If you haven’t done any wealth management or asset protection planning, your finances are vulnerable to potential future creditors and, should the worst happen,you could lose everything.
Lawsuits, taxes, accidents, and other financial risks are facts of everyday life. And though you’d like to believe that you’re safe, misfortune can befall even the most careful person. What can you do? First, identify your potential loss exposure, then implement strategies that are designed to help reduce that exposure without compromising your other estate and financial planning objectives.
A good investment portfolio will spread your risk
It is an almost universally accepted concept that most portfolios should include a mix of investments, such as stocks, bonds, mutual funds, and other investment vehicles. A portfolio should also be balanced. That is, the portfolio should contain investments with varying levels and types of risk to help minimize the overall impact if one of the portfolio holdings declines significantly.
Many investors make the mistake of putting all their eggs in one basket. For example, if you invest in one stock, and that stock goes through the roof, a fortune can be made. On the other hand, that stock can lose all its value, resulting in a total loss of your investment. Spreading your investment over multiple asset classes should help reduce your risk of losing your entire investment. However, remember that there is no guarantee that any investment strategy will be successful and that all investing involves risk, including the possible loss of principal.
Asset Allocation: How Many Eggs in Which Baskets?
Asset allocation is one of the first steps in creating a diversified investment portfolio. Asset allocation means deciding how your investment dollars should be allocated among broad investment classes, such as stocks, bonds, and cash alternatives. Rather than focusing on individual investments (such as which company's stock to buy), asset allocation approaches diversification from a more general viewpoint. For example, what percentage of your portfolio should be in stocks? The underlying principle is that different classes of investments have shown different rates of return and levels of price volatility over time. Also, since different asset classes often respond differently to the same news, your stocks may go down while your bonds go up, or vice versa. Though neither diversification nor asset allocation can guarantee a profit or ensure against a potential loss, diversifying your investments over various asset classes can help you try to minimize volatility and maximize potential return.
So, how do you choose the mix that's right for you? Countless resources are available to assist you, including interactive tools and sample allocation models. Most of these take into account a number of variables in suggesting an asset allocation strategy. Some of those factors are objective (e.g., your age, your financial resources, your time frame for investing, and your investment objectives). Others are more subjective, such as your tolerance for risk or your outlook on the economy. A financial professional can help you tailor an allocation mix to your needs.
More on Diversification
Diversification isn't limited to asset allocation, either. Even within an investment class, different investments may offer different levels of volatility and potential return. For example, with the stock portion of your portfolio, you might choose to balance higher-volatility stocks with those that have historically been more stable (though past performance is no guarantee of future results).
Because most mutual funds invest in dozens to hundreds of securities, including stocks, bonds, or other investment vehicles, purchasing shares in a mutual fund reduces your exposure to any one security. In addition to instant diversification, if the fund is actively managed, you get the benefit of a professional money manager making investment decisions on your behalf.
Note: Before investing in a mutual fund, carefully consider its investment objectives, risks, charges and expenses, which are outlined in the prospectus that is available from the fund. Obtain and read a fund's prospectus carefully before investing.
Choose Investments that Match Your Tolerance for Risk
Your tolerance for risk is affected by several factors, including your objectives and goals, timeline(s) for using this money, life stage, personality, knowledge, other financial resources, and investment experience. You'll want to choose a mix of investments that has the potential to provide the highest possible return at the level of risk you feel comfortable with on an ongoing basis.
For that reason, an investment professional will normally ask you questions so that he or she can gauge your risk tolerance and then tailor a portfolio to your risk profile.
Investment Professionals and Advisors
A wealth of investment information is available if you want to do your own research before making investment decisions. However, many people aren't comfortable sifting through balance sheets, profit-and-loss statements, and performance reports. Others just don't have the time, energy, or desire to do the kind of thorough analysis that marks a smart investor.
For these people, an investment advisor or professional can be invaluable. Investment advisors and professionals generally fall into three groups: stockbrokers, professional money managers, and financial planners. In choosing a financial professional, consider his or her legal responsibilities in selecting securities for you, how the individual or firm is compensated for its services, and whether an individual's qualifications and experience are well suited to your needs. Ask friends, family and coworkers if they can recommend professionals whom they have used and worked with well. Ask for references, and check with local and federal regulatory agencies to find out whether there have been any customer complaints or disciplinary actions against an individual in the past. Consider how well an individual listens to your goals, objectives and concerns.
Stockbrokers work for brokerage houses, generally on commission. Though any investment recommendations they make are required by the SEC to be suitable for you as an investor, a broker may or may not be able to put together an overall financial plan for you, depending on his or her training and accreditation. Verify that an individual broker has the requisite skill and knowledge to assist you in your investment decisions.
Professional Money Managers
Professional money managers were once available only for extremely high net-worth individuals. But that has changed a bit now that competition for investment dollars has grown so much, due in part to the proliferation of discount brokers on the Internet. Now, many professional money managers have considerably lowered their initial investment requirements in an effort to attract more clients.
A professional money manager designs an investment portfolio tailored to the client's investment objectives. Fees are usually based on a sliding scale as a percentage of assets under management — the more in the account, the lower the percentage you are charged. Management fees and expenses can vary widely among managers, and all fees and charges should be fully disclosed.
Where the Dangers Lie
Unexpected liability can come from just about anywhere:
Asset Protection Techniques
There are three basic asset protection techniques: insurance, statutory protection, and asset placement. None of these techniques is a complete solution by itself, but may make sense as one limited component of an asset protection plan.
Caution: To avoid complications in the event that your marriage ends in divorce, both you and your spouse should agree to the division of assets in writing. This is especially important in community property states.
Caution: The limited liability feature may be lost if, for example, the corporation acts in bad faith, fails to observe corporate formalities (e.g., organizational meetings), has its assets drained (e.g., unreasonably high salaries paid to shareholder-employees), is inadequately funded, or has its funds commingled with shareholders’ funds.
Caution: A number of issues should be considered when selecting a form of business entity, including tax considerations. With a C corporation, taxation may occur at both the corporate and shareholder level; with an S corporation, income and tax liabilities pass through to the shareholders. Consult an attorney and tax professional.
Professionals (e.g., doctors, lawyers, and accountants) face liability for damages that result from the performance of their professional duties. While no business structure will protect you from personal liability for your professional activities, an LLP will protect you from the professional mistakes of your partners. That is, if one of your partners is sued, and the LLP is also named in the lawsuit, any malpractice judgment is the personal liability of the partner who’s been sued, but a business liability for you and the other partners. Your personal assets aren’t at stake if your partner commits malpractice, although your investment in the business may still be at risk.
An FLP is a limited liability partnership formed by family members only. At least one family member is a general partner; the others are limited partners. A creditor can’t obtain a judgment against the FLP — it can only obtain a charging order. The charging order only allows the creditor to receive any income distributed by the general partner. It does not allow the creditor access to the assets of the FLP. Thus, a charging order is not an attractive remedy to most creditors. As a result, the limitation to seeking a charging order can often convince a creditor to settle on more reasonable terms than might otherwise be possible.
Example: Harry would like to leave property to Wendy. However, Harry is afraid that his creditors might claim the property before he dies and that Wendy will receive none of it. Harry establishes a trust with both himself and Wendy as the beneficiaries. The trustee is instructed to allow Harry to receive income from the trust until Harry dies and then to distribute the remaining assets to Wendy. The trust assets are then safe from being claimed by Harry’s creditors, so long as the debt was entered into after the trust’s creation.
Under these circumstances, any of Harry’s creditors would be able to reach assets in the trust only to the extent of Harry’s beneficial interest in the trust. Say that Harry’s interest in the trust is a fixed income distribution each month in the amount of $1,000. Assuming Harry’s creditors obtained a judgment, they would only be entitled to the $1,000 per month.
Caution: Unlike an irrevocable trust, a revocable trust provides the assets in the trust with absolutely no legal protection from your creditors.
Here’s how it works: In order for a creditor to be able to reach assets held in a trust, a court must have jurisdiction over the trustee or the trust assets. Where the trust is properly established in a foreign country, obtaining jurisdiction over the trustee in a U.S. court action will not be possible. Thus, a U.S. court will be unable to exert any of its powers over the offshore trustee.
So, the creditor must commence the suit in the offshore jurisdiction. The creditor can’t use its U.S. attorney; it must use a local attorney. Typically, a local attorney will not take the case on a contingency fee basis. Therefore, if a creditor wants to pursue litigation in the offshore jurisdiction, it must be prepared to pay the foreign attorney up front. To make matters even less convenient, many jurisdictions require the creditor to post a bond or other surety to guarantee the payment of any costs that the court may impose against the creditor if it is unsuccessful. Taken as a whole, these obstacles have the general effect of deterring creditors from pursuing action.
Caution: Domestic self-settled trusts may not be as effective as a foreign trust, because a judgment from an individual state must be honored by another state under the United States Constitution.