What We Talk About When We Talk About Estate Planning*

A scientist spends a lifetime of research to develop a popular chronic illness drug and makes US$120 million off the patents. The sub-prime crisis promptly reduces that amount by almost 50 per cent and the client inevitably sues, claiming he was given bad advice and made investments he wouldn’t normally have made and that were not in line with his risk-taking profile[i]. A single person’s story, but one that was repeatedly seen during the tumults of 2007-9 when the ‘bottom fell out of the markets’ and there was seemingly no safe haven anywhere. Curious risk-decisions were made by clients who subsequently claimed the investments they had made were not in line with their risk profile or capacity, and fortunes were lost.

In Singapore, the financial markets authority, the Monetary Authority of Singapore (MAS) has acted decisively to investigate these claims by consumers and have issued strict guidelines for the sale of ‘structured’ financial products[ii]. Similar initiatives are making their way through most of the OECD markets’ approval process, ostensibly with a view to making investing a safer activity.

A full review of the financial markets regulatory changes that have been put in place or that are on the drawing board is beyond the scope of this article, but I would like to share some musings on what we, as estate planners, ought to think about when we discuss ‘planning’ with our clients; particularly with a view to what advice we should give when the clients are presenting us with investment ideas that carry significant risk to the principal of the investment.

Where did all these ‘structured’ products come from?

It is an old saying that investors tend to get more bullish at the top and bearish at the bottom but we can only know which end of the market we are at in hindsight. As the stock market faced a correction from the initial highs in 2000, private investors seemed to turn away from ‘plain’ stock market investments towards more innovative structures that offered higher returns, particularly from emerging markets. Hedge funds were already offered to more or less retail investors with low minimums and the HNW clients were seeking alpha[iii] elsewhere. We are all familiar with the so-called sub-prime mortgages as an example of bundled asset-backed securities and with investors seeking ever greater returns from supposedly less risky assets, the use of leverage increased exponentially. The story played out according to plan, as such schemes invariably seem to do at the beginning, before the ever-increasing flow of capital chasing the same returns became so top-heavy that the market crumbled.

It could be suggested that the easy availability of credit towards financial investments caused its own demise by overwhelming the market and narrowing margins to a point where the amount of leverage needed to produce the returns needed to excite investors simply wasn’t available anymore. Leverage, in a sense, caused its own destruction…at least for a while. We’re now back in market-expansion mode and with historically low interest rates we are seeing a tremendous increase in the use of leverage as financial institutions regain confidence and open up the purse strings.

Low interest rates let companies borrow cheaper funds which sends bond yields (the traditional defensive asset class) lower which in turn causes investors to leverage these bond portfolios in order to achieve a semblance of ‘past’ returns. Investors are rarely willing to accept zero as a target return, though they were willing to pay the US Treasury to lend them money during the worst of the crisis, as seen by the negative YTMs seen on some issues during 2008[iv].

So, as clients became increasingly comfortable with leveraged investments, their use of leverage increased and spread to every corner of their portfolios.

Leverage can essentially take two forms; explicit and implicit. Explicit leverage is when a client takes out a loan, eg a mortgage or a margin account, and the terms of the loan are clearly stated and generally well understood by the client. Implicit leverage is when the leverage is built in to a packaged, or structured, product and the packaged solution is offered for sale on a term sheet basis. The latter category includes the previously mentioned mortgages but also more generally used solutions such as ELNs and so-called ‘accumulators’[v] – structured products where the client commits to buying shares of a company at pre-determined price(s) if the stocks should decline…a relatively harmless activity in a bull market when stocks trade higher, but a decidedly harmful activity if stocks decline - as our scientist in the opening paragraph can attest to.

I urge the individual estate planner and fiduciary to do further research on the various products any given client may want to include in a structure and to have a conversation with the client as to the objectives behind each of these investments as they relate to the client’s long-term goals for the structure, be it a trust, foundation or simple PIC.

“Our powers of investments are being curtailed”

We are often faced with clients who retain significant investment powers over assets in a structure and though this is not always a negative thing, it is clear that the investments should be made in accordance with the terms of the structure and that we have a responsibility to question decisions that we feel may not be in the beneficiaries interest long term.

Our scientist is only one of a number of cases where the client claims to have not fully understood the full ramifications of the investment agreement; though he perhaps understood that he’d be buying stocks if they traded lower, he was obviously not aware of the extent to which the market would decline. Neither was his adviser, I am sure, but a pre-commitment conversation might have been helpful, particularly if the client was shown a graphic representation of the potential gains vs. losses, particularly if the investment had a ‘double-down’ component which would have caused him to buy more and more shares as they dropped. These features are sometimes included in order to create a higher yield on the note – essentially by selling a ratio of puts. The premium received for the option represents the coupon on the note, the increasing amounts of shares the risk. If the note was set to yield, eg eight per cent per annum, and the downside was explained in terms of a reduction of the yield (quickly turning into a large negative), perhaps a smaller amount would have been invested.

Now, I am not suggesting that clients be kept from making any investment they wish, though our regulators are increasingly imposing limitations on what investment advisers can sell them. What I am suggesting is that the client needs to separate risk assets from ‘legacy assets’ and manage them separately – risk assets that can take a 50 per cent reduction without imperiling the estate plan we have so carefully crafted. In other words, if we have established an estate plan that is intended to ensure that part of the client’s assets are protected for the next generation, we should not immediately accept the inclusion of heavily leveraged, structured products that could have a negative effect on the whole.

Charles Monat Associates’ experience during the crisis

Being in the business of very long-term asset protection and legacy creation, CMA have 40 years of experience advising clients on strategies that can help preserve key ‘legacy’ assets over the generations. During this time we have experienced numerous shocks to the financial system, including several ‘boom and bust’ cycles in Asia (by my count at least six ‘crashes’ since 1985) and we have seen firsthand the impact of aggressive management of financial assets and the use of leverage which often has not panned out as intended.

In our practice we tend to focus on the most conservative of instruments in order to create a ‘ring-fence’ around other assets. In my previous article for IFC Review[vi] I dealt with some of the risk-mitigating benefits of employing life insurance as a zero-correlated asset class and also gave some ideas of how properly structured life policies can add an amount of certainty to trust assets. I suggested then, and remain convinced today, that incorporating a life policy in a legacy plan will serve to preserve some of the assets the client intends to pass on down the generations; preserve not just against taxes and other liabilities, but against the ever present temptation to allocate long-term assets to short-term investment opportunities.

During the recent crisis, particularly in 2008 and 2009, a number of our clients found themselves with margin calls to meet on their short-term portfolios and were able to meet these through policy loans; essentially accessing the cash values in their policies in order to overcome a short-term liquidity squeeze, without having to give up the coverage. Policy cash values were unaffected by the large drop in financial markets, contrary to what was happening in the markets at large.

A typical example would be a client who had funded a US$10,000,000 insurance policy with around US$2,500,000 premium and by early 2009 had about US$3,000,000 of ‘cash surrender value’. At this point, 90 per cent of this value would be available as a policy loan and could be used to mitigate an external liquidity event. As 2009 drew to a close, most of these loans had already been repaid as markets recovered, but most clients have yet to see a similar recovery in their investment portfolios.

Conclusion

If we are in the business of long-term estate planning and legacy creation, we must have structures and processes in place to explain the ramification of the clients’ choices with respect to leverage in all its ‘structured’ forms. As estate planners we deal with the (hopefully) very long term and must guard against being put in a position where the assets can be subject to short-term mood swings on the part of the client. I have had conversations with many clients who run the estate plan on the premise of ‘no risk, no return’ and though this may ring true, I have often wondered how much pain they would be willing to put up with in return for a given amount of gain. As we saw in 2008, this decision was often taken for them by stop-outs on margin accounts.

We always explain to our clients that there is a difference between ‘legacy assets’ and ‘investable assets’. Though the client may feel they are interchangeable, they are not. A meaningful conversation about the long-term objectives is indispensable and will prevent that difficult conversation in the future.

* With apologies to Raymond Carver

[i] The Business Times, Singapore, November 2, 2010

[ii] http://www.mas.gov.sg/for_consumers.html

[iii] http://en.wikipedia.org/wiki/Alpha_(investment)

[iv] http://seekingalpha.com/article/102901-understanding-negative-bond-yields

[v] http://moneywatch.bnet.com/investing/blog/wise-investing/bad-investments-accumulators/584/

[vi] http://www.ifcreview.com/restricted.aspx?articleId=1564&areaId=0

Odd Haavik
Odd Haavik is the Chief Executive Officer, Asia & Europe for Willis Global Wealth Solutions (GWS), a division of the Willis Group. A global risk management consultancy, GWS serves individual HNWI, their families and businesses from offices in Singapore, Hong Kong, Zurich and Miami. He can be contacted at odd.haavik@willis.com. Willis Global Wealth Solutions home page is www.willis.com/gws