as: 1) How did the fund achieve its performance? and 2) Does the fund’s performance justify risk taken?

Remember that mutual funds aren’t pieces of machinery that run themselves.  They hire professional managers who develop investment strategies and make specific buy-sell decisions. The performance data is, in effect, the manager’s scorecard. However, the manager may be doing a good job even if the scorecard doesn’t look great at first glance, and the opposite also can be true.

Three Critical Questions

To look behind the numbers, investors should ask three questions that performance analysis can answer:

1. How active or passive was the manager’s strategy?
2. Did the manager’s performance more than justify risk exposure?
3. How did the manager perform against “peers”?

Active Vs. Passive – An index fund is considered totally passive. Its investment decisions are made by formula to match the composition of a benchmark like the S&P 500 Index. On the other extreme are highly active strategies in which managers pit their insights, wits and skills against the market. What most investors don’t realize is that there is a spectrum of semi-active or semi-passive strategies in between the extremes. In today’s competitive mutual fund industry, some fund groups specifically target how active or passive they want managers to be.

Risk vs. Return – If you are evaluating performance over decades, you can afford to focus on returns more than risks. But most performance reviews rank funds based on periods of a year or less. It’s important to take risk into account in evaluating such short-term returns, because the fund that is hottest in an up market is a good candidate to be coldest when the market turns down.

Performance vs. Peers – Before you decide whether your fund’s manager is hero or goat, check to see how performance has compared with “peers” – managers of other funds with similar objectives. Two analytical services, Morningstar and Lipper, divide mutual funds into categories and then rank managers based on either risk-adjusted (Morningstar) or raw (Lipper) returns.

One of the best ways to check your fund’s performance and ranking is to go online at www.Morningstar.com and access a free “Quicktake” report on the fund by typing in its name or symbol. Or, you can ask a professional financial professional to help you access and interpret this information. A financial professional also can help you identify mutual funds that match your needs for specific investment styles or risk tolerance, as well as funds that have consistently pursued active managed and achieved attractive risk-adjusted returns over time.

The Value of Planning as Retirement Approaches

Not long ago, “retirement” for many people meant living on a combination of Social Security and a fixed pension. Today, retired people are living longer and better, and they also are making more personal choices. Most retired people want to “live it up” in their golden years, not watch life pass them by. That puts even more of a burden on the pre-retirement planning process.

Retirement Is Not Predictable

In today’s world, many people slip into retirement gradually in a transition period that occurs over months or years. In some cases, this period begins at an unexpected time, such as when an employer announces layoffs. Few people can predict with certainty which day will be their last on the job, while many people want to keep working (at least part-time) well into the retirement transition.

In the absence of predictable retirement dates, many people put off the serious planning that should take place before retirement. Instead of anticipating changes in their lifestyles or financial circumstances, they wait until too late and then react. This can lead to poor decisions made under pressure, and an unproductive start to their golden years. As a rule of thumb, it’s a good idea to start serious retirement planning at least one year before the transition period begins. This allows adequate time to obtain professional help, understand the many choices available, and make important decisions.

Key Issues and Decisions

What issues and decisions should you evaluate in this pre-retirement planning process? The following are often important:

• Investment asset allocation – Retirement is a good time to assess how much risk you want to take with your investments. Once you stop working full-time, it may be harder to replace assets lost if markets turn down. Also, you may have less time available to recover from a loss. An asset allocation process guided by a qualified financial professional can help to develop an overall investment framework that aims at a specific level of risk, with adequate diversification among asset classes.
  
• Income from investments – Many retiring people expect that investment income will replace part of their paychecks. Since few stocks pay dividends above about
  3-4%, that can mean repositioning assets from the stock market into bonds or cash. Fixed annuities provide guaranteed monthly income payments that can help to fill budget gaps when paychecks stop. In some cases, retired people find that income can be obtained for special needs by borrowing against the accumulated cash values of their life insurance policies. A pre-retirement review can identify the level of income needed and the best sources of investment income.
• Social Security benefits – The decision of when to begin Social Security retirement benefits is important, and usually can’t be changed once made. Whether you apply for benefits as a worker or spouse, you currently can begin receiving benefits as early as age 62. However, permanent benefit reductions are imposed for each month that benefits are received prior to your Normal Retirement Age. As retirement nears, it’s a good idea to check the free Social Security Statement, which contains your earnings history and an estimate of benefits.

• Health benefits – This can be a major issue for people who retire prior to age 65, when Medicare and Medigap coverage may begin. Many employers do not offer to extend group health coverage beyond the period required by law. Even then many retiring workers must dig into their pockets to pay premiums. At age 65, coverage under Medicare Part A (hospital) is automatic for most people, and most retired people also elect to pay the modest premium required for Medicare Part B, which covers doctor bills and miscellaneous medical charges. It’s also important to evaluate private Medigap policies, which cover Medicare co-payments and deductibles.

• Retirement distributions – When workers retire, they can be offered the full balance of “vested” money in their company retirement plans. But before you accept a check for so much money, it is wise to have a clear idea of tax implications and investment choices available. One choice is to receive this money and roll it over to an IRA within 60 days. But even if you meet the rollover deadline, 20% of plan money goes to the federal government in withholding taxes. In many cases, it is better to have the plan directly transfer money into an IRA. Since you don’t handle the transfer, there is no federal tax withholding and 100% of your nest egg can grow tax-deferred.
  
• Estate planning – It’s best to start planning for your estate as early as possible. In recent years, there have been many changes (and proposed changes) in estate tax laws. That makes this a good time to review any existing estate plans, and also to take care of details such as writing a will or creating trusts. Park Avenue Securities (PAS) and The Guardian Life Insurance Company and the representative do not provide legal or tax advice or services.
  

If you reach a point at which you feel pressured to make major decisions without adequate planning, you’ve waited too long. So, obtain the information and guidance you need to calmly consider all your choices. Competent financial professionals will offer illustrations that can help you chart a course through retirement, while projecting the levels of income and assets you need to maintain your lifestyle. In pre-retirement planning, you will make some of the most important financial decisions of your lifetime. Don’t make them in haste or alone.

Wills and Living Wills: A Solid Foundation for Estate Planning

Estate planning helps individuals distribute assets efficiently, during their lifetimes or after death. Whether this planning is extensive or simple, it should begin with two written documents that can be essential in assuring that personal wishes are carried out without hardship to heirs: 1) a traditional will; and 2) a living will.

The traditional will contains instructions that take effect after an individual’s death to distribute property, pay debts, and make arrangements for burial, estate and inheritance taxes. A living will expresses the maker’s wishes for medical treatment in the event of a terminal illness. This article explains why each of these documents should be written and periodically updated.

Why Write a Will?

A traditional will is a legal document that becomes public at the death of its maker. It names the executor of the deceased person’s estate, who will supervise the distribution of assets and the payment of expenses and debts through the estate. A person who dies without a written will is declared “intestate.” The court then names a personal representative for the estate, and state laws often determine how assets are distributed.

Even if a will is hand-written (i.e., a “holographic will”), many probate courts will admit it and honor its requests. It is not a good idea, however, to rely on that kind of will. In addition, verbal wills have little standing in court, especially if they are challenged. To avoid disputes that can be costly and divisive for families of the deceased, wills should be drafted by a competent attorney, witnessed and notarized. In addition to naming the executor, the will can serve several other purposes:

• If an individual dies while responsible for minor children, the will specifies a choice of guardian.

• The will provides instructions for financial assets that pass through its terms. Not all assets pass through a will. For example, most insurance benefits and retirement plan assets pass directly to a named beneficiary.

• The will usually is the best instrument for dividing personal property among heirs, including homes, cars, furniture, heirlooms and tangibles such as jewelry and coins.

• The will can specify charitable gifts to be made post-death, or it can create a trust that takes effect at death to hold specific assets or properties. (A trust created by will is called a “testamentary trust.”)

• The will can direct that specific debts, costs or taxes are to be paid from the estate, rather than from the bequests of heirs.

At least two copies of the written will should be made and stored in safe places that are known and accessible to the maker’s attorney, and the executor. Every will should be updated periodically to reflect changes in circumstances or wishes.

Most people who have large or complex estates prefer to pass the bulk of their assets through beneficiary designations or trusts, rather than wills. While a will is a public document, beneficiary designations and trusts generally are private. For example, any child of the deceased can see and challenge amounts left to others by will. However, terms of a trust usually can be shielded from everyone except the trustee and beneficiary.

Living Wills (Health Care Proxies)

In recent years, many people have become aware of the need to plan for the end of life. A living will (“health care proxy”) is a document in which a person expresses his or her wishes concerning the use of medical measures to prolong life in case of incapacitation. Typically, living wills are used to reject extraordinary measures, such as intravenous feeding and mechanical respirators, in cases when death appears imminent.

A living will is a statement that indicates what its maker wishes in such a situation. It often indicates “informed consent” to withhold food, water, or medications if they are used only to prolong terminal illness of an incapacitated individual. Family members and medical personnel may challenge a living will because of unclear or legally invalid instructions, concern over possible legal consequences, or the emotional difficulty involved in withholding treatment. Also, each state has different laws and regulations that determine the application of such wills, and some states consider the opinions of medical authorities on par with, or superior to, instructions in the will. Even so, most people feel that it is better to have a living will in place than no instructions at all. (Note: A number of states have now adopted the Uniform Rights of the Terminally Ill Act, which recognized declarations made via living wills as valid.)

In summary, writing a will and living will is perhaps the best (and simplest) way to begin focusing on estate planning goals and needs. It doesn’t take much time, isn’t complicated, and doesn’t cost very much. These two simple documents – in writing with notarized signatures – can legally assure that wishes of the maker are carried out and potential save estates and heirs vast amounts of trouble and costs.

Using a Charitable Remainder Trusts (CRT) as a Retirement and Estate Planning Tool

A charitable gift made during a person’s lifetime can be a valuable estate planning technique with three important tax benefits:

1. Estate Tax Break – A lifetime charitable gift removes assets and future appreciation from the potential estate.
   
2. Avoidance of Capital Gains – By giving away appreciated securities, investors avoid capital gain tax that would be imposed if those asset were sold.
3. Current Income Tax Deduction – The fair market value of a charitable gift may qualify for a current income tax deduction in the year the gift is made.

A Charitable Remainder Trust (CRT) can be an attractive way to make lifetime gifts to a charity. In addition to the benefits listed above, it also can provide a fourth important benefit – a lifetime income to the grantor(s).

How a CRT Works

A CRT is an irrevocable trust that names one or more qualified charities as beneficiaries. It requires a trust document and is often funded with appreciated assets. For example, it is common for low-basis stocks to be contributed to a CRT. Once stocks are transferred to the trust, they may be sold by the trustee and the assets can be repositioned to increase income and diversification. Since the trust is a tax-exempt entity, no capital gains tax is due on the sale of trust assets. Because the transfer is irrevocable and the grantor gives up control of assets, they are removed from the grantor’s taxable estate.

The trust generates a current income tax deduction for the grantor/donor in the year the gift is made. It also can provide lifetime income for one or two income beneficiaries. At the death of the last income beneficiary death, the remainder passes to charity and the trust terminates.

The Grantor’s Four Decisions

The grantor of a CRT has four major decisions to make in setting up the trust:

1. Selection of a Trustee – The grantor must appoint a trustee, a person responsible for the CRT’s administration and asset preservation, and perhaps also a successor trustee to act in case the primary trustee dies.
   
2. Selection of a Charity – The law requires that the trust remainder be transferred to one or more qualified charities at the death of the last income beneficiary. However, the ultimate charitable beneficiary need not be irrevocably designated in the trust document. Grantors may change charitable beneficiaries at a later date.
   
3. Selection of Income Beneficiary or Beneficiaries – The income beneficiary receives income payments specified by the trust document for life or a specified period of years. The beneficiary may be the grantor, the grantor’s spouse, another person, or any two people.
   
4. Selection of Income Amount and Duration – An annual income payout to an income beneficiary is required and may be made over a single life, joint lives, or for a period certain of up to 20 years. In making this decision, it is important to take into account the income beneficiary’s income tax needs. While the CRT itself does not pay income tax, the income beneficiary pays tax on trust distributions as received. The character of the income to the beneficiary is the same as it would have been to the trust, were the trust a taxable entity.

How the CRT Tax Deduction is Calculated

The current tax deduction allowed on contributions to a CRT is determined by IRS formula, based on the present value of the remainder projected to be left to the charity.
The formula calculates the discounted value of projected annual income payments to income beneficiaries over the payout period. The total discounted value of these payments is subtracted from the fair market value of assets contributed, and the IRS allows a current tax deduction equal to the remainder. In general, the older the grantor is at the time the trust is established, the greater the current tax deduction will be as a portion of the total value contributed.

Trustee Choices in a CRT

Who can be the trustee of a CRT? Four choices are allowed: 1) a corporate trustee, 2) the charity, 3) an individual; and 4) the grantor.

In reality, the first choice usually is recommended by professionals because of the trustee’s heavy responsibilities. Each year, the trustee must file with the IRS a trust tax return (Form 5227) by April 15. Another important task is the appraisal of property contributed to the trust. Within 90 days after selling trust property, the trustee must submit a signed copy of Form 8282 to the IRS. Corporate trustees have the systems, staffs and objectivity to perform these complex tasks.

Who Can Take Advantage of CRTs?

CRTs can have the most advantages for people: 1) who are generally age 50 or above; 2) have a strong desire to give their time and/or money to charity; 3) are in a fairly high federal tax bracket; and 4) would like to avoid ongoing investment management responsibility, while receiving a steady flow of retirement income that they can’t outlive. When these conditions exist, individuals should consult qualified financial professionals for more guidance on applying this technique.

Advantages of an Irrevocable Life Insurance Trust

Multi-millionaires have always had favorite ways of passing money to their heirs with minimal tax obligations. One of those ways, an Irrevocable Life Insurance Trust (ILIT), has been especially attractive because it combines three types of tax benefits: lifetime reduction of income tax, estate tax planning, and avoidance of income tax on assets passed to heirs. Also, an ILIT can be designed to provide assets for multiple beneficiaries with continuing professional management. Just in the past decade of so, the financial services industry has made ILITs available to people of modest wealth, in addition to the very rich.

How an ILIT Works

In concept, an ILIT is relatively simple. The person who sets up the trust (the grantor) is insured under a permanent life insurance contract owned by an irrevocable trust. In such a trust, the grantor gives up ownership and control. Premiums on the life insurance typically are paid by the grantor through annual gifts. These gifts have no estate tax consequences if they are $12,000 or less per beneficiary per year (as of 2007) and made under a “Crummey power” written into the trust document.

At the grantor’s death, the life insurance pays a death benefit that is income tax free. Because the grantor has given up rights of ownership, the life insurance proceeds generally are not included in the grantor’s estate for estate tax purposes. Virtually all of the death benefit can pass to heirs without tax erosion. Also, the trust can continue to hold money after the grantor’s death and manage it for the future benefit of heirs, using investment strategies that the grantor selects at trust creation. An ILIT can be especially useful in providing for the future care of minor children, and even children yet unborn, when it utilizes professional management after the grantor’s death.

Trust Documents Must Be Customized

ILITs are not for everyone because they require enough confidence and self-sufficiency to give up ownership and control of what may become a significant asset. Also, they aren’t boilerplate trusts that can be set up with fill-in-the-blank forms. Each ILIT trust document should be custom designed, because the grantor must give up control to a third-party trustee – either an experienced individual or a professional trust company (corporate trustee). Specific instructions must be written in the document for the trustee to follow in such important matters as how life insurance proceeds will be managed after the grantor’s death and whether the trustee can exercise discretion.

For example, if the trust is designed to benefit four grandchildren, can the trustee pay out more money to those needing help with college expenses? Can the trustee make discretionary payments or arrangements to provide for a beneficiary with special needs, such as a learning-disabled child? The grantor can be specific in giving instructions during the trust design process, but may have limited flexibility to influence the trustee later.

Several complex areas may require professional attention. For example, the law requires that the life insurance be held in the trust for at least three years after the insured transferred it if the insurance benefit is to escape estate tax at the owner’s death. If the ILIT is the applicant for the policy, and owner from inception, then the three year rules does not have to be met for the proceeds to be excluded.

Yet another complex area involves the Crummey powers that should be written into the trust document, if the annual premiums are to avoid gift tax consequence. Using these powers, named after a landmark legal case, the life insurance premiums that the donor pays each year can qualify for the annual gift tax exclusion (currently $12,000 per person) if they are of a “present interest.” The Crummey court case held that premiums are of a present interest if beneficiaries have even a temporary right to withdraw them. In practice, beneficiaries who are granted Crummey powers rarely withdraw premiums, but they must be legally notified of this right periodically.

The Choice of Insurance

Another important issue is the type of insurance that will fund the program. When a married couple wants to leave a legacy, professionals may recommend a “survivorship policy” that pay a death benefit at the second death. Seek the advice of a financial professional to discuss the various types of life insurance products that may be appropriate for funding an ILIT.

If you are interested in setting up an ILIT, you probably will need at least two financial professional to assist you. One is a trust attorney capable of drafting your document. Unless you already have a personal attorney competent in this area, it’s best to seek a specialist who keeps up to date with issues such as Crummey powers. The second financial professional you may need specializes in helping you implement the trust and select solutions and vendors, including life insurance program and professional trust company. This financial professional should have the advanced training represented by a professional designation such as Chartered Life Underwriter (CLU), Chartered Financial Consultant (ChFC) or Certified Financial Planner (CFP).

If you think an ILIT may make sense for your planning and estate wishes, now is the best time to talk to a professional. Remember the three-year rule, and the fact you can avoid it and have optimum estate tax consequences by having the ILIT apply for the policy as owner from the very beginning of coverage. Also, think about how much better you will feel once you have a well conceived plan in place for the rest of your lifetime, and beyond.

The Truth About Being Well Diversified

We have all heard the saying that warns us to be careful about “putting all our eggs in one basket.” When it comes to diversifying your portfolio, that adage is not only relevant – it could mean the difference between financial success and failure.

Sound investment diversification means choosing balanced investments so that your portfolio will not be heavily impacted by any one trend, event or setback. It involves taking time to identify short-term and long-term investment goals, and then setting a course to reach them through market fluctuations. Any investor can perform well when financial markets are rising. But usually, it’s the well-diversified investor who emerges in the best shape after a downturn in the markets.

Which Risks Can Be Diversified?

Diversification works to reduce some risks, but not all. For example, you could own a Standard & Poor’s 500 index mutual fund that is well diversified among 500 large U.S. stocks. These 500 stocks are components of the index because they mirror the variety of the U.S. economy, including diverse regions and industries. By definition, the S&P 500 Index is well diversified in regard to “stock-specific” and “industry-specific” risks. Yet, if you hold an S&P 500 Index fund through a deep bear market, you would probably lose a substantial part of your money.

The truth is – holding 500 large stocks still exposes you to the “systematic risk” of the U.S. stock market as a whole. Regardless how many different stocks or stock mutual funds you add, you won’t reduce this risk – and in fact you may increase another type of risk, which is the potential to underperform the market average.

The Value of Asset Allocation

The best way to reduce the “systematic risk” of stocks (or any other asset class) is to spread your money among several classes – such as stocks, bonds and cash. This can be accomplished through a disciplined program of asset allocation, which sets guidelines for each asset class based on the individual investor’s return objectives and risk tolerance. The next step is to diversify effectively within each asset class. For the portion committed to stocks, a few carefully selected equity mutual funds can spread money among a variety of industries and company sizes. For the part committed to bonds, you can diversify among short-term and long-term maturities and also among issues with high quality and those with lower quality but higher yield.

Cash has a special purpose in an asset allocation plan for portfolio diversification. Since cash tends to produce more stable performance than either stocks or bonds, it is useful for adjusting overall risk. Even in a terrible year for stocks or bonds (or both), a portfolio diversified partly in cash can emerge without major losses. This not only helps to maintain momentum toward long-term financial goals. It also helps investors maintain confidence.

Important Questions to Ask

Here are some basic questions to ask yourself as you diversify your assets:

• What is my risk tolerance? A financial professional can help you answer this question by understanding your goals and investment experience. The farther away in time your goals are, the higher your risk tolerance can be. Younger people have more time to recover from a setback than older people. On the other hand, novice investors often want to build their confidence at a modest level of risk, which makes diversification even more important. Fortunately, mutual funds enable anyone to diversify among asset classes and investments, even with modest amounts of money to invest.

• How well diversified is my current portfolio? A financial professional can evaluate your current holdings and suggest sensible steps that may increase diversification. For example, many investors now own stocks through a variety of managed portfolios, including mutual funds, IRAs, 401(k)s, variable annuities and variable life insurance. It is possible that these portfolios as a whole are over-concentrated in one or two industries or even a few stocks. In some cases, it can make sense to select different portfolios that reduce concentration and increase portfolio balance.

• How wise is the investment today? All investment strategies have their day. Strategies that performed well in the past often fall out of favor in the future. The historical patterns that make specific investments attractive in one environment may not be repeated in the next phase. Each investment should make sense on its own, as well as in an overall plan for portfolio diversification.

Mutual funds can be a good way to diversify, but there are other solutions that also offer access to different markets, asset classes and professional management styles. They include variable annuities, variable life insurance and individually managed investment accounts. A financial professional can help you evaluate the solutions available for pursuing diversification. Once your plan is in place, the financial specialist can also help you monitor performance and make necessary revisions. Now is the best time to obtain the right amount of diversification for your planning needs.

The Choices in Non-qualified Executive Benefit Programs

To attract and retain skilled employees, small businesses can use a variety of rewards and incentives including bonuses, group benefit programs, and 401(k) plans. For the top tier of executive talent, additional non-qualified executive benefit programs can be offered selectively. This article reviews four types of executive benefit programs:

• Executive Bonus Arrangements
• Split-dollar Arrangements
• Non-qualified Deferred Compensation
• Supplemental Employee Retirement Plans (SERPs)

 

What is a Non-Qualified Executive Benefit Plan?

The term “non-qualified” means that the plan does not comply with a section of the U.S. tax code that grants tax benefits to a “qualified plan.”  A non-qualified plan is not bound by many restrictions imposed on qualified plans, such as requirements to include all eligible employees. Some types of non-qualified plans are not subject to the requirements of the Employee Retirement Income Security Act of 1974 (or ERISA). Thus, they are spared much of ERISA’s red tape. To avoid ERISA requirements, a non-qualified plan must meet the definition of a “top-hat” plan that provides deferred compensation for a select group of management or highly-compensated employees. Although the types of plans described in this article generally meet this test, a tax attorney or employee benefit specialist should be consulted for a determination.

Executive Bonus Arrangements

These arrangements are among the simplest executive benefits to put into place and administer. The company pays the executive a bonus as taxable income, and the expense is deductible for the company. The bonus is used to pay premiums on a permanent life insurance policy with cash value. The executive owns the policy and its cash value and can name or change the beneficiary.  The cash value of the policy can be used by the executive for any purpose, including helping to fund a personal retirement.

The “golden handcuff” element of these arrangements is built into the need to continue funding the life insurance program with annual premiums (via bonuses). If the executive leaves the company, the policy will be worth less or may even lapse. To increase the strength of the “handcuffs,” some companies add a “restrictive endorsement” that requires the employer’s permission to access cash value.

Split-dollar Arrangements

A drawback of Executive Bonus Arrangements is their relatively high cost to the employer, which is equal to the cost of a cash bonus. A Split-dollar Arrangement can create similar advantages at reduced cost. The company and executive agree to split the benefits of a life insurance policy on the executive. Because the company can recover its cash outlays later (when the executive dies or retires) from the policy’s cash value or, in many cases, the full cash value, at most the company’s cost is limited to the “time value of money” on premiums advanced.

There are two basic types of split-dollar arrangements, collateral assignment and endorsement. In the first type, the policy is owned by the employee, who then assigns the cash value to the employer as collateral. In the second type, the company owns the policy and gives the executive (via an endorsement) the right to name the beneficiary. All endorsement arrangements, and those collateral assignment arrangements in which the employer recovers the full cash value, are taxed under what the IRS calls the “'economic benefit regime”; collateral assignment arrangements in which the employer recovers only the premiums it paid are taxed under the very different rules of the “loan regime”.

Non-Qualified Deferred Compensation (NQDC)

NQDC plans fall into a broad category of executive benefits that may take many forms. In simple terms, the plan is an unsecured promise by an employer to pay a benefit in the future. In one common structure, called a “401(k) Mirror Plan,” the executive may voluntarily defer more money from salary than is allowed under regular 401(k) rules. The executive also can decide how this money is invested. The key difference is that the executive does not own any investments in the mirror plan. The company promises to pay a future benefit to the executive, indexed to performance of the investments chosen.

When salary is deferred, the company may not claim a federal tax deduction for the amount deferred and the executive does not include the amount deferred in Federal taxable income. When the employee receives the compensation, the employer then deducts amounts from income taxes and the employee recognizes taxable income.

Supplemental Executive Retirement Plans (SERPs)

A SERP is a type of NQDC plan into which the executive is not required to voluntarily defer salary or bonus. Instead, the company makes a promise to pay a future benefit that can accrue over time based on agreement and executive performance. A key design issue in these plans is how they are funded. Some employers do not fund the liability, but rather pay benefits due from current income. As an alternative, employers may fund the plan with various types of assets.  In most cases, the funding is earmarked among general assets of the company and is available to company creditors. In some cases, these assets are placed in a “rabbi trust,” which provides the participants with some security because assets can’t be touched by the company itself or a future acquirer, although they can be tapped by creditors in the case of the company’s insolvency. 

In summary, having a program for recognizing and rewarding key people is a sign of long-range planning. It shows that the owner has a vision for the future and wants the company’s most valuable people to be part of it. The potential to participate in these rewards also can increase the incentive among rank-and-file employees to work harder, upgrade skills and assume responsibility. Also, rewarding key people can be a preliminary step in identifying a successor owner or manager. This process can potentially help the company survive the unexpected loss of a current owner, while creating the liquidity to buy out the owner’s interest and provide financial security for heirs.

The Choices in Non-qualified Executive Benefit Programs

To attract and retain skilled employees, small businesses can use a variety of rewards and incentives including bonuses, group benefit programs, and 401(k) plans. For the top tier of executive talent, additional non-qualified executive benefit programs can be offered selectively. This article reviews four types of executive benefit programs:

• Executive Bonus Arrangements
• Split-dollar Arrangements
• Non-qualified Deferred Compensation
• Supplemental Employee Retirement Plans (SERPs)

 

What is a Non-Qualified Executive Benefit Plan?

The term “non-qualified” means that the plan does not comply with a section of the U.S. tax code that grants tax benefits to a “qualified plan.”  A non-qualified plan is not bound by many restrictions imposed on qualified plans, such as requirements to include all eligible employees. Some types of non-qualified plans are not subject to the requirements of the Employee Retirement Income Security Act of 1974 (or ERISA). Thus, they are spared much of ERISA’s red tape. To avoid ERISA requirements, a non-qualified plan must meet the definition of a “top-hat” plan that provides deferred compensation for a select group of management or highly-compensated employees. Although the types of plans described in this article generally meet this test, a tax attorney or employee benefit specialist should be consulted for a determination.

Executive Bonus Arrangements

These arrangements are among the simplest executive benefits to put into place and administer. The company pays the executive a bonus as taxable income, and the expense is deductible for the company. The bonus is used to pay premiums on a permanent life insurance policy with cash value. The executive owns the policy and its cash value and can name or change the beneficiary.  The cash value of the policy can be used by the executive for any purpose, including helping to fund a personal retirement.

The “golden handcuff” element of these arrangements is built into the need to continue funding the life insurance program with annual premiums (via bonuses). If the executive leaves the company, the policy will be worth less or may even lapse. To increase the strength of the “handcuffs,” some companies add a “restrictive endorsement” that requires the employer’s permission to access cash value.

Split-dollar Arrangements

A drawback of Executive Bonus Arrangements is their relatively high cost to the employer, which is equal to the cost of a cash bonus. A Split-dollar Arrangement can create similar advantages at reduced cost. The company and executive agree to split the benefits of a life insurance policy on the executive. Because the company can recover its cash outlays later (when the executive dies or retires) from the policy’s cash value or, in many cases, the full cash value, at most the company’s cost is limited to the “time value of money” on premiums advanced.

There are two basic types of split-dollar arrangements, collateral assignment and endorsement. In the first type, the policy is owned by the employee, who then assigns the cash value to the employer as collateral. In the second type, the company owns the policy and gives the executive (via an endorsement) the right to name the beneficiary. All endorsement arrangements, and those collateral assignment arrangements in which the employer recovers the full cash value, are taxed under what the IRS calls the “'economic benefit regime”; collateral assignment arrangements in which the employer recovers only the premiums it paid are taxed under the very different rules of the “loan regime”.

Non-Qualified Deferred Compensation (NQDC)

NQDC plans fall into a broad category of executive benefits that may take many forms. In simple terms, the plan is an unsecured promise by an employer to pay a benefit in the future. In one common structure, called a “401(k) Mirror Plan,” the executive may voluntarily defer more money from salary than is allowed under regular 401(k) rules. The executive also can decide how this money is invested. The key difference is that the executive does not own any investments in the mirror plan. The company promises to pay a future benefit to the executive, indexed to performance of the investments chosen.

When salary is deferred, the company may not claim a federal tax deduction for the amount deferred and the executive does not include the amount deferred in Federal taxable income. When the employee receives the compensation, the employer then deducts amounts from income taxes and the employee recognizes taxable income.

Supplemental Executive Retirement Plans (SERPs)

A SERP is a type of NQDC plan into which the executive is not required to voluntarily defer salary or bonus. Instead, the company makes a promise to pay a future benefit that can accrue over time based on agreement and executive performance. A key design issue in these plans is how they are funded. Some employers do not fund the liability, but rather pay benefits due from current income. As an alternative, employers may fund the plan with various types of assets.  In most cases, the funding is earmarked among general assets of the company and is available to company creditors. In some cases, these assets are placed in a “rabbi trust,” which provides the participants with some security because assets can’t be touched by the company itself or a future acquirer, although they can be tapped by creditors in the case of the company’s insolvency. 

In summary, having a program for recognizing and rewarding key people is a sign of long-range planning. It shows that the owner has a vision for the future and wants the company’s most valuable people to be part of it. The potential to participate in these rewards also can increase the incentive among rank-and-file employees to work harder, upgrade skills and assume responsibility. Also, rewarding key people can be a preliminary step in identifying a successor owner or manager. This process can potentially help the company survive the unexpected loss of a current owner, while creating the liquidity to buy out the owner’s interest and provide financial security for heirs.

How a Business Valuation Helps Company Owners Avoid Guesswork

Many owners of small companies know intricate details about all facets of their business, from sales and marketing to payroll and personnel. Yet, they rarely know one of the most critical facts of all, how much their companies would be worth if they were put on the market.

Determining the “fair market value” of a business is important not only when the owner is putting up a “for sale” sign; it also can affect long-range planning. For example, succession planning can help a business owner make arrangements for transferring shares to a partner or heir through a buy-sell agreement funded with life insurance. To determine the buy-out price and fund it with adequate insurance, it is necessary to know how much the business is worth. At the death of an owner, the value that passes to heirs often is of great interest to the IRS in calculating capital gains and estate taxes.

To obtain an analysis of business value, small businesses may wish to hire a professional appraiser. This individual or company will use techniques described in this article to establish an objective opinion on value. This determination then can be used in a variety of planning applications and may eventually help the owner achieve a higher sale price or lower tax impact after a sale.

From Fair Market Value to Book Value

The goal of a methodical business valuation process is to arrive at a clear and supportable estimate of “fair market value.” Under a section of the Internal Revenue Code, this is defined as:

“…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge or relevant facts.”

In 1959 the IRS issued a revenue ruling that identified specific factors that can influence fair market value. They include the nature of the business, the economic outlook, book value, earnings, dividends, goodwill and recent prices paid for similar businesses.

On an accounting level, the most basic measure of worth is book value – defined as balance sheet assets less liabilities. However, most businesses are sold at prices well above book value, because the balance sheet shows assets at original cost less accumulated depreciation, not true replacement value. For example, suppose a piece of machinery was purchased for $50,000 five years ago and the accumulated depreciation has been $15,000. The balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace it at today’s prices. Generally, only in distressed businesses does book value provide an accurate indication of fair market value.

Enhanced Valuation Tools

Most business appraisers use more sophisticated valuation methods than book value, including those described below:

• Capitalization of earnings – The calculation begins with annual earnings over one or more years. It then divides earnings by a “cap rate” that reflects the cost of capital and the risk of the company. For example, suppose a company has average annual earnings of $200,000 and a cap rate of 10%. Its estimated value under the capitalization of earnings method would be $200,000/10% = $2 million.

• Discounted cash flow – This method, often used to value new businesses or companies with volatile earnings, begins by forecasting future earnings over several years. To account for the time value of money, a discount rate is then applied to each year of forecasted earnings. The discount rate reflects a weighted average cost of capital for similar companies. Finally, a discounted residual value is established at the end of the forecast period. The business value is the sum of all discounted cash flows over the forecast period plus the discounted residual value.

• Comparables and Discounts – Some appraisers modify their estimates of value based on an analysis of recent sales of comparable companies in the same market or industry. Under any valuation method, results may be discounted to account for a reduction in value due to a minority interest (less than 50% of a company) or lack of marketability – the inability to resell shares quickly or easily in a competitive market. Small private companies often qualify for high marketability discounts.

The cost to conduct a comprehensive business valuation can range from a few thousand dollars up to $50,000 or more. Regardless of the cost or methods, it is important for the process to be conducted objectively by a qualified professional based on facts. Normally, the end result of this process is a document in which the appraiser describes the methodology and provides an estimated fair market value that will satisfy the scrutiny of the IRS and courts. In turn, this estimated value is a useful input for the owner in developing succession, estate or personal retirement planning.

An appraisal also may help owners pursue steps for increasing business value over time. As economic cycles and market conditions change, so may the value of a business – and it can be useful to update the process and valuation outcome every few years.

In summary, although many business owners have a vague idea of what their companies are worth, most are merely guessing – and over time, wrong guesses can prove costly. In the worst case, not knowing fair market value could cause owners to sell businesses for less than they actually are worth. For these reasons, the cost to hire a professional business valuation process usually is money well spent.

A Blueprint for Business Succession Planning

The equity that small business owners build in their companies represents a valuable personal asset. But in a privately-held company, how can equity be converted to liquid cash when the owner exits the business?  Creating an exit plan (or “succession plan”) is an integral part of strategic business planning. This article will help business owners understand: 1) why a succession plan is important; 2) how to begin the process; and 3) how to put the plan into action.

The Tax Impact at an Owner’s Exit

Succession planning aims to achieve an optimum outcome for the business (e.g., passing ownership to an heir or selling the company) while also converting business equity into liquid cash when it is needed. This goal is important for two reasons:

1. At retirement, business owners usually want to enjoy their leisure time or pursue other opportunities. After giving up control, they don’t want to worry about the health of a company they have left behind.
   
2. An owner’s heirs may lack the expertise or interest to manage the business. At the owner’s death, they would like to receive cash to increase their own personal financial security, and perhaps also to meet income and estate tax obligations. 

 

The value of a business passed to non-spouse heirs is included in the owner’s estate at death and could be subject to federal estate taxes. These taxes must be paid in cash, and the filing deadline for federal estate taxes is nine months after the date of death, unless an extension is requested. So, even if heirs do not need or expect a business to produce immediate cash after an owner’s death, federal and state governments require cash to settle taxes. In the worst cases, valuable businesses have been put on the market at “fire sale” prices just to meet estate tax pressures.

Aside from taxes, heirs may need cash for other needs including business debts and obligations, the cost of business appraisals, audits, and the cost of closing down the business and paying severance to employees. Almost every business needs a pool of liquid cash to work through a period of transition in ownership. Providing this cash is one of the most important steps in the succession planning process.

Three Key Questions

One starting point for business succession planning is to ask and answer three questions:

1. What is the business worth now on a “fair market value” basis? Fair market value is the amount that a willing buyer would pay a willing seller in an arm’s-length negotiated transaction. A business appraisal conducted by a qualified professional can help to answer this question.
   
2. What will the business be worth when the owner exits? Any future growth in revenues or profits should increase business value. Owners also can increase value by making provisions to groom one or more successors.
   
3. How will heirs obtain a fair value for the business when the owner exits? A solution called a buy-sell agreement pre-determines the terms of a sale (including transaction price) and also provides the cash necessary to complete the sale and pay expenses and taxes.

 

Terms of a Buy-Sell Agreement

A buy-sell may be formed between two co-owners or partners, who each agree to buy out the other’s interest. Alternatively, it may involve the current owner and a designated successor owner, perhaps a family member or top manager.

Most buy-sell participants lack the resources to pay “cash on the barrel” to buy a valuable business. Without planning, they may be capable of completing the transaction only by: 1) borrowing heavily; or 2) paying in installments over time. Since most business owners and their heirs prefer to receive cash at the closing, it is necessary to define the source of the cash well in advance. Often, the primary source is permanent life insurance.

Valuing the Business

After a successor is determined, the next step is to determine the buy-out value. While small business owners have some flexibility in setting the price of a buy-out transaction, the IRS and courts may insist on a valuation that represents fair market reality, as determined by an accepted method. The methods include:

• Comparable recent transactions – Business value is based on the terms of sales or mergers involving companies of comparable size in the same industry or market area.
  
• Multiple of revenue or book value – Business value may be pegged to a multiple of gross revenues in the year or two just before the owner exits. For example, many service-oriented businesses sell for about one to two times annual gross revenues. Or, the value may be pegged to an audited balance sheet as a multiple of “book value.”
  
• Discounted cash flow—The value is based on total cash flow that the business is projected to generate for a period of years (typically three to five) after the owner’s exit, discounted by a cost of capital.
  

Hire an Attorney to Draft a Legal Agreement

The next step is to formalize the buy/sell arrangement through a written agreement with the help of an attorney experienced in succession planning. Ideally, this attorney also has some proficiency in estate tax planning and business valuation. An important section of the agreement defines the “trigger events” that will require ownership to change hands. Common trigger events include an owner’s death, disability, retirement, divorce, or separation from employment. When a buyout is triggered by an event other than death, the legal agreement also may include provisions that prevent the departing owner from competing against the company or disclosing its trade secrets.

Provide Funding to Assure that the Agreement is Carried Out

Permanent life insurance typically is used to fund buy/sell arrangements because coverage can continue, and premiums remain affordable, at any age. Funding buy/sell arrangements with permanent life insurance also has other benefits:

• Quick and convenient cash for heirs – Life insurance solves the problem of turning an illiquid asset (the business) into liquid cash for heirs or estate settlement.
  
• Tax advantages – Life insurance pays a death benefit that is free of federal income taxes. In buy/sell arrangements, the benefit is usually paid to either a surviving party or else the company itself, so the death benefit does not create estate tax consequence for the estate of the deceased.
  
• Affordable, level premiums – Permanent life insurance can be purchased at affordable level premiums, especially when the insured person is fairly young and in good health.
  
• Cash value—The cash value of a permanent policy can provide buyout funds if an owner exits at a trigger event such as a divorce or normal retirement. Most agreements include provisions for terminating the buy/sell by mutual consent or if specified events occur. In this case, policy’s owner can recoup part of the premium cost from cash value.

Planning for a Long-Term Disability

In addition to an owner’s death, another trigger event that can be pre-funded with insurance is an owner’s long-term disability. In this case, disability income insurance can be purchased to fund an obligation written into the buy-sell agreement. This insurance pays to the beneficiary a stated amount of lump-sum or periodic income (after a waiting period) that can be used to fund part or all of a buyout.

In summary, business owners rarely stop working long enough to ask why they are working so hard. But there will come a day when this question will become paramount. Ultimately, a small business may not maximize long-term success for the owner and heirs unless the owner plans ahead to reap the rewards.