It is easy to help those in the first group see the need for protection against the sudden loss of their salary due to an illness or accident. Often people in this first group are on such a tight budget, which in part causes them to be in this first group, that they have trouble adding disability income insurance premiums to already stretched budgets. For this group, selling the need is easy, while selling the cost is difficult. Often, this group contains workers whose occupations make it difficult to obtain coverage at desired rates or for desired coverage periods.

The second group, often professionals, executives, or business owners, have sufficient assets and other sources of income, that a loss of salaried income is seen more as an “inconvenience.” By inconvenience it means plenty of adjustments, giving up some luxuries and some desired discretionary expenditures, but it would not be the financial disaster similar to those of the first group. It is very difficult to convince this group of the need for disability income insurance with an urgency to take action. However, if this group were convinced of the need, allocating additional dollars for premiums would not be seen as a big obstacle. For this second group, selling the cost is easy, while selling the need is difficult.

Ironically, disability income insurance is often easier to obtain for the second group since their occupations are usually less hazardous with preferred occupational classes. It is much easier for this group to get the disability income coverage they desire. Since the second group generally has larger salaries, the amount of disability income needed is larger resulting in larger sales. Many times, the same sales presentations used to sell the needs for the first group are used, often unsuccessfully, with the second group.

PlanLab’s Financial Needs Analysis has the needs presentation pages to sell the need to the first group. But, it also has a unique sales presentation page designed to show the need of disability Income insurance to the second group. Since Financial Needs Analysis has true monthly cash flow calculations, the effects of various periods of disability can be calculated. By showing the effects of being disabled for just two years, five years, or from now until retirement, it is easy to see the “overall” effects of a loss of salaried income. The full impact of the lost salary is calculated including the missed 401(k) contributions. The cash flow calculations use the appropriate assets to pay ongoing expenses and illustrate the long-term effects of using those assets. To make it easy for the client to understand, the effects of various periods of disability are illustrated by the estimated net worth at retirement.

A sample of this unique presentation page shows that the client should have a net worth at retirement, age 65, of $5,321,674 if no periods of disability are assumed and everything goes as planned. However, just missing the next two years due to a disability, would reduce his net worth at retirement by 9.39% or almost half a million dollars. Missing the next five years would reduce the retirement net worth by 23.57% or approximately $1.25 million. If he were disabled from now until retirement, his retirement net worth would be reduced by two-thirds—about $3.5 million!

The emphasis of this page is to point out that the disability income insurance is not just providing funds to replace missed paychecks; it is maintaining his standard of living for the rest of his life and retirement. This page also shows the likelihood of a long-term disability for a person his age as compared to dying before retirement. In this example for a man age 50, he is almost three times (2.93) more likely to suffer a long-term disability than die before age 65.

The second group needs disability income insurance, just as much as the first group. By showing the long-term effects on retirement and long-term standard of living, with the likelihood of a disability occurring, you have the tool that makes selling the need of disability income easy. Now, you can sell disability income to the group that needs it and can get it.

All of these financial “sound bites” may be excellent advice in specific situations. But, do we try to apply these money rules without considering the entire situation? Are we too busy to get all of the facts?

Using financial sound bites to influence our financial decisions is a two-edge sword: one, you use the sound bite when it is not applicable to your situation; and, two, you reject good advice, because it is inconsistent with a sound bite. Remember, almost every sound bite is a reminder of good advice in certain circumstances. How do you know if the circumstances are right? There is never a substitute for research, knowledge, and experience. All of these take time.

In financial decisions there can be no substitute for reviewing all of your facts and goals, and then applying various “what if” scenarios to see what is best for you. You can use a “what if” scenario based on a sound bite to evaluate how it would work for your circumstances. Using established methods and proven financial practices, offer the best chance of making the right decisions.

PlanLab®  is a collection of financial tools designed to assist in determining how various options will work in specific circumstances. Knowing that the purpose of any financial analysis is to help someone make a financial decision, all of the PlanLab tools use principles from Neil Rackham’s SPIN® Selling.

A brief and simplified explanation of SPIN is that people make major decisions based on getting answers to four types of questions: (1) What is the Situation? (2) What is the Problem of this situation? (3) What is the Implication of the problem? And, (4) what is the Need-payoff for this implication? If a person has the answers to these questions, then the decision is simple: does the cost of the solution have more benefits than the costs of doing nothing? People tend to make the right decisions, when given all of the facts in this manner.

PlanLab provides these decision-making facts. The modeling of monthly cash flow for each “what if” scenario, provides answers for every situation. Users of PlanLab often comment that they are surprised at the various outcomes – for some situations the outcomes do not follow the “sound bites.”

SPIN® is a registered trademark of Huthwaite, Inc. European SPIN® trademarks are held by Huthwaite, Ltd. SPIN® Selling, by Neil Rackham, published by McGraw-Hill, Inc., New York, NY.

The fact that businesses are built on people, has been recognized throughout America’s history.
Andrew Carnegie, who in the late 1800s was considered one of the richest industrialists in the world and creator of the first business valued over $1 billion, once said: “Take away my factories, my plants; take away my railroads, my ships, my transportation; take away my money; strip me of all of these, but leave me my people, and in two or three years I will have them all back again.” He knew that it is not the things that a business has that counted; it is its people that count.

A successful business often has many key people. Although the owners of a business are usually key individuals, many non-owners may also be a key person. Exactly who is a key person?

The business owner can usually identify a key person by considering a few questions. If an employee was suddenly lost due to death or disability, would there be a hard adjustment period? Would sales be disrupted significantly? Would creditors have less confidence in the business? Would productivity be adversely affected? When the names of employees come to the owner’s mind when asked these questions, those employees are the key people.

Identifying a key person is only part of the problem: the tough problem is determining the dollar value that would be lost if the key person were lost. When an economic value can be placed on the loss of a key person, then insurance and other arrangements can be made to protect the business.

Unlike a machine, people have unique qualities and abilities that make valuing their services difficult. The only right way to value a key person is to consider all areas where the employee affects the business.

Twelve Factors for Considering the Impact of a Key Person

1. Impact on Profits

Impact on profits is very subjective, but when a key person would have a significant impact on profits, the employer knows it. It’s easy to see that a person is responsible for half or three-quarters of the profit; it is very difficult to see that someone is responsible for 5% or 10% of profits.

2. Impact on Sales

The percent of total sales is usually known when the key person is directly involved in sales. When considering the impact on sales, the indirect effects must be considered. Often the key person’s role in the community and relationship with customers impact sales. Non-sales personnel may have a major impact on sales.

3. Unique Qualities

How difficult would it be to find another person with the unique qualities of the key person being considered? How important are those qualities to the success of the business? Answering these two questions helps to determine the impact of the key person.

4. Relationship with Other Employees

Some employees are responsible for the morale of the entire staff. Would the loss of the key person affect morale of the other employees to the extent of lost productivity? This is an often overlooked trait in measuring the impact of a key person.

5. Impact on Company Credit

A key person often is responsible for obtaining credit for the company. The more dependent the business is on its credit lines, the more valuable this relationship. The key person may not be the direct contact with creditors. If creditors see the key person as being essential to continued profits, then the key person could have a major impact on credit.

6. Impact on Future Business Plans

Is the key person being counted on for the continuation of the business when an existing owner retires? Is he or she part of a business succession plan? What is the impact of this key person on the future plans of the business and of the owners of the business?

7. What Is Owed the Key Person

If the business has any accrued payments or debts owed the key person, that amount will probably be due at the key person’s death. The impact of any type of deferred compensation, incentives, bonuses, or debts must be considered when measuring the key person’s impact.

8. Training of Key Person’s Replacement

How long would it take to train the key person’s replacement? When considering the training, you must be sure to consider the time and loss of productivity of those doing the training. In addition, the loss productivity during the training period must be considered.

9. Documentation of Duties

The better the duties of the key person are documented, the quicker a replacement will be up to speed. Often, a combination of existing staff can divide these documented duties to minimize the loss of productivity. However, usually the more valuable the key person, the less the duties are documented. The lack of knowing how the key person functioned day-to-day should be considered in estimating the effects of losing him or her.

10. Impact of Ownership Succession Plans

When the key person is also an owner, are all business continuation and succession plans in order? If not, additional costs may occur in legal settlements or a succession that is not productive.

11. Expectations of Key Person’s Survivors

Although there may not be a legal obligation to provide for the family of the key person, what are the expectations of the family and other long-term employees? Nothing can affect employee morale any more than what appears to them as the employer’s unconcern for a long-time valued key person.

12. Opinion of Owners

There is no one who has a better idea of intuitive value of the key person than the other owners. Their opinion is invaluable in determining the impact of the key person. It is helpful to review all of these factors with the owners, but the owners’ opinions should always be a major consideration.

After determining the impact of the key person for each of these factors, a value of the key person to the business can be derived. There are several methods for determining a value. Often the best method is a function of which of the twelve factors above are the most significant.

There are six basic methods for determining the key person’s value.

1. Business Value Method

The key person’s value to the business is estimated by applying the percentage that represents the portion of profits for which the key person is responsible times the estimated value of the business.

2. Multiple of Salary Method

One of the most common methods for valuing a key person is to use a multiple of salary. Usually a multiple of 3 to 10 is used.

3. Sales Replacement Method

This method tries to amortize the sales loss due to the key person over the period required for the replacement to duplicate sales. Each year fewer sales are considered lost. The present value of the potential lost sales revenue is a good estimate of the key person’s value.

4. Training Cost Method

This method tries to amortize the lost earnings while the replacement for the key person is being trained. Excess earnings are calculated by the adjusted average annual earnings (earnings plus any excess owner salary) less the fair rate of return on the book value. These excess earnings are amortized over the years to train the replacement, assuming that each year has less impact than the previous. The present value determines the cost of training the replacement.

5. Business Life Value Method

For a very valuable key person, the effects could be over the anticipated working lifetime of the employee. The present value of the excess earnings between now and when the key person would have retired is used to estimate the key person’s loss to the business.

6. Owners’ Estimate Method

The other owners’ have a vested interest in their estimate of the value of the key person.

There are many ways to value a key person, and in many cases, it is a combination of these methods that best represents the total value of the key person.

PlanLab’s Key Person Presentation helps determine the value of each impact factor. By combining those values with the six methods described above, Key Person provides a quantitative approach to valuing a key person.

“Yes, your finances are likely taking a beating this year. Which means it’s the perfect moment to transfer as many assets as you can.”

Stock values are depressed. Interest rates continue at historic low rates. Transfers are generally valued based on their market values – values that are very low today. For many types of transfers, especially those that delay the recipients’ use of the gift use prescribed IRS rates to determine the value and taxation. These IRS rates are adjusted monthly to reflect the current economic conditions – conditions today that produce very low rates.

Ms. Tergesen suggested a number of effective strategies to transfer wealth to your heirs that are advantageous when the transferred values are depressed. One such idea included establishing an intentionally defective grantor trust (IDGT). Even though IDGTs are complex and often expensive to establish, the rewards can be worth the extra efforts and expense. These trusts can provide a tax-advantaged way to pass assets to heirs, limit future taxation of the assets, and remove these assets from your estate. To better illustrate these benefits, a case study using PlanLab and its suite of financial tools is presented.

Case Study

Kevin and Rebecca Strangelove have been very successful in recent years. They have a daughter, a son-in-law, and a new grandson (named for his grandfather) with whom they want to share their fortunes. Their hopes are that it could benefit future generations as well. About two-thirds of their assets are in stocks. Stocks that were worth $15 million a few months ago, but due to the “melt-down” are worth only $10 million now. Kevin figures that the market will eventually recover, although it may take up to twenty years to do so.

The Strangeloves establish the trust. It will need some cash which should be at least 10% of its initial holdings. Since they plan to put $10 million of stock into the trust, they make a gift of $1 million cash. One million dollars is also the limit an individual may give away gift tax free during his lifetime. Since they want the trust to last for possibly generations, they must either pay generation-skipping transfer tax on the $1 million gift or use some of the $2 million credit for that tax. They will do the latter. (Gifts of more than $2 million may have generation-skipping transfer tax up to 45% of the additional amount.)

They then lend the trust $10 million using an installment note. In this case, a fifteen year interest only note is used. Interest is set at the Applicable Federal Rate for loans of more than 9 years which for October 2008 was 4.32%. The length of the note is usually long enough for the trust to accumulate enough funds to repay the note, but hopefully less than life expectancy of the grantor. Any unpaid balance of the note is included in the estate of the grantor. The trust then uses the loan to buy the $10 million of stock from the Strangeloves.

Being a grantor trust, income taxation to the trust is passed through to the grantors. Therefore, for income tax purposes, the Strangeloves “bought the stock from themselves” for tax purposes; thus, no capital gains tax due. Also, the interest paid by the trust for the installment note is not considered income to the grantors.

The Strangeloves wanted to use conservative assumptions throughout their plans. Previously for their long-term planning, they assumed the stocks would appreciate in value by 3.6%, doubling in value in 20 years. They assumed that the stocks would produce an average of 2.4% earnings or dividends each year. (Basically, they wanted to assume a total return of 6 %.) That assumption was decided prior to the recent market collapse. Since they felt the market would recover over the next 20 years, they increased their appreciation assumption to 5.7%. (The original value of $15 million growing at 3.6% for 20 years equals the depressed value of $10 million growing at 5.7% for 20 years.)

Advantages of the IDGT

• As a grantor trust, no capital gains tax was due when the stock was sold to the trust.
• No income tax is due on the interest payments from the trust for the loan.
• All appreciation in the trust is outside of their estate. (Only the balance of the unpaid installment note is included in their taxable estate.)
• The Strangeloves pay income tax on all income received by the trust. These tax payments further reduce their estate, but more importantly, allow the trust to appreciate faster since it does not have to pay the taxes.
• Life insurance on the grantor’s life owned by the trust, assures the grantor that the installment note could be repaid at the grantor’s death.

How will all of this work for the Strangeloves?

• The IDGT is established and the $1 million cash gift is made to it.
• A $10 million loan is made to the trust — a 15 year interest only installment note at a rate of 4.32%.
• The IDGT buys the $10 million stock from the Strangeloves.
• The IDGT purchases $10 million of life insurance on Kevin with a monthly premium of $4,000. The trust is the owner and beneficiary of the policy.

In addition to the IDGT strategy, several other techniques were recommended. Their wills needed to be revised to take advantage of the large available estate tax exemptions. Annual exclusion gifts could be used to provide additional cash for estate settlement. There are many additional techniques and strategies that could be applied, but the Strangeloves preferred just the basic ones.

Results

PlanLab’s suite of tools allows us to see the results in various situations. For these results, (See Executive Summary from Estate Tax Analysis) it was assumed:

• No additional changes were made
• The markets recover over the next 20 years
• Change their wills to leave an amount equal to any applicable exclusion amount to a Family Trust
• Kevin dies in year 2028
• Rebecca survives him for 5 years

The net value to the heirs at Rebecca’s death in 2033 would be $40 million.

Adding the IDGT as described above, the net to the heirs in 2033 would be $57.1 million.

• Establish an irrevocable life insurance trust (ILIT) to acquire a survivorship policy and make annual exclusion gifts to the trust for the premiums
• ILIT purchases $20 million of survivor life on Kevin and Rebecca for $8,000 monthly premium.

The net value to the heirs in 2033 would be $85.8 million.

When this strategy was analyzed with Wealth Distribution Analysis, (See Planning Impact) the Strangeloves would have their new worth reduced by 38% but would have doubled the net to heirs or an increase of 102%. This was possible while meeting all lifestyle expenses.

Risks associated with this strategy

Neither the tax code nor case law specifically addresses IDGTs. The IRS has been known to challenge them on occasion. Establishing the trust with a cash gift some time before selling the assets is thought to reduce the chance of a challenge.

The biggest risk is for the trust to run out of income. Income is needed to make the interest payments on the loan and to pay the premiums on any life insurance it acquires. Gift taxes and possibly generation-skipping transfer taxes may be due, if the trust cannot meet its interest payment. Testing the cash flow arrangements of the trust is essential to avoid this costly problem. (See Trust Ledger from PlanLab)

In addition to the illustrations shown above, PlanLab effectively can illustrate all aspects of this case study. PlanLab’s Estate Tax Analysis shows how the proposed strategy would work. (See Estate Flow Chart) Since there is uncertainty as to what estate taxes might be in the future, “Needs over Time” graphs can be printed that show the current law and a hypothetical illustration assuming the 2009 limits and rates are extended (which is similar to the proposals of both Presidential candidates). (See Needs Over Time Compared)

PlanLab’s Wealth Strategies or Retirement Test Drive can consider the Strangelove’s strategy from different vantage points. Both of these tools can perform extensive Monte Carlo Simulations to determine the likely results when all variables fluctuate in accordance with their historical results. The year-by-year results and likely range of results can give the clients confidence that their strategy will work. (See Likely Net Worth)

PlanLab’s suite of financial tools help the advisor make “lemonade” out of the “lemons” of our present economy.

Photo credit: Adrian MB

But what if things you never anticipated happen? Retirement Test Drive lets you make those adjustments, and repeat your test drive. With the revised analysis, you can reconsider your retirement plans and make the necessary adjustments.

Retirement Test Drive: Case Study 1

Dr. Rusty Scalpel and his wife had just been working with their advisor on their retirement and estate planning. Much of the planning dealt with estate planning manners, as their retirements seem to be well funded. In fact, he had worked closely with the advisor to consider exactly when to retire. PlanLab’s Estate Tax Analysis was used to formulate an estate plan. Then Retirement Test Drive was used to see how it would work and the advantages and disadvantages of various retirement dates. The whole process was being finalized. Then the economic crisis of 2008 occurred.

Rusty and his wife became very concerned—would their plans still work? Should they take their losses and convert everything to cash? Did their plans allow time for the market to recover? Should they start over? It was time to take another Retirement Test Drive.

Their advisor modified their plan to reflect the current values of their investments and retirement plans. The results were favorable; the program showed that even after adjusting the values for the current market losses of almost 40% in the past year, their plan could still provide for the lifestyle spending they desired.

But October 2008 was a very scary time. Had the economy reach bottom? What would the new president and new Congress do? At what point would their plans not work?

The advisor, using alternative scenarios with their Retirement Test Drive analysis, made additional changes. The cost of living assumptions were adjusted upward in the event of increased inflation in the future. Values of investments and retirement plans were set to twenty-five percent (25%) of their 2007 values. Retirement Test Drive showed that their plans still could support their desired retirement lifestyle through year 2040, although their net worth would be significantly decreased and the net to heirs would be somewhat decreased. Rusty and his wife now felt confident that their plans did not need to be changed at this time.

Retirement Test Drive, with its scenario “what-if” planning features, can reassure clients when things change. Its graphics (Illustration 1) makes it simple to see the effects of changes. The second illustration (Illustration 2), using Monte Carlo Simulations, showed that the probability of success for the first ten years was about the same in both scenarios, but that continued success after that were less. The advisor was able to put some of their fears to rest—they did not need to make any immediate changes.

Retirement Test Drive: Case Study 2

Take the case of Robert and Andrea. Their planning had required considerably more adjustments in the initial planning. Using Retirement Test Drive last year, they were able to make a number of adjustments so that their retirement lifestyle could be met. They had not prepared for retirement to the degree of the Scalpels in the prior sample. However, they were able to make the adjustments that could meet expenditures for many years. Of course, in October 2008 their advisor received their panic phone call, “What should we do?”

By adjusting the values for the current market conditions, and using the revised scenario, they were able to retake their Retirement Test Drive. The results showed that for the next eight years (8), their plans would continue to work. However, unless the market recovered some of its recent losses, adjustments would have to be made. Again, a simple graph (Illustration 3) was used to show Robert and Andrea the effects of the current conditions on their plan. It showed when the shortfalls were likely to occur. By retaking their Retirement Test Drive from time to time, they would know when changes would be necessary.

Retirement Test Drive is not just a great tool for analyzing retirement plans, but it is a great tool for restoring a clients’ confidence in their retirement plans.  Retirement Test Drive can be used with any plan developed with one of PlanLab’s analysis tools. Retaking a Retirement Test Drive lets you see how your plans work in a world of changing conditions.

For example, a retirement calculator prompts for desired retirement income, years until retirement, and the amount of retirement savings. After adjusting for inflation and anticipated earnings, it determines that additional monthly savings of $1,000 are needed from now until retirement. This is a one-sided solution: if everything else remains the same, then this solution works. BUT, in real life, where does the $1,000 month come from?  Will other expenses or savings have to be reduced to save an additional $1,000 a month? In reality, expenses and/or discretionary spending must be reduced by $1,000 per month in order to save an additional $1,000 a month – that is the other side of the calculations.

A cash flow analysis considers not only the benefits of the solution, but also the costs of the solution. For the above example, a cash flow analysis would determine that the same $1,000 of additional savings is necessary, but it would also show the impact on other expenses and help determine which expenses needed to be cut, or other assets used to make the solution work. If assets that would have been used for retirement are now used for the additional savings, then it is not a solution. It would be the same as moving money from one pocket to the other with no net benefit.

Simple illustrations and calculators are great for providing pieces of the puzzle. This can be very useful in setting expectations of a solution. Only with a cash flow analysis can you show both the benefits of a solution and its impact on other financial items. Only with a cash flow analysis can you show the other side of the solution.