Financial Planning: Understanding Insurance and Investment Bonds in the United States

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Financial planning is the process of meeting one’s life goals through proper management of one’s finances. Life goals can include buying a home, saving for your child’s education or planning for retirement. The financial planning process consists of six steps that help you take a ‘big picture’ look at where you are financially. The process is designed to help you work out where you are now, what you may need in the future and what you must do to reach your goals. The six steps are: – Establishing and defining the relationship between you and the financial planner. – Gathering data and determining your goals and expectations. – Analyzing and evaluating your financial status. – Developing and presenting financial planning recommendations or alternatives. – Implementing the financial planning recommendations. – Monitoring the recommendations.

Importance of Financial Planning

Financial planning is essential to success in life because it’s creating a strategy of how to manage your financial future. A well-formulated financial plan enables you to accomplish financial goals and provides security. Through financial planning, you will understand how investment is important to your financial future. Financial planning can be done in various ways. If you are a salaried person, you can do the financial planning with the help of your personal financial planning. Personal financial planning is needed to make sure that you can have a better tomorrow and to achieve your short and long-term personal goals. There are 6 steps to make personal financial planning successful. The steps are: 1. Establishing the goal 2. Gather the data 3. Analyzing the data 4. Developing a plan 5. Implement the plan 6. Monitor the plan By the end of these steps, you will need to monitor the financial plan. If there are changes or the goals are not met, you might need to revise the plan and take appropriate action.

Overview of Insurance and Investment Bonds

Investment bonds are debt securities under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest and/or to repay the principal at a later date. There are many types of investment bonds. They can be classified in many ways, one method is to separate them into either registered or unregistered bonds. A registered bond is a bond which has the name of the holder and the issuer registered and a certificate is issued to the holder. This type of bond has fallen out of favor because it is relatively inefficient and the bond is often held by a nominee in street name. In contrast, an unregistered bond is a bond with no name of the holder or issuer recorded. This means that it can be transferred to another person and will be redeemed by the issuer regardless of who is holding the certificate. Another type of bond is government or public sector bonds. These are issued by governments or a government agency. The issuer of a government bond will pay the holder a predetermined amount of interest and repay the principal at a predetermined date.

Insurance bonds are an agreement between a person and a company. In return for periodic payments, often continuous, the insurer will pay a designated beneficiary a sum of money upon the insured’s death or other adverse event. There are many types of insurance bonds. Whole life, universal life, and term insurance are the most common. With whole life or universal life insurance, the insured pays continuous periodic payments and in exchange the company will pay the beneficiary a sum of money upon the death of the insured. Term insurance is different from the previously mentioned because it is only for a specified period of time and the company only pays if the death of the insured occurs during the term of the insurance.

Insurance Bonds

Life insurance companies have started to offer a wide range of insurance bonds which can be considered as investment products. Traditional insurance bonds are designed to pay out a lump sum after an investment period or on the policyholder’s death. High taxation on life funds and personal tax rates provided an opportunity for insurance companies to develop insurance bonds which pay a minimal level of income (usually around 3-4%) and are not taxed assuming no withdrawals are made. These bonds were referred to as non-qualifying bonds. In addition, new legislation for individual savings accounts (ISAs) and high income tax rates on higher earners increased the popularity of insurance bonds that are designed to provide prospects of higher returns with medium to high risk. These can be achieved using distribution or insurance bonds which are open-ended or closed-ended funds that invest in a range of options using distribution theory. High taxation and volatility of investment markets resulted in some of these bonds being provided with capital guarantees which appealed to investors who wished to attain higher returns with high risk, yet were not willing to risk losing their initial investment. It is important to note that insurance bonds are complex products and it is often beneficial to seek advice when considering to purchase a bond.

Definition and Purpose of Insurance Bonds

An insurance bond is a single premium life insurance policy which is linked to an investment. The investment is made on the part of the policyholder and a portion of the investment unit price is used to pay for the life insurance element of the policy. The objective of the investment can be for capital growth purposes, to produce income, or a combination of both. The main purpose of an insurance bond is to provide capital or an income for the life assured or other beneficiaries should the life assured die whilst the policy is in force. If the life assured survives the policy, the bond can be cashed in. However, tax and the age of the policyholder can affect when the bond may be encashed. If you’re looking for more detail on how insurance bonds could affect your tax liability, then you should consult a financial adviser or the insurance provider. Another common reason when people decide to invest in an insurance bond is to fund school or university fees for their children. This is known as an education or school fees plan. The policy is structured such that when the fees become due, there is an option to cash in the bond and switch the funds into a higher income or capital growth withdrawal to fund the education costs. The availability of partial withdrawals and the 5% per annum tax deferred allowance can make an insurance bond a tax efficient and flexible method to save for such costs.

Types of Insurance Bonds

There are three basic types of insurance bonds: a) Investment in Government Securities (IIGS) requires insurance companies to invest in certain types of government securities. If the securities meet the requirements of the state code, the company will receive favorable tax treatment on the growth of income from the bonds. If the securities do not meet these requirements, the favorable tax treatment may not apply. IIGS is considered to be a less risky form of investment for insurance companies because government securities are considered low risk. b) Registered Bond and Required approval for securities laws of 1933 and 1934. This type of bond requires that the investment be in a registered form of corporate security that is subject to regulation under the 1933 and 1934 securities acts. This investment will also carry certain terms and conditions that are favorable to the policyholders and other claimants. The company will be required to make a statement as to the purpose of the securities, and the securities must then be approved by the insurance commissioner. c) Guaranteed Investment Contracts are the most simplified type of insurance bonds where the insurance company agrees to invest money with a financial institution at a fixed interest rate and term. These types of contracts have become popular with the development of the stable value fund, which is the grouping of many individual contracts into a pooled investment fund for the purpose of providing a stable investment fund for variable rate policies. Despite this popularity, they have been subject to controversy due to interpretations of the nature of the contracts and court cases that have led to the liquidation of funds. This controversy has caused some policyholders to question the safety of these contracts.

Benefits and Risks of Insurance Bonds

This investment rating will be a key determinant for the success of an insurance bond. It could impact on the tax status of the bond, the returns achieved, and the caliber of the investment companies that will manage the bond’s funds. If the rating is below triple B, then the bond will not be a worthwhile investment. Tier one companies will only manage funds that are rated as low risk. This means that the top-quality investment companies will only consider managing a bond if it has a top-class rating, and therefore investment companies can use the rating of an insurance bond to determine the quality and prestige of the potential clients they may want to manage funds for. This can be a benefit for the client in terms of caliber and reputation of the investment company. High caliber is an important selling point of an insurance bond.

Benefits Insurance bonds are structured as an investment in the form of a life insurance policy. This means that the investment will be given a rating depending on the issuing company and the objectives of the investment. If the policy is a non-eventful one, resulting in loss to the company, it could affect the investment rating and risk of capital.

Investment Bonds

Investment bonds can be purchased in a variety of ways. They can be bought as a specific investment in bonds from a company in a unit that will have a set monetary value, for example £50, and will have a predetermined rate of interest that a purchaser can keep until the bond matures. These types of bonds can be traded on what is called the bond yield, which is the interest rate of the bond multiplied by 100 divided by its current price. If, for example, you buy a £50 bond with a 10% interest rate, and a few months down the line the same bond can be bought for £40, that bond will then yield 12.5%, so the bond you have can be sold at a profit.

If you buy an investment bond, you are lending your money to a company or to the government (depending on whether you buy a corporate or government bond) in exchange for a promise to repay the money at an agreed future date, plus interest at a rate defined at the outset (unless the issuer defaults). This can provide a useful income stream which is higher than that available from deposit-based savings accounts, and as long as you understand the risks and rewards, bonds can be an important part of a diversified investment strategy.

Definition and Purpose of Investment Bonds

Investment bonds are an increasingly popular financial instrument. They are quite similar to insurance policies in that a lump sum is paid into an investment bond by the investor, but unlike insurance policies, there is no life cover provided as investors are concerned with income and/or capital gains. The bond is actually a loan to the government or a company, which it pays back with interest. This interest is received by the investor in the form of periodic payments or it can be rolled up with the capital in the bond to provide a higher payment at a later stage. Investment bonds are a fairly flexible financial option as they can cater for those seeking income or capital gains and higher or lower risk investors. This is due to the huge range of investment bonds available, each with different investment options. Common investment options include stocks and shares, pooled funds, with profits funds and unit linked funds. These provide a means to invest in a risk level that suits the investor and to change investment options throughout the life of the bond. Step up or step down options are sometimes available with investment bonds to cater for different financial commitments at different stages of an investor’s life. Step up options allow an investor to increase the level of an investment, it may be useful for a couple planning for retirement. Step down options allow an investor to move the capital of the bond into less risky investments to provide a steady income, this may be useful for someone who has taken the decision to stop work due to a disability.

Types of Investment Bonds

Unit and investment trusts are collective investment schemes. The difference between the two is that a unit trust is open-ended, meaning that the number of units in the trust varies depending on investor demand, and the price of the unit is equal to the net asset value of the underlying investments. A trust investment is closed-ended with a fixed number of shares and a share price that may be significantly different from the net asset value. These trusts produce bond-like returns by investing money into a range of securities, and if the trust performs well, there is potential for a good return with medium to high risk. Finally, a guaranteed bond is a bond with the added security of some or all of the initial capital investment. The potential returns can be good, but often the high costs and charges make them less beneficial to the investor.

The most common bonds are the government and municipal bonds, which are primarily used to provide capital and/or lower ongoing costs for an issuer. They are also used to fund specific projects when an issuer believes it can borrow money at a lower cost on a bond than a loan. Mortgage securities are effectively a “slice” of a loan or a pool of loans to finance the purchase of a home. Returns are generally good relative to the risk, although they tend not to perform well in times of declining interest rates due to higher prepaid principal on the underlying loans. Corporate bonds are typically a good way for a company to borrow a large sum of money at a favorable interest rate. If anything goes wrong, the value of the company’s assets can be sold off to cover what is owed, making it less risky for lenders and creditors. A company can secure a creditor bond on a certain asset or all assets, effectively stating that if the company defaults, the creditor becomes an owner of the given asset(s). In the same way, a debenture bond can mean the issuer sells a specified asset if it falls into bond default. It is not necessary to sell a specified asset, but more risky bonds would issue a floating charge debenture, effectively giving the creditor legal pull on all asset shares and borrowing with the company. Step-up and payment-in-kind bonds are forms of interest type, the former having a low initial coupon that steps up to a higher rate at a certain point, and the latter allowing the issuer to pay interest in extra bonds to the same value of regular interest payment. High yield (junk) bonds are issued by companies with lower credit quality, providing a higher interest rate to compensate for the added risk. Emerging market bonds offer a higher return compared to domestic bonds, but the risk involved is generally much greater due to the unstable political and economic state in the issuing country.

Benefits and Risks of Investment Bonds

Investment Bond is a single-premium life insurance policy that is paid for with a single, large payment. The policy owner immediately owns a paid-up policy and is entitled to allow the policy to grow in value over time or to cash it in at some time in the future. The features and advantages of an investment bond are much similar to a whole-of-life policy. Typically, investment bonds are written under non-qualified status (meaning they are not part of a qualified retirement plan), and they are often used in tax-sensitive investment situations. There are several benefits to owning an investment bond as it can be used as an effective estate planning tool. The policy owner can grow an investment bond’s value over time and/or provide a future cash inheritance for beneficiaries. Upon policy owner death, the named beneficiaries will receive a death benefit proceeds that are income tax free. If the policy owner wishes to gain access to policy cash values at any time during the policy owner’s life, he/she will have the option to do so through policy loans and withdrawals. Any money taken from an investment bond is received income tax free to the extent of policy basis and/or policy loan, as long as the policy stays in force. If policy loans or withdrawals exceed policy basis, there could likely be taxable consequences. Another benefit of an investment bond is that it can be used in funding future education costs for children, as cash withdrawals can be made penalty free at any time to pay for education expenses. A policy owner can also use an investment bond to fund a medical expense or long-term care situation, as cash withdrawals can be made penalty free at any time to pay for medical costs.

Considerations for Financial Planning

The considerations for financial planning section examines the steps involved in constructing an insurance/investment based financial plan. Basically, it breaks down how to “put it all together.” With the information gathered in the previous chapter, individuals should have a good understanding of their current financial situation and how much additional insurance and investments they need to meet their goals. Considerations will assist individuals in developing a plan or strategy on how they should invest their money to achieve their financial goals. Creating a strategy that’s right for you requires knowledge of investment options, knowing how to match an investment with a goal, a timeline, and how to regularly review/change the strategy. Moving through all these steps, one can implement a well-defined financial plan that’s right for them. Some of the factors that can affect an individual’s or family’s financial plan and investment decisions, which may alter the steps in the investment planning process, include an earlier than expected retirement or a child going to college, which would increase the timeframe for their goals and possibly increase their risk tolerance. High-yielding investment options and investment into asset classes with high expected return could be possible, bearing in mind it’s always important to not invest too much money into one place and maintain diversification. Other factors could include changing income levels, personal injury or illness, and inheritance. All these considerations can alter the choice of investment and the ongoing strategy.

Evaluating Risk Tolerance and Financial Goals

Step four and five is revisiting the investment decisions, assessing the investment bonds that best match those decisions, and making changes to existing investment portfolio to better reflect an investor’s investment bond choices and risk tolerance. This is an ongoing process that is logical to start at the beginning of a financial planning and continue through till evaluation of investment bond choices and financial goals has been assessed.

When evaluating risk tolerance and investment goals there are investment bonds in the United States that can be matched to the needs of the individual investor. U.S. Treasury Bonds are an extremely low risk and are backed by the federal government. They are ideal for investors who only want to avoid losing money and are willing to accept very low returns. Series EE savings bonds are similar in that they are low risk and are ideal for investors who are saving for education. The return on these bonds though, are tax-free when used for tuition and fee payments at a qualified institution. The risks and returns of TIPS, I Bonds, and HH/H bonds can be matched with specific investment goals of individual investors.

Financial goals can be quite a few and also vary in the time which they are wanted to be achieved. They can be to fund a child’s education, saving for a home, preparing for retirement, or something much less concrete like achieving great wealth. What often gets overlooked is the importance of how an individual’s investment will help them achieve their financial goals.

In order to remain sensible and logical when planning a financial strategy, an understanding of financial goals and risk tolerance is necessary. Risk tolerance is the amount of variability in investment returns that an individual is willing to withstand in his or her investment portfolio. Understanding the implications between risk and return is an important step in evaluating which types of investments are right for you. The risk associated with an investment may vary. In general, the chance of higher returns comes with a higher risk. Some investments can become very risky with the potential of losing most or all of the invested money, while others may become so safe that there is little chance of any return. Step one is to evaluate your own feeling about investment risk, and how risk affects your investment decisions.

Assessing Insurance and Investment Bond Options

When assessing insurance and investment bond options, one of the most important benefits of insurance products is the tax-free death benefit paid to the beneficiaries of the policy. This can be a very substantial sum of money and has been known to solve many tax problems for heirs of the deceased. The laws on the inheritance tax have remained ambiguous as it is uncertain what the future government will do about it. For example, in the UK, the inheritance tax threshold remains at £325,000 until 2015. This means any estates valued over this amount will be taxed 40%. One of the main financial planning strategies to prevent the inheritance from being taxed is to spend it, rather than save it. People may give large sums of money to their children to prevent it from being taxed when passed on to the next generation. Although, if the money is given away, the person must live for a further seven years for it to be exempt from tax. If they die within the seven years, the gift is still liable for tax. By taking out an insurance policy with a sum assured of the estimated tax liability, it could effectively solve the problem. This strategy will also help people in a situation in the near future. With the increasing national debt, there may be an increase in tax on earnings and pensions. This could have an impact on any source of income or lump sum, and once again, an insurance policy could be an effective remedy. An investment bond will not have as much simplicity but could still be effective. Bond withdrawals can be taken to the value of 5% of the original amount invested each policy year (cumulative). Withdrawing a segment could be used to work out whether it eases a tax problem, for example, school fees. The flexibility of a bond also allows assignment to any tax-paying person, providing greater top slicing relief on partial surrender.

Creating a Diversified Portfolio

Any difference in the price of risk on individual assets compared to the price of risk on the market portfolio results in an investor having to choose a strategic asset allocation. Finally, an investor will implement their decision by selecting assets and changing the composition of their portfolio. This is the most detailed view of the portfolio management process and concerns understanding how different asset mixes and allocations affect risk and return. This is an important insight for a financial planner to have in understanding how different insurance and investment bonds fit into a client’s overall financial plan in terms of their risk and return characteristics.

Any change in investor preferences can be referred to as a shift in the supply of capital in the economy and can be evaluated using the capital market line. The capital market line depicts the return, risk-efficient portfolios based on investors’ risk aversion. An investor who is risk-averse would like as high a return as possible for as little risk as possible, and the slopes of their indifference curve, the capital allocation line, and the capital market line will indicate this.

An investor who takes on too little risk to reach their return objective has an inefficient portfolio, just as one who takes on too much risk in relation to the return objective. A bond or stock with the highest return for a given level of risk would be an optimal investment. By bonding together all the optimal investments in the form of two-fund combinations, every risk level can be satisfied. This is the capital allocation line.

The risk and return characteristics of individual categories of assets, as well as the construction of portfolios, is an integral part of the subject of investment. An investor’s goal is to have a portfolio with a combination of investments that has the highest expected return for a given level of risk. Usually, the more risk an investor takes on, the higher their potential return. Thus, there has to be an assessment to decide how much risk should be taken on and in what form. This is part of the portfolio management process, and the objective is to take the right amount of risk to optimize the return.

A portfolio is a grouping of financial assets such as stocks, bonds, and cash equivalents, as well as their mutual, exchange-traded, and closed-fund shares. Portfolios are held directly by investors and/or managed by financial professionals. The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk.

Monitoring and Adjusting Financial Plan

The second way is to set goals in the now; near term. Given that people are more motivated to achieve goals that are just above the current level of performance, it is especially important to identify and adjust any goal that is not currently being achieved. All goals should be time specific. Locking in a time to revisit and analyze goals is a great strategy to maintain discipline. At least once a year is a good rule of thumb but it should also be done during times of change in personal circumstances, health, employment, economic conditions or capital markets. When it comes to investments, time spent monitoring often has a low marginal return so it is important to invest the time, just not too much of it! Regular reviews of investments are the best way to keep them in line with changing goals. Wiener and Intriligator (1994) suggested an asset allocation revision rule based on a formula not previously applied to finance – the Taylor rule for setting interest rates. Although a Taylor principle for investment revision is beyond the scope of this article, it is interesting where it may lead in future.

Tracking goals and portfolio performance are important but often overlooked aspects of financial planning. Setting specific, realistic goals and monitoring achievements can be a motivating tool to make relatively small, complex changes and greatly improve success. Success is just as dangerous as failure – goals can give a benchmark to let you know when it’s time to stop doing something stupid! There are 2 ways to improve the probability of accomplishing goals. The first is to set a target relative to a benchmark. The more specific the better. For example, “I want to have 50% more money in 2 years” is a much better goal than “I want to make money” because it includes a clear objective that can be quantitatively measured.

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