Session 12 - Private Wealth Management (I) Flashcards
Contrast private client and institutional client investment concerns;
1/ Investment objectives
- for private, may not be clearly defined or quantified, may compete with one another, changes over time
- vs. institutional, more clearly defined objectives, unlikely to change over time
2/ Constraints
- for client, shorter horizon, lower risk tolerance, higher liquidity requirement
– different horizons for different objectives
– portfolios are smaller in size - limitations to certain asset classes
– not tax-exempt
- vs. institutional, long horizon, single investment objective
3/ Other Distinctions
- private client has no formal governance structure
- more vulnerable to emotional or biased investment decisions
- regulatory different for indvl and inst. inv
- private clietns w/ similar sets of financial considerations and objectives may pursue different investment strategies
Discuss information needed in advising private clients;
1) Personal Info
- - family situation
- - Proof of Client ID
- - Employment/ Career
- - Source of client’s wealth
- - Explicit return objectives
- - Investment preferences - liquidity, ESG
- - FInancial objectives and risk tolerance
2) Financial info
- - Asset, liabilities, CF
- - Projection of expenses, planned disbursement
3) Other relevant info
- - Wills, trust, life, and disability insurance
- - Decision-making parameters (who can approve or change IPS, approve the trade, etc), Service needs, and expectations
Identify tax considerations affecting a private client’s investments
- Taxes on income
- Wealth based taxes –> property, gifts
- consumption/spending taxes
- Tax avoidance (tax-free accounts, tax-free gifts)
- Tax reduction (tax-exempt bonds, low turnover funds)
- Tax deferral (retirement accounts, defer gains)
Identify and formulate client goals based on client information
1/ Planned goals -- can be reasonably estimated or quantified within an expected time horizon 2/ Unplanned goals -- unforeseen financial needs -- property repairs, medical expenses - Wealth Manager's Role: -- goal quantification, prioritization
Evaluate a private client’s risk tolerance;
- Risk tolerance
- Risk Capacity
- Risk Perception
Risk Capacity
= ability to accept financial risk
- determined by wealth, income, investment time horizon, liquidity needs
- clients with greater risk capacity can tolerate greater financial losses without compromising goals
Risk Perception
= the subjective assessment of the risk involved in the outcome of an investment decision
- use of risk tolerance questionnaires, conversations with clients
Risk tolerance
= level of risk an individual is willing and able to bear
– opposite of risk aversion (high RA = lower RT)
Describe technical skills needed in advising private clients;
Technical skills - specialized knowledge and expertise necessary to provide investment advice
1/ Capital market proficiency
- generalist understanding of markets and asset classes
2/ Portfolio construction ability
- portfolio that is appropriate for each client
- understanding of each asset class risks/ returns, correlations, investment vehicles, managers, strategies, etc
3/ Financial Planning knowledge
- working knowledge of estate law, taxation, and insurance
4/ Quantitative skills
5/ Technology Skills
- Portfolio optimization software, simulation tools, PM software
6/ Language Fluency
Describe soft skills needed in advising private clients;
Soft Skills - Ability to effectively interact with others
1/ Communication skills
- Active listening, effective verbal and written communication skills, presentation skills
2/ Social Skills
- Ability to understand and relate to others, empathy
3/ Education and coaching skills
4/ Business development and sales skills
Evaluate capital sufficiency in relation to client goals;
- Process to determine if a client has, or is likely to accumulate, sufficient financial resources to meet objectives
1/ Deterministic forecasting – straight-line manner, Simple but unrealistic 𝑷𝑽𝒑(𝟏.𝟎𝟔)𝟏𝟓 = 𝑭𝑽
– requires return assumptions, PV of anticipated future contributions/variables
2/ Monte Caro simulation – allows for the uncertainty of key variables
When capital will not be sufficient to meet goals/objectives
1/ Contributions must increase
2/ Goals must become more modest
3/ Goals must be delayed
4/ Higher expected returns (within risk tolerance) must be pursued
What tools can you use to analyze retirement goals?
1/ Mortality tables - indicates life expectancies at specified ages
2/ Annuities - provide a series of fixed payments in exchange for a lump-sum payment
- immediate annuity (begins right away)
- deferred annuity (begins at some later date)
3/ Monte Carlo simulation
- uses actual portfolio to estimate retirement needs
- produces a prob. of reaching a goal, but not a shortfall measure
Behavioral Considerations during Retirement
1/ Heighten loss aversion
2/ Consumption gaps - retirees spend less than expected
3/ The annuity puzzle - individuals tend not to prefer annuities
4/ Preference for investment income over capital appreciation
IPS purpose and + of it
- written planning document – objectives and risk tolerance over a relevant time horizon
(+) - encourages investment discipline
- reinforces the client’s commitment to follow the strategy
- focuses on LT goals
- evidence of client-focused inv. mgmt process
Expand on Background and investment objectives sections of the IPS
- labeled as ongoing or one-time
- detailed and quantified whenever possible
- which are the primary objective when there are multiple
- MV of portfolio and relevant accounts
- any other investment assets outside the portfolio + any CF from external sources
Expand on Investment parameters of the IPS
- risk tolerance
- investment time horizon
- asset classes used
- other investment preferences
- liquidity preferences - ESG, legacy holdings, non-advised holdings
- constraints - restrictions investments and strategies
Expand on Portfolio Asset Allocation of the IPS
- target alllocation for each asset class
- SAA –> target + upper/lower bounds (for rebalancing)
- TAA–> asset class target ranges
Expand on Portfolio Management of the IPS
a) Discretionary authority - ability of manager to act without client approval
b) Rebalancing - methodology and frequency of reviews - time-based or threshold-based
c) Tactical changes - if allowed, when and to what degree
d) Implementation - types of investment vehicles (MF, ETFs, proprietary investments)
- use of outside managers
Expand on Duties and responsibilities of the IPS
a) Wealth Manager responsibilities
- Developing the SAA, investment recommendations, monitoring, rebalancing, cost management, the use of derivatives and leverage, drafting/maintaining the IPS, performance reporting, voting proxies, perhaps 3rd party responsibilities (e.g. custodian)
b) IPS Review - how freq.
Expand on IPS Appendix
a) Modelled portfolio behavior
b) Capital market expectations
Traditional approach vs Goal-based investing approach
a/ Traditional approach
- Identify asset classes, develop CME (E(R), s.d., corr), determine portfolio allocation, asset constraints, implement the portfolio, determine asset location)
b/ Goal-based investing approach
- same process as above but align investments with goals (assign investments to goals)
- perform MVO for each sub-portfolio
- goals stated as max. volatility or min. probability of success
Describe effective practices in portfolio reporting
- asset allocation report
- performance summary
- detailed performance (by asset class, indvl securities)
- historical performance since inception
- contributions/withdrawals
- purchases/sales
- currency exposures
- WM might add economic/market commentary letter
- if goal-based investing –> reporting may focus on progress towards goals (vs. performance of asset classes/securities)
- BM reports - performance by asset class relative to the BM
Describe effective practices in a portfolio review
- actual meeting with the client
- review the investment plan, ask about investment objective changes, risk tolerance, time horizon, circumstances, comparisons of asset allocation vs. target
Evaluate the success of an investment program for a private client;
- Goal achievement - do not ask if investment strategy succeeded during the last period, but whether it is likely to succeed in meeting client goals without requiring meaningful adjustments
- Process consistency - has the plan been followed with respect to 3rd party managers, rebalancing, tax considerations, unique
circumstances, tactical allocations - Portfolio performance
- absolute and relative risk & return
- downside risk consistent with risk tolerance - Definitions of success - manager and client should have the same definition of what success looks like
Discuss ethical and compliance considerations in advising private clients;
- Fiduciary Duty & suitability → given client circumstances
- Obligation to deliver a high standard of care when acting for the benefit of another party - Know your client (KYC) – obtain essential facts about every client for whom they open and maintain an account
- Confidentiality
- Conflicts of interest - Investment product commissions
- Fees based on activity or AUM
⇒ Compliance considerations/
- Regulatory requirements for dealing with clients”
Private Client Segments
- Mass affluent
- High Net Worth Segment
- Ultra High Net Worth Segment
- Robo advisors
Expand on Mass affluent
→ Financial planning, risk management, retirement planning → Non-customized solutions - High client/manager ratio - Commissions structure to fee-based - Can be discretionary or not
Expand on High Net Worth segment
→ Lower client-to-manager ratio
- Customized investment management, tax planning, wealth transfer issues
- Less liquid investments (due to higher wealth), more sophisticated portfolios, the requirement for stronger product knowledge
Expand on Ultra Net Worth segment
- Multi-generational time horizons, highly complex tax, and estate-planning considerations
- Few clients/ manager
- Other services → bill payment, travel planning, advice on acquiring assets such as artwork, wine, etc.
- Typically, multiple family members – family governance issues
Expand on Robo-advisors
- Primarily digital client interface/experience
- Gathers info, uses MVO to recommend portfolio allocation, implements w/ MFs & ETFs
- Will also monitor and rebalance as needed
- Provide regular reporting
What are different tax structures and typical major tax categories?
- Tax structures – national, regional, local
- Typical major categories:
1/ Taxes on income – interest, dividends, realized and unrealized capital gains
2/ wealth-based taxes – property and transfers
3/ Taxes on consumption – sales & value-added taxes
What are global common elements?
• Most are progressive, some flat
• Many have special tax provisions for interest (exemptions, favorable rates, exclusions)
• Dividends may have special treatment (exemptions,
special rates, exclusions)
• Capital gains/losses may have special rates/provisions (long vs. short term, partial/full exclusion)
General tax regimes
1/ Common progressive regime 2/ Heavy dividend tax regime 3/ Heavy cap. gains tax regime 4/ Heavy interest tax regime 5/ Light cap. gain tax regime 6/ Flat & light regime 7/ Flat & heavy regime
Common progressive regime
– progressive tax rates for ordinary income, favourable treatment for interest, dividends, capital gains
Heavy dividend tax regime
– progressive, dividends taxed as ordinary income (int. + cap. gains favourable)
Heavy cap. gains tax regime
– progressive, cap. gains taxed as ordinary income (div. + interest favourable)
Heavy interest tax regime
– progressive, interest taxed as ordinary income (div. + cap. gains favourable)
Light cap. gain tax regime
– progressive for all, cap. gains favourable
Flat & light regime
– flat tax, div. + int. + cap. gains favourable
Flat & heavy regime
– flat for all, interest favourable
Expand on Interest and dividends taxed if every year
- If taxed every year, use 𝐅𝐕𝐈𝐅 = [𝟏 + 𝐫(𝟏 − 𝐭)]^𝐧, Tax drag > tax Rate
- tax drag increases with time and return
- If taxes were deferred to the end of the period, Tax drag = tax rate
Expand on Deferred Capital Gains
- 𝑭𝑽𝑰𝑭 = (𝟏 + 𝒓)^𝒏(𝟏 − 𝒕𝒄𝒈) + 𝒕𝒄𝒈
- value of the capital gain deferral increases with return and time horizon
- can be even more efficient if tax rates are the same for dividend, interest, and capital gains
Expand on Cost Basics
- proportion of current MV
- 𝑭𝑽𝑰𝑭𝒄𝒈𝒃 = (𝟏 + 𝒓)^𝒏(𝟏 − 𝒕𝒄𝒈) + 𝒕𝒄𝒈𝑩
Expand on Wealth-Based Taxes
- for Typically property and Maybe on aggregate assets (including financial assets) above a certain amount
𝑭𝑽𝑰𝑭 = [(𝟏 + 𝒓)(𝟏 − 𝒕𝒘)]^𝒏
Expand on Blended Taxing Environments
- in reality, portfolios are subject to a variety of different taxes for interests, dividends, capital gains
- 𝒓∗ = 𝒓(𝟏 − 𝒑𝒊𝒕𝒊 − 𝒑𝒅𝒕𝒅 − 𝒑𝒄𝒈𝒕𝒄𝒈) = after-tax return = pre-tax return (weighted coverage tax rate)
- As more of the current return is taxable (i.e. not deferred), the impact of the deferred cap. gains are diminished
- As less is taxable, the impact of deferral ↑
- when there are unrealized capital gains use the effective capital gains tax rate
Discuss the tax profiles of different types of investment accounts and explain their effects on after-tax returns and future accumulations;
1/ Taxable - Investments are made on an after-tax basis - Returns taxed as previously discussed
2/ Tax-deferred accounts
- Contributions are typically made on a pre-tax basis (i.e. tax-deductible)
- Funds accrue tax-free, all withdrawals are treated as ordinary income (said to have ‘front-end loaded tax benefits’)
Tax-Deferred Accounts = FVIFTDA = (1+r)^n(1-Tn)
3/ Tax-free accounts - ‘Back-end loaded tax benefits’
- Contributions are not tax-deductible, but all returns are tax-free
- FVIFTaxFx = (1-To)(1+r)^n
- if use after-tax asset allocation
– estimating time horizons is difficult
– difficult to communicate to clients
– portfolio may be too risky on a pre-tax basis if the allocation is done on an after-tax basis
Discuss the relation between after-tax returns and different types of investor trading behavior;
⇒ The value created by using investment techniques that effectively manage tax liabilities called “tax alpha”
• Trading Behavior/ – tax burden for many asset classes depends on an investors trading behavior
• Trader
• Active investor
• Passive investor
• Tax-exempt investor
Expand on Trader
- Recognizes all portfolio returns in the form of annually taxed short-term gains
= $1000[1+r(1-tcg-short)^]n
Expand on Active investor
- Gains are longer-term in nature, may receive more favorable tax treatment
- Active managers must earn greater pre-tax alphas than passive managers to offset the tax drag of active trading
= $1000[1+r(1-tcg-long)]n
Expand on Passive investor
- Passively buys & holds
= $1000[(1+r)^n(1-tcg-long)+tcg-long]
Expand on Tax-exempt investor
- Never pays capital gains taxes
= $1000(1+r)n
Explain tax loss harvesting and highest-in/first-out (HIFO) tax lot accounting;
- The practice of realizing a loss to offset a gain or income
- The tax savings can be invested, increasing the asset base
- Highest-in, first-out (HIFO) tax lot accounting
- When lots are purchased at different prices, select those purchased at the highest price for the first sale
- When the current yr. the tax rate is low, maybe worth letting the loss remain unrealized if tax rates will be higher next period
Demonstrate how taxes and asset location relate to mean-variance optimization.
- Pre-tax efficient frontiers may not be reasonable proxies for after-tax efficient frontiers
- The same asset at different locations (i.e. type of account) is essentially a distinct after-tax asset
- It will produce different after-tax accumulations
- Use accrual equivalent returns (vs. pre-tax returns) and after-tax s.d. (vs. reg. s.d.)
Definition of Estate and Estate Planning
- Estate ⇒ all of the property a person owns or controls
- Estate planning ⇒ the process of preparing for the disposition of one’s estate upon death and during one’s lifetime
Definition of Will, Testator, and Probate
- Will/Testament ⇒ outlines the rights others will have over one’s property after death
- Testator ⇒ the person who authorized the will and whose property is disposed of according to the will
- Probate ⇒ the legal process to confirm the validity of the will so that executors, heirs, and other interested parties can rely on its authenticity
Disadvantages of Probate and how it can be avoided
- The process can be lengthy & costly, delays the transfer of assets
- Can be avoided (or its impact limited) by holding assets in other forms of ownership
• Joint ownership with right of survivorship
• Trusts
• Insurance (e.g. segregated funds)
Legal Systems
- Common law system – testator usually has the freedom of disposition (the right to use their own judgment regarding property)
- Civil law system – restrictions on such dispositions
- Common law – law is primarily developed through decisions of the courts
- Civil law – law developed primarily through legislation
Forced heirship rules
– children have the right to a fixed share of a parent’s estate (spouses as well)
Marital property rights
➀ Community property regimes – each spouse has an indivisible 1⁄2 interest in income earned during marriage - Upon death, spouse gets 1⁄2 of the community property (other 1⁄2 transferred through will)
➁ Separate property regimes – each spouse is able to own and control property as an individual
Explain the two principal forms of wealth transfer taxes and discuss effects of important non-tax issues, such as legal system, forced heirship, and marital property regime;
⇒ Lifetime Gratuitous Transfers (inter vivos transfers)
- Made during the lifetime of the donor
- May or may not be taxed (depends on jurisdiction)
⇒ Testamentary Gratuitous Transfers
- transfers made after the death
- Taxes may be applied to the transferor or the recipient
⇒ Wealth transfer tax inheritance tax
- May be a flat or progressive tax
- May be a threshold allowance
Determine a family’ score capital and excess capital, based on mortality probabilities
- Core capital can be estimated by calculating the expected future cash flows by multiplying each future cash flow by the probability that it will be needed
- 𝒑(𝒔𝒖𝒓𝒗𝒊𝒗𝒂𝒍) = 𝒑(𝒉𝒖𝒔𝒃𝒂𝒏𝒅 𝒔𝒖𝒓𝒗𝒊𝒗𝒆𝒔) + 𝒑(𝒘𝒊𝒇𝒆 𝒔𝒖𝒓𝒗𝒊𝒗𝒆𝒔) − 𝒑(𝒉𝒖𝒔𝒃𝒂𝒏𝒅 𝒔𝒖𝒓𝒗𝒊𝒗𝒆𝒔) × 𝒑(𝒘𝒊𝒇𝒆 𝒔𝒖𝒓𝒗𝒊𝒗𝒆𝒔)
⇒ Safety Reserve – adds to core capital estimate to incorporate the risk of asset underperformance - produce a sequence of poor returns (uncertainty of capital markets)
- Allows spending beyond that articulated in the spending needs (uncertainty of future commitments)
Estimating Core Capital w/ Monte Carlo simulation
- Estimate the amount of capital required to sustain a pattern of spending over a particular time horizon with a 95% level of confidence
i.e. determine core capital that sustains spending in at least 95% of the trials - Safety reserve may also be added but would be
smaller than mortality table method
Estimating Core Capital w/ Sustainable Spending Rates
– what %age of capital can be spent each yr. such that the probability of outliving assets is below some threshold level
e.g. prob. of ruin < 9%, 4% of capital/yr = sus. spending rate $500,000 spending needs
Core capital = 𝟓𝟎𝟎,𝟎𝟎𝟎/0.04= $𝟏𝟐,𝟓𝟎𝟎,𝟎𝟎𝟎
Explain the estate planning benefit of making lifetime gifts when gift taxes are paid by the donor, rather than the recipient;
⇒ Lifetime gifts – will lower estate or inheritance taxes
→ Tax-free gifts/ – fall below periodic or lifetime allowances
→ Taxable gifts:
- Can also gift assets with higher expected returns to the second generation, first-generation holds assets with lower expected returns (lowers estate tax)
⇒ Location of the Gift Tax Liability/
- Tax liability of a gift may be with the donor or the recipient - A cross border gift may result in both being taxed based on tax laws in each jurisdiction
- If the donor pays taxes, the tax benefit of the lifetime gift vs. the bequest increases (tax paid decreases the size of the estate, and ∴ estate tax)
Spousal Exemptions
- Many jurisdictions with the estate or inheritance taxes allow for bequests & gifts to spouses without tax liability
- If the value of the estate is below some exclusion threshold, the estate can pass without inheritance tax
Valuation Discounts
– discounts for illiquidity and lack of control - Transferring assets subject to valuation discounts reduces the basis on which transfer tax is calculated
∴ can intentionally create illiquidity and lack of control by placing assets in a family limited partnership (FLP)
- Transfer minority interests
Deemed Disposition
- rather than an estate or inheritance tax, some jurisdictions used ‘deemed disposition’
- Estate pays tax on any unrealized cap. gains (i.e. the estate is deemed to have disposed of the assets at current market values)
Charitable Gratuitous Transfers
– most charitable donations are not subject to transfer taxes (quite the opposite ⇒ qualify for tax reductions)
Explain the basic structure of a trust and discuss the differences between revocable and irrevocable trusts;
Trust – holds and manages the assets of a settlor for the benefit of the beneficiaries
- governed by the trust document
Revocable Trust
- Settlor retains right to rescind trust, regain ownership of assets
- Settlor is the owner of assets for tax purposes
- No creditor protection
Irrevocable
- Creditor protection
- Trustee pays taxes
- Trust is the legal owner of the assets
- Both forms bypass probate
- Transfer of assets dictated by the trust document and not the Will
- the beneficiaries are not legal owners of the assets
Fixed Trust
⇒ Fixed/ – distributions to beneficiary occur at certain times or in certain amounts (terms of the distribution are pre-determined)
Discretionary Trust
⇒ Discretionary/ – trustee determines whether and how much to distribute (trustee has sole and uncontrolled discretion)
- Discretionary trusts protect assets from claims of creditors against beneficiaries
Concepts of trust, control, asset protection, taxes of trusts
- Concept of trust is unique to common law (may not be recognized in a civil law jurisdiction)
• Control – trusts make resources available to a beneficiary without yielding complete control over the resources
• Asset Protection – irrevocable trusts protect assets of the settlor from creditors
• Tax reduction – income generated by trust assets may be taxed at a lower rate - Lower progressive tax bracket
- Set up trust in the low tax jurisdiction
- Assets may be transferred to a trust for estate tax purposes but not income tax purposes (income may remain taxable to the settlor)
Foundations
– based in civil law countries and unlike a trust, is a legal person
- Choice of trust or foundation usually an issue of jurisdiction
Source jurisdiction vs residence jurisdiction taxes
⇒ Source jurisdiction – country taxes income as a source within its borders
- Also called a territorial tax system
⇒ Residence jurisdiction – all income (foreign & domestic) is subject to taxation (worldwide income)
- Most common
- Typically noncitizen residents, resident citizens, but not non-resident citizens
- No international standardized residency test (residency thresholds differ between countries)
Taxation on wealth & wealth transfers source
⇒ Taxation on wealth & wealth transfers
Source - tax wealth economically sourced
• Wealth in the country
Residence – tax worldwide wealth
Taxation on wealth & wealth transfers
⇒ Taxation on wealth & wealth transfers - Wealth transfers – depends on
a) donor country b) recipient’s country c) location of asset
Exit taxation
→ Exit taxation – if applicable, applies to unrealized gains (i.e. deemed disposition)
Residence-residence conflict
- Residence-residence conflict – 2 countries claim residence of the same individual, subjecting the individual’s worldwide income to taxation by both countries
Source-source conflict
– 2 countries claim source jurisdiction of the same asset
Residence-source conflict
– individual in Country A subject to residence jurisdiction, assets in Country B subject to source jurisdiction
– most common source of double taxation, most difficult to avoid with tax planning
Evaluate a client’s tax liability under each of three basic methods (credit, exemption, and deduction) that a country may use to provide relief from double taxation;
- Source countries have primary jurisdiction to tax income within their borders, residence country is typically expected to provide double taxation relief
• Credit method: taxpayer tax liability is reduced by taxes paid to a foreign country exercising source jurisdiction (e.g. dividend withholding) - Credit is limited to the amount taxpayer would pay domestically
e.g./Tres = 50% Tsource = 40%
40% paid to foreign country 10% top-off paid domestically
Tcm = max [TRes, TSource]
• Exemption method – residence country imposes no tax on foreign-source income
TEx = TSource
• Deduction Method – residence country allows taxpayers to reduce taxable income by the amount of taxes paid
TDed = TRes + TSource (1 – TRes) = TRes + TSource – TResTSource - Results in the highest tax liability
- Tax treaties exist between countries (tax relief specified can be credit, exemption, or deduction)
Tax avoidance
– strategies that conform to both the spirit and the letter of tax codes
Tax evasion
– circumventing tax obligations by illegal means by misrepresenting/not reporting information
Discuss how increasing international transparency and information exchange among tax authorities affect international estate planning.
- Information exchange between tax authorities in increasing
- Exposing once ‘secret banking’ relationships
⇒ Increased transparency
