FAMILY INC Using Business Principles to Maximize Your Family’s Wealth Douglas P McCormick Cover design: Wiley Cover images: Paper cut out family © Tooga/Getty Images, Inc.; $100 bills background © Cimmerian/Getty Images, Inc.; Family Inc logo: Scott Hummel Copyright © 2016 by Douglas P McCormick All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com ISBN 978-1-119-21973-6 (Hardcover) ISBN 978-1-119-21976-7 (ePDF) ISBN 978-1-119-21974-3 (ePub) CONTENTS Foreword Acknowledgments With Appreciation for America’s Armed Forces Service Members Introduction SECTION I EVERY FAMILY NEEDS A CHIEF FINANCIAL OFFICER Chapter Why Do I Need a CFO? I Don’t Even Own a Business Assumptions and Reality But What Does a Family Chief Financial Officer Specifically Do? The Big Picture Key Conclusions Notes SECTION II MAXIMIZE THE VALUE OF YOUR SINGLE BIGGEST ASSET—YOUR LABOR Chapter Double the Value of Your Labor through Education Educated People Earn More Educated People Work Longer Not All Degrees Are Created Equal Education May Be a Great Investment, But How Do I Pay for It? Reality Check Key Conclusions Notes Chapter Make Career Choices that Extend Your Possibilities Reconciling Contradictory Arguments Allocate Your Labor Like a Growth Investor Allocates Capital Key Conclusions Chapter Think Like an Investor When Making Career Decisions Evaluating the Opportunities Key Conclusions Notes Chapter Don’t Overlook Retirement Benefits Just Because They’re Not Imminent Obstacles to Planning Key Conclusions Notes Chapter Complement Your Career Decisions with Insurance How Needs Evolve Key Conclusions Notes SECTION III MANAGE YOUR ASSETS LIKE A CFO MANAGES A BUSINESS Chapter Your Financial Assets Serve Many Functions in Your Family Business The Elements of Asset Management Key Conclusions Chapter Diversify Your Family Business with the Right Investments Strategic Asset Allocation: How to Arrange the Big Picture The Conventional Asset-Allocation Models Weaknesses of the Conventional Models A Wealth Effect Tactical Asset Allocation Asset Classes with Unique Characteristics Key Conclusions Chapter Define the Right Goals for Your Asset Management Business Where the Money Disappears Key Conclusions Notes Chapter 10 Use History to Make Reasonable Investment Assumptions Long-Term Investment Returns Living with Volatility Should You Borrow? How Do Taxes Affect the Case for Equities? Theory versus Real World Application When Markets Gyrate, Think Like a Business Owner Combining History with Today’s Environment Managing in a World of Dollars, Not Percentages Key Conclusions Notes Chapter 11 Safeguard Your Assets from the Main Risks Key Conclusions Chapter 12 Not All Debt Is Bad! Use Debt to Purchase Assets and Maximize Your Liquidity Debt or Fixed Income as an Investment Borrowing for Family Inc Key Conclusions Chapter 13 Which Is Better, Active or Passive Investment Management? It Depends The Case for Passive Management The Case for Active Management Key Conclusions Notes Chapter 14 Use Indexing for Your Low-Cost Investment Portfolio International Allocation Rebalancing Your Portfolio to Maintain Appropriate Market Exposure Key Conclusions Chapter 15 Understand When It Makes Sense to Pick Individual Stocks and Managers Active Management by the Family CFO Actively Managed Broker Accounts Actively Managed Funds The Unfortunate Reality of the Investment Management Game Recommended Role of Your Financial Adviser Key Conclusions Chapter 16 The CFO’s Step-by-Step Guide to Building the Family Investment Program Reality Check Chapter 17 Know Yourself—Understand the Psychological Factors That Can Torpedo Your Goals Chapter 18 Don’t Sweat the Details of Your Asset Management Business A Word of Caution—Time’s Impact on the Quality of These Recommendations SECTION IV FAMILY INC DOES NOT MANAGE ITSELF Chapter 19 Create Tools and a Reporting Dashboard for Managing Family Inc The Family Inc Income Statement Adding a Balance Sheet Asset Composition Liability Composition Set Up a Financial Dashboard An Owner’s Manual Employing Forecasting, What-If Scenario Analyses, and Monte Carlo Simulations Understanding the Mathematics of Saving Beyond the Balance Sheet Key Conclusions SECTION V MANAGE YOUR FAMILY ENDOWMENT IN RETIREMENT Chapter 20 Understand How Your Family Business Changes in Retirement Chapter 21 Sleep Well—Protect Your Retirement through Insurance Longevity Insurance Techniques to Minimize Annuity Costs Rules for Annuity Purchase Programs Rebuttal to Annuity Critics Social Security as an Annuity Health-Related Insurance Products Long-Term Care Insurance Key Conclusions Notes Chapter 22 What’s Your Number? Determine When and How Much You Can Afford to Spend in Retirement The Percent Withdrawal Rule First Determine Your Acceptable Shortfall Rate Identifying Your Withdrawal Rate Modifications to Personalize Your Unique Withdrawal Rate The Modified Percentage Withdrawal Calculation Turbocharging Your Retirement Number A Number Is Just a Number Managing Your Retirement Portfolio to Minimize Taxes Using Debt to Defer or Minimize Your Tax Liability Understanding What Inflation Does to Your Purchasing Power in Retirement Key Conclusions Notes SECTION VI AVOID THE RAT RACE—CHANGE THE GAME BY CHANGING THE RULES Chapter 23 Pay Yourself What You’re Worth through Entrepreneurship Key Conclusions Notes Chapter 24 Jump-Start Your Heirs’ Financial Security Key Conclusion Chapter 25 Develop a Succession Plan to Groom Your Replacement(s) Key Conclusion Chapter 26 Develop and Manage Your Estate or Uncle Sam Will Key Conclusions Chapter 27 Maximize Your Charitable Legacy How to Select Worthy Charities How to Give Key Conclusions SECTION VII A CALL TO ACTION Chapter 28 “But It’s Different This Time .” Key Conclusions Chapter 29 Put Down the Book—Just Do It! The Real Prize Appendix: How to Calculate Expected Lifetime Labor Value Notes Glossary Notes Index EULA List of Tables Chapter Table 2.1 Table 2.2 Chapter Table 4.1 Chapter 10 Table 10.1 Table 10.2 Chapter 13 Table 13.1 Chapter 18 Table 18.1 Chapter 19 Table 19.1 Table 19.2 Table 19.3 Table 19.4 Table 19.5 Chapter 22 Table 22.1 Table 22.2 List of Illustrations Chapter Figure 1.1 The Three Parts of Family Inc Net Worth and How They Evolve Over Time Figure 1.2 Annual Family Inc Cash Flow Projection Chapter Figure 2.1 Family Inc Net Worth–Retirement at 67 Figure 2.2 Family Inc Net Worth–Retirement at 70 Chapter Figure 6.1 Term Life Insurance Ladder Chapter Figure 8.1 Asset Allocation for 40-Year-Old Figure 8.2 Family Inc Net Worth Asset Allocation Model (for 40-year Old) Chapter Figure 9.1 Average Annual Returns (IRRs) over 30 Years Based on Three Different Gross Returns Figure 9.2 Value after 30 Years Based on Three Different Gross Returns Chapter 10 Figure 10.1 Inflation-Adjusted Growth of a $1 U.S Investment, 1802–2012 Figure 10.2 Change in Returns Over Various Five-Year Periods Figure 10.3 Average Annual Volatility of After-Inflation Returns Figure 10.4 The Tax Effect: After-Tax Real Asset Returns, 1871–2012: Compound Annual Rates of Return Figure 10.5 Real Lifetime Returns Chapter 11 Figure 11.1 Percent of Years with Negative Return Chapter 13 Figure 13.1 Annual Dispersion of Private Equity Returns, June 1988 to June 2009 Chapter 14 Figure 14.1 Weighted Capitalization of World Stock Markets Chapter 15 Figure 15.1 The Confidence Trap—Investor Confidence and Subsequent Dow Jones Average Performance Chapter 16 Figure 16.1 401(k)s Make Investments Surge Chapter 19 Figure 19.1 Income Statement Analysis Figure 19.2 Liquidity Measurements Figure 19.3 Asset Composition Analysis Figure 19.4 Liability Composition Analysis Figure 19.5 Tracking and Analyzing Net Worth Figure 19.6 Monte Carlo Simulation Figure 19.7 Monte Carlo Shortfall Simulation Figure 19.8 Probability That at Least One Member of a 67-Year-Old Couple Is Living at Various Ages Figure 19.9 Probability of Financial Shortfall with One Member of a Couple Still Living Chapter 21 Figure 21.1 Probability That at Least One Member of a 50-Year-Old Couple Is Living at Various Ages Figure 21.2 Components of Guaranteed Lifetime Annuity Payouts Male Age 65, $100,000 Investment Figure 21.3 Monthly Benefit Amounts Differ Based on the Age You Decide to Start Receiving Benefits Figure 21.4 Mean and 95th Percentile of Remaining Lifetime Health-Care Costs Including Nursing Home Care, at Selected Ages Chapter 22 Figure 22.1 Estimated Portfolio Failure Rates Based on Various Inflation-Adjusted Withdrawal Rates, Investment Allocations, and Payout Periods Figure 22.2 Median End-of-Period Portfolio Value (as a Percentage of Initial Portfolio) at Various Inflation-Adjusted Withdrawal Rates Chapter 23 Figure 23.1 An Entrepreneur’s Business Plan Hubbard, Carl M I Illiquid/illiquidity Impairment: asset asset classes and defined risk of Income: after-tax, calculating competition and from investments using percent rule lifetime, level of education and retirement, change affecting Income (or revenue) concentration Income statement Income statement management, CFO and Indexed equity Index funds Index futures Indexing, for low-cost investment portfolio Index mutual funds Industry size Inflation: asset management business and assets and investment gains and purchasing power in retirement and as risk as threat to financial security Inflation-protected dual longevity annuities Insurance: career decision and disability health-related products longevity long-term care insurance products protecting retirement through Intangible assets Interest rates, global Internal rate of return (IRR) International markets Investment assets Investment management: active and passive in entrepreneurship, CFO and reality of Investment(s) annuity as asset allocation models and assumptions, history and choices in equities global equity in labor development, subsidized long-term returns portfolio, using debt as part of residence as returns Investor(s): challenges for criteria successful thinking like business owners venture capital, private equity and IRA IRR See Internal rate of return (IRR) J Jefferson, Thomas Jobs J-shaped accrual pattern K KKR Klinger, William L Labor allocation decision Labor assets Labor business, underperforming Labor capital, charity and Labor decisions, portfolio diversification and Labor development, subsidized investments in Labor market: education and volatile Ladder structure, in life insurance program Leaders, generalist Legacy management Liability(ies): composition contingent Life expectancies Life insurance Lifetime labor value, expected Liquidity: accounts analysis for contingencies maximizing ratios short-term Loans: auto education real estate variable rate Longevity insurance Longevity risk See Shortfall risk Long-term borrowings Long-term care insurance Long-term disability insurance Long-term equity investing Long-term growth potential, evaluating Long-term investment returns Loss aversion bias Low-cost investment portfolio Low cost strategies Lump sum bias M Management: of broker accounts of funds Managers, picking Margin analysis Market capitalization Marx, Groucho Matched savings program Medicaid Medicare Merger arbitrage strategies Microsoft Middle age, insurance needs and Models, conventional: asset allocation weakness of Modified percentage withdrawal calculation Money: attitude and behavior about borrowing chances of running out of expected value of management skills market funds markets Monte Carlo simulation Month's borrowing capacity Months' contingency capital Mortgage(s) loan prepaying Multinational corporation Municipal bonds Murphy's Law Mutual funds N NAV See Net asset value (NAV) Near-cash Needs: evolution of financial, developing Net asset value (NAV) Net debt Net debt to after-tax earnings Net-debt to investment assets Net financial assets Net savings Net worth Nominal Nondeductible borrowings Nursing home costs O Opportunity(ies): cost evaluating for failure, creating geography of prioritizing Ownership bias P Participation, promoting Passive investment management Payout period P/E See Price-to-earnings ratio (P/E) Pension Performance: appropriate measurements of of stocks and bonds strategic planning and Personal brand P/Es See Price-to-earnings ratios (P/Es) Planning: estate strategic succession tax and estate, CFO and Population growth, global Portfolio: of charity relationships, building composition diversification, labor decisions and equities family, residence as asset in Family Inc., asset classes in managing retirement market exposure and rebalancing minimizing volatility mix, modifying reducing fixed income in taxes, fees, and “Portfolio Success Rates: Where to Draw the Line,” (Cooley, Hubbard, and Walz) Present value Present value growing annuity Price differential variable Price-to-earnings ratios (P/Es) Private equities Publicly traded equities Purchases, financing Purchasing power R Real, defined Real estate: as asset class loans return for Real-estate investment trusts (REITs) Reserve, maintaining Residence, as asset and investment Resources, third-party Retirement annuity and payment on assets at allocation model and benefits deciding on goals, achieving home equity in inflation and plan after programs protecting through insurance spending in turbocharging Return on assets (ROA) Return on capital Return on equity (ROE) Return on invested capital (ROIC) Return on tangible invested capital (ROTIC) Returns after-tax asset class for buyouts and venture capital of equities and bonds gross high, risk and investment long-term investment real, measuring Revenue, predictability of Rightsizing annuities Risk management, CFO and Risk-return profile, establishing Risk(s): appetite defined-benefit plans and embracing of exhausting assets higher returns and managing competing safeguarding assets from shortfall ROA See Return on assets (ROA) ROE See Return on equity (ROE) ROIC See Return on invested capital (ROIC) ROTIC See Return on tangible invested capital (ROTIC) S Savings Savings account Secured debt Seed capital, funding Self-insure annuities Semi-fixed expenses Sensitivity analysis See What-if-analysis Service delivery model, local Sharpe ratio Shortfall risk Short-term borrowings Siegel, Jeremy The Future for Investors: Why the Tried and True Triumph Over the Bold and the New, Stocks for the Long Run, Size bias Skills: breadth of for Family CFO, establishing quantitative Social Security: as an annuity assets and benefit deferring to age income value of Social Security Disability Insurance (SSDI) Spending: adjusting employing annuities and in late retirement patterns in retirement SSDI See Social Security Disability Insurance (SSDI) Standard deviation Stock market, world, composition of Stock options Stocks, individual, picking Stocks for the Long Run (Siegel) Strategic asset allocation Strategic planning, establishing periodic Strategy(ies): of giving low and high cost Succession planning Sunk-costs bias Surplus (savings) margin Sutton, Willie Swensen, David T Tactical asset allocation Tax and estate planning, CFO and Tax-deductible borrowings Tax(es) efficiency equities and estate evaluating charities and investment gains and leakage minimizing rate, effective twenty five percent rate Technology innovation Temporary labor business Time variable TIPS See Treasury Inflation Protected Securities (TIPS) Treasuries Treasury bills Treasury Inflation Protected Securities (TIPS) Treasury securities Trends, long term Two-way communication, promoting U Umbrella insurance Unions, belonging to U.S.-centricity in equity allocation, asset-allocation models and V Value of lifetime labor Vanguard Vanguard Investment Counseling and Research, “Portfolio Construction for Taxable Investors” Variable cost margins Variable costs, fixed vs., Variable rate loans Vehicles Venture capital Volatility W Wall Street Journal, Walz, Daniel T Waste Management, Inc Wealth: accumulating creation, education and effect environment and measure of starting business and ten examples hazardous to transfer of What-if-analysis Withdrawal rate Work experiences WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA .. .FAMILY INC Using Business Principles to Maximize Your Family s Wealth Douglas P McCormick Cover design: Wiley Cover images: Paper cut out family © Tooga/Getty Images, Inc. ; $100 bills... of a family, it’s not just your own labor you need to consider, but that of your family members as well The financial objective of your temporary labor business is to convert your labor into financial... investment program customized for your Family Business s needs and your willingness to accept risks Managing investments in entrepreneurship—funding family owned businesses to complement your human and