Executives Income Sources

Wealth and Income Sources for Public Company Executives

Public company executives and traditional wage earners have different sources of wealth and income. For instance, a CEO of a multinational corporation like Apple Inc. typically has a higher base salary as part of their compensation package, making their human capital usually much larger than that of traditional wage earners such as a school teacher. While the wealth magnitude for public company executives and private company executives can be similar, salary tends to be a larger component of human capital for public company executives. This is in contrast to private company owners like a local bakery owner who derive a larger proportion of their wealth from their equity stakes.

Bonus

Another source of income for executives is the annual performance-based bonuses. These bonuses are tied to the company’s financial results or individual performance metrics and can vary significantly from year to year. They typically represent a larger proportion of the source of wealth for public company executives than owners of private companies. The wealth manager should consider the variability of this uncertain income in cash flow planning.

Stock options and equity awards

Executive compensation refers to the remuneration package provided to top-level management in a company. It is a multifaceted structure that includes various forms of payment and benefits, designed to align the interests of executives with those of shareholders. This often involves elements of risk and reward.

For instance, a CEO might be granted stock options in Apple Inc., which become valuable if Apple’s stock price rises. However, this also exposes the executive to risk due to the concentrated position.

Deferred Compensation

Executives, like those at Google, may defer a portion of their income for tax planning purposes or to receive it in later years, often at a favorable tax rate. If this compensation is in the form of equity, it adds another layer of risk.

Retirement Plans

Executives at public companies like Amazon typically have access to generous retirement plans, pension plans, and other executive retirement benefits.

Perquisites (Perks)

Executives may receive various perks, such as company cars, club memberships, travel allowances, and other non-monetary benefits. The nature of these perks can influence the spending patterns of executives.

The nature of their source of wealth has implications for spending patterns of executives of publicly traded companies.

Variable Income

Executives may experience significant variations in their income due to the reliance on bonuses and stock options. This can lead to more cautious spending in years when bonuses are lower.

Wealth Accumulation

Executives may prioritize wealth accumulation through stock options and equity awards, with a focus on long-term financial goals and retirement planning.

High Fixed Costs

Executives may have high fixed costs associated with maintaining a certain lifestyle, including housing, education, and other expenses. This can make them more susceptible to economic downturns.

Managing Concentrated Positions for Professionals and Executives

Liquidity and Public Markets

The liquidity provided by public markets can potentially increase the sale price of equity and eliminate the need to find a potential buyer. This liquidity also removes discounts associated with lack of marketability. For instance, consider the case of a CEO of a tech company like Apple, who holds a significant amount of company shares. The liquidity of the public market allows them to sell their shares at a competitive price without the need to find a specific buyer.

Derivative Contracts and Hedging Strategies

Publicly traded equity often has liquid derivative contracts that use the public equity as an underlying instrument. This provides additional pricing transparency for hedging strategies and avoids the additional costs typically associated with executing economically similar transactions Over The Counter (OTC) through a dealer. Even if an executive chooses to use an OTC hedging instrument over a hedge constructed with publicly traded options, the availability of similar publicly traded derivatives allows dealers to hedge their positions much more easily. This improves transparency and generally improves pricing as a result.

Public Market Considerations

Constraints for Owners of Publicly Traded Concentrated Assets

Owners of publicly traded concentrated assets, such as a significant amount of shares in a single company like Amazon or Apple, often face additional constraints compared to owners of private companies. These constraints can include restrictions from selling stock due to a deferred compensation contract or regulatory provision. For instance, an executive might be unable to sell their shares until a certain date or event. Furthermore, owners may be required to disclose their intended trades publicly before or after the sale, which can impact the market’s reaction to the trade. The institutional and capital market environments can also limit the choice of methods that may be effective in dealing with concentrated positions.

Legal Considerations

The execution of any strategy is dependent on the governing law. The legal relationship among the owners of a business, whether it’s a partnership like KPMG or a corporation like Microsoft, depends on the type of entity being used, the laws governing that entity, and any required documentation or agreements.

Regulations for Company Insiders and Executives

Company insiders and executives must comply with numerous rules and regulations issued by governmental authorities. Like any investor, these individuals cannot trade on material, non-public information. They must also comply with certain notice and disclosure/reporting requirements. There may be specific limitations regarding the timing and volume of sales or hedging transactions.

Restrictions

Beyond legal restrictions, contractual restrictions such as initial public offering requiring “lockups,” and employer mandates and policies, such as a prohibition of trading during certain “blackout periods” can greatly restrict the flexibility of insiders and employees to either sell or hedge their shares. Private companies may require the equity holder to provide a right of first refusal to either the entity or to other equity investors.

Characteristics of Underlying Stock for Hedging Concentrated Positions

In the field of finance, hedging concentrated positions is a strategy used to manage risk. The effectiveness of this strategy is largely determined by certain characteristics of the underlying stock.

Ability to Borrow Shares

• The ability to borrow shares is a key characteristic. For instance, a dealer managing risk for a large tech company needs to borrow shares from the company and sell them in the market.
• However, if the shares are not restricted, tax authorities could view the transaction as a sale, leading to a tax liability.

Liquidity of the Stock

• Liquidity is another crucial characteristic. A dealer managing risk for a pharmaceutical company, for example, will need to adjust its hedge periodically, which requires a liquid stock.
• Dealers often avoid hedging techniques on recent IPOs like a new e-commerce startup until a trading history is established.

The Role of OTC Derivatives

Over-The-Counter (OTC) derivatives are financial contracts traded directly between two parties, outside of a formal exchange. For instance, an example could be a private agreement between two corporations to swap interest rates on a loan. The investor in an OTC derivative contract bears the credit risk of the single counterparty they contract with. This is unlike exchange-traded instruments where a clearinghouse, often owned and jointly backed by all its members, acts as the counterparty and guarantees the instrument, thus significantly reducing counterparty credit risk.

Exchange-traded instruments, such as futures contracts traded on the Chicago Mercantile Exchange, have the advantage of being closed out before their stated maturity by acquiring exactly offsetting positions with any market participant. Conversely, with OTC derivatives, the investor can negotiate an early termination of a contract, but the counterparty usually demands a significant concession for early termination. This cost can be offset by the cost of establishing an offsetting position with a third party, effectively creating an economically neutral position.

A key distinction between OTC derivatives and exchange-traded instruments is their pricing. Exchange-traded instruments provide robust price discovery due to their nature. In contrast, an OTC derivative is priced through negotiation with a single dealer. Therefore, fiduciaries and advisers should solicit, receive, and evaluate competing bids from several dealers to ensure reasonable price discovery. Standard derivative pricing models can provide a reasonableness benchmark for transaction prices, but liquid market pricing is always a valuable benchmark for transparency.

Exchange-Traded Transactions

Exchange-traded transactions are known for their high level of transparency, especially concerning fees and expenses. For instance, when purchasing shares of Apple Inc. on the New York Stock Exchange, all commissions and fees are clearly identified on trade tickets, trade confirmations, and monthly statements.

OTC Derivative Transactions

Unlike exchange-traded transactions, dealers have more flexibility in incorporating their fees into OTC derivative transactions. This is particularly evident in instruments such as prepaid variable forwards, where the collar and loan are combined into a single instrument, similar to a private agreement between two parties to trade Google Inc. shares at a future date.

Prepaid Variable Forward

A prepaid variable forward is a financial instrument that offers the asset owner an immediate cash payment without immediate tax consequences from a sale. For example, a large shareholder in Tesla Inc. could use this instrument to gain liquidity and hedge against price fluctuations without immediate tax implications. The contract outlines varied future delivery options, granting flexibility in deciding the number or value of shares to be delivered later.

Comparing Flexibility in OTC Derivatives vs Exchange-Traded Instruments

OTC derivatives offer investors maximum flexibility with respect to negotiating the custom terms and conditions of any transaction. For example, two parties could agree on specific terms for a swap contract involving Facebook Inc. shares. On the other hand, exchange-traded instruments are standardized contracts that do not offer investors the same degree of flexibility. However, exchange-traded instruments typically have a smaller minimum size than OTC derivatives, which have a minimum size that is typically around USD3 million.

Hedging Concentrated Exposures in Publicly Traded Companies

Publicly traded companies often utilize liquid derivative contracts that use their own equity as an underlying instrument. This approach offers more liquid hedging strategies and additional pricing transparency, circumventing the extra costs usually associated with executing similar transactions over-the-counter (OTC) through a dealer. The array of hedging and monetization options include short against the box, protective put, zero-cost collar, and covered call.

Short Against the Box

A short sale against the box position is a hedging strategy that involves shorting a security that is held long. For example, if an investor owns 100 shares of Apple Inc., they can establish a long position. By borrowing and selling an equal number of Apple’s shares, the investor creates a corresponding short position. As the investor is simultaneously long and short the same number of shares of the same stock, any future stock price change has no effect on the investor’s economic position, except for transaction costs. Any dividends or other distributions received on the long shares are passed through to the lender of the shares that were sold to open the short position. Because the long and short positions together constitute a riskless position, the investor will earn a money market rate of return on the position, effectively transforming the risky stock position into a riskless asset.

By itself, a short against the box is a risk-avoidance or risk-mitigation strategy. However, because the short sale against the box creates a riskless position, devoid of price risk, margin rules typically allow the investor to borrow with a high loan-to-value (LTV) ratio, commonly up to 99% of the stock’s value. The proceeds from the transaction often go into a diversified portfolio. The strategy’s net borrowing cost can remain low as long as there is an interest income offsetting the margin loan interest expenses. However, executing a short against the box typically triggers a taxable event, realizing any unrealized capital gains. This strategy is generally used when the cost basis is high and selling the position would lead to significant tax exposure that needs to be managed. Similarly, this transaction can be used when there is an unrealized loss in the concentrated position and it cannot serve any tax management objectives, such as selling the position to offset gains or other types of income that for tax reasons can be offset by a taxable loss.

Protective Put Strategy

The protective put strategy is a financial strategy that involves buying a put option while simultaneously owning the underlying stock. This strategy is commonly used in publicly traded stocks and their associated options, but it can also be negotiated privately in the Over-the-Counter (OTC) market. For instance, if an investor owns shares of Apple Inc. and fears a short-term drop in its stock price, they might purchase a put option to protect against potential losses.

Benefits of a Protective Put Strategy

• Establishes a minimum selling price for the stock over the term of the option, similar to an insurance policy’s deductible.
• Allows for unlimited profit potential if the stock price increases, much like owning the stock outright.
• Defers capital gains tax, as the put option can be held for a longer period.
• Retains dividend benefits and voting rights for the investor, as they still own the underlying stock.

Selection of Put Options

Investors typically select put options with strike prices at or just below the stock’s current market price. However, this strategy may have tax implications, and profits on the long put options are often taxed as capital gains.

Risk Transfer

The protective put strategy effectively transfers risk by guarding against losses from stock price declines below the put’s strike price. However, counterparty credit risk remains when such transactions are off-market or OTC.

Cost of the Put Option

The cost of the put option depends on several factors, including stock volatility, strike price, the risk-free rate, and the option’s time to maturity.

Put Option-Based Strategies

Put option-based strategies are investment strategies that involve the continuous renewal of options at their expiration. This is done to hedge an investor’s exposure. However, this continuous renewal process introduces a rollover risk, which can potentially expose an investor to losses that exceed the initial protection they purchased. For instance, if an investor purchases 12 options over a 12-month period, the extent of these losses can reach down to the strike prices on each option.

Strategies to Mitigate Out-of-Pocket Expenses

One appealing strategy is the combination of a long stock position with a long put position. However, the out-of-pocket expense necessary to acquire purchase puts can be significant. To mitigate these out-of-pocket expenses, investors can employ various strategies. For example, they can lower the strike price or shorten the maturity. Another strategy is put spreads, which partially offset the purchase of higher-strike puts by selling lower-strike puts with the same maturity. Lastly, investors can use knockout options, which are cheaper over-the-counter (OTC) “exotic” puts that cease to offer protection if the stock price rises past a certain point.

Zero-Cost (Cashless) Collar

The zero-cost collar, also known as a cashless collar, is a popular strategy used by investors to protect against potential losses in a stock’s price, while still allowing for potential gains. This strategy is particularly attractive as it does not require any initial outlay of cash. For instance, an investor in Apple Inc. might use a zero-cost collar to protect against a potential drop in the stock’s price, while still allowing for potential upside if the stock price increases. However, it’s important to note that tax authorities may view such strategies as a taxable event if the price exposure is too narrow.

Tax Considerations

There are several tax implications associated with zero-cost collars, particularly in relation to the treatment of option premiums on both long and short positions.

• For example, if an investor buys a put option on Tesla Inc. and the option expires worthless, the premium paid may be treated as a capital loss for tax purposes.
• If the option is exercised, the premium paid can increase the cost basis, thereby reducing the taxable gain on the Tesla stock.
• If the option is closed before expiration, the premium paid is often offset against the proceeds from closing the position, resulting in taxable ordinary income or a short-term capital gain.

Option Premiums Received on Short Positions

• If an investor sells a call option on Amazon Inc. and the option expires worthless, the premium received is often treated as taxable ordinary income or a short-term capital gain.
• If the option is exercised against the short party, the premium received can decrease the cost basis, thereby increasing the taxable gain on the Amazon stock.
• If the option is closed before expiration, the premium received is often offset against the cost of closing the position, resulting in taxable ordinary income or a short-term capital gain.

Dividend Taxation

The dividend taxation is essential for effective financial planning and investment strategy. For instance, in the United States, the taxation of dividends can be impacted by in-the-money or short-term call options (less than 30 days). In such cases, dividends may be taxed at the standard income rate instead of the more favorable qualified dividend rate. However, these rules can vary significantly across different jurisdictions.

Tax Efficient Structures

Tax efficient structures are designed to:

• Recognize taxable income and capital gains at relatively low tax rates. For example, long-term investments in stocks.
• Recognize tax-deductible expenses and capital losses at relatively high tax rates. For instance, losses from selling a property.
• Defer tax-associated income or capital gains, keeping the timing of pretax cash flow constant. An example could be retirement savings accounts.
• Accelerate deductions or capital losses as preferred, keeping the timing of pretax cash flow constant. This could be seen in the case of business expenses.

The tax profile of a hedging strategy can be compared to the long-term capital gain tax rate, which is often lower than the tax rate on short-term gains or ordinary income in many jurisdictions.

Tax Inefficient Scenarios

Some scenarios that may lead to tax inefficiency include:

• When premiums collected on a covered call position are taxed more heavily (e.g., ordinary income) when they expire worthless. For example, selling call options on a stock you own.
• When the option premium paid for a protective put increases the cost basis of the underlying stock, it reduces the taxable capital gain when the stock is ultimately sold. However, the tax benefit is deferred to when the stock is ultimately sold and does not necessarily match with the initial payment of the premium. This could be seen in the case of buying put options to protect against a drop in the price of a stock you own.
• When capital gains from closing positions are taxed more heavily than the long-term tax rate on the underlying stock. This could occur when selling a stock that has appreciated in value.

Sometimes the premiums received and paid on collar can be netted for tax purposes, making the transaction tax neutral.

Zero-Cost Collars

Zero-cost collars are investment strategies that investors and advisers often find appealing due to their potential for risk management and profit maximization. These strategies can be further optimized using various methods such as wider collars, put spreads, and debit collars.

• Wider Collar: For instance, in the case of Apple Inc., an investor might lower the put strike price to reduce its premium, allowing for the sale of a higher-strike call to fund the put. This strategy increases the upside potential but also expands the downside risk.

• Put Spread: Alternatively, a standard long put can be replaced with a put spread, which lowers the net cost of the long put cost by selling another put. This strategy exposes the investor to declines below the short put strike price, but it also offers greater upside by allowing the investor to increase the strike price on the short call.

• Debit Collar: Lastly, part of the put premium can be paid out of pocket to supplement a lower premium received from the sale of a higher-strike call for financing the net put cost. This strategy is known as a “debit” collar.

Covered Call

A covered call is a financial market strategy where the owner of a specific stock sells call options on the same stock to generate additional income. This strategy is typically employed when the owner anticipates that the stock will trade within a certain range for a foreseeable future.

Key Characteristics of a Covered Call

While often labeled as a hedging strategy, a covered call minimally guards against downside risk. It only offsets losses by the amount of the premium collected, at the cost of capping upside potential. A more accurate description of the covered call strategy would be a “yield enhancement” strategy as it allows the owner to generate additional income from the premiums collected from selling the call options. Using covered call writing can also serve as an alternative to structured selling for staged diversification. A key advantage of a covered call is that it can mentally prepare the owner for eventually selling the shares.

Equity Monetization Strategies without a Sale

Equity monetization is a financial strategy that allows investors to unlock the value of their stock holdings without selling their shares. This strategy is particularly beneficial for investors who have significant capital gains, face selling restrictions, want to maintain their voting rights, or require short-term liquidity. There are several equity monetization strategies, including:

Personal Line of Credit

A personal line of credit is a type of equity monetization strategy where the investor secures a loan using their company shares as collateral. This strategy allows the investor to avoid liquidating their equity and sidestep taxable events such as stock sales or dividends. However, this strategy assumes that there is a lender willing to accept the equity as collateral. The lender often has a “put” option, which allows them to sell the debt back to the company. This can be supported by the company’s existing credit facilities or a standby letter of credit. However, exercising this put option may result in a taxable event for the owner.

The loan can also be structured as a non-recourse loan, also known as a Lombard loan in private banking, where the equity itself serves as the collateral. Due to the volatility of equity, the collateral value usually exceeds the loan amount to ensure a safety margin. If the equity value falls below the loan amount at maturity, the owner can offer the shares instead of repaying the loan. Essentially, the owner has a put option on the equity, setting the loan value as the strike price and creating a synthetic protective put.

Loan Repayment and Control Retention

When a business owner takes a loan, such as a small business loan from a bank, they must repay it over time. However, the owner retains full control of the company and gains cash liquidity without incurring tax. The interest on the loan, like the interest on a mortgage, is generally tax deductible.

Risk Reduction and Reintroduction

If the loan proceeds are invested in a diversified equity portfolio, similar to investing in a mutual fund, non-systematic risk is reduced, possibly even eliminated, and total risk is reduced before considering leverage. However, the remaining systematic risk is leveraged, reintroducing risk and creating a trade-off. This is best considered a monetization tactic rather than a risk-reduction strategy.

Collateral and Loan-to-Value Ratios

Unlike hedged positions, the underlying collateral is risky, leading to lower Loan-to-Value (LTV) ratios, perhaps in the 30% to 60% range, similar to the LTV ratio on a home mortgage.

Monetization Process

The monetization process for the total return swap, equity forward, and synthetic equity forward consists of two steps:

1. Investors hedge a majority of their position’s risk. Hedging is straightforward for large, publicly traded companies with a robust derivatives market. It can be more challenging or costly for smaller or private companies, often requiring an Over-The-Counter (OTC) approach.
2. Investors secure a loan against the hedged position. For a successful loan transaction, a well-developed loan market is essential. Given the hedged position’s reduced risk, lenders often offer high LTV ratios. This assumes that the concentrated equity position—be it in a publicly held business or in financial instruments that may confer ownership in such a business—serves as viable collateral. Because the position is nearly risk free, the interest rate can be very close to the risk-free rate.

Risk Mitigation and Capital Gains Tax

If the loan proceeds are diversified into different investments, stock-specific risk is mitigated without incurring capital gains tax.

Total Return Equity Swap

A Total Return Equity Swap is a financial agreement between an investor and a counterparty, usually a bank. For instance, an investor with a large position in Apple Inc. shares can enter into a swap agreement with a bank. The investor pays the bank for any appreciation in Apple’s share price and receives payment for any depreciation, along with any dividends. The bank, in return, pays a fixed return linked to a reference rate plus any loss in share value. This arrangement fully hedges the investor’s position, as any loss on the Apple shares is offset by a gain on the swap.

Equity Forward Contract

An Equity Forward Contract is a commitment by an investor to sell shares to an institution at a predetermined price at a future date. For example, an investor holding Tesla Inc. shares can enter into a forward contract with a bank to sell the shares at a fixed price in the future. This locks in a guaranteed sale price for the shares, providing a hedge against potential price drops. However, if Tesla’s market price exceeds the forward price at contract expiration, the investor foregoes any potential gains above the forward price.

Synthetic Equity Forward

A synthetic equity forward is a financial instrument that offers an alternative to a privately negotiated Over-The-Counter (OTC) short forward contract for publicly traded companies. This instrument is constructed through a combination of a long put and a short call on the same asset, resulting in a payoff identical to that of a short forward.

For example, consider an investor who wishes to create a synthetic forward for Apple Inc. The investor buys puts and sells calls for Apple with a strike price of USD150, both expiring on the same date, covering 10,000 shares. This strategy, combined with the underlying stock, locks in a sale price of USD150 per share for the investor.

Since the synthetic forward creates a risk-free position, it should yield a money market rate of return. Given that the position in the shares of the company is fully hedged, a high Loan-To-Value (LTV) ratio monetization is attainable.

Key Strategies

There are four key strategies that can be achieved through synthetic equity forward. Firstly, a risk-free position is formed by initiating either a direct or synthetic short position that matches the number of shares owned long. Secondly, a money market rate of return is earned on the entire value of the long position. Thirdly, a high LTV borrowing ratio is feasible against the hedged position, which is similar to borrowing against a government bond. Fourthly, the cost of borrowing is substantially mitigated by the income generated from the hedged position. Lastly, the borrowed funds can be allocated to a diversified investment portfolio.

Tax-Free Exchange: Exchange Fund

The focus of this discussion is on the concept of a Tax-Free Exchange, specifically an exchange fund. An exchange fund is a financial tool that facilitates a tax-free exchange of a concentrated stock position for a diversified asset pool, thereby providing a tax-efficient method for diversifying a concentrated stock position.

For instance, consider a high-ranking executive at Apple Inc. who has a significant portion of their wealth tied up in Apple stocks. They can use an exchange fund to diversify their holdings without incurring immediate tax liabilities.

Working of an Exchange Fund

In an exchange fund, investors contribute low-cost basis stock to a partnership. In return, they acquire a proportional interest in a diversified pool of low-basis assets. This transaction is a non-taxable event, and each partner’s tax basis in the fund remains unchanged.

After a minimum holding period, typically seven years in the United States, distributions are made in the form of shares in the diversified portfolio. The gains from these shares are not taxed until the diversified shares are sold. If distributions are made before the minimum holding period, they generally return the original shares and incur substantial fees.

Limitations of Exchange Funds

Exchange funds come with certain limitations. Portfolio managers hold discretion over share acceptance and the composition of the share basket for withdrawals. At least 20% of the fund must comprise “qualified assets,” typically real estate investment trusts. The fund may be less diversified and could charge redemption fees for early exits.

Comparison with Sell-and-Diversify Strategy

Assuming identical returns between an exchange fund and a sell-and-diversify strategy, the final liquidation value is higher for the exchange fund due to the benefits of tax deferral. However, management fees can offset some of these advantages.

Choosing the Best Hedging Strategy

When devising an optimal hedging strategy, it’s essential to comprehend the tax characteristics of different types of shares. For instance, employees often receive compensation in the form of restricted company shares or employee stock options. These instruments are typically taxed differently from common shares held as long-term investment assets.

Restricted shares and employee stock options are often taxed as salary or bonus, which may have different tax rates than long-term capital gains. The tax attributes of the shares or other instruments being hedged can significantly influence the choice of hedging tool, legal structure, and documentation of the transaction.

Considerations for Athletes and Actors

The field of wealth management for athletes and actors presents unique challenges due to the specific human capital and financial dynamics associated with their careers. These individuals often experience short earning periods and early retirement, leading to a longer retirement phase compared to other professionals such as executives, professionals, or entrepreneurs.

Athletes

Athletes, for example, have relatively short but highly lucrative careers, necessitating early retirement planning and long-term financial stability. For instance, NBA players like LeBron James or NFL players like Tom Brady, typically retire in their mid-30s, with an average career span of 10 to 15 years.

Actors

Conversely, actors often spend their initial years establishing their careers with low-paying and competitive roles. For instance, actresses like Jennifer Lawrence or actors like Robert Downey Jr., often find it challenging to secure roles beyond their 40s and 50s.

A common challenge to both athletes and entertainers is to recognize that their high incomes are finite and that they will need to make it last throughout their retirement. Therefore, early and effective wealth management is crucial for these individuals to ensure financial stability in their retirement years.

Retirement Savings Rate for Professionals and Athletes

The retirement savings rate is a crucial aspect of financial planning. For most professionals, it is typically recommended to save between 10% and 15% of their annual income. This could be directed towards pensions or other retirement savings alternatives. However, professional athletes, who generally have shorter career spans, are advised to allocate a significantly larger portion of their annual earnings, between 50% and 75%, towards their long-term financial security.

This high savings rate serves two main purposes. Firstly, it helps to build a substantial financial cushion that can be used to address unexpected emergencies or disruptions. For instance, an athlete might sustain an injury that abruptly halts their career, resulting in a loss of income. Secondly, this high savings rate establishes a strong financial foundation for their retirement period, which is typically longer than that of professionals and executives.

It is also worth noting that young and successful athletes who experience “sudden wealth” and adopt an extravagant lifestyle often find the cost of maintaining such a lifestyle financially demanding. Once their incomes disappear, they can quickly deplete most, if not all, of their earnings.

Monte Carlo Simulations and Actuarial Retirement Spending Models

In wealth management, professionals often employ tools such as Monte Carlo simulations or actuarial retirement spending models. These are particularly useful when managing the finances of individuals with short but high-earning careers, such as athletes or entertainers. The models help calculate the spending capacity of these individuals while ensuring fund retention. They also assist in determining the amount of money required to maintain a specific lifestyle over a certain period.

Adjustments to Inputs

Adjustments to the inputs in these models often involve extending the actuarial time horizon over which spending must be maintained. This is particularly important for individuals like actors and athletes, whose income distribution is often more discontinuous compared to regular wage earners whose earnings are more evenly spread over time.

Challenges in Advising Athletes and Actors

Advising athletes and actors can be challenging due to their often limited financial literacy. This lack of understanding in areas such as finance, law, and taxes can lead to poor financial decisions, such as excessive credit use, lack of budgeting, uninformed investing, and neglecting emergency funds.

Exploitation of Athletes

Athletes, in particular, may be susceptible to exploitation by friends and family seeking loans or investments. This necessitates awareness, planning, and difficult conversations to protect their newfound wealth.

Practice Questions

Question 1: A wealth manager is working with a client who is an owner of a private company. The manager needs to understand the client’s sources of wealth and income, which are different from those of public company executives and traditional wage earners. The owner’s wealth is largely derived from their equity stake in the company. Compared to public company executives, who have a higher base salary and receive annual performance-based bonuses, what is the primary source of wealth for private company owners?

1. Base salary
2. Annual performance-based bonuses
3. Equity stakes

Answer: Choice C is correct.

The primary source of wealth for private company owners is their Equity Stakes in the company. Unlike public company executives who receive a higher base salary and annual performance-based bonuses, private company owners’ wealth is largely tied to the value of their equity in the company. This means that their wealth increases or decreases with the success or failure of the company. The equity stake represents the owner’s claim on the company’s assets and earnings. As the company grows and becomes more profitable, the value of the owner’s equity stake increases, leading to an increase in their wealth. This is why private company owners often reinvest a significant portion of their profits back into the company to fuel its growth and increase the value of their equity stake. It’s also worth noting that private company owners often have more control over their company’s operations and strategic direction, which can also influence the value of their equity stake.

Choice A is incorrect. While private company owners may draw a base salary from their company, it is typically not their primary source of wealth. The base salary is often modest, especially in the early stages of the company, and is used to cover living expenses. The majority of their wealth is derived from their equity stake in the company.

Choice B is incorrect. Annual performance-based bonuses are more common among public company executives and are typically not the primary source of wealth for private company owners. While private company owners may reward themselves with bonuses in profitable years, their primary source of wealth remains their equity stake in the company.

Question 2: A wealth manager is planning the cash flow for a client who is a public company executive. The manager needs to consider the variability of the client’s income, which can differ significantly from year to year due to annual performance-based bonuses. These bonuses are tied to the company’s financial results or individual performance metrics. What should the wealth manager consider in cash flow planning due to the uncertain nature of this income?

1. The client’s base salary
2. The client’s equity stakes
3. The variability of the client’s annual performance-based bonuses

Answer: Choice C is correct.

The wealth manager should consider the variability of the client’s annual performance-based bonuses in cash flow planning due to the uncertain nature of this income. Performance-based bonuses can fluctuate significantly from year to year, depending on the company’s financial results or individual performance metrics. This variability can create uncertainty in the client’s cash flow, which can impact the client’s ability to meet financial obligations and achieve financial goals. Therefore, the wealth manager needs to account for this variability in the cash flow planning process. This might involve creating a conservative cash flow plan that assumes a lower bonus amount, or setting aside a portion of the bonus in good years to cover potential shortfalls in future years. The wealth manager might also need to consider strategies to manage the tax implications of the variable bonus income.

Choice A is incorrect. While the client’s base salary is a stable source of income and should be included in cash flow planning, it does not address the issue of the variability of the client’s annual performance-based bonuses. The base salary is typically fixed and does not fluctuate from year to year like a performance-based bonus. Therefore, it does not account for the uncertain nature of the client’s income.

Choice B is incorrect. The client’s equity stakes can be a source of income, but they do not directly address the issue of the variability of the client’s annual performance-based bonuses. Equity stakes can provide income in the form of dividends or capital gains, but their value can also fluctuate based on the performance of the company and market conditions. Therefore, while they should be considered in cash flow planning, they do not directly address the issue of bonus variability.

Glossary

• Human Capital: The present value of all future labor income.
• Equity Stake: The proportion of a business owned by the holder of some shares of stock in a company.
• Executive Compensation: The remuneration package provided to top-level management in a company.
• Stock Options: A benefit in the form of an option given by a company to an employee to buy stock in the company at a discount or at a stated fixed price.
• Deferred Compensation: A portion of an employee’s pay that is held back and given to them at a later date, often at a favorable tax rate.
• Publicly Traded Equity: Shares of a company that are traded on a public exchange.
• Liquidity: The degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.
• Derivative Contracts: A financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, equity, or bond prices.
• Over The Counter (OTC): Trading of securities between two parties outside of an exchange.
• Publicly Traded Concentrated Assets: A significant amount of shares in a single publicly traded company.

Private Wealth Pathway Volume 2: Learning Module 6: Advising the Wealthy; LOS 6(d): Discuss and recommend appropriate private wealth management approaches that maximize the human capital, financial capital, and economic net worth of professionals, executives, and others