Investment Counseling for Private Clients III

Overview: Investment Counseling for Private Clients III Janet T. Miller, CFA Partner, Rowland & Company Atlanta “Private client” is a term often used interchangeably with “high-net-worth client.” It is not news that this area of investment management carries a “growth stock” P/E—and for good reason. Cerulli Associates has estimated that this segment of the market has more than doubled in the past four years. In light of such rapid and expansive growth, private client managers are asking themselves how to best serve clients and facilitate client retention—the fundamentals that make this business so attractive. Segmentation of this swelling group of investors (into, for instance, high net worth and ultra high net worth) is important for firms that manage private client portfolios. Segmentation is also key in understanding investing and planning under the newest twists and turns in estate tax law promulgated by the Economic Growth and Tax Relief Reconciliation Act of 2001, which was signed into law by President George W. Bush on June 7, 2001. For example, serving the ultra-high-net-worth client—generally described as someone with more than $50 million in assets—calls for professional expertise and business functions that are different from those needed to serve clients with between $1 million and $5 million in assets. This latter group, estimated recently at around 2.5 million in number, dominates the estimated 3 million millionaires (that is, all with $1 million and more in assets) at last count in the United States. This same group stands to reap a large portion of the benefits and to avoid many of the pitfalls associated with the new tax law. Investment managers and other advisors to the wealthy will be challenged by many aspects of the new tax law, such as the phased-in approach to the reduction and elimination of estate taxes, retirement planning (especially when coupled with recent U.S. IRS rule changes) in light of the effect of the law on inheritance from retirement accounts, and the unusual sunset provision repealing the law in 2011— right after full abolition of the estate tax kicks in. Given the sunset provision and surrounding uncertainties, will the client owe estate tax or not upon death? In the absence of estate taxes, will more money be left for heirs? The decisions of baby boomer parents not convinced of the efficacy of leaving all their money to their

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progeny surely will affect their choice of investments, tax planning, and philanthropic giving. Taxes (and tax law) have always complicated the job of private client managers, as the authors in this proceedings duly note. But regardless of the changes in the tax law, private client managers must assess the asset allocation/location decision, investigate hedging possibilities for low-cost-basis stock holdings, and consider the various structures (and entities such as charities) available for wealth-transfer planning. Finally, managers and their firms must be aware of the non-tax-law changes taking place in the private client industry in order to be adequately prepared for the future.

Asset Allocation/Location Private client managers aim to not only preserve clients’ wealth but also to ensure its growth. Although these goals seem straightforward enough, James Hughes illustrates the difficulty in battling the forces of “entropy” that inevitably erode a family’s wealth. To meet the changing needs of wealthy family clients, Hughes explains that investment advisors must (1) understand how entropy causes wealthy families to lose their wealth often in three generations and (2) understand how they can battle it. The manager must also be tax savvy, keeping up with changing tax laws and providing clients with different wealth-allocation options to ensure that the bulk of client wealth is not simply eaten up by taxes. The family itself must learn how to make joint decisions and encourage the different “callings” of family members. Not everyone is cut out to be a financial wizard, but Hughes explains that if family members can develop their own specific talents to acquire an expertise, they can appreciate the need for experts to help them with financial planning. To ensure proper communication, the investment advisor’s job is to understand what motivates his or her clients. Hughes concludes that, although investment advisors cannot stop the forces of entropy, they can slow down its process to the benefit of clients (for wealth preservation) and themselves (for client retention). Darryl Meyers agrees that investment managers must do all they can to understand client goals and

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Investment Counseling for Private Clients III adequately explain to clients the options available to meet them. Meyers emphasizes that portfolio construction is a complex process that requires a variety of inputs to be successful. Client objectives, capital market expectations, portfolio structures, risks, and performance measurement—all must be addressed and constantly monitored. The manager’s task is to integrate the client’s financial, estate, and investment plans into a comprehensive strategy for attaining client goals—thus achieving integrated, dynamic asset allocation. It is thus critical for managers to explain to clients the variety of wealth-transfer vehicles available and how each has different benefits and risks involved. Managers must also educate clients to appreciate the dual tax drag of income and transfer taxes. And in a multigenerational context, the manager must ensure that clients understand the uncertainties of time, including how wealth-transfer structures and U.S. tax laws can change, to help clients frame their goals across generations. To truly understand the benefits of multi-location asset management strategies, one must compare them with the single- and even three-location strategies of the past. Jean Brunel does just that. He uses a hypothetical family, the Burgers, to illustrate the benefits of multi-location strategies. Brunel shows that a singlelocation solution neither meets all of the Burgers’ varied goals nor provides as much tax efficiency or risk protection as the multi-location solution. With the multi-location asset management strategy, the Burgers can achieve their distinct goals of deferring taxes, diversifying low-cost-basis holdings, and contributing to charity—all while enhancing tax efficiency and lowering risk. Because each location has its own risk– return profile, the Burgers can better meet all of their goals simultaneously. Thus, Brunel shows that when a manager incorporates multiperiod analyses and tactical strategies with an array of available wealthplanning options (such as family limited partnerships and low-basis diversification strategies), a dynamic asset allocation will result that can greatly improve a family’s financial and tax-planning situations.

Hedging Strategies Scott Welch and Robert Gordon discuss how investment managers can best meet the special needs of clients with concentrated equity holdings, particularly holdings of low-cost-basis stock. Before the Taxpayer Relief Act of 1997, hedging low-cost-basis stock was fairly straightforward. The preferred method for hedging a concentrated stock position and capturing value from it, without selling it, was simply a short against the box. The Taxpayer Relief Act of 1997, however, targeted this practice, and now, hedging low-cost-basis stock is far more complex. Welch and Gordon sift through the array of products available

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for hedging and explain the decision making process that must be undertaken to choose a successful strategy for clients. Welch summarizes many of the hedging strategies available to help investors manage the risks inherent in concentrated stock positions and leverage the return prospects for these positions. Among the options available are strategies using equity collars, variable prepaid forwards, charitable trusts, and donor-advised funds. But Welch shows that these strategies are effective only when certain criteria are met, and he stresses that the advantages and disadvantages of each must be carefully weighed in order to correctly structure the appropriate method for diversifying the risk of each client’s position. Gordon focuses on the decision-making process for choosing the best hedging strategy for clients with low-cost-basis stock, specifically the need for investment advisors to carefully question their clients about their goals. He describes a decision tree that divides investors into two distinct groups: those who want to monetize and those who want to hedge. Advisors must understand this distinction because these two reasons for hedging require different hedging strategies that, in turn, create two different economic payoff patterns. Thus, learning client goals, as well as the history of when the shares were originally purchased and their cost basis, is critical to the choice and success of the strategy adopted.

Tax Concerns Central to helping high-net-worth clients build their portfolios is the need to address tax concerns. David Stein explores the fragile balance between seeking tax efficiency and minimizing tracking error versus a benchmark, because it often seems that achieving one negates the other. Different trade-offs between tax costs and tracking error will result from the different investment strategies chosen. Stein discusses how portfolio structure, benchmark choice, and investment philosophy all combine to affect alpha, tracking error, and tax efficiency. Stein argues that for taxable investing, several steps should be taken to reduce tax costs while maintaining diversification, the most important being to simplify the portfolio structure and focus on tax management. Lee Price focuses on a different tax concern— how to construct appropriate after-tax benchmarks. Few of those who manage taxable portfolios or represent taxable clients report after-tax returns, mainly because few after-tax benchmarks exist. Creating an after-tax benchmark is a complex process because it must not only follow standard benchmark rules but also ideally incorporate the appropriate federal and state income and capital gains tax rates for the client whose portfolio is being managed against the

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Overview benchmark. Price shows that if the correct pretax index is chosen from the beginning, however, the biggest obstacle for after-tax benchmark creation is conquered. Price presents three key areas to consider that can help managers choose the correct pretax index and then explains how to calculate after-tax returns according to AIMR-PPS™ standards.

Wealth-Transfer Vehicles and Entities Perhaps no saying carries more weight in the private client management area than “you can’t take it with you.” The reality that a wealthy individual’s assets are no longer needed by that individual at death means that planning for the transfer of assets is crucial. Gregory Friedman looks at the vital role that the investment advisor plays in making wealth-transfer decisions. First and foremost, the advisor must understand the client’s wealth-transfer preferences (e.g., heirs receive $75 million and the remainder goes to charity) and must keep in mind that these preferences are based on both analytical and emotional factors. Once the advisor understands the client’s preferences, the advisor can quantify the impact of those preferences. That is, the advisor can show the client how changing market environments affect how much goes to heirs and charity, depending on the wealth-transfer vehicle chosen. In this way, the advisor can illustrate for the client who bears the residual risk (heirs or charity) under various gifting schemes. Lawrence Macklin looks specifically at the use of trusts and insurance in wealth-transfer planning. The manager’s job (in a wealth-transfer context) is to attain client goals while minimizing costs—notably transfer tax and income tax costs. Through the use of trusts, a client can transfer wealth to his or her spouse, other family members, and charity. The type of trust, however, determines how much control the client has over the assets and how well costs can be controlled. Insurance is an attractive wealth-transfer vehicle because it provides for substantial income tax savings, but as with trusts, the type of insurance determines the degree of control and cost savings. To further complicate matters, insurance can be used within a trust to maximize the control of assets and the cost savings. Consequently, choosing the appropriate wealth-transfer vehicle is not easy, and the decision can dramatically affect to what degree the client’s goals are attained. A family limited partnership (FLP) is a structure that allows wealth to be transferred to family and nonfamily members, but as Patricia Thompson discusses, it is a complicated structure. Several very good reasons exist for establishing an FLP (such as being able to consolidate ownership of assets, con-

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trol the assets in the partnership, and gift shares of the partnership), but perhaps the driving reason is being able to take advantage of the valuation discount that the FLP can provide for the assets in the partnership. Although FLPs offer some tremendous advantages, these advantages come at a cost (both in money and in time). FLPs are expensive to establish, they require the partners to perform ongoing management and control, and above all, they must be run like a business. Furthermore, the valuation discount, the crown jewel of an FLP, provides not only the greatest advantage but also the greatest potential headache—from an IRS audit. As with most wealth-transfer vehicles, the decision to use an FLP must be made carefully.

The Future The private client management business has had a long and successful history, but as any student of the market knows, past performance does not guarantee future results. David Lamere points out that the private client business has been a fantastic business to be in. The number of clients demanding private client services has been growing, the assets under management have been growing, and unfortunately, the number of firms delivering private client services has been growing. Until now, the demand for private client services has exceeded the supply of providers. Thus, firms have had a relatively easy time gaining new clients. But because the supply is beginning to catch up with the demand, firms will find that the strategies and tactics they used in the past may not be the ones that will keep them successful in the future. Firms need to focus on retaining (or gaining) market share, rather than on the absolute number of clients or assets under management, and to retain market share, firms must keep pace with the changes in the market (such as changing private client preferences and needs and marketing approaches). Investment expertise, client focus, asset growth, benefits of scale, and employee retention—all will be important factors determining the future success of a firm.

Conclusion The number of high-net-worth clients (and their assets) has been growing dramatically, as has the demand for private client management services. But private client firms cannot rely on continuing growth to bring in new clients. Firms (and their managers) must concentrate not only on investment performance but also on client relationship issues. And in this ever-changing world, firms and managers must be on top of new developments that affect their clients (such as changes in the tax law) if they expect to be around for the next wave of changes.

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Asset Allocation for Family Groups James E. Hughes, Jr. Counselor-at-Law Hughes and Whitaker New York City

To slow down the process of entropy that inevitably erodes a family’s wealth, investment advisors must help high-net-worth families understand the causes of entropy and the ways to disarm it. By equipping clients with the tools needed to promote family governance, encouraging them to establish and lead such institutions as a family bank, focusing on investor allocation, and educating beneficiaries, investment advisors can help their clients create an environment in which younger generations can pursue their dreams while preserving family wealth. When all of these issues are integrally managed, the advisor can expect long-term relationships with future generations of the client’s family.

his presentation addresses the contributions that investment professionals can make to the successful preservation of their clients’—high-net-worth families’—financial wealth. In other words, I will discuss how families can avoid the all too typical problem of losing their wealth in three generations, which is a major concern echoed around the world. I will describe the role of the investment advisor in meeting the changing financial management and planning needs of wealthy family clients. I will then review the obstacles entropy presents to the protection and conservation of family wealth and suggest ways to combat these obstacles. One focus throughout this presentation is to help families develop a governance process that invests in the intellectual and human capital of the family so that younger generations can innovate and further build family wealth.

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Risks to Family Wealth To begin the process of asset allocation for family groups, managers must understand that every wealthy family on earth faces at some time in its evolution the threat that it will prove the truth of the saying “shirtsleeves to shirtsleeves in three generations” (i.e., going from poor to rich and back to poor again in only three generations). The idea exists in every culture; only the symbolism is different. For example, if the first generation creates a fortune in a little village in China by working hard at planting rice and that family creates a financial fortune, the success

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usually does not significantly alter that generation’s way of life. The family usually stays in the same village, for instance. Members of the second generation, however, are apt to move to the city, buy beautiful clothes, attend the university, participate in cultural activities, and evolve into prominent members of society. The third generation, with no work experience, consumes the wealth and winds up back in “shirtsleeves”—or in this case, the rice paddy. This saying alludes to a similar phenomenon that modern physics speaks about in the second law of thermodynamics, entropy. The second law of thermodynamics states that every time energy is transformed from one state to another, the penalty is a reduction in the amount of energy available to perform useful work in the future—that penalty is entropy. Thus, entropy is the tendency of energy to spread out or to become less concentrated in one physical location. Few families whose wealth was, or continues to be, generated by a family business believe in the inevitability of this transformation, but more often than not, families in business fail to preserve their wealth over a long period of time. Nature’s laws eventually prevail; it is just a matter of time. The challenge for those of us who deal with private clients—regardless of whether our field is law, accounting, investment advice, or management services—is to help families slow down this process. (I say “slow down” because the process cannot be stopped completely.) If we do not slow the process,

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Asset Allocation for Family Groups we lose the family as a client. So, doing whatever we can to help protract the process is absolutely in our self-interest, as well as in the interest of humanity. No matter how well a family manages its financial capital, that success will have no long-term effect on the family’s ability to overcome the shirtsleeves saying unless family members are prepared to invest the majority of their time in the development and growth of the human beings who are the real assets of the family. Advisors can provide information to the family members that will allow them to make good decisions for the next generation and encourage them as a family to become an intellectual, lifelonglearning enterprise. Although what managers do in the administration and growth of financial capital is extremely important, excellent tax plans and wonderful investment plans alone cannot overcome the ultimate sad effect of the saying. The family needs guidance in identifying and taking ownership in a family philosophy of value education and transmission that addresses the total well-being of family members—individually and collectively.

Client Needs: Past and Present Today, when managing financial capital, particularly when managing a family’s wealth, investment advisors are in a peculiar and interesting historical place. Before 1974, managers of family wealth were in the client-relationship business. The businesses of investment management, law, and public accounting for private clients were all about the client relationship. Suddenly, in 1974, a strange set of events changed the nature of the business. The markets collapsed, and profitability in the private banking industry and the investment management business, whose fees were based on assets under management, dropped menacingly. Also, in 1974, almost miraculously, ERISA was born. Money managers who earlier appeared to be at the end of their careers were thrown a lifeline with ERISA. Between 1974 and the mid-1990s, the money management business moved from being relationship driven to being focused on the creation of products and services to match a statutory regime set forth by ERISA. The pre-1974 and post-1974 investment management worlds are vastly different—about as different as could be imagined. In the mid-1990s, another change occurred as the investment advisory business began to discover that the pension plans created under the auspices of ERISA were overfunded. The plan sponsors and their actuaries determined that less expensive alternatives to pension arrangements (from the corporation’s perspective) were available for their employees. Thus, the previously heavy distribution of resources to the directed pension plans industry was reduced and ©2001, AIMR®

redirected to the private client arena. As a result, the business of money management appears destined to come full circle. I predict that in the next 20 years, money managers will again be involved, first and foremost, in a client-relationship business that reflects the needs of private clients. To operate successfully in these new client-relationship businesses, managers will need to rediscover many of the methods and approaches that were used prior to 1974. Another change is evident in the philosophical outlook of private clients whose fortunes are being created in the “new” economy. Old-economy entrepreneurs, particularly those who made their fortunes from the industrial revolution, asked their investment advisors how they could make more money to leave to their heirs so their heirs would be grateful. New-economy entrepreneurs are asking very different questions: How much is enough? Or, at a much deeper level, how do I avoid making my children remittance-addicted trust funders? The essence of these questions indicates the philosophical chasm between the old-economy and new-economy wealth creators. The old-economy entrepreneur cared about wealth as a monument; in contrast, the new-economy entrepreneur is deeply worried that wealth, rather than standing as a self-aggrandizing monument, will produce children and grandchildren completely dependent on the family trust. Wealth can provide independence, but it can also engender dependence. In the new-economy world of wealth creation, the private clients who are the beneficiaries of this newfound wealth are seeking advice and aid in avoiding the production and perpetuation of trust-funddependent heirs.

Disarming Entropy The basic purpose of professional advisors in dealing with families and their financial wealth is to support a process that dynamically preserves the family financial capital. As the shirtsleeves saying attests, the second or third generation of a family is not typically concerned with creating new wealth: Its role is preservation, conservation, or better yet, stewardship. The second or third generation’s role is to manage and increase that which was created by the first generation. The act of stewardship must, however, be dynamic and vigorous. If it is static, entropy will emerge to quickly dissipate the product of the first generation’s energy—the family wealth—and the saying “shirtsleeves to shirtsleeves in three generations” will be proven accurate. Ent ro py’s Armamen t. Entropy has certain weapons in its armament to help realize the shirtsleeves saying—family demographics, the U.S.

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Investment Counseling for Private Clients III government, a lack of family governance, neglect, and unintended consequences. ■ Demographics. Entropy’s most important weapon is demography: In normal evolution, each family member will have two or three children, sometimes five or six. These children will repeat the same reproductive pattern, and gradually, more and more family members become heirs to the same fortune. Therefore, the financial assets comprising the family wealth must grow to encompass the needs of a larger and larger community. The professionals advising wealthy families must develop financial plans that recognize this truth. ■ U.S. government. In the current U.S. tax system, entropy has the U.S. federal government on its side. The U.S. Congress could change this situation, but at present, for any family with an estate of $10 million or more, the federal government is tantamount to the wealthiest family member simply waiting for the opportunity to collect its share of the family wealth when each successive generation passes away.1 ■ Lack of governance. Entropy also has the lack of family governance in its armament of destruction. Governance, by definition, is the joint decision-making process of a group of people, which could be a family. The failure of family members to govern the family enterprise (i.e., to make joint decisions over a period of time about the family enterprise), which may or may not include an ongoing business venture, leads to entropy. In this connection, viewing the family as an enterprise is important. Families do not often see themselves as such; they may say that they own an enterprise but will probably ask what being an enterprise means. When a client with financial wealth considers the wealth to be held in common with other family members—that is, the client is prepared to manage the wealth in a way that includes the family rather than exclusively for the benefit of the individual wealth creator—then the family is an enterprise. After all, by definition, a family is two or more people; when linked this way, two or more people are automatically faced with making joint decisions. If a family cannot govern itself, entropy wins. Perhaps the most complex weapon entropy has in destroying the financial wealth of a family is a lack of calling, or interest, in managing the wealth on the part of the second and third generations. More important than the human or intellectual capital of family members is their calling in life, an innate urge to pursue a particular vocation or activity. Consider 1

Since this presentation was given, the tax law has changed. Please see “Update” in Mr. Macklin’s presentation for more information, or go to http://thomas.loc.gov/ and search by bill number H.R.1836.ENR for a complete description of the final bill.

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the DNA shuffle that occurs in two parents to produce a child, and consider the statistical possibilities that the work to which that new organism is called will be the same as that of the parents. The likelihood of a child in the second or third generation being called to a successful entrepreneurial life or having a devotion to financial and investment management is infinitesimally low. So, if advisors begin with the premise that every generation will produce an heir who will be a creator and rejuvenator of significant financial wealth, they have a failed plan from inception. Advisors cannot wait for the fairy godmother to come to each generation and replenish the wealth of their clients. The greatest obstacle to the successful accumulation of family wealth is failing to appreciate the calling of each family member and then failing to ask all family members to use the skills attained in their true calling to apprentice themselves to master a financial understanding. Once people have apprenticed in a beloved vocation, they can appreciate the steps that must be undertaken to learn how to do other things. At the very least, they can appreciate the necessity of finding the professionals who can help them with the parts of their lives in which they have no interest, no calling. Trying to explain the management of the family fortune to a family member without a financial calling is like trying to talk to a person who does not speak your language. As you realize this person does not understand you, you speak more and more slowly and louder and louder. The person who has no affinity for financial concerns hears the advisor in exactly the same way as before the advisor began to speak louder and more slowly—with absolutely no improvement in comprehension. Entropy wins. To defeat entropy, advisors must discover the learning capacity and style of the family member with the nonfinancial calling so the advisor can present financial information in a way that the family member can understand. An apt metaphor is the class offered at Princeton University called “Physics for Poets.” There is no expectation that the young poets will become students of nuclear physics, but all of them leave the course fully understanding the general concepts of physics. Such an understanding is the aim when advisors work with clients. The clients are not expected to become experts in the advisor’s field; rather, the intention is to help them make the risk and reward decisions that will keep entropy from the door. ■ Neglect. Entropy also makes headway by the failure of the family’s professional advisors to exercise the necessary carry-through on planning mechanisms recommended by the advisors and instigated by the family. For example, family advisors often suggest the 2001, AIMR®

Asset Allocation for Family Groups creation of legal entities that bind various family interests together—family limited partnerships (FLPs), limited liability companies (LLCs), or trusts. These entities are used to achieve some adversarial success with the federal government. Most advisors appear to think that their work is done with the creation of the new entity. The documents are terrific; the tax opinions are excellent; the accounts have been created and are ready to be administered; and the books and records are in superb shape. The advisors behave as if their work is done, and they return to their offices and proceed with other business. Suddenly, the family members who have never in their lives been FLP members or beneficiaries and trustees of trusts have to take up the mantle. Do advisors teach their clients how to undertake the responsibilities mandated by those roles? No, they do not. Thus, it is not surprising that a family’s patriarch or matriarch comes to the advisor who had initially recommended the family’s planning structure and says something like, “This FLP was created a couple of years ago, and I didn’t know that my son-in-law as a member of the FLP would have the ability to ask me questions or that my daughter’s lawyer could ask me questions. Nobody explained that to me. Nobody has told me how to govern this entity, and the entire situation is a mess.” Entropy is winning because clients were not told that these entities require governance, and aid in governing them is not regularly proffered. ■ Unintended consequences. The final volley that entropy lobs at clients is the law of unintended consequences. There will always be unexpected powers at work to reinforce the other armaments in entropy’s war chest—armaments that are constantly waging war on the balance sheet of wealthy families. Defeating Entropy. In the role as defender of the families who honor advisors in all fields by their patronage, advisors have a mandate to battle the forces of entropy. Several weapons in the advisor’s arsenal can help clients triumph over the forces of entropy. The strongest of these are advisory actions that are guided by the primary sentiment of “do no harm,” but the institution of a family bank, the concept of investor allocation, and beneficiary/trustee education are other weapons that can be used. ■ Do no harm. Advisors should begin every meeting with their client families by remembering this simple dictum: First, do no harm. If an advisor starts the dialogue with “how can I help” rather than “what do you need,” the potential for harm is almost always reduced. In this manner, advisors will find out what the person actually seeks—in the sense of aid and advice, not in the sense of products and services. Products or services alone may be harmful ©2001, AIMR®

to the family or family member because an accurate judgment of the unintended (and unexpected) consequences arising from the delivery of the product or service is difficult to assess. In handing over a product or by completing a service and then stepping away, the advisor opens the door to harm that may flow from the family’s lack of governance ability, the lack of calling in certain family members, or whatever entropic force may be at work to support the saying “shirtsleeves to shirtsleeves in three generations.” ■ The family bank. When I was 28 years old and my younger brother and two younger sisters had almost finished their education, my father took me aside and said that he and my mother had decided they would now be a bank. Their financial responsibility from then on was to be a friendly bank that made grants and loans to my brother, sisters, and me. In adopting this strategy, my father was intuitively asking my siblings and me what our dreams were and how the family as a whole could invest in them. My father could have erred like many family patriarchs by tacitly requiring the second and third generations to dream his dream; fortunately, he did not, because this imposition dooms the family’s attempt at wealth preservation. The essence of a family bank is the concept that to succeed in overcoming entropy’s threat to the family fortune, the family must rally and attract the creative juices of its young members as fast as possible. In this way (providing that its youngest members are prepared to be apprentices, then journeymen, and then masters of some vocation), the family wealth can be dynamically conserved. Family banks see themselves as, in effect, financial organizations nurturing the infinite possibilities of the family’s human capital that is cradled in the creativity of the rising generation. Family banks should promote real application processes for grants and loans. They should ask the kinds of questions of their borrowers that all financial institutions ask so that the borrowers (family members) will learn about finances and about financial reality in the world. The learning takes place, however, in an atmosphere of love and caring. The family bank should teach what might be called “the double helix of risk and reward”—that is, that risk and reward are interrelated. Thus, the family bank should promote a proactive view that making mistakes is good, that it is a learning experience. The new-economy wealth creators, in particular, have shown that through mistakes people can learn, overcome obstacles, and eventually become successful. The new-economy entrepreneurs have bet it all, lost it all, and bet again to find financial success. The point of starting a family bank is to educate the family’s younger generations so that moving

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Investment Counseling for Private Clients III assets from the oldest generation to the youngest generation as rapidly as possible is a feasible planning strategy. In this way, the financial assets may be relocated in the family’s best interest and do no harm in the process. Also, part of the goal is to avoid creating financial monuments to the oldest generation, because the federal government will take a large share of that wealth when it is transferred to succeeding generations. The best way to avoid that fate is to get the young family members’ accounts growing quickly. Every family advisor, lawyer, accountant, and so on, knows this platitude, but it is often ignored. If it is followed, however, the results are extraordinary: Not only is the government’s share diminished, but the assets actually get into the hands of those with the greatest creativity. The relocated assets allow the younger members to meet their callings and create the greatest likelihood of the family finding the new financial opportunities that are relevant to the immediate future, rather than relying on the old ideas that will no longer be fruitful. In short, the family bank is a wonderful idea as long as it is premised on fulfilling the dreams of the younger generation, not the dreams of the older generation that created the wealth. ■ Investor allocation. Another way to battle entropy is through the use of investor allocation. The term is slightly different from the asset allocation of traditional portfolio management. Asset allocation applied to families begins by considering their wealth as two pies. One pie is the whole family fortune—the wealth of all family members pooled together with the assets allocated according to the appropriate risk and reward goals for that single pool of wealth. The second pie is, in effect, a laying-over of the family structure, the different generations, on that pool of wealth. Investor allocation ensures that the youngest members of the family are invested in the fastest-growing assets and the oldest members of the family are invested in the slowest-growing assets. The investor allocation approach to family asset allocation is, unfortunately, contrary to the prevailing wisdom of most family leaders and to the reality of who has the money to make the investment when the investment becomes available. With a little effort and foresight, this practical limitation can be overcome. The purpose of investor allocation is to locate the risk where it can best be borne. How many private clients over age 70 can honestly say that they can bear the risks routinely suggested by their advisors? When advisors make such suggestions, they are arguing against their own knowledge of human behavior and the changes that occur as people age. The youngest members in the family are best able to take the risks in the family because they have the time to recover if

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the risks materialize. Another obvious benefit is that by placing the bulk of the wealth with the younger family members, the family’s wealth depletion from the estate tax that will be imposed on the older members’ estate is significantly lowered. If an advisor can determine which of the family members ought to own which of the investments, the advisor can work with the family bank to get the needed loans to the appropriate family members to make the investments. Investor allocation is a viable asset allocation approach for a family, particularly when the approach works in concert with the family bank. A second mechanism for getting the fastestgrowing assets into the hands of the youngest people in the family is to set up LLCs. The young people will have enough money to be qualified investors in an LLC or LLP (limited liability partnership) if the oldest generation puts in enough money so that the whole fund qualifies. This approach also wards off the demographic weapon in entropy’s armament because the wealth is maintained cohesively in one entity and is not fragmented in the hands of many family members. The family as an entity is growing its wealth to maintain and expand its financial base, and in addition, the growth is successfully relocated out of the hands of the oldest generation. One of the greatest disconnects in investor allocation is acting as if the family trusts are not part of the pool of family wealth. So, a final point about investor allocation is that the family trusts must be integrated with the rest of the family wealth. In families with significant wealth, trusts are inevitable— whether 2503C trusts for education, dynasty trusts, or others. The family business is sold, and charitable trusts are created. The trusts proliferate. Trusts are always part of the family wealth, and they should always be in the asset allocation pie. But when the wealth is in a trust, it is simply in suspended ownership; the wealth in a trust is owned by the family members who are the trust’s beneficiaries. If the trust assets are not invested in a manner congruent with the family’s total investor/asset allocation program, the advisors have not done their jobs. Moreover, family trusts are the longest-lived family members. In keeping with the idea that the family wealth should reside with the youngest members (because they are the longest-lived and, therefore, can accept the greatest risk in the hope of earning the highest return), the assets placed in trust fulfill the same goal as the family bank. Using trusts as a planning tool in an integrated family structure equates to taking wealth off the estate tax books, off the creditors’ books, and out of the divorce proceedings of family members. Failure to integrate the family trusts into the investor allocation profile helps the 2001, AIMR®

Asset Allocation for Family Groups shirtsleeves saying come true. The family advisor must make sure the trust documents are drafted so that the trustees of family trusts can be investors in family LLCs and family LLPs. Advisors should also give the trusts the proactive right to participate in the vehicles that are part of the investor allocation. This step is especially important because it brings the trustees into the governance process of the allocations and thus the basic program for the growth of the family’s financial capital. ■ Beneficiary education. Another area that is critical to families having success in wealth preservation—so that advisors can have successful practices—is teaching family members to be excellent beneficiaries. The trustee–beneficiary relationship is an arranged marriage. Beneficiaries never choose their trustees. In effect, they wake up one morning in bed with their trustees, and they are together for the rest of their lives. Beneficiaries have a number of responsibilities for which they must be prepared because trust agreements assume that beneficiaries control the relationship between trustee and beneficiary, except for the final level of discretion over distribution. At that point, the trustee does have overriding authority. But fundamentally, the trust agreement says the trustee–beneficiary relationship is one of equals in which the trustee is accountable to the beneficiaries. The problem is that if the beneficiary does not know how to manage that relationship, the relationship will not be satisfactory. The relationship will not necessarily fail, but it will not work smoothly and has the potential to do harm. On the surface, the trust as an instrument appears to do only good: It solves tax problems, avoids creditors, and provides for intelligent people to look after the beneficiary’s wealth. But I assure you that it has the potential to do great harm. The trust as a mechanism of wealth transfer may create exactly what the wealthy patrons of the new economy fear: children with sandwich boards reading, “I am a trust-dependent person.” Clearly, one reason the third and fourth generations of the industrial flowering of wealth became trust-dependent people is that they were not taught how to be great beneficiaries. The task of advisors is to provide beneficiary education and to create a process within the trust that produces independent people practicing their own natural calling and understanding how to manage the trustee–beneficiary relationship. The first step in achieving this goal is to write the trust agreements so that they offer the principal beneficiaries the opportunity to become trustees, provided that they have been apprentices to learn how to do so. Under such ©2001, AIMR®

terms, many beneficiaries may become trustees when they are young—say, at age 25. Most beneficiaries, however, are not called to be trustees. So, this plan will not work any better than the alternative of no plan at all if young beneficiaries can automatically become trustees without first being apprentices. The beneficiaries must be educated in the skills of trustees before succeeding to that role. What is needed is a governance process that lets people apprentice themselves in this endeavor. The second step in beneficiary education is for all trustees to be mentoring trustees. Trustees who see their function as carrying out good investing, good administering, and humane distributing are simply trustees. Mentoring trustees act as fully participating family members who will bring the beneficiaries to an understanding of trusteeship and to the necessary level of competence to act as a trustee. One good way to ensure mentoring is to include in the initial agreement a provision for “trustee reaffirmation.” For example, every five years, the trustee asks the beneficiary if he or she would like the trustee to continue. This process is separate from the ability of the beneficiary to remove the trustee; it is an affirmative process. The third step in the beneficiary education process is to have protectors in trusts, people whose role is to protect the beneficiary and to make sure that the trustee–beneficiary relationship is a working relationship and who have the ability to fire the trustee and hire a new trustee, if necessary.

Conclusion To ensure the growth and dynamic preservation of a family’s financial wealth (to put the global “shirtsleeves to shirtsleeves in three generations” saying into abeyance), advisors must weave the family members and all the family’s advisors into a process that works to enhance the growth of each individual family member. If all family members, because of the wise use of the family wealth, are leading productive, useful lives based on carrying out their own dreams (provided they are doing no harm), then the family and the family fortune as a whole will rise. Accordingly, the successors to the wealth creators will still need the advisors’ services and gladly continue to work with them. Teaching stewardship of the family’s financial, human, and intellectual capital to all of the family members is a rewarding task that when brought full circle generates its own reward for the family advisor through the advisor’s ability to retain clients.

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Invvestment Counseling for Private Clients III

Question and Answer Session James E. Hughes, Jr. Question: What advice do you have on how advisors can offer help as opposed to the knee-jerk reaction of providing information? Hughes: First, as advisors, we must take some time to try and frame our advice and responses to a family member’s questions in a way that reaches the family member—a way that is consistent with how that member learns and absorbs new ideas. Multiple learning styles exist. Gardner’s book Frames of Mind, which is the Bible in education for explaining the different ways individuals learn, identifies five left-brain (intelligence) and two right-brain (intuitive) learning styles.1 Gardner says that each of us came into this life hardwired to learn in one of those seven ways. As a result, 80 percent of us did not like school because traditional classroom teachers tend to use only one or two of those learning styles. I would bet that most advisors, who typically are traditionally 1

Howard Gardner, Frames of Mind: The Theory of Multiple Intelligences (New York: Basic Books, 1983).

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educated, like the classic classroom learning style. Therefore, advisors will generally frame responses to clients’ questions and explain new concepts to clients in a way that is representative of the way they (the advisors) learn and understand. Thus, when information is presented to clients in the way you would want it presented to you, a significant percentage of the people hearing your message are almost certainly going to be turned off (because it is not presented in a style from which they can learn). The communication you’re attempting doesn’t work. The clients’ dreams, their calling, their businesses, and how they liked school will tell you something about how they learn. Question: How do corporate trustees and private trustees integrate with the concept of the family bank? Hughes: First, whether you have individual trustees or a corporate trustee, you’re still dealing with individuals. Corporate trustees are simply working in an institution under a limitation of liability

for those who are giving the advice. Remember my advice to have mentoring trustees—trustees who care profoundly about outcomes for the human beings who are the beneficiaries during the period of suspended ownership of the family wealth. If the trustees are mentoring properly, they are part of the lending and granting aspects of the family bank because they have control of the substantial assets from which the beneficiaries can borrow. You have to draft the trust agreement broadly to allow for that flexibility. One of my partners drafts trusts that say, “If it were not for taxes and creditors, I would have given the principal income beneficiary the money.” When that statement is added, every trustee can see that the only person it really has to worry about is the principal beneficiary, and the trustees can focus on the beneficiary’s dream and how the trust can invest in it. Mentoring trustees get on with the lives of the living. They don’t get hung up on the monuments to the dead.

©2001, AIMR®

Asset Location: Client Goals and Objectives Darryl L. Meyers, CFA Vice President Wells Fargo Private Client Services Minneapolis

Private client investment managers must use a dynamic asset allocation process in a multigenerational context. The tax exposure of different asset pools (asset locations), as well as the client’s goals and constraints, considerably affect investment strategies and tax-planning options. Capital market expectations, the various sources of risk, tax constraints, and an understanding of the causes of performance drag are all inputs that help determine the most appropriate portfolio strategies for private clients.

uring the course of my prior legal career, I was privileged to serve as an advisor to a number of multigenerational clients, and from that experience, I learned several valuable lessons. One such lesson relates to a client I had in 1987—a small gas station owner. He appeared unannounced in my office with a $12 million estate derived from a lifetime of disciplined investing and a large inheritance from his uncle. Believe it or not, $12 million in 1987 was a lot of money. I immediately hit panic mode. This client did not realize the multiple and complex issues that he had to deal with as a result of the estate tax he would eventually face. My technician’s response was to motivate this client to plan now for the sizeable estate tax burden at his death. In 1987, grantor retained annuity trusts (GRATs) and grantor retained income trusts (GRITs) did not exist in their current statutory forms, which made the job of drafting appropriate documents both easier, because of the increased flexibility, and more difficult, because of the lack of statutory guidance. After my client looked at the incredibly complex tax plan I drafted for him, he decided that it was better to pay taxes. I realized at a young age (and in only two years of practice) that I had achieved a great, if dubious, result: In the eyes of another human being, I had made myself more frightening than death and taxes combined. As a result of this and other experiences, I began to think about what causes some family groupings to

D

Editor’s note: The joint Question and Answer session of Darryl L. Meyers and Jean L.P. Brunel follows Mr. Brunel’s presentation.

©2001, AIMR®

prosper over time and others to simply fail. In this presentation, I will share some of my thoughts and conclusions in this regard. I will focus on the intergenerational asset location decision (the classification of asset pools on the basis of tax exposure) and how managers can ensure that they understand client goals and client constraints. An essential manager task in an intergenerational context is to get the client to understand the uncertainties of time and the impact of the decisions made over time on wealth creation and maintenance.

Asset Allocation When working with private clients, especially in a multigenerational context, managers must thoughtfully adapt the standard tasks involved with dynamic asset allocation. Figure 1 illustrates the dynamic asset allocation process. The manager should always begin with the specification and quantification of investor objectives. Then, capital market expectations are brought into the process to determine the portfolio policies and strategies (i.e., the asset allocation mix) that are appropriate for the client. Next, the portfolio construction takes place, and client objectives and constraints and capital market expectations are continuously monitored. The final step in dynamic asset allocation is performance measurement—the output of which feeds back into the beginning of the circular process, the specification and quantification of investor objectives. In an

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Investment Counseling for Private Clients III Figure 1. Dynamic Asset Allocation

Specification and quantification of investor objectives, constraints, and preferences

Portfolio policies and strategies

Capital market expectations

Relevant macro inputs (economic, political, etc.)

Monitor client objectives and constraints

Portfolio construction: after-tax optimization by holding structure, asset allocation, and implementation

Performance measurement

Monitor capital market expectations

Source: Based on material from William Sharpe, “Asset Allocation,” in Managing Investment Portfolios: A Dynamic Process, edited by John L. Maginn and Donald L. Tuttle, 2nd ed. (Boston: Warren, Gorham & Lamont, 1990).

intergenerational context, if the manager depends solely on the client’s personal goals and constraints, the first step in the asset allocation process will improperly distort the other portfolio-construction steps because intergenerational clients are more than mere individuals. Such clients are akin to a hybrid of individual preferences and institutionally mandated goals and constraints by virtue of the structures required to transmit significant wealth across generations. Thus, the manager must delve deeply into the client’s goals at this first step in the process to quantify and specify the goals as accurately as possible so that both the client and the manager understand the complexity of the task before them. Ultimately, the manager’s goal is to integrate the client’s financial, estate, and investment plans into a comprehensive strategy for achieving client goals— integrated asset allocation. Investor goals and constraints, however, can be idiosyncratic. In an intergenerational context, clients must think about what they want to accomplish across three or more generations. Few clients begin this process without ideas that are contradictory, ill defined, or both. In addition, clients must understand the difficulty of achieving goals across multiple generations. Managers must educate clients to appreciate the dual tax drag of income and transfer taxes. Managers should also try to increase clients’ understanding of certain key issues, such as volatility mismatch and long-term spending targets, with the latter addressing the consumption needs of future generations.

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Multigenerational Issues In dealing with clients who have a multigenerational focus, I recommend that managers begin with what would be called an operational definition of risk—the probability of an adverse consequence given the uncertainty that the client faces. The adverse consequence is defined within the context of client goals and is used to help the client conceptualize the uncertainty that he or she faces. Within this framework, traditional measures of return and variability (i.e., risk) seem incomplete. When risk is thought of in a multigenerational context, the regime-switching aspects that frequently put markets and asset parameter estimates out of equilibrium over time (i.e., an external structural instability), which are outside the manager’s control, are revealed. The primary external driver is tax regime instability. Believe it or not, the U.S. Congress frequently enacts tax legislation that is inconsistent with prior tax legislation. The transmission of intergenerational wealth is also affected by what might be termed “internal structural instability” (i.e., instability caused by the choice of structures designed to transmit and maintain wealth across generations). When clients establish trusts, foundations, and business entities to transmit and maintain wealth, these entities interact with capital markets in ways that may create difficulties in the future. For example, almost any long-term plan will create at least one trust structure. Such trusts typically generate income in the form of dividends and interest that is payable to current beneficiaries, while capital 2001, AIMR®

Asset Location: Client Goals and Objectives gains are maintained for the benefit of remainder beneficiaries. This trust structure limits the ability of managers to invest for total return during periods when the capital markets produce lower dividend yields and interest rates, as they currently do. Instead, managers must either invest in an overly conservative manner to meet the needs of income beneficiaries (disappointing remainder beneficiaries) or invest for total return (disappointing income beneficiaries). Without significant thought ahead of time, many clients will establish wealth-transfer structures that may or may not be able to meet spending targets for future generations. Establishing and then meeting future spending targets is typically the weakest aspect of planning in a multigenerational context. Goal setting in a multigenerational context should begin with the manager fully understanding the client’s goals, objectives, and aspirations, which necessitates good communication by both parties. Is the client a two-generation, three-generation, or fourgeneration thinker? Each type approaches investment decisions from a different perspective. Trying to turn a two-generation thinker, for example, into a three- or four-generation thinker is a fruitless endeavor. Curiously enough, misanthropic clients tend to be very clear in how generational they want to be. I was involved in litigating a case concerning a multigenerational, misanthropic client who loved his wife but who had no children and did not particularly like anybody else in the world, including his niece and nephew. His objective was to create a longterm dynastic trust that would give his niece and nephew each $200 a month for life. He stated to his lawyer at the time that his objective was to tease them. The remainder of his wealth passed to the children of the niece and nephew, who had not yet been born at the time he drafted the trust. Because they did not exist yet, he reasoned that he had no cause to dislike them. For this client, his multigenerational, misanthropic goals were quite clear in his mind. Most clients, however, will not have such clear goals—misanthropic or otherwise. Next, managers should establish a metric of success—exactly how they will measure meeting their goals. Because client goals are idiosyncratic, the measurement metric is often idiosyncratic as well, which can cause problems with comparability and difficulties for managers in understanding how their job fits into the overall scheme. The essential requirement is to devise a quantitative metric of how to measure the plan as the client goals are being developed (such as an inflation-adjusted, real rate of return measure). A real rate of return measure can be based on the post- or preliquidation value of the portfolio. I have found that the following simple ©2001, AIMR®

measure of return, based on nominal values—with an inflation adjustment by compounding the beginning fair market value (FMV) at the rate of inflation, i, at time t—without reduction for expected tax in the event of liquidation, fits with most clients’ sense of how they want return measured and applied to their individual circumstances: FMV End Real Rate of Return = --------------------------------------------t FMV Beg × ( 1 + i )

1 --t

– 1.

Having this type of metric allows clients and advisors to exercise practical judgment at the same time they are engaged in aspirational thinking. Client goals and objectives drive the asset location decision. Thus, the manager, together with the client’s legal and tax advisors, should set forth a feasible set of asset locations. Figure 2 shows the various possibilities. The focus is on the investor and spouse, although they may have received their wealth from a previous generation. The first four boxes to the right of the investor and spouse box in Figure 2 are fixed. Those are, essentially, the only places to put the client’s money. Money can be put in tax exempt or tax-deferred accounts, taxable accounts, charitable giving accounts, or noncharitable giving accounts. The boxes that follow those first four are merely illustrative of the currently authorized techniques for achieving client goals. The currently authorized techniques are subject to legislative whim; hence, the manager should focus the client’s initial goal setting on allocating assets to broad categories (exempt, deferred, charitable transfers, noncharitable transfers, etc.) rather than to particular techniques.

Feasible Wealth Structures The asset location decision must begin with a discussion of what asset location means to the client from the standpoint of ownership, access to property, and taxation, in that order of importance. The client must understand the consequences that flow from the choice of location. From an income tax perspective, client money can be put into vehicles that are income taxable, income tax deferred, or income tax exempt. From a transfer tax perspective, client money can be put into estate tax deferral vehicles, which delay the imposition of estate or gift tax for no more than one generation, and estate tax exempt transfer vehicles for multiple generations (those that have a generation-skipping transfer, or GST, tax exemption). Keep in mind that there may be different owners for the purpose of different taxes. For example, when a client creates a standard trust, the client is treated as the transferor and is liable for the gift tax on completed transfers. A

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Investment Counseling for Private Clients III Figure 2. Client Goal Setting: Establishing a Feasible Set of Wealth Structures

Previous Generation Family Trust

Noncharitable Giving

GST

Grantor

Family Trust

Nongrantor

NextGeneration Wealth

GRAT

Investor and Spouse

Charitable Giving

Charitable Lead Trust

Marital Estate

Charitable Remainder Trust Charitable Entities

Taxable Account(s)

Gift or Transfer Taxes Tax Exempt or TaxDeferred Account(s)

completed transfer for gift tax purposes requires a shift in ownership from one person to another. It is possible, however, for the client to retain certain rights in the trust property (such as the power to substitute property of equal value for the property held in trust). Such a retained right will make the client the owner for income tax purposes on an ongoing basis even though the client is deemed to have given up ownership rights for gift tax purposes. This situation is typically referred to as a gift tax effective, income tax defective trust. Such a trust may allow transferors to pay income on trust earnings, effectively passing on the economic benefit of the taxes paid to the beneficiaries without imposition of additional gift tax. The manager then needs to walk through the issues of beneficial enjoyment and investment authority with the client. State law must be consulted to determine investment authority. The Uniform Prudent Investor Act, which mandates a total return philosophy for the manager, has been adopted in many states. But the new Uniform Principal and Income Act, which allows trustees flexibility in allocating portions of total return to the principal and income accounts of the trust so as to conform with the

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Income or Capital Gains Taxes

Taxes to Government

Uniform Prudent Investor Act, has not been adopted in many states. Thus, trustees and managers are often faced with inconsistent laws governing how trusts are administered and how they must be invested. This type of legal inconsistency can be cured, but frequently is not, by proper drafting of the administrative provisions of the trust document. Trust document provisions must be reviewed with the client in great detail. Trust and other transfer documents are a major source of unintended consequences because they often inadvertently limit the investment authority of trustees, which ultimately affects the ability of the investment manager to execute the strategies necessary to achieve long-term wealth objectives. Managers should always ask to see drafts of wealth-transfer documents before execution and take the opportunity to offer tips for drafting the parts that pertain to the investment manager.

Sources of Performance Drag When counseling a client, the manager needs to explain carefully the factors that can cause a drag on performance: inflation, income tax, transfer tax, and consumption. 2001, AIMR®

Asset Location: Client Goals and Objectives The gravitational pull against wealth accumulation in a multigenerational context is very strong, and clients must be shown how difficult it is over time to accumulate or maintain significant wealth. For example, assume a perfect world where assets earn a constant 10 percent each year (a dividend yield of 2 percent and principal appreciation of 8 percent), are not subject to tax of any kind, and are subject to annual inflation of 2.5 percent. Under such circumstances, a client with $100 million of zero-basis assets might expect his or her assets to grow to about $1.3 trillion in nominal dollars over a 100-year time period. This hypothetical case further assumes that all events occur on the last day of the year and that ending terminal wealth amounts are in nominal, preliquidation tax dollars. The example is not meant to be predictive. Instead, it provides a backdrop to illustrate some key planning variables—taxes, consumption, and return composition—that the client must address in his or her planning and allows the client to see how small changes in design and objectives can have a significant impact on ending results. The real world of investing, however, is not perfect. First, any investment strategy will have a substantial income tax rate drag. Continuing this example, suppose that the client pays (federal and state) an ordinary income tax rate of 48 percent on dividends and a capital gains tax rate of 28 percent. Under such circumstances, assuming a fixed 2 percent dividend yield, the client should reasonably expect a 58 percent reduction in terminal preliquidation wealth, although the final amount is still more than $500 billion under these limited assumptions. Another drag on performance derives from expected turnover of appreciated assets in the portfolio and the resulting payment of capital gains taxes. Holding all previous assumptions the same, if the portfolio is assumed to experience 30 percent turnover of appreciated securities a year, the client’s estimated wealth drops to roughly $76 billion at the end of 100 years. Next, consider the transfer taxes imposed on the portfolio when it is transferred to succeeding generations.1 Assume the transfer tax imposed from the first generation to the second generation is 55 percent; the transfer from the second generation to the third generation is taxed at 50 percent; and the transfer from the third, and final, generation to the fourth generation is taxed at 45 percent. Under such an assumption, the portfolio will still not perform too 1 Since this presentation was given, the tax law has changed. Please see “Update” in Mr. Macklin’s presentation for more information, or go to http://thomas.loc.gov/ and search by bill number H.R.1836.ENR for a complete description of the final bill.

©2001, AIMR®

badly. The expected terminal wealth after 100 years is approximately $10 billion. Of course, I have yet to consider the consumption of the assets by beneficiaries. Consumption drag, typically the gravest drag of all on long-term wealth, should also be factored into the equation. Assume that the first generation begins with a 1 percent spending rate and increases that spending rate by 2 percent annually. The next generation begins (at Year 28) with a 4 percent rate and increases it by 2.5 percent annually. The third generation begins (at Year 56) with a 5 percent rate and also increases it by 2.5 percent annually. At the end of the 100 years, this client group’s portfolio, which began at $100 million, is just slightly more than $67 million after all probable drags on portfolio value have been considered. Such a result is not atypical in practice and confirms the old adage that the best way to create a small fortune is to begin with a large one. Hypothetical illustrations, such as the preceding one, can help clients understand the difficult task before them if they wish to preserve and grow their wealth multigenerationally. The hypothetical illustration also lays down a challenge to managers: Beyond the challenge of identifying and implementing successful investment strategies, the managers of the clients’ wealth must overcome the multiple drags of income and capital gains taxes, transfer taxes, and consumption requirements across several generations.

Tax Constraints U.S. citizens live in a jumble of tax regimes. Those who think that tax statutes and regulations coming out of Washington, DC, follow a logical and consistent policy are wrong. The contradictory nature of many tax laws and regulations arises because of the multiple ways that income and a taxpayer’s estate can be defined. Thus, the manager must understand the logic of the tax constraint imposed by the federal government. Through an understanding of the logic of tax constraints, managers will be able to understand and articulate the logic of their own investment tax strategies. At their core, all tax strategies focus on tax rate, tax timing, tax base, or some combination thereof. If managers can recognize the pattern of their strategies, they will be able to understand the likely upside for the portfolio and the implications of their investment decisions. Income Tax Theory. Income can be thought of in three basic ways: accretion based (also known as comprehensive income tax), expenditure based (also known as consumption tax), and schedular. The classic view is accretion based. The Haig–Simons (1921)

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Investment Counseling for Private Clients III definition of income is the money value of the net accretion to one’s economic power between two points in time.2 An expenditure-based theory of income was propounded by Lord Nicholas Kaldor in 1955. He saw income as the change in value of the net accretion to economic power between two points in time minus amounts reinvested in productive activity. Schedular theories see income as determined by source. The most important continuing example of the schedular theory of income derives from 19thcentury trust and property law and is still used in most U.S. jurisdictions to determine trust income for fiduciary accounting purposes. These different definitions of income thread their way through the tax code, seldom painting the same picture. Income Tax Reality. Accretion is the baseline for the U.S. tax code, and basis (cost) is the key to an accretion system. Basis is used to prevent the same unit of accretion from being taxed twice to the same taxpayer. This practice of preventing double taxation is seen in the common example of computing gains, in which basis is subtracted from value to determine the net accretion to wealth upon which tax will be assessed. The most basic exception to accretion-based taxation, and it is a major exception, is the requirement of realization. Taxpayers are not taxed on gains until gains are realized, a fundamental expenditurebased tax concept. Schedular features of the tax code system, the third tax theory contributing to the overall U.S. tax system, are reflected most strongly in trust accounting and taxation. The general rule in income tax planning is to recover basis now and pay gains tax later. For investment managers, this general rule means managing realized gains (bad turnover) and maximizing realized losses (good turnover) through tax loss harvesting and tax loss swaps. Harvesting losses increases the value of basis recovery, because in an inflationary environment, basis value is a decay function. But managing realized gain by deferring realization is typically more valuable than basis recovery, especially as the time horizon increases.

Transfer Taxation Transfer taxation takes a toll on family wealth in three ways: estate tax, gift tax, and generation-skipping tax. When estimating the client’s estate tax burden, the manager must consider three major components: 2 Those interested in a review of income taxation may wish to consult any of the following: R.M. Haig, “The Concept of Income” in The Federal Income Tax (1921); N. Kaldor, An Expenditure Tax (1955); and H.M. Groves, Tax Philosophers (1974).

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the tax rate that ranges from 37 percent to 60 percent; the value of assets making up the taxable estate; and the taxpayer’s lifetime exclusion amount, which is $675,000 in 2001 (but is set to gradually increase to $1 million in 2010).3 The gift tax burden also imposes a rate that ranges from 37 percent to 60 percent and shares the benefit of the lifetime exclusion amount allowable in calculating the estate tax. In addition, the client is able to take advantage of the annual exclusion of $10,000 per year per recipient for gifts made during the client’s lifetime. The generation-skipping tax is imposed at a flat 55 percent rate and has a limited exclusion of $1,060,000 in 2001. In planning transfer tax strategies that can preserve family wealth over time, the manager must think in terms of rate and tax effect and must consider what the proposed strategy will actually accomplish. That is, is the strategy attempting to affect the tax rate or the tax base? Most tax planning fragments the attributes of ownership to achieve the desired tax effect. Ownership is fragmented in multiple ways—temporal fragmentation (e.g., dividing ownership interests among beneficiaries over time, as in a GRAT) and current ownership interest fragmentation (e.g., dividing interests among current owners, as in a family limited partnership). The strategic objective is almost always the same: Lower the deemed value of the assets that are exposed to the tax base. For example, the estate tax base can be modified (reduced) through valuation discounts when assets are transferred to a family limited partnership. For example, using the prior example and assuming an admittedly aggressive 50 percent discount on family assets, after 100 years, the client’s family may expect to retain slightly more than $157 million with this taxplanning strategy—even after the drag from income tax, turnover, transfer taxes, and consumption. (Remember that without this strategy, the client’s family had only a little more than $67 million after 100 years.) This example continues the previous example with the following changes: 1 percent spending rate with no increase beyond inflation for the first generation, 3 percent spending rate with 1 percent increase beyond inflation beginning in Year 29 for the second generation, and 4.5 percent spending rate with 1 percent increase beyond inflation for the third generation beginning in Year 57. In addition, by simply lowering the percentage drag from consumption and delaying when consumption occurs, this family group can expect to retain more than $1 billion after 100 years— a far cry from $67 million. The example illustrates how modest plan adjustments can have a major impact on 3

See footnote 1.

2001, AIMR®

Asset Location: Client Goals and Objectives terminal wealth. One should keep in mind, however, that the final figure of $1 billion nominal dollars simply represents the approximate purchasing power of $100 million at the beginning of the hypothetical 100-year period.

Conclusion When implementing a dynamic asset allocation strategy, asset location decisions are a crucial driver of the actual strategy choices that must be made to increase the likelihood of achieving client goals in a multigenerational context. In addition, matters not

©2001, AIMR®

discussed in my remarks, such as the impact of volatility on spending targets, must be addressed. As wealth-transfer vehicles become more complex in their structure and more multifarious in the goals they seek to obtain, the more complicated the asset allocation decision will become. Although this additional complexity obviously presents greater challenges in making good decisions, a careful examination of client objectives will allow managers to significantly improve investment decision making on behalf of their affluent clients.

www.aimr.org • 17

Investment Counseling for Private Clients III

Question and Answer Session Jean L.P. Brunel, CFA Darryl L. Meyers, CFA Question: What is the “tax-base effect”?

Question: What role does tax timing play in tax planning?

Meyers: There is a tax-base effect in any aspect of transfer taxation. For example, a GRAT, by definition, has a certain value of assets held in trust from which the beneficiary receives an annuity until death or the trust term ends. At the time the trust is funded, the grantor (also usually the beneficiary) must pay gift tax as determined by the value of the property gifted to the trust less the present value of the annuity. The present value of the annuity payments is calculated according to an assumed rate of return— in this case, 120 percent of the midterm applicable federal rate (AFR) published by the U.S. Internal Revenue Service. This rate is determinative in defining the asset base on which the U.S. government will impose taxes. The rate discounts the annuity payments that sum to a present value that is subtracted from the total assets funding the trust. The difference between the actual assets transferred to the trust and the present value of the stream of annuities is the gift (i.e., the grantor’s tax base). The driver of this strategy is that the manager intends, or expects reasonably to intend, to earn a return on the trust assets that is higher than the AFR used to value the stream of annuity payments. Any amount that is earned in excess of the AFR is not included in the tax base and, therefore, not exposed to tax. In evaluating strategies, managers should seek to understand any tax-base effect embedded in the tax strategy.

Meyers: The income tax rate effect and tax-timing effect are a function of when you pay the tax for income tax purposes. The sooner you pay the tax, the less terminal wealth you will have. Most tax-managed index fund investing, for example, is just a manipulation of the tax-base, which is what tax-managed investing from an income tax standpoint is all about. The point is to harvest losses, which strategically drags basis into the tax base sooner, and to defer as many gains as possible for as long as possible.

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Question: Can you further explain diversification tax cost as used in your model? Brunel: Diversification tax cost simply refers to the capital gains taxes incurred in the context of reducing the client’s exposure to the low-basis stock. So, in the first two examples of the Burger family (with one- and three-location solutions), I am simply talking in terms of how much tax (at a 20 percent federal tax rate) will be paid if $25 million of zero-cost-basis stock is sold. The tax would be $5 million. In the third example (multiple locations), through a private exchange fund structure, the capital gains tax part of the equation has been eliminated, but a gift tax has now been inherited, so to speak, that needs to be considered. This gift tax would be classified as diversification tax cost.

Brunel: The valuation discount is not relevant because if someone makes a gift to charity, that person is trying to get the biggest possible deduction. Thus, it would not make sense to try to reduce the value of the charitable deduction that will result from making the gift. Question: What does a 24 percent passive, large-cap allocation imply about the value of active investment management? Brunel: I have a philosophical view about active management. Having spent about 25 years in the industry arguing that it is possible to add value through active management, I have come to think that the traditional taxable portfolio construction process is flawed. To explain that statement, I need you to visualize a graph, bringing together expected alpha and tax efficiency. Imagine that the horizontal axis of this graph denotes the level of portfolio activity, ranging from passive management on the left-hand side to day trading on the extreme right-hand side. Clearly, the expected alpha line should slope upward, because the only reason to take the trouble to become more active must be that one expects to earn a higher return. Yet, there are two other lines on that graph: They denote tax efficiency. Tax oblivious tax efficiency falls off dramatically as activity increases. This is the point made by Robert Arnott and Robert Jeffrey when they asked “Is your alpha high enough to pay its taxes?”1 Tax-sensitive tax 1

Question: Why would you consider the valuation discount on a CLT to be zero?

Robert D. Arnott and Robert H. Jeffrey, “Is Your Alpha Big Enough to Cover Its Taxes?” Journal of Portfolio Management (Spring 1993):15–26.

©2001, AIMR®

Asset Location efficiency does not fall off as quickly but still eventually does. There comes a point at which alpha generation and tax efficiency are mutually incompatible. Question: How do you apply this explanation in active management strategies? Brunel: Where does the active manager fit in this picture? Well, the traditional answer is for the active manager to have some level of activity producing some alpha and little tax efficiency. I define the

©2001, AIMR®

traditional active manager as an equity portfolio manager aiming to generate a 2 percent alpha with a 3 percent tracking error. The point is that the activity needed to get to that 2 percent has brought the process to the point where tax efficiency is already way down. Rather than aiming for somewhere in the middle of the active–passive spectrum, I have come to believe that managers should “barbell” the portfolio. A portion of the client’s assets should be invested in strategies whose bumper stickers say, “I’m tax efficient, and I may gener-

ate some excess return.” The balance of the portfolio should be in strategies that say, “I generate a lot of excess return, and if I can, I will be tax efficient.” David Stein and Premkumar Narasimhan have written a wonderful piece that talks about the trade-off between active tax management and taxes.2

2

David Stein and Premkumar Narasimhan, “Of Passive and Active Equity Portfolios in the Presence of Taxes,” Journal of Private Portfolio Management (Fall 1999):55–63.

www.aimr.org • 29

Asset Location: Case Study of a Critical Variable Jean L.P. Brunel, CFA Chief Investment Officer, High-Net-Worth Group 1 First American Asset Management Minneapolis

Multi-location asset management strategies offer high-net-worth families opportunities to enhance tax efficiency and lower risk while achieving charitable and family goals— opportunities that single- and even three-location strategies cannot offer. If the manager incorporates multiperiod analyses and tactical strategies with an array of available wealth-planning options (such as family limited partnerships and low-basis diversification strategies), a dynamic asset allocation will result that can greatly improve a family’s financial and tax-planning situations.

sset allocation and asset location decisions are paramount to helping clients achieve their goals. In this presentation, I will use a case study of a hypothetical family—the Burgers—to illustrate the importance of asset location. I will discuss the Burgers’ financial circumstances and constraints and describe how they would have been advised (a single-location solution) roughly 10 years ago. Then, I will describe the multi-location solutions that would be suggested now for the Burgers and the wealth-planning options available. Finally, I will discuss dynamic asset allocation, which I believe is the most beneficial way of conducting wealth planning and which is the new frontier in the private client industry.

A

Background Bill and Linda Burger are a hypothetical family with $100 million in financial assets. That $100 million is composed of $50 million in a zero-basis stock; $40 million in cash; $5 million in municipal bonds, which is their rainy day fund; and $5 million in an IRA that is invested in equities. They also have $10 million in real estate. Their goal is to maximize after-tax wealth across generations. The Burgers think in dynastic terms and are concerned about not spoiling their 1 Mr. Brunel is now founder and managing principal of Brunel Associates, LLC.

Editor’s note: The joint Question and Answer session of Jean L.P. Brunel and Darryl L. Meyers follows this presentation.

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children. Therefore, they want to foster a situation in which the children will be treated as stewards of the family wealth rather than users of the family wealth. The Burgers also feel fortunate because in the early years, they had few financial assets. Therefore, they plan to leave a substantial portion of their wealth to charity. They need $1 million in income annually after tax to support their standard of living and want to give $100,000 a year to each of their three grown children (for a total annual liquidity requirement of $1.3 million). They define risk not as the standard deviation of return but as the probability of having a negative return in any rolling 36-month period. Bill and Linda Burger have five broad constraints on their financial assets. Private equity and hedge fund investments cannot exceed 35 percent of total assets. Small-cap equities cannot exceed one-third of large-cap equities. Non-U.S. equities cannot exceed 30 percent of total publicly held equities. Emerging market equities cannot exceed one-third of non-U.S. equities. Hedge funds cannot exceed 20 percent of total assets. In general, the Burgers have no objection to any particular strategy, provided it is reasonably constrained in the portfolio. In other words, they do not want all of their money in hedge funds or illiquid securities, such as private equities, and they want the manager to exert good judgment in making the allocations between large-cap and small-cap stocks and domestic and international stocks. 2001, AIMR®

Asset Location: Case Study of a Critical Variable

Single-Location Solution

point on the efficient frontier) illustrates that if the model assumptions are on the mark, the Burgers will earn 9.3 percent after tax on the $95 million.

Ten years ago, I was not aware of a model that could have provided a multi-location approach to asset allocation, so my first step in dealing with the Burgers’ assets would have been to aggregate them. I would have used capital market assumptions to derive an efficient frontier. I would have then picked the point of best fit on the frontier, given my understanding of the Burgers’ needs. I next would have compared my recommended point with points on either side of it on the efficient frontier to offer them three portfolio options (shown in Table 1). These portfolios would have been standard asset mixes. Table 2 shows the expected risk and return characteristics of the Burgers’ existing portfolio and each of the three proposed portfolios. The last row in Table 2, “Tax cost of portfolio reallocation,” is an additional constraint. The Burgers did not want to spend more than $5 million in diversification costs. The column for the middle-risk portfolio (the recommended

Multi-Location Solutions Even 10 years ago, those of us working in the private client area knew intuitively that a single-location solution for wealthy clients was not the answer, but the single-location solution was the prevailing model at the time. Probably the biggest difference in investment management between 10 years ago and today is that now we are analyzing risk and return both on a pretax and after-tax basis, which has led to the multi-location model. With the Burgers, by virtue of their assets’ character, obviously a single location is not sufficient to meet their goals and objectives. The Burgers’ IRA indicates their interest in tax deferral, but the Burgers also are concerned about diversifying out of their low-basis stock and want to address their charitable

Table 1. Holdings for Three Single-Location Portfolios Categorized by Risk Level Holding

Low Risk

Tax exempt cash

5.0%

Middle Risk

High Risk

0.0%

0.0%

Tax exempt bonds

25.0

20.0

10.0

Single stock

25.0

25.0

25.0

U.S. large caps (core active)

0.0

0.0

0.0

U.S. large caps (passive structured)

0.0

0.0

1.0

U.S. small caps (passive structured)

5.0

10.0

13.0

Non-U.S. large caps (passive structured)

7.0

10.0

11.0

Emerging market equities (active)

3.0

5.0

5.0

10.0

10.0

15.0

Private equities Nondirectional hedge funds Total

20.0

20.0

20.0

100.0%

100.0%

100.0%

Table 2. Expected Risk and Return Characteristics of the Existing and Three Proposed Portfolios Existing Portfolio

Low Risk

Middle Risk

Expected portfolio pretax compound return (%)

8.4

11.4

12.2

13.1

Expected portfolio after-tax compound return (%)

6.3

8.6

9.3

10.1

Expected tax efficiency (%)

74.9

75.5

76.5

77.1

Expected portfolio risk, pretax (%)

14.2

12.0

13.4

15.1

Expected portfolio risk, after tax (%)

10.1

9.5

10.9

12.3

Characteristic

High Risk

Return per unit of risk, pretax

0.59

0.94

0.91

0.87

Return per unit of risk, after tax

0.62

0.90

0.86

0.82

Probability of negative returns during any rolling 12-month period (%)

27.7

17.3

18.2

19.3

Probability of negative returns during any rolling 36-month period (%)

15.3

5.1

5.8

6.7

Tax cost of portfolio reallocation ($ millions)

na

5.0

5.0

5.0

na = not applicable.

©2001, AIMR®

www.aimr.org • 19

Investment Counseling for Private Clients III intentions. One way to help them achieve their charitable objectives is through the creation of a family foundation. They can transfer, say, $10 million of their zero-basis stock to the foundation, which lowers their exposure to the market risk inherent in a large position of a single stock, gaining a charitable deduction with the transfer. The remaining family assets can be placed in a personal account (an individually managed account). All of this investment activity could be done within the confines of the Burgers’ stated risk–return objectives and within the goal of limiting transaction costs to a maximum of $5 million. Table 3 shows how an asset-allocation optimizer might allocate the Burgers’ assets—assuming that the point on the efficient frontier is identical to that in the single-location solution (the middle-risk alternative)—among the three structures: personal account,

IRA, and foundation. The optimizer, not surprisingly, indicates that the least tax-efficient strategy, the nondirectional hedge fund, should be allocated to the IRA. Actually following through on this allocation would depend on the particular circumstances of the IRA. The optimizer then balances the Burgers’ remaining assets between the foundation and the personal account to optimize total after-tax wealth and to comply with constraints. The optimizer assumes that all but a 15 percent holding of the zerobasis stock is sold and diversified. Table 4 describes the risk and return characteristics for each of the three locations. Each location has its own risk and return profile as well as its own individual goals. Notice that the overall portfolio’s profile is nearly the same as the middle-risk portfolio (the single-location structure) in Table 2.

Table 3. Allocation among Three Structures Holding Tax exempt cash Tax exempt bonds Taxable bonds

Personal Accounta 0.0%

IRA

Foundation

0.0%

0.0%

12.8

0.0

0.0

Total 0.0% 12.8

0.0

0.0

3.0

3.0

15.0

0.0

0.0

15.0

U.S. large caps (core active)

0.0

0.0

3.3

3.3

U.S. large caps (passive structured)

8.9

0.0

0.0

8.9

U.S. small caps (active)

0.0

0.0

1.6

1.6 10.2

Single stock

U.S. small caps (passive structured)

10.2

0.0

0.0

Non-U.S. large caps (core active)

0.0

0.0

1.4

1.4

Non-U.S. large caps (passive structured)

8.9

0.0

0.0

8.9

4.3

0.0

0.7

5.0

10.0

0.0

0.0

10.0

Emerging market equities (active) Private equities Nondirectional hedge funds Total a

15.0

5.0

85.0%

5.0%

0.0

20.0

10.0%

100.0%

Middle-risk portfolio.

Table 4. Expected Risk and Return Characteristics of the Three Structures and Total Portfolio Personal Accounta

IRA

Foundation

Total

12.2

14.5

11.0

12.2

9.7

14.5

11.0

9.5

Expected tax efficiency (%)

79.7

100.0

100.0

78.0

Expected portfolio risk, pretax (%)

13.9

3.8

12.6

13.0

Expected portfolio risk, after tax (%)

11.8

3.8

12.6

10.9

Characteristic Expected portfolio pretax compound return (%) Expected portfolio after-tax compound return (%)

Return per unit of risk, pretax

0.88

3.84

0.87

Return per unit of risk, after tax

0.83

3.84

0.87

Probability of negative returns during any rolling 12-month period (%)

19.0

Probability of negative returns during any rolling 36-month period (%)

6.4

Tax cost of portfolio reallocation ($ millions)

5.0

0.0 0.0 na

19.2 6.6 na

0.94 0.87 17.4 5.2 5.0

na = not applicable. Middle-risk portfolio.

a

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2001, AIMR®

Asset Location: Case Study of a Critical Variable The multi-location solution, however, offers opportunities to enhance tax efficiency and lower risk that the single-location solution does not. Table 5 compares the after-tax return, tax efficiency, and probability of negative returns for the single- and three-location solutions. The risk, in terms of the probability of negative returns, for the middle-risk alternative for the three locations is 5.2 percent, compared with 5.8 percent for the single-location solution. The after-tax return for the three-location solution for the middle-risk alternative is 9.5 percent (0.2 percentage points greater than the single-location solution). Although 0.2 percentage points may not sound like much, if it is compounded over three generations, a net 25 percent increase in wealth results. So, the three-location solution provides a net 25 percent increase in terminal wealth over three generations and a reduction in risk.

Table 5. Portfolio Characteristics for SingleLocation and Three-Location Strategies Single Location

Characteristic/Risk Alternative

Three Locations

Low-risk alternative After-tax return

8.6%

Tax efficiency Probability of negative returns during any rolling 36-month period

8.9%

75.5

76.8

5.1

4.1

Middle-risk alternative After-tax return Tax efficiency Probability of negative returns during any rolling 36-month period

9.3

9.5

76.5

78.0

5.8

5.2

Wealth-Planning Options Going beyond the one location to three locations improved the situation for the Burgers, but even more can be done. The manager has multiple wealthplanning options that can improve the Burgers’ overall financial and tax-planning situation.2 Basic Options. Seven basic ownership options can be used to help the Burgers manage their wealth. I will compare these options by focusing on five key attributes (term, access, control, valuation discount, and tax efficiency) and by using a simple scale of 0– 10, with 10 being the highest. Table 6 summarizes the results of this comparison. ■ Personal account. The personal account has an indefinite life, and the family has complete access to it; after all, it is the family’s money. The family has total discretion and freedom over the account; for example, if the Burgers change their consumption pattern or buy a new business, the money in the personal account is available for them to use. They have complete control over not only the disposition but also the management of these assets. My concern with the personal account, however, is that the location is inherently tax inefficient. Keeping the assets in the family’s own name is not a tax-efficient alternative. The assets are not in a tax-sheltered structure, and the assets do not benefit from a discounted valuation upon transfer to another location that would allow such a discount. Thus, a personal account is rated 10 for both access and control but 0 for availability of a valuation discount and 2 for tax efficiency. ■ GRAT and DGT. A grantor retained annuity trust (GRAT) or an intentionally defective grantor trust (DGT) are used to move assets out of the grantor’s estate and to effectively gift to the grantor’s

High-risk alternative After-tax return

10.1

10.3

Tax efficiency

77.7

78.1

6.7

6.0

Probability of negative returns during any rolling 36-month period

2

Since this presentation was given, the tax law has changed. Please see “Update” in Mr. Macklin’s presentation for more information, or go to http://thomas.loc.gov/ and search by bill number H.R.1836.ENR for a complete description of the final bill.

Table 6. Comparison of Seven Basic Wealth-Planning Options Option Personal account GRAT or DGT GST trust CLT Variable life

Term

Access

Control

Valuation Discount

Tax Efficiency

Life

10

10

0

2

2–10 years

3

8

10

5

Generations

0

8

10

5

Less than 20 years

0

6

0

10 10

Life

8

5

0

IRA and related

Age 59.5

5

9

0

10

Foundation

Ongoing

0

7

0

10

Note: GRAT = grantor retained annuity trust; DGT = defective grantor trust; GST = generation-skipping transfer trust; CLT = charitable lead trust. Options are ranked on a scale of 0–10, with 10 being the best.

©2001, AIMR®

www.aimr.org • 21

Investment Counseling for Private Clients III heirs additional assets beyond the assets transferred to the trust. The term of a GRAT is typically less than the life expectancy of the grantor because the taxplanning value of a GRAT disappears if the grantor dies during the term of the GRAT. In such an instance, the assets in the trust would be pulled back into the grantor’s estate, which would mean that the grantor would have gone to a lot of trouble to accomplish nothing. As for access, the family has some degree of access to the property in trust with a DGT and GRAT as well as the benefit of the income from the annuity paid by the GRAT and the income earned by the DGT, hence the 3 rating for access. The family has good control over the assets and how they are managed in either a GRAT or DGT, consequently the 8 rating for control. Because there are also substantial opportunities for valuation discounts as the assets are transferred from the grantor to the trust, it rates a 10 for valuation discount. The primary reason for creating a DGT is that with a DGT, the grantor pays the taxes on the income earned by the trust, thus effectively gifting tax free the amount of the taxes to the grantor’s heirs because the trust assets are not depleted by the tax payments. The same additional “gifting” ability is also true for a GRAT. Thus, these locations have moderate tax efficiency and are rated a 5. ■ Generation-skipping transfer trust. A generation-skipping transfer (GST) trust is an instrument that allows the grantor to pass assets to a third generation without the depleting effect of having the assets taxed twice—once at the grantor’s death and again at the grantor’s children’s death. In many respects, a generation-skipping transfer trust is similar to a grantor trust in that the income can be available to the grantor during his or her lifetime and to the grantor’s children during their lifetimes. The trust does not terminate typically until the death of the grantor’s children when the assets are distributed to the grantor’s grandchildren. The grantor has no access to the assets placed in the GST but has control over the management of the assets held in the trust. Again, because of the transfer, a valuation discount is available and the tax efficiency is identical to that of the GRAT or DGT. Therefore, the ratings for the GST are 0 for access, 8 for control, 10 for valuation discount, and 5 for tax efficiency. ■ Charitable trusts. Charitable lead trusts (CLTs) are trusts in which the residual value of the assets in the trust at the trust’s termination go to the family and the income earned by the assets in the trust goes to charity. Recently, the lawyer of one of my clients recommended a CLT to the family as a planning mechanism because the family was not in need of income. Thus, in contrast to the traditional approach of a charitable remainder trust (CRT), in

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which the residual interest in the assets at termination goes to charity and the income is paid to the family over the term of the trust, the CLT was a more relevant structure. The CLT not only provided a charitable deduction for the family on an annual basis but also encouraged the next generation to live their own dreams, as opposed to living their parents’ dream. The CLT allows the beneficiaries to live their own dreams because when the trust terminates, the assets are distributed to the beneficiaries, at which point the beneficiaries (the second or third generations) have the option of deciding how to manage the inherited assets. The term of a CLT is usually less than 20 years. The beneficiaries and grantor of the trust have no access to the assets and have only moderate control over the assets during the trust term. There is no valuation discount for the transfer, but the tax efficiency of the trust is good. Hence, the CLT deserves the ratings of 0, 6, 0, and 10, respectively, for the qualities just discussed. ■ Variable life insurance policies. The variable life insurance policy combines the protection of life insurance with the possibility for capital growth. The policy is a wrapper that allows the family to defer the income tax incurred on the income generated within the policy. The construction of these policies is critical to their success in achieving family goals. If appropriately constructed, this structure offers an opportunity for the family to have access to the assets through policy loans (earning a rating of 8 for access) and to retain a substantial amount of control over the investments, often mutual funds (earning a rating of 5 for control). The term of the structure is the lifetime of the insured. The transfer of assets to a variable life insurance policy occurs through the premium payments, and thus, it has no provisions for a valuation discount. So, this structure rates 0 on valuation discount. The policy wrapper does provide a high degree of tax efficiency, however, through the deferral mechanism, which is why it has a rating of 10. ■ Tax-deferred pension vehicles. IRAs and other such tax-deferred pension vehicles are moderately accessible (rating of 5), provide a high degree of control over the assets (rating of 9), and are tax efficient (rating of 10); however, they provide no valuation discount (rating of 0). The term of these structures begins to end when the beneficiary reaches age 59.5, but mandatory distributions can be deferred until age 70.5. ■ Foundation. With the creation and funding of a family foundation, the family relinquishes all access to the assets gifted to the foundation, earning a rating of 0, but does retain some control over the assets, hence a rating of 7. A foundation has an indefinite 2001, AIMR®

Asset Location: Case Study of a Critical Variable term. There is no valuation discount on the transfer of assets to the foundation (therefore the rating is 0) because the transfer is a charitable deduction. The foundation structure rates a 10 for tax efficiency because a foundation’s investment return is virtually tax exempt, provided certain minimum levels of charitable donations are met. Additional Options. In addition to the seven basic ownership options (or locations), managers can use private exchange funds, intergenerational loans, transactions with defective trusts, and family partnerships to transfer and transform family assets to achieve greater tax efficiency. ■ Private exchange funds. A private exchange fund is one way managers can help their clients diversify low-basis holdings, but the manager’s and client’s legal counsel need to be consulted before recommending and enacting such a structure. This structure basically allows a family to put its assets in a partnership and monetize them through a loan collateralized by the assets. The proceeds of the loan are invested in a diversified portfolio. The benefit of such a structure relative to a public exchange fund (which is created by various investors’—not just a single family’s—contributions of low-basis stock holdings) is that the family can have a truly diversified market portfolio, as opposed to a portfolio created by the combined holdings of each of the individual participants in the fund, which in all likelihood will not be optimally diversified. ■ Intergenerational loans. James Hughes defines an intergenerational loan as one way of making the IRS’s chair smaller at the table—one way of reducing the IRS’s claim on the family’s assets.3 Usually, the generation that has the most access to liquidity for making investments is the one whose estate is closest to maturation, closest to being exposed to death taxes (i.e., the older family members). The idea behind an intergenerational loan is that lending by the older generation to the younger generation provides the younger generation with the liquidity (the assets) that will allow them to invest in the higher-returning, riskier assets. The benefit of this type of loan is that the greatest growth will occur in the portfolios of the family members who are farthest away from having to transfer assets at death, when the imposition of estate taxes occurs. ■ Transactions with defective trusts. In transactions with defective trusts, the principals of the income tax and the estate tax regimes are different. Therefore, a DGT could be established so that for 3 James

E. Hughes, Jr., Family Wealth: Keeping It in the Family (Princeton Junction, NJ: NetWrx, 1997).

©2001, AIMR®

estate tax purposes the assets are out of the estate but for income tax purposes the assets are still in the estate. ■ Family partnerships. Family partnerships provide two benefits. First, they allow families to pool their assets, whether one asset class or several asset classes, to achieve economies of scale. For example, the family can implement investment strategies or execute trades without forcing each generation to own exactly the same assets as the other generation. Second, when the units in the partnerships are gifted from the general partners (typically the first generation) to the limited partners (typically the second and third generations), the transfers are eligible for valuation discounts, thus lowering the size of the gift on which gift tax is paid and allowing family members to transfer assets at less than fair market value. By using this mechanism, the older family members can relocate assets to younger family members, a result similar to the intergenerational loan discussed previously. Effect on the Burgers. By including the seven basic structures and the four additional structures just described in the asset-allocation optimization for the Burgers, their portfolio’s risk–return profile (i.e., their efficient frontier) can be improved. Keep in mind that the assets held in each structure should be selected for the benefit of the entire family portfolio, not for each individual structure. The optimal solution for the Burgers—given their goals, constraints, and the risk and return inputs in the model—is to create a family partnership and a private exchange fund. The family partnership is invested in a diversified manner with positions in hedge funds, private equities, emerging market equities, U.S. small-cap equities, and non-U.S. large-cap equities. Limited partnership interests in the family partnership are gifted to a GST and grantor trust or bought with an intergenerational loan or an installment sale between the trust and the grantor. A conservative 30 percent discount is applied in valuing the gift of the interests in the family partnership. The family’s zero-basis stock is contributed to a private exchange fund where it can be optimally diversified with positions in fixed income, U.S. largecap equities, and non-U.S. large-cap equities. The family’s portfolio, or personal account, is completed by buying an interest in the family partnership and through direct ownership in other strategies. The variable life policy and the IRA are both 100 percent invested in hedge funds because these structures are the better locations to shelter the more taxinefficient assets, such as hedge funds. The CLT is invested directly in various asset classes—fixed income, U.S. large-cap equities, non-U.S. equities,

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Investment Counseling for Private Clients III and emerging market equities—and does not have an ownership interest in the family partnership. The last location used is a foundation which is, like the CLT, invested directly in several different asset classes. The family wealth structure is depicted in Figure 1. The seven-location portfolio optimization driving the investment and tax-planning decisions illustrated in Figure 1 is specified in Table 7 by location Figure 1.

with the asset allocations for each. Table 8 lists the risk and return characteristics of each of the seven locations recommended to the Burgers in the optimization process. The most important difference, compared with the three-location solution shown in Table 4, is that the cost of reallocating the assets, moving away from the low-basis stock, has been substantially reduced (a reduction from $5 million to

Asset-Allocation Diagram

CLT Account

Foundation Account

Personal Account

GST Account

Grantor Trust

Private Exchange Fund

IRA Account

Family Partnership

Non-U.S. Large-Cap Equities

Fixed Income

Variable Life Policy

Emerging Market Equities

U.S. Large-Cap Equities

Hedge Funds

U.S. Small-Cap Equities

Private Equities

Table 7. Asset Allocation among Seven Structures Asset

PA

Tax exempt cash

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

Tax exempt bonds

4.2

0.0

0.0

0.0

0.0

0.0

0.0

4.2

Taxable bonds

0.0

0.0

3.0

0.0

0.0

2.8

0.0

5.8

Single stock

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

U.S. large caps (core active) U.S. large caps (passive structured)

IRA

Foundation

DGT

GST

CLT

VLI

Total

0.0

0.0

3.3

0.0

0.0

0.7

0.0

4.0

24.2

0.0

0.0

0.0

0.0

0.0

0.0

24.2 5.8

U.S. small caps (active)

0.0

0.0

1.6

0.0

0.0

4.2

0.0

U.S. small caps (passive structured)

5.2

0.0

0.0

2.6

0.5

0.0

0.0

8.3

Non-U.S. large caps (core active)

0.0

0.0

1.4

0.0

0.0

0.0

0.0

1.4

Non-U.S. large caps (passive structured)

9.1

0.0

0.0

1.2

0.2

0.0

0.0

10.5

Emerging market equities (active)

1.2

0.0

0.7

1.4

0.3

2.4

0.0

6.0

Private equities

4.1

0.0

0.0

5.0

1.0

0.0

0.0

10.0

0.0

5.0

1.0

10.0%

15.0%

Nondirectional hedge funds Total

4.1 52.0%

5.0 5.0%

3.0%

0.0 10.0%

5.0 5.0%

20.0 100.0%

Note: PA = personal account; VLI = variable life insurance.

24 • www.aimr.org

2001, AIMR®

Asset Location: Case Study of a Critical Variable Table 8. Individual Portfolio Risk and Return Characteristics Characteristic

PA

IRA

Foundation

DGT

GST

CLT

VLI

Total

Expected portfolio pretax compound return (%)

10.6

14.5

11.0

15.5

15.5

13.4

14.5

12.3

Expected portfolio after-tax compound return (%) Expected tax efficiency (%)

9.7

14.5

11.0

11.9

11.9

13.4

14.5

9.9

91.6

100.0

100.0

76.7

76.7

100.0

100.0

80.3

Expected portfolio risk, pretax (%)

13.7

3.8

12.6

14.4

14.4

15.8

3.8

12.3

Expected portfolio risk, after tax (%)

13.3

3.8

12.6

12.3

12.3

15.8

3.8

10.9

Return per unit of risk, pretax

0.8

3.8

0.9

1.1

1.1

0.9

3.8

1.0

Return per unit of risk, after tax

0.7

3.8

0.9

1.0

1.0

0.9

3.8

0.9

Probability of negative returns during any rolling 12-month period (%)

22.0

0.0

19.2

14.1

14.1

19.9

0.0

15.8

Probability of negative returns during any rolling 36-month period (%)

9.0

0.0

6.6

3.1

3.1

7.1

0.0

4.1

0.6

0.4

0.2

1.1

Tax cost of portfolio reallocation ($ millions)

—

—

—

$1.1 million). In addition, the seven-location optimization has a nearly identical risk profile but with somewhat higher expected return than that shown in Table 4. The differences are even more striking in Table 9, which shows the risk and return characteristics of all three alternatives (single-, three-, and seven-location solutions). Comparing the one-location with the seven-location solution shows that with the sevenlocation solution, 60 basis points of annual after-tax return is gained (9.9 percent versus 9.3 percent). Compounding 60 bps a year over three generations results in an 80 percent increase in wealth, so this return difference is very significant. Also, note the reduction in risk from the one-location solution (5.8

Table 9. Comparison of One-, Three-, and SevenLocation Alternatives Characteristic

One

Three

Seven

Expected after-tax portfolio risk (%)

10.9

10.9

10.9

9.3

9.5

9.9

76.5

78.0

80.3

Negative returns during any rolling 12-month period (%)

18.2

17.4

15.8

Negative returns during any rolling 36-month period (%)

5.8

5.2

4.1

5.0

5.0

1.1

Expected after-tax portfolio return (%) Expected tax efficiency (%) Expected probability of

Diversification tax cost ($ millions) Overall portfolio mix Cash and bonds (%)

20.0

15.8

10.0

U.S. equities (%)

35.0

39.0

42.1

Non-U.S. equities (%)

15.0

15.3

17.9

Private equities (%)

10.0

10.0

10.0

Nondirectional hedge funds (%)

20.0

20.0

20.0

©2001, AIMR®

—

percent) to the seven-location solution (4.1 percent), as measured by the probability of rolling 36-month negative returns.

Dynamic Location Issues Asset location cannot be conducted within a static framework; it must be dynamic. Producing a strategic asset allocation/location optimization in the context of a single period is purely and simply a nonsensical exercise. The importance of dynamic location rests on the need for multiperiod analyses and tactical transfer of assets between the grantor (the family member) and the grantor trust(s). Multiperiod Analyses. A multiperiod framework is necessary because certain structures have a limited life. For example, a client of mine (a family) has six GRATs—three for the father and three for the mother (with terms of 5, 7, and 10 years for each parent). At the termination of the first GRAT, the disposition of the assets in the GRAT must be considered in the optimization process. Ignoring the issue will not suffice. If a manager asks a client to think in multigenerational terms, the manager cannot dismiss an issue that is a mere five years away. Thinking in a multiperiod context is essential from that point of view. The second reason for using multiperiod analyses is because portfolio rebalancing, by definition, involves multiple periods. Asset classes and asset strategies generate different returns and uncertainty in returns. (If all asset classes had the same return, why in the world would managers bother diversifying in the first place?) Because asset returns differ over time from the returns assumed when optimization was initially calculated, portfolios must be

www.aimr.org • 25

Investment Counseling for Private Clients III rebalanced, which is not a trivial undertaking. In a world with taxes, portfolio rebalancing means that taxes are paid when an investment is sold that has appreciated in value. (I use the word “appreciated” because I believe that the capital market line has a positive slope, which means that over time, returns are positive.) A manager must consider the trade-off between the after-tax proceeds from the sale that are available for reinvestment versus the risk that is diversified away by rebalancing the portfolio. The third reason for conducting multiperiod analyses involves annuity payments. Some annuity payments, thankfully, can be paid in the form of partnership units and involve no sale of underlying assets, but certain payments require liquidation of some assets. Most of the time, this liquidation occurs when the amount of the payment exceeds the accounting income in a trust (interest and dividends), and the corpus (principal) of the trust must be used to make up the difference. T a c t i c a l I s s u e s . Tactical issues—reducing forward-looking return variability, capturing the appreciation of a depressed security, raising total portfolio tax efficiency, and reducing capital gains to remaindermen—are exciting because they are the new frontier in managing assets for private clients. The following examples involve transactions between a grantor and his or her trust. Each of these strategies has the potential to produce desirable outcomes. The tool that is used involves the power that a properly written trust gives for exchanging principal between the grantor and the trust—exchanging that principal in a tax-free manner (no gift tax)—at any time. Imagine the situation in which a family had put in a trust four years ago the shares of a dot-com company—a company the family had founded— prior to the shares being released as an initial public offering (IPO). Those shares were put into a GRAT with the remainder interest going to the children. The dot-com had its IPO, and the value of the shares rose more than a hundredfold. The family went from a situation in which the children had no assets to one in which the children were extremely wealthy. The shares of the dot-com company were sold by the GRAT immediately following the IPO, and the proceeds were invested in hedge funds. (The head of this family is one of the few dot-com multimillionaires who did not go belly up when prices plummeted because, with excellent foresight, he sold his dot-com business when it was still valuable.) The critical feature is that the grantor achieved his objectives and froze the downside risk in the GRAT. In doing so, the grantor reduced the forward-looking return variability of the total family portfolio.

26 • www.aimr.org

If the stock, instead of rising in value after the IPO, had fallen in value and the stock was still in a GRAT for the benefit of the children, the grantor would have had two options. Suppose the family still believed the company was valuable. The traditional option would have been to wait for the stock to recover, but remember, if an asset’s value falls by 20 percent, it needs to rise by 25 percent for the family to be back in the money. The second option would have been to accept that the gift to the GRAT was made at an inopportune moment, have the grantor exchange the stock for an equal amount of cash, and lock in, or freeze, the value in the first GRAT. Then, the manager would create a second GRAT with the same stock so that the value of the gift is leveraged by the stock’s depressed value in the expectation that the stock will appreciate within the GRAT over time, thereby magnifying the gift made to the children when the trust terminates. Another option for a tactical transfer between the grantor and the GRAT that raises the level of tax efficiency for the whole portfolio is to have the grantor pay the trust’s income taxes. Remember that a fundamental benefit of a GRAT is that the taxes paid on the return earned in the GRAT are equivalent to a tax-free gift by the grantor to the remaindermen of the trust. Irrespective of where the grantor’s income is generated—whether in the GRAT or the grantor’s personal account—the grantor will pay the same amount of income tax because the tax liability of both locations is that of the grantor. By the grantor paying the income tax liability of the trust, the trust is not depleted by the amount of the income tax, which effectively increases the ultimate value of the trust at termination; hence, a gift is made that is not subject to gift tax. A second strategy that can raise total portfolio tax efficiency is to have the manager realize losses in the grantor’s personal account and realize gains in the GRAT. In this way, the grantor can effectively gift a greater amount to the next generation than if the opposite occurs. If a manager intends to sell a security and that security is held at a loss, the manager should transfer the security from the GRAT into the family’s account, transfer cash to the GRAT in an equal amount, and sell the security from the grantor’s personal account. The tax gift to the next generation will be greater because the loss is not used to offset the gain in the GRAT. Thus, when the grantor pays the tax on that gain on behalf of the GRAT, one can argue that he or she effectively makes a bigger gift to the GRAT. Finally, the last tactical issue, reducing capital gains to remaindermen, is important for grantors who are advanced in age. This option addresses the 2001, AIMR®

Asset Location: Case Study of a Critical Variable amount of assets that will actually be left to the children. All of these GRAT strategies contribute to the overall preservation and growth of family wealth, but the assets that accrue to the remaindermen, or to the beneficiaries, at the termination of the trust carry the basis acquired when they were transferred into the trust. Thus, they do not receive any step-up in basis at the death of the grantor because they were effectively already taken out of the grantor’s estate. Suppose that five years ago, a grantor placed an appreciated security into a GRAT. Today, that grantor is 75 years old. If the grantor allows the GRAT to mature, the appreciation in that security will be transferred to the remaindermen, and an inherent capital gains tax on the appreciation must be paid by the remaindermen. Typically, the tax will be around 25 percent (20 percent federal tax plus about 5 percent state tax). But the grantor has another option. Before the trust matures, the grantor can transfer the security back into his or her estate (the personal account) and replace the security in the GRAT with an equal value in cash. With this transfer, the next generation (or remaindermen) will be receiving assets with a tax basis equal to market value; the same wealth transfer occurs without the inherent capital gains tax liability. The liability is being absorbed by the grantor’s estate.

©2001, AIMR®

The grantor (or parent) has the option of selling the stock in his or her estate, paying the capital gains tax, and transfering the cash at death or during his or her lifetime. Or, if the grantor is truly thinking multigenerationally, the transfer can be made at death when the appreciated securities will receive a step-up in cost basis.

Conclusion About 10 years ago, I deluded myself into thinking that tax efficiency was basically about managing income and capital gains taxes. With the passage of time, I have come to realize that tax efficiency is an extremely complex issue that involves all the forms of taxation, including estate taxes. In that context, asset location, and particularly dynamic asset allocation, is fundamental to helping clients achieve their goals. Asset location—the new frontier in tax-efficient portfolio management—is a critical element in integrated wealth planning for high-net-worth families. Asset location provides a significant opportunity for the manager to preserve family wealth over time and is by necessity an ongoing, vital process. The management of optimal asset location is a complex activity but one that should be undertaken.

www.aimr.org • 27

Investment Counseling for Private Clients III

Question and Answer Session Jean L.P. Brunel, CFA Darryl L. Meyers, CFA Question: What is the “tax-base effect”?

Question: What role does tax timing play in tax planning?

Meyers: There is a tax-base effect in any aspect of transfer taxation. For example, a GRAT, by definition, has a certain value of assets held in trust from which the beneficiary receives an annuity until death or the trust term ends. At the time the trust is funded, the grantor (also usually the beneficiary) must pay gift tax as determined by the value of the property gifted to the trust less the present value of the annuity. The present value of the annuity payments is calculated according to an assumed rate of return— in this case, 120 percent of the midterm applicable federal rate (AFR) published by the U.S. Internal Revenue Service. This rate is determinative in defining the asset base on which the U.S. government will impose taxes. The rate discounts the annuity payments that sum to a present value that is subtracted from the total assets funding the trust. The difference between the actual assets transferred to the trust and the present value of the stream of annuities is the gift (i.e., the grantor’s tax base). The driver of this strategy is that the manager intends, or expects reasonably to intend, to earn a return on the trust assets that is higher than the AFR used to value the stream of annuity payments. Any amount that is earned in excess of the AFR is not included in the tax base and, therefore, not exposed to tax. In evaluating strategies, managers should seek to understand any tax-base effect embedded in the tax strategy.

Meyers: The income tax rate effect and tax-timing effect are a function of when you pay the tax for income tax purposes. The sooner you pay the tax, the less terminal wealth you will have. Most tax-managed index fund investing, for example, is just a manipulation of the tax-base, which is what tax-managed investing from an income tax standpoint is all about. The point is to harvest losses, which strategically drags basis into the tax base sooner, and to defer as many gains as possible for as long as possible.

28 • www.aimr.org

Question: Can you further explain diversification tax cost as used in your model? Brunel: Diversification tax cost simply refers to the capital gains taxes incurred in the context of reducing the client’s exposure to the low-basis stock. So, in the first two examples of the Burger family (with one- and three-location solutions), I am simply talking in terms of how much tax (at a 20 percent federal tax rate) will be paid if $25 million of zero-cost-basis stock is sold. The tax would be $5 million. In the third example (multiple locations), through a private exchange fund structure, the capital gains tax part of the equation has been eliminated, but a gift tax has now been inherited, so to speak, that needs to be considered. This gift tax would be classified as diversification tax cost.

Brunel: The valuation discount is not relevant because if someone makes a gift to charity, that person is trying to get the biggest possible deduction. Thus, it would not make sense to try to reduce the value of the charitable deduction that will result from making the gift. Question: What does a 24 percent passive, large-cap allocation imply about the value of active investment management? Brunel: I have a philosophical view about active management. Having spent about 25 years in the industry arguing that it is possible to add value through active management, I have come to think that the traditional taxable portfolio construction process is flawed. To explain that statement, I need you to visualize a graph, bringing together expected alpha and tax efficiency. Imagine that the horizontal axis of this graph denotes the level of portfolio activity, ranging from passive management on the left-hand side to day trading on the extreme right-hand side. Clearly, the expected alpha line should slope upward, because the only reason to take the trouble to become more active must be that one expects to earn a higher return. Yet, there are two other lines on that graph: They denote tax efficiency. Tax oblivious tax efficiency falls off dramatically as activity increases. This is the point made by Robert Arnott and Robert Jeffrey when they asked “Is your alpha high enough to pay its taxes?”1 Tax-sensitive tax 1

Question: Why would you consider the valuation discount on a CLT to be zero?

Robert D. Arnott and Robert H. Jeffrey, “Is Your Alpha Big Enough to Cover Its Taxes?” Journal of Portfolio Management (Spring 1993):15–26.

©2001, AIMR®

Asset Location efficiency does not fall off as quickly but still eventually does. There comes a point at which alpha generation and tax efficiency are mutually incompatible. Question: How do you apply this explanation in active management strategies? Brunel: Where does the active manager fit in this picture? Well, the traditional answer is for the active manager to have some level of activity producing some alpha and little tax efficiency. I define the

©2001, AIMR®

traditional active manager as an equity portfolio manager aiming to generate a 2 percent alpha with a 3 percent tracking error. The point is that the activity needed to get to that 2 percent has brought the process to the point where tax efficiency is already way down. Rather than aiming for somewhere in the middle of the active–passive spectrum, I have come to believe that managers should “barbell” the portfolio. A portion of the client’s assets should be invested in strategies whose bumper stickers say, “I’m tax efficient, and I may gener-

ate some excess return.” The balance of the portfolio should be in strategies that say, “I generate a lot of excess return, and if I can, I will be tax efficient.” David Stein and Premkumar Narasimhan have written a wonderful piece that talks about the trade-off between active tax management and taxes.2

2

David Stein and Premkumar Narasimhan, “Of Passive and Active Equity Portfolios in the Presence of Taxes,” Journal of Private Portfolio Management (Fall 1999):55–63.

www.aimr.org • 29

Diversifying Concentrated Holdings Scott D. Welch Director of Equity Risk Management CMS Financial Services, Inc. Rockville, Maryland

Meeting the special needs of clients who have concentrated equity holdings has become a productive way for investment managers to develop client relationships and stand out from the competition. Many hedging strategies for managing low-basis assets are available—from financial strategies using equity collars and variable prepaid forwards to charitable strategies and donor-advised funds. But the strategies are effective only when certain criteria are met, and the advantages and disadvantages of each must be carefully weighed in order to correctly structure the appropriate method for diversifying the risk of each particular client’s position.

t CMS Financial Services, we specialize in working with high-net-worth clients. As a wealth management firm based in the middle of a hightechnology economic region (northern Virginia), we constantly meet with a large number of clients who hold highly appreciated assets, in large part because of the high-technology boom, and whose overall portfolio contains far too high a concentration in one stock. These clients are typically entrepreneurs who successfully managed their companies and then sold them to a publicly traded company in exchange for stock in the acquiring company. They do not want to sell the stock and incur capital gains taxes, and quite frequently, they are still bullish on their shares. An article in the July/August 2000 Bloomberg Wealth Manager said, “A new study finds that individual stock volatility has been rising, suggesting that investors must own more equities to maintain their grip on diversification.”1 In November 1999, the CPA Journal reported “that volatility erodes any stock’s compounding rate—the true measure of wealth accumulation.”2 Thus, because many individuals hold a majority of their wealth in one volatile stock position that is eroding their opportunity to

A

1 James Picerno, “Quantity Control,” Bloomberg Wealth Manager (July/August 2000). 2 Alan R. Feld, “High Exposure to Low-Basis Stock: Too Much of a Good Thing?” CPA Journal (November 1999); www.nysscpa.org/cpajournal/d601199a.html.

Editor’s note: The joint Question and Answer session of Scott D. Welch and Robert N. Gordon follows Mr. Gordon’s presentation.

30 • www.aimr.org

accumulate future wealth, they need equity risk management services. In this presentation, I will discuss several equity risk management products—among them taxadvantaged hedging and monetization strategies— that address the needs of private clients with concentrated equity holdings, and I will explain how to identify potentially good candidates for equity risk management transactions. Finally, I will compare the alternatives available in equity risk management for managing low-basis assets, which include not only collars and forwards but also other financial and charitable strategies.

Equity Risk Management Equity risk management allows high-net-worth investors who hold concentrated positions in one stock or a basket of individual stocks to do four things. First, it allows them to protect the value of their shares at, or very close to, the current market price of the stock, which is a vital feature for many investors. Second, it allows investors to participate in a specified amount of the future growth of the stock. To be a tax-effective transaction, the investor must be at risk to a certain degree, and one way to do that is to allow the investor to keep some upside price potential on the stock. Third, it allows investors to generate immediate, tax-effective liquidity for reinvestment in a more diversified portfolio. And fourth, it allows investors to defer capital gains taxes—the key word being defer, not eliminate; every tax dollar 2001, AIMR®

Diversifying Concentrated Holdings not paid today has a tremendous impact in potential principal appreciation and compounding for clients. The tax bill will come due eventually, but its postponement is very valuable to the client in terms of additional wealth accumulation. Equity risk management products offer investment advisors a great way to enhance the depth and profitability of existing and prospective client relationships. I have never met a client who was not at least willing to talk about these ideas, even if the client ultimately chose not to use them. These products also provide advisors tax-effective liquidity for reinvestment—a great way to increase the amount of assets under management. Finally, even in today’s increasingly commoditized environment, these products offer a unique, high-value-added service to high-net-worth clients. Concerns for Risk Management Clients. Most major financial institutions can provide risk management services to high-net-worth investors, but they typically do not provide price discovery as part of the process. Thus, a client can go to a broker or a private banker from Firm A or Bank X and get a bid on the concentrated stock holding, but the price received is not likely to be competitive, and in any event, the client has no assurance that the price is competitive. In addition, the client has no way to initiate document discovery (the process of negotiating or strengthening the document on behalf of the client without increasing the overall risk of the transaction). Typically, the document provisions on captive (i.e., noncompetitive) deals are not negotiated, even though the off-the-shelf documents governing these transactions that are used by most firms are not written for the benefit of the client. Only a handful of firms that arrange hedging transactions act as objective, conflict-free intermediaries between the investment banking community and investors—sitting on the client’s side of the table to negotiate on the client’s behalf, putting every trade out for competitive bid, working with tax attorneys to negotiate the governing documents for the client to make them stronger from a tax perspective while making them more equitable in terms of flexibility, and so forth. Characteristics of Investors. Several traits characterize the type of client who would be interested in a hedging or monetization transaction. Such clients must • have a fairly high net worth and be financially sophisticated—traits mandated by the particular characteristics of these types of products, which are regulated by the U.S. SEC and bank regulatory authorities. That is, the investor must qualify ©2001, AIMR®

as an “accredited investor” under SEC definitions (i.e., have a net worth in excess of $1 million and/or a current income in excess of $200,000 a year for the previous two years). • still be bullish on the future of the concentrated stock holding. If a client believes that the stock is fairly valued or even overvalued (although I have never actually heard anyone say that), my recommendation will always be to sell. Such a decision is nonemotional, and many tax-effective ways of selling exist, such as through a charitable remainder trust (CRT). • recognize the need for more diversification in their portfolios. • want to defer capital gains taxes. • believe that the continued growth in their concentrated stock holding plus the performance of their reinvestment portfolio will exceed the cost of funds (i.e., the financing cost) associated with the hedging transaction. • qualify as “suitable” counterparties from a regulatory perspective. The typical equity risk management client is an entrepreneur, partner, venture capital investor, or anyone who has sold out an ownership interest in his or her firm to a publicly traded company in a stockfor-stock merger. This description probably represents about 70 percent of my clients. Other candidates for risk management strategies include employees or affiliates who wish to diversify without selling their stock. In December 1999, the SEC issued a “noaction” letter that the markets have interpreted as opening the door for affiliate hedging transactions, which have been a big chunk of our business lately. Another potential candidate for a hedging or monetization strategy is the heir to a low-basis asset (where no step-up in basis was provided by the estate plan) who is seeking to diversify. Conversely, an elderly investor who wants to lock-in the value of an appreciated position for his or her heirs without selling the stock before his or her death is a candidate for an equity risk management strategy. Finally, additional candidates are retired employees who have built up large, concentrated positions through a stock compensation plan or private investors who now hold public shares following an initial public offering (IPO). The ability to hedge, however, for an investor with recent IPO stock is temporarily limited because the stock is subject to a six-month underwriter’s lockup. During this period, the investor is unable to transact with the shares, and after the lockup, the ability to hedge will be dependent on the nature of the shares in question and how they are performing in the market.

www.aimr.org • 31

Investment Counseling for Private Clients III Characteristics of Good Hedge Candidates. Some stocks can be hedged more easily than others. If a stock meets all of the characteristics listed below, I guarantee that a bank will provide a hedging price on multiple structures. The stock should • be publicly traded; • have a market cap in excess of $500 million; • have good “borrowability” in the marketplace, which simply means that lots of institutional investors are willing to lend the stock; • have an average daily trading volume greater than 75,000 shares; and • have a stock price in excess of $20 a share. Furthermore, in the ideal hedging position, the number of shares to be hedged should be less than 3–5 percent of the “market float” and the minimum trade size should be roughly $5 million. Trades can be smaller only if the investor has a net worth of at least $5 million. Although I have devised risk management strategies for stock positions that violate two or three of these characteristics, once as many as four of these characteristics are missing, few banks are willing to quote a price on the stock, because at that point, a bank will have difficulty laying off in the marketplace the risk associated with the position.

The Impetus for Hedging These hedging and monetizing strategies exist largely because of the Taxpayer Relief Act of 1997 (TRA ’97). Before 1997, the preferred method of hedging a concentrated stock position and thus capturing its value without having to sell the stock was simply a short against the box (a short sale of securities when an identical long position is owned but will not be delivered until a later date). It was a great way to lockin the price of the stock and generate a huge amount of liquidity from the position without having to sell the stock. This transaction was targeted explicitly by TRA ’97 because of a deemed abuse by a specific family that was able to shield in excess of $100 million into perpetuity by an elegant and complex shortagainst-the-box transaction. TRA ’97 defined several methods of hedging and monetization as constructive sales that are subject to capital gains tax as if the shares had been sold outright, even if no physical sale of the securities took place. These are • short-against-the-box transactions, • total return equity swaps, • forward or futures contracts that deliver a “substantially fixed amount” of the appreciated asset for a “substantially fixed price,” and • any other similar transaction proscribed in IRS regulations.

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The two phrases in quotes in the third bullet point are important. The minute that a regulation is put into writing, the smart folks in the banking, legal, and accounting communities start to find ways around it. These experts interpreted the phrases in the third bullet point to say that as long as they do not set a substantially fixed price for the asset or, conversely, set a substantially fixed number of shares to be sold, then they have not created a constructive sale. This, in fact, is the impetus behind the two strategies that I will discuss in the next section. These strategies introduce into the hedging transaction enough uncertainty in the outcome, either in the form of the sale price or the number of shares to be delivered, to avoid being a constructive sale. This is not something that is even gray in terms of the tax code; it is rather clear-cut.

Commonly Used Strategies The two most frequently used hedging strategies— not currently defined as constructive sales—are equity collars and variable prepaid forwards. These instruments tend to be (but are not exclusively) OTC options as opposed to exchange-traded options. Equity Collars. The equity collar begins with a long-dated put option. The maturities I work with range between two and seven years, with three to five years being the maturities for the majority of the transactions. The long-dated put option provides the price protection sought by the client on the concentrated stock holding. The put option gives the investor the right to sell the stock at a certain price. The investor pays for that protection by selling a call option at a higher strike price, thus producing (typically) a “zero-premium” structure with no out-ofpocket costs to the investor at the time the transaction is initiated. Or the investor can initiate an incomeproducing collar where the price of the call sold exceeds the price of the put purchased. Regardless of the structure, the idea behind the collar is to create a defined range of potential value for the hedged stock position over the life of the collar. These are European-style options, so at least on the OTC side, they cannot be exercised prior to maturity, although the client has the ability to terminate the trade early at his or her discretion. Suppose a client has a concentrated stock position, XYZ, which is trading at $100, and wants to establish a price floor under the stock. The client wants to keep some growth potential in the stock, but the client also wants to defer the capital gains taxes that would be incurred if the stock were sold and to create a more diversified investment portfolio. Once the equity collar is created that effectively sets a 2001, AIMR®

Diversifying Concentrated Holdings minimum value for the underlying equity position, then the protected equity position can be used as collateral to monetize (take cash out of) the underlying position without physically selling the shares. The bank will lend money against the underlying stock position at an attractive rate of interest, and that money can be used to create a more diversified investment portfolio. The amount an investor can borrow depends on the hedging structure chosen. With the combination of a collar and a loan, the margin-lending regulations (U.S. Federal Reserve Regulations U and T) apply, even though the investor should never be subjected to a margin call because the bank knows that the stock has a guaranteed minimum value at maturity. Thus, the investor must represent to the bank his or her intent for borrowing. If the intent is to reinvest in a more diversified equity portfolio (i.e., the investor seeks a “purpose” loan), then the bank is restricted to lending a maximum of 50 cents on the dollar against the stock position. On the other hand, if the investor wants to buy a ranch, take a world cruise, buy insurance, update his wardrobe, or do anything other than invest in equities (i.e., the intent is a “nonpurpose” loan), then the bank is typically willing to lend up to 90 percent of the put strike value. Therefore, the investor who wants to borrow to invest in a blue chip equity portfolio can borrow 50 cents on the dollar, but the investor who wants to borrow to buy a ranch in Texas can potentially borrow 81 cents on the dollar. I would argue that such a situation runs counter to the intent of the regulations. Nonetheless, that is the way the regulations are written. Variable Prepaid Forwards (VPFs). If the investor is seeking to maximize the amount of money that can be borrowed without any restrictions on its reinvestment, a strategy other than the combination of the collar and the loan is needed. In such a case, many clients prefer the variable prepaid forward. A VPF is essentially a forward sale of a contingent number of shares of an investor’s stock, with an agreed future delivery date, in exchange for a cash advance today. It is not a constructive sale because of the “contingent number of shares” aspect to the trade (i.e., the number of shares that will actually be delivered at maturity depends on the underlying stock’s price at maturity). In this transaction, the investor enters into a contract with a bank to sell his or her shares at some point in the future, but the number of shares that will be sold is contingent on the stock’s price at the maturity of the contract. In exchange for that agreement, the bank advances a discounted current market value of the stock to the investor today. If this trade is properly documented and structured, it is neither a ©2001, AIMR®

constructive sale nor subject to the margin-lending restrictions. Thus, the investor can invest the proceeds however he or she pleases, unlike with the collar and loan strategy. That is, suppose the investor creates a zero-premium collar in which the band is 90 percent on the downside and 175 percent on the upside over a threeyear period. If the investor documents that transaction as a collar and a loan on a traditional basis and wants to reinvest in equities, the most that could be borrowed is 50 cents on the dollar. But if the same structure and range of value—the 90 percent on the downside and the 175 percent on the upside—is documented as a variable forward over a three-year period, the amount borrowed could be as high as about 75 percent of the current market value of the stock, with no restrictions on reinvestment. The decision as to which strategy is appropriate depends primarily on what the client is trying to accomplish with the reinvestment portfolio. Obviously, a VPF is a better choice than a collar when the investor wants to borrow the maximum amount possible to reinvest in equities. Using VPFs is also preferable when the investor is an affiliate of the company that has issued the underlying stock. As I mentioned earlier, in December 1999, the SEC issued a no-action letter at the request of Goldman, Sachs & Company that the markets have interpreted as effectively laying out a road map for how affiliate shareholders can hedge their stock using the VPF. The risk prior to the issuance of the no-action letter was whether entering into a hedging transaction (typically a collar) would put the investor at increased risk of tripping the short-swing profit disgorgement rules, one of the SEC Section 16 rules. The market interpreted the no-action letter as specifying that from a regulatory perspective, the date of sale of the stock is the date that the transaction is entered into, which is helpful when trying to manage Section 16 risk. At the same time, the date of sale for tax purposes is deemed to be the maturity date of the transaction. So, the date of sale for regulatory reasons is Day 1, and the date of sale for tax purposes is the maturity date. At the same time, if done correctly, the bank can take the restricted shares, clean them up, and have the restrictive legends removed (i.e., turn the shares into fully registered, freely tradable shares), which gives the investor increased flexibility. The variable forward is the appropriate hedging transaction for equity investors who would like to maximize the amount of up-front liquidity from a position or, conversely, would like to sell but want to defer capital gains taxes.

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Investment Counseling for Private Clients III

Comparing Alternative Strategies Several risk management strategies are available for low-basis assets, and they can be divided roughly into either financial strategies or charitable strategies. The three most common financial strategies are hedges (using one of the collars or variable forward transactions), exchange funds, and completion funds. The charitable strategies that are typically used are CRTs and donor-advised funds. Collars and VPFs. The ideal collar or variable forward (both of which I have described earlier) is a hedging transaction that protects the value of underlying low-basis shares and allows the investor to participate in the future growth of the stock, to generate liquidity out of the position for reinvestment without selling, and to defer the taxes that would otherwise be incurred if the stock was sold. Such a hedging strategy offers many advantages to the investor. It offers great flexibility in terms of the maturity of the transaction and the structure of the trade—including the amount of upside versus downside protection and the amount of money the investor is trying to get out of the transaction. An investor can terminate the trade early, restructure it, and maintain control of the assets. In fact, being able to maintain control of and retain some risk in the assets is critical to the viability of the tax argument—the ability to defer the tax bill. The investor retains ownership, achieves tax deferral, and gets the diversification sought in the asset allocation model. Several other issues, however, are intrinsic to the hedging transaction and should be considered carefully by the investor. One issue is the leverage incurred by the investor, whether the investor takes a cash advance against the forward sale or borrows with a straight collar and loan strategy. I would suggest that it is protected leverage because of the put option, but nonetheless, the investor is borrowing money to create a diversified portfolio. Another consideration is counterparty risk, because the investor is dealing with a counterparty on the other side of the trade. The investor needs to be comfortable with what will happen at maturity and be familiar with the alternatives that are available to settle the transaction in terms of physical settlement versus cash settlement and the differences between the two. I personally do not find the consideration of tax complexity to be overly burdensome, but because these tax issues are new to most investors and are not symmetrical, investors should be aware of them— and should retain independent tax counsel to advise them. The final issue is that both of these strategies (collars and VPFs) in their typical forms are considered to be straddles for tax purposes (under IRS Sec-

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tion 1092), which affects the tax treatment of the interest expense that is incurred. Also, if a short-term stock (i.e., stock that has not seasoned for 12 months) is hedged, the holding period is lost. So, if I hedge stock that is three or four months old in a three-year collar or variable forward, at the end of three years, my stock will be one day old for tax purposes. Exchange Funds. In an exchange fund, an investor takes an individual holding and contributes it to a partnership of like-minded investors who have also contributed their individual stocks to the partnership. In exchange for the contribution, the investor receives a pro rata ownership position in that pool of assets, which is considered a tax-free exchange, at least under current tax law. So, the investor takes his or her stock and, in essence, exchanges it for a portfolio of other stocks in a tax-free exchange. Exchange funds have several advantages. First, the investor can achieve a tax deferral. Also, some diversification is gained, but because the diversification is limited to a specific pool of assets, it is not true diversification as defined by modern portfolio theory. For example, the investor might achieve diversification in large-cap or tech stocks but not broadly across the market, as defined in a true asset allocation model. Another advantage of the exchange fund is that no leverage is involved because the investor is simply exchanging his or her shares for a pro rata position in a larger pool of shares. Exchange funds, however, also have several drawbacks. In my opinion, for what they deliver, they have very high costs and annual fees. There is typically a seven-year lockup on the fund to achieve the desired tax-deferred status. That is, if the investor pulls out of the fund within seven years, he or she will receive a pro rata number, based on the current market value of the overall portfolio, of the original shares contributed with the original basis intact, which defeats the purpose of engaging in the exchange fund strategy in the first place. Plus, the investor has little control over the assets once they are pledged to the pool. Another consideration is that an exchange fund is effectively a passively managed portfolio, for which the providers charge an actively managed fee. Finally, the rules require the portfolio to have least 20 percent of its assets in illiquid investments, typically real estate investment trusts, which may not fit an investor’s personal investment criteria. Completion Funds. The completion fund is a simple concept. This strategy involves selling the low-basis stock gradually over time and using the proceeds of the sale to create a more diversified portfolio. Thus, an advantage of a completion fund is the achievement of diversification within a given time 2001, AIMR®

Diversifying Concentrated Holdings frame. Other advantages include retaining control of the underlying asset, participating in the price appreciation of the asset, managing the timing of the sale, implementing the strategy with ease, and avoiding the costs and limitations involved with borrowing that other strategies require. The drawbacks of a completion fund include the lack of immediate liquidity and the amount of time needed to implement the strategy. And in the time it takes to liquidate the entire stock position, the investor has no price protection on the stock. Moreover, the completion fund strategy may or may not be tax efficient if the periodic sales generate a high taxable gain for the investor. And because the market value of both the stock and the surrounding portfolio changes over time, periodic rebalancing is required to keep the rest of the portfolio in line with the overall investment strategy. Charitable Strategies. A charitable strategy provides a tax-effective way to liquidate low-basis stock. The investor gains some tax deduction, but the amount of the deduction depends on the strategy used. Thus, a charitable strategy not only provides tax deferral but also some degree of tax relief. Diversification is also achievable when a CRT is used. And leverage is not involved with these strategies. One drawback of charitable strategies is that they are somewhat inflexible. Charitable strategies also require high maintenance compared with other alternatives. Another consideration is that using a charita-

ble strategy means that the asset is effectively removed from the investor’s portfolio and the investor can no longer participate in any potential price appreciation. Investors should realize that the charity, as the beneficiary of the CRT, may be the primary winner in the transaction if the stock and subsequent reinvestment portfolio significantly appreciate in value. If that situation does not fit the investor’s personal goals, then the investor should consider other alternatives to diversify the concentrated holding. Exhibit 1 summarizes the trade-offs between these different risk management techniques for lowbasis assets.

Conclusion By helping investors manage the risks inherent in concentrated stock positions and leverage the return prospects for these positions, equity risk management products can be valuable tools for clients with low-basis stock. In general, investors benefit by using these strategies in that they are able to protect the value of their shares at or very close to today’s price, participate in the future growth of the stock, generate immediate liquidity for diversification, and achieve tax deferral that would not be possible if the shares were sold. The benefits for the investment advisor include creating liquidity for reinvestment, distinguishing the advisor from the competition, and enhancing client relationships.

Exhibit 1. Comparison of Equity Risk Management Products

Collars/VPFs

DonorAdvised Funds

Exchange Funds

Completion Funds

CRTs

Maintain control of asset

Yes

No

No

Yes

No

Protect value of stock

Yes

No

No

No

No

Generate liquidity for reinvestment

Yes

No

No

Yes, over time

Yes

Participate in growth of stock

Yes

No

Yes, to a degree

Yes

No

Philanthropic result

No

Yes

No

No

Yes

Charitable tax deduction

No

Yes

No

No

Yes

Financing cost

Yes

No

No

No

No

Management fee

Yes

Yes

Yes

Yes

Yes

Flexible

Yes

Yes

No

Yes

No

Revocable

Yes

No

No

Yes

No

Feature

©2001, AIMR®

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Investment Counseling for Private Clients III

Question and Answer Session Robert N. Gordon Scott D. Welch Question: What are the typical transaction costs related to diversification strategies? How much profit do the banks make on these strategies? Welch: In general, the transaction costs are determined on a caseby-case basis. The banks play it close to the chest with the exact profit they make on these trades. But I typically assume, and I have been told by my contacts at the banks that it is not unreasonable to assume, that they are pricing a 1.5–2 percent “anticipated” trading profit into the transaction— anticipated being the critical word because the banks have to manage the risk of this position for the life of the transaction to actually realize the profit. Gordon: In terms of short selling, the dealer is shorting the stock and taking the risk of the hedge strategy. Whether money will be made on the trade is debatable. Actually, the crash of 1987 was dynamic hedging gone awry. Yet none of the banks took that event as a lesson, and most banks are still doing exactly what they were doing before: They are dynamically hedging their positions. Dynamic hedging starts with the assumption that you can always sell at the right price without driving the price down, and that is exactly what happened to LOR (Leland O’Brien Rubinstein Associates) in the crash of 1987. I think the profit the banks actually make on these strategies is debatable. Welch: My job is to squeeze the bank’s potential profit margin as narrow as possible for any given transaction by putting the transac-

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tion up for competitive bid. With respect to transaction costs, at least in our case, our fee is priced into the structure in the form of either a slightly lower call strike price or a slightly lower cash advance on the forward, and it is paid to us by the counterparty bank on the other side of the transaction and fully disclosed to the client. Gordon: These trades wouldn’t work for us if we didn’t get institutional pricing. Welch: That is right. We get institutional pricing. Then, with respect to legal costs, we always recommend that every client have his or her trades reviewed by outside independent tax counsel. Again, the legal cost depends on the transaction, but for a typical, not particularly complex, trade, the legal cost is probably going to be $5,000–$10,000. Question: Regarding straddles, if a private company has been in existence for many years and is acquired by a publicly traded company for equity after 1984, does the straddle rule apply? Gordon: The first question is easier to answer than the second one. Whether you owned stock in a public company or a private company that was taken over in a stockfor-stock deal after 1984 does not matter. The legal advisors we work with believe the pre-1984 situation applies, and the straddle rules would not be invoked. We have had only three or four clients get legal opinions on such a situation, but all have been positive. The sale and repurchase may be ignored for the purpose of the reorganization

but might not be ignored in deciding whether it triggers gain. Most of the advisors believe it is ignored for both purposes. Question: Has recent tax law hindered the benefit of equity flex options? Gordon: Equity flex options as they stand now are very useful because they have the same characteristics in the listed market that they have in the OTC market. The option can be European style, or the investor can pick the strike price. With flex options, you always have the AAA rating of the Options Clearing Corporation. If you want to get out early, you can, rather than having to buy your way out from a derivative dealer. So, equity flex options have many advantages. Some proposed regulations were released in the beginning of January 2001, but they have not yet been finalized. The proposed regulations provide some give and take. These regulations implicitly encourage investors that own stock acquired after 1984 to use listed options, because the regulations provide that if you write a call that is out of the money and listed, it is not a straddle—even if you bought the stock after 1984. That situation created fantastic opportunities. Take the case of someone who has just exercised an incentive stock option. Within the one-year period, if she buys a put, it will stop her holding period, but she still could sell the call if it is a qualified covered call under these rules. But it has to be listed. Although the proposed rules would broaden this ability and allow OTC options to be qualified covered calls, none of the ©2001, AIMR®

Concentrated Holdings and Low-Cost-Basis Stock options can be longer than a year. To be in a stock that you purchased after 1984 and to roll over those calls and get whipsawed every 11 ½ months is not worth the strategy required for not being a straddle. If these regulations are passed, I do not see any great advantage to flex options and qualified covered calls. Until recently, however, there was a clear benefit to both. Question: Please briefly describe completion funds. Welch: I think of a completion fund as diversification over time out of a concentrated stock position. Again, I will use my example: You have $10 million worth of AOL Time Warner, and your goal is to lower your exposure. You do not want to dump all the stock today because you do not want to pay the taxes. The investment consultant should create the ideal allocation around that position and then begin to liquidate the position over time. So, you sell 10 percent of the stock today, pay your taxes, and use the proceeds to buy some uncorrelated assets with AOL Time Warner. Six months later, or whatever the time frame is, you sell another 10 percent of your stock; and so over time, you are liquidating your position in AOL Time Warner and creating a diversified portfolio. With each sale you are rebalancing to make sure that the inclusion of AOL Time Warner is being factored into the overall expected return and risk of the portfolio. The idea behind the completion fund is that it is a straightforward, disciplined liquidation over time of a concentrated stock position that redeploys the after-tax proceeds into an allocated portfolio. Question: What happens when options in collars expire after three years? ©2001, AIMR®

Gordon: There can be negative tax consequences to “rolling over” the hedge. This is even more of a problem for those open to the straddle rules. Some hedges can be constructed that mitigate the problems associated with “rolling” the hedge. Welch: There will most likely be a taxable event, which will vary depending on whether the trade is cash settled or physically settled or rolled over into a new trade. As a general comment, if the trade is physically settled—that is, the investor delivers stock to settle the trade—the day the shares are delivered is the date of sale for tax purposes, and the investor will face a long-term capital gains tax on the difference between the sales price and the basis (assuming the stock was already long term when hedged). If the trade is cash settled or rolled over, the investor will face a short-term capital gain (if the bank owes the investor money) or a long-term deferred loss (if the investor owes the bank money)—a loss the investor cannot realize until the shares are actually sold. Investors should always retain professional tax counsel to walk them through the tax treatment of these trades before entering into them. Question: Can you hedge stock held in a GRAT (grantor retained annuity trust)? Welch: I believe stock can be hedged in a GRAT. The counterparty bank will want to see a copy of the trust agreement to make sure the trust is authorized to engage in this type of transaction, and the bank may require an opinion letter to this effect from the attorney who drafted the agreement. Question: What is the cost basis at the end of a forward contract when delivering cash or shares?

Gordon: If you deliver shares, your original basis is the cost basis. If you cash settle the forward, then a gain or loss will be measured from your cash flow on termination, not referenced to the stock you held. Beware of the straddle rules as to whether the loss can be currently deducted. Welch: With collars, your cost basis is your original basis plus the interest expense you paid on any borrowing you may have taken against the collared stock (i.e., the interest on the loan cannot be deducted against current investment income but, rather, is capitalized into your basis). So, you get some relief for the interest you pay, but it is deferred until you sell the stock, and you only achieve a capital, rather than an ordinary, offset. With forwards, the implied financing cost is not added to your basis, but it is taken off the sales price for the shares when you physically settle at maturity. The net result is similar—no current deduction on the implied financing cost but some capital relief realized when you ultimately sell the shares. Question: Can you discuss the tax implications of the rehypothecation of securities pledged as collateral in connection with the hedge/monetized transaction? Gordon: IRC Section 1058 discusses the requirements for loaning securities without triggering a gain. Section 1058 provides a safe harbor if you loaned the shares in a way that did not also transfer risk. Because risk may be limited by lending the security, you may be out of the safe harbor and thus open to questions. We think this strategy is acceptable in the eyes of the IRS, but the client should be informed of the risks.

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Investment Counseling for Private Clients III Welch: Because rehypothecating the shares lowers the cost and risk of hedging the trade for the bank, the investor will receive better pricing on the trade. Remember, however, that one of the main points of any of these trades is to remain the beneficial owner of the shares for tax purposes; that is why these trades do not trigger the constructive sale rules. If you allow the bank to rehypothecate (i.e., borrow and then sell short) your shares, some tax attorneys feel you have weakened your argument that you remain the beneficial owner of those shares. The investor should be made aware of the trade-off associated with rehypothecation (i.e., better pricing versus possible increased tax risk), and the trade documents should specify explicitly whether the bank has the right to rehypothecate. But the ultimate decision lies with the investor, based on input from a retained tax professional. Question: How bullish must a client be on his or her individual stock for these strategies to make sense? Does the expected rate of appreciation need to exceed that of the market to make these strategies worthwhile? Gordon: A client doesn’t need to be bullish, but the client must have a need to lock-in profits without triggering gains. We believe the basis should be 50 percent or less of the current market price, or an outright sale to liquidate the position should be made. Welch: We assume that the portfolio the client reinvests in will be the same whether or not the shares are sold or hedged and borrowed against, so what really matters at the end of the day is how the hedged stock performs over the life of the trade. Hedging is certainly a tax-deferral technique, so in that sense, it doesn’t matter what hap-

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pens to the stock after you hedge. But our clients are typically comparing hedging the stock today with selling the stock today. So, if the stock price falls or stays flat after you hedge, you would have been better off selling (because of the financing cost associated with hedging and borrowing). How much the stock price needs to rise before hedging puts more money in your pocket than selling does depends on the structure and the stock, but my experience is that if the stock increases by more than approximately 4–5 percent a year, then hedging adds value compared with selling. Question: Doesn’t the “least expensive” method (i.e., little upside) expose one to the capital gains tax (i.e., stock called away), making it a very expensive method (vis-à-vis the “more expensive,” more upside method)? Gordon: No, options can be cash settled. There is never a need to deliver shares even if the options are physically settled; other shares can be purchased to deliver against the option. Welch: The contracts we work with are European-style options, so the stock can never be called away prior to maturity, and the client always has the right to cash settle if he or she does not want to deliver stock. Question: How do taxes affect the income-producing collar? Gordon: All option proceeds are without tax at inception and receipt but taxable at their conclusion after gain or loss can be established in a “closing transaction.” Question: Regarding purpose and nonpurpose loans from a collar, is it safe to assume that money

used to pay down margin debt would be considered a “purpose” loan? Is it better to do a variable prepaid forward? Gordon: Paying off a margin loan is not a permitted purpose; it is not allowed. We use prepaid forwards when the intent is to repay a margin loan. Welch: We always use a prepaid forward to repay margin debt because (1) it fixes the interest rate for the life of the trade, and (2) forwards are not subject to Reg T or Reg U, so the issue of purpose does not come into play. Question: What are the costs and other considerations when liquidating part or all of the underlying stock prior to maturity of a collar or forward? Welch: The banks typically are not trying to realize any more profit on an early termination than was already priced into the trade. So, aside from a bid–offer spread, you should get a fair market valuation from the bank when you terminate early. That said, the valuation you receive will depend on the market conditions at the time of the early termination—how much time is left in the original trade, interest rates, volatility, and so on. From my perspective, there are only two situations in which you should unwind early: (1) you expect the stock to skyrocket from that point forward (and thus increase in value by more than enough to pay for the time value you have to pay to unwind early), and (2) the stock has, in your mind, peaked prior to maturity, and you fear that it may fall before the trade matures by more than what it will cost you to terminate it early. ©2001, AIMR®

Hedging Low-Cost-Basis Stock Robert N. Gordon President Twenty-First Securities Corporation New York City

After the Taxpayer Relief Act of 1997 added a few twists to tax law regarding constructive sales, the hedging of low-cost-basis stock positions has become rather complicated. Using options to diversify concentrated holdings can trigger the constructive sale rules, depending on how the transaction is structured. Before a manager can recommend a hedging strategy to one of his or her clients, the manager must begin by identifying the client’s reasons for wanting to hedge. Only then can the manager devise a strategy that avoids unnecessarily large tax bills and achieves the client’s goals. A customized decision tree can help clients find the appropriate strategy for hedging low-cost-basis stock.

any strategies exist for hedging low-cost-basis stock, but tax laws, as well as the proliferation of analytical tools available in the market, make the entire procedure fiendishly complex. Before the Taxpayer Relief Act of 1997, our recommendation at Twenty-First Securities Corporation would have been a short sale against the box (selling securities short that the client owns and creating a sale position that remains open for an indefinite period of time). Once the law changed, however, managers had to begin questioning investors about their goals related to their low-cost-basis stock in order to decide which strategy could best achieve the investors’ objectives. As a result, at Twenty-First Securities, we created an interactive decision tree survey on our Web site (www.twenty-first.com) called “Hedging Low-Basis Stock: An Interactive Guide.” Based on client responses, the survey builds a model suited to the client’s investment needs. The first question the survey asks is:

M

Does the client hold a substantial position in a stock that was acquired for little or no cost? (Screen 1)

The investor must answer “yes” to proceed with the survey; otherwise, there is no need to continue with the exercise. My presentation will go through the subsequent steps of our Web site survey and explain the Editor’s note: The joint Question and Answer session of Robert N. Gordon and Scott D. Welch follows Mr. Gordon’s presentation.

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reasons behind asking the questions. Although I will not cover all the possible branches of the decision tree, I will discuss the main points. Note that the Web site itself offers many opportunities for further explanation on relevant topics to taxable investors, such as links to definitions of key terms and articles of interest.

Hedge or Monetize At Twenty-First Securities, we see two categories of investors who are interested in hedging low-costbasis stock. One group wants to monetize its stockholdings for greater diversification. A person in this group is not willing to liquidate his or her position, however, because of the tax burden associated with that strategy. That is, this client would sell if taxes did not exist. The second group seeks to hedge unrealized capital gains. This type of client loves the stock he or she owns and wants simply to put a floor under the stock’s price—and lock-in a profit if the stock’s price begins to fall. These two reasons for hedging require different hedging strategies, and the differences in these hedging strategies create two different economic payoff patterns. The survey thus asks: Does the client want to protect gains and let profits run? or Does the client want to get the money out of the position without triggering a tax? (Screen 2)

2001, AIMR®

Hedging Low-Cost-Basis Stock If the client answers “yes” to the first question, then the Hedge button is selected. If the client answers “yes” to the second question, then the Monetize button is selected. Choosing to Monetize. At this point, assume the client chooses to monetize. The survey then asks: Is the client’s tax basis less than ½ the current (Screen 3) market price? This question is important because when an investor monetizes—a two-step process that involves hedging the asset while being mindful of the constructive sale rules and simultaneously borrowing money to invest in another security—the investor incurs an ongoing carrying cost to keep the monetizing strategy in place.1 To make the strategy worthwhile, the expected gain from the strategy must exceed the carrying cost of the strategy; in other words, the potential tax savings must outweigh the carrying costs incurred to avoid the tax. For example, if an investor paid 50 cents for a security that is now worth $1, the capital gains tax on that 50 cents of profit would be 10 cents (at a 20 percent long-term capital gains tax rate) if the position is liquidated. If, alternatively, the investor chooses to monetize the low-cost-basis stock rather than liquidate the position, the carrying cost of a monetizing strategy would be about half of a percent. That is, suppose for an investment with a market value of $100 the investor earns 5 percent ($5) in an income-producing collar.2 By borrowing $90 (the put strike price in the collar and thus the maximum the lender will lend) at 6 percent and paying $5.40, the investor has a 40 basis point negative carry, roughly a net cost of 0.5 percent to undertake the strategy. Thus, if an investor has to pay 0.5 percent a year for the benefit of the use of the money that would otherwise be paid in capital gains tax, the investor must earn a return of 5 percent (50 cent carrying cost divided by the extra $10 of capital available for investment) on the borrowed funds to cover carrying costs and to create a cost-effective strategy. This bogey of 5 percent is relatively easy to beat. But if the security has not at least doubled in value (which is the reason behind the tax-basis question in Screen 3), the return bogey on the borrowed funds is larger than 5 percent. If, however, the unrealized gain 1

Section 1259 of the U.S. Internal Revenue Code (IRC) states that investors must retain some potential profit or loss when constructing a hedging strategy or they will trigger a taxable event. That is, investors cannot hedge away too much of the potential loss or gain or they will be seen as having sold an “appreciated financial position,” which is a taxable event. 2 See the discussion of Figure 1 in this presentation for an explanation of how and why the income-producing collar earns 5 percent.

©2001, AIMR®

on the low-cost-basis stock is larger than 50 percent of the market value of the position (i.e., the tax basis is less than half of the market value of the position), then the carrying-cost bogey associated with maintaining the monetizing strategy will be less difficult to overcome. In addition, the benefits of the strategy increase as the tax basis approaches zero because the client is avoiding an ever larger capital gains tax. For an investment with a $100 market value and a zero cost basis, the investor would only have to earn a 2.5 percent (50 cent carrying cost divided by $20 capital gains tax) return on the borrowed funds to breakeven. Compare this 2.5 percent with the 5 percent return needed to breakeven when the tax basis equaled 50 percent of market value. Therefore, if the investor’s stock has not at least doubled in value (the investor answers “no” to Screen 3), then we recommend an outright sale of the stock. If the client replies positively to Screen 3, the investor continues down the decision tree to the following screen: In choosing “monetize,” you indicated a desire to pull money out of the position. The “option combination” strategies are meant to create income. The most income comes with the least potential for profit on the stock. Do you prefer the least expensive monetization method accompanied by the least economic exposure? or A higher annual cost with more contin(Screen 4) ued upside? We tell clients up front that the option combination strategies are meant to create income and that the most income is associated with the least potential for profit on the stock. ■ Least expensive. Suppose the investor chooses the least expensive method to monetize the low-costbasis stock position. The investor is then taken to a screen that discusses the income-producing collar. On the “monetize” side of the tree, we are trying to generate cash to lower the net cost of the borrowing so that the objective—to defer the capital gains tax if the low-cost-basis stock is sold—is worthwhile. To accomplish this goal, we use an income-producing collar. Suppose a client’s stock is valued at $100. To create an income-producing collar, the client buys a put with a strike price of $90 (90 percent of the value of the underlying stock), which would cost $14. Then the client sells a call that gives away most of the upside without triggering the constructive sale rules. (In this case, suppose it is the $105 call.) The client must sell a call with a strike price close enough to the current price of the stock so that the call will be priced higher than the put (i.e., the cash inflow from the sale of the call will exceed the cash outflow from the

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Investment Counseling for Private Clients III purchase of the put). Thus, net–net, the two concurrent transactions create an income-producing collar. For example, the client may sell a call for $30. When the $14 paid for the put is deducted from the $30 received for the call, the client nets a profit of $16. No tax is due in the current period because the collar is considered an “open” transaction for tax purposes. With a three-year option, the client would earn about 5.2 percent a year in income, or the $16 excess premium spread over the three-year option period divided by the current stock price of $100, which equals 5.2 percent. This 5.2 percent a year offsets the 6 percent a year the client pays in interest expense on the borrowed funds that monetize the stock position. As a result, the client’s net cost is only 80 basis points annually to monetize and avoid paying the capital gains tax associated with liquidation of the stock position. Graphically, this income-producing collar is shown in Figure 1. Remember that this collar is composed of a long put at $90, a short out-of-the-money call at $105 (a 15 percent band around the current stock price of $100), and a three-year option; the client is long the stock. The starting point of the potential profit/loss line is a profit of approximately $5. If the stock price is lower at the expiration of the three-year option term and the put is exercised, the collar is guaranteed to leave the client with a $5–$6 profit— the net $16 call premium when the strategy was put in place less the $10 ($100 market value less $90 put price) of lost market value in the stock. On the other hand, if the stock price is stable, the collar will generate roughly a $16 profit. And if the stock price rises, the maximum profit generated by the collar will be $20 with the added appreciation in the stock’s price of $5 (the difference between $100 market value and $105 call price) plus the roughly $16 of net call premium. At this point, the stock position has not yet been monetized. The first step, which I have just described, is hedging the position by creating a collar (the income-producing collar) that affords the client the ability to monetize.

Figure 1. Illustration of the Profit/Loss Scenario of an Income-Producing Collar Profit (+) $20 Potential Gain

$5 Breakeven Loss (–) $0

$50

$100 $105 Stock Price

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The constructive sale rules effectively control the tightness of the bands on the put and the call around the stock’s price. When these rules became effective in 1997, the U.S. government said that options would not trigger the constructive sale rules if the option position was not abusive. The government has yet to define an abusive option position. Consequently, we are relying on the “Blue Book,” a general explanation of tax laws published by the Joint Committee on Taxation. The 1997 Blue Book provides an example of a nonabusive option—a collar with a put at 95 percent of the stock price and a call at 110 percent of the stock price, or a 15 percent band. Thus, hiding behind the skirts of the government’s own words, we never go narrower than a 15 percent band because it would be difficult for the government to claim that an option that conforms to its own example is abusive. ■ More upside. If back at Screen 4 the client had chosen the strategy that presented more upside profit potential, the client would have been taken to the following screen: There are several strategies that increase the potential upside in the position. In considering the different approaches, you should be aware that there is a trade-off between income and potential profit. You should also understand that your choices are limited by the constructive sale rules. These rules state that the investor must retain some ability to win or lose after hedging; otherwise, the trade may trigger a capital gains tax. Here are several possibilities utilizing 3-year options. Please select one: 5¾% income with a maximum 5% profit. 4% income with a maximum 20% profit. 0% income with a maximum 50% profit. (Screen 5)

If the client chooses the first option, the screen describing the income-producing collar appears. If the client chooses the second option, the client is asked whether he or she wants to proceed with a customized analysis. If the client chooses the third option, the client is taken to a screen describing a cashless collar, or zero-cost collar, which will be discussed in the next section. Choosing to Hedge. If instead of choosing to monetize the low-cost-basis stock position at Screen 2 the client had chosen to “protect gains and let profits run,” the client would have been opting to hedge. The following screen in the decision tree would have appeared: The client can purchase insurance in the form of a put option. As an example, the put option could be structured to create a floor at today’s stock 2001, AIMR®

Hedging Low-Cost-Basis Stock price. These options typically cost 10–12% annually. If this is an acceptable cost, please press the continue button. There are alternative strategies that will lower the cost of insurance by giving away some of the stock’s upside potential. If this is of interest, please press the alternatives button. (Screen 6)

Therefore, the hedging strategies available to the client include buying insurance in the form of a put option with a cost of 10–12 percent a year or using an alternative strategy that would lower the cost of acquiring the “insurance” by limiting the stock’s upside potential. Notice that no concern is raised about the tax basis in the stock position, whether or not the tax basis is at least 50 percent of the market value of the stock. This lack of concern about the tax basis occurs because these put strategies have nothing to do with improving diversification; they merely truncate the opportunity for loss in a particular stock position. Many alternatives to the long put strategy exist, the possibilities of which are limited only by the constructive sale rules. Clicking on the Alternatives button takes the client to a screen that says: There are many hedges that cost less than 10% per year. In fact, some hedges even create income. Higher income is associated with the least potential for profit on the stock. The possibilities are only limited by the constructive sale rules outlined in IRC Section 1259. These rules state that the investor must retain some ability to win or lose after hedging, otherwise the trade may trigger a capital gains tax. Here are several possibilities utilizing 3-year options. Please select one. 6% hedging cost with a maximum 80% profit. 0% hedging cost with a maximum 50% profit. 4% income with a maximum 20% profit. (Screen 7)

Thus, as an alternative to the long put option, which has a significant cost but unlimited upside potential, the client can choose one of the three preceding strategies with varying combinations of a cost/profit relationship. The middle strategy, zero cost with potential profit of 50 percent, is a cashless collar, or a zero-cost collar. The collar is created by buying an out-of-themoney put and simultaneously selling an out of-themoney call, with the strike price of the call set so that the call premium is exactly enough to pay for the cost of the put. Figure 2 illustrates the profit/loss scenario for a cashless collar. Assume the client owns a stock ©2001, AIMR®

that trades at $100. The client buys a put with a strike price equal to 100 percent of the market value of the stock (an out-of-the money put). To pay for the put, the client sells an out-of-the-money call. For illustrative purposes, I will use a $150 call. Thus, the client has established, for zero cost, a floor equal to the stock’s current price, but the client has a maximum profit potential of 50 percent of the current price of the stock.

Figure 2. Illustration of the Profit/Loss Scenario of a Cashless Collar with a 100 Percent Put Profit (+) Possible Gain Breakeven Loss (–) $0

$50

$100 Stock Price

$150

Customized Analysis When a client gets to the point in the decision tree where a customized analysis is requested, he or she is asked to supply information on the name of the stock, the number of shares in the position, and what percentage of the market value of the stock he or she wants to borrow. After the client enters this initial information, from which the decision tree creates the client’s basic investment scenario, the survey then generates strategy specifics. If the client chooses to proceed with the suggested strategy, the client must answer a few more questions. The client is asked if he or she is an affiliate or a control person, if the client’s stock is restricted, if the client’s stock is subject to a “lock up” agreement (many lock up agreements today do not allow hedging), if the client’s stock was acquired after 1984 (which I will discuss in more detail later in this presentation), if the client’s stock is involved in a stock-for-stock merger, and if the client wants to borrow more than 50 percent of the current market value of the stock. Merger-Related Stock. We ask if the client’s stock is involved in a stock-for-stock merger because if the client owned, for example, True North Communications and was going to get Interpublic stock in the merger, we would suggest that the client short the Interpublic stock before the deal closes (before the client actually owns the new stock) while there is still deal risk. When the deal closes, the client will be short

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Investment Counseling for Private Clients III against the box in Interpublic, which will be fine because the tax law measures what a person does when he or she does it, not what the transaction becomes later. This is a good short against the box that is totally grandfathered, has a step-up in basis, and is everything that the client could have received previously. For that matter, the short-against-the-box strategy still lives. A manager can still use short-againstthe-box positions for clients who do distress debt investing. If an investor paid $30 for a bond that is now worth $80, this investor should go short against the box on the bond. The constructive sale rules apply only to equities; they do not apply to debt. So, there are many ways that the short against the box can still be used. Pre- or Post-1984. One of the most important questions we ask the client is whether the client purchased the stock before or after 1984. If the stock was bought after 1984, the straddle rules apply to the transaction, which affects the hedge construction.3 If the client does not have to worry about dancing around the straddle rules, then setting up the hedge is much easier. If the stock was acquired after 1984, the straddle rules prohibit an investor from taking any losses until the entire position is closed but do not give equal treatment to gains; taxes must be paid on gains as they occur. ■ Zero-cost collar. If the client owns stock bought after 1984 and wants to hedge, a collar (say, a zero-cost collar) would be the recommended strategy. For example, the client owns stock valued at $100 and wants to establish a $90/$175 collar. The client buys a put with a strike price of $90 for $14 and sells the call with a strike price of $175 for $14. Three years later, the stock is somewhere between $90 and $175; the stock has neither gone below the 90 percent threshold nor above the 175 percent threshold. What happens? The options expire worthless, right? But what happens with taxes? The $14 the client received from selling the call is a short-term gain on which the client must pay tax. The $14 the client paid for buying the put is not deductible until disposition of the entire position, including the stock. Depending on the particular circumstances, the client may never be able to use the deduction. Therefore, the client may pay the short-term capital gains tax, $5.60, before any profits are realized and without the corresponding benefit of a tax loss deduction. This unfortunate phenome3 Straddle rules are governed by U.S. Internal Revenue Code Section 1092. These rules affect stock positions purchased after December 31, 1983, and govern when gains and losses can be taken on the two legs of the straddle.

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non is a by-product of a hedge construction using two separate options. Wall Street offers many products that, for lack of a better technical term, meld the put and the call together, which corrects the mismatch in treatment of gains and losses. The client could do a one-contract option incorporating both the put and the call, which would effectively be a zero-cost collar with a put at $90 and a call at $175. The price of the contract would be zero. When the contract expires worthless, no tax would be imposed. ■ Prepaid variable forward. The client could also use a prepaid variable forward to mitigate the problem caused by the straddle rules. The prepaid variable forward, however, is the worst choice of all the available strategy alternatives and should be used only as a last option. Let me explain why. A client can borrow against an income-producing collar using either a margin loan or a prepaid variable forward. A prepaid variable forward is a type of forward sale contract with an embedded collar in which the investor receives an up-front payment in exchange for a commitment to deliver securities in the future, with the number of shares to be delivered varying with the underlying share price. The leverage available with the prepaid variable forward is equal to the leverage available with a margin loan. The U.S. Federal Reserve, in Regulation T, imposes an initial margin requirement of 50 percent of the value of the underlying security if the purpose of the margin loan is to purchase stock. In addition, an investor can also borrow up to 50 percent of the market value of the securities purchased with the margin loan. Thus, the investor ends up with a dollar’s worth of debt for every two dollars of portfolio value—50 cents against the collared position (the initial stockholding) and 50 cents against the diversified position (bought with the borrowed funds). So, a regular margin loan provides one-for-one leverage, and the prepaid variable forward cannot improve on this leverageability. Furthermore, who would not prefer to have $1 of deductible interest expense today rather than a capital loss when the stock in the forward is sold at the expiration date? Because the margin interest is deductible, every $1 of interest expense is transformed into an after-tax cost of only 60 cents, making the margin loan preferable to a prepaid variable forward. A prepaid variable forward can be illustrated by the following example. Suppose the investor buys a cashless collar executed through a variable forward with a $100 put/$150 call priced at $85. Carrying costs are $15. If at expiration the stock is worth less than $100, the investor sells the stock at $85 and realizes $15 less in long-term capital gains than would otherwise 2001, AIMR®

Hedging Low-Cost-Basis Stock have been the case. These gains would have been taxed at 20 cents on the dollar, so the true cost is $12 after tax. Thus, at the end of the three years, at expiration, the client who has chosen the prepaid forward gets a deduction of 20 cents on the dollar. If, instead, the collar had been combined with a margin loan, the interest expense deduction would have been 40 cents on the dollar in the first year. Who would want a deduction of 20 cents three years from now instead of a deduction of 40 cents today? So, the $15 cost of the prepaid variable forward on an after-tax basis is $12 versus the interest expense of a margin loan on an after-tax basis of only $9. Thus, a 33 percent higher cost is borne by the client simply as a result of choosing the wrong hedging tool. So, when is it appropriate to use a prepaid variable forward? If the client cannot sign the purpose letter required when an amount greater than 50 percent of the underlying stock is borrowed on margin, then a prepaid variable forward makes sense. The purpose letter states that the client does not plan to use the borrowed funds as the original margin to buy new stock. And we believe, and most of the broker/dealers that we clear through believe, that if the client wants to use the borrowed funds to invest in a hedge fund, then the client cannot sign the purpose letter. In a case such as this, a prepaid variable forward would be appropriate. And the only reason that clients are in this position is because they are paying off margin debt. The Federal Reserve does not let an investor use a nonpurpose loan to pay off margin debt and will not let an investor borrow more than 50 percent of the market value of the collateral to invest in equities. Equities that are not marginable are the only ones that cause a problem. If a client wanted to borrow and buy private equity, that would be okay, but if the client wanted to buy public equity, the client would have to do it with 50 cents of debt against the hedge position and 50 cents against the new portfolio. If this client wanted to invest in a hedge fund that was invested in stocks, the broker/dealer might tell him or her that it is not a valid purpose under the purpose test, and then he or she would have to use a variable forward. ■ Swaps. U.S. Vice President Dick Cheney recently faced a similar situation regarding his Halliburton Company employee stock options. It was suggested that he use prepaid variable forwards to hedge his profits; however, I would not recommend this strategy. Halliburton stock is at $60, and Cheney’s options are nonqualifying options; they shed ordinary income. So, if his hedge is at $60 and the stock goes up to $80, he has $20 more of ordinary income on each employee option and $20 of capital losses on ©2001, AIMR®

the hedge. But capital losses are not deductible; they are only offsetable against realized gains. So, Halliburton’s price can skyrocket, but Cheney will not make any money. He will, however, have a giant tax bill because he has $20 of ordinary income for every share he owns and $20 of capital losses he cannot use. I would have recommended another hedging tool—a swap with an embedded collar—for which cash payments paid or received are treated as ordinary losses and ordinary income. Thus, a swap is the better hedging tool to hedge employee options because any income or gain from the movement in the stock price is completely offset in character as well as in dollars. By using a swap, if the option holder has ordinary income, he or she has ordinary losses. If the option holder has capital gains, he or she has capital losses. The swap can even have a collar built into it— $90/$105, $90/$175, or whatever—but no matter what the strategy is called, a swap, a variable forward, and a collar effectively accomplish the same thing. If someone prefers a variable forward, I advise that the variable forward not be done on a prepaid basis. Instead, do a variable forward and borrow against it, because the interest expense deduction is better than throwing away a capital loss, which is the choice effectively made when borrowing is not done on an outright basis. Ultimately, each individual situation determines the appropriate hedging tool to use. For a client who bought stock before 1984, the recommendation is to hedge with a swap because as the stock price rises, the client has the benefit of longterm capital gains taxed at 20 percent in addition to ordinary income deductions. For every dollar the stock price rises, the client receives a tax savings of 20 cents. If the client uses any of the other hedging tools, the capital loss and capital gain will offset each other. If the person bought the stock after 1984, the swap would be considered part of a straddle and the person would not get the 20 cent tax savings. In this case, make sure a one-contract derivative is used that joins the put and the call and that an outright borrowing is done, not a prepaid.

Conclusion Hedging low-cost-basis stock is not a simple process, particularly after the tax laws changed in 1997. Central to the process is the identification of the investor’s reason for wanting to hedge and potentially monetize low-cost-basis stock as well as the knowledge of when the shares were originally purchased and their cost basis. This information is important to the choice and success of the strategy adopted, which can range from income-producing collars to zero-cost collars and prepaid variable forwards.

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Investment Counseling for Private Clients III

Question and Answer Session Robert N. Gordon Scott D. Welch Question: What are the typical transaction costs related to diversification strategies? How much profit do the banks make on these strategies? Welch: In general, the transaction costs are determined on a caseby-case basis. The banks play it close to the chest with the exact profit they make on these trades. But I typically assume, and I have been told by my contacts at the banks that it is not unreasonable to assume, that they are pricing a 1.5–2 percent “anticipated” trading profit into the transaction— anticipated being the critical word because the banks have to manage the risk of this position for the life of the transaction to actually realize the profit. Gordon: In terms of short selling, the dealer is shorting the stock and taking the risk of the hedge strategy. Whether money will be made on the trade is debatable. Actually, the crash of 1987 was dynamic hedging gone awry. Yet none of the banks took that event as a lesson, and most banks are still doing exactly what they were doing before: They are dynamically hedging their positions. Dynamic hedging starts with the assumption that you can always sell at the right price without driving the price down, and that is exactly what happened to LOR (Leland O’Brien Rubinstein Associates) in the crash of 1987. I think the profit the banks actually make on these strategies is debatable. Welch: My job is to squeeze the bank’s potential profit margin as narrow as possible for any given transaction by putting the transac-

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tion up for competitive bid. With respect to transaction costs, at least in our case, our fee is priced into the structure in the form of either a slightly lower call strike price or a slightly lower cash advance on the forward, and it is paid to us by the counterparty bank on the other side of the transaction and fully disclosed to the client. Gordon: These trades wouldn’t work for us if we didn’t get institutional pricing. Welch: That is right. We get institutional pricing. Then, with respect to legal costs, we always recommend that every client have his or her trades reviewed by outside independent tax counsel. Again, the legal cost depends on the transaction, but for a typical, not particularly complex, trade, the legal cost is probably going to be $5,000–$10,000. Question: Regarding straddles, if a private company has been in existence for many years and is acquired by a publicly traded company for equity after 1984, does the straddle rule apply? Gordon: The first question is easier to answer than the second one. Whether you owned stock in a public company or a private company that was taken over in a stockfor-stock deal after 1984 does not matter. The legal advisors we work with believe the pre-1984 situation applies, and the straddle rules would not be invoked. We have had only three or four clients get legal opinions on such a situation, but all have been positive. The sale and repurchase may be ignored for the purpose of the reorganization

but might not be ignored in deciding whether it triggers gain. Most of the advisors believe it is ignored for both purposes. Question: Has recent tax law hindered the benefit of equity flex options? Gordon: Equity flex options as they stand now are very useful because they have the same characteristics in the listed market that they have in the OTC market. The option can be European style, or the investor can pick the strike price. With flex options, you always have the AAA rating of the Options Clearing Corporation. If you want to get out early, you can, rather than having to buy your way out from a derivative dealer. So, equity flex options have many advantages. Some proposed regulations were released in the beginning of January 2001, but they have not yet been finalized. The proposed regulations provide some give and take. These regulations implicitly encourage investors that own stock acquired after 1984 to use listed options, because the regulations provide that if you write a call that is out of the money and listed, it is not a straddle—even if you bought the stock after 1984. That situation created fantastic opportunities. Take the case of someone who has just exercised an incentive stock option. Within the one-year period, if she buys a put, it will stop her holding period, but she still could sell the call if it is a qualified covered call under these rules. But it has to be listed. Although the proposed rules would broaden this ability and allow OTC options to be qualified covered calls, none of the ©2001, AIMR®

Concentrated Holdings and Low-Cost-Basis Stock options can be longer than a year. To be in a stock that you purchased after 1984 and to roll over those calls and get whipsawed every 11 ½ months is not worth the strategy required for not being a straddle. If these regulations are passed, I do not see any great advantage to flex options and qualified covered calls. Until recently, however, there was a clear benefit to both. Question: Please briefly describe completion funds. Welch: I think of a completion fund as diversification over time out of a concentrated stock position. Again, I will use my example: You have $10 million worth of AOL Time Warner, and your goal is to lower your exposure. You do not want to dump all the stock today because you do not want to pay the taxes. The investment consultant should create the ideal allocation around that position and then begin to liquidate the position over time. So, you sell 10 percent of the stock today, pay your taxes, and use the proceeds to buy some uncorrelated assets with AOL Time Warner. Six months later, or whatever the time frame is, you sell another 10 percent of your stock; and so over time, you are liquidating your position in AOL Time Warner and creating a diversified portfolio. With each sale you are rebalancing to make sure that the inclusion of AOL Time Warner is being factored into the overall expected return and risk of the portfolio. The idea behind the completion fund is that it is a straightforward, disciplined liquidation over time of a concentrated stock position that redeploys the after-tax proceeds into an allocated portfolio. Question: What happens when options in collars expire after three years? ©2001, AIMR®

Gordon: There can be negative tax consequences to “rolling over” the hedge. This is even more of a problem for those open to the straddle rules. Some hedges can be constructed that mitigate the problems associated with “rolling” the hedge. Welch: There will most likely be a taxable event, which will vary depending on whether the trade is cash settled or physically settled or rolled over into a new trade. As a general comment, if the trade is physically settled—that is, the investor delivers stock to settle the trade—the day the shares are delivered is the date of sale for tax purposes, and the investor will face a long-term capital gains tax on the difference between the sales price and the basis (assuming the stock was already long term when hedged). If the trade is cash settled or rolled over, the investor will face a short-term capital gain (if the bank owes the investor money) or a long-term deferred loss (if the investor owes the bank money)—a loss the investor cannot realize until the shares are actually sold. Investors should always retain professional tax counsel to walk them through the tax treatment of these trades before entering into them. Question: Can you hedge stock held in a GRAT (grantor retained annuity trust)? Welch: I believe stock can be hedged in a GRAT. The counterparty bank will want to see a copy of the trust agreement to make sure the trust is authorized to engage in this type of transaction, and the bank may require an opinion letter to this effect from the attorney who drafted the agreement. Question: What is the cost basis at the end of a forward contract when delivering cash or shares?

Gordon: If you deliver shares, your original basis is the cost basis. If you cash settle the forward, then a gain or loss will be measured from your cash flow on termination, not referenced to the stock you held. Beware of the straddle rules as to whether the loss can be currently deducted. Welch: With collars, your cost basis is your original basis plus the interest expense you paid on any borrowing you may have taken against the collared stock (i.e., the interest on the loan cannot be deducted against current investment income but, rather, is capitalized into your basis). So, you get some relief for the interest you pay, but it is deferred until you sell the stock, and you only achieve a capital, rather than an ordinary, offset. With forwards, the implied financing cost is not added to your basis, but it is taken off the sales price for the shares when you physically settle at maturity. The net result is similar—no current deduction on the implied financing cost but some capital relief realized when you ultimately sell the shares. Question: Can you discuss the tax implications of the rehypothecation of securities pledged as collateral in connection with the hedge/monetized transaction? Gordon: IRC Section 1058 discusses the requirements for loaning securities without triggering a gain. Section 1058 provides a safe harbor if you loaned the shares in a way that did not also transfer risk. Because risk may be limited by lending the security, you may be out of the safe harbor and thus open to questions. We think this strategy is acceptable in the eyes of the IRS, but the client should be informed of the risks.

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Investment Counseling for Private Clients III Welch: Because rehypothecating the shares lowers the cost and risk of hedging the trade for the bank, the investor will receive better pricing on the trade. Remember, however, that one of the main points of any of these trades is to remain the beneficial owner of the shares for tax purposes; that is why these trades do not trigger the constructive sale rules. If you allow the bank to rehypothecate (i.e., borrow and then sell short) your shares, some tax attorneys feel you have weakened your argument that you remain the beneficial owner of those shares. The investor should be made aware of the trade-off associated with rehypothecation (i.e., better pricing versus possible increased tax risk), and the trade documents should specify explicitly whether the bank has the right to rehypothecate. But the ultimate decision lies with the investor, based on input from a retained tax professional. Question: How bullish must a client be on his or her individual stock for these strategies to make sense? Does the expected rate of appreciation need to exceed that of the market to make these strategies worthwhile? Gordon: A client doesn’t need to be bullish, but the client must have a need to lock-in profits without triggering gains. We believe the basis should be 50 percent or less of the current market price, or an outright sale to liquidate the position should be made. Welch: We assume that the portfolio the client reinvests in will be the same whether or not the shares are sold or hedged and borrowed against, so what really matters at the end of the day is how the hedged stock performs over the life of the trade. Hedging is certainly a tax-deferral technique, so in that sense, it doesn’t matter what hap-

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pens to the stock after you hedge. But our clients are typically comparing hedging the stock today with selling the stock today. So, if the stock price falls or stays flat after you hedge, you would have been better off selling (because of the financing cost associated with hedging and borrowing). How much the stock price needs to rise before hedging puts more money in your pocket than selling does depends on the structure and the stock, but my experience is that if the stock increases by more than approximately 4–5 percent a year, then hedging adds value compared with selling. Question: Doesn’t the “least expensive” method (i.e., little upside) expose one to the capital gains tax (i.e., stock called away), making it a very expensive method (vis-à-vis the “more expensive,” more upside method)? Gordon: No, options can be cash settled. There is never a need to deliver shares even if the options are physically settled; other shares can be purchased to deliver against the option. Welch: The contracts we work with are European-style options, so the stock can never be called away prior to maturity, and the client always has the right to cash settle if he or she does not want to deliver stock. Question: How do taxes affect the income-producing collar? Gordon: All option proceeds are without tax at inception and receipt but taxable at their conclusion after gain or loss can be established in a “closing transaction.” Question: Regarding purpose and nonpurpose loans from a collar, is it safe to assume that money

used to pay down margin debt would be considered a “purpose” loan? Is it better to do a variable prepaid forward? Gordon: Paying off a margin loan is not a permitted purpose; it is not allowed. We use prepaid forwards when the intent is to repay a margin loan. Welch: We always use a prepaid forward to repay margin debt because (1) it fixes the interest rate for the life of the trade, and (2) forwards are not subject to Reg T or Reg U, so the issue of purpose does not come into play. Question: What are the costs and other considerations when liquidating part or all of the underlying stock prior to maturity of a collar or forward? Welch: The banks typically are not trying to realize any more profit on an early termination than was already priced into the trade. So, aside from a bid–offer spread, you should get a fair market valuation from the bank when you terminate early. That said, the valuation you receive will depend on the market conditions at the time of the early termination—how much time is left in the original trade, interest rates, volatility, and so on. From my perspective, there are only two situations in which you should unwind early: (1) you expect the stock to skyrocket from that point forward (and thus increase in value by more than enough to pay for the time value you have to pay to unwind early), and (2) the stock has, in your mind, peaked prior to maturity, and you fear that it may fall before the trade matures by more than what it will cost you to terminate it early. ©2001, AIMR®

Equity Portfolio Tracking Risk in the Presence of Taxes David M. Stein Managing Director and Chief Investment Officer Parametric Portfolio Associates Seattle

The dual goals of seeking tax efficiency and minimizing tracking error against a benchmark are often at odds with each other. An attempt to reduce the tax burden on a portfolio often simultaneously increases portfolio tracking error. Navigating the appropriate course between tax efficiency and tracking error, while still generating added value, requires careful consideration of such issues as portfolio structure, benchmark choice, and investment philosophy.

n 1999, I presented a paper at AIMR’s seminar “Investment Counseling for Private Clients II” on total risk (volatility risk) in the presence of taxes and the need to keep this risk low even if doing so means paying taxes.1 The crucial point I made was that once a portfolio is diversified, the tracking risk relative to a target becomes relevant. In this presentation, I will address the subject of portfolio risk (specifically tracking risk) in the presence of taxes. Tax-efficient investing requires a passive buyand-hold approach (low capital gains realization) and careful active decision making with respect to taxes. In portfolio management, excess return comes at the cost of tracking error—the risk of sometimes outperforming and sometimes underperforming the target or benchmark. This presentation explores tracking error in the presence of taxes. The focus is on what happens to the investor’s taxes as the manager tries to manage tracking-error risk (i.e., the trade-off between tax costs and tracking error).

Charles Ellis has outlined four main decisions in overseeing an investment portfolio: (1) establishing a long-term strategy and asset allocation; (2) structuring the portfolio in terms of goals and benchmarks, risk level, and active or passive management; (3)

selecting the portfolio managers; and (4) implementing and actually managing the portfolio.2 The third and fourth decisions are less important than the first and second ones; however, they are more costly if executed poorly. Sometimes, investors combine the second and third decisions: They select a preferred manager and then try to integrate that manager into their portfolio structure. Doing so can lead to difficulties. The current art in constructing a U.S. equity portfolio is to partition the asset class into a set of subclasses. Table 1 shows a typical case in which the assets are subdivided into large-cap value, large-cap growth, small-cap value, and small-cap growth stocks. In this case, 80 percent of the portfolio is invested in large-cap stocks and 20 percent is invested in small-cap stocks. (Depending on how large cap and small cap are defined, the allocation might differ.) The investor seeks managers in each of these classes. This partitioned approach is derived from the world of tax exempt portfolio management, where it is used by large institutions and many consultants. The structure makes implicit assumptions that should be recognized. The first assumption is that style and size are major dimensions of risk. This assumption has been validated by academic studies.3

1 See David M. Stein, “Diversification of Highly Concentrated Portfolios in the Presence of Taxes” in Investment Counseling for Private Clients II, edited by Dorothy C. Kelly (Charlottesville, VA: AIMR, 2000).

2 Charles D. Ellis, “Levels of the Game,” Journal of Portfolio Management (Winter 2000):12–15. 3 E. Fama and K. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance (June 1992):427–465.

I

Equity Portfolio Structure

©2001, AIMR®

www.aimr.org • 45

Investment Counseling for Private Clients III Table 1. Common Equity Portfolio Construction Size

Total Allocation

Growth Allocation

Value Allocation

Large-cap

80%

40%

Small-cap

20

10

40% 10

Total

100%

50%

50%

The second assumption is that skill requires specialization, or that specialists outperform generalists. Therefore, investors hire a large-cap growth manager and a large-cap value manager, rather than seeking a combined core manager. Sometimes, investors believe that some sectors are more inefficient and have more opportunities for alpha than others. For example, some investors believe that the large-cap U.S. equity sector has relatively few inefficiencies, so they choose to be cautious in that sector while seeking managers who can “shoot the lights out” in the smallcap sector. The third assumption is that partitioning the universe in this way enables clean control of risks; investors have the flexibility to manage risks by rebalancing managers. In seeking active managers, investors implicitly express a belief that they know how to select managers who will beat the averages. Alternatively, if they are willing to admit that they do not know how to select winning managers, they may choose a passive strategy. Investors typically classify the universe of managers by • philosophy (active versus passive), • discipline (quantitative versus fundamental), • specialization (style and size), • skill (stock selection, sector rotation, tactical allocation, hedging, technical analysis, and trading), • risk control methodology (diversification versus concentration), and • tax sensitivity. Investors then construct a complex portfolio emphasizing their preferences. They may observe that they are not exploiting opportunities between growth and value and may hire a tactical asset allocator. Or they may observe that many active managers underweight utilities and may install a completion fund to rectify this situation. The portfolio becomes more and more complex, and the investor’s job is to keep the whole in balance—to balance the sectors, to control risk, to monitor performance, and to hire and fire managers.

Measuring Risk I will focus on the aspects of equity portfolio risk related to taxation. With a complex portfolio struc-

46 • www.aimr.org

ture, investors need to know how each of their subportfolios is aligned within that structure and where their risks reside. One way to do this is to set a target or benchmark for the overall portfolio as well as for each subportfolio and to track performance deviations from the target. Tracking error is a measure of the uncertainty in these performance deviations. Watching how a manager deviates from the benchmark over time tells investors a great deal about the manager’s skill. Importantly, it measures the degree of confidence a client is likely to have in the manager. In fact, the information ratio (alpha divided by tracking error) is closely related mathematically to a t-statistic that expresses confidence in the alpha. If the benchmark is an index, tracking deviations are important not only because the index performance can be achieved relatively inexpensively but also because the index contains the consensus wisdom of the most intelligent players in the market. A manager who wants to step away from that consensus should have a good reason to do so. Unfortunately, the term “tracking error” is used in two different senses, which can be confusing. One use is as a measure of past, or historical, performance; the second is as a predictive measure. Historical Tracking Error. Historical tracking error measures the past performance record of a portfolio. Mathematically, it is the standard deviation of the differences in return between the portfolio and its target each period. (With monthly measurements, the annualized tracking error is the standard deviation of the monthly differences multiplied by the square root of 12.) Figure 1 shows the historical performance of four portfolios with different tracking errors and no excess return. The vertical bars plot the deviations each month, either outperformance or underperformance. The annualized standard deviation of these bars is the tracking error. An index fund that is tracking at 0.5 percent looks like the chart in Panel A. At the other extreme is a typical, weakly controlled active manager with a tracking error of 5 percent, shown in Panel D. Every month, this manager has a good likelihood of being more than 3 percentage points (pps) above or below the benchmark. Some people like to think in terms of a normal distribution. If the distribution of the deviations is normal, the manager’s performance can be expected to track to within the tracking error value in twothirds of the years. So, one might then expect the manager in Panel A of Figure 1 to be within 0.5 percent of the benchmark in two-thirds of the years and the manager in Panel D to be within 5 percent of the benchmark in two-thirds of the years. Note that investors must be cautious because tracking-error 2001, AIMR®

Equity Portfolio Tracking Risk in the Presence of Taxes Figure 1. Portfolio Risk as Measured by Tracking Error A. Annual Tracking Error of 0.5 Percent Monthly Return Difference (pps) 3 2 1 0 –1 –2 –3 B. Annual Tracking Error of 1.0 Percent Monthly Return Difference (pps) 3 2 1 0 –1 –2 –3

C. Annual Tracking Error of 2.0 Percent

Monthly Return Difference (pps) 3 2 1 0 –1 –2 –3 D. Annual Tracking Error of 5.0 Percent Monthly Return Difference (pps) 3 2 1 0 –1 –2 –3

deviations are typically not normally distributed and have fat tails. More observations fall into the extremes than would be the case for the normal distribution; that is, it is more likely that extreme events happen. Predicted Tracking Error. Given a portfolio, a key question to ask is: What is the expected future tracking error? Portfolio managers predict tracking error implicitly, if not explicitly. One simple way to predict tracking error is to consider how the portfolio would have performed compared with the target for, say, the past five years. This historical tracking will provide an estimate for the future. In practice, there are several mathematical models available that provide even better predictions. For example, Barra sells a well-known mathematical model to predict a given portfolio’s tracking error. Models such as Barra’s are based not only on past performance but also on the ©2001, AIMR®

movements of individual stocks relative to one another and additional fundamental risks.

Taxes and Tracking Error The art of portfolio management requires a trade-off between the excess return of the portfolio and its risk (or tracking error). Taxes are an expense that directly affects the excess return, and the trade-off between taxes and tracking error is similar to the trade-off between alpha and tracking error. A link exists between the investor’s expectations of a manager’s outperformance and the tracking-error risks that the manager is taking. A manager who incurs little tracking-error risk is unlikely to outperform the target by much. Controlling tracking error generally has a cost. If tracking is too tight, the investor will pay a cost in taxes or in stock-selection alpha. If tracking is too

www.aimr.org • 47

Investment Counseling for Private Clients III loose, the portfolio will incur undue risk. When tracking-error risk is high, the investor often loses confidence in his manager’s skill. A manager who experiences large deviations may lose confidence in her own stock-selection skill and may respond by changing her models or her approach to portfolio management, both of which present an additional risk to the investor. So, tracking error is something that both the manager and investor want to control. Note that no industry standards exist for predicting after-tax tracking error (i.e., the uncertainty of the difference between the after-tax return of the portfolio and the after-tax return of the target). At Parametric Portfolio Associates, we have found it most useful to predict and control pretax deviations, even though performance is ideally measured after taxes. Active Portfolio Management. An active tax exempt manager does not need to think about taxes, so this manager will be able to establish an ideal active tax exempt portfolio. But for the taxable investor, there is a tax cost to buying and selling securities, and the manager must consider trade-offs between tracking-error risk, alpha, and tax cost. The tax cost establishes a hurdle that the manager must overcome in order to generate after-tax alpha. Consequently, a portfolio that is implemented by an active, taxsensitive manager will differ from an ideal tax exempt portfolio. One can think of measuring the tracking performance of the implemented taxable portfolio against the ideal tax exempt portfolio—and thus trade off deviations from this ideal against the tax costs. In order to sell a security, realize a capital gain, and buy another security to replace the original one, the manager must be able to justify the tax cost. To do so, he must estimate what the performance of the new security will be. The outperformance he needs depends on the expected length of the holding period and on the cost basis of the original security, as shown in Table 2. To illustrate the active manager’s dilemma, suppose the investor has a 20-year investment horizon.

Suppose the investment manager holds Security A, which has a market value of $100 and a cost basis of $50, and the manager is indifferent to A. For simplicity, assume the manager expects A (and the market) to appreciate by 8 percent a year (no dividends) for 20 years. The manager expects Security B to appreciate by 10 percent a year for the next 3 years and thereafter to appreciate in line with the market (8 percent a year). The preliquidation values are as follows, assuming a 20 percent capital gains rate: If the manager holds: V1 = 100 × (1.0820). If the manager trades: V2 = 90 × (1.13) × (1.0817), where 90 = (100 – 50) × 0.2. The postliquidation values are as follows: If the manager holds: W1 = V1 – (V1 – 50) × 0.2. If the manager trades: W2 = V2 – (V2 – 90) × 0.2. Comparing the numerical results, the final values after 20 years are as follows: Position

Preliquidation

Postliquidation Average

If the manager holds

$466

$383

$424

If the manager trades

443

372

408

This does not look like a good trade to make. The manager would need an alpha of 3.5 percent a year for each of three years to justify the trade, a relatively large alpha hurdle that most managers find difficult to achieve. As Table 2 shows, if the security sold is at a full cost basis—that is, if its market value is $100 and its cost basis is also $100—the manager, to have relatively better performance with the new security than with the old security, does not need to recoup any capital gains tax imposed on the security sold. And if trading costs were zero, the manager could trade the security as frequently as desired. For a zero-cost-basis holding, however, an even larger alpha is needed to justify selling the security. Because of the capital gains tax hurdle imposed when capital gains are realized, the manager is inhibited

Table 2. Excess Return on Buy Required to Justify a Capital Gain on Sell Cost Basis Holding Perioda

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1

25.7%

22.6%

19.6%

16.7%

14.0%

11.4%

8.9%

6.6%

4.3%

2.1%

0%

2

12.2

10.8

9.4

8.1

6.8

5.6

4.4

3.2

2.1

1.0

0

3

8.0

7.1

6.2

5.3

4.5

3.7

2.9

2.1

1.4

0.7

0

4

5.9

5.2

4.6

4.0

3.4

2.8

2.2

1.6

1.1

0.5

0

5

4.7

4.2

3.7

3.2

2.7

2.2

1.7

1.3

0.8

0.4

0

a

100%

Measured in years.

48 • www.aimr.org

2001, AIMR®

Equity Portfolio Tracking Risk in the Presence of Taxes from trading securities that have a lengthy holding period (low cost basis). When a portfolio has large unrealized capital gains, the manager is unlikely to find new securities with enough performance potential to overcome this hurdle (the capital gains tax on the security’s unrealized gains), which is a primary reason why active, tax-sensitive managers must incur tracking error vis-à-vis their target portfolio. Their tax-management issues become similar to those of passive managers (discussed next). Think of them managing their portfolios so as to track their tax exempt target portfolios but where tracking error costs them in an alpha reduction as well. Passive Portfolio Management. A “pure” passive manager focuses on the target without considering stock-specific issues. Such a manager who is not concerned with taxes simply balances perfectly to the target every period. She maintains low tracking error by closely matching changes in the benchmark. For the taxable investor, however, this approach may result in tax costs. A tax-sensitive portfolio manager must consider the trade-off between tracking-error risk and tax costs carefully. For example, when Chrysler Corporation merged with Daimler-Benz AG to form DaimlerChrysler and dropped out of the S&P 500 Index, the manager could either sell the security, incurring capital gains for the investor, or hold on to the security, saving capital gains taxes but incurring tracking error risk.

The tax-sensitive manager who is more active with respect to taxes will take advantage of capital losses and investment flows while continually rebalancing the portfolio to keep the tracking error low. He will monitor the portfolio continuously to keep all the fundamental risks within established tolerance bounds, which requires an ongoing, and not completely obvious, trade-off between tracking error and tax costs. Here is one simple example of how the trade-off arises in practice. Table 3 presents the characteristics of an example (but real) portfolio with a market value of about $19 million and a cost basis of $13 million. This portfolio has a combination of securities with unrealized short-term and long-term capital gains and even some unrealized short-term and long-term losses. The portfolio consists of 31 holdings, and it has slightly more small-cap than large-cap securities. It has a high beta and a low yield. Relative to the S&P 500 target, it has a tracking error of almost 5 percent. To liquidate the portfolio would cost the investor about $1,250,000 in capital gains taxes, or about 6.5 percent of the market value. But a tax-sensitive transition of this portfolio to a portfolio that approximates the S&P 500 could be accomplished at a substantially lower tax cost—$245,987, or 1.3 percent. This private index portfolio has about a 2 percent tracking error and saves $1,000,000 in taxes, about 5 percent of the portfolio value. Of course, the investor can select a point between these extremes.

Table 3. Portfolio Characteristics for Existing and Private Index Portfolio Compared with Target Benchmark Portfolio Characteristics

Existing Portfolio

Private Index Portfolio

Market value (millions)

$19.4

$19.4

Cost basis (millions)

$13.0

$14.9

Benchmark (S&P 500)

Unrealized gains Short term

$817,989

$168,400

Long term

$5,884,212

$2,159,388

Short term

$483,043

$483,043

Long term

$308,036

$308,036

Number of holdings

31

281

Number of tax lots

83

301

Beta

1.08

1.00

1.00

Dividend yield

0.75

1.44

1.48

P/E

20.0

20.0

20.0 $72.2

Unrealized losses

©2001, AIMR®

Weighted-average market capitalization (billions)

$62.0

$78.7

Tracking error

4.78%

1.90%

500

www.aimr.org • 49

Investment Counseling for Private Clients III

Equity Portfolio Structure

A curve identifying the tracking error/tax cost trade-off for another portfolio is shown in Figure 2. In this example, the initial portfolio, Portfolio A, has a predicted tracking error of 6–7 percent; the investor wants to move the portfolio to track Benchmark B. The vertical axis shows the tax cost to the investor of such a move. Initially, the investor can reduce tracking error 2 percentage points at no cost because the portfolio has unrealized tax losses that can offset unrealized capital gains. The investor can sell the securities that are incurring the most risk at the start of the process. As she tries to squeeze tracking error further, tax costs increase. What is the most sensible choice for this investor? Again, the answer is not obvious. Some investors will be cautious and want to keep the tracking tight; some will care less about tracking error and wish to lower the taxes. In general, large tax costs are incurred by the process of hiring and firing portfolio managers and at the time of investment flows. It is important to note that I am using the notion of predicted tracking error as a simple proxy for portfolio risk relative to a target. In practice, a portfolio faces many risks, and the portfolio manager needs to focus on much more than just tracking error. The portfolio manager needs to understand other risks and constrain them. A portfolio can have a tight predicted (or even historical) tracking error yet still be taking large economic sector, industry, or fundamental bets. Not all risk models, or the people who use them, are the same. Most models underestimate the likelihood of extreme events, and their estimates change over time. Investors should be certain that they are obtaining expert quantitative skills and that they understand what to expect in tracking performance.

Returning now to the common equity structure of Table 1, what might one expect in after-tax performance? I will make some simple assumptions to determine the magnitude of after-tax expenses. Benchmarks change over time. If growth and value are defined by an equally weighted partition of the stocks by book/price or some other measure, stocks will move from one style to another each time the benchmark is reconstituted. Similarly, some small-cap stocks grow, and some large-cap stocks shrink. Table 4 shows the typical annual turnover needed to reconstitute the benchmark. From Table 1, for each $100, the target is to have $40 in the large-cap growth category. In the example shown in Table 4, of this $40, each year $32 typically stays in the large-cap growth category, $6 moves to large-cap value, $1 moves to small-cap growth, and $1 moves to smallcap value. The table implies a turnover each year of 5 percent for large-cap stocks, 20 percent for smallcap stocks, 18 percent for growth stocks, and 18 percent for value stocks. The aggregate turnover of the portfolio is 22 percent, which is higher than any of the individual sectors. Although the numbers in Table 4 are typical, in some years, the turnover is higher, and in other years, it is lower. Consider what this turnover means for after-tax returns. Assume that all asset classes have a pretax return of 10 percent a year and that the tax rate is 20 percent on capital gains and 40 percent on income. Table 5 shows the different rates of dividend yield and gain realization among the sectors. The growth sectors have lower dividend yields than the value sectors. Value has a higher rate of capital gain realization than growth. Value stocks are priced more inexpensively than growth stocks, and when a stock does

Figure 2. Predicted Tracking Error versus Tax Cost Tax Cost (%) 8 Benchmark B

6 4 2

Portfolio A 0 –2 0

1

2

3

4

5

6

7

8

Predicted Tracking Error (%)

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2001, AIMR®

Equity Portfolio Tracking Risk in the Presence of Taxes Table 4. Annual Turnover in Asset Subcategory Targets of Table 1 To

Market/Portfolio Sector

Large-Cap Large-Cap Small-Cap Small-Cap Growth Value Growth Value

From Large-cap growth

Table 6. After-Tax Return for Portfolio after 10 Years No Liquidation

Total market

Liquidation

9.03%

8.38% 8.17

Partitioned portfolio

32

6

1

1

Large-cap growth

8.56

Large-cap value

6

32

1

1

Large-cap value

7.79

7.58

Small-cap growth

1

1

7

1

Small-cap growth

8.12

7.88

Small-cap value

1

1

1

7

Small-cap value

7.36

7.23

8.09

7.81

Total portfolio

Table 5. Dividend Yield and Gain Realization Model Assumptions, by Market Sector Market Sector

Dividend Yield

Total market

1.2%

Large-cap growth

0.5

Gain Realization 5.% 15

Large-cap value

1.8

25

Small-cap growth

0.3

25

Small-cap value

2.4

35

well, its price increases and it moves into the growth sector. This stock will incur larger capital gains than a stock that decreases in price, moving from growth to value. Similarly, small-cap stocks that become large-cap stocks are those that have increased in market value and thus have realized large capital gains. The value and small-cap sectors are less tax efficient from this benchmark reconstitution viewpoint. Assuming a 20 percent capital gains tax rate and a 40 percent income tax rate, the after-tax return of the portfolio after 10 years is given in Table 6. The return of the total market portfolio, if it is liquidated after 10 years, will be about 8.4 percent. The after-tax return on the liquidated portfolio with a partitioned structure (style and size) will be only about 7.8 percent. The portfolio loses about 60 basis points in return a year just because of the structure. Although partitioning the universe into style and size categories acknowledges important dimensions of risk for the tax exempt investor, it imposes extra costs for the taxable investor. If an investor believes value provides an extra return over the long

term and is willing to incur the risks associated with this decision, he should not select a portfolio defined by a changing book/price partition of the universe. An alternative definition of value is required. What are the characteristics of a tax-efficient style index? Such an index would seek to define style by characteristics that change only very slowly and that are not sensitive to price; it would result in rates of gain realization that are closer to a broad capweighted market—say 5 or 6 percent turnover—than the 20 percent that is common for style benchmarks; and it would have a reasonably high correlation with the standard style indexes. An alternative to the current style indexes is one developed at Parametric Portfolio Associates (PPA). In this approach, value and growth stocks are identified by very slowly moving signals of anticipated earnings growth. Security classifications change very slowly, for example, based on substantive changes in technologies or significant changes in demographics. Table 7 shows characteristics of these style indexes. The turnover of these indexes is much reduced from the more common S&P/Barra indexes, yet the two sets of indexes are reasonably correlated. Under our definition, we do not reconstitute the styles every year, but we must forgo the 50–50 weighting of growth and value. If the price of growth stocks increases, it is meaningful to speak of the overall market as a “growth market.” (With the standard definitions, the market is rebalanced each period and by definition is style-neutral at this time.)

Table 7. Tax-Efficient Growth and Value Indexes Measure

PPA Growth

PPA Value

S&P/Barra Growth

S&P/Barra Value

S&P 500

Average annual turnover

8.1%

5.3%

21%

24%

4.2%

Correlation with Barra style

0.99

0.96

na

na

na

Tracking error against Barra style index

3.2%

4.2%

na

na

na

na = not applicable.

©2001, AIMR®

www.aimr.org • 51

Investment Counseling for Private Clients III

Recommendations For taxable investing, tracking-error risk needs to be rethought. A trade-off exists between tracking and tax efficiency. To reduce tax costs while maintaining risk diversification in a publicly traded equity portfolio, PPA recommends the following: • Simplify the portfolio structure. Seek a single broad core mandate to provide inexpensive diversification and incur no style/size rebalancing costs. • Focus on tax management. Use a passive taxmanaged core for low cost, low turnover, and low realization of gains. This approach can provide economic benefits of tax-loss realization. • Install one core manager. A single manager can centralize all the tax issues in the portfolio. With many managers, each treads on the other, mak-

52 • www.aimr.org

•

•

ing it almost impossible to track what is happening with respect to taxes. Certainly, investors do not want one manager buying what another manager is selling. Choose concentrated active managers as satellites. Give them broad mandates, not style-based mandates. Give them smaller portfolios, and allow them to take concentrated risks. Do not pay them to diversify because diversification comes from the centralized core. These managers should have little focus on taxation. They are included for their active ideas, but their performance should be measured after taxes. The centralized core is “boring,” but these satellite managers provide pizzazz to the total portfolio. Define sectors based on tax efficiency if a style or size focus is needed (or wanted).

2001, AIMR®

Tracking Risk of Equity Portfolios in the Presence of Taxes

Question and Answer Session David M. Stein Question: How would the results of your model change if the goal was to minimize semivariance instead of tracking error? Stein: There are some good models for semivariance. But for long equity portfolios, I have found regular volatility or standard deviation quite satisfactory; rarely does a huge upside occur with no downside, or vice versa. Semivariance is more important in measuring the risk of options and other derivative strategies in which the focus is on what happens below the mean and in which the distributions are skewed. Yet even in this case, I have found it easy to work with tracking error around a target that changes nonlinearly with market movements. Question: Have you looked at using tax exempt accounts to bear the rebalancing burden for the taxable accounts? Stein: Yes. This is a good way to rebalance without paying taxes on the rebalancing. You can do all kinds of restructuring within a tax exempt account.

©2001, AIMR®

Question: Do you see any particular trends in market volatility versus individual stock volatility? Stein: The volatility of the market as a whole and the volatility of individual stocks change over time. In the late 1980s, market volatility was high, and in the mid1990s, market volatility was lower. In the late 1990s, it seems to have risen again. The average volatility for U.S. equities as a whole is somewhere around 15–20 percent. I would not like to try to predict market volatility. If you believe volatility is going to change, you can try and make money from this belief using options and other derivatives. The models I focus on here are mainly concerned with intramarket volatility, not market volatility as a whole. Within the market, volatility patterns also change from time to time. Predicting volatility is a little like predicting the weather. You have a good sense of what it will be long term and a good sense of what’s within the normal range, but extreme events are not at all uncommon. In fact, you know extreme events will certainly

occur. There are stormy days, very calm days, very cold days, and very wet days. The markets are that way too. Some market models tend to predict change a little too quickly. When I say I’m predicting volatility, I’m thinking long term—volatility over the next two, three, or four years. Some models predict volatility over periods as short as three months. When they see market volatility soar in the short term, their predictions change. Sometimes volatility is overpredicted, and at other times it is underpredicted. That is the nature of all predictions. In using models, you need to understand how to interpret them. In managing portfolios for the long term, I do not like to make major changes simply because the prediction of tracking error has changed by a huge amount over the short term, particularly if the tax consequences of the contemplated changes would be large. If volatility stays high for extended periods, however, I do start to be concerned. The trade-offs are tricky and not obvious, as I have said.

www.aimr.org • 53

Taxable Benchmarks: The Complexity Increases Lee N. Price, CFA CEO Price Performance Measurement Systems, Inc. Palo Alto, California

After-tax benchmarks must adhere to standard benchmark rules while incorporating taxrelated concerns (such as income tax rates), but a big hurdle in establishing appropriate benchmarks is choosing which tax rate to use. An after-tax benchmark can best be constructed by using a combination of three levels of approximation as well as a shadow portfolio that allows for adjustments in cash flows and calculations of portfolio-specific cost bases.

f those who manage taxable portfolios or represent taxable clients, only a small percentage report after-tax returns. One of the reasons managers give for not calculating after-tax returns is the lack of generally available after-tax benchmarks. After addressing the issue of benchmarks in general, I will explain how to calculate after-tax returns according to AIMR-PPS™ standards; the same rules apply to calculating after-tax benchmarks. I will then discuss three levels of approximation for the calculation of after-tax benchmark returns and potential combinations of these approaches.

O

Standard Benchmark Rules A number of well-established principles exist for creating benchmarks. A benchmark should be (1) appropriate to the manager’s asset class and investment strategy, (2) unambiguous, (3) specified in advance, (4) investable, and (5) measurable. When constructing an after-tax benchmark, a sixth rule is also applicable: The benchmark should be subject to the same (or similar) tax considerations as those of the clients whose portfolios are being evaluated against it. Obviously, an after-tax benchmark must have the same or similar tax considerations as those of the accounts that are being managed against it, but that does not mean the benchmark can be ambiguous; nor does it mean the benchmark cannot be specified in advance. Most important, the benchmark must still be appropriate to the manager’s investment strategy. The problem with after-tax benchmarks is that no single after-tax performance number applies to all

54 • www.aimr.org

users of the benchmark. One size does not fit all. Whereas pretax benchmark users can expect to have a single number for benchmark performance, aftertax benchmark users should never expect a single value. The S&P 500 Index’s pretax return in 1999 was 21.04 percent, according to Ibbotson Associates. But managers who want to compare their results with an after-tax benchmark must recognize the complications involved. The benchmark has to take into account not only the different tax rates of clients but also the variation in the capital gains tax bite, which is dependent on the client’s starting cost basis. A nuclear decommissioning trust with a 20 percent flat tax rate on capital gains should have a different after-tax benchmark from that of an individual with a 46 percent total state and federal tax rate.1 Equally important is the fact that the after-tax benchmark return depends on the inception date of the portfolio. If the account began in 1998, the 1999 aftertax return will reflect only a minimal amount of capital gains. If the account began in 1989, however, then the 1999 after-tax benchmark return will have a much larger capital gains component generated by every stock sold. The account will reflect 10 years of compounded gains built into the portfolio return, and when the manager sells the stocks, the account will realize much larger capital gains than an account that had been in existence for only one year. 1 Since this presentation was given, the tax law has changed. Please

see “Update” in Mr. Macklin’s presentation for more information, or go to http://thomas.loc.gov/ and search by bill number H.R.1836.ENR for a complete description of the final bill.

2001, AIMR®

Taxable Benchmarks Consequently, after-tax benchmark returns for any given year tend to be smaller than those for longer holding periods.

AIMR After-Tax Standards The initial task of the Taxable Portfolios Subcommittee of the AIMR Performance Presentation Standards Implementation Committee, which I chaired when it was formed in 1994, was to evaluate the various ways of computing after-tax returns. We considered everything from cash basis (using only custodian-computed, tax-related cash flows) to full liquidation, partial liquidation, and a present value methodology that would account for the potential tax liability of future portfolio liquidation in current dollars. The committee decided that the realizedbasis method was the only acceptable way to report after-tax performance. Advantages of Realized Basis. In the committee’s view, the most important advantage of reporting after-tax returns using realized-basis accounting (which the U.S. SEC now calls “preliquidation”) is that implied taxes are linked directly, and in the same period, to the taxable event giving rise to them. Regardless of when taxes are actually paid, the realized-basis method forces managers to be aware of the tax impact of portfolio trading and security selection. This realization of the tax impact is true of both taxes on dividend and interest income and of capital gains taxes on security sales. A second important advantage is that after-tax performance computed in this manner will be completely in sync with pretax performance calculated according to the AIMR-PPS standards. All of the same rules regarding interest and dividend income accrual apply in the after-tax arena as well. Disadvantages of Realized Basis. The biggest disadvantage of using the realized-basis methodology is that it requires complicated accounting—accurate tax lots, calculation of accrued interest, and accretion of OID discounts/premiums—and a great deal of precision. Many investment managers lack the necessary capabilities in their computer systems, even though some software vendors have been working hard to solve that problem. Another disadvantage of this approach is that it slightly understates performance for all assets by charging taxes before they are actually due. AIMR-PPS Standards. For pretax performance, calculations are generally done according to a balance-sheet approach. The balance-sheet approach means that the manager uses the asset values at the end and the beginning of the period and adjusts for ©2001, AIMR®

both the income received and the cash flows (positive and negative) during the period; the calculation is basically the difference between ending and beginning asset values divided by the average asset value for the period: Pretax performance = Ending market value – Cash flows – Beginning market value --------------------------------------------------------------------------------------------------------------------------------------------------. Beginning market value + Weighted cash flows

This method works well for pretax performance calculations but not for the analysis of tax implications. A completely analogous method, using exactly the same numbers, is an approach based on investment flows. The manager looks at the flow activity during the period rather than focusing on the ending and beginning asset values. The manager can divide the return, in terms of flow, among the various sources of return to the portfolio—realized gains, unrealized gains, and income—and then apply the appropriate tax rate to each type of flow. The denominator is the same as in the pretax calculation—the average assets for the period: After-tax performance = Unrealized gains + Realized gains ( 1 – t ) + Income ( 1 – t ) --------------------------------------------------------------------------------------------------------------------------------------- . Beginning market value + Weighted cash flows

With this methodology, the after-tax implication is clearer because no taxes are incurred on the unrealized gains during the period. This equation is a simplification because realized gains and income are taxed at different rates depending on holding period and type of income, but this equation is useful for conceptualizing the process. An easier way to calculate the same result is: After-tax performance equals pretax performance minus the tax burden, where Tax burden =

( Realized gains × Capital gains rate ) + ( Income × Income tax rate ) ------------------------------------------------------------------------------------------------------------------------------------------------------ . Beginning market value + Weighted cash flows

Importance of the Capital Gain Realization Rate The realization of capital gains plays a vital role in after-tax performance. The driving force behind the impact of taxes on a portfolio is the relative size of realized capital gains and the frequency with which they are realized. Table 1 shows the long-term return for a growth portfolio. I assume that the annual capital gains from price appreciation are 7.5 percent, the percentage of gain realized each year is 40.0 percent, the capital gains tax rate is 28.0 percent, the percentage average dividend yield is 2.3 percent, and the client’s income tax rate is 39.6 percent with no dividend exclusion. The long-term pretax return

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Investment Counseling for Private Clients III Table 1. Implications of Varying the Rate of Realization of Capital Gains Item

Year 0

Year 1

Year 4

Year 8

Price index (untaxed)

100.0%

107.5%

133.5%

178.3%

Cost basis

100.0

100.0

111.5

141.6

0.0

7.5

9.3

12.1

100.0

107.5

133.6

173.7

Pretax gain this year Pretax value Unrealized gain (cumulative)

0.0

7.5

22.1

32.1

Realized gain

0.0

3.0

8.8

12.8

Tax After-tax valuea

0.0

0.8

2.5

3.6

100.0

108.0

132.9

172.3

8.0

7.4

7.0

Compound after-tax return

Note: Assume all capital gains taxes paid and dividends received at year-end. a Including dividends after tax.

based on these assumptions is 9.8 percent (7.5 percent + 2.3 percent), and the after-tax return is 6.8 percent. Table 1 shows that in the beginning, taxes have only a minor impact on the portfolio, but as the performance period lengthens, the after-tax return decreases because the amount of embedded gains increases. After a holding period of about 20 years, the after-tax return drops to about 6.8 percent and remains constant. According to these specific assumptions, a 9.8 percent pretax return can convert to a 6.8 percent after-tax return, depending on the holding period. When looking at after-tax performance (particularly long-term after-tax performance), the capital gain realization rate (CGRR) is an important concept. The CGRR is not necessarily the turnover rate. The Taxable Portfolios Subcommittee concluded that the measure of the CGRR should be the net gains or losses realized during the period divided by the average of the available gains during the period. The average stock of available capital gains during the period is ½(Stock of unrealized gains at start + Realized gains + Stock of unrealized gains at end).

Although turnover alone is not the measure that defines the CGRR, keep in mind that portfolio turnover is not necessarily bad. For example, turnover may include the selling, or turnover, of cash equivalents. This type of turnover does not affect taxes at all because the tax basis is always 100 percent of the market value. Or the manager may have intentionally harvested losses, which increases turnover but reduces the portfolio’s net capital gain realization. The effect of the CGRR on after-tax returns is rather dramatic. Table 2 shows the after-tax returns calculated with this same model under slightly different assumptions to illustrate the two things an investment manager can control: the CGRR—at the left of the table—and the investment style (namely, dividend yield)—at the top of the table. A manager cannot control the direction or the volatility of the market, but he or she can control the amount of turnover—a proxy for CGRR—in the portfolio. And the manager can control the investment style, whether he or she invests in high-dividend-yield stocks or low-dividend-yield stocks, growth versus value, and so on. Table 2 uses exactly the same assumptions presented in Table 1, with one

Table 2. Effect of CGRR on After-Tax Return for Various Combinations of Appreciation and Dividend Yield Appreciation/Dividend Yield (%) CGRRa 5%

4.0/6.0

5.0/5.0

6.0/4.0

7.5/2.5

8.0/2.0

9.8/0.2

6.9%

7.3%

7.6%

8.2%

8.4%

9.0%

10

6.5

6.8

7.2

7.7

7.9

8.5

20

6.1

6.4

6.7

7.2

7.4

7.9

40

5.7

6.0

6.3

6.8

6.9

7.4

60

5.6

5.9

6.2

6.6

6.7

7.2

80

5.5

5.8

6.1

6.5

6.6

7.1

Note: Assumes a 28 percent tax rate. a Percent of gains realized each year.

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2001, AIMR®

Taxable Benchmarks exception: The portfolio’s rate of total pretax return is 10 percent (rather than 9.8 percent) a year for the next 20 years, regardless of how the portfolio is structured. So, based on a completely hypothetical efficient market assumption, the after-tax returns range from about 9 percent for a portfolio with low turnover and a low dividend yield to 5.5 percent for a portfolio with high turnover and a high dividend yield.

Converting a Standard Pretax Benchmark One approach to constructing an after-tax benchmark is to convert a standard pretax benchmark to an aftertax one. Roughly 50–100 pretax benchmarks are used by managers, with 10–15 used widely. The after-tax benchmarks can be converted using various tax rates and investment periods (different inception dates). As I mentioned earlier, even if one adopts the AIMRPPS standards’ realized-basis method, there are three levels of approximation in converting a pretax benchmark to an after-tax benchmark, and I will describe those three levels in this section. At the end of this section, I will cover some of the special problems associated with converting a standard pretax benchmark to an after-tax benchmark. First Level of Approximation. To convert a pretax benchmark into an after-tax benchmark, at the first level of approximation, the manager must first split the pretax return between the sources of return: for example, dividend income and appreciation—realized and unrealized. (I will use the S&P 500 as an example, and fortunately, Ibbotson has already split the returns for the S&P 500.) For this first level of approximation, the manager must also assume that the pretax benchmark has a fairly constant CGRR. (I will assume that the CGRR is 5.5 percent for the S&P 500.) Keep in mind that the CGRR can vary widely depending on the index chosen and the number of years used to construct the data. The CGRR could be 25 percent for the Russell 2000 Index or even 50–70 percent for some of the value indexes. And although the S&P’s CGRR has averaged 5.5 percent for the past 12 years, the average depends on which years are used to calculate the measure. The manager must also assume a capital gains tax rate (28 percent) and an income tax rate (39.6 percent) for dividends. Finally, the manager must apply the CGRR to the assumed portfolio appreciation and compound the remaining unrealized gains. The equations for creating an after-tax benchmark for the S&P 500 are as follows: ©2001, AIMR®

Price

= Price(–1) × (1 + Appreciation)

Realized gain = CGRR × [Price – Cost(–1)] Cost

= Cost(–1) + Realized gain (1 – Capital gains tax) + Dividends (1 – Dividend tax)

Tax

= Realized gain × Capital gains tax + Dividends × Dividend tax

After-tax value

= After-tax value(–1) × (1 + Appreciation + Dividends – Tax)

After-tax return

= After-tax value/After-tax value(–1) – 1.

Note that the realized gains and dividends are both calculated as a percentage of Price(–1). To start the calculation, the manager must have a beginning price, and then he or she increments that beginning price by 1 plus the portfolio appreciation. Next, the manager calculates the potential realized gain, which is the difference between the price at the end of the period and the cost basis. The cost minus 1 is for the previous period (which is rolled forward each period). The manager multiplies the potential amount of realized gains by the CGRR, and the cost is incremented to reflect the reinvestment of proceeds, but only arithmetically. The U.S. IRS does not allow managers to compound the cost basis, so the manager calculates the cost using the cost of the previous period plus the realized gains from security sales in the current period times the quantity (1 minus the capital gains tax paid) plus the dividends received in the current period times the quantity (1 minus the income tax paid on the dividends). And then finally, the manager can calculate an after-tax return, which is computed on a running basis divided by the previous period’s value. The methodology is straightforward and, most important, sensitive to the manager’s assumed CGRR and assumed tax rates. Table 3 shows the results of calculating after-tax performance according to methodology. For this example, I used the performance of the S&P 500 for the past 10 years. The table shows the pretax return for the S&P 500 for each of the years from 1990 to 1999 and the after-tax performance for each of the same years. Beginning in 1991, more than one after-tax performance number exists for each year because the starting year for the calculation (for the cost) varies. For example, if the portfolio’s inception date was 1989 and the market was down 3.2 percent (pretax) in 1990, the after-tax return was a negative 4.4 percent, which may seem odd. Even though the portfolio was started in 1989 and should not have realized many gains on average in 1990, thus creating only a minimal capital gains tax liability, the average dividend earned by the S&P 500 in 1990 was high. Thus, the income tax liability alone would have had a significant tax impact on the portfolio. Because of the high dividend tax rate assumed in this analysis, the

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Investment Counseling for Private Clients III Table 3. S&P 500 After-Tax Return for 1990–99 as a Function of Starting Year Item Pretax

a

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

–3.17%

30.55%

7.67%

9.99%

1.31%

37.43%

23.07%

33.36%

28.58%

21.04%

Starting year for after-tax return 1989

–4.43

1990

28.35

6.05

8.46

–0.07

35.13

20.96

31.14

26.43

19.08

28.21

5.94

8.36

–0.17

35.04

20.89

31.08

26.38

19.04

6.22

8.62

0.08

35.28

21.08

31.24

26.51

19.14

8.66

0.11

35.32

21.11

31.27

26.52

19.16

0.19

35.39

21.16

31.31

26.56

19.19

35.34

21.13

31.28

26.54

19.17

21.48

31.58

26.76

19.35

31.81

26.94

19.49

27.27

19.75

1991 1992 1993 1994 1995 1996 1997 1998 a S&P

20.05 500 pretax return.

income taxes paid exceeded the net effect of realizing losses, assuming a 5.5 percent portfolio turnover rate. As the holding period increases, the after-tax numbers are always lower than the pretax numbers, and they get lower the longer the investor holds the portfolio, even with a relatively low 5.5 percent CGRR. This effect is most noticeable in Table 3 for the 1999 period. For a portfolio started in 1998, the aftertax return was down about 1 percent—20.05 percent versus the pretax return of 21.04 percent. But if that portfolio had been started in 1989, the after-tax return would have been 19.08 percent. Table 4 highlights the difference between the pretax and after-tax returns for the S&P 500. The oneyear difference between pretax and after-tax returns is roughly between 1.0 percent and 2.3 percent, with a 1.75 percent average reduction across the 10 sample years (1990–1999). But for portfolios with a holding period of three years, the difference in the pretax and after-tax return is roughly 1.25–2.1 percent, and by six years, the range is 1.9–2.3 percent. By the time the

investor has had the portfolio nine years, the difference is consistently above 2 percent. The significant cumulative effect of taxes on portfolio returns explains the reason for the SEC’s proposal that mutual funds be required to report aftertax returns to their clients. Table 5 shows some of the cumulative differences (for portfolios with holding periods of up to 10 years) in pretax and after-tax returns for the years 1995–1999. Again, the difference is negligible in the first year, only 1–2 percent. But at 5 years, the difference accumulates to 19 percent on average, and at 10 years, the cumulative difference is about 77 percent. In other words, the cumulative 10year pretax return for the S&P 500 in 1999 was about 300 percent, whereas the cumulative after-tax return was about 225 percent, for an approximate difference of 75 percent, which is a fairly striking number. This large cumulative difference is obviously why the SEC is concerned about taxable investors investing in mutual funds to provide for their retirement years. Their realized return will be much lower than what is reported to them on a pretax basis.

Table 4. S&P 500 Example: Difference between Pretax and After-Tax Returns Year

1990

1991

1992

1993

1989

1.26%

2.20%

1.62%

1.53%

1.38%

2.34

1.73

1.63

1.48

1990 1991 1992 1993 1994 1995 1996 1997 1998

58 • www.aimr.org

1.45

1994

1995

1996

1997

1998

1999

2.30%

2.11%

2.22%

2.15%

1.96%

2.39

2.18

2.28

2.20

2.00

1.37

1.23

2.15

1.99

2.12

2.07

1.90

1.33

1.20

2.11

1.96

2.09

2.06

1.88

1.12

2.04

1.91

2.05

2.02

1.85

2.09

1.94

2.08

2.04

1.87

1.59

1.78

1.82

1.69

1.55

1.64

1.55

1.31

1.29 0.99

2001, AIMR®

Taxable Benchmarks Table 5. S&P 500 Example: Cumulative Difference between Pretax and AfterTax Returns Starting Date

1995

1996

1997

1998

1999

1989

17.92%

26.07

39.87%

57.77%

77.43%

1990

16.84

25.04

38.85

56.87

76.78

1991

8.66

13.77

22.37

33.91

47.01

1992

5.93

10.19

17.32

27.09

38.37

1993

3.59

7.00

12.70

20.69

30.11

1994

2.09

5.20

10.34

17.69

26.51

1.59

4.28

8.41

13.60

1.55

4.16

7.63

1.31

3.22

1995 1996 1997 1998

0.99

Second Level of Approximation. The second level of approximation entails the same general concept as in the first level, but rather than make the assumption that the CGRR is constant every year, the manager must go further and determine the actual CGRR of the index for each period. Historically, companies were dropped from the S&P 500 if their market capitalization shrank or if they declared bankruptcy, events that were not likely to create large capital gains. But recently, companies are being dropped because they have been acquired. This heightened merger and acquisition activity has had a noticeable effect on indexes such as the Russell 2000. In addition, the best performers, those that rise to the top, often no longer meet the capitalization requirements and are pushed out of the index. Huge capital gains are associated with such high turnover. Looking at the CGRR in detail, not on an average basis but analyzing it year by year, can add a lot of value to the after-tax benchmarking process. The manager has to determine for each year which companies left the index (because of bankruptcies, buyouts, or mergers) and whether the transition event was taxable. If the transition event was a merger, for example, and the company being dropped from the index was merged in a tax-free exchange with a company in the same index, then no capital gains tax would be incurred. That kind of turnover does not affect after-tax returns. But if the company being dropped was bought out by a company that was not in the index (perhaps a non-U.S. company), then a

manager benchmarked against that index would have to sell that stock and take the capital gain. That is, the manager would have to calculate capital gains based on the actual capital gains realized each period as a function of the tax rate and starting cost basis. The question then arises as to what happens to after-tax returns as a function of CGRRs. Table 6 shows the differential between pretax and after-tax returns for various CGRRs and holding periods. The return differential in Year 1 does not vary greatly as the CGRR varies, but by Year 10, the difference between a CGRR of 5.50 percent (return differential of 1.96 percent) and a CGRR of 30 percent (return differential of 6.54 percent) is substantial. Therefore, calculating an after-tax benchmark using the second level of approximation creates a valuable tool. If the manager assumes a constant CGRR (as in the first level of approximation) when calculating the aftertax return of the benchmark, the result will be better than not accounting for the tax implications at all, even though it will not accurately reflect what really occurred in the index. If, in fact, the manager’s benchmarked index is changing with time (which it is), by incorporating the true CGRR in the after-tax return calculations, the benchmark’s after-tax performance numbers will differ from those calculated using the first level of approximation and will more accurately portray reality. Third Level of Approximation. The third level of approximation involves tracking the actual

Table 6. Average Annual Difference in Pretax and After-Tax Returns as a Function of the CGRR: S&P 500 Index CGRR 5.50%

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

1.50%

1.69%

1.74%

1.84%

1.96%

2.10%

2.08%

2.10%

2.08%

1.96%

10.00

1.71

2.04

2.20

2.39

2.61

2.86

2.92

3.03

3.05

2.93

20.00

2.16

2.79

3.13

3.50

3.90

4.39

4.59

4.88

5.00

4.86

30.00

2.61

3.49

3.96

4.47

5.02

5.73

6.04

6.49

6.70

6.54

©2001, AIMR®

www.aimr.org • 59

Investment Counseling for Private Clients III dividend reinvestment income and reinvesting at the then-current (i.e., at the time of the reinvestment) prices. The manager also rebalances the benchmark portfolio whenever capital action occurs and tracks the new cost basis. Special Problems. The Dow Jones Industrial Average is probably the index most commonly used by taxable investors. The Dow is price weighted rather than market-cap weighted, which means that every time a corporate action occurs—a stock dividend, a stock split, and so on—the index must be adjusted. For example, if IBM splits two for one, a manager benchmarking against the Dow has to sell half of the IBM shares in the portfolio, regardless of the investment implications. As a result, the manager’s portfolio will realize capital gains, pay capital gains taxes, and reinvest the proceeds in the other 29 stocks in the index. So, an entirely new class of events become taxable events for the price-weighted Dow that would not be considered taxable events for the S&P 500 or most of the other indexes that are constructed according to a market-cap weighting. Style indexes also have some unique problems, such as when a stock falls in value and drops out of the Russell 1000 Index (a large-cap index) and goes into the Russell 2000 Index (a small-cap index). A manager benchmarking against the Russell 1000 must sell that stock and realize the gain. In this case, the gain realized may not be large because the stock has dropped in value, but the process applies in the other direction as well. That is, when a stock moves from a small-cap index into a midcap or large-cap index, huge gains might be realized if that stock has to be sold from a small-cap manager’s benchmark portfolio. Fixed-income indexes pose even greater problems for adjustment to an after-tax basis because index providers frequently do not list the securities in the index. Fixed-income indexes tend to be created by percentages of exposure to sectors—a certain percentage of Treasuries, mortgage-backed collateralized bond obligations, corporates, and so on. Thus, managers typically do not know which specific bonds (issuers, coupons, and maturities) are in the index. Figuring out this index composition can be difficult, if not impossible. Most fixed-income performance, however, comes from income rather than appreciation, so fixed-income indexes do not usually have the problem of accumulating unrealized capital gains, unless there has been a long period of declining interest rates.

Shadow Portfolios Converting a standard pretax benchmark is one way to construct an after-tax benchmark. A more precise

60 • www.aimr.org

methodology, however, is to create a shadow portfolio that varies according to the client. In other words, the shadow portfolio pays the same pro rata capital gains taxes for withdrawals as the actual portfolio. And every time the client gives the manager more money, the shadow portfolio brings that money in at the cost basis at that time. Clients have different cash flows, and the shadow portfolios (i.e., the benchmarks) will be different for each client. Table 7 shows a shadow portfolio of the S&P 500 for a single year. The starting point at the end of 1998 is 100, and then the various monthly returns are shown. Table 7 shows a single withdrawal (half of the initial value, which is admittedly an extreme example) by the client at the end of 1999. This withdrawal causes the pretax return (21.02 percent) to drop significantly (to 15.75 percent) as a result of the capital gains tax paid on the capital gains realized from the security sales—security sales that were needed to generate the proceeds for the distribution requirement (withdrawal). Table 8 shows the impact on the after-tax return for the period (1999) if the withdrawal had been made in each month of the year—January, February, and so on. The return for the “No cash flows” row is the same, 20.2 percent, as in the standard benchmark conversion approach. The benchmark return using a shadow portfolio and a 50 percent withdrawal in January, however, is 16.7 percent. So, this withdrawal makes a big difference in the after-tax return, but the impact of the withdrawal varies by month. If the withdrawal had been made in February, the return would have been 18.4 percent; if it had been made in May, 17.3 percent. Because the index price varies, the benchmark, which is the S&P 500 in this case, also varies as a function of when the withdrawal is made.

Conclusion Constructing after-tax benchmarks is not easy, which is why I have been involved in the AIMR-sponsored effort to create a standardized methodology. Perhaps the most important aspect of constructing an after-tax benchmark is starting with the correct pretax index. The next step is to carry out the first level of approximation—splitting the appreciation and income return sources because of different tax rates and then applying a constant CGRR. The second level of approximation—calculating the after-tax returns with the appropriate CGRR each year—yields an even more accurate view. And finally, a combination of these approximations, plus adjusting for significant cash flows through a shadow portfolio to calculate a portfolio-specific cost basis, produces the most detailed and accurate after-tax benchmark. 2001, AIMR®

Taxable Benchmarks Table 7. S&P 500 Example Shadow Portfolio Inflow

Date

Value

Cost Basis

12/98

100

100

Tax Rates

Outflow

Dividends

Capital Gains

Benchmark Rates Pretax Return Price

Pretax Return Income

Returns

Capital Gains Realization

Pretax

After Tax

39.60%

28.00%

5.64%

0.12%

0.46%

5.76%

01/99

39.60

28.00

4.10

0.08

0.46

4.18

4.14

02/99

39.60

28.00

–3.23

0.12

0.46

–3.11

–3.17

03/99

39.60

28.00

3.88

0.12

0.46

4.00

3.94

04/99

39.60

28.00

3.79

0.08

0.46

3.87

3.82

05/99

39.60

28.00

–2.50

0.14

0.46

–2.36

–2.43

06/99

39.60

28.00

5.44

0.11

0.46

5.55

5.49

07/99

39.60

28.00

–3.20

0.08

0.46

–3.12

–3.17

08/99

39.60

28.00

–0.63

0.13

0.46

–0.50

–0.57

09/99

39.60

28.00

–2.86

0.11

0.46

–2.75

–2.81

10/99

39.60

28.00

6.25

0.07

0.46

6.32

6.28

11/99

39.60

28.00

1.91

0.13

0.46

2.04

1.97

39.60

28.00

5.78

0.11

0.46

5.89

1.90

21.02

15.75

12/99

50

Total

5.71%

Note: Model from David Stein, Parametric Portfolio Associates.

Table 8. S&P 500 Example for 1999 with 50 Percent Withdrawal in Various Months

©2001, AIMR®

No cash flows

20.20%

January

16.73

February

18.36

March

17.53

April

16.87

May

17.32

June

16.47

July

17.01

August

17.12

September

17.71

October

16.66

November

16.38

December

15.75

www.aimr.org • 61

Investment Counseling for Private Clients III

Question and Answer Session Lee N. Price, CFA Question: How would limits on the deductibility of capital losses factor into after-tax benchmarks and portfolio returns? Price: That question was raised when the Taxable Portfolios Subcommittee first met. Our conclusion then, which has been reiterated in the revised AIMR-PPS standards that will be coming out soon,1 was that most investors have more than one basket of investments. As a result, we assumed that all losses could be used, although we knew that would not be true in every situation. These after-tax performance numbers are not a substitute for reported accounting records. We were not trying to create 1099s or any number that would be going to the government. What we were trying to do was look at the investment manager’s added value after taxes to see whether the manager was taking his or her losses, which is generally a good thing to do. For example, if you added a new client in January 2000 and took losses during the year, your after-tax performance was probably higher than your pretax performance for 2000, based on the performance of the S&P 500. If that same account was started in 1995, however, this would not be the case. The huge run up in the S&P 500 would have been reflected in your client’s account; even though you took losses in 2000 and benefited from them, you probably also incurred a fair amount of taxable capital gains in the account. 1

This presentation was given before the redrafted AIMR-PPS Standards were approved and released in final form.

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Question: Can exchange-traded funds (ETFs) serve as a proxy for after-tax benchmarks? Price: Various types of after-tax benchmarks have been proposed. For some mutual funds, such as those based on the S&P 500, you can determine the dividend and appreciation proportions and use that data to construct an after-tax benchmark. In fact, you can get an actual 1099 if you happen to own that mutual fund and appropriately allocate the short-term and long-term gains and so on. Other methodologies, such as using ETFs or options, also exist. These methods are not wrong; their approximations are just different from the ones suggested here. A big problem with creating after-tax benchmarks for mutual funds or ETFs is the timing issue, or the percentage of unrealized gains in the benchmark or portfolio. Suppose you were marketing to private clients and wanted an after-tax performance composite. The Taxable Portfolios Subcommittee brought up the point that when creating groups of after-tax portfolios, putting all 50 of your taxable clients together wouldn’t necessarily make sense, because some might have started with you last year and others 20 years ago. As a result, the percentage of unrealized, or embedded, capital gains in the portfolios would differ dramatically. But that is what a mutual fund in effect is doing when it reports after-tax performance. Its numbers will also be dramatically affected by net cash inflows or outflows, which may reduce or increase the realization of capital gains. One solution for managers of individual accounts is to calculate

after-tax returns by starting year (those from 20 years ago, those from 15 years ago, etc.), but the result might be only one or two portfolios for each composite, which doesn’t make sense and is not helpful to prospective clients. Another way to group those accounts is by percentage of unrealized gains in the portfolios. That same methodology applies to benchmarks. Grouping several different starting years for the S&P 500 and then developing benchmarks that are presented as a percentage of book to value would be easier than having separate benchmarks for every month of every year going back ad nauseam. Question: If a benchmark should be created for each starting year, should you also calculate a separate benchmark for each client? Price: Back in 1995 (roughly), the Subcommittee recommended that managers create separate composites not for each client but for each type of client. Qualified nuclear decommissioning trusts, for example, have a flat 20 percent tax rate. You can combine all such accounts in one composite and not include those of individual portfolios or property and casualty insurance companies, which have different tax regimes. If you look at types of clients as opposed to specific tax rates, few types probably exist. You may end up with four or five different types, and for that reason, you may end up with four or five different after-tax benchmark returns by tax rate in addition to the by-year distinction. In order to be consistent with the AIMR-PPS standards, the goal should clearly be to create composites of similar portfolios ©2001, AIMR®

Taxable Benchmarks rather than to benchmark separately for each client. But as noted in my presentation, individual shadow portfolios can also be helpful in the case of significant cash flows, even if only for purposes of communication with a particular client. Question: Can these approaches be used to create after-tax benchmarks for hedge funds? Price: Conceptually, these same approaches could be applied to hedge funds, but such leveraged portfolios have the more pressing problem of calculating true pretax performance. A hedge fund may have a long–short strategy and be truly market neutral, but what is the divisor? What are the assets at risk? To say that hedge funds don’t have any risk and then divide by zero doesn’t make sense. And if the hedge fund is truly market neutral, the definition of assets at risk is unclear. The same problem arises even if the fund is only partially hedged. A subcommittee of AIMR’s Investment Performance Council (IPC) is studying this issue and hopes to make recommendations soon. Question: How do you account for state taxes? Price: The current AIMR-PPS after-tax reporting standards do not factor in state taxes because the subcommittee wanted to get as close as possible to an “apples-toapples” comparison between managers. Some members thought including state taxes would just muddy the waters. Instead, the suggestion was made that managers use the maximum federal tax rate appropriate for the type of client under management. Nevertheless, since that standard was adopted, managers have found that some clients want to factor in their state taxes. But if man©2001, AIMR®

agers include state taxes for individual clients, they must create two presentations: one that ignores state taxes to comply with the AIMR-PPS standards and one that includes state taxes to meet client needs (the second would be shown as supplemental information). Managers have also found that clients want their actual anticipated federal tax rate to be used, not simply the maximum applicable to their type of investor category. The new standards, I suspect, will allow managers to report based on whichever tax rates they actually use in making investment decisions for clients. The standards will encourage managers to talk to clients about all applicable tax rates, not just federal and state but local as well. If you happen to live in New York or New Jersey and the local tax rates apply to investment income, for example, then those could also be included. Managers would need to create composites of all the accounts that share roughly the same tax rates and would have to disclose what the tax rates were (the weighted average for their composite), but they could then use the same client calculations for their composites. I still have mixed feelings on this issue. Something in the area of comparability is lost when different managers use different rates, yet I understand why we were getting the complaints and the practical reasons for the new standards. Question: Are managers required to report after-tax performance? Price: Remember that all of the AIMR standards regarding performance, including the AIMR-PPS standards, are optional. Nobody has to be in compliance. Even if you feel that the marketplace, your consultants, or your clients require you to be in compliance with AIMR-PPS standards, you do not

have to be compliant with the aftertax standards. They are purely optional; the AIMR-PPS standards merely state that if you intend to claim compliance and show aftertax performance, then you must do so according to the after-tax standards. The same is not true for mutual funds. In January 2001, the U.S. SEC issued its final decision about a proposal that had been floating around for almost a year. Effective April, 16, 2001, mutual funds must report their after-tax performance. Then, starting October 2001, aftertax performance will have to be included in fund advertisements and sales material; in February 2002, mutual fund prospectuses will also provide the information. For mutual funds, the taxable event is when the fund actually declares the dividend, which happens about once or twice a year. So, calculating after-tax performance for mutual funds will be much less complicated than for separately managed portfolios. Requiring managers to report after-tax numbers helps make them aware of the tax impact on their portfolios and also helps clients reduce their expectations of what their returns will be for the long term. If clients consider aftertax performance, they will realize that no matter whether they have an index fund, an IRA, or an actively managed portfolio, the actual after-tax returns will be lower than the pretax returns. Question: Do the after-tax return computations ignore the present value of taxes accrued currently and payable in the future? Price: The realized basis method does ignore the present value of taxes on capital gains that have not yet been realized. Some managers use alternative methodologies to estimate such taxes, based on assumptions of when stocks may

www.aimr.org • 63

Investment Counseling for Private Clients III be sold and what the discount rate would be between now and then. Although I understand such concepts, particularly for use by nuclear decommissioning trusts (which may have fairly welldefined termination dates), the committee recommended against such methodologies because of the huge variability introduced by the timing and discount rate assumptions. We did not feel comfortable in mandating specific numbers, but without such a standard, two different managers with identical after-tax performance on a realized basis could show widely different present value performance. Question: Isn’t the issue of aftertax returns more about forcing the manager to take losses versus just

64 • www.aimr.org

having the losses affect the portfolio market value? Price: This is certainly one of the issues, and it makes sense to take losses, unless you are worried about a wash sale or immediate stock bounce. But after-tax performance covers a lot more than just taking losses; it is about being tax aware when taking gains and selecting a bias toward growth stocks rather than higher-taxed dividend income stocks. Question: As an international manager with clients around the world who are subject to different tax rates, what information am I providing to prospects when I create an after-tax composite rate of return?

Price: AIMR recognizes that both the current and expected newly revised after-tax guidelines are U.S.-centric, which is why they have been developed by the Performance Presentation Standards Committee, the North American representative to the IPC, rather than by the global group itself. Other countries have already expressed interest in doing something similar—Canada and Australia in particular—but because tax rates and methodologies vary tremendously around the world, creating a worldwide standard for reporting after-tax performance is unlikely.

©2001, AIMR®

Philanthropy in Estate Planning Gregory R. Friedman Principal Greycourt & Co., Inc. Portland, Oregon

Many wealthy clients have philanthropic goals, but few receive sufficient guidance regarding how best to balance these goals with personal spending needs. Deciding how to distribute wealth can be a complicated and often emotional process. As a result, investment advisors need to understand their clients’ wealth-distribution preferences and help quantify potential investment risks associated with different levels and forms of gifting. By helping identify who bears residual investment risk under varying gifting regimes, investment advisors can ensure that their clients’ wealth is distributed in a way that fits each client’s individual, family, and philanthropic ambitions.

mong the wealthy, philanthropy is rarely the primary conduit for the distribution of wealth, but it is typically an important goal in the total wealth-distribution plan. In order to advise their clients properly, investment advisors need to understand their clients’ desired hierarchy of wealth distribution. The process for determining client preferences is fairly straightforward if the advisor recognizes that these preferences are influenced by both analytical and emotional factors. Once a hierarchy of desired wealth disposition has been identified, one critical step in establishing an effective investment strategy is determining who actually bears the risk of poor investment performance. This presentation describes a framework for assessing who bears the residual investment risk under different forms of philanthropic giving.

A

Disposal of Wealth Truly wealthy individuals can dispose of their money in three ways—consumption, inheritance, and philanthropy. From the standpoint of the wealth holder, personal consumption is the most important of the three. As defined here, consumption is the purchase of nondurable goods and services that do not retain residual value. Over the years, I have worked with clients whose net worth has ranged from $1 million to many billions of dollars, and regardless of their wealth, they were concerned, first and foremost, about ensuring their ability to maintain their chosen lifestyle. In most cases, these individuals built their

©2001, AIMR®

fortune through hard work, and as they grow older, they want to ensure that they do not have to depend on their children for financial support. Of course, among the wealthy, just as among the general population, some individuals are extremely frugal despite the great wealth they have accumulated and others are somewhat more lavish, with consumption habits that can really take a bite out of their portfolios. Inheritance is the second most common venue for the wealthy to dispose of their wealth, or at least it used to be. In the “good old” days, parents would often ask, “How can I arrange to leave more money to my children so they will think better of me?” Today, that kind of thinking is not as prevalent. The wealthy now seem to be more engaged in philosophical soul searching, trying to sort out the implications of leaving wealth to children (even though such soul searching is, in many cases, often more lip service than reality). Individuals can gift either during their lifetime or at death. Current tax law provides an exclusion from gift tax for annual gifts of up to $10,000 per individual recipient. (A married couple may gift $10,000 each for a total annual exclusion of $20,000 per individual recipient.) Even for substantially larger gifts that would be subject to the 55 percent gift tax,1 the most tax-efficient way to pass wealth to the next generation 1 Since this presentation was given, the tax law has changed. Please see “Update” in Mr. Macklin’s presentation for more information, or go to http://thomas.loc.gov/ and search by bill number H.R.1836.ENR for a complete description of the final bill.

www.aimr.org • 65

Investment Counseling for Private Clients III is to simply make outright gifts to transfer the wealth to the succeeding generation as soon as possible. But despite the demonstrable advantages of such a strategy, few individuals are comfortable irrevocably transferring substantial sums of their wealth to the next generation well in advance of their own demise. A second, and less objectionable, means of transferring wealth is via bequest—the “I hold all my money until I die and then you get it” approach. Even under this simple strategy, certain assets when gifted pose a challenge. Items such as homes, art, and antiques that provide real or psychological benefits to the owner retain residual value that can be passed to the next generation. The problem with such assets is that they are relatively illiquid. When the wealth is transferred to the next generation, problems can arise in terms of generating sufficient liquidity for the recipient to pay the required estate taxes. Philanthropy is typically third in the prioritization of the uses for an individual’s wealth, and the payment of taxes uniformly represents the least desired use of wealth. Despite wealthy individuals’ aversion to the payment of taxes, however, most agree that tax revenues do fund some useful services, such as maintaining a nation’s military and physical infrastructure and aiding the welfare of its citizens. Philanthropy serves an altogether different purpose from the payment of taxes. Philanthropy has been described as the support of institutions that enhance the richness (as opposed to the basic needs) of life. In the final analysis, for exceedingly wealthy individuals for whom consumption represents only a small fraction of their overall assets, ultimate wealth disposition boils down to a choice between philanthropy and heirs.

Inheritance versus Philanthropy Given the limited choices available in terms of wealth disposal, the next consideration is to examine what drives individuals to make the choices they do in allocating their wealth between family members and philanthropy. Financial Security Needs. A sense of financial security is a key consideration in the decision-making process of wealth allocation. For example, investors who were raised during the Great Depression often have a heightened sensitivity to risk. If clients believe they might lose their wealth, they will be less likely to give money to others during their lifetime. The reasons for heightened risk aversion are not, however, always readily apparent. I once worked with a client who should not have had much sensitivity to risk at all. This client was an unmarried 40-year-old man. Although he was third-generation wealthy,

66 • www.aimr.org

worth hundreds of millions, and had no living relatives, he was obsessively concerned about the prospect of losing his money and about the costs of fees and taxes. I could not figure out why. He could not possibly consume his wealth, but as I got to know him, the nature of his fear became clear. He had become addicted to the jet-setting lifestyle that his wealth afforded him and realized that if his wealth was lost, he had no marketable skills to rely on and was essentially unemployable. Family Circumstances. Family circumstances are another important factor in wealth allocation. Whether or not a client is married or has children (as well as the financial independence of the children) can obviously influence a client’s attitudes toward consumption, inheritance, and philanthropy. Personal Philosophy. A very important consideration in wealth allocation is an individual’s attitude toward the impact that transferring substantial wealth to succeeding generations can have on the lives of his or her heirs. Personal philosophies in this regard can be widely divergent. For example, some individuals believe that any inheritance beyond the provision of the basic, not luxury, security of heirs should be used for philanthropy. This sentiment was well expressed by an individual who stated that he saw no justification for self-respecting people to expect to survive on what their forebears had done and was not interested in endowing his children and grandchildren with the ability to live on Fifth Avenue or own a Rolls Royce. Clearly, for such an individual, philanthropy will play a major role in the ultimate disposal of his or her wealth. A more typical philosophy of wealth disposition is often expressed by individuals who are motivated by the desire to leave large estates to their heirs so that succeeding generations will be able to do all the things they were never able to do.

Motives for Giving Those who work with the wealthy know from experience that ensuring sufficient personal cash flow is the most important consideration for clients. A second priority is typically wealth transfer to heirs, and wealth transfer through philanthropy is often the last priority. In the mid-1990s, an associate professor of sociology at Harvard, Francie Ostrower, interviewed 100 wealthy individuals in New York, people she refers to as “elites.” She tried to segment their attitudes toward the transfer of wealth to philanthropy based on personal circumstances. 2001, AIMR®

Philanthropy in Estate Planning Table 1 summarizes Ostrower’s results. The column on the left shows the average percentage of the portfolio that these “elites” plan to transfer to charity during both their lifetimes and upon their deaths. The column on the right shows the percentage of wealth going to charity only upon death. Two types of family circumstances are represented, one in which children were present and one in which they were not. The distinction between the two family types is clear. Individuals with children planned to transfer only one-half to one-third as much of their wealth to charities or philanthropic entities as those who had no children.

Despite his planned pattern of conspicuous consumption, he also would like to be generous to his children. At the end of his life, he wants to transfer $75 million (net of estate taxes) to his heirs. Beyond that amount, he wants to transfer any excess wealth to charity. The first step is to develop a baseline case in which Mr. Generous makes no gifts during his lifetime but upon his death he simply bequeaths $75 million (net of estate taxes) to his children and passes the remaining balance to charity. Now, clearly, this approach is the simplest form of giving, and it preserves the greatest degree of flexibility in wealth transfer from the standpoint of I.M. Generous.

Table 1. Wealth Attitude Survey: Amount Targeted for Philanthropy

Baseline Scenario. In order to estimate the value of I.M. Generous’ portfolio under the baseline scenario and thus the amount available for inheritance, look at Table 2. The investment assumptions used to develop the baseline case are shown in Table 3. Table 2 shows that starting with a portfolio of $100 million, Mr. Generous first withdraws his $2 million annual spending requirement. In 2001, the portfolio generates investment income of approximately $2.99 million, some taxable and some nontaxable. The portfolio also realizes price appreciation of approximately $4.5 million. Management fees of about $394,000 and income taxes of about $306,000 reduce the value of the portfolio. Additionally, the portfolio’s active portfolio managers generate realized capital gains that result in the payment of about $51,000 in short-term capital gains taxes and $149,000 in longterm capital gains taxes. At the end of Year 1 (2001), Mr. Generous’ portfolio is worth approximately $104.6 million, which flows over to Year 2 (2002) as the beginning balance. In Year 2, his spending increases by approximately the rate of inflation (i.e., 3 percent) to $2,060,000. The portfolio earns ordinary income of about $3.13 million and appreciates by about $4.7 million. Again, the portfolio must pay taxes because of realized shortand long-term capital gains caused by active management decisions. Furthermore, the portfolio must pay additional capital gains taxes as it is forced to rebalance to its targeted asset allocation mix. Clearly, the stocks in the portfolio are expected to appreciate faster than the bonds, and therefore, the portfolio needs to be rebalanced—selling off the equity securities, incurring a capital gains tax, and reinvesting the proceeds in bonds. In addition, the $3.13 million of interest and dividend income generated falls short of the actual cash outflow that is required to pay for management fees, taxes, and personal consumption. Therefore, I.M. Generous must invade principal to meet these expenditures. This principal invasion

Item

During Life/ at Death

Only at Death

Family circumstances Without children

50%

59%

With children

21

29

Negative consequences

53

53

Positive consequences

10

18

Believes inheritance causes

Source: Based on data from Francie Ostrower’s Why the Wealthy Give: The Culture of Elite Philanthropy (Princeton, NJ: Princeton University Press, 1995).

Ostrower also segmented the population based on philosophical beliefs about inheritance. Those who associated negative consequences with inheritance planned on transferring an average 53 percent of their wealth to charity during both their lifetimes and at death, and those who associated positive consequences with inheritance planned on transferring a much smaller amount to charity—10 percent during life and 18 percent upon death. Again, both family circumstances and philosophy play a large role in how the allocation decision plays out.

Residual Investment Risk Individuals who are charitably inclined must understand the impact that different methods and magnitudes of gifting may have on their remaining, noncharitable wealth. To illustrate this point, consider the case of a fictitious client named I.M. Generous who has a portfolio of $100 million in cash. I.M. Generous is not the Sam Walton type of millionaire. He needs a $2 million after-tax annual personal cash flow for the rest of his life, adjusted for inflation, which represents a lot of consumption. ©2001, AIMR®

www.aimr.org • 67

Investment Counseling for Private Clients III Table 2. Gifting Strategy: Simple Bequest to Charity (Expected Scenario) Item Starting balance

2001

2002

2021

$100,000,000

$104,571,857

$221,237,094

Less: Annual spending

(2,000,000)

(2,060,000)

(3,507,012)

Charitable gifts Plus: Investment income

2,989,000

3,126,612

6,790,919

Capital gains

4,483,499

4,667,154

10,186,377

Less: Management fee

(394,450)

(412,610)

(896,179)

Income taxes

(305,613)

(319,683)

(694,344)

Short-term gains taxes (manager)

(51,227)

(82,550)

Long-term gains taxes (manager)

(149,352)

(256,187)

Short-term gains taxes (rebalance)

(4,428)

Long-term gains taxes (rebalance)

(18,335)

Estate tax

(91,666,667)

Amount to heirs

(75,000,000)

Ending balance

$104,571,857

$109,234,593

$ 66,450,188

Table 3. Case Study Assumptions Pretax Total Return

Asset Class

Capital Appreciation

Yield

Desired Allocation

Risk

Tax exempt bonds

5.0%

0.0%

5.0%

5.5%

Taxable bonds

7.0

0.0

7.0

5.5

0.0

U.S. equities

8.5

6.5

2.0

14.0

45.0

12.0

11.0

1.0

27.0

15.0

Non-U.S. equities Portfolio pretax return

40.0%

7.6

generates even more capital gains that increase the portfolio’s tax liability. Under the scenario just described, I.M. Generous spends merrily for the next 20 years. At the beginning of Year 2021, the portfolio has appreciated to approximately $221.2 million. Spending that year, given the rate of inflation, is approximately $3.5 million. Unfortunately, by December 30, 2021, I.M. Generous passes away. According to the provisions of his will, his estate transfers $75 million to his heirs, which gener-

ates an estate tax bill of $91.7 million. After his heirs and tax authorities collect their respective shares of the estate, approximately $66.45 million remains to be transferred to charity. Having developed the most likely outcome of this baseline scenario, it is now important to consider who bears the residual risk of poor investment performance—I.M. Generous, his heirs, or charity. Table 4 illustrates that the cumulative distribution of wealth to Mr. Generous for his spending needs over

Table 4. Gifting Strategy: Simple Bequest to Charity (Worst- and Best-Case Scenarios) Expected Scenarioa

Worst-Case Scenarios 2.5%

b

5.0%

b

10.0%

b

25.0%

b

b

Best-Case Scenarios

50.0%

25.0%

b

10.0%b

5.0%b

2.5%b $342.38

Allocation of wealth (millions) Amount to charity

$ 0.00

$ 0.00

$ 0.00

$ 0.00

$66.45

$130.13

$232.73

$282.87

Amount to heirs

37.97

46.01

55.36

74.01

75.00

75.00

75.00

75.00

75.00

Amount to self

53.74

53.74

53.74

53.74

53.74

53.74

53.74

53.74

53.74

a

Expected scenario based on expected return for the period. of occurrence.

b Probability

68 • www.aimr.org

2001, AIMR®

Philanthropy in Estate Planning the 20-year period is $53.74 million. The center column shows the anticipated payouts to the three parties based on the expected returns, which have a 50 percent probability of occurring. To examine what happens to the payouts under both the best- and the worst-case return scenarios, I ran a Monte Carlo simulation that generated 100 sets of normally distributed investment returns. As can be seen from Table 4, even under the worst-case scenario, the amount that I.M. Generous has targeted for consumption is never at risk. Under the expected and best-case scenarios, Mr. Generous satisfies his stated goal of transferring $75 million to his heirs net of estate tax. If economic conditions are bad, however, the amount available to be transferred to his heirs declines. A one in four chance exists that he will transfer less than $75 million to his heirs. In this baseline scenario, despite the potential shortfall to heirs, charity is the real bearer of risk. Once the investment environment falls short of expectations, the amount transferred to charity declines quickly to zero. Cha r it ab le Re ma inde r Un it T rus t . One wealth-transfer technique that is both commonly used and relatively straightforward is the charitable remainder unit trust (CRUT). Using this planning technique, I.M. Generous would shift a portion of his assets into an irrevocable trust designed to distribute

back to him a percentage of the value of the portfolio on an annual basis, say, 7 percent. For engaging in this transaction, I.M. Generous receives a charitable deduction, typically 10 percent of the value of the assets transferred, and at the end of his life, the assets in the CRUT flow to charity. A CRUT is an effective technique to defer the payment of capital gains taxes on the assets transferred and to create a current tax deduction to shelter capital gains realized outside the CRUT. In addition, it establishes personal liquidity in the form of the annuity transferred back to Mr. Generous and helps to satisfy his future charitable goals at his death, when the CRUT transfers to charity. Table 5 illustrates the initial outflow of $10 million in charitable gifts from Mr. Generous’ personal portfolio and an equal inflow of $10 million to the CRUT in 2001. In Year 2 (2002), the CRUT annuity begins to flow back to Mr. Generous starting at the amount of $758,975, reaching an annuity amount of $817,505 in the Year 2021. At the end of his life, Mr. Generous can still transfer $75 million to his heirs, pay the required estate tax, and transfer $66,940,715 to charity—an additional $500,000 compared with the amount estimated in the baseline case. Table 6 shows who bears the residual risk of wealth transfer when a CRUT is part of the wealthtransfer-planning process. With the CRUT, I.M.

Table 5. Gifting Strategy: CRUT (Expected-Case Scenario) Item Starting balance

2001

2002

2021

$100,000,000

$94,082,560

$209,225,109

Less: Annual spending Charitable gifts Charitable remainder unit trust (CRUT)

(2,000,000)

(2,060,000)

(3,507,014)

10,000,000

10,802,250

11,678,644

2,684,000

2,829,837

6,647,905

(10,000,000)

Plus: Investment income CRUT annual inflow Capital gains

4,207,299

758,975

817,505

4,572,477

9,971,857

Less: Management fee

(354,200)

(373,446)

(877,306)

Income taxes

(274,428)

(425,860)

(827,318)

Short-term gains taxes (manager)

(45,999)

(74,714)

Long-term gains taxes (manager)

(134,112)

(231,870)

Short-term gains taxes (rebalance)

(4,207)

Long-term gains taxes (rebalance)

(15,743)

Estate tax

(91,666,667)

Amount to heirs

(75,000,000)

Ending balance

©2001, AIMR®

$ 94,082,560

$99,058,009

$ 66,940,715

www.aimr.org • 69

Investment Counseling for Private Clients III Table 6. CRUT Gifting Strategy: Amount to Charity Expected Scenarioa

Worst-Case Scenarios 2.5%b

5.0%b

10.0%b

25.0%b

50.0%b

Best-Case Scenarios 25.0%b

10.0%b

5.0%b

2.5%b $342.38

Amount gifted to charity (millions) Base case

$ 0.00

$ 0.00

$ 0.00

$ 0.00

$66.45

$130.13

$232.73

$282.87

$10 million CRUT

5.38

5.47

6.47

11.93

66.94

139.83

219.98

279.41

356.82

$20 million CRUT

10.94

11.36

12.59

16.46

69.70

142.51

228.93

290.96

367.54

$30 million CRUT

15.40

17.26

19.71

23.63

69.32

142.80

231.11

293.40

368.20

$50 million CRUT

26.99

28.30

32.21

42.97

69.39

142.59

234.07

299.86

369.39

a Expected

scenario based on expected return for the period. b Probability of occurrence.

Generous can transfer a slightly greater amount ($500,000) to charity than under the base case because the CRUT adds to his overall wealth. The projected increase in wealth beyond the baseline case is in part the result of the beneficial effect of compounding nontaxed assets held within the CRUT structure. This compounding increases the dollar size of the annuity payments paid to I.M. Generous over time. At his death, he has amassed greater wealth to transfer. Table 6 also considers scenarios for transferring $10 million, $20 million, $30 million, and $50 million to a CRUT during Mr. Generous’ lifetime. Not surprisingly, the larger the amount transferred to the CRUT, the greater the amount that charity is certain to receive, even under poor economic circumstances. Risk is a zero-sum game. If charity’s risk decreases as more assets are contributed to a CRUT, then risk to the heirs must increase proportionately, as shown in Table 7. Under the expected return scenario, regardless of the amount transferred to the CRUT, the $75 million desired transfer to heirs is achieved. But relative to the baseline case (i.e., no planning and with wealth transferred only at death), the amount transferred to the heirs under poor economic circumstances decreases markedly as the

amount transferred to the CRUT increases. Furthermore, risk to heirs is not symmetric. Under betterthan-expected economic conditions, all excess wealth accrues to charity because I.M. Generous has capped the amount to be transferred to heirs at $75 million. This asymmetric shifting of risk from charity to heirs may or may not be acceptable to I.M. Generous. Private Foundation. For many philanthropically minded individuals, one downside to a CRUT is that no wealth is transferred to charity until the end of these individuals’ lives. For those concerned about current support of charitable causes, a private foundation may be an effective planning vehicle. To establish a private foundation, an individual irrevocably transfers assets from his or her personal portfolio to the account of the private foundation. By law, a foundation must annually transfer at least 5 percent of its assets to charity to retain its tax exempt status. Should I.M. Generous choose to establish a private foundation, he will receive a charitable deduction equal to the full amount transferred to the foundation. Although there are limitations as to the amount of income that can be sheltered by such deductions in any single tax year, I.M. Generous can use these

Table 7. CRUT Gifting Strategy: Amount to Heirs Expected Scenarioa

Worst-Case Scenarios 2.5%b

5.0%b

Best-Case Scenarios

10.0%b

25.0%b

50.0%b

25.0%b

10.0%b

5.0%b

2.5%b

Amount gifted to heirs (millions) Base case

$37.97

$46.01

$55.36

$74.01

$75.00

$75.00

$75.00

$75.00

$75.00

$10 million CRUT

36.39

43.80

53.50

72.08

75.00

75.00

75.00

75.00

75.00

$20 million CRUT

34.52

41.40

50.94

69.33

75.00

75.00

75.00

75.00

75.00

$30 million CRUT

32.66

39.00

48.42

65.10

75.00

75.00

75.00

75.00

75.00

$50 million CRUT

28.95

34.03

43.01

56.83

75.00

75.00

75.00

75.00

75.00

aExpected

scenario based on expected return for the period. b Probability of occurrence.

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2001, AIMR®

Philanthropy in Estate Planning deductions to shelter income and/or capital gains incurred in his personal portfolio. This approach, although beneficial in creating sizable charitable deductions, potentially reduces the asset base available to I.M. Generous—assets needed to generate personal cash flow. So, if Mr. Generous gives too large an amount to the private foundation and subsequent economic conditions deteriorate, he could actually run short of personal cash flow and the size of the estate inherited by his heirs may be reduced to zero. Again, upon funding a private foundation, consider what happens and who bears the residual risk under different economic assumptions. In this case, it is fairly straightforward, as shown in Table 8. One can see that charity does well relative to the baseline scenario under poor economic environments. To estimate how much is transferred in total to charity, I added the 5 percent distributions that are made to charity each year to the projected value of the assets remaining in the foundation at I.M. Generous’ death. Over a 20-year time horizon, even under the worst circumstances, a $10 million foundation transfers $10.37 million to charity. Interestingly, under favor-

able economic conditions, for all but the $50 million foundation, a lower final, accumulated amount is transferred to charity than in the base case. Although seemingly anomalous, this result arises because the time value of the 5 percent annual distributions paid from the foundation is not taken into account, whereas under the baseline scenario, all of the money is transferred 20 years hence. Now, take a look at who bears the residual risk from the standpoint of heirs. Perhaps not surprisingly, as illustrated in Table 9, I.M. Generous’ heirs bear the brunt of the residual investment risk when a foundation is established. Under the expected return scenario, which has a 50 percent probability of occurrence, heirs receive their maximum bequest of $75 million unless I.M. Generous establishes a foundation of $30 million or greater. If I.M. Generous chooses to transfer $30 million or more of his $100 million in wealth to a foundation today, he will, even under expected economic conditions, be able to transfer only $61.8 million or less to his heirs upon his death. Clearly, this would violate one of I.M. Generous’ own stated wealth-transfer objectives.

Table 8. Foundation Gifting Strategy: Amount to Charity Expected Scenarioa

Worst-Case Scenarios 2.5%b

5.0%b

10.0%b

25.0%b

50.0%b

Best-Case Scenarios 25.0%b

10.0%b

5.0%b

2.5%b

Amount gifted to charity (millions) Base case

$ 0.00

$ 0.00

$ 0.00

$ 0.00

$ 66.45

$130.13

$232.73

$282.87

$342.38

$10 million foundation

10.37

12.30

15.26

20.67

60.29

123.15

225.65

277.42

333.33

$20 million foundation

20.10

23.45

29.95

40.99

58.79

114.51

212.08

266.58

316.02

$30 million foundation

29.04

33.95

45.00

61.25

88.19

114.68

193.22

247.89

292.57

$50 million foundation

42.23

52.98

69.13

99.38

146.98

204.35

276.40

308.88

343.92

a

Expected scenario based on expected return for the period. Probability of occurrence.

b

Table 9. Foundation Gifting Strategy: Amount to Heirs Expected Scenarioa

Worst-Case Scenarios 2.5%b

5.0%b

10.0%b

Best-Case Scenarios

25.0%b

50.0%b

25.0%b

10.0%b

5.0%b

2.5%b

Amount gifted to heirs (millions) Base case

$37.97

$46.01

$55.36

$74.01

$75.00

$75.00

$75.00

$75.00

$75.00

$10 million foundation

31.36

37.19

46.14

62.52

75.00

75.00

75.00

75.00

75.00

$20 million foundation

24.42

28.49

36.39

49.80

75.00

75.00

75.00

75.00

75.00

$30 million foundation

20.36

23.81

31.56

42.95

61.84

75.00

75.00

75.00

75.00

$50 million foundation

9.00

11.30

14.74

21.19

31.34

43.57

58.93

65.86

73.33

a

Expected scenario based on expected return for the period. Probability of occurrence.

b

©2001, AIMR®

www.aimr.org • 71

Investment Counseling for Private Clients III

Gift Form and Timing When advising clients about charitable giving, it is important to understand both the flexibility of the structure chosen and the impact of the structure on the timing of the charitable gifts made. Bequests are the most flexible form of gifting, although they defer the transfer of wealth to charity until the death of the donor. CRUTs are the next most flexible structure because they enable the transfer of a large proportion of the appreciation of the trust’s assets back to the donor. Foundations offer the most immediate trans-

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fer of wealth to philanthropy or to charity but also reduce the donor’s flexibility to the greatest degree.

Conclusion Investment advisors must make a commitment to understand the role that philanthropy plays in the wealth-distribution preferences of clients. Investment advisors should help their clients quantify the implications of different types of gifting structures to clarify who—among the client, his or her heirs, and charity— actually bears the brunt of residual investment risk.

2001, AIMR®

Philanthropy in Estate Planning

Question and Answer Session Gregory R. Friedman Question: How common is the use of a private foundation as the residual beneficiary of the CRUT? Friedman: About half to threequarters of the clients I have worked with have designated their private foundation as a beneficiary of their CRUT. Question: You clearly outlined the economic risk of each option, but what about the risk of a grantor’s early death? Friedman: The risk of a grantor’s early death is an important consideration. In the case of the CRUT analysis, it is assumed that I.M. Generous lives to his full life expectancy, but the risk of early death is significant, particularly if the amount of assets transferred to the CRUT is sizable. To cover this risk, some individuals enter into a

©2001, AIMR®

life insurance policy for the first few years of the CRUT’s existence. Typically, low-cost term policies are used. These policies are often allowed to lapse once most of the balance in the CRUT has been transferred back to the donor’s personal portfolio through annual annuity payments. The problem of early death is not as great a concern when the charitable vehicle used is a foundation. Once the foundation assets have been transferred, the transfer is irrevocable and the foundation operates indefinitely. Question: How aggressive or sophisticated can CRUT asset management be? Can a manager use offshore private equity hedge funds? Friedman: Although the trustee of a CRUT probably has some fiduciary responsibilities to ensure that

its investments are prudently diversified, the CRUT itself can be invested extremely aggressively. Investing CRUT assets in domestic hedge fund partnerships can create potential problems because they often generate unrelated business taxable income (UBTI) that can threaten the tax exempt nature of the CRUT. Investing in offshore funds solves the problem of UBTI, in most cases, but poses an additional problem because the sponsors of those corporations do not track the underlying tax liability or the source of the tax liability for the assets held within that offshore corporation. This means that regardless of the actual nature of the offshore hedge fund’s return, all realized returns from offshore investments must be taxed as income.

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Trusts, Insurance, and Wealth Transfer Lawrence J. Macklin Senior Vice President Bank of America Private Bank Baltimore

Effective estate planning includes having the proper trust or insurance structure. Trusts can be used to transfer assets to a spouse, make lifetime gifts to family members, or make donations to charitable organizations, but clients must be aware that the different kinds of trusts provide different degrees of control over assets and different levels of transfer cost reduction. Life insurance techniques can also provide a degree of control over assets while providing substantial income tax benefits. And because a variety of trust and insurance forms exist, they need to be carefully examined to ensure the effective transfer of client wealth.

ealth-transfer planning (i.e., estate planning) has two primary objectives. The first is to achieve the client’s goals regarding the disposition (transferred during the client’s lifetime and at the client’s death) and subsequent management of financial assets so that the client retains as much control as possible over the assets for as long as possible. The second objective is to minimize taxes (typically the estate tax or gift tax burden), expenses, and other costs associated with the transfer of the client’s assets. In this presentation, I will cover the important aspects of incorporating trusts and insurance vehicles in wealth-transfer planning. I will start with trusts and then discuss insurance, but in some cases, the two are combined. Trusts are central to wealth-transfer planning because the two primary objectives of wealth-transfer planning can be readily accomplished through trusts, whereas achieving both of these objectives with insurance is not always possible.

plished through trusts. Most of these techniques are tax driven; some are asset-control driven.

Trust Techniques

Unified Credit. The unified credit allows an individual to transfer up to $675,000 of assets (in 2001) through lifetime gifts or through his or her estate without paying transfer taxes.1 The amount that can pass tax free is called the unified credit equivalent or the applicable exclusion amount. The

W

Many techniques are available to control the distribution of wealth and to minimize gift and estate taxes. The fundamental techniques used in estate planning are the unlimited marital deduction, unified credit, lifetime gift, life insurance trust, and charitable giving. I will also discuss some of the most popular trust techniques, such as the intentionally defective grantor trust (or irrevocable grantor trust) and the grantor retained annuity trust. Some techniques do not require the use of trusts, but all can be accom-

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Unlimited Marital Deduction. An individual can transfer an unlimited amount of assets to a spouse without paying transfer taxes, although special rules apply if the spouse is not a U.S. citizen. This lifetime transfer is called the unlimited marital deduction. Generally, that transfer needs to be an outright transfer, although the transfer can be to a trust if the trust is a qualifying trust that has certain limitations, such as a mandate to distribute all trust income to the spouse at least annually. Thus, trusts can be used for even the simple purpose of transferring assets to a spouse and would typically be used to retain some control over the ultimate disposition of the assets. For example, if the assets are not all used by the spouse during his or her lifetime, the client may want those assets to go to the couple’s children but not to the children of the spouse’s second marriage.

1 Since this presentation was given, the tax law has changed. Please see “Update” at the end of this presentation for more current information on this topic. Also, go to http://thomas.loc.gov/ and search by bill number H.R. 1836.ENR for a complete description of the final bill.

2001, AIMR®

Trusts, Insurance, and Wealth Transfer unified credit is now a fundamental part of estate planning. The trust mechanism is frequently used for a married couple so that each spouse can pass along the full exemption amount to the next generation without the imposition of taxes. The first spouse to die will typically leave his or her exemption amount in a trust for the surviving spouse, and then those assets will pass to the next generation tax free. Table 1 presents further information on the unified credit and the amount that can be passed along free of estate tax. In 2001, that amount is $675,000. Under current law, this amount is scheduled to increase almost annually until 2006, when it will reach $1 million.

Table 1. Scheduled Changes in the Unified Credit by Year Year

Unified Credit

Unified Credit Estate or Gift Equivalent

2001

$220,550

$ 675,000

2002

229,800

700,000

2003

229,800

700,000

2004

287,300

850,000

2005

326,300

950,000

2006

345,800

1,000,000

Note: This table was created before the new U.S. tax law was signed on June 7, 2001.

The possibility does exist, however, for an estate tax repeal, which could make the unified credit irrelevant. In the summer of 2000, both houses of the U.S. Congress passed a bill that would phase out the estate tax after about 10 years. Although then-President Clinton vetoed the bill, President Bush has prioritized tax issues and supports a repeal of the estate tax. If the estate tax is eliminated, estate planning may no longer be necessary. But even if the tax is repealed right away, as opposed to a phase out, a new Congress or a new president could reenact the tax. And once the American public realizes that a repeal of the estate tax means that Bill Gates and Warren Buffet will never pay taxes (because there are many ways to avoid paying income tax, especially on appreciated stock), the public ultimately will not support such a change. The wealth-transfer tax is a way to generate tax revenue from the Bill Gates and Warren Buffets of the world. Therefore, I believe the specter of estate and gift taxes will always be around, even if they are eliminated temporarily. Some type of compromise will likely be made regarding the unified credit amount. Instead of waiting until the year 2006 for a $1 million exemption, ©2001, AIMR®

perhaps individuals will get a $2 million, $3 million, or even $5 million exemption immediately. Prudence definitely recommends planning around these unresolved estate tax issues, so most estate planners are not suggesting any plan that includes transactions that would currently generate a gift tax. No professional wants to be in the position of having his or her clients be the last to pay gift tax prior to its demise. Lifetime Gifts. An individual can make gifts during his or her lifetime to dramatically reduce the total cumulative gift and estate tax burden. When making lifetime gifts, qualifying trusts are often used. Individuals are allowed to make tax-free gifts of up to $10,000 to any number of individuals each year. This amount will be adjusted for inflation under current tax law. These gifts can be made outright to an individual or put into a qualifying trust to preserve some degree of control over the assets. For example, a gift of $10,000 a year for 10 years, invested to earn a 6 percent annual after-tax return, would grow to more than $131,800 at the end of 10 years. If the giftor is in the 55 percent estate tax bracket, this strategy could result in a tax savings of $72,490. Gifts beyond the $10,000 annual exclusion amount are taxable and will begin to use the giftor’s unified credit. Gifts for tuition and medical expenses, however, can be made in addition to the $10,000 annual exclusion (no tax will be imposed on these amounts) if they are paid directly to the provider. Table 2 shows excerpts of federal estate and gift tax tables for 2001 and 2006.2 In 2001, the exemption provides that for the first $675,000, no tax is paid. The next dollar of transfer up to $750,000 generates a tax at a rate of 37 percent, the marginal rate on the excess. The tax rate increases quickly to 55 percent when transfers (during lifetime and at death) have accumulated above $3 million. On a $3 million accumulated transfer, the tax will be greater than $1 million. On a $5 million transfer, the tax is above $2 million. This is a very heavy tax, but with planning, it can be significantly reduced. Even when the exemption amount changes in 2006, planning will be important. In 2006, the exemption amount is scheduled to increase to $1 million. But with a cumulative $3 million gift, the tax will still be close to $1 million, and a gift between $3 million and $10 million will have a 55 percent marginal tax rate on each dollar gifted over $3 million. At $5 million, the transfer tax is still above $2 million. Irrevocable Life Insurance Trusts. Individuals can dramatically reduce their estate taxes by creating an irrevocable life insurance trust to own 2

See footnote 1.

www.aimr.org • 75

Investment Counseling for Private Clients III Table 2. 2001 and 2006 Federal Estate and Gift Tax Table Examples Value of Estate or Gift

Estate and Gift Taxa

Marginal Rate on Excess

2001 $

675,000

$

0

37.%

750,000

27,750

39

1,000,000

125,250

41

1,500,000

335,250

45

2,000,000

560,250

49

3,000,000

1,070,250

55

5,000,000

2,170,250

55

10,000,000

4,920,250

55.b

15,000,000

7,920,250

60.b

30,000,000

16,279,450.b

55

$

41.%

2006 $ 1,000,000

0

1,500,000

210,000

45

2,000,000

435,000

49

3,000,000

945,000

55

5,000,000

2,045,000

55

10,000,000

4,795,000

60.b

15,000,000

7,795,000

30,000,000

60.b b

16,154,200.

55

Note: This table was created before the new U.S. tax law was signed on June 7, 2001. a Estate and gift taxes shown have been reduced by the unified tax

credit of $220,550 in 2001 and $345,800 in 2006. b The benefits of the tax bracket rates below 55 percent are phased out by a 5 percent surtax imposed on transfers between $10,000,000 and $17,184,000.

their life insurance policies. Life insurance is a taxpreferred asset for various income tax reasons. For example, the proceeds (the death benefits) received under a life insurance policy generally are not subject to income tax in the hands of the beneficiary. But for estate tax purposes, the proceeds will be included in the insured’s estate and, therefore, subject to estate tax. This result can be avoided with careful planning. If the ownership of the insurance policy is in an irrevocable life insurance trust, rather than being owned outright by the insured, the proceeds will not be included in the estate of the insured and thus will escape the imposition of the estate tax. Not only should ownership of the policy reside with the trust, but the trust should also be named the beneficiary of the life insurance policy. Thus, the beneficiaries of the trust ultimately benefit from the policy proceeds. Zero Tax Estate Plan. A zero tax estate plan can be created by combining the irrevocable life insurance trust with charitable gifts. An individual

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can give an unlimited amount of assets to qualified charities, and these assets are effectively removed from the estate prior to the imposition of the estate tax. Thus, one way to avoid the estate tax is to give all assets to qualified charities at the individual’s death. An advantage of that technique is that the individual is able to control all assets until death. The downside is that if all money is left to charities, the individual will not have provided for his or her children, spouse, or other beneficiaries. If the client wants to provide a certain amount to his or her heirs so that not all assets are gifted to charity at the client’s death, then the client can use a life insurance trust in addition to the charitable gifts intended to exhaust the estate. The client names the heirs as the beneficiaries of that trust and creates a death benefit equal to the amount the client wants them to inherit. The client will have to pay the life insurance premium on the policy owned by the trust, but the premium will typically be a much smaller percentage of the total assets than the ultimate 55 percent estate tax that the client would have to pay if this planning were not undertaken. Intentionally Defective Grantor Trust. Unlike most trusts, the intentionally defective grantor trust (IDGT), which I also refer to as the irrevocable grantor trust, can allow assets to grow free of income and capital gains taxes. The IDGT has recently become an extremely popular wealth-transfer technique. In creating a grantor trust, the grantor (i.e., the individual who creates and funds the trust) retains certain powers over the trust. A common retained power is the ability of the grantor to legally unravel, revoke, or cancel the trust. In this case, it is this revocability that makes this trust a grantor-type trust. Once a revocable (grantor) trust is created, for income tax purposes, the trust and client are treated as one and the same because with no difficulty, the trust can be dissolved and the grantor can resume ownership of the assets previously held in the trust. The income, interest, dividends, and any capital gains realized are all taxed to the client on his or her personal income tax return; the grantor trust does not file its own tax return. The IDGT or irrevocable grantor trust is a variation of the grantor trust in that the trust document is written so that the client retains certain other grantor trust power(s)—other than the revocation power— that allow it to qualify as a grantor trust for income tax law purposes. If the irrevocable grantor trust names a beneficiary other than the grantor, typically the grantor’s children, then the irrevocable grantor trust will be a separate and distinct entity for gift tax and estate tax purposes (primarily for gift tax purposes). 2001, AIMR®

Trusts, Insurance, and Wealth Transfer For income and capital gains tax purposes, however, the grantor retains liability for the income tax generated from the assets in the trust. This is a good result because as a separate entity, the trust receives the interest, dividends, and realized capital gains unburdened by tax imposition because the grantor is liable and pays the taxes out of his or her own pocket, not from the assets in the trust. That situation may not at first sound like a favorable result for the grantor. But it is favorable when viewed from the perspective of estate planning because the trust is holding assets for the grantor’s children and those assets will not be diminished by income taxes in any way. And although the grantor has to pay the taxes out of pocket, doing so diminishes the grantor’s other assets that would eventually be subject to the estate tax. Thus, it is a fabulous estate-planning technique. One of the problems with this technique, however, is that the transfer of assets to the IDGT creates a gift. In today’s political environment, any planning strategy that imposes a gift tax on the client is risky. To circumvent this problem, the client could instead sell the property to an intentionally defective grantor trust (or irrevocable grantor trust). This technique, as with a gift, is used to pass the excess appreciation of assets to subsequent generations, but it avoids gift tax consequences because the client sells, rather than gifts, the property to the grantor trust. For example, the client could transfer his or her securities to the trust and receive an equal value in return—typically not cash—represented by a promissory note payable in 10, 12, or 15 years from the date of sale. The interest rate is determined by the U.S. Internal Revenue Service (IRS) and is currently a very low rate, around 6 percent a year. In the meantime, the securities are appreciating in value within the trust, growing at the rate of return of the S&P 500 Index or maybe faster if the securities are more aggressive investments. At the end of that 10-, 12-, or 15-year period, the promissory note is paid off and the grantor receives the value of the original transfer, plus the 6 percent in interest paid on the promissory note. Therefore, the excess return (less the interest paid on the note) remains in the trust, and no additional gift tax is paid because there was never a gift transaction. The client gave away the value and got the same value in return, plus the interest income on the note. The grantor retained annuity trust (GRAT), which I will describe next, is a similar technique, but the irrevocable grantor trust has become more popular because it has greater flexibility. With it, the terms of the sale transaction between the trust and the grantor are not driven by specific tax law but can be ©2001, AIMR®

created to fit the needs of the client. This technique may not be appealing in some cases, however, because the treatment of certain income tax issues associated with the transaction is unclear in the tax law. GRAT. The GRAT accomplishes similar, but not quite as good, results as the irrevocable grantor trust. The GRAT structure first appeared in U.S. estate and gift tax law in 1990. The structure has since been refined and now is pretty well established in current practice. The best way to describe a GRAT is with an example. A client creates an irrevocable grantor trust. The terms of the trust provide that the client transfer assets to the trust, perhaps $1 million, and retain an annuity payable from those assets. The trust has a specific term. For this example, say the trust term is 11 years and the client’s annuity is $100,000 for each of those 11 years. Meanwhile, the assets bought with the $1 million placed in trust at the beginning of the term are appreciating in value (or at least that is the intent). With any gift transfer to an irrevocable trust, gift tax is imposed at the time of the initial transfer. If the client transfers $1 million to the trust and expects to receive a series of annuity payments with a present value equal to $990,000 based on the prevailing discount rate, the balance, which is equal to $10,000, is treated as the gift. This $10,000 is the amount on which the client pays a gift tax. The client may not have to pay gift tax if the client uses some or all of his or her unified credit. This technique works because the assets in the trust and the income on those assets are reinvested over the term of the trust, providing an income to the grantor and appreciating for the benefit of the remaindermen of the trust (the beneficiaries of the principal of the trust). And remember that the grantor is paying both the income and capital gains taxes on the trust. In this example, at the end of the 11-year term, the client’s annuity payments have totaled the original gift of $1 million plus a small interest factor; and still, a substantial amount should be left in the trust at the end of the 11 years. That remainder is then available for the client’s remainder beneficiaries, and no additional gift taxes are owed. It is a great technique when the client wants to minimize gift taxes up front and transfer excess appreciation to the next generation, which is what many clients want to do in today’s political environment. Qualified Personal Residence Trust. The qualified personal residence trust (QPRT) is another wealth-transfer technique that has been in the tax law since 1990. Although it is similar to the GRAT, the only asset contributed to this type of trust (except for incidental cash contributions to cover expenses of the

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Investment Counseling for Private Clients III trust) is a personal residence. The retained annuity is the continued use of the residence. The residence is placed into an irrevocable grantor trust for a certain number of years, and the actuarial value of the use of that residence for the number of years in the trust’s term is subtracted from the full value of the residence to determine the gift that was created when the residence was placed in trust. Suppose a $1 million residence is transferred to a 16-year trust. The grantor will retain the use of the residence for 16 years. At the end of the 16 years, the residence will belong to the beneficiaries of the trust, usually the grantor’s children or a trust for their benefit. The current value of the use of the residence, under actuarial tables prescribed by the IRS, is roughly $820,000. So, the grantor has made a gift upfront of the difference between a $1 million residence and his or her continued use of the residence valued at $820,000. Therefore, the gift is $180,000. At the end of 16 years, the residence may have appreciated from $1 million to $2 million or maybe even to $3 million, but no additional gift is made at the expiration of the trust’s term. Thus, the additional value is now outside the grantor’s estate and not subject to estate tax. Delaware Dynasty Trust. The dynasty trust is another increasingly popular technique for the very wealthy. It is a trust that lasts for many generations and has been used by wealthy families for a long time. For example, in the early 20th century, the Kennedy, Vanderbilt, and Rockefeller families used this type of trust because they knew their wealth was so great that their children and grandchildren would not deplete it; the wealth would be available for many generations. The family patriarch or matriarch would make a single property transfer to the dynasty trust; the transfer at that time might not even have been subject to transfer tax. The assets would then be held in the trust, available for each generation’s consumption, but no additional transfer of those assets would take place, and neither the estate tax nor the gift tax would apply to those assets again. Thus, paying only one transfer tax is the concept behind the dynasty trust in that once the client contributes assets to the dynasty trust, if they are not depleted by the preceding generation, they are available for the next. In this way, dynasty trusts are used to control and minimize taxes. A few years ago, some states, including Delaware, passed legislation that eliminated the time limit on a trust’s term. Trusts typically have a term limited to about 100 years. Now, trusts can last forever in certain states; perpetual trusts are thus possible. Delaware was one of the first states to allow trusts to last into perpetuity, and now 14 states allow perpetual trusts. It took awhile, but lawmakers finally realized that the government was losing revenue on dynasty

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trusts because there were no repetitive transfers from generation to generation on which transfer taxes could be imposed. To address this circumvention of transfer tax, the U.S. government passed the generation-skipping transfer tax about 17 years ago, and it is still around today. The dynasty trust now has limited capabilities because when the initial transfer is made, the generation-skipping transfer tax is also imposed, not just the gift tax. There are still ways, however, in which the dynasty trust can be exploited to minimize the overall estate, gift, and generationskipping transfer taxes. I recently published an article in the Journal of Wealth Management that provides more information about dynasty trusts and wealth management through dynasty trusts.3 Sale of Remainder Interest to an IDGT. The sale of a remainder interest to an IDGT (structured as a dynasty trust) for a payment of equal value avoids gift tax consequences as well as generation-skipping transfer tax consequences. It is an advanced and aggressive trust technique that expands on dynasty trust planning. It is really part of a multistep plan that expands on many of the techniques I have discussed because it incorporates the irrevocable grantor trust and other trust techniques, such as the GRAT, the qualified personal residence trust, or even the charitable lead trust (CLT), which I will discuss later. In the GRAT example, the client transferred $1 million into a trust and retained an annuity equal to $990,000 in present value terms. The $10,000 difference was the gift that was to be reinvested and available for future generations. Now suppose the client creates a GRAT today and the children who are the remainder beneficiaries sell their $10,000 remainder interest to an irrevocable perpetual grantor trust (a dynasty trust) in exchange for a promissory note. Although in this example $10,000 seems to be a small amount, this gift has the potential to create a large benefit because that $10,000 is able to grow untaxed in the dynasty trust in perpetuity. Selling the remainder interest of a GRAT to an IDGT, structured as a dynasty trust, is a complicated technique but, again, a very popular one among the wealthiest clients. Charitable Lead Trust. One charitable planning trust technique is the charitable lead trust (CLT). A client can simply give a large lump sum to a charity; the gift will be excluded from the client’s estate and thus escape estate tax, but an alternative strategy is to create a CLT. With a CLT, the trust holds the assets and then pays an annuity interest not to the grantor but to the charity. The annuity interest can be struc3 Lawrence J. Macklin, “Wealth Management through Dynasty Trusts,” Journal of Wealth Management (Spring 2001):43–48.

2001, AIMR®

Trusts, Insurance, and Wealth Transfer tured over a period of years so that its present value is equal to the value of assets going into the trust—a zero-out CLT. A zero-out CLT is typically constructed so that no gift taxes are paid at the creation of this trust. At the end of the trust term, the remaining principal in the CLT is paid to family beneficiaries with no additional taxes associated with that transfer. Again, the technique is designed to move the tax-free appreciation on the original gift to the remaindermen. The CLT is a great technique. The same charitable gift can be made as with a lump sum payment, although the payments are stretched out over the term of the trust. But the difference is that with a CLT, the family can still benefit from the assets used to make the charitable gift. Charitable Remainder Trust. Another charitable planning trust technique is the charitable remainder trust (CRT). The CRT is the reverse of a CLT and perhaps more frequently used. A CRT pays the annuity to the grantor or to the grantor’s family rather than to the charity as with the CLT. At the termination of the trust, the charitable organization receives the remainder interest, hence the name charitable remainder trust. Because the CRT is an irrevocable trust, as all these trusts are, the grantor can take a current income tax deduction for making the gift to the trust— not for the full value of the contribution but for the actuarially calculated present value of the amount expected to go to charity when the trust terminates. Although the charity does not receive the gift when the trust is funded, a charitable income tax deduction is available nonetheless to the grantor at that time. (For the CLT, the charitable income tax deduction is available on an annual basis in the amount of the annuity payment.) In addition, the CRT itself borrows the income tax exemption from the ultimate charitable beneficiary; charitable organizations do not pay income tax. Because eventually a payment is made to charity, the CRT that is created is also a tax exempt entity; therefore, a client can invest in that entity on a tax-deferred basis so that the benefit of tax-deferred compounding is available. Also, the contribution to the trust might be appreciated property—for example, a highly appreciated single-stock position. Capital gains are not subject to taxation while the proceeds of the sale remain within the CRT. With a CRT, an annuity is paid to the creator of the trust or the creator’s family, and the payment is then subject to income tax. Still, income tax deferral is gained with the CRT.

Life Insurance Techniques Life insurance, although not really complicated, is a misunderstood asset. Two types of life insurance ©2001, AIMR®

exist: term insurance and permanent insurance. Term insurance is in effect for a defined period of time—1 year, 5 years, 10 years, and so on—and is generally not used in wealth-transfer planning. Instead, permanent insurance—insurance that remains in effect for the lifetime of the insured—is the preferred type of insurance for wealth-transfer planning. Types of Permanent Insurance. There are three types of permanent insurance: whole life, universal life, and variable life. ■ Whole life. Whole life policies have been around for more than 100 years. Whole life policies provide a guaranteed death benefit but usually have fixed premium amounts that are higher than other types of permanent policies. The two main components of the insurance policy are the investment element and the insurance cost element. Insurance companies guarantee the investment performance of the cash value portion of the premiums. Those guarantees typically are in the 3–4 percent a year range. Insurance companies also guarantee the maximum insurance costs that they will charge against the policy, although typically the charge is less than the guarantee in an effort to remain competitive within the industry. The guarantee amounts are intrinsic to the pricing of the whole life policy; risk and return are low, but premiums are typically high to allow for the provision of the guarantees. The truth is that the underlying investments made by the insurance company, which are used to provide the income that fulfills the guarantee, will typically earn much more than the 3 or 4 percent guaranteed in the policy. So, the insurance companies are not really providing much of a guarantee. The insured pays for those guarantees, however, and the guarantees are reflected in the pricing structure of the premium. Also, whole life is an inflexible product that requires a fixed premium structure, paid every year until the insured’s death. If the investment performance is better than 3–4 percent, which it typically is, the excess can be paid as dividends to the insured or additional insurance can be purchased. Whole life is a very expensive product because those insured are paying for guarantees they might not need. ■ Universal life. Universal life and variable life insurance policies were first offered about 25 years ago. Universal life is similar to whole life except that fewer guarantees exist, particularly related to investments. The higher investment performance that the insurance companies typically earn on their investment portfolios is anticipated in the universal life structure, whereas it is not in the whole life structure. Therefore, the premiums for universal life are lower than for whole life.

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Investment Counseling for Private Clients III With universal life and whole life, the insurance company invests the cash value element, the excess amount above the insurance cost in the early years of the policy, for the benefit of the insured in future premium years. Fixed-income-type investments are made with the cash value element, and thus, the associated returns are limited. Insurance companies choose this type of instrument out of concern for maintaining their credit ratings and to ensure steady returns; therefore, whole life and universal life policies have low investment risk. Even with low investment risk, the actual investment performance of universal life will typically be better than the 3–4 percent guarantee on a whole life policy (maybe around 6–7 percent). Because these better returns are anticipated with universal life insurance, it can be an attractive product. Many years ago, when interest rates were much higher than they are today, those unusually high return projections were used in calculating premiums on policies issued at that time, and of course, when these high returns did not materialize over the life of the policy, it created a problem for universal life policy issuers and policy holders. If the expected returns used in structuring the policy are not achieved, the insured must pay a higher premium. But if the returns are better than expected, the insured can pay a smaller premium. It is a flexible arrangement as opposed to whole life, which charges steady premiums. ■ Variable life. If universal life policies shift risk to the insured, then variable life policies shift even more risk to the insured. With a variable life policy, the insured, the owner of the policy, can direct the investments made with the cash value element of the premium. The investment options are usually limited to a family or families of mutual funds that the insurance company provides, which include equity stock investments. Therefore, with variable life, the insured has the opportunity to earn a higher return in the equity market and to reduce the premium even further than with a universal life policy. But the risk in choosing a variable life policy is that the guarantees associated with investment performance under a whole life policy, and even the limited guarantees under a universal life policy, are forfeited. If the insured invests in a small-cap fund, for example, and small-cap stocks perform miserably, the insured may have to increase premium payments over time to make up for the poor investment results, rather than benefiting from a decrease in premium payments because investment returns were good. On the other hand, if the insured invests in a diversified portfolio and enjoys the greater returns that the stock market

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should provide over the long term, a variable life policy can be a less expensive alternative for life insurance coverage. Income Tax Benefits. The death benefit proceeds of an insurance policy are generally free of income tax to the beneficiaries, which is a great advantage. Additional income tax benefits are also associated with life insurance. For example, the cash value that is invested within a life insurance policy grows on a tax-deferred basis, just like an investment within an IRA; the investments can grow rapidly through tax-deferred compounding. Moreover, if that tax-deferred compounding continues until the policy’s death benefit is paid to the beneficiaries and because income tax is not imposed on the death benefit, then that tax-deferred compounding turns into tax exempt compounding. Also, with a life insurance vehicle, as long as the policy itself is not classified as a modified endowment contract (which is, in general, associated only with single or quick-pay premium policies), the insured can withdraw his or her previously paid life insurance premiums without having to pay tax on those withdrawals. Thus, life insurance can provide great income tax benefits. Note that modified endowment contract (MEC) laws were enacted in 1986 to combat tax-deferred investing within insurance policies without a real life insurance purpose. This type of investing was characterized by accelerating premium payments into a policy in the first several years—more typically, the first year only—instead of stretching premium payments over numerous years. In the case of an MEC, the first dollars withdrawn from a policy are deemed to be the policy investment earnings and are immediately taxed as ordinary income. To avoid MEC status, premiums must be paid into a policy over several years, with the specific limitations varying with factors that include policy face amount and the age of the insured. Private Placement Life Insurance. As a result of the outstanding income and estate tax benefits that can be gained through the use of an irrevocable life insurance trust, private placement life insurance was developed. A private placement policy is structured as a variable life policy, but the insured can invest with an outside investment manager as opposed to the insurance company only. Private placements typically deal with large premium dollars, so the insurance company is gaining millions of dollars of premium for each policy, rather than the standard thousands of dollars of premium. 2001, AIMR®

Trusts, Insurance, and Wealth Transfer Because no marketing costs are related to the private placement, the private placement policy has lower costs than retail universal or variable life insurance. And private placement policies are also easily customized to the needs of the particular client. Of particular interest is the insured’s ability to bring his or her favorite outside portfolio manager to the table—for example, a favorite hedge fund or highyield bond fund—and the investment returns will be tax deferred. Until recently, private placement insurance was typically available only to institutional investors, but it is now increasingly being used by high-net-worth individuals. Private placement insurance first became available in the United States to high-networth individuals who could pay cumulative premiums of $20 million or more. For premiums of this size, the death benefit would be in excess of $100 million. As the private placement insurance market has expanded to encompass the high-net-worth individual, the majority of the business has occurred in the offshore (nondomestic) market. Several offshore life insurance companies began to offer private placement insurance at reduced premiums—the $5 million to $15 million level as opposed to the $20 million domestic quote. Other cost advantages are also associated with going offshore, such as the avoidance of state and federal insurance costs. Going offshore, however, does incur expenses that are not incurred domestically, including the expenses associated with creating a foreign trust. The planning strategy requires that the insurance policy be held in trust so that when the death benefit is paid and subsequently invested, the assets will not be subject to estate tax. Now, however, several domestic insurance companies are offering private placement insurance at very competitive premiums, some even below $5 million. As a result, high-net-worth individuals no longer are forced to go offshore to take advantage of private placement insurance. Life Insurance Ownership Planning. Ownership planning of the life insurance policy is crucial for effective wealth transfer. If the insured will be subject to estate tax, then the policy should not be owned by the insured outright but by a trust. When the ownership of the policy rests in a trust, then the trust must pay the annual premiums. Typically for smaller policies with premiums of $10,000 to $50,000, the donor (the insured) makes a gift of the policy premium to the life insurance trust. The trust is usually structured in a way that the gift qualifies for the annual exclusion of $10,000 for each of a number of trust beneficiaries so that the premium gifted to the trust annually is not considered a current taxable gift. This ©2001, AIMR®

approach will not work for a policy with a very large premium because there are not enough trust beneficiaries to absorb the separate annual gift exclusions. A popular technique to avoid gift tax in the case of large premiums is to use split-dollar life insurance. Split-dollar life insurance simply means that the policy has two owners. For purposes of estate planning, this typically means that the insurance trust is an owner of the policy along with the insured, but the insured is an owner only in the sense that he or she lends money to the trust to make the premium payments. The amount of the premiums lent to the trust will be returned to the insured from the proceeds of the death benefit. Suppose with a $25 million policy ($2 million premium) the wealthy individual (the insured) loans $2 million to the trust to buy the policy. When the death benefit is paid, the first $2 million is included in the owner’s (the insured’s) estate, and the remaining $23 million remains in the trust and escapes estate taxes. It is a wonderful wealth-transfer technique. When split-dollar life insurance was first introduced in a planning context, the legal, accounting, and investment professionals who were recommending this strategy to clients were relying on IRS rulings that approved the basic structure as well as the interestfree loan treatment for the payments made by the insured to the trust for the premium. In recent years, however, the IRS has indicated that using split-dollar life insurance to escape estate taxes will not be looked upon favorably. In January 2001, the IRS issued Notice 2001-10 officially stating its position against splitdollar life insurance in estate planning. Consequently, another method of insurance ownership has emerged. The life insurance trust itself can borrow from a third party, such as a bank, using the insurance investment as collateral coupled with the insured’s guarantee of the loan. The trust uses the borrowed funds to buy the life insurance policy. The problem with this variation is finding a bank that is willing to do the transaction because the loan is not repaid until the insured’s death, which triggers the death benefit proceeds.

Conclusion Tax-efficient wealth transfer is at the heart of effective estate planning, and at the heart of wealth transfer is the trust structure. Although many forms of trust can, and should, be used in estate planning, life insurance structures should also be considered. Ultimately, the manager’s goal is to achieve client objectives while minimizing costs (in particular transfer tax costs and income tax costs), and trusts and life insurance structures are key vehicles for this purpose.

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Investment Counseling for Private Clients III

Update Subsequent to the conference and prior to publication of this conference proceedings, a new tax law (the “2001 Act”) was enacted that significantly modifies the estate and gift tax by first increasing available exemption amounts beginning in year 2002 and then repealing the estate tax in year 2010. The 2001 Act also reduces the highest tax rates with respect to estates of decedents dying before 2010, as shown in Table 3. The 2001 Act increases the unified credit available against estate taxes from the present year 2001 $675,000 exemption equivalent to the equivalent of a $1 million exemption in 2002, a $1.5 million exemption in 2004, a $2 million exemption in 2006, and a $3.5 million exemption in 2009. The 2001 Act, however, caps the gift tax exemption equivalent at $1 million, without the additional increases after 2002. The gift tax rate changes with the estate tax rate, so the 2001 Act reduces the gift tax rate between 2002 and 2009 as well. The 2001 Act does not, however, repeal the gift tax in 2010. Instead, the 2001 Act reduces the top gift tax rate in 2010 to the same percentage as the top individual income tax rate, which is scheduled to drop to 35 percent in 2006. The most significant feature of the law is that it reinstates the estate and gift tax into the law in year 2011 as if the year 2001 changes had not occurred. So,

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Table 3. Federal Estate and Gift Tax Changes under the 2001 Act Yeara

Estate Tax Exemption

2001

$ 675,000

55.b

2002

1,000,000

50.c

Top Marginal Rate (%)

2003

1,000,000

49

2004

1,500,000

48

2005

1,500,000

47

2006

2,000,000

46

2007

2,000,000

45

2008

2,000,000

45

2009

3,500,000

45

2010

—

Full repeal

2011

1,000,000

55.b

Note: The gift tax exemption remains at $1,000,000 from 2002 through 2011. a

Estates of decedents dying or gifts made in listed year.

b Plus 5 percent surtax on certain transfers greater than $10 million. c

No surtax for years 2002 through 2010.

in 2011, the estate and gift tax exemption will again be only $1 million and the highest tax rate will again be 55 percent (along with the additional 5 percent surtax in certain cases). Therefore, the estate tax repeal is effectively scheduled to last for one year (if Congress does not make further changes prior to that time).

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Trusts, Insurance, and Wealth Transfer

Question and Answer Session Lawrence J. Macklin Question: When appreciated property is sold to an IDGT in exchange for a promissory note, what is the cost basis of the property and the character of the gain when it eventually passes to the heirs? Macklin: Because this is a grantor trust, the property is just moving from the right pocket to the left pocket of the grantor, and the promissory note is moving from the left pocket to the right pocket of the grantor. The sale of property is not a taxable transaction because in reality the property never changes hands. Thus, the low-basis property that is transferred to the trust retains its low basis because there is no sale for income tax purposes and thus no change in basis and no gain recognized; the transaction is ignored for tax purposes. A major issue associated with the irrevocable grantor trust technique and the sale of property using a promissory note is what happens if the promissory note is still outstanding at the death of the grantor (i.e., the seller of the property). The best result is to close the transaction before the grantor dies. If the transaction is closed before the death of the grantor, ownership of the property will be successfully transferred to the trust and the promissory note will be paid off. The property took a carryover basis into the trust and will retain that carryover basis at the death of the grantor. If the transaction remains open at the grantor’s death, however, there are several different schools of thought as to the correct tax treatment for the situation. The lack of clarity revolves around the income tax treatment of the open transaction. Some tax commentators argue that the trust receives a ©2001, AIMR®

fair-market-value cost basis on the transferred property and that no taxpayer (the grantor’s estate or the trust) recognizes any gain related to the appreciated property. Other commentators believe that the property retains its carryover basis. Some commentators believe that a taxable transaction occurs at death and that the tax is paid with the decedent’s final income tax return, while others believe that the tax is paid by the estate. Others believe that an increase in tax basis occurs but only to the extent of the payments of principal made on the promissory note. Unfortunately, there is no clear authority on this transaction in the tax law. Question: Does using a trust to transfer assets to the next generation always result in those assets being passed on with restrictions? Macklin: A trust is an incredibly flexible vehicle and can be written with as many or as few restrictions as the settlor intends. Almost any asset can be put into a trust, except of course something that is against the law or against public policy. And assets placed in trust can be restricted in almost any way. For example, incentive trusts, which restrict trust withdrawals for the settlor’s children to amounts equal to their earnings, are growing in popularity with the newly wealthy. Other types of incentive language can be incorporated into the trust document as well. In a typical trust, assets can be distributed to a trust beneficiary for health and education purposes and/or to maintain a beneficiary’s standard of living. I recommend using an attorney to draft the trust document,

and the attorney should draft the trust document to be as flexible as possible, especially in today’s political environment in which there may be certain provisions included in the trust document for estate tax reasons that may not be relevant down the road. Question: Do effective strategies for passing assets “free and clear” to the next generation exist? Macklin: If you mean “free and clear” of estate and transfer taxes, the best strategy is to implement a perpetual dynasty trust in a way that will minimize the impact of the initial transfer on estate and gift transfer taxes. Then, as the dynasty trust is used by second, third, and fourth generations, the impact of the potential generation-skipping transfer (GST) tax is minimized. What I unfortunately didn’t have time to discuss in the presentation is the ability to use the million dollar exemption for the GST tax.1 This can be used very effectively. For example, the GST exemption is a very tax efficient way to get assets into a perpetual dynasty trust. This generationskipping exemption can be leveraged to transfer much greater amounts into a dynasty trust through borrowings, life insurance policies, and various other trust or entity-planning vehicles. In my recent article in the Journal of Wealth Management that I mentioned earlier, I discuss in detail the GST tax and the various ways to leverage the GST exemption. 1

See “Update” at the end of Mr. Macklin’s presentation for more current information on this topic.

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Family Limited Partnerships: Pros and Cons Patricia M. Thompson Partner The Bowden Law Firm, P.C. Atlanta

Family limited partnerships (FLPs) can be useful instruments for estate planning in a variety of situations, but investment advisors and clients alike must understand the intricacies associated with them. For instance, FLPs are complex and expensive to create, and they are prone to U.S. Internal Revenue Service scrutiny. Nevertheless, not only do FLPs allow for valuation discounts, but they also allow clients to organize, control, and amend the partnership agreement as needed.

he family limited partnership (FLP) can be a very effective tool in estate planning and wealth transfer, although care should be exercised in its use. I will begin this presentation with a description of an FLP, the steps in its creation and funding, and the basic premise for its existence. I will then discuss the advantages and disadvantages of FLPs—going beyond the typical discussion of valuation discounts—and then delve into how the U.S. Internal Revenue Service (IRS) challenges those discounts. I will then present four case studies that examine FLPs from a practical perspective—who they work best for, in which circumstances they are most appropriate, and the potential problems associated with their use. Finally, I will conclude with recent and possible developments with the estate and gift tax and how those developments could affect FLPs.1

T

Structure and Function An FLP is simply a variation of the standard limited partnership in which the partners are typically family members. In some states, a limited liability company (LLC) can be used for the same purpose, but to simplify the terminology used in this presentation, I will just refer to FLPs. To create and fund an FLP, mom and dad (assuming they are the family members with the 1

Since this presentation was given, the tax law has changed. Please see “Update” in Mr. Macklin’s presentation for more information, or go to http://thomas.loc.gov/ and search by bill number H.R.1836.ENR for a complete description of the final bill.

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greatest wealth) create the new legal entity (the FLP) and contribute assets to the FLP in exchange for fairmarket-value general and limited interests. General interests hold the voting power in the entity, and limited interests share the equity ownership. When I structure an FLP, I like to give each spouse equal control—a 1 percent general partnership interest and a 49 percent limited partnership interest for both mom and dad. The general partnership interests control the FLP, regardless of the fact that they constitute a minority of the total partnership interests. The general partners make all of the investment, business, and management decisions for the FLP. It is analogous to voting and nonvoting stock. The general partners make all the decisions; limited partners have about as many rights as my two-year old in timeout. Once the FLP is created and funded, mom and dad no longer own the individual assets—securities, real estate, promissory notes, oil and gas rights, or whatever the assets may be—that they have contributed to the FLP. Instead, they own general and limited partnership interests. Often, mom and dad still think of the contributed assets as theirs, but the critical point is that now they own partnership interests. Mom and dad then proceed to make lifetime gifts of limited partnership interests to family members. Mom and dad may take advantage of their annual gift exclusion and each make partnership gifts of $10,000 a year to each of their children and grandchildren, and/or they may use their unified credit amounts (currently $675,000 each for mom and dad, but that amount is going up to $1 million under the current

2001, AIMR®

Family Limited Partnerships law by 2006) to make gifts free of transfer tax.2 Mom and dad can also gift (or sell) their limited interests to a family trust. The basic motivation for using an FLP is to be able to gift the limited interests or to use some other transfer-tax-favored way to move the assets in the partnership to family members, generally at a “discount” to the assets’ fair market value. If the value of gifted partnership interests exceeds the annual exclusion amounts ($10,000 for each gifting spouse), mom and dad must file gift tax returns to report the gifts, which notifies the IRS of the transaction. In conjunction with making the gifts and filing their gift tax returns, mom and dad must have the FLP assets appraised and the limited partnership interests valued to determine the applicable valuation discount for any year in which a gift is made, which is one of the downsides of FLPs. All partners have proportionate economic interests in the FLP assets and income. If mom and dad each give a 5 percent limited partnership interest to their child (call her Sally), the income tax allocation and distribution of the FLP assets on liquidation of the FLP will be 45 percent to both mom and dad (made up of a 44 percent limited partnership and a 1 percent general partnership interest) and 10 percent to Sally (made up of a 5 percent limited partnership interest gifted to Sally by mom and by dad). Mom and dad, as the general partners, have complete management authority over the FLP. Furthermore, because Sally owns 10 percent of the partnership, at the end of the year, Sally gets a K-1, just like she would with a trust. On Sally’s personal income tax return, she has to take into account 10 percent of the profits (or losses) of the partnership, and she is allocated 10 percent of the discount on the partnership assets. If the partnership has made any charitable gifts, she receives her 10 percent share of the charitable deduction. If mom or dad owns FLP interests at death, the FLP interests, rather than the pro rata portion of the actual assets owned by the FLP, are reported on her or his estate tax return.

Advantages and Disadvantages An FLP holds great appeal for wealthy individuals because it allows valuation discounts on the assets with which the FLP is funded. Ideally, they would like their $50 million stock portfolio to be worth only $25 million, and valuation discounts are a route to this goal. But beyond this consideration, many other nondiscount reasons exist for creating an FLP. Advantages. FLPs have many advantages. First, they consolidate the ownership of multiple assets into one entity for management and family 2

Please see footnote 1.

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transfer purposes, which essentially creates a family mutual fund. Thus, the family members share one pool of assets, which allows them to diversify the pool. FLPs also aggregate fractional interests in real estate, permit joint investments by multiple family members, and allow the division of the economic benefit of a large asset among several family members that would otherwise be indivisible (e.g., a family farm). For example, a parent who owns a 1,200 acre tract of timberland would find it extremely difficult to give each child a $10,000 interest in that land each year. Doing so would pose problems with the title and would be extremely costly. And then, if the parent sold the tract of land, he or she would have to deal with all of the individual parcels of land owned by the children. With an FLP, however, the undivided land is put into a partnership, which provides an easy way to gift an equity interest in the land and allows the donor to continue to manage the entire property. Thus, FLPs allow general partners (usually the senior family members) to retain control of family investments. Suppose mom and dad have a large tract of farmland or timberland and want to sell part of it and develop other parts. When doing this, however, they want to avoid having 5 or 10 family members appear at the closing and having the bank act as the trustee. With an FLP, the general partners (mom and dad in this case) are the only ones who have to sign the papers. They are the ones with the legal authority to act regarding FLP issues. The general partners control where the partnership assets are invested and make the financial decisions related to the FLP, but from a tax perspective, the equity interest in the assets is passed to the children (the limited partners), which cannot be done as easily with a trust. In most trust situations, if an individual makes a transfer for tax purposes and the asset is removed from his or her estate, that individual loses control of the asset. The general partners also determine the amount of the FLP’s annual cash flow to distribute to the limited partners, which is a significant power. Typically, mom and dad will distribute enough for the children to pay the tax bill associated with the partnership. An FLP facilitates the transfer of wealth to the younger family members while permitting senior family members to keep control of the assets by retaining general partnership interests. The FLP allows parents to determine when and if the children are ready to step in and take control of the family assets. The parents, or general partners, can permit the younger generations who own limited partnership interests to have input into the management decisions in order to ready them for taking control of the FLP in later years. So, FLPs can create an environment for teaching children how to handle, manage, and invest significant wealth in a responsible manner.

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Investment Counseling for Private Clients III FLPs can create valuation discounts, or adjustments as I call them, for gift and estate tax purposes. These adjustments allow mom and dad to leverage their transfer tax exclusions. Mom and dad can use limited partnership interests to make annual exclusion gifts and/or unified credit gifts at discounted values. Still, for very wealthy individuals, the $675,000 lifetime exclusion or $10,000 annual exclusion will not accomplish much in the way of taxsheltered wealth transfer. An advantage of FLPs that is becoming increasingly important is protection from creditors, principally creditors (ex-family members) resulting from a divorce. Because the general partners completely control the cash flow of the partnership, they can very effectively pressure a partner (the creditor) to withdraw from the partnership. For example, if the partnership has $50,000 in income for the year and the unfriendly creditor owns a 10 percent interest, the creditor will have to pay tax on that 10 percent income interest, whether or not the creditor sees a dime from the partnership. This phenomenon is called “phantom income.” That is, the general partners can decide not to distribute any of the income to the partners in the year the income is earned and income tax is owed. Such a situation often makes the creditor want to sell his or her partnership interest. FLPs also provide some options and flexibility in dealing with “renegade” family members through the use of phantom income. With the general partners’ decision-making powers, mom and dad have more assurance and control that the family assets will remain with lineal descendants. FLPs provide general liability protection, which is particularly important when mom and dad own commercial real estate in their individual names. An FLP will generally limit a partner’s liability to the partner’s respective ownership interest in the FLP. FLPs also provide flexibility in financial and estate planning, which is a big advantage. Much uncertainty surrounds future tax law, the number and behavior of descendants, the stability of marriages, and even environmental hazards associated with the property in a partnership—all of which can complicate planning. But partnership agreements are completely amendable; the terms can be modified so that the partnership can be appropriately managed and invested in light of changing circumstances. Modifying a trust is much more difficult. FLPs also provide much greater flexibility than trusts in the management of business affairs because the general partners are held to a reasonable business standard (the standard of a reasonably prudent businessperson) rather than the fiduciary standard imposed on trustees under the governing state law.

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FLPs provide for the orderly succession of control of the partnership assets in the event of mom and dad’s death or disability (i.e., this situation is specified in the partnership documents). Without an FLP or another type of succession plan, when the sole surviving parent dies, one of the children needs to take the lead in dealing with the parent’s property, which can cause dissension among family members. (Timberland real estate, for example, is neither easily divided among nor managed by several children.) But by providing for orderly succession, the FLP is a tool that preserves family relationships and helps achieve a common goal. Finally, FLPs can prevent the underlying partnership assets from being involved in probate or estate administration. Under some circumstances, FLPs can avoid state death taxes on property located in states other than the deceased partner’s state of residence. FLPs also simplify the continuation of an ongoing business or active investment plan. For example, suppose I have a client who has property in Florida, North Carolina, and West Virginia. If the client dies owning all of the real property in his or her own name, without an FLP, I would have to do estate administration and potentially pay estate death taxes in each of those states. With an FLP, however, I have changed the holding from real estate to an intangible. Although the securities would still be taxed and need to be administered in the home state, an FLP lowers administrative costs. Disadvantages. Even in this perfect world of partnerships, some disadvantages exist. One disadvantage is that FLPs are very complicated animals. FLPs involve considerable technical complexity and require significant professional expertise and advice to be properly planned, implemented, and administered. The professionals involved should include an attorney, accountant, investment advisor, valuation expert, and appraiser. Another big disadvantage of an FLP is that as a partnership, it is an ongoing, living, breathing organism. Thus, FLPs require continued involvement by mom and dad as general partners and later on by the children who become the general partners. Income tax returns must be filed every year, partnership meetings are needed, and the FLP should be treated like a real business. An FLP is a separate entity for both tax and state law purposes. Mom and dad must treat the FLP accordingly—not as their alter ego. The costs to create and administer an FLP (transaction and maintenance costs) are significant. The costs include attorney’s fees, appraisal and valuation fees, accounting fees, and any out-of-pocket expenses triggered by the transfer of assets. Moreover, done improperly, the transfer of assets to an FLP can trigger income taxes. When assets are put in the FLP or 2001, AIMR®

Family Limited Partnerships when gifts are made to transfer an interest in the FLP, an appraisal of the assets is needed to make the valuation adjustment. This valuation report may cost $3,000–$10,000. Another huge disadvantage is that FLPs are a red flag to the IRS. An estate or gift tax form (Form 709) that reports the transfer of FLP interests will typically increase the IRS’s level of scrutiny for that return. The FLP is the IRS’s most disliked estate-planning technique. I have heard it called a sham and a device for tax avoidance (the latter is not illegal but is certainly frowned on by the IRS). In years past, gift tax forms were never audited, but the IRS has specifically beefed up its auditing team for gift taxes. If a partnership gift is on Form 709, it will be pulled. The individual gifting the FLP interest might not be audited, but his or her return will be reviewed. The IRS has added a little box to page two of Form 709 that says, “Do any of your gifts on this return have a valuation discount? If so, check this box.” That makes the search for gifted FLP interests very simple for the IRS. A final disadvantage is that FLPs can have a major impact on family dynamics. FLPs can divide a family when mom and dad clearly say they are picking one child over the others to be the next general partner. This is a difficult decision for the children and family members, but the FLP does not work to the benefit of all the partners if leadership is shared.

Valuation Discounts Valuation discounts, although not the only reason, are at the heart of why families want to establish FLPs. Thus, families must be aware of the range, type, and factors affecting valuation discounts. Discount Range. The range of discounts that has been reported during the past seven or eight years in tax cases with published settlement results has been 15–75 percent. Karen Sumler, the National Director of Estate and Gift Tax Administration with the IRS, recently stated that the national average for FLP discounts (discounts made because of minority interests and lack of marketability) was 42–45 percent. The IRS, however, considers discounts in the range of 20–22 percent to be appropriate.3 Therefore, clients must be advised that they are facing a battle over 20 percentage points if they opt for a valuation discount that falls within the average range. I have successfully defended audits that were resolved at a 30 percent discount and even one fairly unusual instance that was resolved (outside tax court) at a 70 3

As reported in “Chapter 11,” in the Thirty-Fourth Annual Philip E. Heckerling Institute on Estate Planning publication (University of Miami School of Law, 2000).

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percent discount. The important point is that the facts and circumstances of each case affect each valuation discount. In the 10 years that I have done partnership work, the discounts have risen markedly. Some have called it the tax version of grade inflation. Now is a particularly good time to take valuation discounts because securities prices are depressed. Therefore, a more conservative discount at first glance, in combination with depressed asset values, will reap a total discount that is equally aggressive in its effect but will draw less IRS scrutiny. Types of Discounts. Several types of discounts are available with FLPs. A valuation expert may consider a discount appropriate in valuing an FLP interest when accounting for fractional interests, minority interests, lack of marketability, blockage or market absorption, built-in capital gains, U.S. SEC Rule 144 or other securities law restrictions on the transfer of securities, and risks of litigation. A fractional interest means that the partnership interest being valued represents only a partial ownership interest in an asset, such as real estate. A minority interest means that the partnership interest being valued owns less than a 50 percent, or whatever the voting requirement is, interest in an asset. Lack of marketability is another big discount consideration. No one other than a family member would want to buy an interest in the Jones’ family partnership because Mom and Dad Jones can do whatever they want as the general partners. To a lesser degree, blockage and market absorption are taken into consideration in determining the valuation discount. Built-in capital gains have become a much greater concern for the IRS over the past few years, but the taxpayers have prevailed in most of those cases. With the increase in the dot-com stocks and initial public offerings, more restrictive stock has found its way into personal portfolios. Thus, when Rule 144 securities or other securities with restrictions are moved into partnerships, discounts are given to them for valuation purposes. When there is a risk of litigation associated with an asset, a discount can be taken that accounts for this potentiality. Environmental hazards with real estate fall within this category. Factors Affecting Discounts. The particulars of cases that have affected the size of discounts are as significant as the range of discounts agreed to by the IRS. One factor in the discount’s size is the type of assets owned by the FLP. For example, does the FLP own income-producing real estate or non-incomeproducing real estate? The valuation discount for the FLP interest in the real estate may be larger if the real estate produces lots of income and if the partners face

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Investment Counseling for Private Clients III the possibility of receiving a K-1 but with no cash distribution to pay the income tax liability. Such a situation may cause a deeper discount than if the FLP does not have an income-producing asset. Similarly, with non-income-producing real estate, there may be a capital call requirement to pay taxes or maintain the real estate, which may present a potential hardship to a partner who has minimal cash to meet the capital call. Also relevant is whether the FLP has closely held business promissory notes that are illiquid and whose ultimate value is questionable. Another factor is the state law governing the FLP. The IRS says that if the restrictions in the partnership agreement are more restrictive than those imposed under the applicable state law, they can be disregarded and no discount is allowed that would otherwise result from those restrictions. A person cannot write whatever he or she wants into the partnership agreement. Texas, for example, at one time said that limited partners could withdraw from a partnership unless the partnership agreement said they could not. If the agreement was written saying limited partners could not withdraw, then the agreement was more restrictive than state law. In such a case, the IRS did not have to recognize any discount from that partnership. In contrast, Georgia’s statute took the opposite tack, saying that limited partners were not allowed to withdraw unless the agreement provided for it. Therefore, states could be “shopped” for the conditions most favorable to the specific partnership’s needs and discount availability. The differences in state partnership law have now been reduced. Another key factor in discount determination involves the age, health, and competence of mom and dad when the FLP was created and when the gifts were made, as well as any precedents for the action. Have mom and dad created an FLP before? Was it a reasonable action for them to take, or was it completely an estate-planning device? I, of course, believe that a sound argument for reasonableness can always be made. Another critical element is the manner of operation of the FLP. Does a partnership bank account exist? Does the FLP hold regular meetings and keep books and records? Moreover, was the FLP operated with respect for the legal and tax partnership formalities? The quality and existence of property appraisals is another factor that could affect the amount of the discount on the partnership interest. I have clients who maintain that they do not need an appraisal. All I can say to them is that if they get audited, which they have to anticipate, that will not be the appropriate time to get an appraisal. The IRS looks much more favorably upon appraisals and partnership valua-

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tions that are prepared contemporaneously with the allocations of FLP interests—those made among the partners in exchange for their contributions to the partnership as well as those for any gifts of partnership interests—than on those made after the fact. When dealing with the IRS, it is always better if an action is taken prospectively, rather than with 20/20 hindsight (although it is not always fatal). And, of course, the appraiser must be qualified. A final factor that is becoming more significant in discount determination is the percentage of mom and dad’s assets that were contributed to the FLP. In the IRS’s view, it is not reasonable and prudent that an individual or a family would put 98 percent of his, her, or their assets into a partnership with the accompanying tremendous restrictions and limitations; the resulting implication is that the use of the FLP is purely to avoid transfer taxes. I have a client who has about $9 million in securities and $2 million in real estate; probably only about $5 million in securities will be put in an FLP. The client will not get a discount on all his assets (only those put into the FLP), but that is reasonable. The IRS believes that including all of an individual’s, or a family’s, assets in an FLP undercuts the business purpose and the reasonableness of the FLP, and any discount taken under these circumstances is vulnerable to repudiation.

IRS Challenges The disadvantages of FLPs may be manageable and, to a great degree, quantifiable for a client, with the sole exception of an IRS audit. FLPs are on the IRS’s “hit list.” I tell my clients that if they are doing any significant gifting and have a discount in excess of 22 percent, they have to be prepared for an audit. The costs and duration of an audit will vary depending on the facts of the case—including the quality of the appraisals, the terms of the partnership agreement, the nature of the property owned by the FLP, the degree to which participants observed the partnership requirements, the value of the gifts or estate, and the amount of tax in question. I have one client who is very wealthy and has had a partnership for several years. He got the idea this year, because his company has had a downturn, to make $1 million of partnership gifts to his children. I suggested an alternative. His stock portfolio was off by 30 percent, and if he made gifts of his securities, which are publicly traded, he could still make his $1 million gift and the IRS would have nothing to audit because there would be no stated discounts; the markets had done this work for him. There would be no “funny business.” On the other hand, if we went for a 40 percent discount in his partnership, which did not own those same marketable securities, I could 2001, AIMR®

Family Limited Partnerships guarantee that when he made a $1 million gift, on which he would pay $500,000 of tax, he would be involved with an audit starting in about 18 months that would last probably two more years. Much to his children’s chagrin, he told me to forget the whole thing. He kept his million and said the children had enough money. When the IRS audits, inevitably the taxpayer being audited will not come out ahead but will have to pay something. The amount of tax may be minimal, but some form of payment will be made. How much is paid sometimes depends on how long the person fights. The audit begins at the examining level, which is when the initial letter from the IRS is sent, but the examiner has limited discretion in what he or she can do. Examiners are limited to accepting about a 32 percent valuation discount and cannot settle every case at the maximum discount level. So, typically, an agreement is made to disagree at the end of the examination, and the audit moves to the appeals level. The people at appeals are typically more seasoned, smarter, and have much more discretion. (My 70 percent case I referred to earlier was settled at the appeals level.) But again, more time is put in, more legal fees, more accounting fees, and more appraisal fees. The last resort for most taxpayers is tax or district court. Trial preparation adds further costs. The initial audit letter sent to mom and dad (referred to by the IRS in its letter as the “Donor”) for gift tax returns is usually a form letter that asks a list of questions and requests a list of documents. The letter is used on a national basis regardless of the facts of a particular case. Some of the questions are as follows: Was the FLP created in conjunction with estate planning? If so, what was the role? At whose suggestion was the FLP created? What notes were kept of the advice received? Of what benefits was the Donor advised? The IRS also requests all correspondence about the FLP from the attorney who recommended the strategy. So, attorney–client privilege can be claimed as a response, but the IRS will ask if the term “valuation discount” was mentioned. Therefore, it is best to talk about “adjustments” and gifting and tax savings as the primary reasons for creating an FLP and to focus the motivation of the FLP on investment strategy, family harmony, keeping assets together, and running a family business. The following question on the initial audit letter is especially important: If the FLP consists of marketable securities held in brokerage accounts, are the investment decisions made by the general partner or by an investment advisor or manager who is responsible for the account, and has this changed since the creation of the FLP? If the investment manager is doing all the work with an FLP, the IRS will question ©2001, AIMR®

whether the manager could have done this work without an FLP. Why was a general partner needed if nothing changed? In an audit, the IRS asks for an exhaustive number of documents. The IRS requests all documents relating to the creation of the partnership (including bills) from any attorney, accountant, or firm involved in recommending the creation of the partnership or in drafting the partnership agreement. I have been challenged on the appraisal of real estate when it was made a year prior to the gift. The IRS said it was a stale appraisal that took advantage of the depressed value of the real estate market at the time. So, if the IRS could not get us on the discount for partnership interest, it was going to disagree with every real estate value we used. The IRS also asks for articles of incorporation of the general partner (if the general partner is a corporation), such documents as the minutes of all partnership meetings, and evidence showing how the value of each partnership asset was determined as of certain dates (the date the asset was contributed to the partnership and the date of each gift of a partnership interest). For each partnership, the Donor has to explain how the asset was used by the Donor since its acquisition and how the partnership has used the asset since the formation of the partnership (i.e., held for rent, personal residence, investment, etc.). For each gift or transfer of a partnership interest, the Donor must provide any assignment of a partnership interest and any partnership amendment. Finally, the Donor must supply a statement describing the Donor’s health at the time of the formation of the partnership and for the six-month period prior to the formation of the partnership. An audit of mom or dad’s estate tax return on death may also occur. An estate tax return, however, can be audited for many issues in addition to the reporting of an interest in an FLP.

Case Studies FLPs are an appropriate estate-planning and management vehicle in a wide variety of circumstances. The following four case studies, which are amalgamations of my various clients, show why I have recommended FLPs and how they have been beneficial. Case Study 1. The first case study involves a 70-year-old widow. She has three adult children and two grandchildren. She owns seven multifamily dwellings totaling 35 units with a value of $3 million and marketable securities with a value of $3.5 million. She inherited these assets and has owned them for 50 years. Two of the three children are involved in managing and renting the multifamily units. The widow, the mom, lives in one of the units, and one

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Investment Counseling for Private Clients III of her sons lives in another as the manager of the building. I advised her that she needed a partnership because first and foremost she needed the liability protection but also because she needed the leverage that the valuation adjustments would provide. She and I agreed that all we would put in the partnership was the real estate because she felt comfortable giving away partnership units and with keeping her nest egg of securities outside the FLP. The other issue with this case is that one child is not involved at all in the management of the real estate. He would be happy to sell, but the real estate is the livelihood of the other two children. Without a partnership, when mom dies, this child could force a sale. A liquidation would be a devastating blow to the two other children. Instead, the real estate is held in a partnership. The partnership has a buy/sell agreement between the two children and the one child who is not involved. The partnership has taken what was an informal family business and put it in a formal business wrapper where it needed to be. And knowing there was estate planning to do, the FLP made this easier to accomplish as well. My client also gave a 1 percent interest in the FLP to her church. Because the partnership has a nonfamily member, when she dies, the partnership may get a significant discount in her estate. The IRS makes certain presumptions about the partnership when it is composed of family members, so if a partnership has one partner who is not a family member, the IRS cannot make the same presumptions. Therefore, the discount on death will often be deeper and more defensible. My client could not easily or practically gift little deeds in her real estate holdings every year, and she did not want to gift her securities because her securities portfolio was her financial cushion should the real estate rental market become depressed. So, in this case, the FLP benefits were that it provided liability protection, served as a management vehicle, facilitated gifting (no changes in deeds were required), offered discounts for lifetime gifts, and offered a possible estate tax discount. Case Study 2. The second case involves an 80year-old real estate developer with a second wife and three adult children from a previous marriage. The client owns undeveloped land and income-producing properties with a value of $8 million. He needs a dependable income stream from his income-producing properties to cover his living expenses. No children are involved in the business, and one child is a “renegade.” Although the client is 80, he is active. I have tried to convince him to liquidate his holdings, but he will not do it. With an FLP, he can put his real estate in the partnership and act as the managing

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general partner and get an income steam from the partnership. So, he can give equity away without completely gutting his income stream. As for the renegade child, a major goal was to keep him separate from the rest of the family. An FLP is the best way to prevent one child from constantly challenging the other family members. Remember that a limited partner has no rights unless the general partner lies, cheats, or steals. This is not the case with a trust; a beneficiary of a trust has significant rights. If this client had established a trust with the second wife as the trustee, the renegade son could have sued her for breech of her fiduciary duty. He may not have prevailed, but he could have been a big nuisance. He cannot do that in a partnership. This client is now trying to decide who takes over when he dies. He views his life expectancy as 98, so he does not see why I am counseling him to wind down a little. He still must decide who will be the general partner upon his death. Is it his one son who has some interest, or is it his second wife? If he picks his second wife, it will anger the one son who is showing some interest in the business and will send the renegade son to put on war paint. It is a difficult decision, but the partnership agreement has been written to limit the renegade son’s ability to challenge the father’s ultimate decision. The FLP is also a good choice in this case because the client is more comfortable making gifts when he can continue to have some control over the assets represented by the gift. The benefits of the FLP in this instance are that it is a management vehicle in case of disability, it offers discounts for lifetime gifts, it facilitates gifting, it limits the ability of a renegade child to cause legal problems, and it ameliorates the problem of a “fire sale” of real property at the donor’s death. The FLP also allows for separate property to be bequeathed to the spouse and children, and the donor can retain control of the assets in the FLP. Case Study 3. The third case study presents a totally different example—the dream clients. The clients are a 50-year-old married man and woman with a $25 million high-basis portfolio of marketable securities that are blue-chip all the way. The couple has two unmarried adult daughters and significant charitable inclinations. They are considering an FLP because they are wary of their daughters becoming too rich too quickly. They want a vehicle to pass some of the wealth to the children but one that allows the children to grow into their responsibilities for the wealth. They want to include them in the partnership meetings, and they plan to let the children have a say in investment diversification. But if the children exercise poor judgment, the parents will retain ultimate control over the assets. 2001, AIMR®

Family Limited Partnerships The main issue the couple must address is that neither of their daughters is married at this point, but they will probably get married and have children within the next 5–10 years. Parents do not like to plan on their children marrying louses, but when the divorce rate is 50 percent, they need to ensure they do not learn this lesson the hard way. Another issue is that if they give their daughters money—$20,000 a year in securities to each daughter—they are splitting up this nice, big portfolio, which is really the family mutual fund. They have inherited all of these securities relatively recently, so they can diversify or liquidate them because the tax consequences are minimal. With $25 million, a lot of clever investments can be made. If each daughter gets $20,000 a year ($10,000 from each parent), the daughters are limited to putting the money into a real mutual fund, while mom and dad with the large pool of assets have many more opportunities. The FLP allows the assets to grow with less interruption, and it may also help control management and investment fees. Therefore, the benefits of the FLP in this case are that it provides a greater measure of creditor protection from their children’s future spouses. It also allows for gift and estate tax discounts, controls the amount of liquid wealth being transferred to the children, and allows for unified investment management and fees. Case Study 4. The fourth case involves a married couple in their late 60s. Their principal asset is the family farm, which includes timberland and cattle with a value of $5 million. Additional assets include $750,000 in closely held bank stock with many restrictions. Thus, the couple has no liquid assets. The husband is a practicing physician but is in declining health. They have three married children and seven grandchildren. They cannot give away the bank stock easily on an annual basis. Valuing it is an issue, and actually getting the permission to gift it is an issue. They cannot give away pieces of their farm without incurring great costs to have it surveyed each year; thus, gifting a parcel worth $10,000 from the $5 million piece of property is too difficult. Therefore, the couple was not making gifts. These clients and I decided to put the bank stock and the farm in a partnership. Mom and dad receive a management fee. They cut timber to generate the management fee, which they had never done before, and the children are gradually being transferred the equity in the family assets. The grand-

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children also get equity in their name and have trusts that hold the partnership interests. Another issue is that the father is suffering from early onset dementia. He will be incompetent before he dies, and mom has always deferred to dad. The three children are very strong willed, so who is going to take over the management of the partnership? The decision they made at this point is that mom and the three children will do it, although I have counseled them that I think that is a powder keg. Their reasoning is that mom gets to see how the family dynamic works among the three children, and then she can make the leadership decision. In this case, the FLP provided liability protection, allowed mom and dad to make gifts when they could not have otherwise, provided a management vehicle, created discounts for lifetime gifts, and allowed a management fee to be generated.

Conclusion The four case studies may look similar on the surface, but they clearly show that FLPs serve different people in different ways. The big issue with FLPs is the potential challenge from the IRS, because the IRS is suspicious that the FLP is purely a mechanism to escape transfer taxes. The big unknown is what the U.S. Congress and President George W. Bush will do with the estate tax (whether it will be repealed).4 Consequently, it is a difficult time to counsel clients to make a large gift for which they may owe substantial gift tax; under new tax law, the tax might not be owed, but the U.S. Treasury will not be cutting a check to refund the tax paid on gifts made prior to any law change. And in President Bush’s quest to get his income tax program passed, the estate tax and gift tax may be his negotiating points, so there is significant uncertainty surrounding the ultimate resolution and its impact on wealthy individuals. On the other hand, any action regarding estate and gift tax may be delayed for a number of years, and even then there could be a multiyear phase-in. With so much uncertainty, wealthy individuals concerned with planning the transfer of their wealth may not be willing to accept the risk of an 8- or 10-year phase-in that could get repealed before it even kicked in. 4

Please see footnote 1.

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Invvestment Counseling for Private Clients III

Question and Answer Session Patricia M. Thompson Question: What options are available to “nontraditional” families with FLPs? Thompson: The advantage of being married is that there is no gift tax or transfer tax for gifts between spouses. If you are not legally married, you run smack dab into a gift tax, and you will really need the leverage that the FLP discount can give. The donor can give (to whomever he or she wants) a limited partner interest, but the donor will remain the general partner. A middle step is to give away a general partnership interest that is smaller than the one the donor has. So, at the end of the day, FLPs can be beneficial to nontraditional families because the nonfamily members can get a vote but the donor can always trump them. An alternative way of structuring an FLP is to start the partnership as a family with the children participating too. Typically, the children will have a lot less money to contribute than mom and dad do, but it adds a little heft to have them be partners from the beginning. FLPs are good planning vehicles, but keep in mind the disadvantages, such as the fact that once you put assets in an FLP, you cannot get them back. Question: What is your experience in gifting partnership units to a 501(c)3 or donor-advised fund? Thompson: Most charities, including foundations, do not want these partnerships anymore, unless it is a big gift, because they have to deal with a lot of paperwork. It is like giving them a savings bond that may not mature for 25 years and that they cannot cash. So, because of the recordkeeping

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and paperwork, I have had poor luck helping clients make limited partnership gifts to universities and hospitals. I have had better luck gifting to a church or synagogue that the client has a one-onone relationship with. In terms of donor-advised funds, if you have too much unrelated business income tax, it can be a problem. Most nonprofits do not want to get stuck with any tax liability. Your friendly church or synagogue or other religious institution is more likely to accept this possibility. Question: Can FLPs shelter assets in a bankruptcy proceeding? Thompson: Yes and no. I think FLPs provide some shelter, but the big issue with any sort of creditor claim—be it a bankruptcy proceeding or something else—is that you cannot put the asset in an FLP once there is an action pending, because then you have fraudulent conveyance. But say you put everything in a partnership and then hit hard times and file for bankruptcy. The only thing you have in this case to give creditors is an interest in your partnership, rather than the securities or the real estate, and partnership interests are not desirable. An FLP does not allow you to avoid creditors, but it may alter how much is paid to creditors. The general partner of the partnership can say to the creditors, “We are not making any distributions. You are stuck with the income tax on the partnership’s income, however.” In addition, the general partner can call the shots, and the creditor has no input. I think an FLP can be helpful but not if you are already in financial trouble.

Question: Based on your experience, what minimum level of aggregate family wealth is necessary to make FLPs cost effective? Thompson: The first thing is to figure out how much money the person needs or wants to live comfortably, because the last thing you want to do in a partnership is start to liquidate it. An FLP is like a lot of other securities: You want to buy (contribute assets) and hold. It looks terrible from an IRS perspective if every year mom and dad sell securities to get money for living expenses. The costs to create an FLP will be about $20,000—between legal fees, accounting fees, and appraisal fees. Typically, mom and dad can give their two children in one year about $40,000. With an FLP, they will be giving $40,000 of partnership units, but they are able to put $80,000 of underlying assets into the FLP to get the $40,000 gift because they are getting a 50 percent discount. The tax on that extra $40,000 gift, if they had not moved the assets into the FLP, would have been $20,000. So, with $80,000 in an FLP, it costs $20,000 to set it up, and in one year, they have saved $20,000 in tax. It is worth thinking about. The associated costs are uncertain. The legal fees today are not even the biggest unknown. The greatest unknown factor is the expense involved in appraising the assets destined for the FLP. Depending on what those assets are, appraising them can be difficult. The greatest influence on whether an FLP makes sense is the family’s situation and the assets it owns, not the dollar amount involved. ©2001, AIMR®

Family Limited Partnerships Question: Can the FLP hire minority partners for management tasks without IRS scrutiny? Thompson: Yes. With Georgia law, you can get the same discounts with an LLC as with an FLP. One family has real estate holdings that are varied and require management, and mom is looking for a

©2001, AIMR®

way to get the children a salary. So, instead of doing an FLP, we will do an FLLC (family limited liability company). But either way, the general partner is authorized to hire agents and pay them reasonable compensation. What I do not think you can do is pay the limited partner $45,000 to come to one meeting. The only caveat is that the payment

is earned income. The payment is subject to withholding and payroll taxes. So, paying a limited partner out of the partnership may be a fairly expensive way to get that person some money. It might be simpler to increase that person’s limited partnership interest.

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The Future of Private Client Management David F. Lamere President Mellon Private Asset Management Boston

The recent growth in demand for private client services, coupled with a lack of supply, bodes well for the private client asset management industry. Private client firms will only be successful, however, as long as the firms’ managers keep pace with the relentless industry changes that threaten the ever-important factor of market share. The strategies that worked in the past—for both small and large firms—are not likely to work in the future. Only those firms that develop management and marketing strategies that emphasize investment expertise, client focus, asset growth, benefits of scale, and employee retention will be able to successfully compete for client assets in the future.

he future of private client management is bright, but the nature of the business is in flux. The shifting landscape of the private client business means that manager skills, firm tactics, and firm strategies will differ in the next few years from those of the past 5–10 years. The successful private client managers of tomorrow will be those who formulate strategies today that are responsive to the rapid developments and changes in the business—changes that are an inevitable part of the future of private client management. In this presentation, I offer my perspective on the future of private client management. I will begin with a few important points. First, the private asset management business is the best business in the financial services industry and will continue to be. Second, almost every firm associated with private asset management has grown over the past few years, which is good news. The bad news is that this growth has come as much from an imbalance between the supply and demand of private client services and a remarkably strong securities market as from the excellent efforts of private asset managers. Third, the tactics and strategies that have allowed firms to grow in recent years may not be the ones needed for firms to experience continued growth and success in the future. Shifts in demand and supply, coupled with an evolving client profile, will require private asset managers to change as well. And change is not easy for an individual or for an organization.

T

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I then discuss the specific challenges faced by small and large firms and how they can be overcome. I conclude that only by considering five key areas of improvement—investment expertise, client focus, growth, scale, and people—can private asset management firms ensure their future success.

The Best Business The private client market is huge, and it continues to experience tremendous growth. Few markets have grown as quickly—from $3 trillion in total assets in 1990 to a projected $14 trillion in 2004. In recent years, demand for private client management services has outstripped supply, and excellent opportunities have abounded within the industry. Most compelling is a comparison of the growth in the high-net-worth population (those families that have investable assets of greater than $1 million) with the growth in the total population. From 1997 to 1999, the number of high-net-worth families grew from 5.8 percent to nearly 17 percent of total households, while the growth in total households was down slightly (1.9 percent to 1.3 percent) over this period. This phenomenal growth in the number of wealthy families explains why the private client management business is in the bull’s eye of every financial services firm worldwide. In 1999, wealthy households numbered 3.3 million (or around 3 percent of the total U.S. population), yet these households generated 22.4 percent of the

2001, AIMR®

The Future of Private Client Management financial services industry’s revenue in the United States. There is simply a huge opportunity in the private client area of the investment management industry. In terms of revenue growth, asset growth, operating margin, and fees as a percentage of assets, the high-net-worth asset management business ranks at or near the top of potential opportunity when compared with the other financial services businesses. Couple this market opportunity with the fact that if private asset managers do a good job for clients, they are typically rewarded with great client loyalty. Some managers measure loyalty in terms of generations as opposed to years. Compare that longevity of client loyalty with that for equity mutual funds: A client with a portfolio of $5 million or greater remains an average of 8.6 years with his or her manager; the mean holding period for an investor in a U.S. equity mutual fund is 2.7 years. Private client managers clearly have an advantage in terms of client loyalty and retention. As a result, every investment management firm wants a piece of the private client business. Consider the number of firms either entering or expanding into the high-net-worth business over the past few years. The pace has been astonishing, and the increasing number of suppliers has created a significant market imbalance. Fragmented competition has been the result and can be construed as both good news and bad news. At Mellon Private Asset Management, I am often asked who I consider to be the competition, and my short answer is “everyone!” Every firm in the

country would love to have the franchise and the business relationships that many private asset managers have in their organizations. The traditional competition includes brokerage and investment firms, both large and small, and national trust companies. Financial planning firms (small, large, national, and regional) are also entering this market at a rapid pace. Another form of competition is coming from the online private client service providers. The icing on the cake is the proliferation of regional firms—brokers, banks, financial planning firms, and boutique money managers. Everybody wants in, and everybody can get in because the barriers to entry are low and the opportunity is high. The result is that no single firm, at least according to the market information I have seen, holds a double-digit market share in this business. That is the good news—and also the bad news for some firms. The players, in terms of who the top money managers are, have changed dramatically from 1990 to 2000, as shown in Table 1. The only money managers listed by Institutional Investor in the top 15 (by all assets under management, not just private client assets) in both 1990 and 2000 are Fidelity Investments, Merrill Lynch, J.P. Morgan (now J.P. Morgan Investment Management), and Mellon Bank (now Mellon Financial Corporation). American Express, which ranked at the top of the heap in 1990, would have had to grow 20–25 percent on a compound basis to hold on to that top position. Fidelity, creeping from fifth to first, grew at a compounded rate of 26 percent. The money management business has experienced a

Table 1. Top Money Managers, 1990 and 2000 1990 Money Manager

2000 Assets under Management

Money Manager Fidelity Investments

Assets under Management

American Express Co.

$157,172

Prudential Insurance

156,326

Barclays Global Investors

$955,986 782,600

Bankers Trust

114,769

State Street Global Advisors

672,376

Equitable Investment

110,282

Capital Group Companies

558,066

Fidelity Investments

108,835

Merrill Lynch & Co.

557,265

Merrill Lynch & Co.

100,694

Mellon Financial Corp.

463,641 462,672

Wells Fargo

92,797

Axa Financial

Metropolitan Life

89,364

Morgan Stanley Dean Witter

419,925

J.P. Morgan & Co.

81,432

Citigroup

419,222

TIAA-CREF

80,871

Putnam Investments

391,304

Aetna Life Insurance

77,320

Vanguard

375,041

Mellon Bank

68,090

UBS Asset Management

359,367

Sears, Roebuck & Co.

62,405

J.P. Morgan Investment Management

348,997

Kemper Financial

59,253

Amvescap

308,467

PNC Financial

51,808

Scudder Kemper Investments

298,385

Source: Based on data from Institutional Investor’s “Top 100 Money Managers,” July 1990 and July 2000.

©2001, AIMR®

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Investment Counseling for Private Clients III lot of growth and some consolidation, and it certainly operates in a very different environment from just 10 years ago. And 10 years out, I believe money managers will again see a different picture.

Market Growth The private client management business has recently seen dramatic growth; the question is why. Are the skills of private client managers the cause for that growth? Are brilliant strategy, innovation, and execution the reasons for the market growth? Or is it a matter of being in the right place at the right time— in the middle of a trend and an unbelievably strong market? And have the assets of private client firms simply grown, or have the firms actually been able to increase their market share? Asset growth and market share growth are completely separate issues.

Panel A of Figure 1 graphs U.S. bank-managed discretionary asset growth for the 1990–98 period. U.S. bank-managed asset growth of 16 percent appears strong at first glance; however, if the market appreciation is removed, the growth rate looks rather meager, about 6 percent for the eight-year period. That difference represents market share erosion on the part of U.S. banks. Panel B of Figure 1 presents the growth in U.S. discretionary personal trust assets for the same period. The figure shows that the deterioration is even worse in the personal trust business. When adjusted for market appreciation, personal trust asset growth over the past eight years has been negative. And banks should be worried. Research indicates that from 1993 to 1998, banks’ share of U.S. living trusts dropped from 60 percent to 35 percent. For the same period, the brokerage firms’ share of U.S. living trust assets rose

Figure 1. Asset Growth, 1990–98 A. U.S. Bank-Managed Discretionary Asset Growth

1990 = 100 500

400 With Market Appreciation

300

200 Without Market Appreciation

100

0 90

91

92

93

94

95

96

97

98

B. U.S. Discretionary Personal Trust Asset Growth

1990 = 100 200

With Market Appreciation

160

120

80 Without Market Appreciation

40

0 90

91

92

93

94

95

96

97

98

Source: Federal Financial Institutions Examination Council and VIP Forum analysis.

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2001, AIMR®

The Future of Private Client Management from 6 percent to 25 percent. Clearly, although assets under management are increasing, a changing of the guard is taking place in the management of those assets. Another tool to analyze recent market growth is the 1999 Corporate Executive Board study of assets. The U.S. and Canadian managers surveyed in this 1999 study reported a 23 percent total annual asset growth rate and a 13 percent private client asset growth rate, both of which appear to be respectable growth rates. But adjusted for the market appreciation embedded in those growth rates, private client asset growth was negative (–2 percent). Although this study may not reflect reality for the entire industry, the results are troublesome.

Supply and Demand The changing supply and demand picture for the private client management business means that the party could be over for some managers. Given this dour projection, it is important to consider where the private client management industry is in its life cycle. Throughout the 1990s, the demand for private client asset management significantly outstripped the supply of firms. A commonly cited statistic is that half of the people who are eligible for and want a professional money management relationship do not have one. In the past, the most crucial part of a private client manager’s sales strategy was simply to make the initial contact with the potential client because in some cases no competition existed for that client’s business. At Mellon Private Asset Management, we frequently have closed significant pieces of new business with zero competition. In such situations, it is obvious that demand and supply are significantly out of balance. But the increasing number of new managers in the market suggests that the supply of private client managers will equal the demand for their services in the not-too-distant future. The private client business, like any business, is characterized by the typical product life cycle. In the beginning of an industry’s or product’s life cycle, everyone wants in. In this introductory period, high risk, high margins, and low price elasticity are prevalent. The growth stage that follows is characterized by low barriers to entry, an easily replicable product, and increased price elasticity. An influx of supply usually occurs throughout the growth stage, but then the number of suppliers in the industry begins to dwindle, even though demand may not have slowed. The maturity stage is characterized by market fragmentation, the fight for brand recognition, and lower profits and margins. Consolidation then occurs, which leads to the final stage—decline. ©2001, AIMR®

The private asset management industry is probably closer to the top, or maturity stage, of the industry life cycle than to the bottom, or introductory stage. Consider some related indicators. In 1980, 119 mutual fund complexes existed; today, there are more than 400. In the late 1980s and early 1990s, 2,000–2,300 financial planners were in business; now, 10 times that number are in operation. Clearly, the industry cannot continue with this pattern of growth. So, if the private client asset management business is truly in the maturity stage, managers must start thinking about their business strategies in light of this predicament. Outwit, outplay, outlast—managers need to think more about those concepts, as well as their personnel and organizational strategies, than they have in the past.

How Great Firms Survive How will firms not only survive but also excel, grabbing market share when the markets are weak and when demand for private client asset management services no longer exceeds supply? In the past, survival in the private asset management business might have centered on a set of basic investment products, or perhaps the firm had what would be described as a “hot dot”—a specific investment or planning capability that attracted clients. The firm also may have generated pretty good returns, and the client through a certain degree of inertia was lax to break away. Or maybe the firm provided excellent service, which everyone knows can make up for a lot of sins. The firm might also have been the only game in town. Or finally, the firm may have survived because of word of mouth: Existing clients can be a firm’s best source of new clients. Although those tactics may have meant success in the past, in the future, firms will need to innovate and execute in order to survive and thrive. Firms can choose either innovation or execution to survive, but they must choose both to excel. General Electric Company is a prime example of a company that has innovated and executed far more effectively than most of its competitors. Think about innovation. GE has made often unpopular decisions to divest traditional businesses or acquire businesses not logically in its product mix. For example, GE divested the housewares division, which was more aligned with the traditional GE model, and acquired companies such as NBC, which is not at all a traditional GE business. Today, two-thirds of GE’s revenues and profits come from businesses that were not in existence 15 or 16 years ago. GE has embraced change in many ways. But more important, it has also adopted a strategy that revolves around its people. GE’s core strategy is not as much about a particular business as

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Investment Counseling for Private Clients III it is about people. GE’s strategy centers on recruiting, retaining, motivating, and challenging people in a changing environment to devise better ideas than the competition’s. Accordingly, GE has out-executed most of its competitors. For example, GE’s Six-Sigma strategy embraces a highly disciplined process committed to producing and delivering near-perfect products and services. The objective of Six-Sigma is to get as close to zero defects as possible, which translates into more efficient use of time and materials, allowing those resources to be re-invested in other areas of the business. Although GE is in an entirely different industry from private client asset management, GE nevertheless serves as a great business model.

Table 2. Percentage of Respondents Indicating What Clients Want from Their Money Managers Category/Item

Respondents

Investment returns and expertise Consistently high returns

71%

Wide range of investment services

45

Investment know-how

27

Investment powerhouse

18

Relationship/advice Solutions

56

Trusted advisor

54

Expertise in managing client finances

48

Staff members who understand client needs

41

Immediate response

37

The Private Client Today

Staff who get the job done

34

Over the years, the typical private client has changed. To excel in the future, private client asset management firms must first acknowledge this evolution and then address it. I believe that the ways private asset managers need to change are already outlined in the minds of clients. The new client of today is very different from the client of 10 years ago. Consider the sources of clients’ wealth today. Inheritance is no longer a significant source of client wealth, as it was 10 years ago. Instead, employer equity, investment returns, earned income, and entrepreneurial business success are the major sources of wealth. As a result, clients’ expectations of the services provided by private asset managers have changed. Consider this statistic: Two-thirds of the people on the Forbes 400 list of the wealthiest individuals in the United States are self-made. This situation is exactly the inverse of what it was 15 years ago. The most significant effect of that development has been how clients think about their investment strategy. Many still seek advice from their provider, but they are much more involved than in years past. How many clients browbeat their managers 18 months ago to load their portfolios with technology stocks only to have their managers dump those technology stocks when the market went south? Client anger or frustration with the investment process certainly existed 10 or 12 years ago, but today, that anger and frustration is accompanied by starkly precise questions and an increased level of involvement in the entire decision-making process. Table 2 depicts what clients today want from their investment managers. The most important areas of interest are investment-related issues. Clients want high returns, period. They want a range of investment management capabilities and people with investment know-how. In total, however, the qualities related to

Special products

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Product expertise

21

International capabilities

17

Latest technology

15

New product development leader

9

Fast response when arranging complex deals

7

Source: 1997 VIP Forum Buyer Value Study.

creating a relationship and giving advice are just as critical. By contrast, specialized products and technology are of significantly less importance. The end result is that clients’ expectations of their managers have changed significantly over the past decade. Clients now are result oriented and result driven. These are people who have made their own money, and they expect their managers to be as smart and as hard working as they are. They expect to be “best in class” in everything they do, and they expect the same from their managers. Although these clients are smart, they still need help. They know they are not experts in investment management issues and need to depend on the investment manager’s expertise. Clients seek a proactive relationship with their managers. Relying just on the annual meeting and the quarterly telephone call for information is a relic of the past. Most managers now have almost weekly communication with clients, and the communication is expected to be manager initiated. In some cases, managers e-mail their clients daily. Nothing frustrates clients more than having to ask for something, rather than having their need anticipated by the portfolio manager. Clients are also much less loyal than they have been in the past. They are more willing today to fire their managers and will be even more so in the future. 2001, AIMR®

The Future of Private Client Management

Imperatives for Private Client Management

perspective is a major issue: Which business should the firm pursue and how?

In the past 12–15 months, I have had discussions with probably 60 firms that have come to Mellon Private Asset Management to talk about strategy, the future, and the tone of the industry—essentially, the challenges they are facing. In some cases, these are acquisition discussions; in other cases, they are partnering discussions. The challenges that confront firms may differ for small and large firms, but they all involve making strategic decisions about the future.

Summary. These challenges, although different for small and large firms, involve making strategic decisions about the future. There is no one correct strategy. The salient point is that private client managers must think about the future and their role in the industry over the ensuing years.

Small Firms. Small firms face the following six distinct challenges. • Distribution: They have insufficient distribution channels, and they are either unable or unwilling to make the necessary investment to improve them. • Product breadth: They lack product breadth, particularly in such areas as alternative assets. • Resources and expertise: They are limited in the resources and expertise that are needed to satisfy increasingly demanding and sophisticated clients. • Technology investments: They often do not have the resources to make an investment in technology on a comparable basis with competitors. • Succession plan: They often do not have a succession plan but recognize the need to devise one as the owners, founders, or other key people approach retirement or move on for another reason. • Brand: They frequently do not have strong brand recognition but acknowledge that branding is important and frequently crucial to continued success. Large Firms. Big firms face just as many challenges as small firms, and in some cases, they can be more difficult to resolve. The client relationship poses a huge challenge for a large organization. Manager turnover, for instance, presents a problem when clients meet the third portfolio manager on their account in an 18-month period. Therefore, employee retention is vital for large firms as they try to maintain a solid relationship with their clients. Replicability of the investment process and manager performance is another challenge. A firm cannot market Manager A’s impressive investment performance but give the client Manager B, whose performance for an extended period has not been comparable to that of Manager A. Tax management in investment decision making is another important issue. Finally, the central focus of the firm from a marketing and servicing ©2001, AIMR®

Areas of Improvement Because there is no “right” strategy for addressing the competitive challenges a firm faces, each firm must make its own decision regarding what strategy to adopt. In deciding, the firm should consider the following five areas: investment expertise, client focus, growth, scale, and people. Investment Expertise. The first thing that draws clients to a firm is investment expertise, but expertise is a broader concept than just good performance in a single asset class. What often goes unsaid is that a repeatable, understandable process and philosophy are as important as good results. But if managers are underperforming the benchmark, they can only explain their investment philosophy and process just so many times before clients become dissatisfied. The bottom line is that clients demand consistent, strong performance. Asset class capabilities is another facet of investment expertise that a firm needs to offer clients. A firm does not necessarily have to have its own expertise in all asset classes, but it must have access to those capabilities. Replicability of performance, tax efficiency, and sophistication are also important, as are new ideas. A firm should continue to offer new products, such as private equity and hedge fund investing, to its clients. The firm does not need to manufacture these capabilities but must have access to them. Without such access, competing firms will gladly provide them, gaining a competitive advantage. Another important area of investment expertise is total “wealth management.” No two words are more overused in the lexicon of this business, and they mean something different to everyone. Tax efficiency is a primary aspect of wealth management. Furthermore, in contrast to the need for broad asset class expertise is the need for asset-specific expertise— expertise in stock options, executive compensation, concentrated wealth, and charitable giving. A firm must be able to articulate and offer these strategies to clients or a competing firm will. Providing executive compensation expertise is a good example of how a firm can retain clients. Five years ago, 60 percent of executive compensation was in cash, almost the opposite of the situation today;

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Investment Counseling for Private Clients III 23 percent of executive compensation is now in the form of cash—basically salary and bonuses; 75 percent is noncash. If a firm does not have a strategy to help clients go from noncash compensation to a cash position, its managers will not be able to invest and diversify for the client, which poses a real problem. The firms that have figured out how to help clients get from that noncash compensation to liquidity are the ones that have captured a significant amount of the new business generated by private clients who have earned, rather than inherited, their wealth. Because of the fantastic market performance experienced in recent years, many people have a lot of new wealth to manage. Wealth protection and transfer are key components of wealth management, as are charitable giving and advice. More clients than ever before are wrestling with charitable giving for the first time. It is an area where manager expertise can add value. Thus, expertise in terms of investments and wealth management is critical to a firm’s future success. Client Focus. A second concern for firms is their client focus. A firm cannot create a relationship with its clients and simply offer advice. The firm must be proactive, earn clients’ trust, and have intelligent managers who not only give advice but also are accountable for and consistent in their investment performance. So, how does a firm develop and market these intangible qualities and then differentiate itself from those firms that do not? If a firm’s relationship managers do not possess these skills and attributes, they are unlikely to assume the role of key advisor to their clients. And the goal is to be that key advisor—whether from a planning, money management, wealth management, or tax standpoint. A manager wants his or her phone to be the one that rings when a client has a question or needs advice. One of the ways firms such as Mellon Private Asset Management have promoted a client focus is by creating a “web” around the people who have direct contact with the client—the portfolio manager and the team of people who support the portfolio manager. Mellon then develops the expertise of the respective support areas for these teams. Small firms can also create a web of expertise by accessing it externally. A firm needs a web of experts because, realistically, one person cannot ensure the necessary breadth and depth of investment knowledge. Ultimately, all clients want the power of a big organization, but they want the organization to feel small on a relationship basis; achieving this small firm feeling in a big firm is not easy. Technology has significantly changed how private asset managers do business; however, managers cannot ignore both the opportunities and the risks

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that it presents. Technology can be useful in product distribution, branding, and advice delivery. But technology presents a challenge in the transparency it brings to the investment process and the information overload that results. Technology has also made immediacy an issue. On Mellon Private Asset Management’s Web site, for example, our clients can see their portfolios as of the night before, which has both positive and negative implications. Technology has forced managers to be on top of their game on a daily basis. It has a huge capability to commoditize what managers do, thus making managers just one more provider in a basket of services. Finally, technology raises challenges with profits because it is expensive. Statistics support these assertions. A survey by Forrester Research in February 1999 shows that wealthy households primarily use the Internet for information gathering and, to a much lesser degree, for advice and transactions. Only 20 percent of respondents (wealthy households) said they seek financial guidance on the Internet, and only 12 percent claimed to trade stocks online. Wealthy households will likely continue to use online sources for information delivery and will increase their use of online sources for transactions in the future, but I do not believe online advice will replace personal advice; rather, I see online advice as a means to augment personal advice. Most investment management clients want both online and offline channels of communication, so managers have little choice but to offer clients both delivery methods. Moreover, having only a well-developed, sophisticated Web site without an interactive method of communication is not sufficient. When strategizing about the future, client communication should be a priority. G r o w t h . Growth revolves around the concept of branding, even though branding is usually associated with such companies as Procter & Gamble, not the private asset management business. Yet in the 2000 VIP Forum Affluent Survey, about 55 percent of those surveyed said brand was a very important component in their decision to choose an investment manager. Brand is what a firm represents in the public’s mind. In the past four years, the rate of growth in brand spending has been phenomenal. The question is: How can those managers at smaller firms compete with the kind of brand spending done by larger firms? Table 3 shows the critical attributes of branding in the private client industry and their relative importance. Returns are at the top of the list, followed by fees and service. Note that years in business outranks product, technical sophistication, and firm prestige. So, both years of service and reputation can be important components of building brand recognition. 2001, AIMR®

The Future of Private Client Management Table 3. Relative Importance of Brand Attributes Item

Percentage

Returns

49.5%

Fees

35.9

Service

30.4

Years in business

24.1

Product

20.1

Technical sophistication

17.5

Firm’s prestige

16.1

Source: Corporate Executive Board 2000.

One of the most important and frequently missing strategies in many private client businesses is a distribution strategy. A well thought out distribution strategy is essential. Firms cannot rely on old ways of doing business if they are to grow their asset and client base. Private clients are acquired by successfully selling them a service. A firm’s growth rate cannot be sustained by waiting for clients to come to it. Thus, a distribution strategy is needed. The distribution strategy can take several forms. If it relies only on client enrichments, the firm will probably be unable to compete in the market share game. A second option is direct sales. Direct sales are expensive, time consuming, and hard to manage but are hugely profitable. Once a firm comes to terms with the critical mass of a direct sales strategy, direct sales are the cheapest way to acquire new clients. But once this commitment to a salesforce is made, retention is absolutely critical for the investment to pay off. New asset growth that is attracted by a direct salesforce increases over time. A salesperson in place for less than 1 year can generate an average of $97,000 in new annualized revenue, but a direct salesperson in

place for more than 10 years can generate on average $645,000 in new annualized revenues. Direct sales is management intensive and can demand significant resources. A firm needs talented managers to be able to recruit, retain, motivate, and maintain salespeople in tenured positions. Establishing and maintaining a direct sales network requires substantial, repeated cash outlays. Nevertheless, firms must use direct sales. Competition is stiff for good salespeople, more so than for other professionals now in the private client area. Indirect selling is another form of distribution available to a firm. Indirect selling can range from making alliances with third parties that will partner with a smaller firm to establishing a distribution system via a wrap business. The goal of indirect selling is to attract the clients that a firm would not otherwise have been able to reach. Alliances and joint ventures offer promising avenues of increasing a firm’s distribution. Unfortunately, they are not always successful. Another way to increase distribution is through acquisitions of other investment management firms. Acquisitions will likely increase in the future, and eventually, through acquisition, the supply of private client managers will diminish in terms of raw numbers. Exhibit 1 shows acquisitions in the private client business from mid-1999 to 2000. Scale. Successfully acquiring expertise, fostering client focus, and resolving growth issues to garner additional assets under management can result in benefits of scale. But large size can be both an advantage and a disadvantage. A major advantage is that the firm can grow faster. Profit margins tend to be wider for larger firms because this is a leverageable business. Compare the statistics reported by

Exhibit 1. Private Asset Management Acquisition History, Mid-1999 to 2000 Year

©2001, AIMR®

Seller

Buyer

2000

The Trust Company of Washington

2000

Bel Air Investment Advisors

Mellon Financial Corporation State Street Corporation

2000

Reed, Conner & Birdwell

City National Corporation

2000

Fiduciary Trust Company International

Franklin Resources

2000

Glenwood Group

ED&F Man Group

2000

Brundage Story & Rose

Bessemer Trust Company

2000

Glynn Capital Management

Bessemer Trust Company

2000

Sanford C. Bernstein & Company

Alliance Capital Management

2000

Sand Hill Advisors

Boston Private Financial Holdings

2000

U.S. Trust Company

The Charles Schwab Corporation

1999

Global Asset Management

UBS

1999

Estabrook Capital Management

Bank of New York

1999

North Carolina Trust Company

U.S. Trust Company

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Investment Counseling for Private Clients III Investment Counseling’s Competitive Challenges 2000 survey, which shows an average profit margin of 23 percent for firms generating annualized revenue of less than $20 million versus a profit margin of 33 percent for firms generating annualized revenue of greater than $150 million. A higher margin on a higher base gives a firm the ability to reinvest in itself. By doing so, the firm’s product array can be broadened, technology investments can be more substantial, and management and selling capabilities can be enhanced. Disadvantages in firms of large size include, notably, replicability and strategic focus. Replicating investment returns in a large firm, however, is a less daunting task than replicating personalized service and nurturing long-standing client/officer relationships, for which high volume and high turnover are major challenges. In large firms with multiple business units, developing and executing a strategy around a specific and dynamic clientele can be difficult. People. The most critical strategy a firm can adopt deals with its plans to acquire and retain talented people. Firms can strive to achieve competitive returns, manage client relationships efficiently, understand client needs well, and generate competitive profit margins. But without the right people, all the effort placed in creating an excellent strategy is irrelevant. The supply of talented people is not large enough to feed the demand from investment firms. Consider the tasks a firm asks its professionals to do. A relationship manager must have financial expertise, investment acumen, unquestionable integrity, and the ability to provide wealth management advice

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of consistently high quality. In addition, the manager must be able to articulate his or her ideas and have a passion for what he or she does. Passion, in fact, distinguishes a good manager from a great one. In return, employers must offer relationship managers a competitive opportunity, both in terms of compensation and responsibilities, if they are to attract and retain good managers. The prospective manager first considers compensation, both financial and nonfinancial, but a commitment from the firm to support professional development and to provide the opportunity for direct contact with clients is also important. The firm–employee relationship must be a two-way street if the firm expects to be successful.

Conclusion Private asset management in the future will focus on the client–firm relationship and on the development of the professionals who deliver the firm’s capabilities through that relationship. All management firms will not be successful, at least not to the degree they have been in the past. Firms that embrace an innovative culture and execute their strategies flawlessly and consistently will be the future successes of the private client industry. This is a great business, and it will continue to thrive. But the factors that have cultivated growth historically will be less significant in the future and, in fact, could disappear altogether. Thus, private client investment managers and their firms need to develop and carry out a fine-tuned strategy. Private client managers need to embrace a willingness to change and to be flexible, because future success will not be achievable by relying on the strategies of the past.

2001, AIMR®

The Future of Private Client Management

Question and Answer Session David F. Lamere Question: How important is investment advice (e.g., asset allocation recommendations) versus product performance for high-networth clients?

Question: What do you think about having a portfolio manager with investment responsibilities as the relationship manager compared with a generalist in the firm?

Lamere: No capability is more important in attracting and retaining clients than investment performance. It is significantly more important in terms of acquiring clients than retaining clients. If a manager underperforms for a short period of time but is doing everything else well and has the trust and loyalty of the client, that client will most likely stick with that manager. But poor performance can no longer be excused by pointing to a philosophy and process.

Lamere: There is no one right way to manage the client relationship, but value lies more in execution than in strategy. At Mellon Private Asset Management, we have been significantly more successful when we have had an investment person running the relationship, not a generalist. Most clients want to talk to the person who knows what is going on, not to the person who’s going to get them to the person who knows what’s going on. Ultimately, most people want to interact with somebody who has specific skills.

Question: Do high-end clients (i.e., $10 million and up) want one firm to handle both their estate planning and investment management or would they rather use different firms for each product? Lamere: Significant assets are usually handled by multiple firms. Overwhelming evidence shows that the number of firms that people deal with is going up, not down. I do not think monopolizing the relationship is possible or advisable. Each firm needs to devise its own strategy. When something happens, a manager wants his or her firm to be the first firm called, even if it is to help a client pick another money manager in a different asset class. A manager wants to be central to the client relationship. Clients will most likely continue to use multiple providers, but the manager should be at the center of those multiple providers. ©2001, AIMR®

Question: What changes will a possible bear market bring about in client expectations of investment managers? Lamere: If we are in a bear market for any extended period of time, it will take awhile to sink into the typical client’s psyche. Expectations are so high right now on a long-term basis that many people are still in denial. I’ve recently encountered clients who ask when are we going to get through this and get back to the good old times of mid-teen returns. The crucial point is to communicate with clients during down periods and not avoid them. Question: What is your opinion of “open architecture?” Lamere: Open architecture (i.e., selling products of other firms) is a topic of much debate. First, I do not

necessarily think that what people want is open architecture. They want excellent architecture. To the extent that a firm does not have excellent capabilities, it needs to think about open architecture. To the extent that a firm has excellent capabilities, many clients are looking for advice. My own experience suggests that many firms offering open architecture are those that have struck alliances with other firms that compensate them well for that open architecture. Second, open architecture creates the challenge of when to hire and when to fire managers. It takes skill to know when to displace one organization with another in an open architecture environment. Yet a firm should not depend solely on its own capabilities and should align with organizations that can give it excellent choices. But I’m not sure the answer lies in having a potpourri of choices either; it is somewhere in the middle. Question: What emerging models appear most promising? Lamere: The winning model has not been created yet. Most people are still going to be comfortable doing business with an investment management firm, but firms must broaden their scope toward giving advice. No firm seems to have bridged that gap. Plenty of firms provide advice, and plenty provide investment management; if a firm can combine those two skills and enable its people to do both simultaneously, it has as good a chance of being successful as any other firm. Also, a high-technology component might appeal to some clients but probably not to the majority of clients.

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Investment Counseling for Private Clients III Question: What do you think about brokerage firms’ model of independence? Lamere: Can the broker model survive over a long-term period? The answer is yes—not necessarily for every client, but for a lot of clients. For example, 10 years ago, how many people would have raised their hands if I had asked them whether no-load funds were going to dominate the mutual fund business? It seemed obvious at that time that no one was going to pay the load to go through an advisor to buy mutual funds. Now, how-

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ever, they’re doing just that. Few firms that are not operated on a direct sales basis in the mutual fund business are attracting net flows. So, if the broker model can succeed with the advice component required by private clients, it will be a sustainable model. Question: How would you compare the business models needed to succeed for brokerage firms with those for banks and investment firms? Lamere: Each of them has different strengths and weaknesses. If

you consider that different firms are really good at different things, then one can see why a certain firm is successful and how it can be more successful. For example, one of the huge strengths of a brokerage firm is its distribution strategy. Some brokerage firms have 10,000 brokers. Suppose that 90 percent of them can’t compete with my firm but 10 percent can. Such a firm has a 1,000-person distribution force, whereas in my firm, only 75 people sell full time. That is a huge imbalance; the brokerage firms have a huge leg up on the distribution side.

©2001, AIMR®