Managing Your Personal Liabilities: A Goals-Based Approach GWIM CIO Office • SUMMER 2016

A thoughtful approach to managing debt can be an integral part of a sound wealth management strategy. For many families, holding debt is a fundamental part of financial life — with aggregate household debt in the U.S. exceeding $12 trillion (see Figure 1). Though debt is used widely, professional guidance on how best to manage it is scarce. To help fill this void, this paper presents ideas for managing your debt in the context of Merrill Lynch’s disciplined Goals-Based Wealth Management (GBWM) approach to pursuing your financial goals. MANAGING PERSONAL LIABILITIES THROUGH THE LENS OF THE GOAL-BASED WEALTH MANAGEMENT PROCESS

Figure 1: Household Debt Balances $9

CHIEF INVESTMENT OFFICE

To help you manage your wealth and pursue your financial goals, Merrill Lynch has developed a 3-step Goals-Based Wealth Management (GBWM) process, which includes:

$8.4

SPRING 2016

$8 $7 $6 Trillions

1. Understanding Your Life 2. Your Financial Strategy 3. Staying on Track

Nevenka Vrdoljak, Director David Laster, Managing Director Anil Suri, Managing Director

$5 $4 $3

This paper examines how applying GBWM to managing debt can help you pursue your financial goals such as: funding unexpected expenses, creating liquidity, stabilizing your cash flows and building wealth. Through case studies, the paper illustrates the GBWM process and potential impact of credit.

$2

$1.3

$1.1

$1

$0.7

$0.5

Credit cards

HELOCs

$0 Mortgages

Student loans

Auto loans

Source: Federal Reserve, Quarterly Report on Household Debt and Credit, August 2016

Goals Categorized Assets

Portfolio Strategy

Understanding your life

Your financial strategy

Staying on track

Learn about your priorities, investment personality and resources.

Defining and prioritizing your goals, including how much risk you’re willing to assume, will help your advisor recommend an appropriate financial strategy and can help you feel confident that the recommendation is aligned with what you want to achieve.

As your life and the markets change, your advisor can help you track progress toward reaching your goals and revisit your financial strategy.

Merrill Lynch makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”), a registered broker-dealer and member SIPC, and other subsidiaries of Bank of America Corporation (“BofA Corp”). Investment products offered through MLPF&S and insurance and annuity products offered through Merrill Lynch Life Agency Inc.: Are Not FDIC Insured

Are Not Bank Guaranteed

May Lose Value

Are Not Deposits

Are Not Insured by Any Federal Government Agency

Are Not a Condition to Any Banking Service or Activity

Merrill Lynch Life Agency Inc. (MLLA) is a licensed insurance agency and a wholly owned subsidiary of BofA Corp. © 2016 Bank of America Corporation. All rights reserved.

1. Understanding Your Life Through focus group research, Merrill Lynch has identified seven life priorities that capture the key concerns and opportunities for clients (Figure 2). Debt can help you achieve a range of your life priorities, such as funding education, expanding a business or making a significant purchase.

Family Family Family Family Family

Family

Your Financial Advisor can help you evaluate your financial strategy, which can include the use of debt to help you achieve your broader financial goals. What is an acceptable level of debt?

Figure 2: Your Life Priorities

Family

Managing your personal liabilities helps assure that liquidity will be available if and when you need it. This will enable you to stay focused on your long-term goals.

Giving

Giving Giving Giving Giving Giving

Giving

A variety of lending metrics can help you determine whether your overall debt level is appropriate. Here are two commonly used measures:1 I. Debt-to-Income (DI) ratio, the ratio of debt payments to total income, is calculated by lenders to determine whether a potential borrower can bear additional debt.

Health Health

Leisure

Health

Finances

Leisure Leisure Leisure Leisure Leisure

Finances Finances Finances Finances Finances Finances

Leisure

Home

Work

Work Work

Home Home Home Home Home

Home

Source: Merrill Lynch Wealth Management

2. Your Financial Strategy In developing your financial strategy, clearly defining and structuring your goals is an important first step. Articulating your goals enables you and your financial advisor to plan ahead, helping to ensure that your cash flow needs are met as you work towards achieving financial goals. Used judiciously, credit can help you:

Annual mortgage payments+annual student loan payments+annual credit card payments DI= Annual mortgage payments+annual student loanIncome payments+annual credit card payments Gross Family DI= Gross Family Income

Lenders generally consider a result less than 36% indicative of an acceptable level of risk, for homeowners.2 Consider Sue and Jack, two working professionals with a monthly mortgage payment of $2,000 (annual payment of $24,000), annual student loan payment of $6,000, annual credit card payments totaling $5,500, and a gross family income of $125,000. This would give them a Debt-to-Income ratio (DI) of 28.4% (= $35,500÷$125,000). Based on the benchmark of 36%, Sue and Jack appear to be carrying an acceptable amount of debt. II. Debt ratio (DR) is total liabilities divided by total assets.

Outstanding mortgage+outstanding student loans+outstanding credit card debt DR= Outstanding mortgage+outstanding student loans+outstanding credit card debt Property value+Financial assets DR= Property value+Financial assets

• Fund unexpected expenses without having to liquidate assets • Stabilize your cash flows • Minimize the tax consequences of asset sales • Build wealth and potentially meet financial goals • Pursue passions and interests The importance of liquidity Maintaining liquidity — the ability to obtain cash on demand — is a key element of sound wealth management. Liquidity can be realized by: • holding cash • liquidating assets

Lenders generally consider a result less than 40% an acceptable level of debt, but they will also weigh other factors, such as your income, time horizons and the cost of servicing your debt.3 A high DR may be acceptable to a lender, if you make adjustments (e.g., forgoing a purchase or selling an asset to raise cash) and can meet the loan payments. In our example, Sue and Jack have an outstanding mortgage of $175,000 and other debt including car and student loans totaling $50,000. The value of their house is $400,000, and they have financial assets of $75,000. This gives them a DR of 47% (= $225,000÷$475,000). Based on the benchmark of 40%, Sue and Jack appear to be carrying a higher level of debt than advised. They should aim to pay down their debt.

• borrowing A variety of additional metrics can be considered. For further discussion, refer to Shawn Brayman, “Introducing the ‘Debt Policy Statement.’” Journal of Financial Planning, Vol. 24, No. 4, April 2011. 2 Source: Consumer Financial Protection Bureau, “Your Money, Your Goals.” May 2014. 3 Source: Shawn Brayman, “Introducing the ‘Debt Policy Statement.’” Journal of Financial Planning, April 2011. 1

Managing Your Personal Liabilities: A Goals-Based Approach

2

Figure 3: Lending rates can vary widely 25.24%

25% 20% 15% 10% 5% 0%

9.33%

8.875% 4.76%

4.43% 4.75% 2.78% Securities-Based Lending

Margin

3.48% Mortgages-30 Year Fixed Rate

12.24%

5.99%

4.2% Home Equity Line of Credit

Personal Loans

Credit Cards

Note: Rates as of 08/02/2016. Margin is not appropriate for all investors.* * Borrowing on margin and using securities as collateral involve certain risks. When considering a margin loan, you should take into account your individual requirements, portfolio composition and risk tolerance, as well as capital gains taxes, portfolio performance expectations and investment time horizon. Source: Mortgages, HELOC and credit cards - Bankrate; Margin and Securities-Based Lending Merrill Lynch; Personal loans — LendingClub

What type of debt? There are many types of debt, including unsecured lending (e.g., credit cards), deferred debt, overdraft arrangements, securitiesbased lending, home equity lines of credit (HELOC), mortgages and customized lending solutions. In deciding which mortgages and customized lending solutions. In deciding which type of debt to use, borrowers should also consider the loan features available to them. In evaluating your loan options, we recommend that you work closely with your Financial Advisor to find ways to gain efficiencies among the various types of debt available. • Rate differences: Mortgages and HELOCs often have lower interest rates than unsecured personal loans and credit cards, whose rates can vary dramatically (Figure 3). Home mortgages are the most commonly used form of debt. Mortgages are typically either fixed- or adjustable-rate, though other varieties exist. A fixed-rate mortgage offers borrowers the comfort of knowing their payments will not change during the life of the loan. It may therefore be more appropriate than an adjustable-rate mortgage if you plan to live in your home for a long time or if you believe rates are likely to rise. An adjustable-rate mortgage may be more appropriate for borrowers who expect rates to hold steady or decline, because in these environments the rates on adjustable-rate mortgages are generally lower than those on fixed-rate loans. An adjustable-rate loan may also

Managing Your Personal Liabilities: A Goals-Based Approach

be preferred if it has a lower starting rate and, over the expected life of the loan, the amount paid on that loan is less than what would be paid on a fixed-rate loan. • Secured or unsecured: Borrowers may use assets, such as securities, as collateral for a loan. Secured strategies are generally used for larger purchases or expenses, whereas unsecured strategies may be more appropriate for meeting smaller or shorter-term liquidity needs. • Amortizing or balloon: An amortizing loan requires periodic payments. A balloon loan offers flexibility because principal is due at the end of the term. • Fixed or revolving: You can access credit for a fixed term or on an ongoing, revolving basis. Rates may change periodically or be fixed for a certain duration. • Flexibility: There may be limitations on using a credit facility, such as on the number of times a line of credit may be accessed. • Tenor: You should consider the tenor of the loan in relation to its purpose. If you intend to keep your house for seven years you want to consider a loan with seven years. If the loan is for various needs as they arise, then a variable-rate loan may be preferable. Other factors to consider include: tax consequences (i.e., capital gains if sold), debt-servicing costs, transaction costs, appreciation potential of your assets and your ability to rebuild the portfolio if sold. Try, where possible, to consolidate assets. Besides simplifying your finances, it may help you achieve a lower rate. There are often several credit solutions available that can help you achieve a goal. For example, instead of taking out an auto loan to purchase a car, you might instead draw down on a HELOC or securities based loan. Choose the credit solution whose terms best meet your needs. Risk considerations It is important to consider possible adverse personal scenarios when using credit. Few people think about worst-case scenarios when they use their credit cards or take a sizable mortgage loan. Paying off debt could prove difficult if interest rates increase or you lose your job. Conversely, a line of credit can be a big help in the event of a major unexpected one-time expense. Adding debt to a balanced portfolio may boost its returns in favorable market scenarios, but it may also reduce them when markets fare poorly.

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CASE STUDIES The following case studies illustrate how debt can be used strategically. Case Study 1: Consolidating debt Understanding Sue’s Life Sue, a 55-year-old investor, has $800,000 invested at Merrill Lynch, primarily in mutual funds and separately managed accounts. During a discussion with her Financial Advisor, she mentions that she has several outstanding loans, at various interest rates, whose balances total $80,000 (Table). She intends to pay off this debt before retiring. Sue’s current debt holdings Amount

Interest rate

Term

Credit card

$20,000

14.0%

variable

Car loan

$50,000

4.0%

5 years

Personal loan

$10,000

8.0%

20 years

TOTAL DEBT

$80,000

7.0% weighted average

Sue’s Financial Strategy When discussing Sue’s financial situation, her Financial Advisor highlights a few possible ways that she might manage these loans. One approach would be to sell $80,000 of investments to pay off the debt. Doing so, however, would require Sue to pay substantial capital gains taxes. Another option would be for Sue to refinance the car and student loans and transfer the credit balance to a card with a lower interest rate. This would lower her monthly payments, which is a step in the right direction. Her Financial Advisor suggests a securities-based loan (SBL) as a third possibility. An SBL is a line of credit secured by marketable securities or similar investments. The interest rate on Sue’s SBL would be 4%, making it a cost-effective lending solution that can provide immediate funds to pay off all of her debt. The SBL would reduce her interest costs and, by consolidating her debt, would simplify her finances. Sue should verify that no prepayment charges exist on her current debt obligations. As long as she has sufficient available credit, Sue would not have any required monthly payments. That said, she plans to reduce her debt. Sue will be receiving additional income from a consulting engagement starting next month, and will dedicate some of that income to paying off the SBL. By moving some of her outstanding debt to a lower interest rate and retiring higher-interest debt, Sue can strengthen her personal assets. Also, by not selling financial assets to pay down her debt, she does not disrupt her investment strategy and does not experience an adverse tax event. But, as Sue’s Financial Advisor explains, an SBL involves borrowing against securities, which entails special risks. Sue needs to maintain sufficient securities to support the debt. If, for example, the pledged securities decrease in value, Sue may be required to deposit more securities or cash into her account. Sue’s proposed debt holdings Securities-based loan

$80,000 loan on a line of credit

Staying on Track Sue meets regularly with her Financial Advisor to review progress toward goals. In addition, she schedules a review following a material change in her personal situation or goals or a significant market move. Case Study 2: Buying an investment property Understanding John’s Life John is an experienced 50-year-old investor with a total net worth of $4 million, including a home valued at $1.3 million, which he owns outright. His long-term financial goal is to own investment real estate, but his short-term goal is to capitalize on low property values and interest rates. Knowing that a good deal often becomes even better with ready cash in hand, John wants to be prepared to purchase real estate upon finding an attractive opportunity. After evaluating available properties for the past year, John finds a rental property for $850,000.

Managing Your Personal Liabilities: A Goals-Based Approach

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John’s Financial Strategy At the suggestion of his Financial Advisor, John establishes a Home Equity Line of Credit (HELOC) when he starts looking into potential real estate investments. A HELOC, or simply “home equity line,” is a loan for a predetermined amount on which he may draw as needed. This form of lending may not be used to purchase, carry or trade securities or to repay debt incurred for those purposes. Making an all-cash offer gives him an advantage over other prospective buyers whose bids are contingent on financing. Once the purchase is final, John can seek longer-term financing through a traditional mortgage loan, freeing up his borrowing power to use for the next attractive deal he finds. John expects interest rates to increase in the near term and also anticipates holding the property for some time. He therefore plans to take out a fixed-rate mortgage. John expects to use the rental income from the property to repay the mortgage within seven years. This example illustrates a highly effective credit strategy: using readily available short-term credit to secure an asset quickly, and then replacing it with a longer-term credit facility that better aligns with the long-term structure of the asset. John’s debt management strategy helps him secure an aspirational asset that positions him to accumulate significant wealth.

Case Study 3: Purchase and renovate a hotel Understanding Bob and Linda’s Situation Bob and Linda, an ultra-high net worth couple, seek to invest in real estate to diversify their wealth and create a business that provides a legacy for their children. The couple needs $15 million to buy and remodel a flagship hotel in the Southeast. After initially exploring a commercial mortgage-backed securitization, Bob and Linda discuss this opportunity with their Financial Advisor. She suggests there may be a better way to finance the investment and introduces the couple to a Bank of America Credit Specialist, who customizes a solution to meet their goals. Bob and Linda’s Financial Strategy The challenge that Bob and Linda face is to finance the purchase and year-long renovations, during which the property will not be generating income. After analyzing Bob and Linda’s diversified their balance sheet and stable, recurring cash flows, the Credit Specialist suggests a loan with the flexibility to account for the renovation timeline and then establish permanent financing. Unlike other types of commerical real estate financing, this would entail pledging not only the hotel but also a portion of the couple’s marketable securities to allow for more flexible loan terms. Bob and Linda are offered a customized 5-year, $15 million Structured Lending Investor Commercial Real Estate Term Loan with a combination of the commercial real estate and marketable securities as collateral and competitive pricing. The loan is interest-only during the first year, allowing the clients flexibility while the hotel is undergoing renovation. This allows Bob and Linda to purchase and renovate the hotel without disturbing their other investments. The couple decides that this customized solution provides a flexible and cost-effective alternative to other forms of commerical real estate financing that better meets their needs. Bob and Linda’s proposed debt holdings Structured Lending

$15 million, 5-year term loan, to be renewed upon review

The case studies presented are hypothetical and do not reflect a specific strategy we may have developed for an actual client. They are for illustrative purposes only and intended to demonstrate the brokerage products and services available at Merrill Lynch and banking products and services available at Bank of America. They are not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Results will vary, and no suggestion is made about how any specific solution or strategy performed in reality.

Case studies are intended to illustrate brokerage products and services available at Merrill Lynch and banking products and services available at Bank of America. You should not consider these as an endorsement of Merrill Lynch as an investment adviser or as a testimonial about a client’s experiences with us as an investment adviser. Case Studies do not necessarily represent the experiences of other clients, nor do they indicate future performance. Investment results may vary. The investment strategies discussed are not appropriate for every investor and should be considered given a person’s investment objectives, financial situation and particular needs. Clients should review with their Merrill Lynch Financial Advisor the terms, conditions and risks involved with specific products and services. Managing Your Personal Liabilities: A Goals-Based Approach

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Consider, for example, a balanced portfolio. From 1990 to 2015, the use of leverage would have boosted the average returns of the portfolio but also its range of returns (Figure 4). Over this period, the annual returns the portfolio ranged from a high of 29.2% to a low of -20.5%. If this portfolio had 30% leverage, this range of returns would have spanned wider, from 36.2% to -27.2%. When considering the use of leverage to enhance investment returns, you also should weigh the additional risk as well as transaction costs (such as origination fees).

Good market scenario Average return Bad market scenario

40%

Portfolio return

30%

36.2%

29.2%

20% 10% 0% -10% -20%

-20.5%

-30% -40%

In the final step of the Goals-Based Wealth Management approach, you and your Financial Advisor should regularly review debt obligations, potential future needs, and the type of credit structures you have supporting them. Your debt strategy may need to adapt to changing circumstances in your life or if there are significant market moves.

CONCLUSION Many associate debt with excessive risk and therefore avoid it. But the prudent use of debt can help you achieve your financial goals. Sound debt management can help you manage ongoing liquidity, fund unexpected expenses and limit the tax consequences of asset sales while building wealth. Using the Goals-Based Wealth Management process, your Financial Advisor can help you evaluate your options and understand how the decisions you make regarding your liabilities can enhance your ability to pursue your broader financial objectives.

Figure 4: Leverage and portfolio returns, 1990 – 2015 50%

3. Staying on Track

-27.2%

0%

10%

20%

30%

40%

50%

Leverage Good market scenario Average return Bad market scenario

0% 29.2% 8.9% -20.5%

10% 31.5% 9.5% -22.7%

20% 33.9% 10.1% -25.0%

30% 36.2% 10.7% -27.2%

40% 38.6% 11.3% -29.4%

50% 41.0% 11.9% -31.6%

Note: For a balanced portfolio allocated 60% to U.S. stocks (proxied by the S&P 500), 35% to bonds (proxied by the Bank of America Merrill Lynch U.S. Broad Market Index) and 5% to cash (U.S. Ibbotson 30-day T-Bill Index). Referring to historical data for the period 1990 to 2015, the bad market scenario represents the lowest annual return of the balanced portfolio (2008) and the good market scenario represents its highest annual return over this period (1995). Past performance is not indicative of future performance. Hypothetical Illustration. Source: Calculations by Merrill Lynch Wealth Management

Managing Your Personal Liabilities: A Goals-Based Approach

REFERENCES Shawn Brayman, “Introducing the ‘Debt Policy Statement.’” Journal of Financial Planning, Vol. 24, No. 4, April 2011. Consumer Financial Protection Bureau, “Your Money, Your Goals.” May 2014. Federal Reserve, Survey of Consumer Finances, 2013. Merrill Lynch Credit & Lending, “Liability Management Strategies for Any Rate Environment.” November 2013. Merrill Lynch Credit & Lending, “Help Clients Restructure Debt and Meet Cash Flow Needs.” December 2013.

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Nevenka Vrdoljak, Director, Retirement Strategies, holds analytical responsibilities in the areas of asset allocation and retirement investing. Nevenka developed Merrill Lynch Wealth Management’s target date asset allocation approach for institutional plan sponsors. Her research has been published in the Journal of Wealth Management and Journal of Retirement. Previously, Nevenka held analytical roles at Goldman Sachs Asset Management (London) and Deutsche Bank Asset Management (Sydney) in the fixed income, currency and derivatives areas. She holds a bachelor’s and master’s in economics with honors from the University of New South Wales (Sydney). She was awarded an Australian Commonwealth Scholarship where she completed advanced studies in econometrics at Georgetown University. Nevenka graduated from Columbia University with a master’s in mathematics of finance. David Laster, Managing Director, Head of Retirement Strategies, is responsible for developing analytical solutions and thought leadership in the area of retirement investing. His research has appeared in the Financial Analysts Journal, Journal of Investing and Journal of Wealth Management and has been discussed in The Wall Street Journal, Financial Times and Fortune. Before joining Merrill Lynch, David was an economist at Swiss Re and at the Federal Reserve Bank of New York. He also taught at Columbia Business School and NYU Stern School of Business. In 2013, David conceived of, and helped Institutional Investor Journals launch, The Journal of Retirement, a new quarterly journal sponsored by Bank of America Merrill Lynch. David earned a Ph.D. in economics from Columbia University and a B.A. in mathematics from Yale University. He is a CFA® charterholder.

Anil Suri, Managing Director, Head of Innovation Development and Portfolio Analytics, leads the development of frameworks and solutions for portfolio construction and management, retirement investing, Goals-Based Wealth Management, asset allocation, and performance measurement across traditional, market-linked and alternative investments. Anil has been with Merrill Lynch since 2004, where he previously led investment strategy development and analytics in the Alternative Investments area and was a Senior Investment Strategist on the Merrill Lynch Research Investment Committee (RIC). Anil’s research has been published in the Journal of Wealth Management and discussed in Barron’s and The Wall Street Journal. His prior experience includes roles as a senior AI strategist at Citigroup, trader at Credit Suisse and management consultant at McKinsey. Anil earned an M.B.A. with honors from the Wharton School of the University of Pennsylvania, an M.S.E. from Princeton University and a B. Tech. from the Indian Institute of Technology at Delhi.

CFA® - and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. Managing Your Personal Liabilities: A Goals-Based Approach

7

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