Each year, we send a letter to clients to help guide year-end planning discussions and to offer ideas for consideration with their other advisors. In our year-end discussions with clients, we aim to ensure that their plans are updated as needed, based on changing external conditions as well as their specific circumstances. Our goal, as always, is to stay on track to deliver the long-term outcomes that each client seeks.

There are issues and uncertainties to consider every year when revisiting one’s plans, but 2020 has been a uniquely challenging year on many fronts. The COVID-19 pandemic continues to loom as a dominant factor over every aspect of our lives, and while our concern is largely directed to those who have contracted the virus, and the health care and other front-line workers who are seeking to protect us, we are also very aware that the pandemic and its aftermath are likely to heavily impact capital markets and government policy decisions in the coming months and years. The pandemic has also had a profound impact on our communities and many of the non-profit organizations that are important to us and to our clients. Additionally, the recent U.S. presidential election season offered a wide range of potential scenarios for tax and other policy matters that impact our planning efforts for clients. While election results are not totally settled, we believe that the balance between parties in Congress is likely to temper both the pace and magnitude of possible tax law changes.

Many other factors—from growing concern regarding climate change, to uncertain trade relationships with China and other global competitors, to the potential for tax increases to grapple with rising deficits—are also contributing to an uncertain picture going forward.

Many of our clients have expressed concern about how to plan effectively with such an unclear horizon before us. In all honesty, we never really know what is coming around the corner, and today we don’t really know what will happen with COVID-19, or with the policy decisions that come out of Washington. We know that many clients are experiencing feelings of uncertainty right now that are more intense than normal—partly due to the unprecedented nature of the pandemic, partly because of the deep political and social divides in our country, and partly because of the emotional toll of the extended lockdown. But we need to remember that good planning never assumes the ability to predict what’s going to happen with capital markets, tax policy, or one’s own personal, family or business circumstances. We can only weigh probabilities, and take actions that position clients to do well in the context of their individual goals.

Thus, our task this year is to help clients consider their options, make wise choices and develop a sense of equanimity during a highly uncertain time. Some of that equanimity can come from consistency; our planning letters each year include a checklist of planning considerations, and that checklist is largely identical from year-to-year precisely because good planning requires a consistent, long-term approach. This checklist should be viewed as a starting guide for more tailored conversations between clients and their various advisors. Beyond that, our letter this year focuses on some key principles of planning that we believe are especially relevant during uncertain periods: filter out the noise, focus on what you can control, and take opportunistic steps toward long-term goals. If we keep these principles at the forefront of our decisions, we are confident that those decisions can continue to help our clients make progress toward their long-term goals.

FILTER OUT THE NOISE

Short-term crises create a lot of “background noise” that can be distracting and therefore detrimental to sound planning. We suggest filtering out that noise by focusing on long-term goals and objectives.

Start by identifying what matters most to you. We try to engage clients regularly on “big picture” questions, such as where they want to have the most impact, where their passions and beliefs lie, and what their most deeply held goals are. In this regard, we want clients to consider not just financial goals, but human, intellectual, and community-based goals. In some cases, our clients have found “working backward” to be a helpful exercise—first defining what they want their legacy to be, and then reordering their priorities accordingly.

For a growing number of clients, we find that sustainable investing is becoming an essential component of their long-term plans. The manner in which clients engage in sustainable investing varies greatly, with some clients seeking to start slowly and others looking to comprehensively and decisively revise their investment choices. In all cases, we begin the process with a “discovery” exercise to understand their values, beliefs, priorities and preferences in detail, so that we can help ensure any near-term implementation steps are fully aligned with a set of clearly stated and understood long-term goals.

Engage your broader family. One way to incorporate a long-term perspective is to plan across multiple family generations. Including all family members in the discussion, and allowing each family member to find their voice on a planning topic of their own passion/interest, tends to increase engagement and supports holistic planning. While financial plans should certainly play an important part in the discussions, it is often helpful to begin by focusing on issues of character, leadership, and stewardship, particularly when various family members bring to the table differing levels of experience and sophistication on all that is needed for a comprehensive planning dialogue. A helpful tool in organizing these family discussions is the development of a family mission statement and strategic plan that start with the purpose of preserving and growing their family capital. This may include outlining important values, philanthropic goals, next-generation education, wealth transfer planning, and sustainable and impact investing objectives.

Revisit estate planning and charitable structures. Once clients have identified their most important objectives, they can more effectively review their wills, trusts and family business structures to help ensure their objectives are being reflected appropriately. For example, do the dispositive provisions of the estate planning documents promote responsibility and positive stewardship among a client’s beneficiaries? Do these documents fully incorporate the client’s charitable intentions? Do the documents promote and enhance family unity and multi-generational planning? In this regard, it is especially important to update “family governance” arrangements with respect to family businesses, charitable entities and “legacy assets” (such as family vacation homes), to guard against the unintentional creation of conflict and to encourage a smooth transition of ownership and management.

FOCUS ON WHAT YOU CAN CONTROL

We cannot control external factors or exogenous threats, but we can seek to make our plans more durable to those factors by preparing for the unknown.

Start by positioning portfolios to address risk. When we think about investing our clients’ money, we use a “three-bucket” approach to broadly manage risk: an operating account of cash and cash equivalents, to provide stability and liquidity for near-term expenses; a core portfolio, which is invested across asset classes to pursue long-term investment goals (and to refill the operating account); and an opportunistic allocation, to take advantage of timely investment opportunities as they arise. Reviewing, and revising as necessary, the relative sizing of these three buckets can provide confidence that a client’s portfolio can ride through market volatility. In particular, we want each client’s operating account to be large enough to provide for spending needs and emotional peace, so that they can comfortably maintain their long-term investments without feeling the need to disrupt them.

Create confidence in one’s investment plan by developing a comprehensive financial plan. Good financial plans provide peace of mind and help bring our clients’ goals into focus by creating roadmaps for long-term financial success. The process starts with evaluating current financial circumstances and accounting for potential changes to income, portfolio performance and composition, and spending habits over time (inclusive of large funding goals for items such as retirement, second homes and large gifts to family or to charity). We model multiple possible outcomes based on varying capital-market assumptions and the impact of market volatility, to assess the probability of success in achieving a client’s financial goals. By “stress testing” these plans to understand potential outcomes from worst-case scenarios, we help clients develop confidence that their portfolios can withstand the shock of unforeseen events.

Plan for health care events and expenses. The current pandemic has refocused attention on the possibility of serious illness and incapacity. It is important to have appropriate health care proxies and advance directives; if a client becomes incapacitated, we want to ensure that someone has legal authority to manage their health care and specify their personal wishes with respect to end-of-life decisions. These documents are easy to prepare and can help clients and their families avoid the time and expense of a court-supervised guardianship. We also encourage clients to prepare financially for adverse health care events, by fully funding Health Savings Accounts, if available, and considering long-term care insurance options.

Prepare for the unexpected. A full year-end planning conversation would not be complete without a review of risk management plans. This can come in the form of liquidity needs for the expense of long term care, an unexpected death that interrupts income or wealth accumulation plans or even unforeseen liabilities. A review of insurance programs (and in some cases, a self-insurance analysis) and their ownership structure is an important part of a comprehensive and durable financial plan. It is also important to remember that “permanent” life insurance policies (whole life and universal life) have investment components which, like any other part of your portfolio, must be reviewed and assessed regularly to evaluate financial performance.

BE OPPORTUNISTIC WITH CURRENT PLANNING

Changes in public policy and the ups and downs of capital markets always offer a mix of planning opportunities and challenges. As we approach the end of 2020, we see a number of ways to act on current circumstances.

Higher wealth transfer tax exemptions and proactive gifting strategies. Currently, each U.S. taxpayer has a lifetime gift, estate, and generation-skipping transfer (GST) tax exemption of $10 million, indexed for inflation ($11.58 million in 2020; slated to increase to $11.7 million in 2021). That means an individual can make lifetime gifts to children and other family members of up to $11.58 million (or $23.16 million for a married couple) before incurring a gift-tax liability. Moreover, such gifts could be made to a “dynasty” trust, through the allocation of one’s GST exemption, thereby helping to protect the gifted assets from wealth-transfer taxes for multiple generations.

Our clients have had questions about the possible impact of the 2020 elections on these exemptions. Before the election, some observers predicted a significant decrease in lifetime exemptions in 2021—perhaps to $3.5 million per person—if Democrats won the White House and the Senate. While it appears fairly certain now that Joe Biden will become President in 2021 (notwithstanding potential legal challenges), the outcome of several Senate races remains in doubt, and control of the Senate hinges on those races. In our view, the prospect of divided government makes it less likely that significant tax law changes will occur in the near term. However, we believe clients should continue with proactive gifting strategies now, where consistent with their long-term objectives, for at least two reasons.

First, the individual provisions in the 2017 tax overhaul (which ushered in the current exemption amounts) are not permanent, and are set to expire at the end of 2025, just five years from now. A divided government today may mean these exemptions are safe for the moment, but there is no guarantee the exemptions won’t be reduced, or the sunset date won’t shift, as a result of future elections. The mid-term elections in 2022 could alter the balance of power again, perhaps leading to significant changes ahead of the 2025 sunset.

Second, regardless of tax policy, making lifetime gifts earlier vs. later can provide the added advantage of removing future income and appreciation of the gifted assets from the donor’s taxable estate, thereby making it possible to avoid estate taxation at the donor’s death (and if the gift is made to a dynasty trust, perhaps for many generations). Making gifts sooner can magnify that advantage. In the illustration below, we can see how a $10 million gift hypothetically shelters almost $14 million of appreciation, earned over 15 years, from estate taxes that otherwise would have been imposed upon the donor’s death.


EFFECTS OF REMOVING APPRECIATION FROM TAXABLE ESTATE

This example shows how the benefit of using one’s exemption early can compound over time. Here, $10 million was placed in a trust outside of a taxable estate, and over 15 years, these assets produced an additional $14 million in growth—also outside of the estate (assuming a 6% growth rate). If the grantor’s estate is eventually taxed at a 40% estate/gift tax rate, the action to place these assets outside the estate could produce estate tax savings of almost $5.6 million.

Source: Brown Advisory analysis.


Importantly, the size of the current exemption means that, in order to take maximum advantage, clients must make large gifts—as much as $23 million for a married couple. Many clients are uncomfortable or unwilling to commit that much capital irrevocably to younger generations, and we believe that personal financial security should always take precedence in these discussions. Accordingly, before embarking on a gifting strategy, clients should have a complete understanding of the size of their taxable estate, their potential tax liability, possible sources of liquidity, and the level of assets needed to maintain their lifestyle. If clients are seeking to take advantage of their exemption but have concerns about irrevocable gifts, there are some planning techniques (such as Spousal Lifetime Access Trusts and Delaware Asset Protection Trusts) that can allow clients continued access to the gifted assets.

HEDGING YOUR BETS: PLANNING WITH ONE SPOUSE’S EXEMPTION

A married couple can take advantage of current laws and lock in at least one spouse’s $11.58 million exemption, by having one spouse use his or her entire exemption to fund specific types of trusts.

This approach may make sense where a couple has more than $11 million of assets, but cannot give away more than one exemption amount without adversely affecting their lifestyle.

Spousal Lifetime Access Trust A SLAT is an irrevocable trust of which the grantor’s spouse is a beneficiary, along with his/her children and descendants. It allows a married couple access to assets gifted to the trust by way of making distributions to the beneficiary spouse. Both spouses can fund SLATs naming each other as beneficiary, so long as the reciprocal trust doctrine is avoided.
Delaware Asset Protection Trust A DAPT is somewhat similar to a SLAT, although it allows both the grantor and grantor’s spouse to be beneficiaries of the trust. It must be created in a jurisdiction (such as Delaware) that allows self-settled spendthrift trusts.

Source: Brown Advisory analysis.

In general, we would advise clients who were already planning to make 2020 year-end gifts, and are fully comfortable making those gifts, to move forward with their plans. The election results suggest that any downward adjustment in exemptions is unlikely to occur before the 2022 mid-term elections at the earliest, so clients have some breathing room to be thoughtful and deliberate about how best to utilize their exemptions. This additional time can be particularly important with strategies that involve complex trust and entity structures and/or multi-step transactions—such strategies typically require an extended period of time to properly execute, to minimize any risk of challenge by the IRS or state tax agencies.

Take advantage of equity market returns to “lock in” gains and further planning objectives. The significant gains earned by some equities and sectors this year may help enable several planning steps.

Use appreciated securities for gifts to charities. When using long-term appreciated securities for charitable gifting, charities receive the full fair market value of the gift while the donor receives an income tax deduction for that same value and avoids the tax on the capital gain that she would pay if she had sold the stock and made a gift of the proceeds to charity. An additional benefit is that the income tax deduction could be used to offset capital gains that the client realizes this year due to activity from portfolio rebalancing or increasing liquidity.

Review any current GRATs for opportunities to capture the gift value from recent appreciation. A popular strategy for transferring appreciation to the next generation in families with little or no gift tax exemption applied are Grantor Retained Annuity Trusts (GRATs). When the assets of a GRAT appreciate faster than today’s interest rates, the excess growth transfers to the remainder beneficiary (typically, a next generation family member or a trust for their benefit) at the end of the trust term.

These trusts usually allow the grantor to substitute assets, value for value, during the term of the trust. This allows for the opportunity to “freeze” the value of a GRAT that has experienced high appreciation, by substituting the higher-growth asset(s) in the trust with low volatility assets like cash or bonds. For example, if a GRAT was funded with $1 million in a technology stock in 2020 and it appreciated to $1.3 million during the term of the trust, the grantor could exchange the assets used to fund the GRAT with cash and fixed income from her personal portfolio during the term of the trust to preserve the implied gift of almost $300,000 to the next generation at little or no transfer tax cost. This helps protect against the possibility of the original funding asset declining in value before the end of the trust term.

Low interest rates and intra-family loans. Finally, clients should consider utilizing low interest rates to help achieve family financial goals. The interest rate on intra-family debt transactions (loans or installment sales of assets) is governed by Applicable Federal Rates (AFRs) set by the IRS, which have been at historically low levels for many months. For November 2020, AFRs (which differ depending on the term of the loan) range from 0.13% for short-term loans to 1.17% for long-term loans. Thus, clients can currently loan money to younger family members (or trusts for their benefit) at exceptionally low rates; those younger relatives can invest for long-term growth, and the older generation can receive a stable, fixed-income asset in their own estate. If the younger generation’s investment results outpace the AFR, there is a resulting wealth transfer benefit without any gift-tax consequences. Low interest rates also help improve the effectiveness of certain specialized gifting strategies, such as Charitable Lead Annuity Trusts and Grantor Retained Annuity Trusts. Furthermore, a low-rate environment is an attractive time to consider refinancing existing loans, such as third-party mortgages or intra-family promissory notes that were created during a higher interest-rate period.

CONCLUSION

Our goal with our year-end discussions is to provide a consistent, year-in and year-out structure for reviewing and revising long-term plans. While consistency is our goal, we cannot pretend that 2020 is a normal year, and we understand that our conversations this year with many clients will be different. However, our oft-stated axiom, “just because you can do something does not mean you should do something,” is especially important to remember this year, when volatile external conditions and unsettled emotions may create strong temptations for clients to meaningfully diverge from well-considered plans. We are confident in the plans we have in place for our clients, and equally confident that we can work with them, alongside their other advisors, to make thoughtful year-end decisions that are supportive of their long-term aims. 

 

 

 

 

 


The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.

The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.