Post-Divorce Cash Flow and Financial Workability

Absent factors such as fraud, collusion or duress, it is well established that, once a stipulation of settlement is entered into or a divorce has been finalized, courts are reluctant to negate, reform or modify the terms. Without such finality, achieving closure for both litigants and the courts would be extremely challenging. If a client's complaint is that he or she was uninformed, made a poor financial decision, or did not properly handle the assets post-divorce, the likelihood of modification or reformation is, at best, slim.

What Went Wrong?

In retrospect, trading cash for the brokerage account turned out to be a major mistake by the husband. Was this poor judgment on his part? The settlement agreement was apparently prepared with great deliberation. According to the court, “The parties, represented by counsel, spent two years negotiating a detailed 22-page settlement agreement, executed in June 2006.”

Based on the size of this asset and the length of the deliberations, it would be fair to conclude that both parties had wanted a share of it and had probably fought hard to get it. The account seemed to have been producing 12% annual returns over a long period of time, with great consistency. But were these returns too good to be true? It turns out that the SEC had been alerted about the possibility this might be a Ponzi scheme as early as 2000 but had failed to act, and since that time, concerns by various financial entities had been publically raised. The problem was not that the husband had been duped, but that he had ignored a basic principle of investing. He had increased his risk by failing to diversify his holdings and had effectively “put all his eggs in one basket.”

Responsibilities of the Attorney

Red zones in divorce are defined as legal and financial coordination points between the attorney and the divorce financial planner ' the latter bringing a broad financial perspective to the case that compliments the attorney's legal perspective.

In analyzing the court's decision in the case above, the most important question may not be whether the decision arrived at by the court was “legally correct,” but whether the decision made by the client was financially sound. Does the attorney's responsibility begin and end with the legal aspects of the case, or should the attorney, directly or indirectly, need to help ensure that decisions made by the client are “financially informed?” From the client's perspective, should the question be how much income will I have or how much income will I need? Should the question be how much maintenance do I want or how much maintenance will I need? Is it incumbent upon the attorney to ensure that the client is educated, informed and aware of the financial ramifications of alternative settlement scenarios or other potential outcomes or does that responsibility fall totally on the hands of the client?

Financial Mistakes Are Common in Divorce

Although the mistake made by the husband in the Simkin case was associated with a Ponzi scheme that had not yet been exposed, his actual mistake was that he ignored a basic principle of investing ' diversification.

Financial mistakes are fairly common in divorce proceedings, primarily due to the following:

• Divorce, like marriage, is an emotional process. In this case, the husband may have been driven by greed, a need to “win,” a strong emotional attachment to the brokerage account or a whole host of other emotional factors;
• Financial illiteracy, in its various extremes, can make it difficult to understand fully the financial consequences of alternative scenarios or to manage financial outcomes successfully;
• Although outside experts for valuations and other types of investigative work are commonly used, divorce cases are not frequently informed by experts with lifestyle or financial planning expertise. This puts an unfair burden on the attorney, who often has limited financial planning education, training or experience.

A Case in Point: The Marital Residence

Mistakes associated with settling the marital residence, typically one of the largest marital assets, touch upon all three of these potentially problematic areas. Frequently, and often for emotionally driven reasons, one party will want to keep the house at all costs. While a sympathetic situation that can easily drive a case, it can be a serious disservice to the client's financial (and emotional) health to pursue this course of action steadfastly without the client's rigorous understanding of its financial consequences.

Housing costs are generally the largest budgetary expense item. As a general rule, the lower the income level, the higher the percentage of expenses that must be dedicated to housing and the lower the percentage available for food, clothing and other necessities. When home ownership and carrying costs are taken into consideration, maintaining the home can consume 50% or more of total household expenses. Aside from normal carrying costs, large and unanticipated expenses can arise, sometimes at inopportune times. And sometimes these expenses cannot be deferred.

To further complicate matters, if the house, generally an illiquid, non'income-producing asset, is taken by one of the parties in exchange for income-producing assets, less income will be available for support. The marital residence is a complex asset, and taxes and other financial issues need to be carefully considered. For example, if the parties continue to be financially connected through a mortgage, there is risk to both parties. Furthermore, if the new homeowner is unable to support the carrying costs on the house, that person, who may have exchanged retirement and investment assets for the home, is at risk for financial ruin, including the ability to become a homeowner in the future.

Cash Flow Projections and the Viability of Outcomes

The more detailed and thorough the analysis of potential outcomes, the better the understanding and predictability of scenario-specific post-divorce cash flow. Cash inflows come in the form of support payments from the ex-spouse, income from employment, loans and withdrawals from savings and investments, and from other sources.

The discussion below focuses on using assets for cash flow. Because of issues such as income needs, limitations on liquidity, taxes, risk management and risk tolerance, this is a complex area in which mistakes are frequently made. Furthermore, the matter of cash flow is often not taken into serious consideration until after an agreement has been finalized and the various elements of the settlement have been set in stone. Ignoring cash flow during negotiations and advising the client to invest solely in money market accounts, certificates of deposit or government bonds ' because they are “safe” ' will limit inflows and also be subject to inflation risk.

Determining an Appropriate Withdrawal Rate

Prior to contemplating taking distributions from an investment account, it is imperative that an appropriate rate of withdrawal be estimated. Numerous assumptions and factors play into the determination of what might be an appropriate withdrawal rate. This rate must be customized to the client's unique circumstances, and regularly reexamined in the context of changing market conditions and changes in personal financial position in order to ensure that the client does not outlive the underlying assets.

A common misperception, and one that can lead to serious financial consequences, is that an appropriate rate of withdrawal is synonymous with an investment's average total return. Simply put, total return is a combination of income generated and changes in value of the asset. Contrary to popular belief, total return may have little to do with how much income an investment is generating. As an illustration, the stock market has historically grown at an average rate of return of 9% to 10%. While there may be an income component to this rate of return, actual income associated with any particular investment may be anywhere from 0% to 100% of the total return. Total return can also vary greatly, even within certain investments. This is especially true over short time periods. An investment with an average annual return rate of 9% may have a very high total return over some time periods and also suffer high losses or high volatility during others.

Sequence of Returns

If money is being periodically withdrawn from an account, the sequence of returns is also important. Suppose a client's post-divorce portfolio has an average rate of return of 9% over a four-year period, the returns broken down as follows: -13 in year 1; 7 in year 2; 11 in year 3; and 23 in year 4. If the client begins withdrawing assets in year 1, the negative effects of the poor returns that year will negatively impact future withdrawals and thus be magnified. If the client continued to make such withdrawals, it would be very difficult for the investment to recover, and the underlying assets could be depleted long before the client had expected.

On the other hand, if the sequence of returns was: 23% in year 1; 11% in year 2; 7% in year 3; and -13% in year 4 ' still a four-year average of 9% ' the client's early withdrawals would have a much smaller negative impact on the final account value, and the assets would last significantly longer. Because markets are unpredictable, potential effects of the sequence of returns makes it crucial for the client to regularly monitor a withdrawal strategy. Mid-course corrections may be required, and the amounts withdrawn may need to be adjusted, thereby affecting the client's overall cash flow.

What Is an Appropriate Rate of Withdrawal?

Numerous assumptions and factors play a role in determining an appropriate withdrawal rate, and each individual has unique goals, sources of income, savings, assets, lifestyle choices, health issues, investment risk tolerances and life expectancies. If assets are going to need to be used to support post-divorce cash flow, the required withdrawal rate and any associated risks need to be carefully considered before the client agrees to a settlement.

In a seminal study 20 years ago, based on a long-term analysis of market performance over overlapping 30-year periods, certified financial planner William Bengen argued that an annual withdrawal rate of 4%, with a yearly inflation adjustment, was a safe across-the-board strategy to help ensure that assets in a balanced portfolio last approximately 30 years. This 4% rule has been widely followed for many years and appears to be a good rule of thumb. For several reasons ' primary among them today's markedly lower interest rate environment ' financial professionals have recently been cautioning that even a 4% withdrawal rate might be too high. Clearly, a 9%-10% withdrawal rate is too high. To avoid an unsustainable withdrawal rate, it is best to be cautious about withdrawals and to monitor both the portfolio and the markets carefully. Also, because today's life expectancies are substantially longer than at the time Bengen conducted his study, the client's assets may need to last even longer than he had considered.

A Word of Caution About Early Withdrawals from Retirement Assets

Although this article focuses on post-divorce cash flow, it does not discuss specific assets and their unique financial properties. For example, although I have referred to the marital residence as an illiquid asset with unique tax and financial properties, I have not discussed reverse mortgages, which in some situations might be good sources of post-divorce cash flow.

Penalty-free 72t distributions can also be taken from retirement assets. This can sometimes be helpful, but because the client will be drawing on assets that might later be needed for support and because the client is sacrificing tax-deferred growth on the money withdrawn, the long-term consequences of such withdrawals need to be carefully considered. Discussion of 72t distributions is left for a subsequent article.

Importantly, to avoid mistakes, all potential sources of post-divorce cash flow need to be carefully considered during the pre-divorce process and not after the division of marital assets has been settled.

Need for Financial Expertise

Mistakes affecting post-divorce financial issues occur frequently during the divorce process. When they do occur, they are often difficult or impossible to fix. This article asks the following questions: Should the attorney play a role in educating the client about the post-divorce consequences of financial alternatives, or do the attorney's responsibilities begin and end with the legal aspects of the case? What should the attorney's the level of involvement be? Given the financial complexities of the divorce process, should the process be informed by specialists with lifestyle and financial planning training and expertise?

Carl M. Palatnik, CFP', CDFA, a member of this newsletter's Board of Editors, is a Certified Financial Planner and Certified Divorce Financial Analyst. He is president of Divorce Analytics, Inc., a provider of divorce analytical services, and founding president emeritus of the Association of Divorce Financial Planners, an international not-for-profit professional association. He can be reached at [email protected] or at 631-470-0331.

The New York case of Simkin v. Blank, N.Y.3d 46 52 (2012), infamous for its ties to Bernard Madoff, illustrates one of the common financial mistakes made in divorce. In this case, pursuant to a settlement agreement incorporated but not merged into their judgment of divorce, the parties retained respective ownership of separately titled properties, including a brokerage account in the husband's name, managed by the Madoff firm, which had an agreed-upon value of $5.4 million. To balance this exchange and effectuate what they believed to be a fair and reasonable division of marital property, the husband paid the wife $6.25 million, and transferred to her $368,000 in retirement assets to equalize their retirement holdings.

Approximately two and a half years later, the Madoff brokerage account was effectively rendered valueless when Madoff's Ponzi scheme was exposed. The husband asked the court to reform the agreement based on the doctrine of mutual mistake, but the court declined, stating: “This situation, however sympathetic, is more akin to a marital asset that unexpectedly loses value after dissolution of a marriage; the asset had value at the time of the settlement but the purported value did not remain consistent.” As the court emphasized, rescission or reformation of a property settlement is limited to “exceptional situations.” Id . at 52 (quoting Da Silva v. Musso , 53 N.Y.2d 543, 552 (1981)).

One Chance to Get It Right

Absent factors such as fraud, collusion or duress, it is well established that, once a stipulation of settlement is entered into or a divorce has been finalized, courts are reluctant to negate, reform or modify the terms. Without such finality, achieving closure for both litigants and the courts would be extremely challenging. If a client's complaint is that he or she was uninformed, made a poor financial decision, or did not properly handle the assets post-divorce, the likelihood of modification or reformation is, at best, slim.

What Went Wrong?

In retrospect, trading cash for the brokerage account turned out to be a major mistake by the husband. Was this poor judgment on his part? The settlement agreement was apparently prepared with great deliberation. According to the court, “The parties, represented by counsel, spent two years negotiating a detailed 22-page settlement agreement, executed in June 2006.”

Based on the size of this asset and the length of the deliberations, it would be fair to conclude that both parties had wanted a share of it and had probably fought hard to get it. The account seemed to have been producing 12% annual returns over a long period of time, with great consistency. But were these returns too good to be true? It turns out that the SEC had been alerted about the possibility this might be a Ponzi scheme as early as 2000 but had failed to act, and since that time, concerns by various financial entities had been publically raised. The problem was not that the husband had been duped, but that he had ignored a basic principle of investing. He had increased his risk by failing to diversify his holdings and had effectively “put all his eggs in one basket.”

Responsibilities of the Attorney

Red zones in divorce are defined as legal and financial coordination points between the attorney and the divorce financial planner ' the latter bringing a broad financial perspective to the case that compliments the attorney's legal perspective.

In analyzing the court's decision in the case above, the most important question may not be whether the decision arrived at by the court was “legally correct,” but whether the decision made by the client was financially sound. Does the attorney's responsibility begin and end with the legal aspects of the case, or should the attorney, directly or indirectly, need to help ensure that decisions made by the client are “financially informed?” From the client's perspective, should the question be how much income will I have or how much income will I need? Should the question be how much maintenance do I want or how much maintenance will I need? Is it incumbent upon the attorney to ensure that the client is educated, informed and aware of the financial ramifications of alternative settlement scenarios or other potential outcomes or does that responsibility fall totally on the hands of the client?

Financial Mistakes Are Common in Divorce

Although the mistake made by the husband in the Simkin case was associated with a Ponzi scheme that had not yet been exposed, his actual mistake was that he ignored a basic principle of investing ' diversification.

Financial mistakes are fairly common in divorce proceedings, primarily due to the following:

• Divorce, like marriage, is an emotional process. In this case, the husband may have been driven by greed, a need to “win,” a strong emotional attachment to the brokerage account or a whole host of other emotional factors;
• Financial illiteracy, in its various extremes, can make it difficult to understand fully the financial consequences of alternative scenarios or to manage financial outcomes successfully;
• Although outside experts for valuations and other types of investigative work are commonly used, divorce cases are not frequently informed by experts with lifestyle or financial planning expertise. This puts an unfair burden on the attorney, who often has limited financial planning education, training or experience.

A Case in Point: The Marital Residence

Mistakes associated with settling the marital residence, typically one of the largest marital assets, touch upon all three of these potentially problematic areas. Frequently, and often for emotionally driven reasons, one party will want to keep the house at all costs. While a sympathetic situation that can easily drive a case, it can be a serious disservice to the client's financial (and emotional) health to pursue this course of action steadfastly without the client's rigorous understanding of its financial consequences.

Housing costs are generally the largest budgetary expense item. As a general rule, the lower the income level, the higher the percentage of expenses that must be dedicated to housing and the lower the percentage available for food, clothing and other necessities. When home ownership and carrying costs are taken into consideration, maintaining the home can consume 50% or more of total household expenses. Aside from normal carrying costs, large and unanticipated expenses can arise, sometimes at inopportune times. And sometimes these expenses cannot be deferred.

To further complicate matters, if the house, generally an illiquid, non'income-producing asset, is taken by one of the parties in exchange for income-producing assets, less income will be available for support. The marital residence is a complex asset, and taxes and other financial issues need to be carefully considered. For example, if the parties continue to be financially connected through a mortgage, there is risk to both parties. Furthermore, if the new homeowner is unable to support the carrying costs on the house, that person, who may have exchanged retirement and investment assets for the home, is at risk for financial ruin, including the ability to become a homeowner in the future.

Cash Flow Projections and the Viability of Outcomes

The more detailed and thorough the analysis of potential outcomes, the better the understanding and predictability of scenario-specific post-divorce cash flow. Cash inflows come in the form of support payments from the ex-spouse, income from employment, loans and withdrawals from savings and investments, and from other sources.

The discussion below focuses on using assets for cash flow. Because of issues such as income needs, limitations on liquidity, taxes, risk management and risk tolerance, this is a complex area in which mistakes are frequently made. Furthermore, the matter of cash flow is often not taken into serious consideration until after an agreement has been finalized and the various elements of the settlement have been set in stone. Ignoring cash flow during negotiations and advising the client to invest solely in money market accounts, certificates of deposit or government bonds ' because they are “safe” ' will limit inflows and also be subject to inflation risk.

Determining an Appropriate Withdrawal Rate

Prior to contemplating taking distributions from an investment account, it is imperative that an appropriate rate of withdrawal be estimated. Numerous assumptions and factors play into the determination of what might be an appropriate withdrawal rate. This rate must be customized to the client's unique circumstances, and regularly reexamined in the context of changing market conditions and changes in personal financial position in order to ensure that the client does not outlive the underlying assets.

A common misperception, and one that can lead to serious financial consequences, is that an appropriate rate of withdrawal is synonymous with an investment's average total return. Simply put, total return is a combination of income generated and changes in value of the asset. Contrary to popular belief, total return may have little to do with how much income an investment is generating. As an illustration, the stock market has historically grown at an average rate of return of 9% to 10%. While there may be an income component to this rate of return, actual income associated with any particular investment may be anywhere from 0% to 100% of the total return. Total return can also vary greatly, even within certain investments. This is especially true over short time periods. An investment with an average annual return rate of 9% may have a very high total return over some time periods and also suffer high losses or high volatility during others.

Sequence of Returns

If money is being periodically withdrawn from an account, the sequence of returns is also important. Suppose a client's post-divorce portfolio has an average rate of return of 9% over a four-year period, the returns broken down as follows: -13 in year 1; 7 in year 2; 11 in year 3; and 23 in year 4. If the client begins withdrawing assets in year 1, the negative effects of the poor returns that year will negatively impact future withdrawals and thus be magnified. If the client continued to make such withdrawals, it would be very difficult for the investment to recover, and the underlying assets could be depleted long before the client had expected.

On the other hand, if the sequence of returns was: 23% in year 1; 11% in year 2; 7% in year 3; and -13% in year 4 ' still a four-year average of 9% ' the client's early withdrawals would have a much smaller negative impact on the final account value, and the assets would last significantly longer. Because markets are unpredictable, potential effects of the sequence of returns makes it crucial for the client to regularly monitor a withdrawal strategy. Mid-course corrections may be required, and the amounts withdrawn may need to be adjusted, thereby affecting the client's overall cash flow.

What Is an Appropriate Rate of Withdrawal?

Numerous assumptions and factors play a role in determining an appropriate withdrawal rate, and each individual has unique goals, sources of income, savings, assets, lifestyle choices, health issues, investment risk tolerances and life expectancies. If assets are going to need to be used to support post-divorce cash flow, the required withdrawal rate and any associated risks need to be carefully considered before the client agrees to a settlement.

In a seminal study 20 years ago, based on a long-term analysis of market performance over overlapping 30-year periods, certified financial planner William Bengen argued that an annual withdrawal rate of 4%, with a yearly inflation adjustment, was a safe across-the-board strategy to help ensure that assets in a balanced portfolio last approximately 30 years. This 4% rule has been widely followed for many years and appears to be a good rule of thumb. For several reasons ' primary among them today's markedly lower interest rate environment ' financial professionals have recently been cautioning that even a 4% withdrawal rate might be too high. Clearly, a 9%-10% withdrawal rate is too high. To avoid an unsustainable withdrawal rate, it is best to be cautious about withdrawals and to monitor both the portfolio and the markets carefully. Also, because today's life expectancies are substantially longer than at the time Bengen conducted his study, the client's assets may need to last even longer than he had considered.

A Word of Caution About Early Withdrawals from Retirement Assets

Although this article focuses on post-divorce cash flow, it does not discuss specific assets and their unique financial properties. For example, although I have referred to the marital residence as an illiquid asset with unique tax and financial properties, I have not discussed reverse mortgages, which in some situations might be good sources of post-divorce cash flow.

Penalty-free 72t distributions can also be taken from retirement assets. This can sometimes be helpful, but because the client will be drawing on assets that might later be needed for support and because the client is sacrificing tax-deferred growth on the money withdrawn, the long-term consequences of such withdrawals need to be carefully considered. Discussion of 72t distributions is left for a subsequent article.

Importantly, to avoid mistakes, all potential sources of post-divorce cash flow need to be carefully considered during the pre-divorce process and not after the division of marital assets has been settled.

Need for Financial Expertise

Mistakes affecting post-divorce financial issues occur frequently during the divorce process. When they do occur, they are often difficult or impossible to fix. This article asks the following questions: Should the attorney play a role in educating the client about the post-divorce consequences of financial alternatives, or do the attorney's responsibilities begin and end with the legal aspects of the case? What should the attorney's the level of involvement be? Given the financial complexities of the divorce process, should the process be informed by specialists with lifestyle and financial planning training and expertise?

Carl M. Palatnik, CFP', CDFA, a member of this newsletter's Board of Editors, is a Certified Financial Planner and Certified Divorce Financial Analyst. He is president of Divorce Analytics, Inc., a provider of divorce analytical services, and founding president emeritus of the Association of Divorce Financial Planners, an international not-for-profit professional association. He can be reached at [email protected] or at 631-470-0331.