FINC320 Final Study Guide
The Retirement Cash Flow Plan
The variables which influence the plan include:
client current age
client age at retirement
projected living expenses
social security benefit
current assets and liability
inflation assumptions (2~5%)
investment assumptions: returns and volatility
life expectancy assumptions
Cash Flow Planning
a financial planner should always remember the sensitivity of variables when evaluating a client’s retirement needs analysis
for example, if a client assumed an 8% rate of return over a 40-year period, the client will actually experience years with returns lower than 8% and years with returns higher than 8%
we will consider cash flow projections using:
a straight line approach
(assume constant rates for growth)
a monte carlo approach (run 1000’s of scenarios)
randomly sample returns each year based on an average return and volatility
Life Expectancy
the amount of money your client needs to accumulate in order to live comfortably depends on how many years she will be withdrawing funds from her retirement accounts (i.e., her life expectancy)
the life expectancy for a 30 year old women in 2018 is approximately 86,
that is 19 years for retirement (86-67)
however, that’s the average. we need to plan around our clients living longer than the average. otherwise, 50% of our clients will run out of money
many planners use ages 90 or 95 as life expectancy
Cash Flow Planning — Monte Carlo Approach (Simulation)
using software, we can take the scenario we just created and run it 1000 more times. Each time we let the variables change: investment returns and inflation
Alternatives if the probability of success is low
if the probability of success is less than 100%, we gain insight into how often the client would need change their plan
example: probability of success = 85%
15% of the 1000 scenarios the client was unable to maintain their spending level through age 9-
options for clients with a low probability of success:
postpone retirement or work part-time in retirement
downsize their home
reduce discretionary spending
consider a lifetime annuity
*The point of the next three topic headers is to make you aware that social security may pay others based on your benefit
Eligibility for Disability Benefits
6 credits in 3 previous years if disabled before age 24
2 credits per year between age 21 and year of disability if disabled between ages 24 and 30
20 to 40 credits, depending on age, if disabled after age 30
Benefits for Spouse
Spouse may receive 50% of employee’s PIA benefit at normal retirement age
Spouse may receive the higher of (1) the above amount. or (2) her own Social Security benefits, but not both
Benefits for Children
Unmarried children under the age of 18 (or under age 19 if still in high school) may also receive benefits
Retired or disabled parents
50% of the parent’s PIA
Deceased parent
75% of the parent’s PIA
Is a retiree taxed on their Social Security benefit?
Possibly! You will pay tax on your Social Security benefits if you are:
“Individual” and your combined income is
between $25,000 and $34,000, you pay tax on up to 50% of your benefits
more than $34,000, up to 85% of your benefits may be taxable
“Married filing joint” and you and your spouse have a combined income that is:
between $32,000 and $44,000, you pay tax on up to 50% of your benefits
more than $44,000, up to 85% of your benefits may be taxable
distributions from 401k and IRA accounts create income!
Retirement Accounts (Vehicles)
equivalent to the decision to buy an automobile
Car, OR
engine: built for speed
tires: designed for comfort
gas mileage: good
terrain: on road only
Truck
engine: built for power
tires: designed for durability
gas: poor
terrain: on or off road capabilities
both a car and truck will get you from point A to point B
however, the choice between using a car or truck has implications depending on the route you take
Company Retirement Plans
Qualified plans
qualify for all kinds of special benefits
lots of rules
ex: 401(k)
there are limits to the employee’s benefits
employee discrimination is prohibited
high salary vs low salary
subject to ERISA rules
coverage, participation, and vesting rules apply
coverage: cover every employee in the firm
participation: on the next slide
vesting: a period of time until matching money in retirement account becomes yours
employer takes deduction in current year
earnings on assets are tax deferred
employees have no income until a distribution is made
benefits are protected from both the employee and employer’s creditors
can rollover assets to an IRA
Non-Qualified plans
not as many rules
there are no limits to the employee’s benefits
employee discrimination is allowed
not subject to ERISA rules
no coverage, participation, and vesting rules
employer takes deduction when employee receives income
earnings on assets taxable to the employer
employee has income unless there is a risk of forfeiture (if the company gets sued, some of the money gets lost in the lawsuit)
benefits are subject to the employer’s creditors
no rollover option
ERISA — The Employee Retirement Income Security Act is a federal law that sets minimum standards for most retirement plans to provide protection for employees
Qualified Plans: Defined Contribution vs Defined Benefits
Defined-Contribution Plans (DC)
employer contributes a dollar amount (the contribution)
employees bear all the investment risk
individual investment accounts for each employee
favors young employees who have a long time horizon to accumulate savings
employee and employer get a deduction for contributions
types of DC plans include
profit sharing plans (most popular)
401(k) plan
employee stock ownership plan (ESOP)
allows employees to buy company stock at a discount without taxes
money purchase plans
target benefit plans)
Defined-Benefits Plan (DB)
employer promise to pay a dollar amount (the benefit)
employer bear all the investment risk
one account for the employer to manage
favors long-term and/or highly compensated employees due to payout formula (front-load the account)
usually only the employer contributes and gets the deduction
types of DB plans include
pension plans (less common today)
cash-balance plans
401(k), 403(b), 457 Plans
employer contributions are deductible up to 25% of participating payroll
solo 401(k) plan
for small business that have no employees (other than a spouse)
cheap and easy
ideal client: wants employees to contribute to their retirement, wants employees to bear investment risk, want deduction for current years
Pension Plans
Defined benefit is determined based on the company formula. For example:
Benefit = Years of Service x 2% of Average Salary x 2%
the benefit can be increased if the employee delays retirement or decreased if the employee retires early
the employer funds the pension account each year based on an amount determined by an actuary
have to hire the actuary
fairly expensive to administer
ideal client: employer wants to bear investment risk (family business), wants to reward older/longer-term employees
Cash-Balance Plans
hybrid DC and DB plan
it is a DB plan
employer bears only the investment risk up to a set rate of return
example: guarantees 7% return on plan assets
not defining payout, defining rate of return
individual accounts are not established
the accounts may appear as separate accounts
Permitted Vesting Schedule
Employee contributions
always 100% vested —> if you quit, that money goes with you
Employer contributions
DC plans
Cliff vesting — 100% vested after 3 years, 0% prior to 3 years
can offer less than 3 years, but cannot offer more than 3 years
if you leave at any point before 3 years, you don’t take the plan with you
Graded vesting — 20% vesting after 2 years and vesting increases an additional 20% per year (total vesting after 6 years)
the “after 2 years” can be changed but must be to the employee benefit
DB plans
Cliff vesting — 100% vested after 5 years, 0% prior to 5 years
Graded vesting — 20% vesting after 3 years and vesting increases an additional 20% per year (total vesting after 7 years)
SEP and SIMPLE plans
100% vested immediately
HCE = Highly Compensated Employee
Coverage Requirements
the DC and DB plans must pass at least one of the following three tests:
Percentage test — At least 70% of non-HCEs (under $155,000) covered by plan —> typically the test they try to pass
Ratio test — percentage of non-HCEs covered equals at least 70% of HCEs covered
example: if the plan covers 90% of HCEs, it must cover 63% of non-HCEs
Average benefits test — Average benefit of non-HCEs equals at least 70% of the average benefit of HCEs
Other Tax Advantaged Retirement Accounts
Not tied to a company
Traditional IRA
Roth IRA
including conversion analysis
Tied to a company
Small business (less than 100 employees)
SEP
SIMPLE
Non-profit organizations
Section 403(b) plans
Government
Section 457 plans
Self-employed
Keogh (HR-10) plans
IRA, 401k, and 403b Timeline
Contributions are tax deductible
Withdrawals are allowed at 59 ½ (penalties if taken out early)
Withdrawal required
Age 70 if born before 1949
Age 72 if born between 1/1/1949-12/31/1950
Age 73 if born between 1/1/1951-12/31/1959
Age 75 if born after 1/1/1960
Withdrawals are taxed as income
the government wants their taxes
about 4% of the account needs to be withdrawn each year
Roth IRA, Roth 401k, and Roth 403b Timeline
Contributions are after-tax dollars
Withdrawals are allowed at 59 ½
No required distributions
due to after-tax contributions
Withdrawals are tax free
Roth IRA Conversions
Traditional IRA’s can be converted into ROTH IRA’s
The value of the Traditional IRA will be considered taxable income in the year of the conversion
The taxpayers are better off with this strategy if they have enough cash in their taxable savings accounts to afford the tax bill associated with a Roth Conversion
Roth IRA Conversion
Step 1: Forecast your future tax bill
Step 2: Identify years with low tax liability
Step 3: Test for optimum amount to convert with breaching higher tax brackets
Use a software such as eMoney is required
Backdoor Roth
(when your income doesn’t allow you to contribute to a Roth IRA)
have to be careful with these
1 — Contribute to a traditional IRA. Assuming you are not allowed a tax deduction because your income is too high. For high income individuals, contributions are made on an after-tax basis
2 — Immediately convert your after-tax IRA contribution into a Roth IRA (after-tax)
What are the tax implications?
There is no tax bill as long as there is no pre-tax money in the IRA
matters when you have a mix of pre and after-tax
There may be taxes if the traditional IRA consists of money contributed on a pre-tax basis. If there is pre-tax money already in the IRA, this will trigger the pro-rata rule. This rule says that if you have amounts in a traditional IRA that consist of money contributed on a pre-tax basis, the amount converted is taxed based on the ratio of after-tax contributions to pre-tax contributions and earnings in total across all traditional IRA accounts you may hold
Ex: you have an IRA that has $1000 of pre-tax dollars in it. If you contribute $500 of after-tax dollars and then convert the $5000 from the IRA into the Roth, it will be a taxable transaction under the pro-rata rule
Pro-rata 33.3% (500/1500) of the $500 will be tax free. 66.6% will be taxable
After-tax contributions / total contributions
SEP IRA and SIMPLE IRA Plans
Employer sponsored IRA
Used by small businesses (less than 100 employees)
Cheap and easy to administer (i.e. not customizable)
Keogh Plans
DC or DB plans for self-employed individuals
403(b) Plans
Similar to a 401(k) but only available to tax-exempt institutions
Non-profit institutions who are 501( c)(3): schools, churches, healthcare, etc.
Premature Distributions Penalties
In addition to the regular income tax on the distribution, there is a
10% tax on distributions from qualified plans, 403(b) plans, IRAs or SEPs prior to age 59 ½
25% tax on distributions from SIMPLE IRAs during the first two years
10% penalty applies to SIMPLE 401(k) plans
Election of Distribution Options
Lump sum distributions
Annuity options
Most common
Rollover
Direct transfer
Rollover
a rollover occurs when an employee physically receives the distribution and then deposits the amount in a rollover IRA, another qualified plan or another SIMPLE
rollovers are tax-free if made within 60 days of distribution
subject to 20% federal withholding
must roll over entire amount
including 20% withheld to make total rollover
only one rollover per year allowed
Direct Transfer
try to do this if possible
the direct rollover or transfer is accomplished by the trustee making payment directly to another qualified plan or rollover IRA
the taxpayer does not receive the cash
not subject to a 20% federal withholding
Employee Stock Purchase Plan
Description
Employer allows employee to buy employer’s stock at 85% of FMV (buy company stock at a 15% discount)
can also grant the option to buy at 85% of FMV at exercise
Features
No taxes are owed until sale of the stock
Net Unrealized Appreciation (NUA)
If a lump-sum distribution includes employer securities. the net unrealized appreciation in the value of the securities i not taxed to the employee at the time of the distribution
this amount of appreciation will be taxed to the employee when the employer securities are sold
at long-term capital gain tax rates
any additional appreciation will be taxed as short-term or long-term capital gains, depending on the holding period
employee can elect to have the net unrealized appreciation included in income at the time the distribution is made
NUA Example
How much income taxes does Beth owe on a lump-sum distribution of employer securities?
The market value of the employer securities is $300,000
The cost basis is $100,000
Her marginal tax rate is 33%
If she distributes the stock “in-king” (don’t sell move the shares) out of the 401k and into a brokerage account
$100,000 (cost basis) taxed as income at 33%
$33,000 tax bill
$200,000 taxed as capital gains when sold
15% x $200,000 = $30,000 tax bill
Total tax = $63,000
If she sell the stock inside the 401k and distributes the cash
$300,000 taxed as income at 33%
Total tax = $99,000
NUA tax savings:
$99,000 - $63,000 = $36,000
Employee Retirement Income Security Act ERISA
Sets forth guidelines for the operation of both qualified and non-qualified employee benefit plans involving retirement income
created pension benefit guaranty corporation
receive premiums for employers to assure that defined-benefit plans which cannot pay the promised benefit will have a government fund to pay some benefit to retirees who might otherwise be left without a benefit
Fiduciary Liability Issues
ERISA fiduciary requirements
act “solely in the interest of the participants and beneficiaries”
act under the “prudent man standard”
diversify plan assets to minimize risk
act in accordance with the plan documents
if you’re advising on retirement accounts ERISA deems you as a fiduciary
IRAs: Contribution Limit
Generally
$7,000 ($8,000 for age 50 and over for 2024)
Contributions must be made by the due date of the individual’s income tax return (without extensions). Usually, April 15th of the following tax year
have until April 15th to remove excess contributions
Excess contributions: Subject to a 6% excise tax for each year that the excess contribution remains in the account
Avoid the excise tax by withdrawing the excess contribution and the attributable earnings before April 15th of the following tax year
Are IRA and Roth IRA contributions allowed beyond age 70 ½ ?
Contributions can be made to traditional IRAs beyond age 70 ½ if working
must have earned income
Note that there is no minimum age limit, although there is a requirement for earned income
Nondeductible IRA Contributions
Tax-deferred growth
Creates after-tax basis in IRA
Distributions will be partially return of capital and partially earnings
File Form 8606 with Form 1040 to track the adjusted taxable basis of an IRA
Because it is likely to appear on the exam: being an active participant within or above the phaseout range only limits your ability to deduct it; it does not prevent you from contributing to IRA (as long as you have earned income)
Backdoor Roth IRA:
Taxpayers can convert any IRA fund to a Roth IRA. The concept of the Backdoor Roth is to contribute nondeductible amounts to a traditional IRA and then convert to a Roth IRA without increasing taxable income. However, the conversion is taxed pro rata based on all of your traditional IRA accounts, so if you have large balances from deductible contributions, you may still pay a significant amount of taxes. More to come!
Roth IRAs
Created by the Taxpayer Relief Act of 1997
Senator Roth was a Delaware Senator
Nondeductible contributions
Distributions are income tax-free
Not subject to require minimum distribution rules during the life of the account owner
Share contribution limits with traditional IRA
(you can’t do $7,000 IRA and $7,000 Roth)
Eligibility based on AGI
Backdoor Roth
No income on backdoor Roth, unless taxpayer has pre-tax funds in their IRAs. If so, then basis must be prorated over all IRA balances
Permits taxpayers who have income in excess of annual contribution limits to fund Roth IRAs
Qualified Distributions from Roth IRAs
Income tax-free and avoids the 10% early withdrawal penalty
must satisfy both tests
1. the distribution is made after a five taxable year period, and
2. the distribution is on account of the owner attaining age 59 ½ , the owner’s death, disability, or first-time home purchase (maximum $10,000)
Nonqualified Distributions from Roth IRAs
If
The distribution is made before five years, or
The distribution is before attaining age 59 ½ , the owner’s death, disability, or first-time home purchase
Distributions/Conversions from Traditional IRAs
Taxed as ordinary income
Except: distributions/conversions of after-tax basis. Requires a ratio (pro-rata) for the after-tax basis (ATB)
After-tax Basis / Market Value of IRA
Comparing Roth IRAs To Traditional IRAs
Roth IRAs are not subject to required minimum distribution rules, unlike traditional IRAs
Inherited traditional and Roth IRAs have unique rules
If the deceased passed away prior to 2020, the beneficary must take a small required distribution every year for the rest of their life
Distribution amount is based on life expectancy
If the deceased passed away after 1/1/2020, the beneficiary must take a small required distribution every year and fully distribute the account by year 10
have 10 years to get all the money out of the account
IRA Investment Options
Permitted
Cash
Stock
Bonds
Options (often limited by custodians)
US gold, silver, and platinum coins
Not Permitted
Life insurance
Collectibles
Other coins
Rollovers From Qualified Plans to IRAs
Loans not permitted from IRA’s but permitted from qualified Plans (401K’s)
May be rolled back to a qualified plan (if permitted by plan)
Lose ERISA protection
However, will have protection under federal bankruptcy law
once it goes into IRA its protected by Federal Bankruptcy
Estate Planning
Goals and Objectives
fulfill client’s property transfer wishes
minimize transfer taxes
minimize transfer costs
maximize net assets left to heirs
provide for guardianship of children or other dependents
provide needed liquidity at death
fulfill client’s healthcare decisions
Gathering Client Information and Defining Transfer Objectives
Information about prospectives heirs and legatees needs to be collected to properly arrange for any transfer that the cloent wants to make
1. Transfer property as desired and minimize estate and transfer taxes to minimize the assets received by heirs
2. Avoid the probate process
3. Use lifetime transfers — gifts
4. Meet liquidity needs at death
5. Plan for children
6. Plan for the incapacity of the transferor
Provide for the needs of the transferor’s surviving spouse
Fulfill the transferor’s charitable intentions
Basic Documents Included in an Estate Plan
Basic documents are
WIlls
Powers of attorney for health care
Living wills or advance medical directives
Do not resuscitate orders
Wills
A legal document that gives the testator (will-maker) the opportunity to control the distribution of his/her property at death, and thus avoid his state’s intestacy laws
May be amended or revoked by the testator at any time prior to their death, provided that the testator is competent
Directives Regarding Health Care
Durable Power of Attorney for Health Care
Living Will/Advance Medical Directive
Do Not Resuscitate Order (DNR)
Sole Ownership
Complete ownership of property by one individual who possesses all ownership rights associated with the property
Number of owners: 1
Right to transfer: freely
Automatic survivorship feature: No, transfers at death via will or intestacy laws
Included in the Gross Estate: Yes, 100%
Included in the Probate Estate: Yes, 100%
Tenancy in Common (TIC)
An interest in property held by two or more related or unrelated persons
Number of owners: 2 or more
Right to transfer: Freely without consent of other co-tenants
Automatic Survivorship feature: No, transfers at death via will or intestacy laws
Included in the Gross Estate: Usually, the FMV of ownership percentage
Included in the Probate Estate: Yes, FMV of interest
Joint Tenancy with Rights of Survivorship
An interest in property held by two or more related or unrelated persons called joint tenants
Number of owners: 2 or more
Right to transfer: Freely without the consent of other co-tenants
Automatic Survivorship Feature: Yes, transfers at death to other owners
Included in the Gross Estate: Yes, FMV times the % contributed
Included in the Probate Estate: No
Probate Process
The legal process through which the decedent’s assets that are not automatically transferred to their heirs by contract or law are retitled in the name of the heirs
Probate can be avoided through
Trusts
Beneficiary designations
Jointly owned asset JTWROS only
POD/TOD Designations
POD: payable on death
TOD: transfer on death
Probate
advantages
implements disposition objectives of testator
provides for an orderly administration of assets
provides clean title to heirs or legatees
increases the chance that parties of interest have notice of proceedings and, therefore, a right to be heard
protects creditors by ensuring that debts of the decedent are paid
disadvantages
can be complex and excruciatingly slow (delays)
can result in substantial monetary costs (costs)
the process is open to public scrutiny (public)
Basis — Step-up When Inherited vs Follows Gifts
cost basis steps up to fair value at death
cost basis follows gifts
inheritance example: mom paid $5,000 for stock in 1980. Child inherits the stock in 2022 when it is worth $30,000. The child’s basis becomes $30,000.
step-up in basis (no capital gains tax)
gift example: if instead, mom gifted the stock to the child, the child’s basis would be $5,000
basis goes to the kid, if they sell it, they pay capital gains
Estate Tax
applicable credit = $13.61 million per person
there is a gift tax that is unified with the estate tax credit
one or the other or a combination of the two
sunset provision 2025
expires (just got recodified this year to 15 million and sunsets in 2028)
$15 million is not based on inflation based on political party in office
Estate Tax Calculation
Gross Estate
Less: Funeral Expenses, Estate Administrative Expenses, Debts, Taxes
Equals: Adjusted Gross Estate
Adjusted Gross Estate
Less: State Death Taxes, Marital and Charitable Deductions (unlimited, will never be taxed)
Equals: Taxable Estate
Gifts
annual exclusion gifts: De minimus $18,000 per person annually
can “gift split” if married (double the gift to each beneficiary)
annual exclusion qualifications
1. present interest
2. outright gift
not eligible if future interest: beneficiary has a delayed right to use gift
general rule: gift by decedent during their life is not included in their gross estate at death
exception: if made within 3 years of death gift is included if it is (a) life insurance, (b) retained interest, or ( c) gift taxes paid
Why Use a Trust
professional management by trustees
minimize and defer taxation (irrevocable only)
creditor protection
prevent asset waste (spendthrift)
split equitable interest between multiple generations
charitable purposes
own tax entity with its own social security number
rules control the money even after death
Trust Property
trusts provide for the management of assets and flexibility in the operation of the estate plan
grantor/trustor/creator/settlor transfers property into the trust and retitles the ownership to the trust
the property is no longer in their name
the trustee is the manager of the trust account and makes investment decisions
the income beneficiaries are for life or for a term
remainder beneficiaries are who receive the residual
Simple Trust
must distribute all income annually
if a trust does not do this it is complex by default
no principal distributions
no charitable deductions
trust income is taxed to the beneficiary (K1)
beneficiary is responsible for taxes
no accumulated income
Complex Trusts
all trusts that are not simple
trust income can be accumulated
if distributed, trust income is taxed to beneficiary
Revocable Trusts
all revocable trusts are grantor trusts
grantor pay income tax on the trust
grantor can amend or revoke at any time
will substitute
not a tax planning trust
irrevocable upon death of grantor
no one can change terms after death
advantages: control retained, grantor can continue to manage assets, can continue pos-mortem, avoids probate
disadvantages: attorneys fees, cost of transferring assets, risk of probate if assets are not transferred
Irrevocable Trusts
grantor relinquishes control over trust property and management and retains little to no rights to change trust
used for high level sophisticated tax planning (gift, income, and estate tax planning)
not included in estate
Gift Tax Exposure for Trusts
when assets are transferred by grantor it is typically via gift transfer
revocable trusts and grantor trusts: no gift tax because the gift is not completed
the grantor can take it back
irrevocable trust: if gift is in excess of unified exemptions gift tax may be due because gift is completed
the grantor cannot take it back
Estate Tax Rules for Transfers to Trusts
assets transferred to revocable trust are includable in grantor’s gross estate
assets transferred to irrevocable trust are not unless grantor has a retained interest or other sufficient level of control
life insurance transferred into a trust within 3 years of the grantor’s death is includable in the estate
Traditional Finance
AKA: Modern Portfolio Theory
Four assumptions
investors are rational
markets are efficient
the mean-variance optimal portfolio is superior
returns are determined by risk (beta)
Behavioral Finance
does not fully reject traditional finance
four assumptions
investors are normal
sometimes don’t make the most rational decision
markets are not efficient
the behavioral portfolio theory is superior
doesn’t mean its right for everyone
risk alone does not determine returns
beta does not explain everything
What makes investors normal instead of rational: cognitive biases, errors, and being human
Open and Closed Questions
open question
one that will result in a person answering with a lengthy respone
used to help the client discover and express what is truly important to them
example 1: What is most important to you for us to discuss today?
example 2: When you leave here today, how will we know that the meeting has been successful?
closed question
seeks a response that is very specific and commonly involves an answer that can be accomplished with a single word or two
example 1: do you want to discuss investments today?
example 2: is todays goal to develop a plan?
Developing a Relationship of Trust with the Client
joining
making a connection with the client and establishing a trusting relationship
communication skills
reflective listening
open-ended questions
mirroring: occurs when the planner synchronizes his or her verbal and nonverbal behavior, including body language, gestures, breathing (fast or slow, deep or shallow), and language and voice quality, with those of the client
match the person that you’re talking to
speed of trust
Patterns of Cognitive Biases
Anchoring
attaching, or anchoring, one’s thought to a reference point even though there may be no logical relevance or is not pertinent to the issue in question. Ex: a stock price drops and your client anchors onto the stock price high from 2 years ago, leading them to believe they should buy the stock
Confirmation bias
only get feedback accepting your research
we tend to find and focus on information that supports our narrative. Ex: you like Apple products and decide to research the stock as an investment. chances are that you will read the positive research articles in depth and only skim the negative research
Herding
people tend to follow the masses, or the “herd.” Jumping on the bandwagon
Gambler’s Fallacy
people mis-use probabilities and lead to faulty predictions
ex: most people believe that if you flip a coin 100 times and it lands on heads each time, there is high probability of tails on the next flip. While this seems logical, it is inaccurate. Every flip is independent of the prior flip so the probability remain 50/50
Hindsight bias
Overconfidence
setting higher win rates than reality
Prospect Theory
people value equal gains and losses differently
ex: the USA is preparing for the next outbreak which is expected to kill 600 people. Which of the following programs would you vote for?
Program A: 200 people are saved (gain)
Program B: 1/3 probability that 600 people are saved and 2/3 probability that no one is saved
72% picked A. When one of the choices shows gains, investors avoid risk
Reframed:
Program A: 400 people will die (loss)
Program B: 1/3 probability that nobody will die and 2/3 probability that 600 people will die
78% picked B. When one of the choices shows losses, investors seek risk
When it comes to investing, the future is more certain than the present. This is contrary to everything else in your life.
over short periods of time, there’s no way to tell
over long periods of time, it is almost a certain win
Fee Structures
commissions (brokers and insurance)
dying structure
fee-only (investment based
flat fee per year: ex $8,000 per year (billed quarterly with deposit)
not very popular
flat fee per hour: ex $400/hour
not very popular
fee-based on % of assets under management (AUM): ex 1% of AUM
most common
$1,000,000 account, Fee = 1% x 1,000,000 = $10,000
margins are higher on commission than on fee-only
Compensation for New Hires
fully entrepreneurial
commission/fees only
small salary + commission
ex: $20k salary that gradually reduces to $0 over 3 years
employee
salary + bonus (performance based on quality of work)
salary + bonus (performance based on new client acquisition)