RESEARCH ABSTRACT

From the Cerulli Report

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TARGETING THE AFFLUENT AND EMERGING AFFLUENT

The following is a research abstract from The Cerulli ReportTM Navigating the Emerging Affluent Marketplace.

INVESTOR SEGMENTATION

Key Points
Effective segmentation methodologies are not a one-and-done exercise. We use a multifactor analysis to identify seven investor segments within the emerging affluent. These segments represent a combination of economic, demographic, behavioral, and psychographic factors. These segments are: business owners, established retirees, real estate wealthy, spenders, up-and-coming professionals, inheritors, and the suddenly affluent. Some investors may fall into more than one of the following segments. Economic factors are used by many firms as a first cut at segmentation, which is very useful. However, it should not be the only cut. Macro factors such as the privatization of Social Security; real estate busts; the repeal of capital gains taxes; or changes in estate, gift, and income taxes may affect the segmentation process.

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Research Abstract The Cerulli Report Navigating the Emerging Affluent Marketplace May 2006

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The investors who comprise the emerging affluent segment of the market are very diversein terms of their net worth, risk tolerance, financial goals, and a myriad of other characteristics. Because of this diversity, in order for firms and advisors to effectively service this market they must perform some level of segmentation. There are many ways to segment any group, and this is especially true of this market. The methods employed by players in this market will depend on the firm and their advisorforce, as well as on the construct of their existing and desired client base. Though differences will exist between factors considered, weightings applied, and techniques employed, there are some commonalities that persist among effective segmentation strategies. Foremost, investor segmentation is a strategynot just an occurrence. The investor segmentation methodology must be defined, constructed, deployed, and promoted via a top-down initiative. If a methodology is employed by only one group, the question arises as to who services all other investors who fall outside of this group. Thus, most methods dictate what segment the firm or individual groups will pursue and determine what is to be done with the leftovers. Second, effective segmentation methodologies are revisited periodicallyit is not a one-and-done exercise. The financial services industry is not stagnant, and the segmentation methods employed by firms cannot be. Markets change, firms redirect their efforts, and advisor migration patterns alter. Thus, segmentation methods must respond to these dynamics. In this chapter, we discuss some of the basics of constructing a segmentation methodology highlighting how to use different segmentation factors in conjunction with each other. We then detail some of the generic factors that can be used to construct a segmentation methodology, such as economic, demographic, behavioral, and psychographic factors. From there, we delineate the seven segments we believe are the most noteworthy in the emerging affluent marketplace as a whole. These segments will not necessarily be ideal for every firm or advisor, as they are segments of the entire emerging affluent population instead of smaller segments being targeted by different firms or advisors. Thus, though these segments may not be the ideal for all in the industry, they give some guidance to those creating a segmentation methodology and some possible outcomes of the application of that methodology. Finally, we conclude this chapter with a discussion of some influential factors that may cause these segments to flourish, or not, and be more or less of an opportunity than they currently present.

Basic Segmentation Methodology

In creating a segmentation methodology, there are two key pieces that must be considered: what factor or factors should be considered, and how should they be used separately or together. As stated, the exact factors employed and how they are utilized will depend upon the individual firm or advisor, but below are detailed some of the generic factors and methods to consider employing when creating a customized segmentation model.

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Segmentation Factors In many instances, the only segmentation factor considered is a clients investable assetsoften not the total amount of those assets, but just the amount capable of being invested with the firm or advisor. However, utilizing just this one economic factor is very short-sighted and relatively uninformative about the true needs of the client. Thus, a variety of factors should be thrown in the hat when considering what factors are appropriate for usage within a firm or advisors segmentation method. There are four basic categories into which generic segmentation factors fall.
EXHIBIT 18 GENERIC SEGMENTATION FACTORS
Economic Investable assets Net worth Liabilities Income Demographic Age Race Sexual orientation Marital status Behavioral Event-driven Strategic Opportunistic Investment style Psychographic Self-directed Validator Delegator Apathetic

Source: Cerulli Associates

Each of these four categories attempts to categorize a different aspect of human nature. The possible variables that comprise each factor are potentially limitless. In order to cite some of these variables and give examples of firms that have employed these factors in their business, we expound upon each of these four categories in the following subsection.

Economic Variables The variables used most often are economic variables, such as investable assets, net worth, income, and expenses. Many firms and advisors use this segmentation factor as the beginning and the end of the process, or as the first step in it, for several reasons. First, it is a useful segmentation factor because firms and advisors can quickly have an idea about the investors potential advice and product needs, and their ability and willingness to pay for them. Second, this is a variable that is fairly easy to plug into a profitability model to measure the potential revenue and profit generated from an investor who falls into a particular economic category. Finally, when dealing with new clients, there is some information they are willing to give from the outset and other information they are not. Many economic figures especially investable assetsare ones that an investor approaching a firm or advisor for financial assistance is prepared and willing to give, which is not necessarily the case with other segmentation factors. Though this information is helpful, it does not reveal some of the other nuances about an investors needs, wants, and actions that may be more significant drivers of the nature and profitability of the ongoing firm-client or advisor-client relationship. However, every process needs a starting point and our analysts believe this is a good one. Most firms utilize economic variables in the segmentation models. However, when you think of the firm that personifies the usage of economic variables, it is Merrill Lynch that jumps to mind.

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EXHIBIT 19 MERRILL LYNCH SEGMENTATION PYRAMID

Private Private Wealth WealthAdv Adv ($10 ($10million million+) +) Wealth Mgt. Advisors ($1 ($1million million-$10 -$10 million)

Financial Advisors ($100,000 ($100,000 -$1 million)

Advisory Division (<$100,000)

Sources: Merrill Lynch, Cerulli Associates

Merrill Lynch segments clients into four distinct groups based upon their investable assets, which dictates the group that will service the investor. Those investors with less than $100,000 in investable assets are serviced by the call center, and are offered a wide array of advice and products by the individuals who staff this center. As investors investable assets increase, the sophistication of the advisor servicing them, array of products offered to them off of the platform, and fee arrangements from which they have to choose continues to increase. Though Merrill does take other factors into consideration when servicing these four different investor groups, the initial cut is purely economic in nature. Demographic Variables Demographic variables are another example of a segmentation factor about which it is relatively easy to gather information. Some examples of these variables include sex, age, race, and marital status. Though this information is relatively simple to collect, it does not as readily generate actionable information as do economic variables. Whereas economic information can dictate needs and be plugged into a profitability model fairly easily, demographic information typically only means something when seen through the lens of the past. With some historical information about typical needs and wants about other investors who have fallen into a particular demographic category, firms and advisors can target their product and service offerings to these clients. Using this information, firms and advisors can lead with more appropriate suggestions or offerings to their current client basemaking the client feel as though they are a relatively important client of the advisors. A firm well known for utilizing this information is Fidelity Investments. Fidelity has created its Retirement Income Advantage Program to position product and service offerings based upon the age or lifestage of its clientas investors nearing or entering the retirement phase of their lives, at around the age of 60 or 65, need assistance in the retirement income planning process. In addition to being of assistance in servicing existing clients, many firms use this information to position special offers or advertising to different groups with whom they want to make a connection in
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order to broaden their client bases and draw in new business from outside of their conventional markets. Examples of firms with recent forays into multicultural markets are ING, Bank of America, and Allstate. ING hired personnel in an attempt to better service certain minority groups from whom they have not traditionally attracted a lot of business. Through this group, ING hopes that the right type of advisor with the appropriate service offering will be able to take advantage of the untapped opportunities presented by certain minority groups. Bank of America is investing millions in multicultural media and considers the cultivation of multicultural markets a key component of its growth strategy. At Allstate, the allocation for multicultural marketing has doubled from 4% in 2000 to 8% in 2005. Allstate also entered into internet advertising this year (lifting its share to 5% from nearly nothing) and plans to spend only 40% of its budget on mass-market TV commercials (down from 70% in 2000). In the next few years, firms that build successful programs based upon demographic differences and differentiate themselves will have an advantage in capturing and retaining the increasing assets of these communities. Behavioral Variables Behavioral variables categorize investors actions or reactions under or caused by certain circumstances. However, it does not take a Ph.D. in psychology to know that it is very difficult to predict individual human behavioreven under exact circumstances, investors reactions can be very diverse. Yet, there are identifiable patternsthough it is difficult to know which investor will exhibit which ones. Additionally, though these variables are helpful in giving firms and advisors some insight as to how a specific investor may react to a particular offering or their willingness to purchase a particular product or service, their implications are only known when viewed in a historical, scientific context. In order to make sense of a certain behavioral variable, firms and advisors must have some type of background information from which to draw in order to correlate predictive behavioral hypothesis with business initiatives and profitability. Some variables that fall into this category are whether an investor is strategic, opportunistic, or event-driven, among others. Bank of America is a firm that uses behavioral variablesoutside of investment style detailed belowto segment their customers. The firm is placing smarter ATM machines in certain geographic regions. These ATMs will be keeping track of certain behaviors that a user demonstrates and using that information for future use and product or service promotions. For instance, the machine will be able to remember that a user has never selected Spanish as the language in which their transaction should be conducted; that they always attempt to withdraw an amount that is not one of the preset amounts and will make that unique amount one of that users preset amounts (as opposed to having to select Other Amount and keying in the exact amount); or, because they have a mortgage with Bank of America, the user will receive information telling them it appears to be time for them to refinance.

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One of the most well-known behavioral variables is an investors investment style: aggressive, moderate, conservative, or risk-averse. These variables describe an investors investment outlook and relative tolerance to investment risk and are typically learned through an advisor- or self-administered investment-style test, which is a basic questionnaire for evaluating investors views regarding investing and planning. Once armed with this information, firms and advisors use them in a variety of ways. First, firms and advisors use this information to recommend a generic group or type of investments to investors fixed income for a conservative investor and individual equities for more aggressive investors, for example. Additionally, firms use this information to construct packaged products, ideally with embedded advice, that can make the sales process easier for advisors or a direct sale. An example of this is the construction of lifecycle funds. Funds in this category can either be lifestyle or target date funds. Target date funds constructions are more affected by a demographic variable: an investors age relative to their predetermined retirement date. However, lifestyle funds are created for any investor simply based upon their predetermined risk tolerancea behavioral variable.

Psychographic Variables Psychographic variables classify investors based upon their psychological profiles. Though everyone is unique, there are four segments into which experts attempts to bucket individual investors based upon their measure of participation and mindset regarding finances and their ability and desire to manage them. The four segments are each a bit different: self-directed (independent investors); validators (investors who only desire limited guidance or advice); delegators (investors who want ongoing advice or discretionary management services); or apathetic (investors who do not know what they want or do not take steps toward attaining what they want). Each of these segments helps better define investors based upon their specific approach to investing. Psychographic variables do give some insight into the choices that investors may make regarding the actual product or advice offering. However, more often, this variable provides information regarding the best way to service a particular clientwhether they are more hands-on or hands-off. Charles Schwab is an example of a firm that uses this variable in developing packaged advice programs and better products. This firm also uses psychographic variables to determine the best method and frequency of delivery of information regarding these products and services. Factor Usage Determining the best variables to measure the different factors is just the beginning of the creation of an investor segmentation methodology. In general, best-practice firms do not rely solely on one or two factors in their segmentation modelsthey employ a totality of factors in their segmentation process. However, there are many firms and advisors who simply rely on investors investable assets when determining if they represent a future client. When advisors almost sole function was to facilitate

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product transactions for clients, this may have been sufficientinvestors investable assets were all that really mattered in measuring profitability and success in that market. Though this may have been sufficient in the past, in the current times with buzzwords such as advice, financial planning, and fee-based pricing on almost everyones mind, there needs to be more investigation into other investor factors. Thus, we contend that this should be just the first step in the process. In constructing this process, which will contain a variety of factors, firms and advisors can use either a multileveled or multifactor process. A multileveled analysis would comprise multiple screens through which an investor would pass in a step-by-step processin order to be considered in the third screen, the investor must pass both the first and second. A multifactor process would have all factors considered in making a decision about an investor. Thus, all factors would be considered at once, potentially in different weightings of importance. Though there are valid reasons for using either technique, we have found that a multifactor analysis tends to be the better method, and is therefore the method we employed in creating the seven investor segments detailed below. Some factors, almost completely on their own, dictate that an investor falls into a certain segment while other segments fall out of a combination of factors. By using a multifactor analysis, this can be taken into consideration more easily. Methodology Outcome Once a segmentation methodology is created and applied to existing and potential clients, several key takeaways will ideally fall out of it. Some of the information that should be learned is related to the most appropriate services, products, and delivery mechanisms for a particular investor segment. However, this is just the beginning of the information-gathering process for a particular investor. Firms and advisors should use the basic information garnered from an investor falling into a particular segment as an in to the beginning of the relationship with the client. By having some quality knowledge about how to or what to approach an individual with, the firm or advisor has demonstrated they have done some level of homework about the individual and should use this information as a springboard into perpetuating a stronger relationship with the client. Thus, segmentation should be viewed as a way of making the relationship with a client better or easiernot the end-all in terms of servicing. Throughout the remainder of this chapter, we detail the seven investor segments that we believe comprise the emerging affluent marketplace. Though there are more possibilities, these are the outcomes of the employment of our segmentation methodology.

Cerulli Emerging Affluent Investor Segmentation

We segment investors into three basic categories: lower net worth, emerging affluent, and higher net worth. We segment the emerging affluent market into seven subsegments. In this section of the report, we highlight differences between the wealth tiers, and also between the seven segments within the emerging affluent market itself.

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Comparisons to Other Wealth Tiers The services investors need in the emerging affluent marketplace are rarely different in kind from those needed in the higher and lower wealth tiers, but there is a significant difference of degree and frequency of delivery. Emerging affluent investors have considerable need for estate planning advice and wealth transfer products, services rarely considered for the vast majority of mass-market investors. Highnet-worth investors, however, find estate planning and wealth transfer advice to be a primary service, sometimes even requiring advice for passing on their wealth to subsequent generations beyond just their children and grandchildren. Conversely, one of the biggest concerns for mass-market investors is the need for retirement savings advice, another service important to emerging affluent investors. And while the middle and bottom wealth tiers view retirement savings as a primary concern, it is far less important to high-net-worth investors, who are often able to retire at any time and fund a high quality of life. It is often difficult for advisors to serve the emerging affluent marketplace because they require different advice and services than their high-net-worth and low-net-worth counterparts. Serving these investors is not as easy as splitting the difference, and offering a wide selection of services that the diverse group of emerging affluent investors may need. Emerging affluent investors need to be broken into smaller segments, made up of advisors with various similarities who often desire similar types of advice. We explore a method for segmenting the emerging affluent market into more easily targeted groups in the following section. Emerging Affluent Segments Firms and advisors will undoubtedly have their own methods of segmentation and their segments will often differ from ours, or they will have additional subsections. However, Cerulli Associates is confident that our wealth tiers can serve as a template, or guidelines, for firms and advisors targeting the emerging affluent market. Some investors may fall into more than one of the following segments, but Cerulli Associates believes that the needs and goals of investors in each segment are similar, regardless of whether they fall into more than one segment. Our seven segments are: business owners, established retirees, real estate wealthy, spenders, up-and-coming professionals, inheritors, and the suddenly affluent.

Business Owners As can be expected, a major portion of the emerging affluent market is business owners: those investors with a significant portion of their assets tied to business interests. Some of these may be typical entrepreneurs who started and run their own small company; others may act more like venture capitalists, investing a large portion of their assets in a business they do not operate themselves; others may have inherited a family business, while some worked their way up in a firm to become part or sole owner. Using data gathered by the Federal Reserve in its Survey of Consumer Finances, Cerulli Associates estimates that 30.8% of emerging affluent households, when viewed by investable asset tier, are business owners, and 48.7% of households by net worth tier are business owners. The large differResearch Abstract The Cerulli Report Navigating the Emerging Affluent Marketplace May 2006
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ence between segmenting by the two methods exposes the large number of potential clients that an advisor may overlook if solely focused on a potential clients investable assets, as business interest is a noninvestable asset and only captured in that net worth total. The importance of analyzing an investors net worth in addition to their investable assets when deciding to take them on as a client cannot be understated.

EXHIBIT 20 BREAKDOWN OF BUSINESS OWNERS BY INVESTABLE ASSET TIER

100.0%
86.4%

80.0%
69.4% 62.0% 59.5% 45.4% 47.5% 71.5%

60.0%

40.0%
26.9% 22.2%

20.0%

18.0% 8.2% 5.3%

0.0% Tier I Tier II Tier III Tier IV Tier V Net worth tier Tier VI

Investable asset tier

Sources: Federal Reserve, Cerulli Associates

Some business owners may have almost all of their assets in a business interest (i.e., the mom and pop pizza parlor), while others may have a much smaller stake (i.e., a partner at a law firm). While the percentage of their assets may vary greatly, the services they need are often similar, varying in degree rather than kind. Whether self-made or a business owner through inheritance, of primary importance to business owners is a financial advisor who can offer them business planning and transition services. The need for business planning advice goes without saying and is the most critical service that a business owner will seek out. Transitioning the business into other hands creates the need for services such as wealth transfer and estate planning advice, and may call for the creation of a family limited partnership or a stock optimization strategy to protect assets and avoid the myriad tax concerns. Various types of business insurance may also be required. Business owners do not have the luxury of having their employer contribute to a 401(k) plan, so they need financial advice on individual retirement. A popular product is a solo 401(k), which is ideal for sole proprietorships with only owner and spouse employees, but others may opt for the tax advantages of other retirement plans. Business owners may also need help establishing an employer-sponsored retirement plan. Some
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of the more common vehicles for employer retirement, especially for small businesses, include SEP IRA, SIMPLE IRA, various defined benefit plans, and numerous 401(k) plans (normal, Safe Harbor, and SIMPLE). Some of these plans are more appropriate than others. Depending on how the company is legally structured (sole proprietorship, LLC, corporation, or partnership) and the size of the company, a business owner will have varying needs for their companys retirement plans. The employer-sponsored retirement planning can take the form of total benefits outsourcing, which includes insurance products, health and welfare, and other benefits offered to employees in addition to retirement plans. Investment planning is important for almost every investor, but is critical for business owners after the sale or transition of their business. The large amount of assets they will have after the sale of the business is often more than they know what to do withsound investment advice is a must for these investors. Linked with the sale of the business comes a variety of tax issues; good tax planning is an absolute necessity. Without the proper tax advice after the sale of the business, an investor stands to squander much of what they worked so hard to create. The above is not an exhaustive list of what services a business owner needs; they need much of the more generic product offerings and advice that every investor, regardless of occupation or financial status, also needs. The same can be said for all of the following market segments. The services mentioned are just the ones that these investors will be seeking because of their background, and is not a full list of the services that these investors require.

Established Retirees Regardless of how they overlap with other segments, whether they are business owners or have significant real estate wealth, established retirees are those investors who have entered retirement some time ago and now have specific needs. We consider established retirees to be any investor 68 years of age or older. Few investors in the emerging affluent marketplace remain in the workforce after this age, with many having retired years earlier. As with all wealth tiers, the wealthiest investors also tend to be the oldest: 26.8% of emerging affluent households by investable asset tier, and 25.9% by net worth tier.

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EXHIBIT 21 BREAKDOWN OF HOUSEHOLDS OVER AGE 68

50.0%
49.0% 47.2%

40.0%

35.8%

30.0%
22.6%

28.0%

27.4%

25.7% 21.5%

26.1%

20.0%

18.9% 15.7% 14.5%

10.0%

0.0% Tier I Tier II Tier III Tier IV Tier V Net worth tier Tier VI

Investable asset tier

Sources: Federal Reserve, Cerulli Associates

Established retirees do not need any retirement savings planning, but may have some concerns for retirement income planning depending on how far they are into retirement. Insurance is needed as these investors age as a safeguard for their spouses and estates. Elder-care planning and cash flow management are a concern for many established retirees to provide assistance later in life and to avoid running down their savings too quickly. Unlike similarly aged investors in the middle market and mass-market wealth tiers, these investors need help with wealth transfer. They have enough assets that they will not use them all up before they die; many wish to pass on some of their wealth to their heirs. Related to the need for wealth transfer planning, established retirees also look for advice on education planning. Often this education planning is not for themselves or their children, but for grandchildren and, in some instances, subsequent generations. Many may create or contribute to their grandchildrens 529 planpossibly using the Five-Time Rule (see Glossary). Additionally, trust services may be needed because many of these investors want to take care of their children and grandchildren while avoiding some of the negative tax implications of other forms of inheritance.

Real Estate Wealthy Some investors in the emerging affluent market would only be included if looking at their net worth, as their investable assets are often not great enough to put them in that wealth segment. These are the investors that have most of their assets in real estate, which is somewhat surprising given their income and the rest of their financial status.

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If these investors decide to liquidate some of their real estate assets, they will remain in the emerging affluent marketplace, and often then have enough investable assets to put them in the emerging affluent marketplace when measured by investable asset tier. The real estate wealthy are often overlooked by financial advisors who only see their comparatively low investable assets, without thinking about the investors future after the sale of their real estate. Overall, 6.82% of emerging affluent households by investable asset tier are real estate wealthy, and 15.6% of emerging affluent households by net worth tier are real estate wealthy.
EXHIBIT 22 BREAKDOWN OF REAL ESTATE WEALTHY HOUSEHOLDS
60.0%
50.9%

50.0%
40.8%

47.6%

40.0%
32.1%

30.0%

20.0%
10.0%

15.9% 7.5% 4.9% 1.1% 0.4% 3.3% 2.0%

10.0%

0.0% Tier I

Tier II

Tier III

Tier IV

Tier V Net worth tier

Tier VI

Investable asset tier

Sources: Federal Reserve, Cerulli Associates

Many of the services these investors need after the sale of the real estate closely mirror those required by a business owner after the sale of the business, including investment planning, budgeting, income planning, trust planning, and estate planning. Because these investors often lack the high salary or significant amount of investable assets that many investors of the emerging affluent have, retirement planning and insurance needs are relatively more of a concern.

Spenders The group most in need of discipline is those who act like most Americans, living beyond their means. They borrow and borrow until they are heavily in debt and in a potentially risky financial situation. However, these are not the investors in dire straits, with one foot in bankruptcythose investors are in need of a good lawyer rather than a good financial advisor. We define these investors as those households with a debt-to-income ratio of greater than 50%. This is considerably higher than the recommended debt load and is enough to put these investors on the path to a less-than-exciting financial future. With a national savings rate close to zero, it is no surprise that many Americans would be considResearch Abstract The Cerulli Report Navigating the Emerging Affluent Marketplace May 2006
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ered overleveraged. This is not just a problem of those Americans with low incomes and a high cost of living, but it is a way of life for many investors at all levels of wealth. In the emerging affluent marketplace, 40.9% of investors are overleveraged according to investable asset tier, and 41.0% by net worth tier.
EXHIBIT 23 DEBT-TO-INCOME RATIO OF GREATER THAN 50%
60.0%
51.6% 49.3% 44.4% 41.6% 41.4%

50.0%

44.8%

40.0%

35.8% 32.2%

30.0%
23.3%

26.7% 19.5% 11.3%

20.0%

10.0%

0.0% Tier I Tier II Tier III Tier IV Tier V Net worth tier Tier VI Investable asset tier

Sources: Federal Reserve, Cerulli Associates

They need debt help. If their debt was under control, their amount of assets would put them in a position to potentially jump into an even higher wealth tier. Unfortunately, some of these investors would be passed over by advisors who are looking at investors by investable assets. If they delved deeper and looked at the investors net worth, they would realize that they might actually make great clients. Their greatest need is debt consolidation. Without reducing their level of debt, their financial future is uncertain. Hand in hand with debt consolidation is budgeting and cash flow planning. Although they are often one of the hardest types of financial plans to implement, they are also one of the most important pieces of advice for these investors. In addition to getting their spending under control, they need advice on saving, especially plans that include automatic savings, to counteract any increase in debt. These investors tend to be reactive: they look for financial help only because they really need it, rather than anticipating that it would help and being proactive about their financial future. If these investors can be found before they are in a somewhat dire situation, the upside for a financial advisor can be incredible.

Up-and-Coming Professionals The group of investors in one of the rosier financial situations is the up-and-coming professionals. These are the investors under the age of 40 who earn more than $100,000 per year. Given their age and income level, these investors are somewhat more likely to move up wealth tiers than some of the
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other emerging affluent investors. Up-and-coming professionals make up a small, but potentially advantageous group of the emerging affluent marketplace, 6.00% of emerging affluent households by investable asset tier are up-and-coming professionals, and 6.71% of households by net worth tier also fall into this category.

EXHIBIT 24 BELOW AGE 40, INCOME GREATER THAN $100,000

8.0% 7.0%
6.2% 6.9% 6.2% 5.6% 4.6% 4.2% 4.0% 3.0% 5.7%

6.0% 5.0% 4.0% 3.0% 2.0%

2.4% 2.4%

1.1%

1.0% 0.0% Tier I Tier II Tier III Tier IV Tier V Net worth tier Tier VI

Investable asset tier

Sources: Federal Reserve, Cerulli Associates

Retirement savings and investment planning are the two most important services for these investors. They want to have their retirement squared away, and early, but also look to grow their wealth for any future plans, such as buying a house or providing for their children. Along with the desire to take care of their family is the need for education planning. Advice on a 529 plan will allow them to finance their childrens education and not have them going into debt later in life. Their children are not the only ones in need of education planning, however, as some of these investors are very young and may still go to school to earn a graduate degree or enroll in a professional program. The majority of these investors have already completed their formal education, which makes debt consolidation a widely shared need among this group of investors. Many of them have significant debt from education, whether it was undergraduate, graduate, or professional school, and these investors can carry upwards of $200,000 worth of debt. Charitable giving, especially for its tax advantages is another desired service. A common characteristic of these investors is their proactive nature: they are seeking help because they want to be in a better financial situation, not because they are in desperate financial shape. This attitude contrasts with the overleveraged investors who often seek out financial advice after realizing (somewhat late) that they are in poor financial condition and need some advice to keep from falling further.
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Inheritors Unfortunately, gauging the number of inheritors in the emerging affluent marketplace is incredibly difficult. For the purposes of our research, it is impossible to tell how many investors received their wealth through inheritance. While there are many inheritors in this marketplace, they are one of the more diverse groups of investors. They represent all age groups, and their wealth may be divided into a broad number of sources. Some of these investors may have been in a favorable financial situation, as an inheritance was something for which they had been planning. However, there are those who enter this marketplace more swiftly, by receiving an unexpected inheritance, or one larger than expected. Estate planning, trust, private banking, and business or real estate advice are all necessary, and are often the vehicles by which the inheritor received their wealth. Depending on the age of the inheritor, the services they require vary greatly. An 18-year-old in this group will need education planning more than a Baby Boomer who may be looking for retirement planning advice and may possibly be in need of retirement income assistance.

Suddenly Affluent The suddenly affluent segment encompasses that group of people who were suddenly thrown into the affluent marketplace. They include lottery winners, athletes entering professional sports, instant entertainment stars, inventors, IPO millionaires, those who received a completely unexpected inheritance, people receiving settlements in lawsuits and, on the flip side, those who lost a large portion of their wealth and now find themselves in a lower wealth tier. Sudden Inflow Along with the dramatic change in their wealth comes a lot of baggage. These investors are rarely ready for the new wealth they have, and sometimes the result is disastrous. All too often we hear stories about lottery winners spending all of their money, ruining their lives, losing their families, and sometimes losing their lives. Without a hand to hold, many of these investors are consumed by their new psychological state, and their wealth can disappear. These investors also need an advisor with experience in charitable giving. An important aspect of newfound wealth is a sense (whether real or imagined) by the investor that their wealth was not earned, and they are under more pressure to give some of that money away. Cash flow planning is needed because much of the newfound wealth comes all at once and without proper cash flow planning and budgeting, an investor could go through their wealth in a short period. These investors need advice in trust planning, and some suddenly affluent investors may even need a specialized product like a special needs trust for their disabled children. These special needs trusts allow a disabled child to receive money without ending their public medical care. If the child received the value of the special needs trust immediately, they would lose out on their ability to receive public funding for their medical care: a special needs trust allows them to maintain this funding while also
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keeping money safe for them in later life. Insurance and elder care planning also remain a concern, as many of these investors, especially those who earned money through a lawsuit or through the lottery, tend to be older and have not adequately prepared for later life. Case Study: Starcare Lawsuits with rewards between $2 million and $5 million have become increasingly common in the last several years. The increase in settlements from these lawsuits has led to one category of suddenly affluent investors, who overnight become part of the emerging affluent segment. However, only a few advisors actually specialize in providing planning services to this niche market. One such firm, Starcare, created by Richard Hearn, a full-service, independent financial planning firm affiliated with LPL Financial, specializes in providing sudden wealth advisory services. He believes that serving this client base can be challenging, as advisors are not only providing investment advice and cash flow management services, they are, in many cases, acting as personal counselors to their clients. Hearn recommends that advisors genuinely interested in serving the sudden wealth segment must first acquire a strong understanding of the unique issues and challenges typically faced by individuals who become suddenly wealthy through settlements. Sudden wealth advisors must garner a thorough knowledge of the overall legal process, expertise in relevant legal issues, and a strong understanding of the investment vehicles designed to protect settlements, such as special needs trusts. Understanding settlement proceduressuch as those that dictate whether or not individuals can receive certain settlements and remain on certain government-funded programsare required to effectively manage assets for sudden wealth clients. Moreover, comprehending the inner workings of the court system to protect the client, their families, and their settlement are essential to perform the job effectively. Next, it would be well advised for sudden wealth advisors to create partnerships with personal injury attorneys, trust accountants, NAELAa nonprofit association that assists lawyers, bar organizations, and others who work with older clients and their familiesand counselors as a means of generating new client referrals. The most important of these is likely the personal injury attorney. Finally, advisors must make sure to design cash flow budgets geared toward protecting assets from uncertain medical costs, from individuals who do not have the clients best interests in mind, and on occasion from the client themselves. Ultimately, advisors who are successful in this market are those who provide emotional support and counseling during their clients most stressful timesby sitting with their client in court or visiting them in the hospital. They are the ones who develop a great deal of mutual trust and respect with their clients, so that being their financial advisor is a natural extension of their relationship.

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Sudden Outflow Not all investors in the sudden affluent segment received an inflow of wealth, however. Many actually lose money and end up in a lower wealth tier. These investors include the former IPO millionaires who lost a significant portion of their wealth after the downturn in the tech market. They are suddenly in the emerging affluent market having recently been in a higher wealth tier. An advisor specializing in high-net-worth clients may be unwilling to retain a client in a significantly lower wealth tier who may need vastly different financial advice than the rest of the advisors clients. These investors, like those with a sudden inflow of wealth, may need some psychological help in addition to a financial plan as they deal with the loss of so many of their assets. Not all firms have clients who fall into each of these segments, not all investors fall exclusively within one of our aforementioned categories, and not all have the same needs. However, in order to wrap up this section, we present a matrix that delineates the service needs of each of the preceding segments.

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Investment Planning Retirement Savings (includes individual and employer-sponsored Retirement retirement) Income Insurance Education Elder Care Estate Planning (includes trusts and wealth transfer services) Charitable Giving Tax Planning Core service After sale of Critical need for employer- business and for On individual sponsored retirement wealth transfer investor and services goals business levels Standard Not a concern As part of business transitioning or needed after transition out of business Important for gifting goals and tax benefits Critical for both personal and business tax purposes Needed to prevent investments being too conservative and inflation eroding assets Not needed Just in case As a wealth transfer vehicle As a wealth transfer vehicle LTCI needed for themselves Important for wealth transfer More prevalent as these investors age If transferring real estate via trust or creating a trust with funds from Not a primary sale concern Standard Standard Big concern: during the sale of the property to minimize capital gains liability Core service, especially needed after sale of real Needed after sale of estate property For their real estate Reverse mortgages if needed Standard Once a budget is established and debt reduced Standard Secondary concern after retirement savings Not a concern Standard Not a concern Once a budget is established and debt reduced Standard Core service Need to maximize Too young for it to be a major Life insurance concern needed For themselves and their children LTCI needed for their parents Too young for it to be a major concern For tax and goodwill purposes Standard Core service Depends on age and size Dependent on of inheritance age Big concern: especially if investor had minimal savings before sudden wealth Standard Standard Standard May be receiving inheritance through a trust Need based on amount of inheritance Standard Dependent on age Standard Standard Dependent on age and health May need to create a trust to protect assets Need based on amount of wealth Standard

EXHIBIT 25 CERULLI EMERGING AFFLUENT INVESTOR MATRIX

Description

Income Planning

Business Owners

Own a business

Standard

Established Retirees

Real Estate Wealthy

Over the age of 68 Standard More than 50% of their assets are comprised of real estate Standard

Overleveraged (Spenders)

Up-and-Coming Professionals

Debt-to-income ratio of greater than 50% Under the age of 40, income greater than $100,000

Biggest concern: these investors need a budget and a plan for debt Core service once debt consolidation and is consolidated and the savings client has savings

Standard

Inheritors

Inherited wealth

Big concern: some of these investors do not work and their inheritance is their income

Sudden Affluent

Core service, especially for those who May spend their wealth beforehand did not have Sudden inflow or too quickly without a sufficient assets for outflow of wealth budget and savings plan investment

Source: Cerulli Associates

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Though this matrix just gives some ideas of investor needs, when used in conjunction with the Cerulli Emerging Affluent Advisor Matrix in the following chapter, a firm attempting to match investor and advisor segments will find some guidance.

Influencing Factors
Though we have segmented emerging affluent investors into seven distinct categories, each investor is unique. Additionally, though some of the needs of the emerging affluent segment are distinct, they share some characteristics and issues with other wealth tiers. Consequently, there are some factors that will have some influence on all investors in the different wealth tiers. However, there are four that we believe will have a greater amount of influence upon emerging affluent investorsin terms of influence relative to that exerted on other wealth tiers and relative to other factors exerting influence on the emerging affluent segment. These factors have the potential to increase or decrease the opportunities presented by the emerging affluent wealth tier in general and potentially by some investor segments in particular. The four influencing factors to which we pay special attention are: the potential privatization of Social Security; the possible downturn of the real estate market; the proposed permanent repeal of capital gains taxes; and shifting focus from estate to income and gift taxes. Throughout the remainder of this section, we go into detail about these factors and their influence on opportunities. Privatization of Social Security Privatizing Social Security is being floated around Capitol Hill as one of a combination of measures to shore up the Social Security trust fund. By allowing Americans to divert a portion of their Social Security taxes into private accounts that invest in bonds and equities, proponents hope that Americans will be able to supplement their retirement income at a level that is equal to or larger than what the government could provide. If privatizing Social Security is approved by Congress, it will impact every working American. For the emerging affluent, it introduces a degree of uncertainty into their overall portfolio construction, which will facilitate discussions with their financial advisor. The Privatization Proposal There are a number of variations on the structure of privatized Social Security accounts. The most popular proposals only offer privatized accounts to individuals younger than 55. The reasons behind this are as political as they are economic. Workers within 10 to 15 years of retirement are counting on Social Security as their main source of income during retirement. In 2004, Social Security provided at least half the income for 75% of retirees. Such a high dependency on Social Security means that politicians are unwilling to create an abrupt change to current and near retirees primary source of income.

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EXHIBIT 26 SOURCES OF INCOME FOR THE POPULATION AGE 65 AND OVER BY INCOME QUARTILE, 2004
Sources: CRS Analysis of March 2005 Current Population Survey, Cerulli Associates

2%

100.0%

2% 0.1% 9% 0.3%

1% 7% 6% 2% 3%

0% 5% 5%

1% 2%

80.0%

35%

21% 9%

60.0%
25%

40.0%
17% 58%

82%

86%

20.0%
21%

0.0%

First (highest) quartile

Second quartile

Third quartile Pensions Earnings

Fourth (lowest) quartile Public assistance Other

Social Security Asset income

Offering near retirees a private account also puts additional strain on the Social Security Trust Funds. Instead of paying into private accounts, near retirees would receive a lump sum equal to the present value of a future stream of income. The government would need to carve these lump-sum payments out of the current trust funds, thus depleting the funds at a faster rate than if they had been paid over time. Most proposals call for the structure of privatized accounts to mirror the Federal Thrift Savings Plan (TSP)the DC plan for Federal and Military employees. The TSP is comprised solely of five index funds and five lifecycle funds that utilize the index funds on its platform. It also offers five basic types of income annuities to participants. Thus, privatized accounts will likely feature a limited number of index funds with the option to annuitize the accounts for life at retirement. Only 4% to 6% of an employees pay, or a little less than half of a workers Social Security taxes, would be diverted into a privatized Social Security account. The vote is still out as to whether it would be optional or mandatory to divert the funds into privatized accounts. Thus, workers would still have a portion of their pay directed into the general trust fund and will still receive a small stream of government-provided guaranteed income during retirement. The goal is that American workers will accumulate enough in their privatized accounts to offset any decreases in Social Security benefits.

General Impact Privatizing Social Security will benefit the emerging affluent more than the average American on
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a dollar basis. Collectively, emerging affluent investors seek professional advice more often than low- to middle-income Americans. Thus, when questions arise on how privatized accounts fit into the overarching asset allocation strategy, they will seek professional advice. Conversely, the average American handles accumulation on their own. They are more likely to invest in one asset class, chase performance, or stick with conservative investments. Emerging affluent investors will have diversified private accounts that are better equipped to handle market volatility. On a percentage basis, privatization will hardly make a dent in emerging affluent investors retirement income. Contributions to Social Security are currently capped at $94,200 in 2006 and annually indexed to inflation. Workers only pay into Social Security up to $94,200; anything above $94,200 is not hit with Social Security tax. On the other hand, this entails that the maximum Social Security benefit anyone can receive is based on the cap. Most emerging affluent investors, who typically have higher wages, will receive a smaller portion of their retirement income from Social Security. Studies estimate that retirees in the top decile of retirement income attribute less than 10% of their income to Social Security. Factor in that workers will divert less than half of their Social Security taxes to private accounts, and the emerging affluent segment ends up with an even lower percentage of their retirement income attributable to private accountseven after higher asset accumulation potential is accounted for. Specific Impact Each emerging affluent segment has its own unique attributes that dictate how privatization affects them. The only groups that wont be affected by privatization are current and near retirees because they will continue to receive promised Social Security benefits under the present systems design.
EXHIBIT 27 PROS AND CONS OF PRIVATIZING SOCIAL SECURITY
Issue Individual Control Pros Clients will be able to accumulate a larger nest egg at retirement and learn the basics of investing. Cons The majority of Americans don't understand the fundamentals of investing. Tracking and administering The success of the Thrift Savings millions of small accounts is an Plan for federal employees shows arduous undertaking and that the government can implement increases administrative burden a streamlined tracking system. on the employer. Higher returns from investing in the Reduces guaranteed income market leads to higher retirement source. benefits.

Recordkeeping and Administration

Social Security Future Benefits

Source: Cerulli Associates

The business owners will be more impacted by how privatization affects their businesses than how it affects their personal retirement goals. Privatization will increase their administrative cost and burden, as they will likely assume some of the responsibility of data collection and account administration. How privatization affects business owners future retirement income, and thus their current savings, will be based on a variety of factors. If the business owner plans on using the sale of his business as the primary source of his retirement income, then Social Security may only supplement their retirement income, and they are unaffected by privatization. The same would be true for business owners who continue to receive income from their business during retirement. However, if the business did not generate sufficient
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income either before or during retirement and there were limited outside savings, then the emerging affluent business owner could be hurt by the loss of a guaranteed source of income. Privatization could affect the real estate wealthy segment of emerging affluent investors to varying degrees. For those who have their money tied up in a large residential estate, privatization means a loss of steady, supplemental income. For those who use real estate as an investment or rental income, privatization creates the potential to accumulate a larger market portfolio. Privatization could negatively affect the overspenders. This group needs structure and limits on how much they can spend. They are not equipped to control their spending, and they run the risk of quickly depleting their Social Security assets at the onset of retirement. During the accumulation phase, the privatized account may cannibalize other retirement savings. Overspenders may view privatized accounts as another another savings vehicle dedicated to retirement, and thus save less in traditional retirement accounts. This segment of emerging affluent investors needs advisors who can control their spending either through product selection or portfolio construction. The up-and-coming professionals will benefit most from privatization. With the help of their advisors, they will allocate the private account investment options to maximize their overall portfolio strategy. They also have time on their side, which allows them to accumulate a large nest egg. The inheritors fall into two camps that would be affected differently by privatization. For those who hope to create a legacy for future generations, privatization is a way to supplement their assets and leave a larger legacy. However, if an inheritor is an overspender who plans to spendor inadvertently squandersall of their inheritance, losing a source of secured income is a detriment for them. Advisors to this group of inheritors would need to find alternative products that provide a steady, predictable, and untouchable stream of income Privatization could affect the suddenly wealthy in any number of ways. Age, assets previously amassed, prior level of income, and future spending needs will all dictate how privatization would affect this cohort. For this group, the role of an advisor is especially important, and the effect that privatization has on them will be determined by the financial advisor. Privatization will affect each group of emerging affluent in different ways. Although private accounts represent only a small percentage of their retirement income, it creates a degree of future income uncertainty and raises questions on its impact on the overall portfolio strategy. Thus, privatization opens the door to discussion with financial advisors to ensure that retirement savings and spending goals will be met, whether or not Social Security is privatized. Real Estate Bust The real estate boom is a hot topic for the media and for many individuals looking to buy their first home. For the past several years, home prices have continued to rise overall and soar in urban areas such as New York, Boston, and San Francisco. Some individuals bought their homes cheaply, and have stayed there because it is their home and they have no desire to sellthey are comfortable there or may want to keep the house in the family. Other individuals viewed this real estate boom as an opportunity to

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make quick profits by flipping property. However, the boom appears to be slowing downthe market in many metropolitan areas is showing signs of softening. One cause: between five and seven years ago, there were many individuals who bought propertythey could get a mortgage cheap because of the low interest rates, and they believed that real estate was going to continue to appreciate and they could sell it at a higher price in a couple of years. Many of these individuals took out large mortgages on their homes, many a five- or seven-year adjustable rate mortgage (ARM) that may have been interest-only. Some of these individuals may have gone even further and proceeded to take out home-equity loans on this propertywith some additional renovations like hardwood floors, stainless steel appliances, and a granite countertop so that they could sell the property for an even higher price. Now, these individuals have to pay more than just interest-only, and they are struggling. Refinancing is not an option as rates have risennot dramatically, but enough to exclude refinancing as an avenue to pursue. Thus, between the individuals or developers who bought property to flip and are now selling and those individuals who must sell because they cannot pay their mortgage, the market is beginning to be flooded with property. Basic economics tell us when supply exceeds demand, prices must fall. For many individuals in the lower wealth tiers, their homes account for the majority of their assets. Though the situation in the emerging affluent segment is not as extreme, on average 27.8% of emerging affluent investors assets are accounted for by their homes. There are some individuals, particularly those who fall in the Real Estate Wealthy segment, whose homes account for a much greater percentage of their total assets. As home values drop, some of these individuals who are included in the emerging affluent market simply because of their valuable homes may no longer fall into this category, which will reduce the potential opportunity for advisors and firms. For some, the short-term sale of their home may allow them to remain in the emerging affluent. However, for some who are going to wait it out, there is a good chance that some of them will fall into a lower wealth tier. Repeal of Capital Gains Taxes Legislation passed in 2003the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) lowered capital gains tax rates, in addition to affecting the taxation of both dividends and estates. Prior to JGTRRA, capital gains were subject to tax rates ranging from 8% to 20%, depending upon the type and term of the capital gain. Under JGTRRA, the tax rates of capital gains for 2003 through 2007 would drop to a range of between 5% and 15%, and, for 2008, to a range of 0% to 15%. Under several provisions of President Bushs proposed 2006 budget, the capital gains being taxed at a range of 0% to 15% would not expire at year-end 2008, but instead would be extended indefinitely. For emerging affluent investors who have an average of $954,468 tied up in brokerage accounts and $907,955 in real estate, the reductionand occasional nullificationof capital gains tax rates could have a rather large impact on their ability and willingness to increase their invested assets. Because of the currently temporary nature of these tax rate reductions, many individual investors and businesses have been hesitant to make decisions that are more long-term in nature. However, a permanent imple-

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mentation of these capital gains rate reductions will spur more immediate investment as well as future ongoing investment in capital goods. If these rate changes become permanent, we believe the opportunities presented by the emerging affluent market for advisors and firms will increase in two manners. First, investors will need some assistance sorting out the implications of the change in tax policy. Second, these investors will also have more disposable assets, because those assets are not being paid in taxes, which could lead to more investment opportunitiesthat can be implemented via a firm or facilitated by an advisor. Estate, Gift, and Income Taxes Much has been made in recent years regarding the federal estate tax, as exemption amounts continue to rise and tax rates continue to decline through 2010 when there is a permanent repeal of the estate tax. For investors falling into the emerging affluent wealth tier, who have net worth totaling between $1 million and $25 million, the estate tax is potentially an issue with which they and their advisors need to be concerned. However, as of 2003 when the exempt amount was $1 million, only 1% of all decedent estates required the payment of any amount of federal estate tax. Granted, assets currently held by estates should appreciate in future years before they are transferred, but the appreciation will not necessarily exceed the increase in the federal estate tax exemption amount, which increases to $3.5 million in 2009 just before its impending repeal in 2010. Thus, the number of decedent estates and amount of assets subject to the tax, which is assessed at a lower rate in totality, will lead to less of a concern about the federal estate tax being levied on the emerging affluent investors estates. Of course, when we need to worry less about one form of taxation, there must be other forms that are there to fill the void and to which our attention must be turned. These other forms are state-level estate taxes and federal- and state-level income taxes. In a nutshell, though attention still needs to be paid to the federal-level estate tax for some emerging affluent clients estates, most often the concern now needs to be focused on the state-level estate tax and income taxesa new perspective needs to be taken on an old problem. In the past, most states estate tax rates were significantly lower than federal rates, and most states took advantage of the state death tax credit. Under this regime, the state would take the maximum amount that would be deducted directly from the federal tax total so that decedents estates did not have to pay anything above and beyond the amount paid to the federal governmentthe amount paid was simply divided between the state and federal governments without hassling the decedents estate. However, the state death tax credit has been reduced in the past several years and was completely repealed in 2005. Consequently, states are not getting paid anything directly from the federal government, and many are looking to fill this revenue gap by imposing state-level estate taxes at higher rates than they currently are imposingif they are imposing any at all. One way around the imposition of the state-level estate tax could be to gift assets, as very few states have a gift tax. However, most states that are looking to impose a state-level estate tax will most likely see the lack of gift tax as a loophole and close that by imposing both an estate and gift tax. An additional consideration if these state-level taxes are imposed: if part of a

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decedent estates assets are in another state in which the decedent does not reside, the tax regime of that other state will come into play as well. On the income tax side of the equation, when estate taxes, at least at the federal level, become less of a concern, income taxes become a greater one. Income taxes have always been around. But, when less time needs to be taken worrying about shielding assets from the estate tax, more attention can be paid to ensuring that the maximum amount of income taxes are avoided. Advisors can take the time to ensure that income is allocated to beneficiaries who fall into lower income tax bracketsmost likely beneficiaries who fall in the wealth tiers below the emerging affluent. Additionally, there is less of a concern about asset values from an estate tax perspective and more of a concern with regard to paying income taxesespecially capital gains taxes. In the past, a focus has been on discounting the transferred assets value in order to reduce the value of the estate. However, now the focus in some instances is on increasing the transferred assets value in order to reduce the amount of taxes that must be paid upon the sale of that asset. Because investors who fall into the emerging affluent category are on the line of total estate assets exceeding those exempt under the federal estate tax, some of these tricky tax maneuvers may be in order. Thus, those emerging affluent investors who know enough to be concerned about federal- and estatelevel estate, gift, and income taxes will most likely seek out the assistance of an advisor to help them navigate through these issues. Therefore, the continued confusion brought about by the current and potential future tax issues could lead to the emerging affluent presenting an increased opportunityespecially for those advisors who have strong tax planning skills. As mentioned previously, these four noteworthy issues that may impact the opportunity presented by the emerging affluent are not unique to this investor group. However, they are relatively more influential in this group and could expand or contract the opportunity presented by this market for different advisors and firmsdepending upon their forte. Therefore, they are issues that should be considered when determining if and how to service the emerging affluent market. Taking the different investor segments and these issues into consideration, we now turn to our next chapter in which we discuss the different service models which can be employed to service the emerging affluent.

Key Implications
Employ segmentation of the client base as a top-down initiative. Decide what factors should be considered in your methodology, then decide whether they should be considered separately or together. Assess macro factors that may affect segmentation, and revisit the methodology yearly.

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