A review of considerations to bring up with clients who are looking at lifetime generational asset transfers.
Multigenerational financial planning and wealth transfer are rarely ever simple. Each client brings distinctive and varied considerations, so even experienced planners can encounter something new every day. The current environment of rapidly rising inflation adds a new element to evaluate and may cause some increased client anxiety, but if planning is done right, then “headline news” should not significantly impact a client’s long-term strategy.
Identifying Objectives
In any estate planning scenario, it is pivotal to focus on identifying client objectives and how to best achieve them. Billionaire investor Warren Buffett once said the perfect amount to leave children is “enough money so that they would feel they could do anything, but not so much that they could do nothing.”1
That is really the balancing act for many clients. The conversation starts with determining how much a client wants to transfer and how they would like their beneficiaries to receive it. For lifetime gifting scenarios, it is essential to ensure that clients never compromise their own wherewithal in the interest of passing on wealth or mitigating estate taxes.
When working with clients to determine how much they are comfortable with passing on and when, planners should run a retirement cash-flow sufficiency analysis that factors in lifestyle objectives and possible philanthropic giving. It makes sense to be overly conservative when conducting this forecast, whether that entails assets not growing as fast as they have historically, increasing expenses, escalating inflation or extreme life expectancy.
The only real negative that could arise from this planning strategy is if the client ends up with more money than expected, which is a far better outcome than the alternative. Once a strategy has been formulated, the planner and client can essentially work backward to determine what dollar amount could be reasonably passed on to beneficiaries.
Then it becomes a matter of devising the best approach to transition wealth to the next generation, while ensuring the client also has a positive outcome. Additionally, steps should be taken to indoctrinate beneficiaries with values that enable them to be successful stewards of wealth.
Essential Elements
When creating a successful estate plan, it is important to keep the focus on the bigger picture and recognize any potential pitfalls. That means flexibility is fundamental. If wealth transfers are being planned to children or grandchildren who are of single-digit age, it is almost impossible to know what type of people they will turn out to be as adults.
To bestow certain privileges, responsibilities, or wealth access upon them without really knowing their mettle constitutes a significant risk. So planning documents should embody certain standards or include allowances to make changes, at least in a limited capacity to avoid compromising their efficacy.
Ideally, the documents should provide for an evaluation period of children and grandchildren as they develop, so benefactors can gain a better idea of their acumen and values as they are coached into a stewardship role. At a future date, restrictive covenants could potentially be relaxed or strengthened, depending on how much confidence the clients gain in their beneficiaries during the intervening time.
This raises a pivotal point — it is important for clients to maintain an honest perspective about beneficiaries. Understanding that nobody is perfect, it is quite possible that certain children or grandchildren will not exhibit the faculties or abilities to manifest the values of the benefactors, especially when substantial dollar amounts are at stake. So clients should understand these limitations, rather than simply hope that beneficiaries will be able to grow into responsible roles.
Creating Covenants
Trusts are popular estate planning options because of their ability to help achieve generational wealth objectives from both a tax-efficient and value-driven standpoint. Restrictive covenants within trusts come in many forms, but all are intended to ensure that beneficiaries make responsible decisions with the assets passed to them.
An example of a simple restrictive covenant would be age-based, where a beneficiary cannot gain access to assets before reaching a certain age. This provision can be gradual in nature, with the beneficiary receiving a specific percentage of a trust at age 22, for example, an additional percentage at age 30, and the remainder at age 40. The idea is to enable the beneficiary to become a better steward of wealth over time through gaining perspective, wisdom, and life experiences.
However, even if a beneficiary is eligible to claim only a small percentage of their total trust at age 22, the amount received per year might still be more than they are likely to earn through a full-time job. For instance, if the trust starts paying the beneficiary $100,000 at age 22 and the jobs they are qualified for at that point only pay $50,000 to $60,000 a year, there could be little incentive for that person to work at all.
One potential solution that encourages children and grandchildren to avoid becoming couch potatoes is stipulating that the percentage of the trust received matches their W-2 income. This type of provision could incentivize some beneficiaries to pursue very high-paying careers in order to maximize the benefit. Alternatively, it might help a beneficiary who is drawn to a less lucrative career, such as social work, feel more comfortable about pursuing that passion because the low salary would not be such a deterrent.
Another common type of restrictive covenant is academic. One example would be stipulating that a beneficiary is not eligible to receive assets unless that person earns a four-year undergraduate degree. Other restrictive covenants might be tied to beneficiaries passing drug or sobriety tests.
Covenants are based on the preferences and values of the client, and can apply to either lifetime or post-mortem gifting. While it is up to estate planners to help facilitate covenants, they should still present counterpoints and ensure clients have thought through any possible ramifications before establishing them. For instance, if a client greatly values education and wants any beneficiary to earn a four-year undergraduate degree before being eligible to claim assets, perhaps point out that many productive members of society such as chefs or airline pilots have occupations that only require vocational degrees.
It is possible to create covenants that reflect just about any criteria clients might have, but remember there can also be workarounds to more limiting covenants. For example, consider a client who greatly values marriage and stipulates that a beneficiary can access funds to purchase a house only after getting married. This could lead to a scenario where a beneficiary marries a friend just to buy a home, then gets divorced, sells the house, and pockets the money. So people can always try to be clever and “game the system,” which should be discussed when clients are considering different restrictive covenants.
Future Flexibility
Client desires and objectives might include passage of wealth to beneficiaries, charitable donations, and lifestyle preferences. What will they want to do or buy in the future and what might their cost of living be? The reality is that people typically do not know for certain. The further into the future that projections are made, the more opaque the view becomes. Circumstances, health, and overall objectives can all change.
Consider a client in early 2020 who considered travel to be a key component of their retirement plans, only to see an unprecedented global pandemic completely disrupt the industry. The best that estate planners can do is apply client preferences today to the future. But changes over time are inevitable, so it is key to provide sufficient resources based on current knowledge while ensuring that flexibility is built into the plan.
Inflationary Impact
This is an area where inflation certainly comes into play. Often when clients are discussing how much money they want to pass on to children or grandchildren, they have a certain dollar figure in mind that subjectively seems like a good number to them, but objectively might not make the impact they expect.
Consider a couple who comes to a planning meeting with the idea that they want to leave $1 million to each of their kids and give the rest of their money to charity. As an estate planner, it is important to ask, “OK, but why that specific amount?” They might respond that it should be enough money to make a significant difference in their children’s lives but not so much that it makes them lazy.
So then the estate planner could say, “What do you think they would be able to achieve with a million dollars? Are you trying to enhance their retirement, help them buy a home, or maybe provide for your grandchildren’s education?”
The reality is a house that cost $300,000 a couple decades ago might cost more than $1 million today, and probably still more five or 10 years from now. A million dollars is not what it used to be and its purchasing power in the future is unknown. So it would be helpful to get a client thinking beyond what sounds to them like a good round number, and critically analyzing the purchasing power of a given amount.
Constructing a Narrative
The numbers that a client might be fixated on do not necessarily reflect their objectives. Part of the role of an estate planner is to construct a narrative and comprehensively understand what a client is trying to achieve, so appropriate assets can be allocated toward those goals.
There are myriad steps that planners can take to help clients navigate periods of high inflation. For instance, consider a client who intends to pass on a specific dollar amount to a beneficiary with the objective of present value. That amount can be tied to an inflation index, so it automatically increases to an equivalent number in terms of purchasing power when the gift is made.
It is also important to model several different retirement scenarios for clients that feature varying inflationary environments, including very conservative approaches. This should be coupled with educating clients about the potential effects of inflation on particular giving strategies or underlying assets, so they are aware of the possible risks. Articulating all of these details is a cornerstone of comprehensive estate planning and enables clients to make educated decisions.
Emphasizing Outcomes
The truth is that rising inflation tends to be more of a headline discussion than a pragmatic planning conversation. That is not to minimize the impact or effects of inflation, which are real and can present many challenges. But if planning is conducted properly, it should be focused on a particular outcome or narrative, and how to best achieve it, while taking inflationary pressures into consideration.
How might inflation impact decisions, investments, transfers, amounts, and how amounts are constituted? All of these aspects can be objectively identified and addressed during the planning process, as well as in the documents established to advance the specific narrative or goal.
In the current environment, more clients are expressing concern about inflation and how it might impact them, which is certainly understandable. But if estate planners have a good education process and strong interaction with clients, where inflationary possibilities have already been articulated and understood, then the current environment should be seen as just that — what is happening right now. It should not significantly impact a well-conceived, comprehensive estate plan.
“What do you think they would be able to achieve with a million dollars? Are you trying to enhance their retirement, help them buy a home, or maybe provide for your grandchildren’s education?”
Estate planners should ensure their clients understand that investment growth charts do not depict a steadily inclining line to the upper-right. Volatility and inflation will happen. When drastic changes are made in response, it often results in a far less successful outcome than trusting a strong plan that has previously factored in various potential economic environments.
Immunizing Lifestyles
Such a plan should include taking steps to immunize client lifestyles, both in terms of income generation and longer-term wealth transfer objectives. Estate planners can point to historical and anecdotal evidence of inflationary impact on investments, such as equities, fixed income, and real assets. In portfolio construction, emphasizing diversified asset allocation that potentially includes alternative investments can provide protection in inflationary environments, helping to mitigate the impact of headline issues while viewing them from a longer-term perspective.
A greater issue is when clients have long-term strategies for short-term dollars. For instance, if their mindset is to be growth-oriented, aggressive, and willing to take risks, but they will need the money in two to three years. This is essentially high-stakes gambling — a dangerous approach with little chance of success due to the significant risk involved.
If a person is nearing retirement, they need accessible assets and a relatively predictable income stream. Nobody wants to retire and then be forced back into working a few years later because their financial plan has proven to be flawed. The goal is to develop a strategy that can weather intermittent volatility and inflationary pressures, while immunizing a lifestyle with that goal in mind, versus gambling and hoping for the best.
If inflationary pressures do pose a threat to a client’s retirement, a comprehensive long-term plan should consider various potential lifestyle changes to ensure that income and savings are sustainable. This might mean a client needs to cut back on certain activities that they would like to do in an ideal world but are not necessarily high priorities. From a planning standpoint, such conversations can be necessary to ensure clients understand the risks they might be taking to achieve a certain lifestyle.
Acting on Opportunities
Furthermore, although inflation is typically seen as a cause for concern, it can also present opportunities. For instance, certain types of investments might historically respond better to inflationary periods in terms of performance metrics, behaviors, or outcomes. So to the extent that inflationary pressures might be more prolonged, it could make sense to slightly adjust portfolio holdings to take advantage of that environment.
Additionally, if inflation is likely to rise in the future, it might be advantageous to set certain expenses now when costs are lower. For example, consider a person who locked in a million-dollar mortgage six months ago when interest rates were 2.5%. If sustained inflationary pressures cause those rates to rise significantly, getting 2.5% while it was available could turn out to be a very astute decision from a planning standpoint.
Painting a Picture
In conclusion, effective estate planning is based on being more proactive than reactive, letting the client paint a picture, and then developing a narrative to perpetuate their values. Estate planners should discuss different options and present various possible solutions to help clients feel comfortable with targeted outcomes and how to achieve them.
Above all, it is about listening to clients and empowering them, ensuring they can make the best decisions for their families and overall objectives. What clients value most about estate planners is objectivity, multifaceted expertise, and the ability to help them understand key concepts.
There is no guarantee that any multigenerational wealth transfer strategy will unequivocally succeed. But if estate planners can effectively educate clients, provide counterpoints to potential courses of action and offer insightful advice, the likelihood of success improves dramatically — no matter the current inflationary environment.
Originally appeared in Estate Planning, a Thomson Reuters publication.