April 8, 2002

RE: James Smith et al versus Bob and Sue Johnson, Ellen Johnson.

Dear Ms. Johnson,

Pursuant to your request, I have been requested to review the activities of James Smith CFP (Smith) regarding potentially unsuitable investments and insurance products that he sold both to you and your parents. I have received extensive material from you and previous advisers and attorneys in reference to all types of life insurance policies, annuities, mutual fund investments, IRA's, budget and more. I have received extensive copies of correspondence from Smith to you and your parents. I have talked personally to many insurance company representatives regarding said accounts and have attempted to reconstruct the activity of Mr. Smith given the financial situation of your parents commencing in 1990 when they engaged Mr. Smith, to your father's death in May 1999 and then currently. I also reviewed the insurance sales to you and your mother commencing in late 1998 since it directly impacts the budget and remaining assets of your mother.

It is my opinion that Smith engaged in activities that dismissed the basic planning criteria and were primarily designed for the personal revenue from commissions. In fact, Mrs. Johnson never had sufficient assets to pay for the life insurance policies he increased for her- a fact that was easily ascertained even by a novice over the years of client review- certainly by a planner involved in all aspects of a clients life.

I would first like to put my comments into perspective and, in order to do so, it is necessary to review part of my background. Of particular relevance to acting as an expert in regards to broker/adviser knowledge is the fact that for about 15 years, I taught most of the securities licensing courses for the two major instructional firms in the United States- Dearborn and Securities Training Corp (STC). Such licensing training included the series 4, 6, 7, 8, 22, 24, 27, 52, 63 and more. As may be evident by the time period I offered these courses, I had an exceptional pass rate. But it must be noted that the material presented was solely focused on passing the exam- not in providing the fundamentals of investing because they are not tested. And if they are not tested, they are not taught. As mentioned in literally all sections, such issues include diversification, alpha, beta, standard deviation, correlation and more. Those are not just idle comments/criticisms. I have also taught investments and financial planning for universities and authored the only course on Securities Application, "Practical Investment Theory and Application" accepted for continuing education by the California State Bar. I have taught investing, real estate and financial planning courses for the University of California (subjects required to become a CFP) and have specifically focused on the real life practical applications of such fundamentals. My web site contains numerous articles I authored on investing, planning, real estate, ethics, insurance (and all other planning issues) with extensive linking to other professional sites on the subjects. I have acted as an arbitrator and continue to provide expert testimony on all financial subjects.

As a more specific reference to this situation is the review of the insurance, annuities, applications therewith and the taxation of same. My background in this area includes being one of the approximately 40 Life and Disability Insurance Analysts in California. Additionally, I have taught insurance continuing education courses for over 6 years encompassing life insurance, annuities, taxation, estate planning, ethics, pension planning, disability insurance, financial planning, retirement planning and more. I have written extensively in the field. In short, the combined education, licenses and other background easily furnishes the ability to analyze the 10 year+ period of activity for the above complaint.

Admittedly, the statute of limitations does not extend back 10 years for potential violations - but the time frame is necessary to reconstruct the (supposed) financial planning process by Smith from inception and determine whatever viability there is of the initial strategies, viability of any changes and then analyze the implications of such towards the budget, income, assets, taxes, estate planning, etc.

Smith Planning for Sue (age 65) and Bob (age 75) in 1990

Smith completed a financial plan dated 4/11/90 (though the date at the top of this Market Value of Assets is dated 5/31/90.) The total net worth was $5,168,000. There are several issues to address. On page 5 of said plan, under "Assets", the Fixed Investments included several IRA's for each. Sue's amount is either $115,600 as per page 5 or 117,400 on note 4, page 6. They consisted of money market funds and treasury notes. Bob's IRA's totaled $555,100 on page 5 or $554,400 on note 5, page 6. In addition to the fixed elements of Bob's IRA, the net worth statement shows $249,100 on page 5 yet only $216,500 on note 7 on the following page. The inconsistencies are similar on all such notes. The only reason I can find for the discrepancies is that there is a date of 5/13/90 on the net worth statement, page 5 and a date of 4/11/90 page 6 where the notes are referenced. But referencing direct notes to a statement that contains other numbers not only is confusing, it also doesn't make sense. Nonetheless, assuming the date of 5/13/90 has some meaning, I will be referencing those numbers in this report.

Smith recommended changes in the allocation of monies. There may be debatable commentary as to whether the selections made were based on current economic conditions but I will dispense with any negative aspects of an opinion to that regard at this point. Irrespective of that however, on page 10, there was a completely illogical and expensive adjustments recommended by Smith. It references the change in IRA monies be put into a variable annuities with the use of mutual funds. The use of an annuity as a tax sheltered vehicle inside of an already tax sheltered vehicle is rarely viable. Further, there is no justification offered by Smith as the report mentions other that an annuity, "accumulates income tax free during the period of deferment". An IRA does that anyway without excess fees or surrender periods and penalties. An annuity may offer a 10% free out without penalty, but the (then) current investments in the IRA could be removed in any amount without penalty.; 2 "avoids probate." True, but beneficiaries are identified on IRA accounts as part of the contracts and bypass probate as well. and 3, "allows the owner to place funds into various investments within an annuity and to switch between funds such as a money market fund, a bond fund, stock growth fund and a government securities fund. This vehicle is similar to a mutual fund, except that all income and gains are tax deferred until withdrawal." The last issue seems like nothing more than an extraneous marketing tool that has no applicability since, if the mutual funds were within an IRA, the same tax scenario exists without the additional constraints of the annuity contract (fees, surrender penalties, limited number of funds available, etc.) And an IRA has almost an unlimited selection of funds from almost any fund family- it is not restricted by an annuity family. Nonetheless, Smith converted ALL of the fixed income of both accounts as well as the stock account of Bob by initiating several variable annuities including all of his IRA funds ($810,016) and also by changing all of Sue's IRA to another annuity of $115,904. That's a total of $925,920 into annuities that serve no valid tax purpose and complicates the planning process through the additional surrender penalties- all this for elderly individuals ages 70 and 65 respectively. The surrender penalties became an issue in later years as money had to be pulled out to pay increasing insurance premiums from a decreasing asset and income base.

Also noted that the IRA annuities were set up with the following allocation- 35% Fidelity Income; 30% Fidelity Growth; 15% Fidelity Overseas, 10% 20th Century and 10% Advisors growth. Recognize that 35% of this portfolio- over $310,000- was converted to income? The existing portfolio already had $184,400 in the Van Kempen Bond Fund and $248,1000 in fixed income securities such as Treasury instruments and FHLB bonds that had significant returns. If Smith's intent was to opt for 35% income allocation in the IRA, why was $310,905 changed to Fidelity Income when it already was income- most of it government and government type fixed income securities. And why was $184,400 of Van Kampen Government Bond fund sold in order to purchase a Fidelity Income fund? It is illogical. I can only surmise it was for commissions since it certainly does not appear to have any valid planning element.

The securities in Bob's IRA account consisted of $69,375 of General Electric; $58,500 of Pepsico Incorp; $102,000 of Philip Morris and $19,250 of Wilmington Tr Co DEL. I cannot address the sale of the specific individual securities since there is no information available of the risk, correlation, beta, standard deviation, etc., of each issue. And I cannot state that the additional allocations by Smith of a 30% Growth, 15% Overseas or 10% 20th Century and 10% Advisors Growth were inherently wrong given the economics of the 1990's. However the 50 year average annual return of the stock market was no greater than about 9.5% in 1990 and it also has a standard deviation of about 21%. The problem is that the income products sold had effectively NO standard deviation and consisted of $49, 453 in a GNMA due 5/92 earning 8.5%; $48,531 in FHLB due 5/93 earning 8.125%; $48, 844 in another FHLB due 4/94 earning 8.5% and $49,016 in a U.S. Treasury Note due 3/93 earning 8.25%. You had substantially guaranteed fixed returns with the highest credit rating and they were sold to go into variable positions with a probable 7% up front load and over a 1% annual fee that would be hard pressed to produce historic equity returns as much as what was currently being earned via pure fixed income products. Further, the Nationwide annuity has a 35% allocation equating to $269,815 of non guaranteed Fidelity Fund while the account currently held $195,664 of guaranteed government returns. Additionally, Smith was charging a 0.5% additional fee through the Insiders Circle (this will be addressed later). The bonds had no annual charge nor would require the additional 0.5% charge by Smith since they could simply mature. .

The same scenario existed for Mrs. Johnson though on a lesser scale due to the smaller IRA accumulation. She had $49,016 in a U.S. Treasury Note due 2/93 earning 8.25%. But the change to a Nationwide annuity where 35% of her $117, 400 annuity went into a of Fidelity Income- $41,090- is effectively the same as the guaranteed fixed income of the Treasury Note of $49,016. And the Fidelity Income fund is NOT guaranteed.

But as more annuities and funds were added, the use of numerous different funds all attempting to do the same thing leads one to conclude that the allocations were nothing more than a loose amalgamation of investments designed for sales and not as an proper plan.

For example, in addition to these IRA annuities, Smith utilized another company called Sunlife for yet another annuity of $250,000. The product was called Regatta and utilized a 35% Capital Appreciation and 65% Total Return. That then represents over $1,000,000 in similar mutual funds in two different annuities. Notice how an additional $87,500 is growth (Capital Appreciation) - the "same" as the Fidelity Growth. The Total Return fund ($162,500) also incorporates growth. Irrespective of that allocation, why did not Smith use the same company for this annuity- Nationwide? That said, why are either of the Nationwide annuities being used within an already tax sheltered IRA? While I give leeway for some "planning elements", I submit that the use of both these annuities is clearly inconsistent with acceptable practice and would appear either to be a gross error or an attempt to generate commissions.

The other planning adjustments are also suspect. The Johnson's had $776,900 in municipal bonds . They consisted of a joint ownership of 16 Municipal bonds earning 7.7% double tax free worth $502,339 and 3 Municipal bonds in Sue's individual account earning 7.6% worth $237,721 (based on notes of 5/31/90). Lastly, there was a Pep Boys subordinated debenture worth $22,000 earning 6% due in 2011. They were all sold outright. While growth is a legitimate investment for younger workers and certain retirees who may have no choice but to use growth in order to survive their actuarial lifetime, the Johnson's did not appear to be in that scenario. Further, they were ages 70 and 65- hardly the time for an aggressive strategy unless needed. Hindsight is always perfect, so one could claim that my position is limited in merit. But what is not limited is the fact that the municipals bonds were producing $56,746.89 annually double tax free. Considering the fact that interest rates were dropping, (1991 Treasury bills dropped to 6.4%; 1992 dropped to about 4%, etc), these were exceptional yields. The 1990 and later tax returns to 1998 were not available, but assuming a 40% federal and state combined tax rate, that equates to an approximate $95,000 (Pep Boys not included) taxable and a rounded 12.66% taxable yield. Though the securities market did exceptionally well later in the 90's, I think any planner would be hard pressed to even remotely consider an equity return in 1990 any greater than the historical level of less than 10% for the last 50 years. I cannot find justification for the sale of the Municipal bonds. There is more. Sue's individual account worth $48,607 consisted of the Delaware Solid Waste yielding 6.3%. I do not know if it was tax free but an inclined to believe so. This was also sold. I submit that such acceptable income positions were sold to generate the up front fees from the funds and/or annuities PLUS the 0.5% charge that Smith was instituting on top of that.

As regards the income element, I note Smith's comments on page 7 of the Financial Plan, dated 4/11/90, "Objectives- Increase after tax cash flow; provide sufficient cash flow for living expense and improve potential survivor income". As identified above, the municipal bonds were producing an excellent after tax return. Further, considering that the FED was already dropping rates, it would have been prudent to even purchase more such bonds to extend the tax free returns for a longer period. But certainly not to eliminate the high rates that already existed. I am not stating that growth, in and of itself, is bad since I use growth oriented funds for various clients. But there are absolute times when an income orientation is valid and this was such a situation. The existing tax free position was desirable and prudent.

There are further inconsistencies. As indicated above, $294,900 of individual stocks (non IRA) were sold. Smith then placed $100,000 in the Decatur II fund as a Growth and Income; $65,000 in the Delaware Fund as a Bond fund; $125,000 in the AIM Weingarten Growth Fund; $75,000 in Colonial Growth Shares as a Growth Fund; and $125,000 in the MASS Total Return Fund. As regards the Delaware Bond Fund, I repeat that the many Treasury instruments and municipal bonds were sold to do what? Put into a bond fund for a commission? But also note that the Decatur fund also contained an element of income. Taken further, the growth section of the Decatur Fund parallels the AIM Weingarten, Colonial Shares as well as MASS Total Return. These investments, absent some defining rationale, which was neither offered nor seems remotely sustainable, is illegal due to breakpoint sales. A breakpoint sale is, in simple terms, the commission charge on a mutual fund that decreases as you add more money. For example, a $90,000 in a fund might have a 7% charge (1990 rate). But if $100,000 was invested, the total commission charge drops to, say, 5%. That's a $5,000 charge versus a $7,000 charge. Additionally, if you use the same fund family, then the different funds are able to be added together to produce a lower commission overall. For example, the combination of the AIM constellation of $75,000 plus the AIM Weingarten Fund of $125,000 would add up to $200,000 and a possible smaller commission. But the use of different fund families provides no benefit- in fact, the commissions are increased. Note that $200,000 was put into the AIM funds; $200,000 into Colonial and $200,000 into MASS funds; $200,000 into Templeton Funds and $200,000 into the Decatur, Delaware and DelCap funds (all Delaware funds) have been purposely separated into sections that cause a much higher commission than that of a $1,000,000 into a singular fund family. The minimum commission on a $200,000 fund investment around 1990 was 6% or $12,000. With five separate fund families, that's a $60,000 commission. However, a singular investment in one fund family (not the same funds) might have been generated only a 2% overall commission for just $20,000. Smith received an additional (approximate) $40,000 of commission. In order for this allocation to have taken place, Smith was required to state the higher charges in writing to the Johnson's and have gotten a formal separate written release by them. No such notice was ever provided. The requirements stated above were taught as part of securities licensing preparation under the section for Breakpoint Sales.

These initial inconsistencies are so suspect that I believe it sets the tone for the subsequent actions that I will define further.

All the common stocks totaling $780,800 were all sold. The basis of the initial purchases was not identified and the tax ramifications upon the subsequent sale are therefore unknown. While it is normal practice for many (supposed) planners to simply sell out whatever positions exist irrespective (or in denial or negligence) of the taxes incurred, it generally represents poor and/or incompetent planning. It can simply overload an already excessive income tax. I cannot state the actual impact of these sales since the 1040 for that year is unavailable, but I submit that the lack of data in the report leans towards an element of either incomplete non disclosure and/or gross ineptness. The tax ramifications of any sale must be identified and incorporated in the client's current tax position. And there is no question that with $1,567,700 in outright sales (stocks plus bonds), there had to be some impact on current taxes. It is my statement that such planning incompetently dismissed an extremely important element of planning. I further submit that the needless utilization of two annuities inside an IRA clearly confirms the overall lack of objective services for the Johnson's. The fact that Johnson's signed off on receipt of the prospectuses in no way relieves Smith of his fiduciary duty to clearly inform the Johnson's of what was truly transpiring. Though I was not privy to Mr. Johnson's investment capability, I am clearly familiar with Mrs. Johnson. She doesn't have a clue to any of the fundamentals whatsoever and is solely trusting Smith for advice.

Estate Planning Issues:

But there is much more that corroborates such lack of correct planning. Smith does define the element of estate taxes starting on page 12. Proper planning was clearly viable to limit the supposed estate taxes that might be due. I say, "might" since the only indication of supposed need are separate numbers as identified under "Present and Future Value of the legacy of Mr. and Mrs. Bob Johnson" prepared by Smith. Smith utilized an actuarial lifetime of 15 years which is NOT acceptable since it is several years shy of the lifetime anticipated for Mrs. Johnson of approximately 19+ years (see Health and Human Resources Life Expectancy). Smith also used a total net worth at the time of presentation of $5,168,660. He then made up a table with certain with growth rates from 2.00% to 10% in half percent increments. At a 3% rate for 15 years (his number), the estate would be worth $8,052,510 and incur an estate tax (then current law) of $3,609,255 with estate percentages of 44.82%. At a return of 7%, the estate would be worth $14,263,330 and incur taxes of $6,713,165 at a 47.08% rate. The numbers are, in and of themselves, correct. The problem is that the assumptions are totally flawed.

The only way to determine a reasonable assumption of the assets that might be left is to offset the asset base by the amount that is being used annually as the budget. Simplistically, having $5,000,000 in assets and spending $1,000,000 a year means nothing will be left at all in far less than 19 years no matter what reasonable return is projected. At a 7% rate, the $5,000,000 would be depleted in about 6 years.

And when looking at the $5,000,000 depletion, it would represent ALL of the Johnson's assets (house, other real estate) - not just investments Smith controlled/suggested. If we take out assets that the Johnson's intended to leave for a legacy, the time frame is that much shorter. Lastly, if the assets are being used up, there is little need for an estate plan or the purchase of insurance since 1) there may not be an estate left to be taxed, and 2) any money used to pay for the insurance to cover the tax on whatever amount Smith indicates (or merely innumerates) simply reduces the asset base even faster. You cannot project an asset value to the future without identifying what depletion is required for ongoing living expenses, emergencies and other incidentals (long term care for example). I repeat- it is absolutely mandatory that the current expenses of the Johnson's be explored in order to have any reasonable opinion if anything at all will be left and when. And the only way to do any type of this analysis is to have the client do a formal budget. This becomes clearer still as the decade progresses.

Budget Example

Since I have taught this issue for years, an example for the Johnson's makes the case real life. If one has a budget of $250,000 a year, an actuarial lifetime of 19 years and expects a return matching inflation, the amount of assets required is $4,750,000. When you look at the asset base of the Johnson's back in the 1990, it appears that the $5,189,600, it appears adequate. But this number consists of non cash assets (homes) of $650,000 for a reduction to $4,500,000 (rounded)- assuming something is to be left to beneficiaries. Now the asset base is insufficient by over $600,000. But recognize that, except for the non cash assets, nothing would be left at the end of that period. Is that the scenario that was bound to happen; or would they run out of money beforehand; or would they have excess monies left? Unknown since, without an specific analysis of the Johnson's spending pattern, no one has a clue. Further, assume that the spending patterns actually drew down the assets to a minimal amount. As such, the validity of large insurance policies instituted by Smith and increased even higher may never have been viable. Even if the initial policies Smith suggested to an irrevocable trust were viable, the real life economic position of the Johnson's throughout the 1990's clearly shows that the asset base was NOT growing and was actually decreasing to the point where there was inadequate assets or income to pay for the increasing insurance premiums.

As reference to the change in the economic situation of the Johnson's, it is true that there was a large income from Mr. Johnson's liquor store of $350,000 annually. But the store was sold with no down payment in 1990 and providing a $10,000 monthly payment for 10 years (this was prior to Smith's planning). But that did not last due to poor new management and the income was cut about in half almost immediately and terminating in 2002. The detail on this income is as follows:

89 70,000

90 120,000

91 120,000

92 74,500

93 58,000

94 13,500

95 55,200

96 53,000

97 50,300

98 57,945

99 58,000

00 58,000

01 62,000

Certainly, as a planner, Smith had to be fully aware of the reductions and would have questioned such reduction- specifically addressing the low payment in 1994. You cannot plan for a future without considering what is happening in the present. It would unquestionably change the asset base for estate planning purposes and reduce the insurance necessary for estate taxes. Beyond what is obvious, it was necessary to conduct a annual budget to see if there was sufficient monies to carry them to their actuarial lifetimes since they may have been spending based on the initial $120,000 yearly. Significant adjustments may need to have been made. The Johnson's looked to Smith to provide the guidance. That's what he was getting paid to do. That was what they expected.

Additionally, Bob was a partner in a Benton Inn that netted an additional $50,000 per year. But that was also sold in 1990 resulting in just a $750 a month payment that culminated in 2001. Smith was aware of these changes indirectly if not directly since his firm was doing the Johnson's taxes till 1998.

Smith's report is completely oblivious to this issue of budgeting since nothing is stated with a numerical identity- or in any other fashion for that matter. By the clear lack of forms and data, it is obvious that Smith did no work at any time on this crucial issue. It is impossible to determine any economic or financial position in the future. This certainly includes the elements for estate planning. And since there is nothing that I found in subsequent years that indicates that anyone has done an appropriate income analysis, the asset retention problem gets worse. That certainly is not proper planning to begin with nor does it reflect the planning that the Johnson's had annually paid additional fees as a member of the Insider's Club. What did the Johnson's received for this cost? Financial planning that they contracted for? Just monitoring of the funds with no other involvement? Sales only? Smith indicates that he will handle everything but it is clear through the lack of subsequent reporting that no added effort was made to ascertain the economic situation of the Johnson's through the years. The asset base and income has decreased and the insurance premiums increased- to the point where there was/is not enough money to pay the escalating costs plus taxes and leave enough for the remaining actuarial lifetime of Mrs. Johnson. The resulting impact of this ineffectual, incompetent and/or non existent planning has been quite emotionally and financially devastating to Mrs. Johnson. Mrs. Johnson would have run out of money in the very near future had not her daughter intervened two years ago. But Smith was actually increasing the budget by increasing insurance premiums almost 100%. Further, the premiums had to come from an IRA account which is fully taxable and then to an irrevocable trust that incurs filing for gift taxes. Mrs. Johnson was taking out $300,000 to pay the $200,000+ of new premiums for a $5,000,000 policy on assets that did not equal that amount. That's not just financially illogical, it's egregiously wrong at every level of planning.

Growth Investing

Additionally, in a letter to the Johnson's dated August 23, 1990, Smith notes "we are investing for a five to seven year period of time. Yes!! We will experience ups and downs along the way. But our initial objective was for this money to perpetuate so as you progress you will be able to take monies from the accounts for cash flow, vacations and keep up with inflation. .........."Past history tells me that growth oriented investments are the place to be in order to provide the needed dollars for the future." There are a number of inconsistencies in these statements.

In respective order, a long term growth investment is well beyond 5 to 7 years. CFP training focuses on growth of about 10 years or more. Smith's statement that there will be ups and downs addresses a problem with distribution of assets on an ongoing basis. A 5 year period is not long enough under literally any teachings to focus on growth with an acceptable smoothing of standard deviation. But Smith sold effectively everything- including the municipal bonds- and proceeded to increase the risk of an elderly couple far beyond necessary. Because of these inconsistencies, one is NOT able to take out a projected return that covers for cash flow, vacations and keep up with inflation (though what required return that is, is undefined by Smith). Analysts such as Bernstein suggest that the maximum amount that can be taken out consistently is only about 4% since a major down market would drop the asset base too low to last for a standard actuarial lifetime. So how does one interpret/justify/analyze Smith's comments, "....... you will be able to take monies from the accounts for cash flow, vacations and keep up with inflation"? It cannot be justified. You cannot say that monies can be taken out unless it is numerically justified by computations incorporating inflation, rates of investment returns, actuarial lifetimes and more. Just making a verbal statement to the effect that funds are sufficient without corroboration provides clients what will probably be an unreasonable expectation that they can spend at almost any level for the rest of their lives. That is wrong. It is absolutely mandatory that a budget for the Johnson's be established at the inception of planning to determine what risk need be taken to provide the income for the actuarial lifetime. How else can one know/estimate whether or not the asset base is growing enough to provide enough for a lifetime? This last statement takes on additional meaning when looking at the significant flipping of life insurance policies at substantially higher premiums as the decade unfolds.


There is another particular area that is frowned upon by literally every planning agency- whether the planner charges a commission OR a fee. Certainly from the early 90's, the advent of fees has taken hold of many planning scenarios. And there are elements where a commission may offset some of the fee associated with a financial plan. But there is no element where the planner takes a full commission on annuities or mutual funds AND adds an annual fee at the same time. Smith, under his registration as a registered investment adviser, added a 0.5% fee under the Insider's Club. It was subsequently increased to 1% a few years later. Since I have researched the entire gamut of the planning practice for at least 15 years, I have rarely ever heard of a planner who is taking both the full commission and adding fees on top of that. Certainly that would have to be explained in detail to the Johnson's or to any other clients. Simply identifying to a novice that they read a prospectus (rarely ever done) and contract a fee fails to state to the client the extensive fees and the associated reduction in total return that would be expected.

The example is best made by the cost of the front end loaded funds at the inception of the investments. There was $2,050,464 invested and the net amount after the front end load was $2,015,249. That's, roughly, a $35,000 commission. Be aware, however that all of Smith's investments were loaded. At an average commission of 5%, that's a total commission of about $102,523. Also recognize that this does NOT include any commissions for the insurance. In a letter of July 5, 1990, Smith also requests a 0.5% Inner Circle Club fee of $5,114. This would reflect a principal of about $1,022,800 at that point. Subsequent monies were added and it is clear that the fee of 0.5% was allocated against all since the statement of July 2, 1992 shows a principal amount of $2,283,251 and a fee of 0.5% annually.

It is my opinion that the lack of full disclosure to the client of the commission PLUS fees and the impact on the investments is a breach of Smith's fiduciary duty to the Johnson's.


The planning focused around the elements of commissionable products. While such effort, in itself, is not wrong nor necessarily focused exclusively for monetary reward, it is clearly shown that the sale of assets, where the funds were reintroduced to the same type of product but commission loaded, represents a breach of duty by the planner. Mr. Johnson had a large IRA in the amount of $770,900 and Mrs. Johnson in the amount of $117,400. An IRA is tax sheltered in itself but Smith has the Johnson's purchase a fully commissionable tax sheltered Nationwide annuity inside the IRA. This is wrong. Further, as the life insurance premium rose, the Johnson's had to take about a third extra money out of the IRA's and pay ordinary income tax to net the premium payments. On top of that, they also suffered surrender charges in pulling monies prematurely in order to make payments for yet other commissionable insurance products Smith was selling. There is no justification for this debacle. Recognize that had mutual funds been utilized instead, there are still fees associated with their sale. But as referenced above, the sale of assets to a change to a commissionable product essentially serving the same purposes is not only illogical but a breach of duty by Smith.


This area is one where, in conjunction with the lack of planning addressed above, has led the Johnson's into innumerable policies at substantially higher premium costs while the asset and income base has diminished during the 1990's. Smith flipped/churned/changed the policies several times. That is bad enough as identified below but what was even more egregious was the use of companies with a lower rating- even none at all. Mrs. Johnson ended up attempting to pay for policies that she didn't need nor could afford.


Prior to the inception of planning. Mr. and Mrs. Johnson (Johnson's), already had a several policies on each. Bob had approximately $468,000 coverage under 6 policies. Two such policies were with Security Connecticut for $375,000.

Company Policy Number Coverage Type Date of Coverage

Travelers 3448695 25,000 W/L 9/66

Security Connecticut 833941 D 250,000 Flex Prem Adj Life 3/86

Same 569561G 125,000 Flex Prem Adj Life 9/82

Continental American 7360613 50,000 W/L 8/73

Metropolitan Life 9594971A 18,371 " 1/35

" 16085039 10,000 " 5/46

Total Coverage $468,000 (rounded)

Premium Total 15,476 annually

Surrender Value 115,093

Sue had 6 policies encompassing $515,000. The bulk of policies were with Phoenix Mutual of (rounded) $500,000 and were put into an irrevocable trust in 1989.

Company Policy Number Coverage Type Date of Coverage

Continental American 78P0234 5,528 W/L 8/78

" 75P0398 1,127 " 8/75

" 7360603 10,564 " 8/73

Equitable 5064542 $1,000 Endowment 1/46

Phoenix Mutual 2421108 259,084

240,084 W/L

Term 8/87 (irrevocable trust 9/89)

Total Coverage $515,000 (rounded)

Premium Total 10,749 annually

Surrender Value 8,616

Note that her cash value was effectively nil

Insurance changes

Mr. Johnson's policies

As a basic planning format, it is generally conceded that small policies may be terminated altogether or rolled into a larger policy. In Bob's case, the Metropolitan policies ($18,371) and the Traveler's policy ($25,000) might have been eliminated. That said, it would have been necessary to take a hard look at the Traveler's coverage since it was whole life (premiums would not increase). Actuarial lifetimes had increased and mortality decreased since 1966 and new premiums for comparable policies would have decreased substantially per thousand dollars of attained age. However, while new premiums had dropped, Bob was almost 15 years older and had other medical issues that might have precluded a similar type of "preferred" policy. It may have been justifiable to have retained the old policy. Also look at the dates of coverage of 1935 and 1946 for other policies. Almost under any conditions, he could not match the same premiums for his attained age. The same could almost universally be said of the Continental Policy issued in 1973. As stated, small policies may be worthwhile to roll into something larger for convenience. But if the new policies are NOT guaranteed (universal life) and the surrendered policies ARE guaranteed for life, the element of convenience may be debatable at best. It would have been simple enough to just add another $1,500,000 coverage to what currently existed. They still could have been put into an irrevocable trust and incorporated as part of proper estate planning.

At the direction of Smith, Mr. and Mrs. Johnson purchased a Confederation Life second to die policy for $2,000,000 (the face amount nor the premiums can be corroborated by documents or Confederation Life. The amount is a recollection by Mrs. Johnson. It might have been more.) It appeared that there was no initial problem with the underwriting since the policy was issued. It also appears that the other policies Bob held were surrendered and the cash rolled into such policy. (The direct facts are not evident from the statements received, but the policies were clearly terminated about that time. I am making an educated judgment that the policies were not surrendered outright and the cash values taxed.) I am, however, questioning why at least the two Security Connecticut policies for Bob (approx $400,000) were not saved.

Mrs. Johnson

Mrs. Johnsons' policies were small save for the two Phoenix Mutual policies (approx $500,000). It would appear that these could also have been saved into an irrevocable trust and to simply add additional coverage. There is no documentation as to the reasoning. One must consider that policies initiated at an earlier age are universally cheaper than those at a later age (assuming same type). The cash values of $8,600+ were rolled into an annuity.

Subsequent insurance history

It is true that all the insurance policies are added to one's estate and may be taxed unless in separate ownership such as an irrevocable trust. A Johnson Irrevocable Trust was established in 1990. It was possible however, to consider the gifting of the policies to Ellen Johnson particularly since the cash values were limited. Regardless, the Confederation Life second to die policy was utilized. Smith selected a physician for Mr. Johnson to attain the policy.

However, before the two year incontestability period had been attained, Smith pushed to increase the coverage by another $1,000,000 (perhaps $2,000,000). That needs clarification in itself since less than two years have gone by and, irrespective of the request, was it necessary to increase his life insurance coverage by another 20% or more? For what purpose? An unsubstantiated increase in estate tax because of???? There is nothing to validate this within the records since there are no documents attesting to any increase. Further, if appropriate numbers were done in 1990, the need for $4,000,000 (or more) would have been identified at that time. But I repeat- it is impossible to validate any estate planning unless one factors in how much is being used up through a budget.

Regardless of the reasoning however, something went awry in that the underwriters now found(?) a problem with Bob's health (new doctor) and not only declined the new submission, but exercised their right to terminate the initial policy as well retroactive to 8/20/90. Since Smith had terminated all of the older policies and the new policy was now excluded in total, the Johnson's then had no insurance coverage at all. There, perhaps, was justification in such action by the insurance company. (It is impossible to determine exactly what happened since Confederation Life went into receivership a number of years ago and the information for all policies was effectively deleted. I have talked with the receivers of this company on several occasions to try to resurrect the conditions, but there is no information other than it was canceled retroactively.) There is nothing in the files sent to me of any written source to indicate the actual reason why the policies were declined nor, in particular, what Smith did upon notification. Mrs. Johnson indicates that the new physician found a problem with circulation that was not addressed previously and that is the reason for the decline. Mrs. Johnson also indicated Smith just verbally told them what had happened and that "everything was going to be O.K."

Smith should have initiated an immediate written appeal to the company to attempt to save the first policy and extensive documentation should be available to validate this effort. I have nothing in the files. Maybe nothing would have worked, but without doing anything, there was no hope at all. And without a formal written appeal, a verbal appeal is extremely limited, if not useless.

In any case, the use of the new Confederation Life policy poses the question as to why Bob's Security Connecticut policies were not retained and put into the irrevocable trust? As whole life policies, the rates were guaranteed and were written at a younger age where they were less expensive than at the attained age. This is questioned for both parties and becomes more evident from the following. Once the Confederation policy was denied, Smith had Sue take out a $2,000,000 policy on her life alone. Premiums were $65,193 annually. Had Smith retained all of Sue's past policies- specifically the roughly $500,000 from Phoenix Mutual- her total premiums would have been less than $11,000 annually for that section. Admittedly, hindsight is "excellent" planning. But it seems incredulous that a couple that both had approximately $500,000 of coverage each with premiums totaling around $25,000 total annually could lose it all. And then the wife takes on a separate $2,000,000 policy costing $67,000+ a year.

More Insurance

By1994, the income received by the Johnson's had slipped dramatically from the sale of the liquor store in 1990. In 1990 and 1991, income was $120,000. But it dropped the following year in 1992 to $74,500 and further still in 1993 to $58,000. The drop was most precipitous in 1994 when it went down to $13,500. There is therefore a huge drop in retirement funds that has been progressively shown for several years. There may have been- probably was- a decrease in net assets to make up the income and budget shortfall. However, there is no documentation by Smith addressing a budget or income flow for the Johnson's before or then. There is no documentation recognizing the precipitous decline in income. However, even in view of the above history, Smith increases insurance premiums for Mrs. Johnson by a substantial amount.

A new 1994 Security Life of Denver policy of $500,000 costing $24,895 annually

A new 1994 Canada Life policy of $750,000 costing $27,959

The existing Confederation Life policy was $2,000,000 of $65,193.

Total insurance coverage of $3,250,000 and premiums of $118,047.

It appears that Smith initially attempted to increase the Confederation Life policy to $2,600,000 at a premium of $130,336. The application was canceled because, it appears, Confederation Life was going into rehabilitation. There is no information to know if the extra $600,000 was supposed to be in addition to the above new policies.

It is notable that the policy premiums increased by $52,854. But that is not the whole picture. The entire amount requires a gift tax filing since the insurance policy is in a trust which will reduce the amount available for estate credit at death. This irrevocable life insurance trust was established in 1990 through the Smith Group. However there is no documentation to the use of a Crummey power to utilize the annual $10,000 gift ($20,000 per couple). Why? In literally all such irrevocable trusts, the use of a Crummey power is almost "mandatory". It saves part of the lifetime exemption.

But that again is not the whole picture. At this point- and certainly later- the Johnson's had to pull money out of the annuities and suffer surrender penalties. Once these annuities were depleted, it was then necessary to pull the funds out of their IRA. At such point, income was taxed at the highest tax bracket. That is inconceivable to proper planning. You don't want to take out money from a tax sheltered position to put it into yet another tax sheltered product. What good is being served to lose money to penalties and taxes and put it in a policy of fixed rates that also has surrender penalties?

But that is not the whole picture. In 1997, Smith also suggested that Ellen Johnson needed two $2,000,000 insurance policies.

Security Life of Denver coverage of $2,000,000 costing $34,077

Pacific Mutual Life coverage of $2,000,000 costing $32,399

Total of $4,000,000 costing $66,476

First, there is absolutely no factual data supporting a need of such a large amount of coverage for Ellen. Coverage is generally only required if someone is financially dependent on the insured. Admittedly, Ellen has a daughter, but Ellen was also the beneficiary of the policies and assets of her parents. Even though the assets were being depleted, it was still far more than adequate to provide for her daughter. Additionally, Ellen did not have the income to pay for the premiums. Her taxable net income had never reached $66,000. It is an egregious breach of any duty to suggest the purchase of a policy that the owner has no reasonable chance of ever paying for- certainly that is may also depleting any asset base as well. As it ends up, it was further depleting the income and asset base of Mr. and Mrs. Johnson since they were gifting the premiums to Ellen. This was an additional depletion of their lifetime estate exemption.

The total of all premiums at this point in time provided by Mr. and Mrs. Johnson was $184,523.

The tax implications of the premiums was apparently lost on Smith. For example, on February 18, 1998, Smith sent a letter to the Johnson's indicating that the premiums of $118,000 for their policies were to be liquidated from four different annuities. That obviously does not address the $66,000 for Ellen's policies. Nor does it express the ordinary income tax on the entire $184,523. If one uses a 40% tax bracket, the amount that would actually need to be withdrawn is over $307,500. Nor does it express the amount of the gift tax that may either adjust the estate exemption or require gift tax payments. Smith's letter had to at least address the taxation element since it is material to a budget. An extra, minimum, $123,000 of cash to pay insurance premiums without specifically addressing the depleting income and asset base for an unsophisticated couple is wrong. The lack of such basic planning for the Johnson's clearly exposes the continued breach of duty owed by Smith. The Johnson's were using up more and more assets due to an income that was declining effectively since the inception of the planning contract. Further, the Johnson's are paying additional fees as part of the Outer Circle Club. Smith was (supposedly) familiar with all financial elements since his firm was also doing their taxes. They had also prepared the estate documents. Smith had all the information either at his immediate disposal to ascertain the economic situation of the Johnson's and to prepare suitable documents to prepare and plan for the changing Johnson scenario.

Net Worth

While the above may be considered a theoretical exercise removed from reality, on September 30, 2001, Domenic Endrico, Enrolled Agent, did a personal Financial Statement for Sue Johnson. The Net Assets were $5,156,490.


Cash $156,000

Marketable Securities 666,081

Notes Receivable 250,000

Investments $2,617,934

Personal Residence $1,800,000

Personal Property 216,474

Total Assets $5,706,490

Liabilities 550,000

Net Worth $5,156,490

Actually, until just recently, there was an additional liability that Sue Johnson was responsible for- the annual $64,000 of insurance premiums for Ellen which were due at that time. As a rounded number, the net assets was actually only about $5,100,000. Yet the net assets in 1990 were $5,168,660- for all intents and purposes, the same. How is it even remotely possible that Smith- who promotes himself as a top notch planner- and with all the other specialists in his company that were- or should have been- providing input as to the financial position of the Johnsons' (and I assume all his other clients) miss the fact that the plan for the Johnson's was completely deficient from inception. If not apparent then, it should have been apparent at any subsequent annual review. The income was going down and the amount that was being withdrawn from the asset base was extensive. Effectively all the suggestions, recommendations and subsequent sales of products needed to reflect the diminishing asset and income base. And this was, at all times, clearly known to Smith because the taxes were being done by his firm. Additionally, any annual review would have noted these reductions and have prompted a complete restructuring of the then current assets. It certainly would have required an adjustment in the Johnson's budget.

I also note that the decrease was not due to any gifting, sale, disposal, etc. of assets subsequent to the complaint against Smith. There were costs to care for Mr. Johnson from January through May of 1999. But at a cost of $30,000 per month (roughly $120,000 total), it would have not materially affected or impacted the (supposed) asset base that Smith had projected in 1990. Smith stated that "......our initial objective was for this money to perpetuate so as you progress you will be able to take monies from the accounts for cash flow, vacations and keep up with inflation. .........."Past history tells me that growth oriented investments are the place to be in order to provide the needed dollars for the future."

Inflation during that period from 1990 to 2000 was 2.79%. If the assets did nothing more than meet inflation, the asset base would have grown to $6,808.950.

But Smith's objective was for the asset base to grow. One of the most simplistic ways to address such growth is to pick an index.

During the 10 years incorporating the S&P 500, the index moved as follows:

Here are the numbers for the S&P 500 index.

Year/quarter 500 Index

1990.01 765.826

1991.01 830.099

1991.01 830.099

1992.01 1018.461

1993.01 1126.211

1994.01 1271.222

1995.01 1277.963

1996.01 1772.079

1997.01 2238.881

1998.01 2841.357

1999.01 3764.508

2000.01 4153.979

The S&P increased an average of 18.42% per year. A $5,168,660 asset base would be worth $28,032,168.

So how is it possible that the Johnson's end up with the same asset amount 10 years later? Not only did it not grow at 18%, it didn't even grow at the rate of inflation. While one could simply look at the selection of Smith's various investments, I submit that it was the fact that the initial planning- as stated repeatedly- never addressed the real life spending patterns of the Johnson's nor took it into account on an annual basis. Additionally, in a rough estimation of the Johnson's current assets in 2002, it appears that the net worth may be down to $3,500,000.

It is clear during this entire period that Smith breached his fiduciary obligation through the sale of additional unnecessary insurance products where the face value greatly exceeded any estate planning needs and, in fact, may have exceeded the asset base itself. That is absolutely a fact if Sue was to continue the annual payment of $200,000 for her own $5,000,000 of coverage and another $64,000 of additional coverage for her daughter. The insurance plan's design was a financial disaster that would bankrupt the Johnson's. Sue has been emotionally programmed through the years to believe that such estate protection is mandatary and was, until most recently, extremely reluctant to change the focus regardless of its impact on her finances. It remains a psychological barrier to her good health right now.

The reality of the problem is out-and-out identified by the activities of Smith in 1998. At that point in time- as shown above- Sue Johnson's coverage was

A 1994 Security Life of Denver policy of $500,000 costing $24,895 annually

A 1994 Canada Life policy of $750,000 costing $27,959

The existing Confederation Life policy was $2,000,000 of $65,193. This was turned over to Phoenix Home Life Whole Life policy during rehabilitation.

On February 18, 1998, a letter from Smith shows the incomplete/incompetent planning. Smith makes reference to the premiums due by Phoenix Home life- $65,193; Canada Life- $27,959.38 and Security Life of Denver- $24,895 for a total of approximately $118,000. But his suggestions that the Johnson's take $50,000 from their Guardian annuity; $18,000 from Nationwide Exclusive; $30,000 from American Skandia contract 88946 and the remaining $20,000 from American Skandia, contract 88800 misses the major problem with taxes. Miscellaneous lump sum receipts from annuities are taxed as ordinary income. Assuming the highest tax bracket of 40% combined state and federal, the amount that actually needed to be taken out was over $196,000. But it doesn't stop there. A subsequent statement dated March 5 notes that additional funds of $32,399 from the Delaware Decatur annuity and $34,085 from AIM Constellation were withdrawn. But these did not reflect taxes but the additional costs of premiums for Ellen. No commentary on taxes. At a combined federal and state tax rate of 40% for total distributions of $184,484, the amount that would need to be distributed is approximately $307,473. And even there is does not end since the premiums by the Johnson's are being gifted to trusts which incur a tax filing and potential taxes in themselves. Further, as indicated previously, I do not find any documentation to the use of a Crummey power.

But there is more since the premiums for Ellen must be gifted to her. A man and wife may gift to her $20,000 without gift tax reporting but the excess also requires a tax filing for the additional $46,424. The whole financial picture for the Johnson's is a fiasco. They cannot afford- never could- a $300,000 annual cost. Add on top of that whatever living expenses the Johnson's and you have a budget of $500,000 that would break any $5,000,000 portfolio that has never grown and is being further depleted.

But what happened next was some of the most egregious activity by Smith. The assets and income were down, the policies initiated in 1994 still retained surrender charges, and then in mid/late 1998 he increases the insurance coverage on Sue to $5,000,000. But that wasn't the worst. He just didn't increase the current policies. He flipped all of the policies- incurring surrender charges. Beyond everything else, the premiums went up from $118,047 to $202,224- and increase of another $84,177 or 71%- for policies that the Johnson's could not afford could not afford previously and were now even less tolerable.

But that's not all. All the existing policies were whole life- guaranteed premiums. The new policies went to non guaranteed universal variable policies. Why? Her daughter had fixed policies which are more conservative. But Sue ends up with a more aggressive policy at over age 75. This makes no sense at all- save for Smith making substantial commissions since the move to a totally new companies carries up to a 100%+ commission. And the fact that Smith could also charge an additional fee for management of the funds.

But that's not all. The older Security Life policy had not passed the surrender charge period. As a result, while there was an account value of $84,870.99, the surrender charge was $20,670.99 leaving just $64,200 that was transferred to the Hartford Variable policy.

How does Smith "justify" these actions? In a letter of December 2, 1998, he noted that "insurance protection for estate preservation for ....the Johnson's.... is a hallmark of good planning."

Agreed- but if you can't afford the premiums and your whole financial life is tanking, what is the validity of a statement that Smith should have known had no relevance to the Johnson's economic situation? Further, it provides an invalid comfort zone to the Johnson's that the need was absolute and should be continued no matter what. Certainly that is what Mrs. Johnson believed and believes today. She is very distraught over the fact of losing the coverage while at the same time recognizing that she can't afford it either. I also note that this insurance was presented to the Johnson's at a time when Bob was very ill having had a series of strokes and had lost 80 pounds. Why was additional insurance needed on Sue? At that point in time? I submit that Smith recognized a weakness in objective decisionmaking on the part of the Johnson's and used their heightened emotion towards probable death in purchasing more of what they already didn't need. But he was guaranteed a huge commission for the flipping of the policies.

There are no figures showing the net worth of the Johnson's in late 1998, but considering the value of $5,000,000+ in September 2001 and a value of $5,000,000+ in 1990, it seems clear that the net worth was probably not that much different between the two dates- certainly where there had been no large extraneous costs against the estate.


Smith, CFP, initiated a plan for a completely unsophisticated couple that would "......... perpetuate so as you progress you will be able to take monies from the accounts for cash flow, vacations and keep up with inflation. .........."Past history tells me that growth oriented investments are the place to be in order to provide the needed dollars for the future." Yet the assets not only did not grow, they did not meet inflation. The defense is that the Johnson's spent too much money and are at fault. Wrong. Whatever the Johnson's spent was known at all times by Smith who had a fiduciary duty to plan anything with this as the material reference.

Smith sold valid investments and purchased almost identical investments that incurred a sales charge

Smith utilized annuities within an IRA for no valid reason whatsoever other than a commission. He knew- or had to know- that the surrender penalties might apply if assets removed early.

Smith used all sorts of investments that he timed for growth. He makes reference to the return for the S&P 500 yet never uses it.

Smith sold initial insurance policies that resulted in no insurance on the male. Policies were increased and the premiums increased on Mrs. Johnson for the supposed reason of estate preservation while the asset and income base of the Johnson's was being reduced- and further depleted by the added insurance premiums. Most egregiously, Smith replaced whole life policies by flipping the companies, incurring surrender charges, and costing Mrs. Johnson hundreds of thousands of dollars which she did not have to make the payments. He did not account for the huge taxes that would be levied on the withdrawal of the assets from either and annuity or IRA. He did nothing to ascertain that the premiums would financially ruin Mrs. Johnson. Such omission also has directly affected Mrs. Johnson's health and emotional well being and severely reduced the amount now available to her beneficiaries. He generated huge commissions to the direct detriment of his planning client.

Smith sold two $2,000,000 to Ellen Johnson costing over $64,000 annually- more than Ellen Johnson ever netted. Further that the premiums had to be gifted from Mrs. Johnson, further depleting her asset base.

In short, Smith violated literally all of his fiduciary duties to the Johnson's by instituting products that never worked as intended, were in the wrong place, and were far beyond the client's ability to pay.

Very Truly,

Errold F. Moody Jr.