Corporate executives and business owners tend to spend very little time proactively tending to their personal tax and financial affairs. Most of their time and focus is spent managing the affairs of their company, and not planning or strategizing for the benefit of their own personal financial goals. Many make one-off decisions, made in a vacuum with little regard to integrating the various aspects of their financial lives. Although some executives have accountants, lawyers and stockbrokers assisting them with their affairs, there may be little coordination of the tax, legal and investment components into one cohesive plan. Part of the challenge is that advisors tend to be focused in a relatively narrow area of expertise relative to a family's broader financial management needs. Worse yet, it sometimes is further complicated when the objectivity of an advisor is diluted by how they are compensated.
These conditions tend to divert attention from the singlemost important aspect of managing personal finances - fundamental financial planning. It is comprehensive in nature and rooted in a sound consideration of both the qualitative as well as the quantitative aspects of one's financial affairs. It is fundamental because it covers both the rudimentary as well as the technically complex aspects of wealth management. The process of fundamental financial planning is not static but rather an ongoing process that requires updates, and proactivity to clarify family needs. In its purest sense, it will help define and prioritize financial goals. It will create a roadmap to implementing everything from tax planning, estate planning and individuals' management of their investable assets.
While fundamental planning will help define goals and assess how and if one will reach them, it also creates a sound foundation for making specific decisions. These decisions include:
• For executives:
• When should I exercise my stock options?
• How much income should I defer, and when should I have it distributed?
• Should I take my pension in an annuity or lump sum?
• For business owners:
• How do I create a succession plan for my business that is tax-efficient?
• If faced with a buy-out, how should it be structured to mitigate the effect of taxes?
• What type of compensation structure should I employ for myself?
While these questions are just a sample of the myriad of possible issues, participating in the process of a long-term plan will allow for a much more effective way to address and resolve these questions.
The process of fundamental financial planning begins with taking a thorough inventory of the qualitative and quantitative data related to your personal finances. On the qualitative side, it pertains to career and family matters - such issues as, how long do I want to work, or do I want to cash out at some point? What are my broader life and family goals and quality of life concerns? The quantitative side relates to concrete data such as income, assets and liabilities, compensation and benefits, and liquidity matters.
From a process perspective, the aggregation of the qualitative and quantitative information culminates in the development of a series of financial analyses and illustrations. From personal balance sheets to long-term security analysis, this Personal Financial Profile (PFP) can provide details, for example, on:
• estate planning
• cash-flow analysis
• current asset allocation
• stock option breakeven analysis
• family needs analysis ("death planning")
The PFP becomes a dynamic set of analyses, typically updated and revised for changes in assumptions and circumstances over the short and long term. It is the roadmap to draw specific observations and recommendations, which, in turn, results in an action list for implementing specific strategies and goals to effectively manage wealth. These strategies and goals are then assessed on an ongoing basis to ensure that the design is working.
While ideally an ongoing process combined with managing one's investments and taxes, fundamental planning can also be used as a diagnostic tool or "second opinion." In this capacity it becomes an evaluation of one's overall wealth plan and what needs to be changed and what doesn't. Some individuals or families may find that there is one particular area that emerges as a concern and, therefore, focus on that. For instance, it is not uncommon to have an outdated estate plan that has not been looked at in quite a while. Between changing family needs, changes in asset values and the ever-changing tax laws, it is inevitable that restructuring and updating a family's estate plan becomes imperative. More so, the current landscape for estate and gift planning may provide a window of opportunity to implement strategies given historically low interest rates and larger estate and gift tax credits. This window affords through 2012 for a $5 million estate and gift tax credit ($10 million for a married couple). This means that at death an individual will be able to pass on $5 million without incurring estate taxes, with a 35 percent top rate on assets above the $5 million level. However, it is unclear, particularly in the supercharged political environment in Washington, as to what may happen after 2012 with estate and gift tax legislation.
This makes it an opportune time for individuals to re-evaluate their estate plan. Furthermore, the low interest rates and $5 million gift tax exclusion may make current gifting of assets more efficient. The low interest rates work in favor of implementing such Tier II estate planning strategies as Grantor Retained Annuity Trusts (GRATs) and various types of installment sales. On a side note, these low rates also make intra-family loans and the refinancing of such loans more valuable. It's also a good time to evaluate Tier I strategies such as Irrevocable Life Insurance Trusts (ILITs) and how one's estate documents expedite the transfer of assets between spouses at the death of the first spouse. For instance, most states don't afford the same $5 million that the federal government does potentially resulting in estate/inheritance taxes at the state level upon death. Language built into estate plan documents can give the surviving spouse more flexibility in controlling how much money flows to them versus trusts designed for the benefit of the next generation. Incidental to some of the decisions made regarding your estate plan is having a sense of how much you can afford to gift to children/grandchildren as well as charitable concerns. Here's where the integration of different planning disciplines become critical. Doing long-term "cash flow" planning or capital needs analyses may be critical to determine how much you should be gifting to your private foundation or family limited partnership (FLP) versus preserving for your own use.
In a similar fashion, fundamental planning defines and shapes how you manage your investable assets. It facilitates a tax- and risk-managed approach to investment planning. The volatile markets of late are a reminder that you can't manage returns, but you can have an impact on the asset classes and specific investments used in your portfolio, as well as manage the impact of taxes.
Developing a financial model known as a Long-Term Security Analysis, with use of a reasonable set of assumptions for tax rates, inflation rates and life expectancy, allows you to define at what rate you can spend down your assets, coupled with your other sources of income. This model gives you significant insight into what your "target rate of return" should be to reach your preferred lifestyle. This target rate helps to define what level of risk you may need to assume in managing your assets. In other words, it helps in defining your risk tolerance because it shows you, at different assumed rates-of-return, what your ability to spend down your capital looks like. This fusion of target rate of return, risk tolerance and time horizon results in the development of a proper asset allocation. Development of an asset allocation in the absence of this fundamental planning greatly undermines its effectiveness. Many corporate executives and business owners may find that this financial model reveals that they can take less risk with their investment assets because it indicates a lower than expected target rate of return.
Just as you need to periodically review your asset allocation to make sure, one, it's still appropriate, and, two, it hasn't become skewed due to asset value changes, you too need to update your Personal Financial Profile as a whole due to macro and micro economic changes. Even when employed as a diagnostic tool, fundamental planning needs periodic re-evaluation. Tax law changes, interest rate changes, career and life changes all constitute the need to update your planning. Factor in such liquidity events as a corporate change-in-control or the sale of a private business and the need becomes even more pertinent. Liquidity events can also come in the form of diversification strategies where a plan is created for the sale of shares related to stock options and restricted stock.
Managing personal wealth involves a series of decisions and action steps that need to be implemented synergistically. They need to be based on a comprehensive set of guidelines. These guidelines need to be the by-product of fundamental planning and analyses.
Michael S. Maglio is a Managing Director of WTAS (Wealth and Tax Advisory Services) in the firm's Madison, New Jersey office. Mike concentrates on integrating tax and financial planning to create long-term strategies for his clients. Besides financial planning, he focuses on investment consulting services, tax planning and compliance and retirement planning.