Wealth Management and Financial Planning

Marginal Utility of Wealth

  • The marginal utility of wealth decreases as wealth increases.
  • Beyond a certain point, additional wealth may have negative value.
  • Example: A dollar given to a starving person has immense utility.
  • As one moves out of poverty and fulfills basic needs, the utility of an extra dollar decreases.

How Much Wealth is Enough?

  • This concept raises questions about how much wealth is sufficient.
  • Earning more money than one can use in a lifetime leads to questions about the purpose of wealth accumulation.
  • There is an argument that excessive wealth can diminish motivation.
  • Marginal incremental wealth might become negative.

Purpose of Wealth

  • Why are we creating wealth?
  • Why are we working hard?
  • How do we ensure our wealth continues to be useful as we grow?
  • How do we recycle wealth productively?

Potential Adverse Consequences of Excessive Wealth

  • Some people work themselves to death.
  • Excessive wealth may ruin children.

Rate of Return on Working Assets

  • What rate of return do we need from our financial portfolio, real estate investments, or operating business to achieve certain goals?
  • Consider leakages when determining the required rate of return.

Leakages

  • Distributions: Dividends, excess earnings, coupons, income from real estate.
  • Wealth Management Fees: Family office costs, accountants, trust and estate lawyers, custody fees, staff costs.
    • Typical range: 0.5% to 1.4% per year.
  • Taxes: Driven by the nature of assets and investment strategy. Important factor in leakage analysis.
  • Inflation: Long-term inflation rate.
    • Using 3% as a baseline, but the cost of living well may have a higher inflation rate.
  • Intergenerational Factor: Wealth dilution across generations.
    • Example: With multiple children, maintaining wealth across generations becomes challenging.

Chart Analysis

  • X-axis: Various spending rates after tax.
  • Y-axis: Required gross compounded rate of return needed to achieve goals, including asset management fees
  • Yellow Band: Rough approximation of expected returns from a well-managed portfolio of stocks and bonds.
    • Conservative approach (20% stock, 80% bond): ~3.5% per year before tax.
    • Aggressive approach (80% stock): ~7-8% per year.
    • Caution advised if a financial advisor promises 15% returns year after year.

Goal 1: Spend All Wealth Before Death

  • Nico wants to spend all his million dollars, leaving nothing to his kids.
  • He can spend $40,000 to $55,000 a year.
  • Problem: Longevity risk - outliving his money.
  • This strategy works for 15-20 years, but checks may start bouncing before death.

Goal 2: Maintain Nominal Value of Wealth

  • Nico wants to maintain the million dollars for the rest of his life, possibly giving it to kids or charity.
  • He can spend around $40,000 a year.
  • Problem: Loss of purchasing power due to inflation.
  • Annuities generally do not grow with inflation.

Goal 3: Maintain Real Value of Wealth

  • Nico wants to maintain the real value of his million dollars and purchasing power.
  • This requires higher rates of return to offset inflation and spending.
  • When adding leakages, achieving this goal becomes very difficult.
  • Taxes vary based on portfolio mix and management style.

Goal 4: Maintain Real Per Capita Wealth

  • This goal considers the intergenerational factor (growing family size).
  • Requires very high rates of return.

Tax Considerations

  • Tax-efficient portfolios can lower the required rates of return.
  • Private equity and alternative investments may offer opportunities to increase returns, but they are not easy to achieve.

Communicating with Family

  • Use the math-based analysis to facilitate conversations with family about wealth management and expectations.
  • Example: Share balance sheet and spending rate with children to encourage them to supplement their inheritance with their own income.

Family Trusts and Distribution Policies

  • Pooling assets into a single pool with a unified investment strategy.
  • Implementing a common distribution policy.
  • Example: Distributing 3% of the trailing five-year average assets of the trust.
  • Temporarily cutting distributions during financial crises to conserve value and encourage financial responsibility.

Spending as a Risk Factor

  • Higher spending increases risk.
  • Example: Market downturns can significantly impact portfolios, especially with high spending rates.
  • Taxes on gains during downturns exacerbate the problem.
  • Spending should be tied to the state of the world, connecting family members to the value of assets.

Distribution Formula

  • Base distributions on a percentage of the average value of the portfolio over the previous five years.
  • Implement a safeguard: Measure the distribution against the current year's value; cut the distribution if it is too high.

Annuities

  • Investing in annuities to protect against longevity risk
  • Annuities have purchasing power risk as payouts often don't grow with inflation

Portfolio Performance and Market Downturns

  • Consecutive years of market downturns can severely impact portfolios.
  • It's essential to prepare financial models that account for market downturns rather than assume normal distribution of returns.

Geopolitical Risk

  • Need to build cushion because of geopolitical risks in the world today.

Impact on Individuals with Limited Resources

  • Those on fixed incomes may not be able to take risk.
  • They are at risk of not being able to afford basic needs.
  • For people in advantageous situations, there is flexibility to spend less.

Communication with family

  • Allows children to be involved and understand trade-offs

Tax-Free Municipal Bonds

  • Investing in Tax-Free Municipal Bonds will hurt purchasing power
  • Good option for someone who prioritizes sleeping well at night

Financial Portfolio

  • Operating assets and liquid assets should be separated

Equity vs Bonds

  • Equities are better than bonds

Liquidity Events

  • Executives who are paid via equity compensation are encouraged to diversify the portfolio.

Balance Sheets

  • It is important to use Roth IRA and get kids to work
  • Complicated area to structure so will likely need good advice.

Deferred Tax Liability

  • More is better
  • Occurs when assets are given without transferring the cost basis
  • Cool because government takes disproportionate risk on downside. Can harvest losses and offset gains.
  • A free loan from the government with no maturity date or interest rate.
  • The government is a silent partner.

Accounting Equation

  • Incomplete Picture: Assets = Liabilities + Owner's Equity
  • Can fine-tune amount to show relative to business or non-business assets.

Deferred Taxes as Risk Mitigation

  • Government gets disproportionately impacted when value drops.
  • If capital gains rise or lower, the deferred tax liability changes immediately.

Switching Investments

  • When considering selling Assets to buy new ones, there is a lot of friction
  • Consider all angles before switching investment to new investments

Concentrated Position

  • Diversification is not always better. If you're already diversified, then focus on diversification.

Planning for Extended Lifespans

  • Longevity is increasing.
  • If a couple is aged 65, there is a 25% chance one reachers 94.
  • Useful to discuss financial needs that span over the upcoming future.

Foundation Discussions About Spending

  • It is important to let younger generations plan for long-term spending

Retirement Plans

  • Important opportunity to push retirement plans early
  • Great way to teach kids about wealth management and growth of financial assets without talking amount of family assets

Family Trusts

  • Grantor Trusts - power of trusts to transfer wealth.
  • Husband and wife - when one spouse dies, ability to step up the basis.