Succession success

PORTFOLIO POINT: Estate planning is vital to ensure money does not 'leak' in the transfer from one generation to another.

Over the next 20 years in Australia more than $6 billion of family wealth will be lost through non-optimal investment restructuring. This is my estimate based on applying a conservative 1% factor to the $600 billion of wealth that Goldman Sachs JB Were reports will be handed from one generation to the next.

Here I would like to provide examples of where wealth can leak away well before, during and after transition, and how an “Investment Succession Plan” should become part your Estate Plan.

A word of warning: comprehensive estate planning is a challenge because it must deal with the complexities of overlapping estate, trust and superannuation law as well as investment theory and taxation. When it’s time to implement the plan, decision making authority is often ambiguous and full of emotion including intra-family sensitivities (often heightened when there is money to divide).

If you think about it, it is no surprise that maximising after-tax investment outcomes falls off the list of things to do. But you should have a plan to avoid losses at key steps along the way. Here’s a guide.

Losses preceding wealth transfer

Medical science describes dementia as a progressive loss of cognitive and intellectual function that is not necessarily evident to the sufferer. It follows that some people as they get older find change difficult and may outgrow their ability to manage their investments. I sensitively describe this as “Investment Dementia” and it can lead to direct financial loss or loss of opportunity in a number of ways:

• Portfolios left unmanaged, which have become overgrown in shares or property after decades of unpruned growth. These portfolios can fall further in a correction than need be, as discussed in a previous article (see Get ready to rebalance.)
• One investment or several of a similar kind dominate, whereby failure in that company or disruption to that industry has a more devastating effect than it should.
• Lazy money sitting dormant in a low-interest savings account, which is in the bank’s – not the saver’s – interest.
• Money sitting in high-fee products such as old life insurance savings plans, where the policy holder has become a tributary to an insurer’s “rivers of gold” income stream.
• Lost opportunity to participate in a wave of property redevelopment or to enhance a property to earn more rent.
• Investment in an inappropriate entities such as a company structure when perhaps a trust or super could have been used to reduce or eliminate tax.

Losses at wealth transfer

Death is often accompanied by the transfer of large lump sums of money. It is during this time that money can be lost through inadvertent investment decisions or through paying higher tax than necessary. All this is understandable given emotion and the lack of specialist skill by both the family executor and even their advisers. Just getting the money from the deceased to the inheritor is often seen as the success benchmark, rather than getting the maximum amount.

Many do a great job managing risk by diversifying assets across different investments, however not all diversify sufficiently across time. Improper timing of divestment and reinvesting, including substantial proceeds from a business sale or insurance, can be a source of loss in volatile markets. I personally felt great remorse speaking with a woman on ABC radio earlier this year, who asked me whether then was the right time to re-enter the share market after she had sold her deceased husband’s shares in March 2009 when he passed away. (March 2009 was, we now know, the bottom of the market when the ASX 200 sank to 3030 against about 4400 today,)

I consider a core-satellite investment approach (see Put your portfolio into orbit) very suitable to estate planning.

Rather than a skill mismatch, asset allocation can simply be misaligned where, for instance, an inheritor desperately needs to sell an inherited asset to pay off debt. Just as you would tell your son or daughter to avoid the stockmarket to fund a home purchase a couple years away, you might wish to change in advance an investment strategy or bring forward giving if the beneficiaries have different needs. From an overall family perspective, it may not make sense for one generation to be getting 5% on cash deposits while another generation is paying away 7% on loans to the same bank.

Sometimes you may not be able to control investment decisions; for instance, if a public offer super fund’s policy is to automatically divest into a capital guaranteed cash fund upon notification of death. This also can often be inadvertently done for you by a well-meaning executor who may take several months or more than a year to accumulate then disburse assets.

During that time assets may be out of the market for an unprofitably long period. It is ironic that shares are sold into cash so money can be given to beneficiaries who reinvest them back into shares.

While accountants are great proponents of the maxim “tax deferred is tax saved” if you and/or your partner pay little tax, then having your high-income daughter or son inherit your unrealised capital gains may inadvertently cause more of your wealth to be shared with the tax office than kept in the family. While in some cases it may make sense to bring forward rather than defer tax, it may also be worthwhile directing tax liabilities further down your lineage to your grandchildren through the use of Testamentary Trusts.

Superannuation is both a source of opportunity and loss when it comes to wealth transfer.

Many miss the opportunity to keep assets in super (including sometimes insurance) where they might compound tax-free, funding pension payments to a surviving spouse or dependent children. New contribution limits often mean if the money is paid out of super your beneficiary might not be able to recontribute it back effectively into super or may need to wait until 60 to access it.

On the other hand, an inheritance-like tax means you may need to reach for your cheque book rather than your nitroglycerin tablets in the event of a sharp chest pain. This is because a death benefit paid to adult children from super may be taxable including unrealised capital gains. If instead money was taken out of super and gifted prior to death it could be received tax-free.

It may also make sense for your fund to apply for an “anti-detriment” payment, which could add up to 20% to the balance of a deceased’s lump sum payment. This however might be reduced or eliminated if assets were paid out and recontributed to avoid the above-mentioned tax or if a pension is a more desirable outcome.

It has to be said that many in the legal profession who practise estate planning as a non-core activity don’t fully understand all the benefits of or pitfalls associated with superannuation. A dominance of “Will thinking” among individuals also may lead to the wrong conclusion that if you have a Will, you have an Estate Plan.

Finally, many who leave charitable giving to the after-life may find they don’t get to fully appreciate the joy of giving and its associated tax deductions.

Losses during legacy investment

When money is managed for future generations, leakage can sometimes arise through poor governance. Flat-pack furniture and legacy money have one thing in common: both should come with instructions. Rules, or an investment policy, are needed to explain what to invest in and not, how to keep the portfolio in trim, what to pay out versus reinvest, who has decision-making authority, how to deal with conflicts including amongst suppliers and how to manage tax.

I sometimes find legacy funds invest too much in Australian shares. I don’t know if this is to do with a love of franking credits and hatred of tax, or sometimes a bias that comes from working with one type of investment adviser. Unlike the Yale Endowment fund, most funds have no new money being contributed and a similar high equity bias needs to be challenged. Inflation-linked bonds, of which I’m a fan (click here) would seem a good fit for legacy investments. Annuities are making a come back and even the legendary stock market trader Jesse Livermore found a use for them.

Investment succession planning

A good Investment Succession Plan needs at least answer the following questions:

• If I’m unable to manage my investments, how capable is my partner, another family member or executor to do so? Is my current investment approach suitable? Do I have or is my current advisor able to assist? Do I need now a contingency plan? Do I need a Power of Attorney to effect this?
• What do I think my beneficiaries will do with my assets and is my current allocation be aligned to their needs? How should money left for others be managed? How much should be spent versus reinvested so it doesn’t run out?
• Is the transfer and reinvestment of assets from superannuation, insurance, family trust, and other structures which may all bypass my will, properly considered? Should my will incorporate a testamentary trust or can those objectives be met through superannuation pensions? Am I passing on an immediate, expensive tax bill or one that can be eliminated or postponed?
• Are my plans understood by all and records accessible? Have I struck the right balance between control to ensure who gets what and flexibility to deal with ever changing legislation, family needs and overall wealth?

While many individuals have worked with their advisers to establish sensible arrangements to ensure the transfer of legal ownership of assets, sometimes more planning is needed to ensure investments are efficiently transferred.

Doug Turek is the principal advisor of Professional Wealth and a member of the Society of Trusts and Estate Practitioners. This article is based on a presentation given to the Dealer’s Group 'Family Wealth Investing Forum’ in May 2010.