FEBRUARY 2006 INTRODUCTION Although the winter Newsletter just about didn't make it until spring, we are happy to present this edition, which begins with a major article on the field of financial planning. It is our hope that it might stimulate your thinking about some area that you have overlooked or neglected. Also included are articles on the new Medicare Part D (prescription drug coverage), on donating appreciated securities, and on the reasons why we normally use bond funds rather than individual bonds. The concluding pieces are on the free credit reports that are now available, an obituary - of sorts, and, as always, Office Matters. We hope you find this Newsletter useful. David W. Otto, Editor FINANCIAL PLANNING 101 Otto & Associates offers "a full range of financial planning services." But just what does that mean? This article is written with the hope that, as you read our explanation, you will be reminded of personal planning areas that may need attention. One of the formal definitions of our field states that we deal with "the process of meeting your life goals through the proper management of your finances." We interpret this somewhat more broadly when we say that we view financial planning as the process of understanding your goals in life and then helping you with the financial part, making finances understandable and as problem free as possible. It is useful to break the work we do into six general areas: budget and credit management, insurance, taxes, investments, retirement, and estate planning. We will discuss them here in that order. BUDGET AND CREDIT MANAGEMENT: This area addresses cash flow, debt analysis and management, and the balance between income and expenses. It is often younger people who seem to have particular problems here. Unfortunately, they often fail to find their way to financial planners. The significant problems we see, however, are not limited to young people. Many "Budget and Credit Management" matters we deal with can be formulated as questions: Are you spending too much money and if so, how will you get things back in balance? If there is a problem here, addressing it is often among the biggest challenges that clients encounter. Is your debt greater than it should be? Is your debt at the lowest interest rate available and is it tax deductible? Is your mortgage at a competitive rate or should you consider refinancing? If you have cash flow problems that are temporary, how can that situation be managed at the lowest cost? What is the best way to plan for children's education? If your expenses are reasonable but your income is insufficient, should you evaluate alternative or additional ways of making money? In recent years the management of debt has undergone a major change for homeowners who can readily use a home equity line of credit (HELOC). In the past, people were advised to keep six months of family spending easily available for emergencies. That plan, however, put a crimp on investment savings because of the amount of money that was placed in a low yielding savings account. Now, however, a HELOC, at little or no cost when it is not being used, can serve as the emergency pot. Current rates are fairly competitive (and until recently, were very attractive) and interest is normally tax deductible. There are two potential problems with a HELOC: a) money is so readily available that it is easy to incur too much debt, and b) it should not be used for long term financing because the interest rate can change and become non-competitive rather quickly. The interest rate for a typical HELOC has increased 3.5% in less than two years. The current rate of 7.5% for many HELOCs is pretty good, but should it go up another 3.5% in two years (which is very unlikely), that debt would be very expensive. INSURANCE: The two general insurance areas which we are regularly called upon for help are property and casualty (p&c) insurance (for cars, homes, boats, etc., including liability insurance), and life insurance. There are two guidelines in buying insurance that are often helpful to keep in mind: insure against only those things that you cannot afford to lose and, don't buy insurance to try to make money. This latter point can be applied to all forms of insurance, including the "extended maintenance" on appliances, but the truth of the guideline seems to elude many people. Some typical p&c questions are: Is your property insured adequately at competitive rates? Do you have too much insurance, or are you insuring things for which the primary value is sentimental, in which case it may not be worth the cost of insurance? Do you have sufficient liability insurance for your situation? While life insurance can occasionally be used in more esoteric ways, such as buying insurance in a trust that is designed to pay estate taxes, most of the time life insurance questions are pretty straightforward. Do you need life insurance, and if so, how much? If you need life insurance, how long do you expect to need it? Should you buy term insurance or some kind of cash value policy? After answering the above, does your current coverage satisfy the needs? Is it competitive? If you have more life insurance than you need, what should you do with your current policies? There are several other insurance matters that we address: Do you need long term care insurance, and if so, which of the many options should you choose? Should you look into disability insurance, sometimes available from an employer? When it is not provided through work, it may be problematic and take some skill in finding a satisfactory solution because the individual policies are often not very good (i.e. cover limited disabilities for a limited time) and are quite expensive. In those cases, a question we often ask is, is self-insuring (i.e. assuming the risk yourself or making alternative provisions should you be disabled) a viable option? Is my medical insurance adequate and are the costs reasonable? (It is often difficult to answer Yes to both issues, but that is another matter.) TAXES: Income taxes are an area in which we often depend on our accounting friends. There are a number of questions that we feel competent to answer, and when it gets more complicated, we consult. For instance, the Alternative Minimum Tax (AMT) is difficult for many to understand. Often the additional tax that is due because of AMT is not substantial, but for some it is significant, and for many it will get increasingly significant. Some of the questions we normally address ourselves are: Are you claiming all legitimate deductions? Are there legal ways you can reduce your taxes, such as prepaying certain bills, thereby getting a greater deduction in the current year, or delay paying a bill that will give you a minimal deduction this year but may be more valuable next year? While state taxes are lower than federal taxes, what might you do to reduce state taxes? (Opening a College Savings Plan for those who have pre-college children or grandchildren is one obvious way to accomplish this in many states.) If you are inclined to give to charities, have you considered tax advantageous ways to make those gifts (such as giving appreciated securities)? Do you have sufficient money so that you would do well to consider making larger gifts to charities and thereby also saving income taxes? INVESTMENTS: Virtually all past Newsletters have focused at least one article on this area so we will pass over the subject rather quickly. However, several common questions are: What allocation is best for me? What kind of return can I expect over the long term? Are there alternatives to the typical stocks, bonds and mutual funds? Perhaps the most frequent: what is a closed end fund? RETIREMENT: How much money do I need to retire? While that is often the basic retirement question, there are regularly other important issues of concern, particularly for those who have not yet retired. We try to ascertain when people would like to retire and whether or not they are likely to continue to have some earned income. Our concern is for quality of life and we want to make sure that our clients do not plan to retire at a certain age with no thought of how they will find satisfying interests after they stop working. We encourage looking at avocations that might be expanded, or at different work that they have always wanted to do but did not pursue, perhaps because it was not sufficiently lucrative which, in retirement, will normally be a diminished concern. If travel and/or "playing more" (golf, bridge, tennis, sailing) is a high priority, we want to make sure that these clients have some goals that are more than pure pleasure. There is nothing wrong with pure pleasure, but it is our view that without some larger goals, that can lead to boredom and worse. While the main issue continues to be around the adequacy of retirement savings, specific questions arise: What is the best way to accumulate retirement savings? Which retirement plans are best for you? When you need additional money in retirement, what money should be tapped first? If you have retired and it appears that you might outlive your money, what alternatives do you have? ESTATE PLANNING: Here, too, there is one basic question: how do you want your estate to be distributed upon your death? Sometimes the initial answer is very straightforward: I want everything to go to my spouse, or to my children if my spouse does not survive me. But sometimes there are complications such as a second marriage with children from a previous marriage; special needs of survivors, such as a disabled child, or a parent or other relative that needs financial support; or children with very disparate financial situations, where consideration might be given to leaving varying amounts to each. This last issue can range from children who don't manage money well and always seem to need more, to children who marry into wealth or have created their own wealth with lucrative jobs. Then there are more subtle issues. It has often been assumed by many parents that whatever they have left at the end of their lives will go to their children. But for a significant group, life is different than it was a generation or two ago. People have more money in general and people in their 30s and 40s often have considerably more wealth than did their parents or grandparents. All of this leads to the question, does it make sense to include charities or other individuals in a will, rather than leaving everything to children? There are interesting options available in the charity world. One example is Community Foundations, which have been around for a long time (the New York Community Trust was founded in 1924), but have become increasingly popular. One of the services that Community Foundations provide is to permit donors to establish their own fund under the Foundation's umbrella, and then to direct the funds in whatever amount to charities of the donor's choosing. This is an intriguing way in which to involve younger family members in philanthropic pursuits. This process can also encourage thinking about where an individual donor or family might want to focus their energies in order to make a greater impact for good. Some estate planning questions in addition to those suggested above include: What are some good strategies for eliminating or reducing estate taxes? Do special considerations need to be given to state as opposed to federal estate taxes? Should children receive money outright, or should partial distributions be made as they reach certain ages? We hope this article has stimulated your thinking. The goal of financial planning, strictly speaking, is to help people with their financial lives so they can accomplish their other goals of living. But finances can become sufficiently fascinating and/or consuming that the larger goals of living get short shrift. That is the reason we regularly raise questions that go beyond the strict world of finance. And that is the reason we end this article with a quote from Winston Churchill: "What is the use of living, if it not be to strive for noble causes and to make this muddled world a better place for those who will live in it after we are gone?" Medicare Part D Last month Deborah attended an excellent presentation on the new Medicare Part D prescription drug program by Maura Carley of Healthcare Navigation, Inc. at a Financial Planning Association meeting. The new program is complicated, so it can be hard to decide whether to sign up, and even harder to decide which plan to sign up for. Carley offered some good basic rules of thumb to help make these decisions, which we are happy to share with you. If you don't have prescription drug coverage now, she strongly recommends signing up. She thinks it's worth paying the monthly premium for the additional benefit, because the new program provides good catastrophic coverage. She reminded us that people that currently have Medigap (Medicare supplement) plans A through F don't have drug coverage. If you currently have Medigap plan H, I, or J, you should enroll in the new prescription drug plan instead, as it provides better protection for a lower premium. If you have drug coverage through a former employer, union, Medicare HMO or PPO, you probably already have better coverage than the new drug plan and, if so, should keep what you have. You may have already received a letter from your current provider which states that their coverage meets the government's requirements for creditable prescription coverage. If it does, keep your current coverage. If it doesn't, you'll need to do more research to decide what to do. If you don't have a letter, call their office to get one. The next decision, which plan to select, is difficult because there are big differences in plan premiums and coverage. Each plan provider has its own list of drugs that are covered, called its formulary. You'll want to be sure that any drugs you take now are on that provider's formulary. Carley advised that plans available in all states ("national plans") be considered first, because they generally have the largest formularies and may also have more competitive premiums. Some providers that offer national plans are United Healthcare/AARP, Wellcare, Aetna, and CIGNA. We have some additional detailed information in the office that can be helpful in deciding among the many choices. There is also a lot of information at the Medicare web site, www.medicare.gov. The deadline for signing up for 2006 is May 15, 2006, and you are allowed to switch plans once a year in November and December. While we are not experts on these new plans, if you need assistance, give us a call. APPRECIATED INVESTMENTS The U.S. Government encourages individuals to make donations to charitable causes. In many cases, individuals are allowed to deduct from their Taxable Income every dollar they give to charity. We consulted with the accounting firm of Heckler and O'Keefe, who worked out the exact numbers for a married couple who has an Adjusted Gross Income (AGI) of $100,000. With exemptions and deductions, their Taxable Income might get to $80,000. The federal taxes they would owe on that income would be $13,330. However, if they gave another $8,000 to charity, their taxes would be reduced by $2,000. In this case, while they gave $8,000 away, the out-of-pocket cost only would be $6,000. However, there is another way to give to charity through which taxpayers can save even more money. This method has to do with donating appreciated securities. The government says that if you donate appreciated securities, including stocks, bonds, and mutual funds, directly to a charity, you may take a deduction of the full value of the securities, without paying tax on the gain. Let's go back to the above example. If the charitable gift given by this couple was not cash but a stock or mutual fund that they had bought many years ago, the tax savings could be significant. For purpose of illustration, let's assume that the cost of the stock or mutual fund was $2,000, but it is now worth $8,000. If they sold the investment, they would owe taxes on the $6,000 of gain, approximately $900. But if they gave the investment directly to a charity, there would be no tax due. In this illustration the $8,000 gift actually cost the family $5,100. (Taxes are normally not as simple as this illustration and the actual savings could be more or less, but the figures are fairly close for many tax payers.) Confused? Is your situation related to the above, but sufficiently different that you have as many questions as answers? That's what O&A is here for. Clients who would like to discuss this further are encouraged to talk to their accountant or call the office. BONDS vs. BOND FUNDS Not infrequently a client asks us why we use bond mutual funds rather than individual bonds. The argument typically goes like this: "I can buy individual bonds, hold them to maturity, and know exactly what I will get at the end without having to worry about losing money. And the interest payments are also predictable. In contrast, bond funds vary in price and in interest payments." We recently read a somewhat lengthy, but excellent paper entitled "Why We Use Bond Funds Instead of Individual Bonds", published by Advisor Intelligence (a service we subscribe to), on just this subject. The paper expresses our views very well, which is why we reference it. For those readers who would like the more detailed response, we will gladly send you the paper. Here we offer a few highlights from it: We view bonds as volatility reducers rather than income generators. For those who need to withdraw cash (typically retired folks), we generate cash from an investment that is ready to be sold, and rebalance the portfolio if necessary. It is a myth that individual bonds do not fluctuate in price. On a really bad day, a 15-year Treasury bond could lose 2%. While an investor may plan to hold a Treasury bond to maturity, things change, and the bond may be sold for more or less than the purchase price. Finally, we prefer not to be locked into an investment decision for 15 years. In the last 29 years there has been only one 12 month period when the loss on the most commonly used bond benchmark was more than 3.2%. Individual bonds during that same period would have lost at least that much. In addition to diversification, one of the biggest advantages of owning a bond mutual fund is that the investor gets professional management at a very low cost. Bond funds in which we invest regularly outperform the benchmark index for just that reason. It is much easier to rebalance a portfolio using a fund than using individual bonds. Buying and selling bonds is expensive. Adding to or reducing a mutual fund investment costs little or nothing. If a client has need of a specified amount of cash in the relatively near future, a short-term Treasury bond or a CD might be a reasonable option. But for longer-term needs, we think bond mutual funds are the better choice. CREDIT REPORTS Since last September, all Americans can request a free credit report each year from each of the three major credit bureaus: Equifax, Experian, and TransUnion. These reports give you very detailed information on all of your credit accounts, including the amount available, the amount owed, the length of time you've had the account, and the payment experience. Because these reports are so detailed, people may find them a bit daunting. Nonetheless, we think it is worth the trouble to make sure that there are no errors and, if there are errors, to report them, get them corrected, and then check to be sure they've been corrected. You can order the reports by going to www.annualcreditreport.com or by calling (877) 322-8228. You will be asked a number of questions to identify clearly who you are, and you will be asked to pick which credit company's report you want. You can ask for all three at once, but it may be better to pick one now and then get a different one later in the year. We read one article that suggested that TransUnion has been more difficult to deal with, but haven't confirmed that ourselves. If you're married, you may want to start by getting your report from one company and your spouse from another. Note that these reports do not give you your credit score, which creditors use to decide whether to give you credit and at what rate. Although we don't think it's necessary, you can buy your score from the credit companies if you're curious. DEATH OF A LEGEND With all the turmoil going on in the world, it is worth reflecting on the recent death of a very important person, which almost went unnoticed. Larry LaPrise, the man that wrote "The Hokey Pokey" died peacefully at the age of 93. The most traumatic part for his family was getting him into the coffin. They put his left leg in. And then the trouble started. OFFICE MATTERS First, a quick reminder: for those retirement accounts to which you can contributed directly (e.g. IRA, Roth IRA, etc.), don't forget to make a contribution before April 15. I have written previously about Dr. Horace "Woody" Brock, an economist and strategic thinker who has made a number of presentations at conferences I have attended. Last year several of us decided to hire him to consult with our group. After our first meeting in Chicago, we agreed to get together with Woody on a twice a year basis. The Gateway Group, the name we have chosen, will meet next on May 4 - 5, in New York City. Also in May, I will attend the annual NAPFA conference, being held this year in Grapeville, Texas, outside Dallas. Accompanying me to the conference on May 17 - 21, will be my older daughter, Susan, who has begun working part time with O&A by lending administrative support when I am in the Norwich office. In the last Newsletter I reported that Mary and I had gone to Berlin, Germany, in October for the opening of the photomontage exhibit of Marianne Brandt (1893 - 1983). The exhibit was curated by our younger daughter, Libby. I am very pleased to report that the exhibit is coming to two museums in the United States. It will be in Cambridge, MA., at Harvard's Busch - Reisinger Museum from March 11 - May 21 . After that it will travel to New York where it will open on June 9 at the International Center for Photography on Avenue of the Americas and 43rd Street. It will be in New York until August 27. Our entire family will, of course, be attending an event at each museum. Deborah and Judy hope to attend the opening in New York.