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Tag: Forbes

The Good, The Bad, and The Ugly of Projected Tax Implications

There has been a lot of talk about the House Ways and Means Committee’s tax proposal. Whether in The Wall Street Journal or from Take the Long View podcast guest, John Jennings’ break down of the good, the bad, and the uglyspeculation is all over the placeAs a client of Hill Investment Group, you can rest assured that we are planning for all of the potential iterations.

Below we’ve reviewed the most relevant points for our clients. Have questions? Feel free to reach out to us to discuss how the potential changes may affect you. Set up a time to talk here.

House Ways and Means Tax Proposals Current Law
Top Income Tax Bracket Increase the top individual income tax bracket to 39.6 percent. This new top bracket would start at taxable income levels of $400,000 for single filers, $450,000 for joint filers. Effective 1/1/2022. The current top tax rate is 37 percent on taxable income over $523,600 for single filers and $628,300 for joint filers.
Capital Gains Increase the statutory capital gains rate to 25 percent. Effective 9/13/2021, subject to a binding contract exception. The current top statutory capital gains rate is 20 percent.
Estate and Gift Tax Reduce to an inflation-adjusted $5 million. Effective 1/1/2022. Inflation-adjusted $10 million ($11.7 million in 2021).
Roth Conversion Eliminate Roth conversions for both IRAs and employer-sponsored plans for single filers with taxable income over $400,000 and joint filers with taxable income over $450,000. A person can convert their eligible IRA assets to a Roth IRA regardless of income.

Have questions? Feel free to reach out to us to discuss how the potential changes may affect you. Set up a time to talk here.

Make It and Preserve It

In one of his latest pieces for Forbes, Take the Long View podcast guest, John Jennings wrote about how the actions and values that lead to creating wealth are not the same as those used to preserve it. For example, risky and concentrated bets may have worked well in creating wealth but can be disastrous for preservation.

Preserving Wealth Is A Very Different Discipline Than Creating It

By John Jennings

Forbes.com  –  June 30, 2021

When I first started in wealth management, I thought that entrepreneurs, being risk-takers, would want high-octane, risky investment portfolios. I came to realize the opposite is true – a top priority for them is to preserve the wealth they have created. While building their business, they knew they could lose everything. As they take money out, they want to be sure to keep it.

Reid Hoffman is a partner in the venture capital firm Greylock Partners and a founder of PayPal and LinkedIn. At a conference I attended years ago, he was asked whether his PayPal experience led Greylock to invest in payment companies. He replied that Greylock hadn’t made any investments in payment firms since he became a partner because he had vetoed them. Hoffman knew how hard it was to create PayPal and how lucky they had been, so he was hyper-aware of the barriers that payments companies face. Hoffman knows that everything it takes to make your first $100 million can work against you when you’re trying to keep it.

Generating Great Wealth

While there are exceptions, if you want to generate significant wealth, you must own part of a successful business. High-income earners – like doctors and lawyers – make a nice living, but people who vault into tens of millions or more are business owners with remarkably similar strategies. They:

  • Concentrate their assets, usually in a single company. This increases the chances of winning big if their one big bet pays off.
  • Tolerate a high level of risk: their success or failure depends on their company. If it takes off, they are rich; if it flounders or fails, they aren’t.
  • Are obsessed: they invest almost all their time and talent in their business. Building the company is their singular focus and takes over much of their lives.

And luck plays a role too. Looking back, successful company owners can identify how everything seemed to come together “just so.” If a few things had happened a bit differently, their company wouldn’t have been as successful. On the flip side, bad luck kills off many otherwise promising businesses.

Preserving Great Wealth

The strategies for preserving wealth are the opposite of those for generating it.

  • Instead of being concentrated, diversify. Spreading wealth among many investments eliminates the chances of losing it all.
  • Lower the overall level of risk by reducing leverage and building a margin of safety by allocating to bonds and cash
  • Involvement moves from active to passive. Being an investor means investing in someone else’s company. Investors generally don’t influence the success of the companies in which they invest, so let the money do the work.
  • Mitigate the effects of luck by following a disciplined investment process. Setting portfolio strategy and rebalancing are essential tools for long-term success.

Preserving wealth requires a mindset and discipline that avoid huge losses. I recently discussed with a client whether to put half of her wealth into a new business venture. If the business failed and she lost that money, it would affect her lifestyle and financial security. On the other hand, if the startup business took off and doubled or tripled her wealth, very little would change – she already had enough to achieve all her lifestyle and financial goals. Accordingly, she invested 20% of her money into the new business and found other investors to make up the difference.

Note that preserving wealth doesn’t preclude excellent returns; over the past decade, a 70/30 portfolio of globally diversified stocks and bonds more than doubled in value. Compounding returns in a diversified portfolio can turn great wealth into even greater wealth. But if you start with a modest investment, a doubling of value in a decade is a long way short of the outsized returns needed to turn it into tens or hundreds of millions of dollars.

Think of Two Buckets

After a successful business is sold, it’s important to keep the generating versus preserving wealth paradigm in mind when deciding how much to invest in another new business. Prior success doesn’t guarantee you’ll catch lightning in a bottle a second time.

I advise my clients to imagine two buckets and decide how much of their wealth should be in each. Taking this bucket view helps in several ways.

First, thinking in terms of two buckets help set expectations. The money in the generating wealth bucket can generate great returns or go to zero; 20% of new businesses fail within their first year, half survive five years, and only one-third make it to age ten. Money in the preservation bucket grows wealth less spectacularly, but reliably over the long term.

Second, as the value of a business grows, it may make sense to move value from the creating bucket to the preserving one. As William H. Vanderbilt once said, “Any fool can make a fortune. It takes a man of brains to hold onto it.” Or a person with two buckets.

Deadly Sins of Our Industry

Forbes writer and TLV podcast guest John Jennings wrote a piece comparing the norms of the wealth management industry to the seven deadly sins. Because we have seen these sins committed regularly and built our firm to avoid them, in the spirit of clarity and transparency we feel that it’s our obligation to our clients and friends to make sure that you are fully aware of them. Read his piece below.

The Seven Deadly Sins Of Our Industry

By John Jennings

In his investment book “Where are the Customers’ Yachts?” Fred Schwed opens with the story that gives the book its title:

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York Financial District. When the party arrived at the battery, one of his guides indicated some handsome ships riding at anchor.

He said, ‘look, those are the bankers’ and brokers’ yachts.’

‘Where are the customers’ yachts?’ asked the naïve visitor.

Although the wealth management industry has evolved since Schwed’s book was published 81 years ago, the underlying issue remains: it is first and foremost a money-making machine for those who work in the industry. This doesn’t mean the wealth management sector is made up of bad people (I’m one of them!) but rather that their incentives aren’t usually aligned with acting in clients’ best interests. Like Upton Sinclair says, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

According to Roman Catholic theology, the seven deadly sins are the primary feelings or behaviors that inspire further sin. The misaligned incentives of the wealth management industry roughly correspond to those deadly sins, and knowing them is essential to being a wise consumer of financial services. Once you understand what drives the wealth management industry, you can better choose which advisors to work with, evaluate their advice with clear eyes, and push back as necessary.

The seven deadly sins of the wealth management industry are:

1.    Advisors are incentivized to provide the least amount of service possible (sloth). An investment professional I know who works in the trust department of a large bank told me that a common refrain at their bank is “don’t wake the dead.” In other words, don’t call clients unless they call you first. There’s a fundamental tradeoff in any business between customization and scalability. And it’s particularly acute in the financial services industry. Wealth management firms are incentivized to scale rather than customize because the more clients they can serve with limited people and resources, the higher the profits. By ignoring clients and being reactive rather than proactive, advisors can handle huge client loads, collect more fees and increase firm profitability.

2.    Advisors spend most of their time looking for their next client (lust). Years ago, I interviewed an advisor from a global investment brokerage who was looking to change jobs. When I asked why he was interested in our much smaller boutique firm, he told me he went into the financial services business to help people but doesn’t get to do that much. “About 80% of my time is spent on business development, and only 20% on actually advising and helping my clients,” he said. Unfortunately, this is common in wealth management firms because they’re structured so that advisors “eat what they kill.” To make more money, they must constantly obtain new clients. As a result, most advisors spend most of their time wooing new clients instead of caring for those they already have.

3.    Most advisors are compensated based on revenue and profitability, making them view clients as profit centers (greed). The compensation structure for most financial advisors creates an inherent conflict of interest that can lead to bad advice. For example, while reviewing the portfolio of a new client, we noticed he had a substantial margin loan. When we asked about the purpose of the loan, he said his previous advisor had recommended he use a loan rather than sell investments to fund his living expenses. Considering that the advisor was compensated based on a percentage of this client’s invested assets, this advice was suspect. By recommending a margin loan, the advisor not only maintained the full level of fees from the client’s investment assets but also earned fees on the loan.

I’ve also seen advisors discourage clients from making lifetime charitable gifts because it would reduce the assets under management and, in turn, the advisor’s fees. Or they use a higher fee mutual fund even though the fund has a lower fee share class because they make more money from the higher fee one. Similarly, many investment firms sell structured products like hotcakes because they are very lucrative for them but not necessarily for their clients. These are just a few examples.

4.    Wealth managers introduce needless complexity to justify their existence (wrath). Investment diversification is essential, but most portfolios are stuffed with way more funds than is needed. Why do advisors use five funds when one would suffice? A primary reason is the Shirky Principle, which holds that “institutions will try to preserve the problem to which they are the solution.” If advisors design simple portfolios, why would their clients need them?

I experienced this first-hand at a seminar for investment professionals who work for family offices. The 40 of us were divided into six investment committees and tasked with recommending an investment strategy for a hypothetical client family that had recently sold its business for hundreds of millions of dollars. The first five investment committees presented similarly complex portfolios with allocations to muni bonds, taxable bonds, high yield bonds, distressed debt, equity index funds, actively managed funds, growth and value funds, large and small-cap funds, developed and emerging markets international funds, hedge funds of various styles, private real estate, venture capital, and so on. Their pie charts were colorful and had many slices. By contrast, our investment committee, which presented last, proposed a portfolio of two funds: a muni bond fund and an index fund that tracked the global stock market. At first, the other participants were incredulous. It seemed crazy to suggest such a simple portfolio. But when our committee asked who was confident their complex portfolio would beat our simple one, no one raised their hand. A chief investment officer for a multi-billion-dollar family office noted that the biggest problem with our portfolio wasn’t its likely after-tax performance but that he’d have to fire his staff of 10 investment analysts and possibly himself.

5.    Most advisors won’t say “I don’t know” (pride). The economy and stock market are inherently uncertain. Pandemics, boats stuck in canals, major pipeline hacks, terrorist attacks, Elon Musk tweets, and a host of other unpredictable events affect the economy and financial markets. The wealth management industry typically responds to all this uncertainty with overconfidence. Predictions of what the stock market will return and how clients should shift their portfolios are the rule rather than the exception. Yet investment professionals’ track records show they are terrible at making these predictions. But they continue to do it anyway. Why? One reason is that they think their clients expect them to have all the answers, so they don’t feel comfortable being honest about not knowing what will happen in a financial system that’s inherently nonsensical. But which do you think is better? Investing in flawed predictions or constructing portfolios with the recognition that the future is uncertain?

6.    Lack of transparency about fees (gluttony – sort of). This wealth management sin is more dishonesty than anything else, but it’s driven by gluttony: the desire to feed the endless craving for more fees. Even if your wealth management firm clearly states their management fee, such as a percentage of assets under management, figuring out the total fees you’re paying is tough. Underlying investments also charge fees, which can take some digging to figure out. For example, when we became the family office for a client whose investments were spread across several large banks and brokerage firms, one of our first projects was to find out how much he was paying in total fees. When we asked the relationship managers at the investment firms, they didn’t know or were reluctant to tell us. It took one of our junior analysts hours of pouring through fund prospectuses to arrive at an answer, which was that our new client had been paying fees much higher than he realized. Because high fees are a significant drag on investment returns, doing this calculation is essential.

7.    The tax drag of investments is treated as secondary or ignored altogether (not exactly envy, but it’s the only deadly sin left). Like fees, taxes weaken investment performance. In fact, they’re typically greater than or equal to the total investment management fees. Yet, the wealth management industry tends to pay lip service to the tax drag on a portfolio. They use sophisticated software to track investment performance, but tax drag isn’t something they report. It takes work to figure out how much tax is generated by various investments. Advisors may use portfolio turnover as a proxy for tax efficiency, but that’s only a rough estimation. Assessing the actual tax drag requires looking through a client’s 1099s or tax returns. Considering the impact that taxes have on returns, this is a massive industry oversight.

What To Do About the Sins
Most advisors aren’t sitting around the office thinking of new ways to underserve and overcharge clients. Rather, the seven deadly sins are subtle; advisors serve multiple masters, and clients aren’t usually at the top due to misaligned incentives.

As a financial services consumer, the most effective thing you can do is choose an advisor at a wealth management firm that has structured itself to minimize the seven deadly sins. To do this ask prospective and current advisors questions such as:

1.    How does your firm make money? Do you receive any income from products? Any indirect compensation from any other financial firm?

2.    How are your people compensated, and on what metrics is their compensation based?

3.    What metrics do you use to assess client profitability?

4.    How many other clients does my advisory team serve?

5.    How do you incorporate tax efficiency into your portfolio recommendations?

6.    Will you provide a completely transparent report of all fees that my portfolio will incur?

The answers to these questions will reveal to what extent your relationship with your advisor will be negatively affected by self interest. You work hard for your money and deserve to have a yacht, too.

Featured entries from our Journal

Details Are Part of Our Difference

Embracing the Evidence at Anheuser-Busch – Mid 1980s

529 Best Practices

David Booth on How to Choose an Advisor

The One Minute Audio Clip You Need to Hear

Hill Investment Group