by Frazer Rice
Leverage is not a one-way street to newfound riches! While leverage can augment an investment’s performance and make for higher returns, it can work against you, and happen in reverse. If investments go poorly, the money borrowed is still owed. This is how bankruptcies happen.
Compounding Wealth
Compounding interest, as Albert Einstein is famously credited with saying, is one of the most powerful forces in the world. The use of time in building investment returns is an important concept when it comes to building wealth. As interest is earned and reinvested into the investment principal, that principal grows. As the principal grows, the interest generated grows as well. The cycle continues as long as the interest is reinvested in the principal. As you get wealthier, the law of compounding works in your favor in a massive way.
In the same way that compounding works for you when you’re saving, it works against you when you’re borrowing. The law of compounding can work against you if you borrow money and don’t pay down the interest; the loan principal will increase and the interest will roll back into the loan balance. People with heavy student loans, gigantic credit card debt, or underwater mortgages have learned this painful lesson.
Consumption Differs from Investment
Not all assets you put money into should be considered investments. This is most often misunderstood in personal real estate, when people buy a house to live in and claim it’s a great investment.
The house you live in can ultimately increase in value. However, in my opinion, that same house should be considered a form of consumption and not an investment. You’re buying that house and consuming it by living in it. If you happen to sell it for a profit later, that’s great. However, if you really look underneath the hood and analyze the costs involved—the mortgage payments, interest, utilities, furnishings, upkeep, taxes, and any other expenses—it’s often not as good a return on your money as you’d think.
Therefore, despite the possibility that your primary residence can be a driver of your future wealth, it’s more prudent to look at it as a form of consumption, and not an investment. By the same token, vacation homes should also be considered consumption, not investment. There are likely better ways to invest your money if the goal is to beef up your balance sheet.
Real estate that generates income, on the other hand, can be a great investment. I look at well-located, high-quality, income-generating real estate as good characteristics to look for when deploying money. If you start removing some of those features (i.e., it’s not generating income, needs a lot of investment/oversight, or not well-located), then real estate becomes a more speculative (“buy and hope”) investment. Many people discovered the downside of speculation in the recession that began in 2008, especially if they borrowed to do it—recall what happens to leverage when an investment goes poorly! To view real estate as an investment, it’s best to make sure it’s generating some type of income to cover the expenses of owning and maintaining it. Otherwise, it’s a speculative gamble.
For instance, my hometown of Bedford, New York, is a pretty fancy place, but they’re currently in the midst of a real estate depression. You can buy a house now in Bedford for the same price or lower than it was fifteen years ago, assuming that the house has been well maintained. Beyond the consumption aspect, is that a great investment?
No, it’s not a great investment. For the people who have put their money into an asset like that, their home can effectively become a savings account with a low or negative yield.
To make things worse, personal real estate can be extremely illiquid. You can’t pay for a hammer or a pizza with your house—it’s not cash. It’s possible to borrow against your house (and many people do), but then they experience the positive or negative effects of leverage and compounding. If they’re borrowing to build an asset or investment that will grow, that makes sense to me. If they’re borrowing to fund consumption, however, that makes no sense to me whatsoever. That’s when I would caution people to do something else.
Following Up on Jimmy’s Question
Let’s get back to Jimmy’s question: “Am I rich?”
“Jimmy,” I said, “your family is wealthy. They have the resources to provide you with a lot of great experiences and opportunities. However, you are not wealthy yet. Without some work on your part, as you grow up and take on the responsibilities that your parents have, you and your kids may not be able to have these experiences in the future. Let’s set up a time for you to come into my office, and your parents and I will take you through what’s in place and what you need to do to prepare for the future.”
Chapter Two
2. Preparing for the Hurricane of Wealth
Like a hurricane, the issues of wealth can come at you hard, and they can come at you from all sides. In dealing with the issues of wealth—both good and bad—many people react by effectively boarding up the house, hiding in the basement, and hoping for the best. That approach won’t work.
Again, to a hammer, every problem looks like a nail. For many wealthy people, their problems appear to them as nails that need a hammer, when their circumstances might be better suited for a screwdriver, duct tape, or a staple gun (or all three). What has been a blueprint for success for wealthy families may no longer apply if and when the family’s circumstances change.
In fact, many wealthy clients recognize a change in circumstance but have trouble articulating the goals they want to achieve. Even upon establishing a set of goals, these families find themselves in a situation armed with little personal experience and a host of horror stories heard from friends and colleagues. Wealth management—done well—addresses these conditions early on by prompting forethought and reflection at the clients’ end up front.
The following email came from a prospective client, who had obviously done some thinking and was well organized.
Dear Frazer,
My husband and I have done quite well for ourselves. My parents sacrificed a lot for my brother and me to go to college. When I finished college, I went into the family business, while my brother went into the U.S. Navy. My dad and I built it ourselves, and I took over the business when my father became ill. The business is my pride and joy, and it provides jobs and supports our town. I’m very proud of that.
My husband, lest I forget him, has been a big part of the community by being one of the major lawyers in our county. After decades of hard work, we feel like we’re in good shape financially and want to start thinking about retirement. We want to do some other things in life too. I have never been to Venice! Can you believe that?
We think we have plenty of money for our retirement, but we want to be able to give back to a lot of causes in our town that were there to support us as became successful.
There is something else on our minds. We’ve got teenagers and we’re worried about the impact of our money on their futures. We want them to have enough resources to lead motivated lives like my husband and I did. We want them to take on things they want to do, but we don’t want to give them so much that they blow it with bad habits or lose the work ethic and values we had.
They’re good kids and they’re smart, but they are already running with a fast crowd. They should be all right for now, but we’re worried about the influence of people who will come into their lives later: girlfriends, spouses, kids, or even just bad friends. We’ve heard too many stories.
I know I sound crazy, but I want to make sure that my husband and I can enjoy our retirement but also protect our kids and have them be productive adults. So, Frazer, our questions are:
What can we do to protect our lifestyle in retirement?
How do we protect our wealth for our kids? And protect our kids from our money?
How do we educate our kids on the ins and outs of money?
How do we get our kids interested in our legacy and philanthropy?
When is it appropriate to get our kids involved wi
th our wealth?
Is there anything else we should be thinking about and talking about?
My Initial Answer
If all my clients had laid out their concerns in such an organized way, I would have time to learn the violin! (Actually, I don’t think there is enough time for that with my musical talent.) That said, this type of inquiry is common. Notice the concerns are less about investments than they are about education and the transfer of values and culture to a new generation. Major life events beg for analysis of one’s current wealth situation. They provide a timely opportunity to open a discussion regarding your goals for your current and legacy wealth. These major life events could include any of the following:
birth of a child or grandchild
marriage
divorce
any substantial shift in your occupation or business
changes in laws and regulations affecting your wealth
death
These are fulcrum events within the life cycle of a family or a business, where legacy wealth issues become acute and need to be discussed. When possible, it’s always good to prepare for these major life events and have a road map laid out. Solid planning will prevent costly mistakes.
People come to me in various stages of angst when making decisions about their legacy wealth. Some people have had something successful happen in their lives and realize they’ll need a different type of planning as they move forward. Other people come to me when they’ve had to face their own mortality and realize it’s time to look beyond their own lifetime. That could be a person about to undergo open heart surgery, who isn’t sure if their bare-bones estate plan is adequate. When someone is coming to grips with their own mortality, legacy wealth issues move directly to the front burner.
People who come to me from the world of trust funds are typically more knowledgeable, if not more prepared. They have probably grown up hearing the vernacular of wealth management in much the same way parents talk about what they did at work at the figurative dinner table. (I say “figurative” because I feel like few families have dinner together anymore.)
Business executives and entrepreneurs, on the other hand, have spent their lifetime running their businesses. They’ve focused on expansion and are accustomed to taking risks, not setting up trusts and business ownership succession plans. These concepts can be alien to them, especially when they are being told to envision a world in which they are no longer involved.
Your Goals Drive Your Planning
In both current wealth and legacy wealth planning, it’s important to fully understand what’s important to my clients. I start by asking them what they’d like to accomplish with their current wealth in their lifetime and proceed to help them move from amorphous ideas to specific outcomes. I ask if there are any “bucket list” experiences they want to have in their lifetime, such as climbing Mount Everest, funding a movie, or living in an exotic island home.
After that, the conversation shifts to what they’d like their wealth to accomplish beyond their lifetime, and we continue to set as many specific goals as possible. These could be anything involving the consumption of wealth, whether it’s the purchase of a vacation compound for grandkids to enjoy or funding college scholarships for underprivileged students.
When your goals are cloudy and imprecise, it can lead to unpleasant surprises for you or your family later in life. You could be taking on more risks than necessary or dialing up the spending of your current wealth. Your family may have difficulty dealing with life’s surprises as it relates to your legacy wealth. Defining specific goals now will enable your advisors to organize and manage the wealth efficiently, from investment management strategies to future estate planning structures.
In the investment management component, having clear goals will make it easier to analyze the wide range of available options and make the best decisions possible in terms of liquidity, transparency, and yield.
For instance, if one of your goals is to pay for your grandkids’ college degrees in twenty years, we should assign a pool of assets to cover that. Since we’ll have twenty years before those funds are needed, short-term liquidity is less important. In the industry, this is known as goals-based investing.
If one of your goals is to provide short-term income to cover your living expenses, then liquidity and yield will be much more important. Additionally, the transparency of your investment is crucial. Convicted felon Bernie Madoff attracted investors by reporting exceptionally strong and consistent returns, but the overall transparency of his strategy was zero. This lack of transparency fueled Madoff’s Ponzi scheme and made it enticing by promising a certain outcome by mysterious means, like a magic trick. We know how that turned out. The money vanished, even for many sophisticated investors. The Madoff example is an excellent reminder of why transparency should be of paramount importance to investors. You don’t want to invest $10 million and get only $500,000 back.
Many people in the current wealth environment are worried about having a set income for life, so they purchase the lifetime cash flow of annuities as a solution to their worries. Annuities generate a yield, are fairly transparent, and have liquid cash flows. They have a place in certain portfolios in certain circumstances. However, the underlying investment itself is not liquid and is expensive to unwind in an emergency. Do you really want to be locked into that income stream for the rest of your life when circumstances could change? Annuities generally aren’t tax-efficient either. Opinions vary on the subject. I’m not lost on the value of predictable income streams, but I favor the flexibility and liquidity of a standard portfolio when compared to the inflexibility and illiquidity of annuities.
The most prepared clients go through some real soul-searching on what they need now, what they would like to have later, and what they want to provide for the future. When clients can communicate those things to their advisors, they are on the road to a well-thought-out and flexible plan.
Questions to Ask and Answer
To determine the most important goals, we start with the most important questions. For business owners, I begin by asking, “What are your goals for your business?” Some entrepreneurs simply want to sell their business and move on to the next opportunity. Meanwhile, other business owners are extremely concerned about the legacy of their business. Perhaps their business is the cornerstone of a community, and the business owner wants the business to continue to benefit that community from an economic and social perspective.
When it comes to family considerations, I’ll ask some tough questions:
What’s important to you regarding your family?
Who constitutes your family? What do you feel responsible for, in terms of their expenses?
If your children are an important part of your planning, for what length of time do you want to support them?
Is it important to pay for your children’s education, weddings, rent, or mortgages? How about your grandchildren?
Where do your children’s spouses and children fit in, and how responsible do you feel for them?
Most parents want their kids to cut the cord and be their own productive people in their adult lives. How and when that happens, however, comes down to each client’s unique goals and preferences. There’s no right or wrong here in terms of how responsible people feel for their family members, friends, or charity. Everyone’s situation is different and circumstances can always change.
Mistakes and Consequences
Without tough, probing questions, the real issues don’t come up. No grit, no pearl. It’s a costly mistake when advisors give their clients mechanical plans and investment advice without understanding the unique dynamics and motivations of each client and their family. I’ve met with intelligent clients who have made assumptions about their own situation and have received advice based on those assumptions, without addressing the most important questions about their current and fut
ure goals.
You shouldn’t assume that common and mechanical estate planning techniques will solve for everything and serve your actual needs. Without doing the heavy lifting of thinking about your specific goals and situations, your planning could suffer. Plans may also have to evolve to deal with new circumstances as well.
One nasty consequence of improper planning is the need to dismantle ineffective structures in the future. The issues come to a head when a planning structure is tested by a major life event, and the structure doesn’t work the way the family thought it would. Fixing or undoing these complicated structures can be expensive and annoying.
During your lifetime, it’s a mistake to assume there’s enough money for everybody and they’ll just work it out when you’re gone. Estate taxes and legal costs may greatly reduce the amount of transferred wealth, and there may not be enough money for everyone to continue to live in their accustomed style. This assumption can lead to a series of bad consequences for your family, and the lack of planning can cause hurt feelings and conflict between family members. Let’s look at an example. Perhaps one couple had multiple kids and needed more resources than another family member, or someone was more integral to the family business and should have logically inherited more of its ownership.
Your passing will be a time of pain and sadness. If family members must deal with settling your estate during those emotional days, it’s easy for there to be misunderstandings and hurt feelings, especially if the purpose and function of your wealth transfer plans do not have buy-in from the family, or worse, the plans have not been communicated to the family at all. This can be prevented by thinking through your legacy issues and goals in advance of your death, planning around those goals, including the family in the development of those goals and structures, and communicating your plans to the next generation.