What’s missing in traditional financial planning analytics? Here are a few things to consider. As it turns out there are a few gaps.
Financial planning grew up fundamentally as an investing and retirement portfolio accumulation service. And so we evolved planning programs that are terrific at modeling how much a client will have accumulated by age 65, assuming certain amounts invested per month at certain rates of return over the next 20-40 years. Our software can spot rebalancing opportunities and which investments have embedded capital gains.
But the profession’s planning tools are remarkably weak at helping advisors answer crucial questions for clients reaching the next phase of their lives: decisions that will have the most impact during those crucial years leading up to retirement, or when clients are decumulating portfolios after they’ve left work. They don’t offer much guidance on a client’s optimal Social Security claiming strategies, or the current and future tax impact of converting traditional IRA assets to a Roth.
And as people approach or reach retirement age, when research shows the impact of market drops can be most catastrophic, the mainstream portfolio management tools aren’t very good at evaluating the actual fat tails of downside risk associated with different asset mixes.
Right now, to fill these analytic gaps, you have to buy additional software packages. Recently, I’ve been looking at an integrated package of software tools offered by Omaha, NB-based Covisum (http://www.covisum.com), which has quietly become a one-stop-shop for rounding out your planning and investment toolkit.
Covisum offers three highly-specific, surprisingly powerful programs: Social Security Timing, Tax Clarity and SmartRisk. The package was put together by Joe Elsasser, who has, at various times, trained employee benefits brokers and financial planning offices on COBRA Rules related to health insurance plans. He opened a small planning office in 2009 as an IAR with another firm, then went out on his own in 2012, writing software on his spreadsheets in his spare time.
During his years as a trainer, talking with a variety of practices, Elsasser watched the top advisory firms struggle to add value with their planning services, at a time when their investment management and AUM revenue began to look increasingly commoditized, as older clients no longer needed the retirement modeling that traditional planning software offered.
As he sought the value proposition at his new advisory firm, Elsasser decided that he would try a different approach to providing advice to his clients. “I wanted to focus most of my attention on the places where the client has to make a decision, where there will be a default decision made for you if no decision is made,” he says. “That led me to Social Security and tax planning, and I quickly discovered that there were not a lot of good tools addressing those aspects of a client’s life.”
Covisum’s Social Security Timing tool was born out of an increasingly complicated spreadsheet that Elsasser created to provide accurate advice to his clients. As he continued to read into the claiming rules and build out the spreadsheet capabilities, he realized that there was a lot about this basic source of retirement income that most people didn’t know about. “I started doing Social Security seminars here in Omaha,” he says, “and almost from the beginning, they were packed to the gills. There was overflow. There were waiting lists. It became obvious that there was pent-up demand for this advice.”
By early 2011, Elsasser had hired a software developer to turn the spreadsheet into a software program. “At first,” he says, “it didn’t even have a user interface. There were data input forms, where you click “submit” and it would generate a PDF report that compared your earliest claiming strategy to your best.”
Instead of simply selling this crude software tool, Elsasser made it the core of an educational and marketing program, where advisors from around the country would fly in for three-day seminars offering a deep dive into Social Security claiming strategies, plus advice on how to do their own Social Security seminars in their communities, plus this new analytical tool that would allow them to quickly provide advice on optimal Social Security decisions.
Even the first version of the software did a better job of calculating a client’s benefits than the Social Security Administration’s own statements. “The statement assumes you’re going to continue to work,” Elsasser explains. “So if you’re age 60, and you’re looking at your age 66 number, and you’re thinking that is your primary insurance amount, you should know it’s assuming that you’re going to continue to work all the way up to age 66. For some people,” he adds, “that’s a really bad assumption.”
And unlike the Social Security Administration statements, Social Security Timing evaluates the various strategies that would be available to a single client or married couple, taking into account their expected lifespan and the return they could expect to receive on monies they take from Social Security and put aside—important for giving an apples-to-apples comparison to people who are considering taking early distributions and investing these sums in a taxable retirement account.
“Once those strategies are laid out,” says Elsasser, “the program will put each of them through an algorithm that lays out what the cash flows would be under each strategy. And then it presents values for all of those, and it accounts for the fact that you can claim early and invest the money.”
The user inputs a client’s taxed Social Security earnings, year by year, off of the Social Security statement or website (it took this writer about four minutes) and then you do the same thing for the spouse. You enter an assumed future inflation rate (default: 2.6% a year) and a long-term rate of return on the client’s portfolio (default 9% a year, which I scaled down to 7%), plus the desired monthly pre-tax household income upon retirement (which determines how much of an early claiming will be set aside and invested) and the monthly income desired after the first death.
Obviously the higher the portfolio return assumption, the more the program will tend to recommend early withdrawal. The higher the inflation assumption, the more it will favor delayed claiming strategies. The earlier the client is assumed to die, the more the program will favor early withdrawals.
Once the client data has been entered, the program generates a one page report (see graphic) showing a wide range of possible total wealth outcomes, depending on which of many claiming strategies (month of client’s claiming date, month of spouse’s claiming date, restricted application) are used.
All the total cash flow amounts, added up from initial claiming until death, are ranked, and the program selects an optimal one—that is, the one that produces the highest total benefit. You can change the assumptions (expected lifespans, projected rates of return, inflation rate, etc.) and run the numbers again. In each report, you see the break-even point for each spouse; that is, the age they would have to live longer than for the recommended claiming strategy to produce better total cash flow.
SMOOTHING TAX RATES
Eventually, Elsasser decided to abandon the idea of creating a community of Social Security experts, and began selling Social Security Timing as a standalone software product. By that time, he was well into developing another monster spreadsheet around the second area he had identified as a pain point in clients’ lives: tax planning.
“Historically, the way advisors have done tax planning using BNA or some other product, they will iterate,” Elsasser explains. “They’ll say, if we put $5,000 into an IRA, what would the result be? That will save the client X dollars. Okay; what if they do a Roth conversion of, say, $10,000? What would the impact of that be this year? How would it impact taxes when required minimum distributions have to be taken? Suppose we raised the conversion to $25,000? Let’s try $30,000 and see what happens.”
The point is that a diligent advisor might spend hours behind the computer searching for an optimal solution, and even more hours trying to do what CPA planners are advocating in light of the new tax bill: preventing clients from hitting very high future tax rates when they start taking RMDs by making IRA withdrawals or Roth conversions today at a lower tax bracket.
Elsasser decided to turn the problem around, and show advisors how each dollar of taxable income is subjected to marginal tax rates. “I wanted to know, how much do I actually lose to federal income tax and FICA once I account for the interactions between the different income types,” he says, “taking into account the phaseouts, deductions and past exemptions.”
The result—the Covisum program now called Tax Clarity—maps out, visually, the different types of income, the marginal tax rates, the overall marginal rate and the overall tax rate on all income—along with, of course, the projected federal tax obligation. You can see the impact of changes that you can make today, and then skip forward to see how today’s decisions impact projected taxes in the future.
SOLVING FOR INCOME
Tax Clarity was designed to integrate with Social Security Timing, and the real world value of this integration can be a bit tricky to explain. Brent Turner, a 22-year veteran of the planning business who practices in Mt. Juliet, TN, started using Social Security timing in 2015 and was an early adopter of Tax Clarity, which he says he uses every day to make presentations to clients. “I can show them how the decisions we make with retirement plans, harvesting IRAs before distributions, Roth conversions or sales that trigger capital gains will hit their tax return,” he says. The inputs are not difficult: estimated income figures for Social Security, dividends, capital gains, IRA distributions, client employment income and any self-employment earnings.
Suppose, for instance, a client has decided to take early retirement. “They may be in a situation where they’re living on their taxable account, and they’re not paying any income tax at all,” says Turner. “But they have a lot of IRA money. I’ll show them what a $40,000 Roth conversion would look like today and how it will impact their tax returns in the future, and then we might look at $50,000. I say to them, you’re going to have to pay the tax at some point. If we wait until age 70, here is how much your RMD is going to be, and this is what your taxes will be.”
If the Roth numbers don’t look appealing, he may simply recommend that clients spend a couple of years living off of IRA assets rather than from the taxable account.
In many cases, he’ll also recommend that clients delay taking their Social Security benefits—and the integration with Tax Clarity can make this argument more visual to the client.
“I might say to a client, you have parents who are still alive at age 87 and doing well, and your grandparents lived into their 90s, so there is no reason to believe you’re going to die tomorrow,” says Turner. “Instead of taking your benefits at 65, let’s think about taking them at age 70, using the claiming strategies that the software will show us, and how they can live on their other assets until then.” Tax Clarity can show how living on IRA assets (rather than Social Security) would reduce required minimum distributions in the future—a double benefit. And it shows the tax impact of suddenly receiving Social Security income at age 70—and how that income will be taxed.
Jeremy Armagost, a planner in Kearney, NB, works with a middle market clientele, and he says that he’s always surprised that other planners aren’t focusing a lot of their attention on optimizing what has become these peoples’ biggest retirement asset. “People always underestimate the value of Social Security, and the amount of benefits that are actually sitting there for them,” he says. “When we look at retirement planning, I always start with Social Security. We can design the income however they want it: we can maximize it or take it early, and I show them the trade-offs and options.”
In his experience, few clients are willing to wait until age 70, so his primary value is getting them to delay long enough that the benefits are meaningful to their retirement. “It’s not easy,” he admits. “Social Security Timing will show them that the break-even is somewhere around age 84, and nobody thinks they’ll ever live that long. But you know one or the other will.”
In addition, he says, many clients will look at the Social Security statement and not realize that this isn’t what they’ll actually put in their bank account. Nobody ever told them that the Medicare payment has to come out first.
The Social Security income number is input into Tax Clarity, and Armagost will try to aggregate all assets and then solve for the amount of lifetime income the couple needs. “My average client may have $700,000 between IRAs and taxable accounts,” he says, “so we have to figure out, how are we going to create the income they need? Are we going to do Roth conversions? Or pull a little income out of the IRA this year and put it in a taxable retirement account? The tool allows us to play around and say, if we created more gains this year, that will save you a lot more down the road.”
He points out that most clients in this net worth bracket don’t have a high need for investment management. So the value he adds has to come from modeling and planning services.
Turner agrees. “In my opinion, investment management is becoming a commodity, and advisors need to find better ways to justify their fees,” he says. “This kind of analysis brings the kind of value to a relationship that clients are willing to pay for. Most of the public out there is dumping as much money into their IRAs and 401(k)s as fast as they can, and they’re creating a huge tax bomb,” he continues. “When they come to me, I say, the bomb is already created and the fuse is lit. Let’s figure out how to de-fuse it as much as possible.”
DYNAMIC CLIENT STAGE
The most sophisticated Covisum user I talked with is David Cechanowicz, an attorney, enrolled agent and Accredited Investment Fiduciary who is the senior planner at the REDW Stanley CPA firm in Albuquerque, NM. He says that his typical client family will have a high wage-earner who is male and a younger female spouse who has lower lifetime earnings but a longer life expectancy. “When the male postpones taking Social Security,” he says, “what you’re really doing is creating a much higher longevity family benefit for the surviving spouse.”
The integration with Tax Clarity then allows him to project a client family’s future tax rates 10-20 years down the road, and smooth them out so that RMDs aren’t mostly funneled back to Uncle Sam.
“Somewhere between the ages of 62 and 70 1/2, peoples’ financial situation is rather dynamic,” says Cechanowicz. “From a tax planning standpoint, you can model how Social Security might enter the income stream at different times and in different amounts. They have opportunities to draw down their IRA assets before the required distributions kick in. You’re looking at their tax situation and making decisions about whether—or how much—to move into Roth accounts. You see that they’re going to pass a 50% tax bracket on some of their money when they turn 70 1/2, and you ask them, why would you want to expose those withdrawals to a 50% tax hit when you can do Roths today at a much lower rate?”
As one example, last year, Cechanowicz met with a client couple who both turned 66 in 2016. The wife was the low wage earner, and was claiming her full benefit that year, while the husband was making a restricted benefit claim to turn the income on in March. The Tax Clarity inputs for 2017 were ten months of Social Security income, $12,000 of earned income, $5,200 of ordinary income, and IRA distributions of $25,000—enough to meet the couple’s lifestyle income needs for the year.
The initial Tax Clarity output for this couple is shown on this page, with the green dot marking where the couple’s income falls mapped on a grid, income vs. marginal tax rate. It shows that the couple will pay at a 28% effective marginal rate for the last $8,000 or so of income, but overall the effective rate is a low 6.03%.
“Projecting ahead to 2022,” says Cechanowicz, “the marginal income tax rate will rise to 50% as they take RMDs of $800,000 on their combined IRAs.”
His recommendation: increase the 2017 IRA distribution by $40,000, pay the taxes and use the after-tax income that will be taxed at a 16% rate to eliminate all household consumer debt, including a car loan. “That,” he says, “will reduce the future required budget by $8,000 a year.”
In year two, the couple would take the same IRA distribution, and this time use the money to replenish their savings account that had been used for medical expenses. As you can see from the lower graphic, which shows the couple’s new tax scenario, the effective tax rate actually went down, even though the total tax paid almost doubled.
In another example (see graphic) Cechanowicz showed a client who was working well past normal retirement age the benefit of rolling his IRA accounts into his company’s 401(k) plan at age 70, to stop the required minimum distributions altogether. The red dot (and the red lettering below) illustrates the “before” scenario, and the green dot shows the “after” situation.
“We reduced total retirement income and he will make the maximum $25,000 contribution to the 401(k),” says Cechanowicz. “This is the most efficient strategy, since that last $5,000 of income would be taxed at a combined federal/state rate of 45.65%. Why work for 50 cents on the dollar?”
The analysis is very helpful, but Chechanowicz says that Tax Clarity is also a robust communication tool. “Being able to show these things visually is very magical,” he says. “I’m sometimes stunned at how fast I can communicate very complex issues to clients.”
Armagost says he’s been surprised how often he turns to Tax Clarity in his work with clients. “Initially, I got it because it went so perfectly with Social Security Timing,” he says. “But I ended up using it to show our high-earning clients simple concepts like the power of deferral, and the tax impact of adding a dollar of this kind of income vs. another kind—all laid out graphically.”
Recently, he used the software to help a client make a fairly basic financial decision. “He has $500,000 in an IRA, not much in taxable accounts, and he’s selling his house and moving to Wyoming,” says Armagost.
The problem is that the client needs to buy (and move into) the new house before the old one is sold. “He was asking me if he could take $100,000 from his IRA to put down on the new house,” Armagost explains. “I pulled out Tax Clarity, we looked at his situation, and I showed him what the $100,000 distribution would do to him taxwise: it would cost him $15,000 in taxes this year.”
A few keystrokes brought up the illustration of a different approach. “I showed that if he took just $50,000 out of the IRA it would keep him in the lower bracket,” says Armagost. “It would keep his taxes down to $4,100 this year—and meanwhile, he can take a bigger mortgage loan, and pay it off in three or four years, with the savings on taxes. I couldn’t,” Armagost says, “have convinced him that this was the best approach before I had Tax Clarity.”
The third software element to the Covisum package, Smart Risk, is actually a continuation of a program some of you may be familiar with: Prairie Smart, which was created by Dr. Ron Piccinini. The goal was to address all of the problems you already know regarding Monte Carlo Analysis: the fact that the actual risk of big losses in client portfolios is much greater than the standard deviation calculation would suggest.
“According to traditional measures, Black Monday should happen only once in every 100,000 times the age of the universe,” Elsasser says. “Yet it happened, and it may happen again, maybe more than once, in our lifetimes. The volatility in February that caused the short vol funds to collapse should happen only once every 4,000 years,” he adds. “Clearly we aren’t getting accurate measures of the actual risk in the markets.”
Elsasser had identified more precise portfolio risk measurement as a third blind spot in traditional planning software. But wasn’t sure how to go about addressing it with his spreadsheets until he talked with the Prairie Smart founders.
“They had created statistical models that allow you to model heavy-tailed distributions, which is what Ron had written his finance Ph.D. dissertation on,” Elsasser continues. “We took over the software, and added some simplicity to it.” Early last year, SmartRisk was transferred to Covisum, with Piccinini retained as director of product development.
The result is an interface where the advisor would input an actual client or model portfolio, and get quarterly and annual downside return numbers with what Piccinini’s calculations would show to be a 99.5% certainly level—that is, a high certainty that the losses will not be greater than this figure.
The output is likely to be alarming. Elsasser showed me a plain vanilla 60/40 portfolio whose standard deviation calculation would suggest a six-month possible loss of about 8.8%. Smart Risk’s alternative (fat tail) calculation puts the possible six-month loss at around 26%.
“That isn’t what we think will happen; it’s what could happen,” Elsasser emphasizes. “Having that more realistic estimate of the risk allows me to have a conversation with the client in advance of the next downturn, and set a reasonable expectation that is not likely to be exceeded. Otherwise, using the old math, I’m going to look foolish when the downside is exceeded regularly.”
Of course, once advisors see that much larger downside possibility, they start looking for ways to mitigate the risk. “As an advisor,” says Elsasser, “I have the ability to go into Smart Risk and change the models on a security-by-security basis. What if I change this or that allocation? What if I move a client from model four down to our model two? They can see immediately how any of these actions impacts the downside risk.”
HOT BUTTON ISSUES
Right now, Covisum seems to be attracting most of its popularity in the CPA planning world, where planners put an emphasis on detailed tax modeling, and are math-smart enough not to give standard deviations much credence in making future return expectations. CPA conferences are still the only place where I hear advisors talking about taking premature IRA distributions and episodic Roth conversions to smooth out tax rates over the next 10-15 years—analytical tasks that Tax Clarity is perfectly suited for. When I attended the AICPA Engage Conference, Covisum was running a popular booth, not just for the taxes, but also for hard-to-find Social Security analysis.
Elsasser says that the software currently has 1,700 direct advisor subscriptions. But if you count enterprise relationships (some of them white-labeled), the total user count is closer to 20,000.
Cost? Social Security Timing and Smart Risk each cost $49.99 a month, or $500 for an annual subscription. Tax Clarity costs $79.99 a month, or $800 a year.
Elsasser ultimately expects all advisors to be providing more detailed Social Security and ongoing tax planning advice than what you get from the financial planning software programs, and to give more realistic assessments of the risks in client portfolios than you get from Monte Carlo calculators. Social Security Timing allows advisors with little expertise to quickly provide detailed advice on Social Security decisions, and Smark Risk helps advisors help clients navigate the huge sequence-of-return risks they (perhaps unknowingly) face early in their retirement years.
One might argue that these tools more directly address the typical client hot button issues than traditional planning tools. “Most people don’t walk into an advisor’s office with a stack of performance statements and say: ‘What do I do?’” Says Elsasser. “They walk in with a problem. And the advisor needs to solve that problem for them.”
As millions of advisory firm clients are transitioning from accumulation of retirement portfolios to the more treacherous waters of managing the tax consequences and portfolio decumulation risks that come in retirement, Covisum represents the most direct path to addressing these new challenges. As asset management incrementally becomes commoditized, these tools help advisors add real value in the planning relationship. Covisum is a one-stop opportunity to fill what most of us never before realized are the gaping holes in traditional planning analytics.
Bottom line: These tools address client pain points more specifically than traditional planning software. As portfolio management becomes increasingly commoditized, these represent areas where clients will pay for professional advice.