The Investment Gods Are Furious

Market Cycle Investment Management (MCIM) is an historically new methodology, but with roots deeply embedded in both the building blocks of capitalism, and financial psychology— if there is such a thing.

The earliest forms of capitalism sprung from ancient mercantilism, which involved the production of goods and their distribution to people or countries mostly around the Mediterranean.

The sole purpose of the exercise was profit and the most successful traders quickly produced more profits than they needed for their own consumption. The excess cash needed a home, and a wide variety of early entrepreneurial types were quick to propose ventures for the rudimentary rich to consider.

There were no income taxes, and governments actually supported commercial activities, recognizing how good it was for “Main Street” — as if there was such a thing.

The investment gods saw this developing enterprise and thought it good. They suggested to the early merchants, and governments that they could “spread the wealth around” by: selling ownership interests in their growing enterprises, and by borrowing money to finance expansion and new ventures.

A financial industry grew up around the early entrepreneurs, providing insurances, brokerage, and other banking services. Economic growth created the need for a trained workforce, and companies competed for the most skilled. Eventually, even the employees could afford (even demand) a piece of the action.

Was this the beginning of modern liberalism? Not! The investment gods had created the building blocks of capitalism: stocks and bonds, profits and income. Stock owners participated in the success of growing enterprises; bondholders received interest for the use of their money; more and better skilled workers were needed — the K.I.S.S. principle was born.

As capitalism took hold, entrepreneurs flourished, ingenuity and creativity were rewarded, jobs were created, civilizations blossomed, and living standards improved throughout the world. Global markets evolved that allowed investors anywhere to provide capital to industrial users everywhere, and to trade their ownership interests electronically.

But on the dark side, without even knowing it, Main Street self-directors participated in a thunderous explosion of new financial products and quasi-legal derivatives that so confused the investment gods that they had to holler “’nuff”! Where are our sacred stocks and bonds? Financial chaos ensued.

The Working Capital Model was developed in the 1970s, as the guts of an investment management approach that embraced the cyclical vagaries of markets. This at a time when there were no IRA or 401(k) plans, no index or sector funds, no CDOs or credit swaps, and very few risky products for investors to untangle.

Those who invested then: obtained investment ideas from people who knew stocks and bonds, had pensions protected by risk-averse trustees, and appreciated the power of compound interest. Insurance and annuities were fixed, financial institutions were separated to avoid conflicts of interest, and there were as many economics majors as lawyers in Washington.

MCIM was revolutionary then in its break from the ancient buy-and-hold, in its staunch insistence on Quality, Diversification, and Income selection principles, and in its cost based allocation and diversification disciplines. It is revolutionary still as it butts heads with a Wall Street that has gone MPT mad with product creation, value obfuscation, and short-term performance evaluation.

Investing is a long-term process that involves goal setting and portfolio building. It demands patience, and an understanding of the cycles that create and confuse its landscape. MCIM thrives upon the nature of markets while Wall Street ignores it. Working Capital numbers are used for short-term controls and directional guidance; peak-to-peak analysis keeps performance expectations in perspective.

In the early 70s, investment professionals compared their equity performance cyclically with the S & P 500 from one significant market peak to the next — from the 1,500 achieved in November 1999 to the 1,527 of November 2007, for example. Equity portfolio managers would be expected to do at least as well over the same time period, after all expenses.

Another popular hoop for investment managers of that era to jump through was Peak to Trough performance —managers would be expected to do less poorly than the averages during corrections.

Professional income portfolio managers were expected to produce secure and increasing streams of spendable income, regardless. Compounded earnings and/or secure cash flow were all that was required. Apples were not compared with oranges.

Today’s obsession with short-term blinks of the investment eye is Wall Street’s attempt to take the market cycle out of the performance picture. Similarly, total return hocus-pocus places artificial significance on bond market values while it obscures the importance of the income produced.

MCIM users and practitioners will have none of it; the investment gods are furious.

Market Cycle Investment Management embraces the fundamental building blocks of capitalism — individual stocks and bonds and managed income CEFs in which the actual holdings are clearly visible. Profits and income rule.

Think about it, in an MCIM world, there would be no CDOs or multi-level mortgage mystery meat; no hedge funds, naked short sellers, or managed options programs; no mark-to-market lunacy, Bernie Madoffs, or taxes on investment income.

In MCIM portfolios, lower stock prices are seen as a cyclical fact of life, an opportunity to add to positions at lower prices. There is no panic selling in high quality holdings, and no flight to 1% Treasuries from 6% tax free Munis. In an MCIM portfolio, dividends and income keep rolling, providing income for retirees, college kids, and golf trips — regardless of what the security market values are doing.

Capitalism is not broken; it’s just been overly tinkered with. The financial system is in serious trouble, however, and needs to get back to its roots and to those building blocks that the Wizards have cloaked in obscurity.

Let’s stick with stocks and bonds; lets focus on income where the purpose is income; let’s analyze performance relative to cycles as opposed to phases of the moon; let’s tax consumption instead of income; and let’s not disrespect the gods, the “Bing”, or the intelligence of the average investor…

So sayeth the gods. Amen!

The “Total Return” Shell Game

No “Interest Rate Sensitive” Security is an Island…

Just what is this “total return” thing that income portfolio managers like to talk about, and that Wall Street uses as the performance hoop that all investment managers have to jump through? Why is it mostly just smoke and mirrors?

Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — and this is supposed to be the ultimate test for any investment portfolio, income or equity.

Applied to Fixed Income Investment Portfolios, it is useless nonsense designed to confuse and to annoy investors.

How many of you remember John Q. Retiree? He was that guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio while he secretly wondered why he only had about 3% in actual spending money.

The next year he’s scratching his head wondering how he’s ever going to make ends meet with a total return that’s quickly approaching zero. Do you think he realizes that his actual spending money may be higher? What’s wrong with this thinking? How would the media compare mutual fund managers without it?

Wall Street doesn’t much care because investor’s have been brainwashed into thinking that income investing and equity investing can be measured with the same ruler. They just can’t, and the “total return” ruler itself would be thrown out with a lot of other investment trash if it were more widely understood.

  • If you want to use a ruler that applies equally well to both classes of investment security, you have to change just one piece of the formula and give the new concept a name that focuses in on what certainly is the most important thing about income investing — the actual spending money.

We’ll identify this new way of looking at things as part of “The Working Capital Model” and the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same! The difference is what the investor elects to do with the spending money after it has become available. So if John Q’s Investment pro had taken profits on the bonds held in year one, he could have sent out some bigger income payments and/or taken advantage of the rise in interest rates that happened in year two.

Better for John Q, sure, but the lowered “total return” number could have gotten him fired. What we’ve done is taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in an investment portfolio that is diversified properly and comprised only of investment grade, income producing securities.

Most of you know who Bill Gross is. He’s the fixed Income equivalent of Warren Buffett, and he just happens to manage the world’s largest “open ended” bond mutual fund. How was he investing his own money during other interest rate cycles?

Well, according to an article by Jonathan Fuerbringer in the Money and Business Section of January 11, 2004 New York Times, he’s removed it from the Total Return Mutual Fund he manages and moved it into: Closed End Municipal Bond Funds where he could “realize” 7.0% tax free.

(Must have read “The Brainwashing of the American Investor”.)

He doesn’t mention the taxable variety of Closed End Fund (CEF), now yielding a point or two more than the tax free variety, but they certainly demand a presence in the income security bucket of tax-qualified portfolios (IRAs, 401k(s), etc.).

Similarly, the article explains, Mr. Gross advises against the use of the non investment grade securities (junk bonds, for example) that many open-end bond fund managers are sneaking into their portfolios.

But true to form, and forgive the blasphemy if you will, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community — totally. He is still giving lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS (Treasury Inflation Protected Securities).

TIPs may be “safer”, but the yields are far too dismal. Inflation is a measure of total buying power, and the only sure way to beat it is with higher income levels, not lower ones. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc.

No interest rate sensitive security is an Island!

As long as the financial community remains mesmerized with their “total return” statistical shell game, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer switching decisions between fixed income and equity investment allocations, simply on the basis of statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

You have to both understand and commit to the premise that the primary purpose of income securities is income production. You have to focus on the “Income Received” number on your monthly statement and ignore the others… especially NAV.

If you don’t agree with the next three sentences; if they don’t make complete sense: you need to learn more about Income Investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to both the total spending money and total working capital numbers.
  • Changes in the market value of investment grade income securities, Yogi says, are totally and completely irrelevant, 97% of the time.

I Want Tax free Income

The LinkedIn discussion considered ROTH vehicles invested in equities and “cash value” Life Insurance as two ways to obtain Tax Free Income… something was missing.

Why not buy tax free muni bonds in the form of Closed End Funds (CEFs)…. more than 6% tax free, in monthly increments, plus the opportunity to take profits (taxable, yes) and compound the income until it is needed. Or spend it right away, for that matter.

The vast majority of Tax Free CEFs continued (raised even) their monthly payouts during the financial crisis, and no payments were missed.

ROTHs have a “lock up” period, and cash value life insurance…. someone please tell me how this provides tax free income and when.

If left in the ROTH vehicle, should one still be buying equities? or investing in income producers?

Experienced, taxable CEFs pay in the 7% to 8% range right now… and seemed to be financial crisis proof in 2008 through 2010.

Growing income portfolios is my business… can’t be done nearly as well with funds and insurance policies. For over 6% tax free income right now, create a diversified portfolio of tax free CEFs.

Yes, market value fluctuates, but with little or no impact on income production. I want tax free income too… and this is how I get it, both personally and for my managed portfolios.

The principles explained in this video webinar are equally applicable to the Tax Free Income building portfolio:

S&P 500 Index: Morning After 401k Musings

March 2000 witnessed the S&P 500 Index breach the 1,500 barrier for the very first time… seven and a half years later, it was in just about the same position.

Inter-day October 15th, after an incredible bounce from its 56% drop through March 6th 2009, the S&P was just 20% above where it had been 14.5 years earlier… a gain of roughly 1.4% per year.

Just how low will it go this time? and are you prepared… this time?

The long term chart (Google “s & p 500 chart”, look mid page and click “max”) shows the volatility over the past fifteen years. Just for kicks, see if you can find the “crash” of 1987  (October 19th).

Could any stock market image be more beautiful? Could any be more in-your-face damning… tactically?

What if your 401k investment strategy had required selling before the profits started to erode?

What if your 401k strategy made you hold equity-destined cash until Investment Grade Value Stocks fell at least 20% before selective, patient, cautious buying began?

What if your 401k investment strategy called for at least 40% of your investment portfolio to always be invested in income purpose securities?… securities rising in price so far today, in the midst of a major sell off.

Such an approach has been available since the 1980’s for a lot of happy investors who have never had to change their retirement dates; and the same program has been available to 401k investors since March 0f this year…  but you have not been allowed to know about it!

You can’t use it because your 401k plan rules don’t allow you to invest in 40 year old “makes-a -lotta-sense” strategies, just because they have a new label and/or not enough millions under management… who’s protecting whom?

This is precisely how the big operators keep new and innovative solutions on the sidelines. Tough luck investors… you’ll just have to bite the bullet and watch your “by-design” speculative portfolios crumble  for the third time in fifteen years.

Pity, but one-size-fits-all rules are every bit as bad for your financial health as one-size-fits-all products. How are those TDFs doing… and with all that experience and mega millions under management.


Dealing With Stock Market Corrections: Ten Do’s and Don’ts

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, corrections adjust equity prices to their actual value or “support levels”.  In reality, it may be easier than that.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking.

The two former “becauses” are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

Mutual Fund holders rarely take profits but often take losses. Additionally, the new breed of Index Fund speculators is ready for a reality check. If this brief hiccup becomes a full blown correction, new investment opportunities will be abundant.

Here’s a list of ten things to think about doing, or to avoid doing, during corrections of any magnitude:

1. Your present Asset Allocation is based upon long-term goals and objectives. Resist the urge to decrease your Equity allocation because you expect lower stock prices. That would be an attempt to time the market. Asset allocation decisions should have nothing to do with stock market expectations.

2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of Investment Grade Value Stocks as they move lower in price. I start shopping at 20% below the 52-week high water mark… the shelves are full of bargains.

3. Don’t hoard the “smart cash” you accumulated during the rally, and don’t get yourself agitated if you buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, and selling too soon is investing brilliance.

4. Take a look at the future; you can’t tell when the rally will resume or how long it will last. If you are buying IGVSI equities now, you will to love the next rally even more than the last… with yet another round of profits.

5. As the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There’s more to “Shop at The Gap” than meets the eye, and you should run out of cash well before the new rally begins.

6. Your use of “Smart Cash” proves the wisdom of Market Cycle Investment Management; it should be gone while the market is still falling… gets less scary  every time. So long your cash flow continues unabated, the change in market value is just scary, not income (or life) threatening.

7.  Note that your Working Capital is still growing in spite of falling market values, and examine holdings for opportunities to reduce cost basis per share or to increase yield on income Closed End Funds). Examine fundamentals and price; lean hard on your experience; don’t force the issue.

8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of media hype and propaganda. Focus on Investment Grade Value Stocks; it’s easier, less risky, and better for your peace of mind.

9. Examine portfolio performance with your asset allocation and investment objectives in focus and in terms of market/interest rate cycles as opposed to calendar quarters and years. The Working Capital Model allows for your personal asset allocation.

Remember. too, that there is really no single index number to use for comparison purposes with a properly designed MCIM portfolio.

10.  So long as everything is “down”, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should NOT be discarded during general or group specific weakness.  BUT, you must have the courage to cull them during rallies… also general or sector specifical (sic).

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional rear view mirrors. The short and deep ones are most lovable (kind of like men, I’m told); the long and slow ones are more difficult to deal with.

If you overthink the environment or overcook the research, you’ll miss the party.

Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight. Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction:

There has never been a correction or a rally that has not succumbed to the next rally or correction..

There Are Varieties of Unknown

“Fear the unknown” is not very good advice.

The unknown is just that, unknown.  Could be good, could be bad, could be boring.  You need to know how to make it become part of the known and how to retain the knowledge.  That will require an open mind, curiosity and some effort.

As with most exploration, there is a protocol.  One good one recognizes that information and your awareness of it falls into one of four categories.  Each has techniques for coping.

  1. The Known Known.  Things you know that you know you know.  Could be facts or details (like your wife’s birthday, the price you will pay for gold or the combination to the door at the office) or skills (all of that technical material, facts, formulae and methods) or people connections, or just useless information that you have not gotten around to forgetting yet (the backup shortstop for the 1957 Boston Red Sox.)  It will pay you to have a fairly clear idea of what fits here, because if you do not work at it, the material will fall into another category.
  2. The Unknown Known.   All the things you know but don’t know you know or have forgotten you know or that you can recall only after a trigger is pushed.  Like a joke.  If someone asks me to tell 20 jokes, I probably could not.  If we talk for a while, I can probably find 100 or more.  A lot of what we know we only know contextually.  If the context is not there, the knowledge is unavailable.
  3. The Know Unknown.  The things you don’t know and you know you don’t know them.  Many of these are things you don’t know because you don’t need to know.  Like how fuel-injection works.  There can be gradation here.  If you run a business, knowing at least something about marketing, finance, engineering, personnel management and the law will be useful.  Probably, managers know enough to recognize problems, opportunities and traps.  In most cases people can buy the required knowledge.  Just be sure you know enough to recognize when it is time to look for help.
  4. The unknown unknown.  This is why you need to stay curious and build a circle of friends and acquaintances with diverse knowledge, skills, and experience.  I learn interesting things from business owners and professionals, but I learn really interesting things from authors, artists, geologists, athletes and old people.  Stay awake.  Everyone knows something you don’t and given the opportunity, they will happily tell you.

For people in transition, like succession planning or estate planning, the unknown known area is the most productive to attack.  If you do not work hard at it, your intuitive knowledge and much of your business network will be lost and you cannot be sure that the loss will be unimportant.

I had a client write down who he knew, why he knew them, their contact information and how they connected to others.  For a year he added to it as he talked to someone or remembered a connection.  By the time he retired there were thousands of names.  His son claimed that he knew of barely half of them.  Same thing with customer or supplier foibles, or how the motor on machine 3 tends to overheat, or why we shut down in July because the heat affects our product, or which service technicians will do the best work or ………

Known and unknown unknowns are for the successors.  Parents need to make sure the Unknown knowns come to the surface and then store and communicate them.


Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. Contact:

What If You Live to 120?

In Arles France, on Monday 4 August 1997, Jeanne Calment died.  I am sure that many other people died that day, but Jeanne Calment is special.  When she died she was 122 years 164 days old.  We should notice.  If many of us live to 120 then our social services and ideas about what life should mean will change.

The ability to age successfully is more common than it was only a few decades ago, yet old norms remain.  Retire at 65?  Why?  130 years ago, 65 was ancient.  In 1881 Bismarck in Germany, proposed mandatory retirement at 65 with government pensions.  At that time life expectancy was less than 10 years.  Today it is about 17 for males and over 20 for females.  The similar retirement age today would be in the late 70′s.

It gets more challenging as we go forward.  The US Department of health and Human Services has estimated that of all the people 65 or old in 2050, 10% will be more than 89.  Today it is about 3%.

The Baby Boom demographic will last a long time and medical science could develop something that make us last much longer than the estimates.  What if instead of 24% of people being over 65, in 2050 it turned out that 35% were and of those a quarter of them were over 89.  Hopefully most of them will decide to keep working past 65 or 67 or whatever it becomes.  Otherwise, financial Armageddon.

Being poor at 30 is not necessarily forever.  Being poor at 90 is forever.

Society as a whole and people specifically will need to change attitudes and expectations.  While there is no guarantee you will live to be 100, there is a higher probability than there used to be and that probability is growing.

Most people have the hope that they will live a long life.  Some financial plans build in elements that assume death by the mid-80′s.  Leveraged life insurance is one.  Try to avoid plans wherein you get what you want and then are punished.  Running out of money at life expectancy by design is not a wise strategy.  On the other hand, maybe it does not matter.  A typical 85 year-old will starve to death in less than 10 days.  Build very long plans.

On a happier note, you could implement some of Jeanne Calment’s longevity tricks.

  • Have some money.  She made a life tenancy deal on her apartment at age 90 whereby she would get 2,500 francs per month for life and the buyer would get the apartment on her death.  She outlived both the buyer and his wife.
  • Be physically involved.  She enjoyed tennis, swimming and cycling but apparently was neither athletic or particularly health conscious.
  • Have interests.  She enjoyed piano and took up fencing when she was 85.
  • Watch your diet.  She put olive oil on everything and enjoyed red wine.
  • Get rid of bad habits.  She quit smoking at 117 and gave up her weekly kilo of chocolate at 119.
  • Be immune to stress.  “If  you can’t do anything about it, don’t worry about it.”
  • Stay sharp and interested.  Reply to a friend taking their leave at her 117th birthday party.  Upon hearing the wish.  “Until next year, perhaps.”  she replied, “I don’t see why not!  You don’t look so bad to me.”

Or maybe her explanation makes most sense.  “Perhaps God has forgotten me.”  If God forgets you, make sure you have the money and the excitement to enjoy your life.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Everyone Has A Will

Here’s why.

There may be 56% who have no signed will but there are 0% who have no will at all.  In Ontario, the succession law reform act provides a will for you and there are similar acts in every other jurisdiction.

There is our government working on our behalf again.  If you need it, they provide it.

The will they provide for you may not be exactly the same as the one you would draw up for yourself.  In fact I would estimate that the probability of your creating their will, by choice, is about 1 in a million.  Maybe even less than that.  Their idea of fair is a little more aimed at pleasing everyone possible.  And, of course, it will cost more and take longer.

Most jurisdictions have their own rules so you you should ask a lawyer what your particular rules are.  In Ontario your will looks roughly like this:

I require the court to appoint an administrator for my estate

I require the administrator to post a bond of two times the value of my estate

I require that the administrator make no effort to reduce any income taxes that I may owe as the result of my death.

I instruct my administrator to take no care to keep assets in specie even though my family may prefer that treatment.

I instruct my administrator to make no effort to consider what the heirs want of my assets in settling the estate.

I instruct my administrator to make no effort to complete their task expeditiously.  Certainly not in less than one year.

I instruct my administrator to be very cautious about interim distributions

I instruct my administrator to pay all liabilities including taxes and to sell whatever assets will sell easiest to provide any cash my estate may need.

As to distributions of what remains, I instruct my administrator to:

  1. Transfer $200,000 to my spouse.
  2. Divide the remaining 2/3  as follows.  If one child 50-50 with spouse.  If more than one child then 1/3 to spouse the remainder equally to the children.
  3. In the event any child is less than 18, I instruct the public trustee to hold the assets for that child until their 18th birthday and then to deliver the assets to them intact.
    1. An illegitimate child is a child for purposes of distribution.
    2. A predeceased child provides complications too.

It is not impossible that this will would work out, but that is not the way to bet.  Many people who own complex assets do not have wills.  They are looking at higher than needed tax and other costs and will likely have no described plan that suits their own ideas.

If you have assets are even slightly  more complicated than a home in joint tenancy, a small RRSP, and a bank account, seek the services of a knowledgeable attorney.

Oh, why restrict it!!  Talk to any attorney.  Even an attorney who won their law degree in a poker game two weeks ago could draft a more appropriate will.  And while there, notice that 71% of Canadians have no powers of attorney.  Address that too.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Liquidity Matters In Your Estate

Lynne Butler is the purveyor of useful estate planning information. Her Blog “Estate Law Canada” provides good answers to questions that come up regularly and for some others that are rare. There is an extensive and searchable archive. You will benefit from her collection.

A recent one caught my attention. It deals with taxation and covers the ground for the majority of people. Taxes due when the second parent passes away.

It would be useful as a client handout and might help reduce the inevitable surprise that taxes payable by an estate engender in the previously uninformed heirs. A younger client might want to forward a copy to Mom and Dad.

In the client situation, facts, problems and opportunities are interesting. People will need to have an idea how to fix it as well as how to know about it. Offering implementable solutions is always welcomed.

A planner should help create the “irreducible minimum” for all of the demands in the estate. This means take the steps that are cost and/or cash reducing that are consistent with your preferred lifestyle, your tolerance for complexity and other life goals. Spending a two dollars to save one is not smart, even if it eliminates a tax dollar due.

Once the irreducible minimum cost is known, you can find ways to deal with it.

An adviser should address the matter of funding the liabilities that arises. In addition to taxes there are fees to myriad people. Lawyers, accountants, business and property evaluators, the courts and executors are some. These can often be 10% of an estate and should not be overlooked. There are some minimizing techniques available.

With income taxes, things like an RRSP or mutual fund can self fund the liability, but for other assets like cottages, rental properties and businesses, the liquidity must be created. Watch for promises, preferences, pledges and guarantees while estimating the needed cash.

Do not make the mistake of treating the irreducible debt, fees or taxes as problems. These are not problems, they are merely facts. The problem in an estate is finding cash to deposit so that the executors can write the necessary checks.

All estate plans need to address liquidity and the distribution plan of any estate needs to be based on what is likely to remain after costs and taxes and the liquidation of other obligations.

Be prepared. The net amount is, not infrequently, much less than people expect.

Your will gives you the necessary clue to how things will work out. Follow the logic. The form of your will shows that the executors are to find the assets, pay the liabilities, costs, and legacies like charitable donations, and then distribute the rest to the heirs. Despite the clarity, many people intuitively plan around the idea that they can distribute what they own intact. Seldom true and that rarity can, does, and will in the future, create problems.

Every estate distribution plan is multipart. 1) Discover the assets owned, 2) go through the hoops imposed by the courts, 3) liquidate the liabilities, fees and specific bequests that arise, and finally 4) distribute to heirs.

Miscalculations or inability to meet step 3 will delay and probably reduce step 4. No executor has ever complained about having more cash than they need, but many have problems with a shortfall.

Understand how liquidity will come to be. There are only four ways the executor will have that cash to meet the obligations. (Exactly four.)

Two are controlled by the deceased and two are controlled by the executor.

Controlled By The Executor

  1. Sell Something . Typically, time is of the essence and they will need to sell the best and keep the rest. Does “Estate Sale” imply a bargain? Then there are the costs and the time it takes to sell complex assets for full value. Estate shrink and added costs.
  2. Borrow tends to tie up the estate for much longer than the heirs might prefer. You will need to pledge almost the whole estate to get 25% of it as a loan. The interest will be non-deductible for taxes. Delay and some shrink.

Controlled by the Deceased

  1. Own liquid assets before death. This method has high tax costs and low yields while living. There is a material opportunity cost with this one. Owning liquidity is typically the most expensive way to solve the problem.
  2. Own life insurance, possibly second to die life insurance. When you arrange life insurance, it is merely a post-dated check with an unknown date of payment. In the estate need situation, the date is, coincidentally, the same day the executor needs the money. In almost every case, it is less costly than any of the other three alternatives. Provably so. You might want to check it out.

You can try to anticipate what is likely to occur and find good ways to deal with the deficiencies. If your estate is more than minimally complicated, then you might usefully work with your accountant or other advisers and “Test your will.” Preferably pre-mortem. It is a bit technical but in the end little more than a big arithmetic question.

Get busy. You have the information at hand and know your wishes. Your executor and your heirs will know less. Guaranteed.

Well prepared usually leads to well done.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Give Away The Taxes Your Estate Will Owe

If you intend to benefit a favored charity upon your death, life insurance is a fertile area for research. If you have liquid assets set aside to meet estate obligations and are in good health, you might find this example interesting. If you are a charity, you might want to find some folks to participate with you.

Bill and Jean, both 70, have transferred their business to their children and have a frozen capital gain of $1.5 million. They estimate the taxes on that gain to be about $375,000 but not due until they are both gone. They have set aside $500,000 for their tax obligation and to leave $125,000 to their favorite charities. While either of them is alive, they will invest this money in liquid, interest bearing investments, like short term bonds and spend the income. (For convenience, we have assumed a tax rate of 50%. The actual maximum rate in Ontario at the time of writing is 48.4%.)  They assume that they can earn 3% or $15,000 pretax and they will spend $7,500 after taxes are paid. A tidy plan that takes care of two estate issues and provides a bit of income in the interim.

When they visit with their accountant, they find that their charitable bequests will reduce their income taxes due at death by about 50 cents per dollar given away. On discovering this, they revise their plan. Instead of $125,000 for charity, they now allocate $250,000. The donation will save about $125,000 in income taxes and they will owe only $250,000 on their capital gain. Their $500,000 remains enough. $250,000 to the government and $250,000 to their charity.

Bill and Jean will likely never find out that there is a much better way to arrange their affairs. If they happen to meet the right person, they will find it is possible to give away their taxes while increasing their annual spending from $7,500 to $9,500. All guaranteed by major financial institutions.

Here’s what they need to notice.  Now they invest to meet two goals with one investment.  Retain liquidity against the cash need in the estate and accept whatever income a secure, liquid investment can provide.  In their estate no net capital will remain from the $500,000 and in the interim there will be $7,500 per year of after tax income.  Their $500,000 means $7,500 per year to spend and money if the estate to meet two obligations.

Here’s how they can get more money with the same meaning.

Instead of investing in liquid investments Bill and Joan recognize that the only time they need their capital to be liquid is when the second of them dies and the income in the interim is not crucial to their lifestyle. With those recognitions in mind, they arrange specialized products to meet their specialized needs.  They do that instead of using general purpose investments.   See the Swiss Army Knife Problem.

The first of these products is a joint life, second to die, life insurance policy for $750,000 with level cost of insurance. Once approved for insurance, they will use their $500,000 to buy a life annuity with payments due while either is alive.

The annuity will pay them about $30,000 annually the insurance cost will be $18,000. Taxes will be another $2,500. Their net cash flow while living is $9,500 annually – up from $7,500 before. (All numbers approximate)

On the second death, their estate will donate the $750,000 insurance proceeds to charity and get a tax credit of $375,000. Enough to eliminate their income tax liability.

The summary. Their spending money will be 30% greater while they are alive and their favorite charities will receive an extra $500,000 on their death.

The example here is about the simplest example possible.  Given more information about their intentions, significantly different answers could appear.  You might want to investigate.

Also, notice that not everyone is in “standard health” and rates change with age and from time to time. Your mileage may vary, so check with a professional.

A great portion of financial success is finding options. You will be looking to get the same meaning in a more efficient way.  Reorganizing apparently disconnected aspects of an estate plan into specialized products sometimes can benefit everyone. Well, I suppose everyone but the government.

I’m okay with that.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.