WEALTH TRANSFER PLANNING Structuring Transactions to Enhance Financial Results


 Rosamund Stephens
 1 years ago
 Views:
Transcription
1 WEALTH TRANSFER PLANNING Structuring Transactions to Enhance Financial Results
2
3 TABLE OF CONTENTS In this white paper: Introduction 1 Investment Management Concepts 2 Financial Instruments (Derivatives) 5 Grantor Retained Annuity Trust (GRAT) 9 Enhancing GRATs 11 Sale to Intentionally Defective Grantor Trust (IDGT) 18 Enhancing IDGTs 19 Total Return Swap of a Synthetic Portfolio with an IDGT an Alternative to the Sale Transaction? 20 Conclusion 26 Written by: Bryan D. Austin, CFP, CIMA Director, Financial Planning
4 Wealth Transfer Planning Introduction 1 Simply stated, wealth engineering in wealth transfer is the process of structuring transactions to improve financial results. Obviously, forecasting results depends on the reliability of assumptions used in the particular analysis. All factors used in traditional investment analysis, including expected return, standard deviation and correlation should be utilized to model the wealth transfer strategy under consideration. In the past, most of the estate planning community exclusively relied on one factor expected return to forecast wealth transfer planning benefits associated with a specific strategy. The inherent problem with this linear fixed return analysis is that market returns are random and do not follow a predictable pattern. Today, a greater number of planners are using Monte Carlo analysis to forecast the probability of success for techniques in wealth transfer, which is a vast improvement over a traditional linear analysis. Monte Carlo incorporates several investment factors and uses a statistically significant number of simulations of random investment returns to project a range of future results. While a Monte Carlo simulation exercise does not guarantee future results, it does a much better job of identifying the investment risks and the probability of success for the wealth transfer technique under consideration. It is safe to say that most wealth transfer planning incorporates concepts of leverage to project winning results. The ultimate success of these planning strategies depends on the probability of outperforming a reference rate, such as the 7520 rate, 2 used for various annuity trusts. Others rely on outperforming the Applicable Federal Rate (AFR), 3 a rate used for intrafamily loan based strategies. A primary goal in wealth engineering is to increase the leverage associated with a particular transaction. Wealth engineering could be as simple as using different note payment terms in connection with a traditional sale to an Intentionally Defective Grantor Trust (IDGT) and analyzing the projected results. It could also be as complex as introducing structured derivative products to hedge risk or take advantage of unique investment opportunities, with the ultimate goal of increasing the strategy s leverage and likelihood of success. The purpose of this paper is to explore some of the financial strategies that may increase the likelihood of enhancing traditional wealth transfer techniques. Since wealth engineering depends on a reasonable forecast of investment returns, this paper will 1 Wealth Transfer Planning
5 begin with a general overview of investment concepts and principles of diversification. The most widely used financial instruments will then be explored to introduce the concepts of risk reduction and leverage beneficial to wealth transfer. Some wealth engineering principles will then be applied to two commonly utilized planning strategies: the Grantor Retained Annuity Trust (GRAT) and a sale to an IDGT. The final section of this paper will introduce an alternative wealth transfer technique, swapping a synthetic portfolio with an IDGT, as an example of the type of transaction that we may see in the future when advisors from different disciplines collaborate to introduce new planning ideas directed at high net worth clients. Investment Management Concepts Most of us have heard never to put all of our eggs in one basket, and history has provided countless examples of devastating events that caused individuals to literally lose fortunes overnight. We have also heard stories of others who risked everything but were finally rewarded for their efforts. The concept of risk and reward is obviously not a new one and, logically, no one should be willing to take on investment risk unless there is a reward associated with the level of risk assumed. The investment reward for participating in the market is generally referred to as a market risk premium and, while risk premiums have varied over different investment periods, higher risk assets like equities have generally produced greater returns when compared to money markets, treasuries, or other low risk assets. Portfolio Theory and the Efficient Frontier Investment diversification is also not a new concept, but the approach developed over the last five decades is. Until the early 1950s, the decision to invest in any asset was almost exclusively based on financial analysis and the asset s risk and return characteristics. Diversification was achieved merely by investing in different firms, with limited consideration of whether those firms engaged in the same business. However, in 1952, Harry Markowitz revolutionized the investment decisionmaking process with his research paper Portfolio Selection. 4 Dr. Markowitz theorized that investors are not only interested in earning high investment returns, but that they are also interested in reducing risk. To reduce risk, investors should consider how an investment impacts a portfolio rather than simply focusing on the merits of the investment itself. Since it is assumed that investors behave rationally, they will only invest in those portfolios that represent the highest return for any given level of risk. This riskreturn tradeoff was graphically represented in the first efficient frontier. 5 Dr. Markowitz later developed a working mathematical model for analyzing portfolio risk and reward culminating in what is referred to as MeanVariance Portfolio Theory. 6 Through detailed calculations, the efficient frontier graphically represents the set of diversified portfolios that produce the highest possible return for any given level of risk. It is ideally derived from selecting investments from the entire universe of possible investments. Exhibit 1 illustrates a sample efficient frontier with five possible portfolio allocations represented, ranging from conservative to aggressive. It is impossible for any one particular investment to lie on or above the efficient frontier, since individual investments are by definition inefficient, i.e., they are not diversified. Exhibit 1. The Efficient Frontier RETURN (%) 12% 11% 10% 9% 8% 7% 6% 5% Moderate/ Conservative Moderate/Aggressive Conservative Aggressive Moderate Current Portfolio 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% RISK (STANDARD DEVIATION %) Wealth Transfer Planning 2
6 The sample portfolios lie on the efficient frontier while the current portfolio represents a hypothetical inefficient portfolio. No logical investor would choose the current portfolio, since it does not provide adequate return for the level of risk assumed. Efficient frontiers are generally created from three factors: risk, return, and correlation of returns. Risk is generally assessed by the degree of volatility associated with a portfolio s returns. To measure portfolio volatility, investment professionals frequently use the reference calculation of standard deviation. A high standard deviation indicates a wide variation of returns from the mean and thus significant volatility. A low standard deviation indicates low volatility with returns that are generally closer to the mean. Two portfolios may have the same mean return value but very different standard deviations. Standard deviation is widely accepted as representing the risk axis of an efficient frontier. While portfolio return is simply a weighted average of the returns of each investment, portfolio risk, as measured by standard deviation, is not calculated from the weighted average of the standard deviation of the underlying investments. The calculation of standard deviation for a portfolio includes one other important statistical measure: correlation. Correlation measures the extent by which returns of one asset can predict the movement in another and is expressed in a range between +1 to 1. A correlation of +1 between investments indicates that the investment returns move identically in the same direction, a correlation of 0 indicates no movement relationship, and a correlation of 1 indicates investment returns always move in opposite directions. Diversification benefits are achieved by adding investments with different correlation statistics to a portfolio, resulting in a lower overall standard deviation than the individual component parts. For example, assume Investment A has a 9.0 percent expected return and a 16.0 percent standard deviation, while Investment B has a 9.5 percent expected return and a 14.0 percent standard deviation. Further assume that the correlation coefficient of returns between the two investments is.20 and the portfolio is balanced equally between A and B. Without using the correlation statistic, one would erroneously calculate the expected portfolio return as 9.25 percent with a 15 percent standard deviation by averaging both statistics. By accurately including correlation, the expected portfolio return is still 9.25 percent but with a much lower percent standard deviation. 7 Thus, the combination of Investments A and B is more efficient than A or B alone, as it produces a higher level of return for the risk assumed. It is important to briefly note that standard deviation measures the total investment risk of the portfolio. Total risk includes both systematic (market) risk and nonsystematic (firmspecific) risk. Diversification can only lower the nonsystematic risk of an investment portfolio. Systematic risk can never be diversified away and participation in the market will always expose an investor to the associated market risk. Therefore, movements along the efficient frontier, from conservative to aggressive, mostly result from allocating less or more to the market. Overall, risk can be reduced by allocating less to the market portfolio, but opportunity is also reduced. The relative simplicity of the efficient frontier has wide appeal, since the investor can visually see diversification at work. It has a tendency to lead to quick investment decisions but it is important to note that each decision must be carefully weighed to make sure that it is suitable for the particular investor. As stated above, the efficient frontier is derived from three basic factors; but its creation is still dependent upon several other input variables, including the universe of investments considered as well as the investor s liquidity needs, tax situation, and attitude towards risk. For example, certain asset classes, such as private equity or complementary strategies, may not provide the necessary liquidity for the investor. Some investors may not have access to certain investments due to net worth or income limitations, or possibly even legal restrictions. Other investments may be undesirable to a particular investor such as tobacco, alcohol, or petroleum companies. Finally, many investors view risk differently depending on the direction of the volatility. This is an especially important 3 Wealth Transfer Planning
7 consideration that will be raised later in enhancing certain wealth transfer techniques. Furthermore, the actual inputs on asset class returns (volatility and correlation utilized to create the frontier) can be subject to widely varying assumptions. Since past performance is not an indication of future results, efficient frontiers based solely on historical data may badly miss the mark. What historical data will be used? Does it include the down market of 2008 and the related performance data, where most assets classes exhibited extremely positive correlation? And what about using analyst forecasts for the inputs? Should recent extreme events be weighted more heavily or discounted as historical aberrations? In reality, many software programs used to model the efficient frontier today use a combination approach: blending historical data, forecasting data, or using simulations of random investment returns with assigned probabilities for performance. The result is arguably improved advisory tools to measure and communicate investment risk that allow an investor to make betterinformed decisions to meet their personal objectives. Linear Versus Monte Carlo Analysis in Wealth Transfer Communicating risk is probably the single most difficult but important role that advisors have to assist clients in making informed decisions about meeting specific goals including investment, retirement, philanthropy, and wealth transfer. Although risk takes on many forms, the focus here is on communicating financial risk, especially as it relates to wealth transfer. As alluded to earlier, investors love the volatility associated with positive market movement, but most cannot tolerate the volatility associated with major market declines. Unfortunately, volatility moves in both directions and investors who cannot tolerate a certain level of risk will miss out on opportunities when markets advance. Risk with respect to wealth transfer cannot possibly be communicated effectively to a client through linear or fixed return modeling. Linear modeling assumes that the subject investment will earn steady, predictable returns over the given period, which is obviously unrealistic. 8 It also ignores the time horizon, treating shortand longterm strategies similarly. Fortunately, many planners today are using better tools to communicate risk to clients considering wealth transfer. As mentioned previously, Monte Carlo simulation is one of the tools gaining popularity in the financial planning community, not only in modeling asset sufficiency for today and into retirement but also in modeling wealth transfer strategies and the likelihood for success. Monte Carlo simulation traditionally is based on the same criteria used to create the efficient frontier, namely returns and volatility. In fact, some software actually uses the Monte Carlo simulation method to create an efficient frontier. Based on the inputted criteria, a significant number of simulations of random returns (often thousands) are selected over the subject time period to project a range of future results. These simulated projections are then compared to a specific target to determine the likelihood of outperforming the target. Exhibit 2 illustrates a hypothetical Monte Carlo probability distribution analysis for a basic fiveyear term GRAT funded with a $10,000,000 balanced portfolio and a Section 7520 hurdle rate of 2.0 percent. As we will discuss later, so long as the trust portfolio returns exceed the 7520 rate, the GRAT should be successful. The yaxis identifies the projected ending trust portfolio value and the xaxis identifies the percentage of trials greater than a target of 0, meaning beneficiaries are projected to receive something when the GRAT terminates. In this simulation, roughly 82 percent of the 1,000 portfolio trials would successfully transfer value at the end of the GRAT term. However, in 18 percent of the simulations, the GRAT is projected to transfer nothing to beneficiaries. Compare this message with that used in a fixed return analysis where the GRAT is always assumed to be successful, especially given a low 7520 hurdle rate. Of course, there are other methods to increase the likelihood of success even in this basic example that we will explore later. While Monte Carlo simulation does have some inherent flaws, few would argue that it is not superior to fixed return modeling when analyzing the risk associated with specific wealth transfer planning techniques. 10 Wealth Transfer Planning 4
8 Exhibit 2. Monte Carlo Probability Distribution 9 ENDING VALUES (MILLIONS) $6.9 $6.5 $6.1 $5.8 $5.4 $5.0 $4.6 $4.2 $3.9 $3.5 $3.1 $2.7 $2.3 $2.0 $1.6 $1.2 $0.8 $0.4 $0.1 $0.3 $0.7 $1.1 $1.5 $1.9 $ PERCENTAGE OF TRIALS GREATER THAN OR EQUAL TO GIVEN LEVEL Financial Instruments (Derivatives) The term derivative has become a negative reference for many, especially given the events leading up to the banking and financial credit crisis of 2007 and One of the most widely publicized comments regarding derivatives came from Warren Buffet in 2003, when he referred to derivatives as financial weapons of mass destruction 11 While Mr. Buffet s letter attempted to broadly address derivatives, it seemed to focus on unregulated contracts, their associated counterparty risk, and problems in valuing companies with substantial derivative exposure. However, derivatives historically have served a vital function in commerce, helping companies deal with their unique business risk. Properly used, derivatives help individuals and businesses mitigate risks including those associated with rising interest rates, currency exchange, commodity prices, and overexposed equity concentrations. Unfortunately, the focus in recent times seemed to be on the minority of those who abused an otherwise viable investment and risk management strategy. Generally, a derivative contract is a delayed delivery agreement between two parties where the value of the contract is derived from something else, typically referred to as the underlying. The underlying can be almost anything: an asset or collection of assets, an interest rate, a specific currency, or a commodity such as oil, gold, sugar, or corn. A basic derivative contract has a buyer and a seller. The buyer of the underlying is said to be long the position while the seller is short the position. The parties negotiate to purchase/sell the underlying at some specific date in the future at a predetermined price. The underlying asset rarely changes hands, and parties normally settle the contracts before maturity in cash, enter offsetting derivative positions closing their exposure, or allow certain contracts to expire worthless. The most common types of derivatives are options, futures, forwards and swaps. Before examining the utility of derivatives in wealth transfer, it may be helpful to briefly summarize these common derivatives and identify some of their features. Options Option contracts commonly fall into two categories, calls and puts. While the combination of different option strategies can be rather complex, a call or put is a fairly straightforward transaction. In a basic call option, the contract buyer of the call has the right, but not the obligation, to purchase a fixed quantity of an asset at a fixed price (the exercise or strike price) before the expiration date specified in the option agreement. Alternatively, the purchaser of a put option has the right, but not the obligation, to sell a fixed quantity of an asset at a strike price prior to the specified expiration date. Option contracts have a buyer (the holder) and a seller (the writer). The holder of the option pays the writer a premium for acquiring the right to buy or sell a specified amount of the asset under the agreement. Unlike futures, forwards, and swaps, an option is considered a unilateral agreement, since only the holder has the right to force performance (i.e., exercise the option). The public is widely familiar with the Americanstyle option, which can be exercised at any time until the specified expiration date. Contrast this with the Europeanstyle option, which can only be exercised 5 Wealth Transfer Planning
9 at maturity. The timing of exercise is the main distinction between these two types of options, not the location where the option is negotiated. Because of the flexibility in timing of exercise, logic dictates that the premium paid for an American option should be higher than a similarly structured European option. Since security returns fluctuate and do not follow a straightline predictable pattern, the flexibility to exercise an option during any point of the option term should be more valuable to the holder. Option prices are traditionally determined from six factors: current price of the asset, strike price of the option, expiration date of the option, volatility of the asset, the riskfree rate of return, and cash flow (e.g., dividends) from the asset. If the existing price of an asset in a call option is higher than the strike price, the option is considered in the money. The premium for a call option logically increases with increases in the underlying asset price. Option premiums also increase with increased time to expiration and higher volatility, since the holder has more opportunities to benefit from large price movements. Finally, increases to the riskfree rate of return increases the price of an option due to the time value of money. Alternatively, call option prices decrease with increases to the strike price or cash flow (e.g., dividends) paid from the underlying asset that the holder does not receive. Forwards and Futures In contrast to options, both parties ( counterparties ) to a forward contract are obligated to perform. A forward contract is a formal agreement between counterparties to exchange a specified amount of an underlying asset at a fixed price on a specific future date. The agreed upon price is referred to as the forward or delivery price, and the spot price is the current price of the asset. While the value of the forward contract fluctuates over the term of the agreement, nothing changes hands between the counterparties until maturity. Although some forward contracts require physical delivery of the underlying asset by the seller at maturity, forward contracts are often settled in cash. Forward contracts are privately negotiated between the actual counterparties and are not traded on a regulated exchange. While increased flexibility of terms is the advantage, there is still a risk that one party may not perform at maturity. Thus, the parties to forward contracts are generally limited to highlycapitalized institutional participants that have lower risks of default. Futures contracts are essentially a series of daily settled forward contracts. Like forwards, futures contracts outline each party s obligation to sell or purchase a specific amount of the underlying asset at maturity. However, unlike forwards, futures contracts are traded on a regulated exchange (e.g., Chicago Board of Trade), have standardized terms, and are settled daily. 12 The exchange establishes a clearinghouse that is positioned between each buyer and seller, guaranteeing each party s performance. As further security for performance, counterparties must deposit funds ( margin ) initially and on an ongoing basis. Each futures contract is revalued daily (markedtomarket) and parties realize gains or losses on the day they occur. Should the value of a party s margin account fall below the required threshold, additional deposits must be made to restore the margin. Since futures contracts are standardized and traded on an exchange, parties have additional flexibility in closing out positions prior to maturity by entering into offsetting futures contracts, effectively eliminating any investment position. Futures and forward prices are determined from many of the same factors that apply to options. These include the underlying asset s current spot price, expected future delivery price, delivery date, riskfree rate of return, and cash flow or yield from the asset. However, futures and forward prices may differ even on the same underlying with the same maturity date as there may be additional settlement and transaction costs associated with futures contracts. Swaps A swap contract is an agreement where two parties make a series of payments to each other based on different scenarios referenced within the agreement. The components of a swap contract include a referenced investment or index, notional amount, maturity date, and payment frequency. The notional amount is simply the overall value of the referenced investment and generally never changes hands between the parties, but it is used Wealth Transfer Planning 6
10 as a proxy to calculate each party s responsibilities. Swap arrangements usually involve a swap dealer or facilitator who arranges to match counterparties to the swap transaction. In some cases, the swap dealer may also participate as counterparty. However, for purposes of this discussion, the swap dealer is removed from the transaction and it is assumed that the counterparties have contracted directly. Parties enter into swap contracts for roughly the same reasons they use derivative contracts: risk management and speculation. For example, the holder of a call option anticipates the price of an asset to rise during the option term, while the writer of the same option anticipates the price of the asset to remain flat or decline. Similarly, in a swap contract one party expects that the referenced investment, or group of investments, will rise over the swap term, while the other party anticipates the opposite result. Just as in futures and forwards, however, the major distinction between the swap and the option is that both parties in a swap have an obligation to perform. One of the better ways to illustrate a swap is to present an example of the commonly used interest rate credit swap accompanied by a graphical representation in Exhibit 3. Exhibit 3. Interest Rate Swap Libor +2% Party A Bank $5 Million Semiannual payments $5 Million x 5% Semiannual payments $5 Million x (Libor +2%) Party B For example: Party A has an outstanding floating rate interest only loan of $5 million that adjusts semiannually. The adjustable rate is linked to the sixmonth London Interbank Offered Rate (Libor) and the rate of interest is sixmonth Libor plus 2 percent. Assuming sixmonth Libor is 0.5 percent, the current rate would be 2.5 percent. Party A would be more comfortable with a fixed rate loan as there is concern that interest rates will rise. Party B believes that interest rates will stay stable or maybe trend lower over time and would like to benefit from lower adjustable rate terms. Parties A and B, the counterparties, negotiate a fiveyear swap contract based on a $5 million notional amount on December 1, Under the terms of the swap, Party A agrees to make a fixed interest rate payment to Party B at an annual rate of 5.0 percent on the $5 million notional amount totaling $250,000 annually, or $125,000 semiannually. This is commonly referred to as the fixed leg of the swap. Party B agrees to make a semiannual interest rate payment to Party A on the same notional amount based on sixmonth Libor plus 2.0 percent. This is the floating leg of the swap. Party B s first payment to Party A will be 2.5 percent of $5 million divided by two, since it is interest for a sixmonth period, with the initial payment being $62,500. Assume that the six month Libor rate will adjust semiannually, December 1 and June 1, during the fiveyear term. The party s semiannual payment responsibilities (the legs) are netted together; therefore, Party A will initially pay $62,500 (125,00062,500) to Party B on June 1, Future netting will depend on changes to the referenced index over the remaining term of the swap. Each party has effectively traded their obligation to the other. The methodology for pricing swaps is similar to other derivatives, using the underlying asset s current and expected future price, contract term, riskfree rate of return, and cash flow from the asset. In the above example, Party A pays a fixed rate of interest in exchange for a floating rate. Party A is willing to pay a higher fixed rate for interest rate protection, but how much of a higher rate will largely depend on market interest rate projections over the term of the swap. At inception of the swap, the present value of the fixed leg should be equal to the present value of the forecasted floating rate leg, since no party would presumably pay more than the market price for a readily available investment. Over time, due to changes in interest rates, one party to the swap contract may build a profit in the contract while the other would have a corresponding loss. At all 7 Wealth Transfer Planning
11 times though, the netting of profit and loss for each leg should be zero. Finally, a central concept in pricing of all derivatives is that there should be no opportunity to make a riskfree profit. This is referred to as noarbitrage or rational pricing. That is not to say that there are never opportunities for arbitrage. Consider the one empty line in an otherwise crowded grocery store. Many of us think to ourselves that something must be wrong because, if that line were really open, people would have already taken advantage of it. However, once someone does make the first move to that empty line, others follow and the opportunity disappears. It is probably more accurate to say that there are limited opportunities for financial arbitrage, but those arbitrage opportunities will quickly disappear as they are exploited by market pressures and opportunistic investors. Risk Management and Opportunity Much of the media attention over the last two decades has focused on the evils of derivatives. The near collapse of hedge fund manager Long Term Capital Management (LTCM) in the late 1990s made headlines around the world and became a case study incorporated in many finance textbooks today. From 1995 through 1997, LTCM produced annual returns to investors of approximately 40 percent, 40 percent, and 20 percent, respectively, by engaging in highly leveraged derivative trading activities. 13 However, in August 1998 alone, the fund lost approximately $1.8 billion, or 44 percent of its equity. 14 The firm s lack of liquidity led to a series of events resulting in the fund s closure in In response to events like these and the recent banking and financial credit crisis, President Obama signed into law the DoddFrank Wall Street Reform and Consumer Protection Act on July 21, One of the purposes of this legislation was to lower risk, promote transparency, and protect the American public by regulating the overthecounter derivatives market. While they can be used for speculation, one practical use for derivatives is risk management. For example, a company that depends on a commodity for business operations, such as heating oil, may be highly sensitive to commodity price movements. A large, unanticipated price increase in heating oil would dramatically impact the company s bottom line as it may not be able to pass this cost on to its customers. Derivatives may be used by the company to mitigate the risk associated with such a significant price increase. Additionally, derivatives are extremely useful for managing risk of investment portfolios. Consider an investment manager with an investment portfolio highly correlated to the S&P 500 who has a shortterm bearish view of the economy. The manager has two alternatives: increase cash by liquidating investment positions or use a shortterm derivative strategy (e.g., S&P futures contract) to mitigate the risk resulting from a large market correction. The futures route would probably be more cost effective and quicker to implement. In short, when properly used, derivatives provide an effective means of insurance protection, thereby mitigating the risk associated with unanticipated events. Derivatives may also be used to simulate certain investment strategies more efficiently or capitalize on specific market opportunities not otherwise practical for direct investment. Consider an investment manager who maintains a market neutral outlook but believes that major economic news is coming that will significantly impact the market. The manager anticipates a tremendous shortterm increase in market volatility but does not strongly favor a specific direction. The investment manager may consider a derivative (or combination of derivatives) that capitalizes on shortterm increases in market volatility in either direction. For example, a straddle is a commonly used option strategy that combines a long call and long put on the same underlying security or index with both options having the same expiration and same strike price. As a result, extreme price movements in the security or index in either direction results in a profit to the holder. Derivatives may also be used to invest in markets or individual assets not otherwise accessible. For example, certain markets may have existing trading restrictions that prohibit foreign investment or make direct investment uneconomical. There is little doubt that derivatives have a reputation of being complex or risky, but, as long as their use is consistent with an investor s risk objective, derivatives serve a critical role. Even Wealth Transfer Planning 8
12 Berkshire Hathaway had exposure to $62 billion in notional value of derivative contracts at the end of 2009, an interesting fact given Warren Buffet s weapons of mass destruction comments in This is not a criticism of the exposure but merely meant to illustrate that derivatives are an integral part of today s financial markets. As to whether increased regulation of derivatives will have a significant impact on its perceived abuse in the future, only time will tell. Grantor Retained Annuity Trust (GRAT) Description and Authority One of the more enduring and popular wealth transfer planning strategies used over the last two decades has been the Grantor Retained Annuity Trust (GRAT). This particular strategy is different from others because it derives its basic design and authority directly from the Internal Revenue Code. Section 2702 was passed in 1990 to eliminate the gift tax benefits of certain intrafamily transactions, such as Grantor Retained Income Trusts and joint purchases. The section s method in eliminating the benefits was to treat the entire value of a transfer as a taxable gift. However, at the same time, Section 2702 established certain exceptions that were still valid one of those excepted strategies is the GRAT. 16 As a result, the structure, as defined by the Code, gives taxpayers some certainty that, if properly structured and managed, a GRAT will not likely be challenged. A GRAT is a technique where an individual, the grantor, transfers assets to a trust (the GRAT) in exchange for an annuity stream for a period of years. At the end of the term, the remaining assets become those of the remaindermen, often the donor s children. The amount of any taxable gift related to the transfer is determined at the time of the initial funding of the GRAT, and the size of the grantor s annuity reduces the value of the taxable gift. The actual calculation of the gift element is performed by applying the 7520 rate of interest. Each month, the IRS publishes a table of interest rates, including the 7520 rate, which is used as a discount rate to calculate the present value of the GRAT annuity. The annuity value is then subtracted from the value of assets transferred to the GRAT, resulting in the net value of the remainder, the taxable gift. (See Exhibits 4 and 5.) If structured with a large enough annuity, the taxable gift can actually be reduced to zero. This is a distinct advantage of GRATs. Taxpayers can engage in this planning strategy, even if they have otherwise used all of their lifetime gift tax exemption, without having to pay any tax outofpocket. A GRAT with such a structure is referred to as a zeroedout GRAT or a Walton GRAT, named after the court case that effectively validated it. 17 For example, to zeroout the gift for a twoyear GRAT when the 7520 rate is 1.8 percent, the annual annuity would be set at percent. 18 However, for a tenyear GRAT, the annuity would be set at percent. 19 GRAT Risks There are essentially two main risks with a GRAT. The first is mortality risk: If the grantor dies during the annuity term, the value of some or all of the assets in the GRAT will be included in the grantor s taxable estate. As a result, the transfer may have been ineffective from a wealth transfer planning perspective. The second is performance risk: If the assets perform at a level higher than the 7520 rate, the GRAT is considered in the money, and all the appreciation in excess of that rate passes to the remaindermen free of future transfer taxes. However, if the assets underperform (i.e., the GRAT is out of the money ) the assets are effectively returned to the grantor through the annuity, and the remaindermen will receive nothing. Again, the effect is as if the GRAT were never implemented. For both risks, this quirk in the system means that a GRAT is a heads you win, tails you tie form of strategy. As a result, the sole cost of failure under both risks is essentially the cost of implementing and operating the trust. Administration s Proposal to Extend Minimum Term of GRATs The application of certain variations on GRATs may be limited by future legislation. For several years, the Obama administration has annually proposed to limit the perceived abusive nature of certain types of GRATs. These proposals generally include requirements that a GRAT have a minimum term of ten years or a maximum term of life expectancy of the annuitant plus ten years. Other proposed changes include prohibitions on zeroedout GRATs and decreasing annuity payment structures. 9 Wealth Transfer Planning
13 Exhibit Year 9% GRAT The following example illustrates a 10year GRAT with a payout annuity rate of 9%. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and a total annual return on trust assets of 6%. Beginning 4.00% 2.00% GRAT Year Principal Growth Annual Income Annuity Remainder 1 $10,000,000 $400,000 $200,000 $900,000 $9,700,000 2 $9,700,000 $388,000 $194,000 $900,000 $9,382,000 3 $9,382,000 $375,280 $187,640 $900,000 $9,044,920 4 $9,044,920 $361,797 $180,898 $900,000 $8,687,615 5 $8,687,615 $347,505 $173,752 $900,000 $8,308,872 6 $8,308,872 $332,355 $166,177 $900,000 $7,907,404 7 $7,907,404 $316,296 $158,148 $900,000 $7,481,849 8 $7,481,849 $299,274 $149,637 $900,000 $7,030,760 9 $7,030,760 $281,230 $140,615 $900,000 $6,552, $6,552,605 $262,104 $131,052 $900,000 $6,045,762 Summary $10,000,000 $3,363,841 $1,681,921 $9,000,000 $6,045,762 Results: Upon the funding of the GRAT, the grantor must report a taxable gift of $1,830,430. However, at the end of the 10year term, the beneficiaries receive $6,045,762 free of further estate and gift tax. Exhibit Year ZeroedOut GRAT The following example illustrates a 10year zeroedout GRAT. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and a total annual return on trust assets of 6%. Beginning 4.00% 2.00% GRAT Year Principal Growth Annual Income Annuity Remainder 1 $10,000,000 $400,000 $200,000 $1,101,649 $9,498,351 2 $9,498,351 $379,934 $189,967 $1,101,649 $8,966,603 3 $8,966,603 $358,664 $179,332 $1,101,649 $8,402,950 4 $8,402,950 $336,118 $168,059 $1,101,649 $7,805,478 5 $7,805,478 $312,219 $156,110 $1,101,649 $7,172,158 6 $7,172,158 $286,886 $143,443 $1,101,649 $6,500,838 7 $6,500,838 $260,034 $130,017 $1,101,649 $5,789,240 8 $5,789,240 $231,570 $115,785 $1,101,649 $5,034,945 9 $5,034,945 $201,398 $100,699 $1,101,649 $4,235, $4,235,393 $169,416 $84,708 $1,101,649 $3,387,867 Summary $10,000,000 $2,936,238 $1,468,119 $11,016,490 $3,387,867 Results: The gift tax value is zero, as calculated on day one since the present value of the annuity is equivalent to the amount initially transferred. At the end of the 10year term, the beneficiaries receive $3,387,867 free of estate and gift tax. Wealth Transfer Planning 10
14 Lengthening the minimum term to ten years may make the GRAT less attractive as more assets may be included in the estate if the Grantor does not survive the term. It would also eliminate the ability to structure a series of rolling, shortterm GRATs, a very favorable wealth transfer strategy which will be discussed later. As for limiting the maximum duration of a GRAT, it appears very few advisors are recommending the longterm GRAT as a viable strategy, even though it may provide a unique benefit in an increasing interest rate environment. Enhancing GRATs Even though the GRAT is a creature of legislation with its basic elements set by the Code, there are still many opportunities to increase the likelihood and magnitude of success for wealth transfer. Certainly, the artful drafting of the trust document itself plays an important role in the success of the GRAT. A skilled attorney will draft a document that creates the best chance for the GRAT to stand up to challenge, escape estate inclusion, leverage grantor trust rules, and offer protection from creditors. However, the focus here is only on the designs that improve the financial success of the strategy. In looking at wealth engineering strategies for GRATs, some involve the design and structure of the trust itself, including the specifics of the annuity payment and the length or term of the trust. However, most involve execution, rather than design, centering on the choice of asset used to fund the trust and ongoing administration of the trust. Design and structure will be discussed first, and then execution. Length of Term: Long Versus Shortterm and Rolling One of the first considerations in designing the trust is the length of the term. Generally speaking, with a longer term, the annuity can be fixed at a lower amount while still keeping the gift tax amount at or near zero. This becomes especially important when the assets used to fund the GRAT are illiquid and don t provide sufficient cash flow to fund a large annuity. In general, if the assets don t provide enough cash flow, the asset itself or some portion of it must be returned to the grantor to satisfy the annuity, reducing the effectiveness of the GRAT. Therefore, it is important to set the annuity low enough that it is able to be satisfied, which in turn may require a longer term to keep the gift value low. A longterm GRAT can lock in a low 7520 rate at the beginning of the term. For example, the 7520 rate for March 2015 was 1.8 percent. This interest rate was applicable regardless of the Exhibit 6. Rolling GRAT The following example illustrates a series of twoyear rolling zeroedout GRATs. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and a total annual return on all assets of 6% Rolling GRATs GRAT Remainder Trust Beginning Income and Payout Annuity Ending Beginning GRAT Ending Year Principal Growth % Annuity % Year Payment Balance Balance Funding Growth Balance Yr 1 GRATS 1 $10,000,000 $600, % 1 $5,135,000 $5,465,000 2 $5,465,000 $327, % 2 $5,135,000 $657,900 $0 $657,900 $39,474 $697,374 Yr 2 GRATS 1 $5,135,000 $308, % 2 $2,636,823 $2,806,278 2 $2,806,278 $168, % 3 $2,636,823 $337,832 $697,374 $337,832 $62,112 $1,097,318 Yr 3 GRATS 1 $7,771,823 $466, % 3 $3,990,831 $4,247,301 2 $4,247,301 $254, % 4 $3,990,831 $511,308 $1,097,318 $511,308 $1,608,626 Results: At the end of the 4 years, the beneficiaries receive $1,608,626 free of estate and gift tax. This rolling strategy could be continued indefinitely, creating additional wealth transfer and limited exposure to estate tax inclusion for the grantor. 11 Wealth Transfer Planning
15 GRAT term. Very simply, the appreciation above that 1.8 percent rate would pass to the remainder beneficiaries. Therefore, it may be very beneficial to lock in a historically low rate over a long period of time. Additionally, not all assets are included in a grantor s estate should the grantor not survive the term. In fact, the amount of included assets is based on the value of assets necessary to produce the same payout for the remaining number of years based on the rate in existence at the time of the grantor s death. Therefore, if interest rates have increased dramatically since the date of GRAT formation, significantly less assets will be included in the grantor s estate. 20 However, in many cases, a shortterm GRAT will be preferred. First, a shorter term reduces the likelihood that the grantor will die during the term, causing inclusion of trust assets in their estate. Second, a series of shortterm consecutive GRATs reduces the impact of one or two years of low performance on the overall financial performance. This is because of the heads you win, tails you tie aspect of GRATs where a period of low performance is isolated and returned to the grantor. Periods of high performance are likewise isolated for the benefit of the remainder beneficiaries. Even so, the strategy does not end with the shorter term, but is then continued through the creation of successive, rolling GRATs. Each year, as the grantor receives an annuity payment, a contribution is made to a new shortterm GRAT. This rolling GRAT strategy can continue indefinitely. By design, as the GRATs roll (after the initial GRAT term), a certain amount is removed from exposure to estate tax as the remainder is passed to the beneficiaries. In addition, high or low performance is isolated, optimizing the strategy. Again, as noted above, shortterm GRATs may be under threat from future legislation, which may mandate a tenyear minimum term for all GRATs. Annuity Amount: Level, Increasing and Decreasing Payout Structures Often, the next factor considered in the design of a GRAT is the determination of the annuity amount. In most cases, as noted above, the annuity is set at a level high enough to minimize the gift tax value (potentially to zero), yet low enough to be achievable with the cash flow expected to be created by the trust s assets. The determination of the overall annuity amount is often a consideration necessitated by the factors of the assets used to fund the GRAT a consideration that becomes much more relevant for trusts funded with illiquid assets providing limited cash flow. If the assets are liquid (e.g., marketable securities), the annuity can be satisfied regardless of cash by way of distributing the assets in kind, thereby allowing a high annuity payment (and potentially a shorter term). On the other hand, illiquid assets (e.g., real estate) cannot be easily partitioned to fund the annuity payment, and the initial determination of the annuity amount becomes a greater concern, largely dependent on expected cash flow. Still, the general idea is usually to set the annuity as high as possible. Additionally, there is no requirement that the annuity payment be level through the term of the GRAT. In fact, the annuity payment can be set to increase or decrease at regular intervals. Currently, it is permissible to structure a GRAT with an annuity that increases up to 20 percent per year, or decreases by an apparently unlimited amount. Increasing Annuity An increasing annuity can be advantageous in deferring a portion of the annuity payable to the grantor, allowing assets to accumulate in the trust. If the assets then outperform the 7520 rate, there will be more assets in the trust at the end of the term passing for the benefit of the remainder beneficiaries. An increasing annuity can also be helpful with illiquid business or real estate assets that are expected to produce cash flows that will increase over the term. In such a case, an increasing annuity may better match the expected trust income. Decreasing Annuity On the other hand, a decreasing annuity may be beneficial for elderly or ill grantors as it reduces the value of the trust more quickly, thereby diminishing the potential exposure to estate tax inclusion if the grantor were to die during the term of the trust. Since the estate tax inclusion amount has become more settled, GRATs structured with Wealth Transfer Planning 12
16 Exhibit Year GRAT, 20% Increasing Annuity The following example illustrates a 10year zeroedout GRAT with an annuity increasing annually at 20%. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and a total annual return on trust assets of 6%. Beginning 4.00% 2.00% GRAT Year Principal Growth Annual Income Annuity Remainder 1 $10,000,000 $400,000 $200,000 $435,400 $10,164,600 2 $10,164,600 $406,584 $203,292 $522,480 $10,251,997 3 $10,251,997 $410,080 $205,040 $626,976 $10,240,141 4 $10,240,141 $409,606 $204,803 $752,371 $10,102,178 5 $10,102,178 $404,087 $202,044 $902,845 $9,805,464 6 $9,805,464 $392,219 $196,109 $1,083,414 $9,310,378 7 $9,310,378 $372,415 $186,208 $1,300,097 $8,568,904 8 $8,568,904 $342,756 $171,378 $1,560,116 $7,522,923 9 $7,522,923 $300,917 $150,458 $1,872,139 $6,102, $6,102,159 $244,086 $122,043 $2,246,567 $4,221,721 Summary $10,000,000 $3,682,750 $1,841,375 $11,302,403 $4,221,721 Results: At the end of the 10year term, the beneficiaries receive $4,221,721 free of estate and gift tax. Exhibit Year GRAT, 20% Decreasing Annuity The following example illustrates a 10year zeroedout GRAT with an annuity decreasing annually at 20%. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and a total annual return on trust assets of 6%. Beginning 4.00% 2.00% GRAT Year Principal Growth Annual Income Annuity Remainder 1 $10,000,000 $400,000 $200,000 $2,395,152 $8,204,848 2 $8,204,848 $328,194 $164,097 $1,916,122 $6,781,017 3 $6,781,017 $271,241 $135,620 $1,532,897 $5,654,980 4 $5,654,980 $226,199 $113,100 $1,226,318 $4,767,961 5 $4,767,961 $190,718 $95,359 $981,054 $4,072,985 6 $4,072,985 $162,919 $81,460 $784,843 $3,532,520 7 $3,532,520 $141,301 $70,650 $627,875 $3,116,597 8 $3,116,597 $124,664 $62,332 $502,300 $2,801,293 9 $2,801,293 $112,052 $56,026 $401,840 $2,567, $2,567,530 $102,701 $51,351 $321,472 $2,400,110 Summary $10,000,000 $2,059,989 $1,029,995 $10,689,873 $2,400,110 Results: At the end of the 10year term, the beneficiaries receive $2,400,110 free of estate and gift tax. Notice how the GRAT balance (and therefore estate exposure) is more quickly reduced than in the increasing annuity example. 13 Wealth Transfer Planning
17 decreasing annuities may become more common. This may be especially true in an increasing interest rate environment where mortality risk may be offset by higher interest rates resulting in lower estate tax inclusion. On the other hand, as discussed previously, the use of a decreasing annuity is itself threatened by future legislation that may no longer allow any decrease within the first ten years. Investment Management Managing Volatility Generally Investment professionals typically attempt to reduce a portfolio s standard deviation while maximizing the expected return. A lower volatility normally causes a higher ending value over a long enough period of time. See Exhibit 9. Exhibit 9. Volatility Consider the returns of two portfolios: Both Portfolio 1 and Portfolio 2 realize the same simple arithmetic total return of 45 percent and the same arithmetic average annual return of 9 percent over 5 years. Year Portfolio 1 Portfolio % 9% 2 35% 9% 312% 9% 4 12% 9% 55% 9% Simple Total 45% 45% 1.6M 1.4M 1.2M 1.0M Year 1 Year 2 Year 3 Year 4 Portfolio 1 Portfolio 2 Year 5 Results: Even though both portfolios realize the same average return, the final result is better in Portfolio 2. An investment of $1,000,000 grows to $1,538,624 for Portfolio 2, while Portfolio 1 only grows to $1,453,637 (geometric/compounded returns). In other words, reduced volatility and consistent compounding over time result in a higher balance for Portfolio 2. Managing Volatility in GRATs Generally The objective to reduce volatility, while generally important for most investment portfolios, is not necessarily as important an objective for GRATs. Remember that the GRAT is a heads you win, tails you tie strategy. Because of that, the downside of negative volatility (i.e., fastoccurring investment losses) is minimized and the upside of positive volatility (i.e., fastoccurring investment gains) is maximized. Chasing volatility can be an effective strategy for a GRAT. Higher volatility can increase the amount that passes to the remainder beneficiaries if positive volatility is achieved; if negative volatility is experienced, the assets simply revert to the grantor. Separate GRATs One very effective way to chase volatility is to isolate it by separating assets with negative correlations and high volatility into separate GRATs. For example, if a client holds two volatile assets with a high negative correlation (one moves up when one moves down) and if those assets were held in one GRAT, the trust may experience a low or even flat combined return over time, underperforming when compared to the 7520 rate and resulting in an unsuccessful GRAT strategy. If, however, those assets were placed in separate GRATs, one may be unsuccessful (but, tails you tie ) while the other may be wildly successful ( heads you win ). The net result is then a success if assets are transferred into separate GRATs, while the net strategy would have been unsuccessful if combined in one GRAT. Therefore, when analyzing the various assets in an investment portfolio identifying those assets with negative correlations and high volatility (i.e., high standard deviations) may present an opportunity. Those assets may then be isolated and dedicated Wealth Transfer Planning 14
18 to separate individual GRATs, each with their own trust document and investment account. In this way, the client may have a better chance to optimize the success of the GRAT. See Exhibits 10 and 11 for examples of separate GRAT strategies. Hedging Against Mortality Risk One of the main risks of a GRAT is mortality risk (i.e., the risk that the grantor will die during the annuity term), which means that some or all of the trust will be included in his or her estate. As discussed earlier, the GRAT is truly a heads you win, tails you tie strategy, in that if the strategy fails, nothing is lost except for transaction costs, gift taxes paid (if any), and opportunity. Still, grantors may want to hedge against the possibility of estate inclusion. One simple and sometimes costeffective way to hedge against mortality risk is to purchase life insurance on the grantor. If the grantor passes away during the annuity term, the life insurance death benefit is received by the estate when the additional tax liability is incurred. Of course, the efficiency of the life insurance as a hedge depends on a variety of factors including internal policy charges and returns, premium costs (largely due to the health and age of the insured), quantity of premiums paid (years until the insured passes), and, of course, the financial ability of the insurance company to pay the death benefit. A qualified insurance specialist should be consulted to ensure the acquisition of an appropriate policy. In addition, an Irrevocable Life Insurance Trust (ILIT) can be used to purchase and hold the insurance policy in order to keep the death benefits outside the insured s taxable estate. Hedging to Lock in Returns: Immunization and Substitution When a GRAT has proven successful during any part of its term (by way of significant appreciation of the assets in excess of the 7520 rate), it may become imprudent to continue to subject the GRAT assets to the risk of loss. By the same token, it may be wise to isolate and writeoff a GRAT that has suffered significant losses when it appears unlikely to rebound. When such significant gain or loss occurs, it may be prudent to lockin the returns. There are many ways to accomplish this. One of the most common methods is the practice of immunization. Immunization is simply the process of attempting to lockin the success (for an inthemoney GRAT) or isolate the loss (for an outofthemoney GRAT) by exchanging or reallocating assets. One simple option is for the trustee to liquidate certain assets and purchase other low volatility assets to lock in gains. Equities or other high standard deviation assets are reallocated into cash, fixed income, certain hedge funds, or any number of other asset classes that are less volatile. The risk of future loss in the GRAT is reduced, making the final success of the transaction more likely. This works especially well in rolling GRATs where shortterm volatility has greater impact. Another option is to exercise the power of substitution, a power commonly reserved to the grantor in many trust documents. The power as outlined in Section 675(4)(C) allows the grantor to reacquire the trust corpus by substituting other property of equivalent value and causes the trust to be treated as a grantor trust for income tax purposes. Under the grantor trust rules, the grantor has the legal obligation to pay any income taxes on trust assets. This allows the trust to grow unreduced by any income tax liability. While the power of substitution creates an ideal transfer tax environment, the power has broader application and can be used by the grantor from time to time to enhance the GRAT s effectiveness. The power of substitution may be applied by the grantor when it becomes desirable to immunize the GRAT by exchanging highperforming assets in the GRAT for lessvolatile assets of equivalent value that are held individually (e.g., exchanging equities for bonds). Because of the grantor status of the trust, such a transaction is ignored for income tax purposes and creates no recognized gain or loss. Effectively, the grantor is exchanging assets with themselves. As a result, using the power of substitution is generally more tax effective than performing immunization internally via the trustee liquidating trust assets. If the grantor wants to continue the wealth transfer cycle, after the substitution the grantor can then regrat the highperforming assets to a new GRAT. This process can continue 15 Wealth Transfer Planning
19 Exhibit Year GRAT The following example illustrates a 2year zeroedout GRAT. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and varying investment returns. Case #1: GRAT with Investment Gains Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance Yr 1 GRATS 1 $10,000,000 10% $1,000, % 1 $5,135,000 $5,865,000 2 $5,865,000 12% $703, % 2 $5,135,000 $1,433,800 Case #2: GRAT with Investment Losses Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance Yr 2 GRATS 1 $10,000,00010% 1,000, % 1 $5,135,000 $3,865,000 2 $3,865,00012% 463, % 2 $3,401,200 $0 Results: In Case #1, the assets outperform the 7520 rate and $1,433,800 passes to the remainder beneficiaries, free of estate and gift tax (i.e., heads you win ). In Case #2, the assets underperform and the GRAT is out of the money. The trust has no assets to pass to the remainder beneficiaries. In essence, the assets are all passed back to the grantor and it is as if the GRAT was never implemented (i.e., tails you tie ). indefinitely. In that way, the highperforming assets continue to offer wealth transfer potential, and success or failure is periodically lockedin. When combined with a shortterm rolling GRAT strategy, regular immunization (by using the power of substitution) can provide even greater potential. As discussed earlier, a shortterm rolling GRAT generally provides more wealth transfer potential than a longterm GRAT because of the continued utilization and transfer of assets. In fact, performing regular immunization on a twoyear rolling GRAT at the end of the first year effectively turns it into a oneyear rolling GRAT. Consider one caveat that may go against conventional wisdom: While immunization may create a greater likelihood to achieve success for a particular GRAT (and for the overall success of a series of GRATs), the overall amount of wealth transferred may actually be lower on average. This is because switching to the lowervolatile assets may generally be expected to produce a lower return. This is the typical risk and reward conundrum and becomes a question of whether the grantor is more interested in creating a greater potential for GRAT success or in maximizing the potential amount transferred to heirs. One answer may not be correct for all. Overall Family s Asset Allocation Considerations While the strategies discussed above surrounding investment options, volatility, correlation and isolation can be important in the success or failure of a GRAT, one must not overlook the trust s relation to the overall investment strategy for the family. Advisors should not ignore such items as the family s risk tolerance and overall asset allocation. A GRAT investment strategy that makes sense on a spreadsheet may not be a good fit when considering the family s other investments. For example, if the family s other assets are balanced in a rather conservative and welldiversified allocation, it may not make sense to focus the GRAT on highly volatile equities, even if that strategy is expected to work well from an estate transfer perspective. Certainly, the risk tolerances and investment policy concerns of all stakeholders in the transaction must be considered. The grantor/annuitant and the remainder beneficiaries may have very different interests, risk tolerances, and investment policy Wealth Transfer Planning 16
20 Exhibit 11. Combined Versus Separate GRATs The following example illustrates a 2year zeroedout GRAT. First analysis assumes one combined GRAT of assets with negative correlations and, therefore, combined minimal returns. Second analysis assumes creating two GRATs, one for each negativelycorrelated asset class. Assumptions are $10 million beginning principal, a 1.8% 7520 rate, and varying investment returns. Case #1: Combined GRAT with Negative Correlation Assets Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance Yr 1 GRATS 1 $10,000, % $110, % 1 $5,135,000 $4,975,000 2 $4,975, % $135, % 2 $5,110,240 $0 Case #2: Separate GRATs with Negative Correlation Assets Separate GRAT#1 Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance Yr 1 GRATS 1 $5,000, % $525, % 1 $2,567,500 $2,957,500 2 $2,957, % $331, % 2 $2,567,500 $721,240 Separate GRAT#2 Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance Yr 1 GRATS 1 $5,000, % $415, % 1 $2,567,500 $2,017,500 2 $2,017, % $196, % 2 $1,821,500 $0 Combined Results of Separate GRATs Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance Yr 1 GRATS 1 $10,000, % $110, % 1 $5,135,000 $4,975,000 2 $4,975, % $135, % 2 $4,389,000 $721,240 Results: In Case #1, the assets collectively underperform the 7520 rate and the trust has no assets to pass to the remainder beneficiaries. In Case #2, the same assets are split into two separate GRATs. While Separate GRAT #2 underperforms and no assets pass to the beneficiaries, Separate GRAT #1 does outperform and $721,240 passes to the beneficiaries. Collectively, the GRAT strategy performs better when the assets are splitup. 17 Wealth Transfer Planning
Let's take a look at how annuities (fixed, variable and indexed) can help individual investors in achieving these objectives.
W hy do people buy annuities? It's a fundamental question every salesperson asks. In this chapter we'll explore various types of clients, their needs, financial objectives and other factors that go into
More informationGenerating Guaranteed Income: Understanding Income Annuities
Generating Guaranteed Income: Understanding Income Annuities Vanguard Investment Counseling & Research Executive summary. Income annuities are a form of insurance intended to address the uncertainty investors
More informationWith any annuity, there are two distinct time periods involved: the accumulation period and the payout or annuity period:
A n annuity is simply a stream of periodic payments. Start with a lump sum of money, pay it out in equal installments over a period of time until the original fund is exhausted, and you have created an
More information1 BASIC PRINCIPLES OF LIFE INSURANCE 1
1 BASIC PRINCIPLES OF LIFE INSURANCE 1 Learning Objectives An understanding of the material in this chapter should enable the student to 1. Define the basic principles of life insurance. 2. Explain the
More informationA guide to investing in mutual funds
A guide to investing in mutual funds What you should know before you buy Wells Fargo Advisors wants to ensure that you are investing in the mutual funds and the share classes that best suit your investment
More informationTargeting Income. Retirement Income for Today s DC Plans. By Chip Castille
Targeting Income Retirement Income for Today s DC Plans By Chip Castille Editor Tony Mastrogiorgio 4156702195 phone tony.mastrogiorgio@blackrock.com About the author Chip Castille Mr. Castille is head
More informationUnderstanding Variable Annuities
JUNE 2015 5 Benefits and Features of a Variable Annuity 9 Other Features, Benefits and Considerations 12 Before You Decide to Buy a Variable Annuity Understanding Variable Annuities What is a Variable
More information12. Insurance 2: Life Insurance
12. Insurance 2: Life Insurance Introduction Once you understand the basics of insurance, your understanding of the importance of life insurance increases greatly. Much of what is written on the subject
More informationAnnuity Transactions: Ensuring Suitability
Annuity Transactions: Ensuring Suitability i Contents Introduction... 1 Learning Objectives... 1 National Association of Insurance Commissioners... 1 1.0 Obtaining Consumer Suitability Information... 2
More informationWhat. Mutual funds and collective investment. you should know about. Information Guide
What you should know about Mutual funds and collective investment Information Guide This CNMV guide is for investors. It explains the essential terms, helps you to ask the right questions, sets out the
More informationIndex Annuities. A Suitable Approach
Index Annuities A Suitable Approach Jack Marrion & John Olsen, CLU, ChFC, AEP Index Annuities: A Suitable Approach Chapter 1 Annuity Basic 1 Chapter 2 Annuity Interest 21 Chapter 3 Crediting Methods 45
More informationThe sensitivity of life insurance firms to interest rate changes
The sensitivity of life insurance firms to interest rate changes Kyal Berends, Robert McMenamin, Thanases Plestis, and Richard J. Rosen Introduction and summary The United States is in a period of low
More informationAnnuities Table of Contents
Annuities 1 Annuities Table of Contents Chapter One Introduction to Annuities and Annuity Buyers Important Lesson Points Introduction Demographics of NonQualified Annuity Purchasers The Annuity Concept
More informationAmerican Retirement Savings Could Be Much Better
AP Photo/Jae C. Hong American Retirement Savings Could Be Much Better By Rowland Davis and David Madland August 2013 www.americanprogress.org American Retirement Savings Could Be Much Better By Rowland
More informationAnnuity 4Hour Course
Life or Health Agents Only Annuity 4Hour Course Online Study Book You Are On Page 1 Use Your Page Down Button To Start Reading The Book Click to Search or Ctrl + F Save This Book Exam / Submit Answers
More informationUnderstanding The Longevity Annuity And Its Potential Role In Retirement Income
Understanding The Longevity Annuity And Its Potential Role In Retirement Income July/ August 2014 Executive Summary  A longevity annuity is similar in concept to an immediate annuity, where a lump sum
More informationPrinciples of Annuities
While a great deal of care has been taken to provide accurate and current information, the ideas, suggestions, general principles and conclusions presented in this text are subject to local, state and
More informationVariable Universal Life Insurance: Is it Worth it? James H. Hunt, F.S.A. February 2003
Variable Universal Life Insurance: Is it Worth it? James H. Hunt, F.S.A. February 2003 I. Introduction Variable life insurance provides death benefits and cash values that vary in accordance with the performance
More informationOptimizing Retirement Income by Combining Actuarial Science and Investments
Optimizing Retirement Income by Combining Actuarial Science and Investments by Wade D. Pfau, Ph.D., CFA For retirement income, we must step away from the notion that either investments or insurance alone
More informationIntroduction. Introduction. Qualified Versus Nonqualified
1 Introduction Page ID: 526283 Introduction As we begin this course on Annuity Riders and Suitability of Transactions, it may be beneficial to review some of the basics about annuities. Fundamentally,
More informationS. Stacy Eastland Houston, Texas
SOME OF THE BEST ESTATE PLANNING IDEAS WE SEE OUT THERE THAT I HAVE NOT ALREADY TALKED ABOUT (That Also Have the Merit of Playing Havoc With Certain Conventional Wisdom ) S. Stacy Eastland Houston, Texas
More information4HOUR ANNUITY TRAINING
4HOUR ANNUITY TRAINING SECOND EDITION 4 Credit Hours, Approved For Life Insurance Licensees California Approved Course License Number 290774 All Life agents who sell annuities in California must complete
More informationAccounting for Derivative Instruments
CHAPTER 26 Accounting for Derivative Instruments isky Business R It has been said that until the early 1970s most financial managers worked in a cozy, if unthrilling world. Since then, however, constant
More informationWhy insurers differ from banks
Why insurers differ from banks October 2014 About Insurance Europe Insurance Europe is the European insurance and reinsurance federation. Through its 34 member bodies the national insurance associations
More informationANNUITY SUITABILITY. This course is Clearcert Certified. Commonwealth Schools of Insurance, Inc. P.O. Box 22414. Louisville, KY 402520414
ANNUITY SUITABILITY This course is Clearcert Certified P.O. Box 22414 Louisville, KY 402520414 Telephone: 502.425.5987 Fax: 5024290755 Web Site: www.commonwealthschools.com Email: info@commonwealthschools.com
More informationGuide to buying annuities
Guide to buying annuities Summary of the key points contained in this disclosure document Before you purchase your annuity contract, make sure that you read and understand this guide. While reading this
More informationThe Emerging Alternative Investment Life Insurance Assets 1
The Emerging Alternative Investment Life Insurance Assets 1 I. Introduction Edward S. Adams 2 The historical volatility of the equity and real estate markets, coupled with historically low interest rates,
More informationEQUITYINDEXED ANNUITIES: FUNDAMENTAL CONCEPTS AND ISSUES
EQUITYINDEXED ANNUITIES: FUNDAMENTAL CONCEPTS AND ISSUES October 2006 Bruce A. Palmer, Ph.D. Professor and Chair Emeritus Department of Risk Management and Insurance Robinson College of Business Georgia
More informationBasic Principles of Life Insurance
1 Basic Principles of Life Insurance Learning Objectives An understanding of the material in this chapter should enable you to 11. Define the basic principles of life insurance. 12. Explain the concept
More informationFinancial planning and insurance
Chapter 4 44 Eliminating debt and student loans 45 Starting a family parental benefits 46 Tax basics 47 Tax instalment payments 49 Incorporation 52 Investing basics 54 Protecting your lifestyle 57 To rent
More information