Investing Post-Divorce

Most clients are shell-shocked following the conclusion of their divorces, but that is one of the most critical times for them to get their lives back on track. Failing to overhaul their financial, estate, insurance and related planning in light of post-divorce realities can have tragic consequences. Too often, once the divorce itself is finalized, practitioners assume their responsibilities are over. While that may be the case, a little guidance to the client as to how to proceed with the rebuilding process can have a tremendous and lasting impact.

Introduction

A key issue to address in this evaluation is the client's investment posture. This article provides an overview of many of the issues, stumbling blocks and action steps to consider. Evaluating the client's portfolio must be done in the context of his or her income, living expenses, and asset base. Much of these data are already available and current as a result of the case information statements, settlement agreement exhibits, and other documents used in the divorce. The client must be directed to evaluate and rethink these data because the post-divorce environment is generally radically different from that which preceded the divorce. Since the existing decisions regarding the holdings in the portfolio were made under those pre-divorce assumptions, most or all of which have changed, the investment decisions should be updated accordingly.

Divorce and Portfolio Analysis

Divorce wreaks havoc with the construction of portfolios that are based on the family unit. Post-divorce, each spouse may end up with non-coordinated pieces of the former family portfolio. Diversification, which may have been adequate before, may be undermined by a divorce settlement that focused on tax basis, accounts in different spouses' control, and other non-investment factors. Consequently, every post-divorce portfolio must be reviewed, to conform with the new investment objectives and risk tolerance of the owner.

Cash Flow

Even if the portfolio was well constructed to meet the family needs pre-divorce, it may be inappropriate post-divorce. Many couples in their 30s, 40s and 50s may have had portfolios that were focused on growth, likely dominated by equity securities. The financial realities of divorce often necessitate a portfolio geared more toward generating cash to cover post-divorce living expenses than growth for the future. Example: For clients in need of cash flow, real estate investment trusts (REITs), oil and gas pipeline master limited partnerships (MLPs), higher-yielding banks, and utilities generate generous and rising dividends to meet cash-flow needs. These types of investments may be substituted for growth-oriented equities in the portfolio. Yields on bank stocks and utilities range currently from 3%-4% and REITs and MLPs range from 5%-8%. The types of investments appropriate to generate cash flow at a future date may differ, perhaps substantially, but the investment concept of restructuring the portfolio to meet post-divorce cash flow needs will remain the same.

An issue to address in the conversion process is that the portfolio likely has a carry-over cost basis under Code Section 1041 from the ex-spouse, or low basis equities purchased and held by the client. Thus, some strategies need to be considered to convert the portfolio in a cost-effective manner. The economic answer is sometimes to sell off all inappropriate holdings and reinvest in a manner to create the portfolio that the client now needs.

Psychologically, many clients will be averse to paying the tax cost. If a client has a $100,000 embedded tax gain, is it advantageous to spread this over 2 tax years to defer tax? While many clients may prefer to stretch out the tax hit over time, this must be weighed against a year lost in having the appropriate portfolio in place. In some instances, selling covered calls against some of the holdings, with the intention of having the calls exercised, can produce incremental income to offset some of the tax liability. Example: ABC stock is selling at $48/share. Cost basis is $25/share. If a client sells 1000 shares, the capital gain is $23,000, which at 15% (ignoring state tax) implies a tax liability of $3450. If a $50 call (an option or right to purchase the stock at the $50 strike price) is sold for one point, this would generate $1000. The client would sell the call, and hope the stock exceeds $50/share prior to the expiration of the call. If so, the call would be exercised and the client would realize $51/share, an additional $3000 above the current market value of the shares. That incremental revenue will offset most of the tax liability. If the stock price does not exceed $50, the call won't be exercised, but the client has received $1000 toward the tax cost to be in-curred on restructuring the portfolio.

Risk

Aside from the risk of the portfolio itself, the client's risk tolerance may change to reflect post-divorce economic reality, which is often much harsher than before. Intact families can often accept more risk in their portfolios when comfortable with their employment situation, and can rely on that cash flow for expenses. Post-divorce, this certainty is often undermined by lower earnings, higher support or alimony payments and the increased costs of maintaining separate homes and lives. Too often, clients ignore the changed risk, or take the opposite approach and become so fearful of this new risk profile that they assume anything other than a money market account or CD is too risky. Clients seeking low- risk portfolios often build a portfolio based on bonds, etc. They assume price risk is eliminated when they hold the securities to maturity. The reality is that the price risk remains because interest rates fluctuate. With any fixed-income portfolio, they are unknowingly assuming a major new risk, namely inflation. Even a modest rate of inflation can devastate a fixed-income portfolio over time.

Example: Assume your client received a divorce settlement of $1 million cash and she invests it all in 10-year U.S. Treasury securities paying 5%, believing that will be a safe investment. This $50,000/year income is judged sufficient to cover the difference between the alimony she receives and her living expenses. Now assume 3% inflation. By the time the bonds mature in just 10 years, the purchasing power of the $1 million will be reduced to $744,000. Even worse, the real value of $50,000 of income will be reduced to $37,205. If the divorced client is young, inflation and the passage of time will dissipate her income and wealth.

Inflation is devastating to a purely fixed income portfolio. Therefore, alternative investments would be preferable if they produce adequate cash flows to meet current needs, yet they rise at least as rapidly as inflation. Instead of the client buying just Treasuries, some of the income producing investments noted above, may include growth to offset inflation, as well as current cash flow.

Investing for a Child's Education

While the divorce settlement will dictate who may be responsible for the children's college expenses, your client must be concerned that whoever is responsible will be able to meet these goals in light of the post-divorce financial realities. Your client should monitor not only his/her investment savings for this goal, but if addressed in the divorce agreement, the ex-spouse's savings toward this goal. The investment allocation that is appropriate will depend on the resources and ages of the parents as well as the children. The results may be an investment allocation that is perhaps vastly different from that used by the client for his/her own funds. Many people assume that the mix of assets should move toward income assets as the child's college age approaches. This, however, is really a more complex decision that depends on family assets as well as financial aid that is likely to be received, scholarships, etc.

Other Investment Issues

There are several other matters that are not considered 'investment decisions':

• Insurance Policies. The purpose of life insurance coverage should be re-evaluated in light of the new circumstances. Often, the primary bread winner in the pre-divorce family sought to protect the children, and perhaps the now ex-spouse, in the event of premature death. If the dependent spouse works full time post-divorce, and there are no additional dependents, the need for insurance coverage may no longer exist, or be much less. For clients with permanent insurance policies, it may prove more efficient from a cost or investment perspective to grow investments outside of the insurance envelope, post-divorce.
• Residence (including mortgage). Cli-ents often view their residence as a place to live, and not as an investment. It really is both. For a post-divorce client, this broader view could have tremendous positive financial implications. This is particularly true because most homes have mortgages that make the home a leveraged real-estate investment. That makes the home a very important part of the post-divorce family portfolio. Most clients view a mortgage as something dictated by the terms of the divorce, or a choice made on the monthly nut with which they can feel comfortable. Neither of these approaches is the broad family investment perspective that is optimal. Clients should take a broader perspective on all their financial needs and on how different investments can affect them over time. Depending on circumstances it might make sense to have a larger mortgage and invest some of the proceeds, assuming the payments can be financed. In other circumstances, paying down the mortgage by liquidating lower yielding investment assets, may be more prudent.
• Pension and Retirement Benefits. Too many post-divorce clients with little or no pension (perhaps the ex-spouse retained it) defer ad-dressing retirement planning, believing it is a luxury that cannot be addressed in light of current financial needs. Younger clients/investors often fail to realize that even small periodic investments over time can, with the power of compounding, produce meaningful sums for future retirement. Example: Assume your 30-year-old post-divorce client invests $500/month in various retirement plans. If this compounds at 8% (the historical rate of return on the S&P 500 over the past 50-plus years has averaged about 10% a year), this would be worth $1,155,000 at age 65. If instead a 10% return were realized, it would be worth $1,914,000 at age 65. If the post-divorce client waits 10 years to 'get back on her feet' before beginning the program, the value at age 65 would be $436,000 at 8% and $600,000 at 10%.

Conclusion

Careful evaluation of investment options and the impact not only on the immediate post-divorce situation, but on the client's future, is vital to getting the client back on track and moving toward sound financial footing.

Martin M. Shenkman, CPA, MBA, JD, a member of this newsletter's Board of Editors, is an estate planner in New York City and Teaneck, NJ. His Web site: www.laweasy.com. Charles Lieberman, Ph.D., is Chief Investment Officer of Advisors Capital Management, LLC, Paramus, NJ. He is the former Chief Economist of Chase Manhattan. Web site: www.advisorscenter.com. E-mail: [email protected].

Most clients are shell-shocked following the conclusion of their divorces, but that is one of the most critical times for them to get their lives back on track. Failing to overhaul their financial, estate, insurance and related planning in light of post-divorce realities can have tragic consequences. Too often, once the divorce itself is finalized, practitioners assume their responsibilities are over. While that may be the case, a little guidance to the client as to how to proceed with the rebuilding process can have a tremendous and lasting impact.

Introduction

A key issue to address in this evaluation is the client's investment posture. This article provides an overview of many of the issues, stumbling blocks and action steps to consider. Evaluating the client's portfolio must be done in the context of his or her income, living expenses, and asset base. Much of these data are already available and current as a result of the case information statements, settlement agreement exhibits, and other documents used in the divorce. The client must be directed to evaluate and rethink these data because the post-divorce environment is generally radically different from that which preceded the divorce. Since the existing decisions regarding the holdings in the portfolio were made under those pre-divorce assumptions, most or all of which have changed, the investment decisions should be updated accordingly.

Divorce and Portfolio Analysis

Divorce wreaks havoc with the construction of portfolios that are based on the family unit. Post-divorce, each spouse may end up with non-coordinated pieces of the former family portfolio. Diversification, which may have been adequate before, may be undermined by a divorce settlement that focused on tax basis, accounts in different spouses' control, and other non-investment factors. Consequently, every post-divorce portfolio must be reviewed, to conform with the new investment objectives and risk tolerance of the owner.

Cash Flow

Even if the portfolio was well constructed to meet the family needs pre-divorce, it may be inappropriate post-divorce. Many couples in their 30s, 40s and 50s may have had portfolios that were focused on growth, likely dominated by equity securities. The financial realities of divorce often necessitate a portfolio geared more toward generating cash to cover post-divorce living expenses than growth for the future. Example: For clients in need of cash flow, real estate investment trusts (REITs), oil and gas pipeline master limited partnerships (MLPs), higher-yielding banks, and utilities generate generous and rising dividends to meet cash-flow needs. These types of investments may be substituted for growth-oriented equities in the portfolio. Yields on bank stocks and utilities range currently from 3%-4% and REITs and MLPs range from 5%-8%. The types of investments appropriate to generate cash flow at a future date may differ, perhaps substantially, but the investment concept of restructuring the portfolio to meet post-divorce cash flow needs will remain the same.

An issue to address in the conversion process is that the portfolio likely has a carry-over cost basis under Code Section 1041 from the ex-spouse, or low basis equities purchased and held by the client. Thus, some strategies need to be considered to convert the portfolio in a cost-effective manner. The economic answer is sometimes to sell off all inappropriate holdings and reinvest in a manner to create the portfolio that the client now needs.

Psychologically, many clients will be averse to paying the tax cost. If a client has a $100,000 embedded tax gain, is it advantageous to spread this over 2 tax years to defer tax? While many clients may prefer to stretch out the tax hit over time, this must be weighed against a year lost in having the appropriate portfolio in place. In some instances, selling covered calls against some of the holdings, with the intention of having the calls exercised, can produce incremental income to offset some of the tax liability. Example: ABC stock is selling at $48/share. Cost basis is $25/share. If a client sells 1000 shares, the capital gain is $23,000, which at 15% (ignoring state tax) implies a tax liability of $3450. If a $50 call (an option or right to purchase the stock at the $50 strike price) is sold for one point, this would generate $1000. The client would sell the call, and hope the stock exceeds $50/share prior to the expiration of the call. If so, the call would be exercised and the client would realize $51/share, an additional $3000 above the current market value of the shares. That incremental revenue will offset most of the tax liability. If the stock price does not exceed $50, the call won't be exercised, but the client has received $1000 toward the tax cost to be in-curred on restructuring the portfolio.

Risk

Aside from the risk of the portfolio itself, the client's risk tolerance may change to reflect post-divorce economic reality, which is often much harsher than before. Intact families can often accept more risk in their portfolios when comfortable with their employment situation, and can rely on that cash flow for expenses. Post-divorce, this certainty is often undermined by lower earnings, higher support or alimony payments and the increased costs of maintaining separate homes and lives. Too often, clients ignore the changed risk, or take the opposite approach and become so fearful of this new risk profile that they assume anything other than a money market account or CD is too risky. Clients seeking low- risk portfolios often build a portfolio based on bonds, etc. They assume price risk is eliminated when they hold the securities to maturity. The reality is that the price risk remains because interest rates fluctuate. With any fixed-income portfolio, they are unknowingly assuming a major new risk, namely inflation. Even a modest rate of inflation can devastate a fixed-income portfolio over time.

Example: Assume your client received a divorce settlement of $1 million cash and she invests it all in 10-year U.S. Treasury securities paying 5%, believing that will be a safe investment. This $50,000/year income is judged sufficient to cover the difference between the alimony she receives and her living expenses. Now assume 3% inflation. By the time the bonds mature in just 10 years, the purchasing power of the $1 million will be reduced to $744,000. Even worse, the real value of $50,000 of income will be reduced to $37,205. If the divorced client is young, inflation and the passage of time will dissipate her income and wealth.

Inflation is devastating to a purely fixed income portfolio. Therefore, alternative investments would be preferable if they produce adequate cash flows to meet current needs, yet they rise at least as rapidly as inflation. Instead of the client buying just Treasuries, some of the income producing investments noted above, may include growth to offset inflation, as well as current cash flow.

Investing for a Child's Education

While the divorce settlement will dictate who may be responsible for the children's college expenses, your client must be concerned that whoever is responsible will be able to meet these goals in light of the post-divorce financial realities. Your client should monitor not only his/her investment savings for this goal, but if addressed in the divorce agreement, the ex-spouse's savings toward this goal. The investment allocation that is appropriate will depend on the resources and ages of the parents as well as the children. The results may be an investment allocation that is perhaps vastly different from that used by the client for his/her own funds. Many people assume that the mix of assets should move toward income assets as the child's college age approaches. This, however, is really a more complex decision that depends on family assets as well as financial aid that is likely to be received, scholarships, etc.

Other Investment Issues

There are several other matters that are not considered 'investment decisions':

• Insurance Policies. The purpose of life insurance coverage should be re-evaluated in light of the new circumstances. Often, the primary bread winner in the pre-divorce family sought to protect the children, and perhaps the now ex-spouse, in the event of premature death. If the dependent spouse works full time post-divorce, and there are no additional dependents, the need for insurance coverage may no longer exist, or be much less. For clients with permanent insurance policies, it may prove more efficient from a cost or investment perspective to grow investments outside of the insurance envelope, post-divorce.
• Residence (including mortgage). Cli-ents often view their residence as a place to live, and not as an investment. It really is both. For a post-divorce client, this broader view could have tremendous positive financial implications. This is particularly true because most homes have mortgages that make the home a leveraged real-estate investment. That makes the home a very important part of the post-divorce family portfolio. Most clients view a mortgage as something dictated by the terms of the divorce, or a choice made on the monthly nut with which they can feel comfortable. Neither of these approaches is the broad family investment perspective that is optimal. Clients should take a broader perspective on all their financial needs and on how different investments can affect them over time. Depending on circumstances it might make sense to have a larger mortgage and invest some of the proceeds, assuming the payments can be financed. In other circumstances, paying down the mortgage by liquidating lower yielding investment assets, may be more prudent.
• Pension and Retirement Benefits. Too many post-divorce clients with little or no pension (perhaps the ex-spouse retained it) defer ad-dressing retirement planning, believing it is a luxury that cannot be addressed in light of current financial needs. Younger clients/investors often fail to realize that even small periodic investments over time can, with the power of compounding, produce meaningful sums for future retirement. Example: Assume your 30-year-old post-divorce client invests $500/month in various retirement plans. If this compounds at 8% (the historical rate of return on the S&P 500 over the past 50-plus years has averaged about 10% a year), this would be worth $1,155,000 at age 65. If instead a 10% return were realized, it would be worth $1,914,000 at age 65. If the post-divorce client waits 10 years to 'get back on her feet' before beginning the program, the value at age 65 would be $436,000 at 8% and $600,000 at 10%.

Conclusion

Careful evaluation of investment options and the impact not only on the immediate post-divorce situation, but on the client's future, is vital to getting the client back on track and moving toward sound financial footing.

Martin M. Shenkman, CPA, MBA, JD, a member of this newsletter's Board of Editors, is an estate planner in New York City and Teaneck, NJ. His Web site: www.laweasy.com. Charles Lieberman, Ph.D., is Chief Investment Officer of Advisors Capital Management, LLC, Paramus, NJ. He is the former Chief Economist of Chase Manhattan. Web site: www.advisorscenter.com. E-mail: [email protected].