Comprehensive Wealth Planning
Comprehensive wealth planning, also known as integrated planning or wealth structuring, is a holistic approach to managing a client’s financial and business affairs. This approach is often used by high-net-worth individuals (HNWIs) with the aim of growing wealth for various personal and philanthropic purposes.
Key Principles of Comprehensive Wealth Planning
There are several key principles that underpin comprehensive wealth planning. These include:
- Legal Ownership: Establishing clear and unequivocal legal ownership and protection to safeguard wealth. For instance, a real estate mogul would ensure all properties are legally registered under his/her name or company.
- Tax Liabilities: The tax liabilities and obligations on wealth and income are dependent on the investor’s legal domicile. For example, a tech entrepreneur based in California would have different tax obligations compared to one based in Texas.
- Cost Minimization: Minimizing costs, including tax liabilities, to increase the growth of wealth. This could involve hiring a tax consultant to identify potential tax deductions and credits.
- Conflict Resolution: Proactively addressing potential conflicts within the family and between heirs and other stakeholders to mitigate the probability of squandering assets amidst disputes. This could involve setting up a family trust or drafting a will.
Goals-based Planning vs Integrated Planning
Goals-based planning focuses on asset allocation from a bottom-up perspective, while integrated planning takes a holistic view accounting for all assets, liabilities, and associated risks. For example, a goals-based plan might focus on saving for a child’s college education, while an integrated plan would consider the entire financial picture, including retirement savings, real estate investments, and business ventures.
Internally and Externally Managed Assets
For a thorough analysis, individual or family wealth is divided into internally and externally managed assets.
Internally Managed Assets
These consist of businesses in which the individual or family holds controlling or direct ownership, privately owned residential real estate, and other properties that generate value through the client’s activities. Human capital is an important component of internally managed assets. For example, a family-owned restaurant or a self-managed rental property would be considered internally managed assets.
Externally Managed Assets
These include financial and investment assets managed by a hired external manager, for which the client has determined that the manager can add more value than the client could. These instances may range from hiring a wealth manager to manage retirement assets to establishing a family office to oversee generational wealth and its management and transfer. For instance, a stock portfolio managed by a financial advisor would be an externally managed asset.
Internally Vs Externally managed assets
Understanding the difference between internally and externally managed assets is crucial for wealth creation and business success. Families need to identify which assets they can manage effectively and which need external help. The main risk in entrepreneurship comes from the potential loss of a key person affecting both the business and family wealth. Family risk is essentially key person risk. For example, if a family business is heavily reliant on the expertise of one family member, their sudden departure could pose a significant risk to the business and the family’s wealth.
When considering comprehensive wealth planning, there are several key questions that need to be addressed:
- What strategies does the family have for maintaining wealth?
- How reliant is the client on various asset types for income?
- Is the business easily sellable, and what risks are involved?
- Is the business dependent on a few key people?
- Is there a succession plan or need for external management?
Family Business as an Investment
When a family chooses to maintain ownership and operation of a business, it should be considered as a single-stock portfolio. This implies that it should be incorporated into the family’s comprehensive financial plan as an investment. Moreover, for family members who are actively involved in the business and receive compensation from it, the company should be recognized as a source of human capital.
Considerations for Selling the Family Business
However, if appointing a manager for the family business becomes challenging, the family might contemplate selling the business and distributing the proceeds among the family members. This approach is often beneficial when family members lack the interest, skills, experience, or aptitude to manage the family business.
Benefits of Selling the Family Business
When the family sells the business, it converts an illiquid and generally hard to value asset into liquid financial assets at a price the market is willing to bear. This liquidity event transforms previously illiquid internally controlled assets into more liquid assets, either in the form of cash or securities. In other words, it monetizes the human capital that the family has in the business.
Emotional Implications and External Expertise
However, this process often requires external expertise for accurate valuation, considering factors beyond physical assets, like brand and customer loyalty, that all converge around the owning family. Selling a business that has been in the family for generations can also have serious emotional implications on the family.
Opportunities from Liquidity
The liquidity from the sale enables the family to take on diverse investment opportunities and allows for portfolio diversification as well as funding other interests. This aligns individual financial goals and risk preferences, constraints, and personal values.
External Risk in Wealth Management
External risk in wealth management is a function of the external manager’s proficiency and performance, as well as the overall risk from external factors like economic fluctuations and market volatility. Both internally and externally managed assets carry legal, tax, and governance considerations. It’s essential to house assets in a legal entity that confirms ownership and management. In some scenarios, multiple legal entities may be created to manage a single client’s assets.
Consider a client transferring their business shares to a holding company where their children and other family members can own equal or varied stakes. While most legal systems allow such transactions, they can lead to complex tax and legal challenges. The best approach depends on several factors, including the asset size, legal frameworks, potential tax implications, and the client’s perception of their wealth and values.
Role of External Experts
Consulting external experts like tax attorneys may be necessary in such situations. It’s crucial that the client understands and accepts this structure. The wealth manager plays a pivotal role among several advisors for a successful transaction.
Asset Structuring
Asset structuring is a strategic approach that aims to optimize wealth from various financial holdings, including investments and business interests. It takes into account several factors such as the physical and legal locations of the assets, their ownership, beneficiaries, and control. The strategy also involves strategic asset transfers and protective measures to maximize value and mitigate obligations.
Determining the Legal and Physical Location of Assets
The legal location of an asset refers to the legal framework that governs its ownership. This involves determining who has direct ownership over the assets and whether the ownership is straightforward or more complex, involving entities like holding companies. For instance, consider a tech startup owner who directly owns all the assets of the business, or those assets could be owned by a separate legal entity like a corporation or partnership in which the startup owner owns shares. Adding another layer of complexity, those shares might themselves be owned by another company or set of companies, with the startup owner ultimately controlling ownership. The way ownership is structured directly affects the tax obligations for both the entity that holds the assets and the individuals or entities that own that holding entity.
Impact of Ownership Structure on Asset Value
The ownership structure, along with the physical and corporate location of the assets, plays a critical role in determining asset value. For example, a company like Apple choosing to incorporate in a jurisdiction with low corporate income tax but high capital gains tax can be beneficial if the owner does not consider asset sales or the sale of the business. Conversely, incorporating in a high income tax and low capital gains tax jurisdiction would mean higher income taxes but potentially lower taxes should the business sell assets, or if the business is sold by the owner. Thus, the choice of jurisdiction impacts not only day-to-day profitability but also long-term financial planning, particularly if asset sales are on the horizon.
Effect of Physical Location on Asset Value
An asset’s physical location can also affect its value. Real estate prices, for example, reflect geographical factors. Different jurisdictions have varying laws that can lead to various transfer taxes upon the sale or acquisition of assets including financial assets. Therefore, the location factors into both the immediate valuation of the asset and the tax implications tied to any potential future disposition.
Addressing Tax, Legal, and Other Obligations
Asset structuring is a strategy that enhances tax efficiency, legal protection, and clarity of ownership. For instance, a company like Apple Inc. uses a corporate structure to lower taxes and simplify the process of asset transfer.
Legal Compliance
Legal compliance is a critical aspect of asset structuring. This involves ensuring assets are transferred to future owners, like in the case of a family business, without altering the overall ownership structure.
Arms-Length Transactions
Arms-length transactions, such as the sale of a property between two unrelated parties, ensure fair pricing and competitive negotiations by operating solely in their self-interest.
Related-Party, Arms-Length Transactions
In related-party, arms-length transactions, a company and its owners or executives conduct a transaction on terms comparable to the open market. For example, a CEO selling his shares to a family member at market price.
Ownership of Business Shares
For entrepreneurs, the manner in which business shares are held is of utmost importance. Shares can either be directly owned, like Mark Zuckerberg’s ownership in Facebook, or held through intermediary holding companies.
Understanding Asset Ownership Structures and Tax Implications
Asset ownership structures can be complex, especially when dealing with entities like real estate or subsidiaries. It’s essential to keep detailed records of ownership, transactions, and finances to avoid legal ambiguities and potential tax consequences. For instance, Apple Inc. might own a subsidiary in a high-tax country like Germany, with two holding companies in a low-tax country like Ireland sharing the subsidiary’s ownership. If German tax rules state that a local company not wholly owned by a single foreign holding company incurs additional taxes, this could lead to an increased tax burden.
Mitigating Tax Liabilities
By consolidating the ownership of the foreign holding companies into one entity, it’s possible to reduce this additional tax burden, thereby lowering the corporation’s overall tax liability. This strategic financial decision requires a thorough evaluation of the business’s ownership structure and legal framework, often necessitating the assistance of legal, tax, and accounting advisors.
Risk Management and Asset Structuring
Risk management is a vital process that aims to safeguard asset values and income streams from unforeseen life events. It works hand in hand with asset structuring, which establishes the groundwork for assets from a legal, tax, and financial perspective. The primary tools of risk management are diverse insurance products that protect wealth, capital, and income.
Self-Insurance vs Purchased Insurance
One of the pivotal decisions in risk management is the choice between self-insurance and purchasing insurance. This decision involves evaluating the probability and impact of potential losses. For instance, a small business might opt for self-insurance for minor, predictable losses, but a large corporation might purchase insurance to cover unpredictable, substantial losses. When making insurance decisions, it’s crucial to balance the impact of potential losses against the value of the asset or income stream, as well as the combined value of all assets, including human capital.
Human Capital and Insurance
Human capital, which directly correlates with an individual’s earning capacity, is a unique and significant asset class. The two main risks associated with human capital are morbidity and mortality. For example, health insurance coverage can mitigate the effects of morbidity, health issues, and disability by providing compensation. Different types of life insurance, such as term life or whole life insurance, provide financial protection against mortality, ensuring financial security for dependents.
Public vs Private Insurance
In countries that offer public, state-provided, government-sponsored, or mandatory insurance against unemployment, health, and disability, the need to proactively secure coverages for such risks might not be warranted except for clients with high human capital or high net worth and inadequate public coverage. These clients should secure insurance coverage outside of the public system either through self-insurance or in the open market to maintain income generation capabilities, fulfilling familial and other financial responsibilities.
Understanding Behavioral Risks and Financial Implications
Behavioral risks, such as reckless driving or extreme sports, can have significant financial implications. For instance, a person who enjoys skydiving may face higher life insurance premiums. While securing insurance for such risks can be costly, it can help mitigate potential financial losses.
Property and Casualty Risks
Property and casualty risks encompass events like house fires, floods, or earthquakes, as well as legal risks from lawsuits. For example, a business owner might face a lawsuit for a customer’s injury on their premises. These risks can be mitigated through insurance and legal structures that limit exposure.
Personal Liability Insurance for High Net Worth Individuals (HNWIs)
HNWIs, due to their wealth, can be targets for lawsuits, legitimate or frivolous. For instance, a celebrity might face a defamation lawsuit. Personal liability insurance can provide a safety net for these individuals.
Legal Tools for Asset Protection
Legal tools, such as trusts or corporate structures, can protect assets from creditors lawfully. For example, a business owner might transfer assets to a separate legal entity to protect them from potential lawsuits.
Corporate Ownership Structures
Assets owned through corporate structures offer control and limited liability protection. For instance, a shareholder in a corporation is not personally liable for the corporation’s debts.
Trusts as an Asset Protection Approach
In legal systems recognizing trusts, they are often used for asset protection. However, in civil law systems, this approach is usually not recognized.
Moving Assets Offshore
Moving assets offshore can offer tax benefits and make it harder for creditors to seize assets. However, these transactions must be legally valid and properly reported.
Asset Structuring
Asset structuring is a strategic approach to wealth and investment allocation, designed to withstand fluctuations in the business and financial landscape. It aims to cater to immediate liquidity needs and long-term financial objectives. This becomes particularly crucial when a significant portion of a family’s wealth and human capital is tied up in a privately owned business, such as the Walton family’s ownership of Walmart, which consistently generates substantial cash flow and serves as the primary income source.
Challenges and Considerations in Asset Structuring
However, a potential issue arises when the family lacks investments outside the business, similar to the Walton family’s heavy reliance on Walmart. This could provide additional income should the primary source of income disappear, indicating an inherent lack of diversification. If the family accepts that their financial future is tied to a company (an internally controlled asset), the sustainability of the company for the lifetime of the family members, and perhaps even beyond, becomes a crucial consideration.
If the family does not accept that their financial future and wealth is tied up in the family business, the question becomes whether the family would consider selling the business and transform their illiquid wealth into liquid wealth or accept the risk of linking their wealth and human capital to an illiquid entity.
Role of Wealth Manager in Asset Structuring
The wealth manager can then devise strategies with the other assets to compensate for the unique risk exposures. Asset structuring is crucial in wealth management, especially for family businesses with concentrated, illiquid assets. Understanding different asset types, their locations, control mechanisms, and the benefits of legal entities helps maximize wealth and secure financial futures. However, given the intricacies involved, professional advice is often necessary to navigate the many considerations of asset structuring effectively.
Comprehensive Perspective on Internal and External Assets
In “The Aspirational Investor: Taming the Markets to Achieve Your Life’s Goals”, Ashvin B. Chhabra introduces a wealth allocation framework for clients with significant internally managed assets. This framework suggests the allocation of assets across three portfolios, considering both internally and externally managed assets.
Safety Portfolio
The Safety Portfolio is designed to meet non-discretionary spending demands with minimal risk. For instance, it could cover living expenses and other non-discretionary purchases over a short-term interval, such as five years. The portfolio is expected to generate relatively low, potentially below-market, returns, thus mitigating the risk of wealth loss. The target for this portfolio should be a zero real rate of return.
Market Portfolio
The Market Portfolio sustains long-term living standards and incorporates both discretionary and non-discretionary spending. It balances out capital needed to meet spending needs and provides capital appreciation to counterbalance potential inflation. Investments in this portfolio comprise a diversified selection of stocks and bonds in liquid markets. Historically, a globally diversified portfolio held for the long term suggests mid to high single-digit returns.
Aspirational Portfolio
The Aspirational Portfolio creates wealth by directing capital towards business ventures or investments that involve idiosyncratic — both market and individual — risk and the potential for significant gains or losses. This portfolio sits at the top of the wealth allocation framework and, depending on the size and source of the wealth, may be the single largest component.
Strategic Allocation
Asset management involves the strategic allocation of investments across various portfolios to achieve specific financial goals. This includes internally managed assets, market portfolios, and high-risk aspirational portfolios.
Internally Managed Assets
Assets like your own home, whether mortgaged or not, fall under the internally managed assets. This category also includes cash reserves and high-quality bonds, such as US Treasury bonds.
Market Portfolio
The market portfolio comprises traditional investments like stocks, bonds, and mutual funds, guided by the principles of modern portfolio theory.
High-Risk Aspirational Portfolio
Family-owned businesses and high-risk investments like venture capital and leveraged real estate holdings constitute the high-risk aspirational portfolio.
Wealth Allocation Framework
The wealth allocation framework focuses on maximizing the likelihood of achieving long-term goals rather than merely outperforming the market. Each portfolio’s progress is benchmarked separately to assess success.
Goals-Based Financial Planning Methodologies
Both the wealth allocation framework and goals-based financial planning methodologies stress the alignment of personal financial goals with suitable investment strategies.
Understanding Wealth Allocation and Goals-Based Frameworks
Both the Wealth Allocation Framework and the Goals-Based Framework are strategic tools designed to align financial goals with suitable investment strategies. They are particularly useful in wealth management, especially for affluent individuals with diverse financial priorities.
Personal and Safety Portfolio vs Non-Discretionary Lifestyle Spending Goals
For instance, the personal and safety portfolio of the wealth allocation framework corresponds to the non-discretionary lifestyle spending goals of the goals-based framework. These portfolios are designed to address essential personal needs and ensure financial security. An example could be a retired couple investing in low-risk bonds to secure a steady income stream.
Market Portfolio vs Discretionary Lifestyle Spending Goals
The discretionary lifestyle spending goals of the goals-based framework align with the market portfolio of the wealth allocation framework. This portfolio aims for broader market investments. For example, a young professional might invest in a diversified stock portfolio for potential growth.
Aspirational Portfolio
A significant difference exists in the aspirational portfolio of the wealth allocation framework. This portfolio not only merges philanthropic and dynastic goals from the goals-based approach but also uniquely accommodates family businesses and entrepreneurial activities. For instance, a business owner might include their private business as part of their overall portfolio.
Comparison with Behavioral Portfolio Framework
Unlike the behavioral portfolio framework, the wealth allocation framework avoids a rigid prioritization process. In this model, investment choices are directly tied to specific goals, closely aligning with those objectives.
Practice Questions
Question 1: A family business is considering the division of their wealth into internally and externally managed assets. They own several businesses, residential real estate, and other properties that generate value through their activities. They also have financial and investment assets that could potentially be managed by an external manager. Which of the following best describes the assets that would be considered as internally managed in this scenario?
- The financial and investment assets
- The businesses, residential real estate, and other properties
- Both the financial and investment assets and the businesses, residential real estate, and other properties
Answer: Choice B is correct.
The assets that would be considered as internally managed in this scenario are the businesses, residential real estate, and other properties. Internally managed assets are those that are managed by the owners themselves or by their employees. In the case of a family business, these would typically include the businesses they own and operate, as well as any real estate or other properties that they manage directly. These assets generate value through the activities of the business or through the rental or sale of properties. The management of these assets involves making decisions about how to operate the businesses or properties to maximize their value, and this management is typically done by the owners or their employees, rather than by an external manager.
Choice A is incorrect. The financial and investment assets are not considered as internally managed in this scenario. These assets are typically managed by an external manager, such as a financial advisor or investment manager, who makes decisions about how to invest the assets to achieve the best possible return. The management of these assets involves making decisions about which investments to make, and this management is typically done by a professional who has expertise in financial markets and investment strategies.
Choice C is incorrect. Both the financial and investment assets and the businesses, residential real estate, and other properties are not considered as internally managed in this scenario. While the family business does own and manage both types of assets, they are managed in different ways. The businesses, residential real estate, and other properties are managed internally, while the financial and investment assets are typically managed externally. Therefore, it is not accurate to say that both types of assets are internally managed.
Question 2: A family has been running a successful business for generations. However, the current generation lacks the interest and skills to manage the business. They are considering selling the business and distributing the proceeds among the family members. This strategy would transform the business, an illiquid and hard to value asset, into liquid financial assets. What is the primary advantage of this strategy for the family?
- It allows the family to retain ownership and operations of the company.
- It enables the family to take on diverse investment opportunities and allows for portfolio diversification as well as funding other interests.
- It ensures that the family business will continue to be managed by a family member.
Answer: Choice B is correct.
The primary advantage of selling the business and distributing the proceeds among the family members is that it enables the family to take on diverse investment opportunities and allows for portfolio diversification as well as funding other interests. This strategy transforms the business, an illiquid and hard to value asset, into liquid financial assets. The liquidity of financial assets allows the family to invest in a variety of different assets, thereby diversifying their investment portfolio and reducing risk. Additionally, the proceeds from the sale can be used to fund other interests or needs of the family members. This strategy also provides the family with the flexibility to invest in assets that align with their risk tolerance and investment objectives. Therefore, the primary advantage of this strategy is the increased liquidity and investment opportunities it provides.
Choice A is incorrect. Selling the business does not allow the family to retain ownership and operations of the company. In fact, it is the opposite. When the family sells the business, they relinquish ownership and control of the company. Therefore, this choice is not the primary advantage of the strategy for the family.
Choice C is incorrect. Selling the business does not ensure that the family business will continue to be managed by a family member. Once the business is sold, the new owners have the discretion to appoint whoever they deem fit to manage the business. Therefore, this choice is not the primary advantage of the strategy for the family.
Glossary
- Human capital: The skills, knowledge, and experience possessed by an individual or population, viewed in terms of their value or cost to an organization or country.
- Key person risk: The risk that a business would face if a key person in a company becomes unable to work.
- External risk: The risk associated with factors outside the control of the wealth manager, such as market volatility and economic fluctuations.
- Legal entity: A lawful organization that has a legal identity separate from its owners and can own property, enter into contracts, and sue or be sued.
- Asset structuring: A strategic approach to optimize wealth from various financial holdings.
- Legal location: The legal framework that governs asset ownership.
- Physical location: The geographical location of an asset which can affect its value.
- Ownership structure: The arrangement of who has direct ownership over the assets.
Private Wealth Pathway Volume 1: Learning Module 3: Wealth Planning;
LOS 3(b): Recommend and justify methods to manage a family’s financial exposures holistically across their lifetime and retirement