by Frazer Rice
“That sounds complicated,” he said.
“It’s not as bad as it sounds,” I said. “You’re about to be a megastar. I’m not trying to kill your buzz here. I simply mean that there are some things that you need to be aware of as you go forward. This should help you avoid costly mistakes and set you and your family up for the rest of your life and beyond.”
“That doesn’t sound so bad,” he said. “Okay, so what do I need to watch out for?”
My Initial Answer
It’s no fun to have to walk away from a lifestyle you’ve developed, especially if you are about to experience life as a world-famous action hero. There are simple principles to ensure your incoming pile of money will support you, your family, and your legacy. These principles apply to all situations where access to major wealth is about to become a new and potentially intoxicating experience.
As we discussed before, you need to do a lot of up-front thinking about your needs, wants, and your legacy. You’ll need to understand your needs and get a handle on your current and future costs. You’ll need to avoid bad investments by setting up guardrails around your investment decisions. Last, you’ll need to continue to generate the needed current cash flow and future return on an after-tax, after-fee, and after-inflation basis. (Recall that we discussed inflation and the preservation of spending power in the previous chapter.)
Additionally, you have to defend your resources against a variety of threats to your wealth. What are these threats, and how do you mitigate their risks? In short, the primary threats to wealth can be summarized as bad investments, taxes, infighting and poor communication, lawsuits, excessive spending, divorce, and predators. Let’s look a bit closer at each of these threats and learn how to protect against them.
Bad Investments
Bad investments can be made when people fail to put a long-term plan in place or lose sight of their current long-term plan. Instead, they invest haphazardly, without any framework for understanding how these investments fit into their longer-term objectives. You need a solid long-term investment plan if you are to avoid the heartbreak of losing your wealth from too many brother-in-law apps or car wash deals that end up being little more than full-employment scenarios for the people seeking your money.
This long-term road map should include diversifying your risk and maintaining an asset allocation process, so you understand what you’re investing in and why. The plan must also integrate how much you cost now and how much you expect to cost in the future. By marrying those two calculations—asset allocation and spending needs—you can create guardrails to minimize your risk. With guardrails in place for making good decisions, you’ll be able to avoid big investment losses and major surprises in cash flow and spending. The plan should be reviewed periodically to ensure that your advisors continue to have you pointed in the right direction. Your advisors should be held accountable for their performance, and your plan should be updated if there are changes in your circumstance.
You need to have a good process for evaluating investment opportunities that land on your doorstep (and they will—it’s amazing who comes out of the woodwork). It’s helpful to revisit the concepts of liquidity, transparency, and yield. After the investment policy statement, this knowledge is your second line of defense when it comes to investment discipline. I meet many people who are raising money for great business ideas, and after they deliver an awesome pitch and I’m captivated by their charisma and vision, my first instinct can be, “Where’s my checkbook?”
Instead of whipping out said checkbook and investing in the opportunity, I harken back to my long-term plan and disciplined strategy for evaluating investments. I ask three questions:
Do I have the ability to pay for this out of my investment allocation?
Does this investment look good from a liquidity, transparency, and yield perspective?
Failing that, are there significant social impact reasons that are strong enough to trump the other elements of my investment process?
This “next” level of discipline and questioning helps to prevent bad investment decisions. It can also help correct previous mistakes.
Sometimes people are busy, disinterested, or don’t have the skills to create this structured approach to evaluating investment opportunities by themselves. In this case, a good wealth manager can step into that role and codify the structure of decision-making for investments. Your manager can maintain that investment discipline with scheduled check-ins regarding your wealth, income, and spending. A second (or third or fourth) set of eyes helps in making better decisions.
Among other things, having regular meetings with your wealth manager ensures you don’t overconcentrate in one investment or overdiversify across too many investments. If you have thirty or more mutual funds in your investment program, you’re most likely not getting the benefit of scale, and you are probably paying excessive fees for middling performance.
Good questions to ask your advisors are:
Is my asset allocation too complex?
Am I overdiversified?
Why are we allocated to this asset class? This fund? This position?
Does having a 0.5 percent allocation to this investment really make sense?
It’s also important to understand where you are on the spectrum that spans from wealth creation to wealth preservation. If you’re an eighty-five-year-old with a defined amount of money that must last for the rest of your life, you’re on the wealth preservation end of the spectrum. Putting assets earmarked for current cash flow in risky, concentrated, illiquid investments is inappropriate. Younger people, however, are more likely to be able to take those risks. Given the early stage of their careers, they often find themselves on the wealth creation side of the spectrum.
Being older doesn’t necessarily mean that none of your investments will be focused on wealth creation. It’s possible you might invest a portion of your wealth to benefit your kids and grandkids, who have longer time horizons for wealth growth. That is the point of having a solid investment policy statement. Many investing mistakes can be avoided by defining specific life and legacy goals and allocating resources accordingly. Placing those assets in tax-efficient entities or structures can be useful in meeting your various objectives.
Taxes
Everyone tries to minimize taxes, but if you’re following the law, you can’t avoid them. There are a variety of taxes that you need to worry about. Most people are familiar with income taxes. When you make money, you must pay income tax to the federal government, and most states also collect a state income tax. If you’re lucky enough to live in a city that charges a tax, you’ll owe that too. People use many types of tax deductions and other strategies to minimize the amount they owe in income taxes.
The capital gains tax applies to people who have assets that they buy and sell, and this is an important tax to keep an eye on. Mistakes can be made in buying and selling assets if you don’t have a fix on the capital gains landscape. Basic strategies here—such as holding investments for longer than one year—can have a significant impact on the amount of capital gains tax you’ll owe when you sell an asset and post a gain. If you built a business or have a huge asset within your wealth and you wish to sell that huge asset, structuring your planning in a way that minimizes capital gains taxes can be one of the greatest drivers of your future wealth. You might structure the sale in such a way that the asset is sold over a period of years as one simple strategy toward reducing your tax hit. As a side note, there are strategies that seek to characterize income as a capital gain. People do this because capital gain is often taxed at a lower rate and has other favorable treatment. Before doing this type of planning, speak to an experienced accountant.
The use of mechanisms such as trusts can also help to avert a state income tax, which can be as much as 10 percent. Accountants and advisors have a host of mechanisms and strategies at their disposal to help you
minimize that capital gains tax. Accountants can also make sure you pay what you owe and that you pay on time.
Beyond your gains, you can also minimize taxes by taking losses in a portfolio if there are poor-performing investments you’d like to sell. Over the long haul, you can add a lot of return to your overall portfolio by taking losses and netting them against gains elsewhere among your holdings.
You should also keep an eye on estate taxes. This includes the gift tax and generation-skipping tax. As you move into multigenerational wealth, you can plan around the estate tax regime, sometimes avoiding as much as a 50 percent tax hit that might surface as you transfer wealth from one generation to the next. The marital deduction is a big tool here as well. There is an entire industry of lawyers whose sole job is to help minimize the estate tax hit as you try to move wealth from one generation to the next.
You can also use a life insurance policy to pay part or all of the estate taxes generated upon your death and help fund the income needs of your spouse and family. Life insurance can be a factor in minimizing the bite of estate taxes. Similarly, the use of philanthropy and charitable trusts can also help reduce your estate tax burden. Family foundations can provide a nice structure for executing your philanthropic goals, and those foundations also carry components that can be useful in mitigating the taxation of income, capital gains, and your estate.
Estate planning is a field that is not only complicated and time-consuming, but also the laws change so often that your plan may need to be adjusted regularly. You’ll want to stay abreast of estate taxation issues and work with experienced advisors in this area to avoid overpaying estate taxes.
There is a massive industry and support structure devoted to tax policy and helping clients legally avoid taxes. Hundreds of books and articles are written every year dealing with the arcana associated with the subject. The law and practice around taxation changes quickly, so it’s best to get an experienced set of advisors in place as you arrange your affairs.
Infighting (Communication Breakdown)
Infighting can develop in tandem with an increased dependence on wealth. This gets back to our previous discussion of the dangers of becoming addicted to private jets, big trips, fancy cars, and the hot and cold running champagne that can come with sudden wealth. Good communication, as we discussed earlier, is truly one of the most important foundations for transferring values and preventing infighting. You’ll start to see the destructive impact of infighting when family members begin to behave in ways that betray the values you have established.
If your wealth becomes more limited, serious issues can surface. Consider this common scenario: you have two children, and then your two children get married and have two children of their own. This means you’ve gone from covering the expenses of two people (your children) to the expenses of eight people (your children, their spouses, and their four children).
As I mentioned before, there is a saying that the first generation makes the money, the second generation takes care of it, the third generation spends it all, and the fourth generation is left with nothing. With each successive generation, the number of people under your wealth umbrella increases, and it’s difficult for linear investment returns to keep up with the exponential growth of families.
This brings us back to the importance of family communication. Before any infighting begins, explain to the family why certain structures exist and how they work, so all family members will understand their purpose and importance. Hopefully, that will prevent infighting, create buy-in, and establish an appreciation for where the wealth came from and what purpose it serves going forward.
Build Teamwork and Prevent Problems
As I noted in the hurricane chapter, getting a head start on communication practices is vital for wealthy families. There are exercises you can implement toward building communication and teamwork within your family and helping them understand how investments work. Let’s look at a couple of examples of how these exercises can work.
First, let’s say you have $5,000 earmarked for philanthropy, and you have four children. You give each child $1,000, and they are to give their portion away to the charity of their choice. This exercise helps to cultivate an interest in the community and teaches your kids the value of supporting causes that are greater than themselves. Then, you ask the four children to decide jointly where the remaining $1,000 goes. This teaches them a bit about one another’s values and helps them learn how to make broader decisions together. This is a great way to build healthy communication, prevent future infighting, and transfer family values.
A similar exercise can teach children how investments work and what happens when you lose your money. In this exercise in investing, the goal could be anchored around a family vacation or other shared experience. Let’s say you have a $4,000 pot of money for vacation, and you ask your children to investment that money. If they lose it all, there’s no vacation and they stay home. If the money doesn’t grow, then you go on a $4,000 vacation. If the money does grow, however, you’ll go on a really fun and exciting vacation that costs much more. In doing this, the kids are nudged to learn what investment options are out there, and they learn to make decisions about money for which they are held accountable. They also get experience working together toward a common goal. Last, they’ll learn about their interests and talents, and conversely, they’ll identify the areas where they’ll need improvement or support.
The four kids might decide to invest in a penny stock, hoping it will skyrocket and turn their $4,000 into $50,000 so they can gas up the family jet and take a ski trip to Whistler. By attempting investments like this, they’ll have a range of valuable investment experiences. If the penny stock goes completely bust and the kids lose their vacation, that experience might teach them to invest their money a bit more conservatively. Perhaps they’ll have success and will take away a different lesson from that.
Regardless of the outcome, they will see what happens to their invested money, not just on a printed statement but also in real life. The goal of the exercise is to create a teamwork environment while also educating each person on investing. They learn how to work and communicate around their individual strengths and weaknesses to make financial decisions as a group, which will benefit them later if they need to settle an estate or sell the family business.
When a family has an elevated level of wealth, it can make sense to create a family bank. With this vehicle, family members with entrepreneurial interests can receive money from the family to start a business. The family bank would be comprised of family members able to handle the quantitative analysis needed, with less hard-heartedness than Wall Street. This would help entrepreneurial family members learn how to give a business presentation and how to raise money for an enterprise using resources they don’t currently have. In other words, they would learn the valuable skill of how to get people to invest in their ideas. This lays the foundation for successful entrepreneurship. At the same time, the family bank provides a safeguard around the wealth, preventing uninformed or excessively risky investment decisions.
There is no perfect solution for every family, but these are great ways to prevent infighting, build teamwork, educate your kids, and help them learn from rookie mistakes. When they are faced with much bigger decisions later, they are more prepared. These lessons and exercises could begin at a younger age, before the children discover their family wealth is worth hundreds of millions of dollars.
Divorce
Divorce can be a major threat to wealth. They say romance is dead, and they’re probably right. A wealthy family with a marriage on the horizon should always have a discussion around a prenuptial agreement, in my opinion. At a minimum, it’s a good time to review the assets on each spouse’s side. Statistically, the odds of divorce are a coin flip, and it is therefore necessary to protect your wealth from the threatening outcomes of divorce.
If you get divorced in community-law states like
California, you’ll be taking a 50 percent haircut, depending on when your assets were earned and other factors. Most other states try to be friendly to the “nonearning” spouse to ensure their lifestyle (and the lifestyle of the kids) is supported. Understanding this fact should open your eyes to the risks of a failed marriage, ideally before you go into it. During a divorce, attorneys and advisors are positioned to advocate for their client and get the best result possible. Properly thinking through what may happen to your financial situation in the event of a divorce, and having adult discussions around the topic, can save emotional and financial pain later.
Also, if you’re going through a divorce, don’t use your lawyer as your psychologist. This is expensive, it distracts the attorney from his or her core work, and it usually leads to worse outcomes. I recommend hiring experts to perform the functions they are experts in. Be a good client, be prepared, and try to take care of your emotional damage outside the lawyer’s office.
Excessive Lifestyle
When people become accustomed to the finer things in life, their lifestyle preferences can become difficult to support. There is nothing that can be done for a client that spends more than they have (or will have). Remember, private jets are the billionaire’s crack. I’d reexamine the question, is flying privately truly worth the increased expenditures? If you’re flying first class, you must really hate first class to want to join NetJets or another plane-sharing program. And you must really hate sharing a plane if you want your own private jet, because the expense of ascending each of these steps is unbelievably high. The expense rises geometrically for relatively small gains in convenience and experience. In the case of our younger actor, what happens to him if his career dries up at age forty, and he has spent all of his money? That private jet habit will be unsustainable, and this will end up being an extremely bitter pill to swallow later in life.