Managing a windfall

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A windfall, in personal finance, is defined as an amount of money that a person gets unexpectedly. Windfalls can range in magnitude from small additions to an individual's wealth to a significant increase in fortune. Since a large windfall almost invariably means huge changes in a recipient's life, psychological and emotional factors [footnotes 1] are often the most important factors determining outcomes. The National Endowment for Financial Education advises windfall recipients to take the following course of action. [1]

Do nothing rash. Set aside one year's living expenses [footnotes 2] and place the rest of the windfall into low risk investments (FDIC insured accounts, money market funds, treasury bills) for one year. As it may take as long as five years for the windfall recipient to adjust to a new life, this pause provides a chance for emotions to cool, helps avoid impulsive behavior, and, if warranted, allows the recipient time to put together a team of professional advisers.

Imbox notice.png "Most financial practitioners agree that well over 50 percent [of windfalls] are lost in a relatively short period of time. NBC News reported that more than 70 percent of lottery winners exhaust their fortunes within three years." -Larimore, Lindauer, and LeBoeuf (2006). The Bogleheads' Guide to Investing. Chapter 15, p.180: Wiley. ISBN 978-0471730330.


Common sources of windfalls

Windfalls come in many forms. Here are some common types:

  • Legal settlements : Settlements include personal injury settlements, settlements involving workers compensation and settlements of employment discrimination. Settlements are taken as either a lump sum or, alternately, as a structured settlement of annuity payments.
  • Inheritances: These can often involve retirement accounts and assets held in trust.
  • Gifts: These can range from annual gift exclusions up to the lifetime estate taxation credit limit.
  • Lottery winnings: Taken as a series of payments; or as the sales value of payments exchanged for a lump sum.
  • Insurance settlements: These can be in the form of death benefits received as either a lump sum or annuity; as pre-death cash surrender values; or as life settlements, the sale of a life insurance policy by the owner to a third party in exchange for a lump sum.
  • Retirement lump sums: Usually taken in lieu of a lifetime series of annuity payments
  • Sudden increases in income: These can come in the form of bonus payments; stock options; or cashing shares in an IPO. [2]

While not being external sources of new wealth, other common sources of receiving large lump sums include the following: [3]

  • A real estate sale
  • The sale of a business
  • Widowhood and divorce

Sales of businesses and real estate involve the conversion of an illiquid asset into large sums of fungible cash. Death and divorce not only cause dislocation and trauma, but often result in suddenly thrusting an individual who has had little or no interest or no experience in investing, into the position of managing family wealth.

Managing a windfall

Finance authorities are in agreement that avoiding immediate impulse decisions, especially in regard to large life changing windfalls, is a key to prudent management of the situation. Common errors of commission include buying extravagantly priced automobiles or engaging in other expensive consumption spending; feeling overconfident about one's business or investing acumen, resulting in jumping into new high risk investments (such as hedge funds) or as an "angel" investor in start-up companies; falling prey to overcomplicated estate and investment management schemes (be on the alert for people who may be trying to exploit you or take advantage of your new wealth. It’s important to recognize that you can be a target for all kinds of financial schemes); and finally, by being too generous to family, friends, and charities. [4] To avoid such errors, the following management techniques are recommended.

Take your time

Finance authorities are in agreement that avoiding immediate impulse decisions is key to prudent management of the windfall situation. Among the recommendations for this period are the following:

  • Set aside six months to one year's income requirements in a transaction account such as your checking account. Place the remaining windfall assets in separate accounts holding secure low-risk savings vehicles, such as FDIC guaranteed bank accounts and CDs, money market funds, and treasury bills.
  • Use this period of time to begin resolving emotional, family, and social issues. [footnotes 3]
  • Begin to think about long term goals and how they might be attained. Whether or not you are inclined to "do-it-yourself", this period is a good time to read some recommended books on personal investing. This can help you know what to look for in an adviser or advisers. [footnotes 4]
  • Begin thinking about creating a new financial plan that incorporates the windfall.

Determine your tax situation

A windfall often involves tax obligations. Estimated taxes may need to be filed. Complex tax issues may surround distributions from retirement plans, inheritances, and lottery winnings, [5] as well as the exercise of stock options. If professional tax assistance is warranted, enlisting the help of a Certified Public Accountant (CPA) who does not sell investment products may be a prudent step. [3]

A CPA may have a Personal Finance Specialist (PFS) designation. [footnotes 5] A good CPA can do the following:

  • Calculate any taxes due on the windfall and potentially minimize the taxes owed;
  • Recommend any additional types of insurance you may need, or what current types of insurance you hold may no longer be needed;
  • Determine whether you need to enlist an estate planning attorney; [footnotes 6]
  • Calculate whether it is better to receive a lump sum or annuity stream of payments from a settlement, lottery winning, or retirement package. [3]

Formulate a plan

Imbox notice.png "Once you begin to become comfortable in your new financial reality, you may be ready for the successive phases, which include reviewing your situation and deciding how the money will be used. This is the fun part, when you'll choose -- with the help of... a solid financial plan -- whether to retire, buy a vacation home, donate to charities or set up trust funds for your children. The ultimate goal of all these steps is to create a sensible plan for handling your windfall that also allows you to come out with your relationships and sanity intact." - Susan Bradley from 4 steps to profit from a financial windfall


A financial plan [footnotes 7] is a long-term process of managing your finances so you can achieve your goals and dreams, while at the same time negotiating the financial barriers that inevitably arise in every stage of life.[6]

The steps necessary for implementing the inclusion of a windfall into a financial plan will be affected by the windfall recipient's age and investment knowledge as well as the size of the windfall relative to the recipient's current wealth. An individual with an established financial plan and investment portfolio, upon receiving, for example, a profit-sharing bonus, might simply invest the bonus into the investment portfolio. For life-changing windfalls, and situations involving inexperienced investors, the step by step process of establishing a financial plan can help the individual to rationally meet goals.

Here are the steps you should consider taking as you develop and implement a financial plan:

  • Establish goals. The initial and most important step is identifying objectives (in a family, agreeing on shared objectives), e.g., buying a house, retiring early, ensuring that children get an excellent education, and so on. Determining what the objectives are, and when you would like to meet them, is primary. See also: Investment Policy Statement
Divide your goals according to when you want them realized. Rank each goal within each time frame in order of importance:[3]
  1. Short-term goals you want completed in one year;
  2. Intermediate goals to be completed in the next five years;
  3. Long-term goals.
  • Evaluate your financial status. Carefully include the windfall into your financial situation, net worth, and budget, and insurance planning. Supposing that retirement is one major goal, see if your new wealth provides for an adequate income (using a withdrawal rate of 3% to 4%) that would allow you to live off your capital. If this is not feasible, your new wealth can be invested towards a future retirement.
Among the prudent steps one can implement during this stage is to pay off high interest credit card debt and establish an emergency fund. [7]
  • Investing your capital. The investment strategy you adopt will be defined by the time horizon of your goals. Investment authorities commonly advise investors with goals coming due within five years to restrict investments to short-term instruments such as bank CDs, money market funds, and short-term treasury securities that all mature by the time the funds are needed.
For long-term investments, the key decisions will involve what asset classes should be selected; in what proportions (asset allocation); and how these should be adjusted over time. Since many asset classes can rise and fall in value, you must understand your need, willingness, and ability to take investment risk. See implement the plan for further details.


Imbox notice.png For further guidance involving the selection of an investment portfolio refer to these pages:


  • Execute needed estate planning documents. You may need to create an Estate plan. Commonly this will require the establishment of wills, powers of attorney, and trusts. Estate planning also includes any planned giving you wish to make. [8]
  • Monitor the plan & make necessary adjustments. Once a year, reevaluate your goals and compare to your time horizon. Adjust your insurance, estate matters, and rebalance your investment portfolio.

Notes

  1. A wide range of responses can accompany a financial windfall. Persons who have experienced financial windfalls have shared that they’ve experienced some or many of the following emotions as they adjusted to their new circumstances.
    Emotional reactions to windfalls Source: Financial Psychology and Lifechanging Events, NEFE
    • Elation
    • Fear of loss of money
    • Fear of a change in relationships with others
    • Anxiety
    • Paralysis
    • Inability to see the money as a gift or an advantage
    • Not knowing what to do with the money
    • Depression
    • Resistance
    • Anger
    • Grief
    • Distrust
    • Numbness
    • Isolation
    • Feelings of unworthiness
    • Resentment
    • Lack of confidence
    • Guilt
    • Desire to give it all away
    • Intimidated
    • Lack of identify
    • Sense of loss
  2. Some advisers suggest that the yearly expense account can be placed in an individual's checking (transaction) account, with the balance of the windfall placed in a separate account (CD, money market). This behavioral ploy is designed to help keep an individual from spending more of the windfall.
  3. The emotional and social issues surrounding windfalls are explored in greater detail in the following links:
  4. Should you decide to use an adviser, the authors of The Bogleheads' Guide to Investing (Chapter 16, p.193: Wiley. ISBN 978-0471730330) recommend choosing an adviser who has earned a CFA (Chartered Financial Analyst) or a CFP (Chartered Financial Planner) designation; uses a fee-only payment arrangement; and advocates an index fund investing approach.
  5. To avoid conflicts of interest, it is advisable to select a CPA (PFS} who does not sell financial products and does not accept compensation from the other professionals the CPA may recommend. The American Institute of Certified Public Accountants has a website where one can search for a CPA (PFS) in your locale: Find a CPA
  6. The authors of The Bogleheads' Guide to Investing (Chapter 15, p.185: Wiley. ISBN 978-0471730330) recommend Martindale & Hubble for checking out the credentials of an attorney.
  7. A sound financial plan incorporates these steps: Source :What is Financial Planning?, by the Financial Planning Association
    1. Establish Goals
    2. Gather Data
    3. Analyze & Evaluate Your Financial Status
    4. Develop a Plan
    5. Implement the Plan
    6. Monitor the Plan & Make Necessary Adjustments
    A list of things to do:
    1. Create a realistic budget with adequate insurance
    2. Plan for paying off existing credit card debts and other loans
    3. Plan for saving to meet your goals
      1. The time horizon will define your investing strategy (dream home, retirement, college)
      2. Understand your need, willingness and ability to take investment risk
      3. Write an Investment policy statement (IPS) or Investment plan
    4. Create an estate plan

See also

References

  1. Financial Psychology and Lifechanging Events, NEFE
  2. CFP Study Guide investopedia
  3. 3.0 3.1 3.2 3.3 Larimore, Lindauer, and LeBoeuf (2006). The Bogleheads' Guide to Investing. Chapter 15: Wiley. ISBN 978-0471730330.
  4. Financial Planning for a Windfall in Wealth: Lotteries, Stock Options, Inheritances and Other Surprises, Stephen L. Nelson, CPA, PLLC.
  5. Coming Into Money: How to Manage a Windfall, American Century Investments
  6. What is Financial Planning?, by the Financial Planning Association
  7. What should investors do with a windfall?, John Waggoner, USA Today, (5/24/2012)
  8. What to Do with a Financial Windfall, Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management.

External links

Vanguard: Your Investing Life: Managing Financial Windfalls