Wealth, Actually

by Frazer Rice

  The costs involved in boat ownership can be blinding. The purchase is just the beginning; the maintenance soon follows. Suddenly, you discover that the engine needs to be rebuilt, or that the hull is cracked and covered in barnacles and needs a professional skin diver to keep it from sinking. Fuel costs can register in the thousands of dollars. If you plan to buy a boat, be aware of the full range of costs and plan accordingly.

  Scenarios Where Knowing Your Cost Is Important

  Regardless of the source of your wealth, your advisors will face the challenge of making your money accommodate the life you want to live. Advisors work with their clients’ perceived spending needs, but the truth is the money lasts only as long as the money lasts.

  Sudden Wealth and Inheritances

  There are especially challenging scenarios where it’s crucial to understand your costs. One is when the newly rich want to ensure their wealth translates to a carefree retirement. This might be a lottery winner, professional athlete, or entertainment star who previously had a lockdown on their spending as their lives unfolded in lesser financial conditions. When they finally have resources, that sudden onset of freedom can create a flood of bad habits. They don’t have context around how wealth works and the lifestyle it can support.

  When I come into contact with someone in that situation, I explain to them that it’s my job to ensure they’re taken care of for the rest of their lifetime (and beyond, hopefully). Their wealth needs to be managed to support a level of spending that can be sustained over time. Even for the most gifted or lucky of unicorns, it will be difficult for them to create another sizable liquidity event or generate another income stream. In most cases, lightning strikes only once—you shouldn’t expect it to strike again.

  There are also challenges presented by individuals who are born into money. They may be familiar with the culture and trappings of wealth, but they were not participants in the creation of the wealth. Their education might have been paid by trusts or out-of-pocket by relatives, reducing the size of the fortune that they are dependent on. They often need guidance and discipline in managing their costs to remain within the confines of the wealth that has been created for them. For people born into wealth, the lightning that struck at birth may never strike again.

  Divorce

  Divorce is a disruptive occurrence that often requires a correction in the way clients think about their wealth. Take the example of a recent divorcee who has been part of a well-heeled community for many years. The spouses were joined at the hip and (seemingly) loved each other, taking luxurious vacations and seeing their children receive coveted educations. After the divorce, however, one spouse suddenly found themselves in an environment where their assets and cash flow had been significantly reduced.

  When I have clients like that, I must separate the necessary money conversations from the important (but difficult) emotional rebuilding that needs to take place. The dissolution of a marriage involves anger, guilt, sadness, confusion, and fear. Untangling those emotions is difficult, although some are able to work through the emotional wreckage of a divorce without letting it interfere with their ability to logically work through their new financial reality.

  To assist the divorced spouse, I must help that person understand the lifestyle costs of their previous chapter of life (which may have stretched over years or decades) and take an inventory of the money or assets needed going forward. That can be difficult. The spouse may not have been concerned with money matters previous to the divorce. This is often the case when a spouse (or a spouse’s advisor) handled the financial matters for the couple. Often, divorce results in a notable distance between the “before” and “after” positions of the couple.

  Most divorce proceedings are designed to promote transparency and fairness. However, the financial outcome of the divorce can be a cruel surprise for the spouse who was unaware of how their lifestyle had been financially supported. This can be a tremendous adjustment, but it can be made with solid advice and the development of a plan. To chart the next course of life and make smart decisions, the spouse will have to identify what is important, what isn’t important, and what expenses can be supported in the new financial situation. This isn’t easy, but it saves a lot of pain and confusion later.

  The scariest scenario occurs when an aggrieved spouse in a divorce discovers that the assets he or she thought were in place are not. They may find out that money was borrowed without their knowledge and there is now debt, or that the couple’s net worth is much less than believed. Any divorce settlement will fall far short of expectations. These spouses are caught off guard, and it can get ugly when they find out what adjustments will be needed going forward.

  The Sale of a Business

  There are other challenges for people who have grown a business and now want to retire and do the things they enjoy. They ask me, “What do I need to think about when it comes to spending so we don’t run out of money?” They want to maintain their spending levels in a way that allows them to continue their endeavors while accommodating the life risks that may be ahead.

  For the retiring business owner, one consideration is whether they will keep their business for the next generation or sell it. That decision can be tricky for people accustomed to operating a business and living from the cash flow it generates. It can be jarring to transition from a business-driven cash flow to one that is generated by a portfolio of stocks and bonds.

  Let’s say you had a business worth $10 million, and suddenly that is replaced with $10 million in stocks and bonds. The stocks and bonds may not yield as much cash flow and may not have the same flexibility as the business income that you were used to seeing. Further, many business owners run their expenses through their businesses. For example, they may tack their personal vacation onto the end of a business trip, which makes the cost of travel significantly less expensive. When the business is no longer there to absorb some of those expenses, they may be surprised by the increased costs. My job is to gently remind them that wealth has different structures. As you move from one structure to another, expenses and complications will fluctuate, and your thinking will also need to change to accommodate this new reality.

  In discussing these scenarios, we also discuss the option of shifting management of the business to the next generation but maintaining ownership in order to retain the higher cash flow. Case-by-case analysis helps determine the best solution, which is often driven by the answer to the question “What do you cost?” A solid understanding of your expenses and objectives will help you leverage the best tools, tax advantages, and safety nets to protect you now and in the future.

  Goals Should Drive Spending Decisions

  Identifying and prioritizing your goals is critical. You can’t achieve your goals if you don’t know what they are, and prioritizing your goals is helpful when you need to make decisions affecting your wealth. You don’t want to channel resources to one goal at the exclusion of another and discover during the next market crash that your most important goal is now unattainable. That yacht will look less exciting if its expenses jeopardize a safe and comfortable retirement.

  By and large, most wealthy people will first address their own living and retirement situation and will then determine the amount of wealth to provide their families. Most people do not want to be a burden to their families or children, and that serves as a goal that drives spending decisions. There will be a bit of a balancing act for individuals who want to provide wealth for their children. Invariably, problems arise, and depleted assets may also put children in a difficult position when it comes to making end-of-life decisions for the parents and grandparents who supported them. Can the family afford the million-dollar treatment to extend the life of the eighty-five-year-old grandfather for another three months?

  Those are the kind of scenarios that most people don’t want to put in the hands of their kids. It’s stressful, unpredictable, and can deplete the current and legacy weal
th. If multiple family members are involved with decision-making, there may be conflict rather than consensus—and conflict can be costly.

  When discussing the planning required to deal with these worst-case scenarios, I’ve often heard the refrain, “If I get that way, shoot me.” Well, that’s not currently legal in this country, so you’ll need to devise another plan. When common sense creeps back in, wealthy people who plan well create their own frameworks to accommodate their end-of-life wishes. This ensures that there will be a disciplined structure to guide a family’s decisions during times when emotions are at their peak. However, even the best of plans run the risk of creating bruised feelings, which is why family communication is so important. If people understand why things were done the way they were, there will be fewer surprises and problems when the hard decisions need to be made.

  Conclusion: Know Your Costs and Goals

  We began the chapter with the example of my friend who was frustrated and unable to think beyond his second house and a trip to the Porsche dealership. Being a vegan, marathoning law partner raises all sorts of different questions! The bigger problem was that his short- and long-term goals weren’t clearly defined and prioritized, and the collective costs of those goals were astronomically high.

  If you don’t know your goals, don’t prioritize them, and don’t know how much you cost, you’ll waste time and set yourself up for disappointment. You must take the time to establish what’s important to you and be willing to make choices that foster those goals. Understanding your expenses, as well as the resources paying for those expenses, helps you to look inward and clarify what you truly value. This will help you make more informed decisions toward the goals that matter to you.

  I think the question “What do you cost?” helped my friend. He is now happily married with two children, and his financial future looks bright.

  Chapter Four

  4. What Makes a Good Investment

  Many of my scary examples start with a call from a friend looking for advice. It’s my nature to be helpful, but many times, I’m the deliverer of conservative, long-term advice that is either uncomfortable and boring or as fun as a trip to the dentist. So imagine the issues that arise when a seemingly random phone call from a friend turns into a pop quiz for the financial advisor.

  “Hey, Fraz,” said my friend on the other end of the line.

  “Hey! Terrific to hear from you! How are things?” I replied.

  “Things are great,” he said. “And you?”

  “All good at my end,” I said. “The family is fine, my girlfriend still tolerates me, business is good, and my hobbies are still fun. No complaints! How about you?”

  [Hopefully, a big frosty beer is in the near future.]

  “Doing fine. Actually had a business question for you,” he said.

  [The frosty beer prospect isn’t looking too good now.]

  “Fire away,” I said.

  “As you know, I’ve got this advisor. I’ve known him forever. I’m pretty happy with him. We catch up once a quarter or so. But he can’t really add much value for me because my company is rigid with my investments from a compliance standpoint—they want everything on autopilot,” he said.

  “That’s definitely an issue,” I said. “We see it all the time.”

  “So I’m with this advisor and I’m boxed in with this off-the-shelf program that my employer is comfortable with. But you know me, I want some more action. I’m also at the point in life where I have to start putting some chips on the table for later. Nothing too crazy and certainly nothing too big, but some more deals,” he said.

  “I hear you. We’ve talked about this before. You want to have a good conservative approach for the long term, as long as these bets don’t threaten that,” I said.

  “Ha ha ha ha!” he laughed in reply. “I knew you would say that. It wouldn’t be a big thing. And I would be helping my brother-in-law out. He has an awesome app he thinks I should invest in. He says it’s got huge potential and could really take off once it goes live and he converts the users into paid subscribers. I know it’s a long shot, but if there’s a way to make some big money with this…what do you think? Should I invest?”

  My Initial Answer

  Ugh! Nothing like being put on the spot when you were hoping a pint of Guinness was on its way. The initial answer isn’t satisfying and harkens back to a lawyer’s standard answer to everything: it depends.

  Aside from the issues of getting into business with your brother-in-law (red flag, red flag!), the answer to that question hinges on two concepts: whether the investment itself is a good idea, and whether it’s a good investment for you, in your current environment. Even if you can say yes to these two questions, should you throw $50,000, $100,000, or a million dollars at an app whose user base still has to be converted into paid subscribers?

  In addition to understanding the basics of traditional investments like stocks and bonds, you need a framework for evaluating other types of investments (like my friend’s shot in the dark with a start-up company). You need tools in your toolbox to keep disciplined in your investment decisions. Whenever I come across an entrepreneur (usually in the start-up phase), I’m usually impressed by their idea, their vision, and their energy. Invariably, the idea will be a game-changer that promises massive riches, and the founder comes equipped with a halo of charisma.

  To prevent yourself from making decisions based on emotion instead of logic, it’s important to develop the skills to withstand the initial pitch. Discipline, diligence, and analysis should be a part of any investment decision. The road to financial hell can be paved with bad investment decisions fueled by the initial rush of novelty and euphoria.

  The other important point to remember is that while some things may be excellent investments, they may not be excellent investments for you. To understand the difference, you need to define your goals, identify what resources you have, understand your income requirements, and decide how to reach your goals.

  Earlier in the book, we examined the importance of understanding how much you cost and to set goals for your current and future wealth based on that cost. Next, you’ll need to identify the assets and resources you currently have and expect to have going forward. For the uninitiated or for those who would like a second set of eyes, a financial advisor can be helpful to you there. Once you understand what you will cost and what you will have, you can marry those two concepts and begin to form your plan going forward. While this sounds simplistic, almost every well-run institution, business, foundation, and family begins their analysis with these basic precepts. I’m always surprised at how many families with successful businesses fail to transfer these concepts over to the management of their wealth.

  Evaluating Investments Using Income Goals

  Investments can be a driver of current income or future return, and each investment falls somewhere on that continuum. For example, many people who receive a windfall are interested in making sure that they have enough (current) income to live on for the rest of their lives. Let’s say you have $10 million from the sale of a business or a windfall inheritance and you decided that you “cost” about $300,000 per year. You would look for investments that generate income of $300,000, which equals 3 percent per year on your $10 million. The bond (or fixed-income) market is where many people look to satisfy these returns with a minimal amount of risk and volatility.

  For future investment returns, let’s say that you have taken care of your $300,000 of annual family costs with the investment of $10 million, but you also have another $2 million that you would like to use to provide a benefit to your grandchildren at some point in the future. These funds aren’t needed by your children in the short term for income or cash flow purposes—your kids are doing a good job of providing for your grandchildren. In other words, you have a longer time horizon for these funds.

  One typical option is to invest these funds in ris
kier assets like stocks that are expected to provide a higher rate of return. Since you don’t need the money in the short term and you are not expecting this pool of assets to generate the income needed to fund your current costs, you can earmark these assets for future returns to fund future goals (like to benefit your grandchildren).

  While you should expect a well-chosen pool of riskier assets to provide higher returns, they are more volatile (meaning they can go up and down). Some will be home runs and some will be strikeouts. If you have earmarked $2 million for your grandchildren, investing those assets with a longer time horizon in a pool of riskier assets with the expectation of higher returns—let’s say it’s a diversified stock portfolio with an annual return of 7 percent, the current industry consensus—could generate a much larger pool of assets to be used in the future. An investment of $2 million earning 7 percent a year for twenty-five years would leave you with a pool of assets totaling more than $10 million.

  A good question that I often get is, “Why don’t I invest my current assets at the 7 percent return-level bucket?” I have to remind clients of the word riskier. That 7 percent expected return is not linear. Those riskier assets are volatile and can go up and down, or they might not happen at all. When marrying the costs of a client with the return capabilities of their assets, I have to be careful to make sure that there is an understanding that taking on “risk” means taking on the possibility of loss—especially in the short term. Those losses can have an impact on the ability to fund current cash needs.