The arrival of a new year is when smart advisors take advantage of the fact that their High Net Worth (“HNW”) clients are open to discussions about long-term trends and concerns about their financial future. It is also the time to propose realistic and practical strategies to mitigate these concerns. One increasingly adopted solution is what I refer to as a Financial Back Up Plan – which is the focus of this article.
I have found that HNW client concerns can be classified in one of two ways:
1) Concern about things with catastrophic outcomes but unknown dates:
These include concerns such as:
- growing debt and deficits;
- huge costs to recover from increasing occurring natural disasters such as hurricanes and earthquakes;
- entitlement obligations for an aging population;
- costs to rebuild crumbling infrastructure;
- and future military expenditures…all made worse by political deadlock.
These types of long-term concerns are extremely important but are often ignored because they are not immediate.
HNW persons mitigate against these concerns through tax planning, liability insurance and personal preparedness.
2) Concerns about things with unknown outcomes but specific dates:
For HNW Americans the issue is the November 2020 election where uncertainty abounds.
On one side are the questions of “Who will be the Democratic POTUS candidate?” and “What will be the Democratic platform?” Clarity will only occur at the conclusion of the July Democratic National Convention. However, all of the candidates have stated their tax policies… and there is an increasing possibility of a Democratic ‘Grand Slam’ no matter who is the Democratic POTUS candidate. So we know at a minimum there could be the loss of preferential treatment of carried interest and all capital gains would be taxed at ordinary tax rates. Additional ‘Tax the Rich’ proposals include annual deemed dispositions; loss of step-up on death; limits on charitable contributions; significant estate tax increases; and a new Wealth Tax.
On the other side of the uncertainty coin are a number of events that will occur and impact during 2020. These include the impeachment process, the health of the economy, and the resolution of the current trade wars.
Exit, Voice or Loyalty
When considering how to deal with these concerns, I often refer to the possible responses articulated by the famous economist Albert Hirschman: “Exit, Voice or Loyalty”:
- Wealthy Americans who agree with Democratic tax proposals can chose ‘Loyalty‘ by joining the “Patriotic Millionaires”;
- Those who do not buy into all of the Democratic tax proposals can express their ‘Voice‘ by making contributions to specific candidates, super- PACS or lobbyists; or
- Those who want to ‘Exit’ can give themselves the power to ‘Vote with their Feet’.
In my experience relatively few fully explore the “Exit” option. This is often due to a lack of awareness, information or objective analysis. However, those who do the research are often intrigued by what they discover.
Overcoming ‘Life Inertia’
A growing number of HNW American clients will consider overcoming their ‘life inertia’ on the small scale. They’re happy, for instance, to move from a high tax to a low tax state. However, few clients currently seriously contemplate leaving the US tax system… no matter what tax burden is imposed upon them. I would attribute this prevailing attitude to:
- Underestimating the actual total financial cost if various Democratic tax proposals become law;
- Underestimating the potential cost to their children and future generations of deteriorating general conditions in the US;
- Overestimating the cost and complexity of developing a Back Up Plan that will give them and their children a practical and livable Exit. A Back Up Plan is a comprehensive citizenship, residence and domicile solution. It addresses potential specific and general concerns that could negatively impact the wealth and/or personal security of their family;
- Misunderstanding the reality that only one family member typically ‘Exits’. With proper planning this individual can still spend significant periods of time in the US without re-acquiring US taxpayer status through substantial physical presence;
- Overestimating the ‘Exit Tax‘ cost of triggering a Back Up Plan at a future date (i.e. deemed disposition for capital gains purposes). They are not aware of the various mitigation strategies to reduce the capital gains nor do they appreciate the significantly higher future cost should the capital gains rate increase significantly; and
- Under-appreciating the benefits for all present and future family members of having a Back Up Plan (that includes a second citizenship and residence). This includes the ability to live, study and work abroad.
A Financial Back Up Plan: Insurance for Your Lifestyle
To overcome these misconceptions advisors can first ask clients to mentally compare the idea of a customized Financial Back up Plan to house insurance. HNW American clients inherently understand that they don’t buy house insurance because they are sure that they will have a fire. Rather, they understand that should the possibility of a fire become a reality, the impact would be devastating. The same logic applies to their family’s wealth and well being.
The next step for an advisor when exploring the idea of a Financial Back up Plan with their client is to review their family and financial background, goals and fears. Working with experienced Back Up Plan experts, the advisor should ‘run the numbers’ on the costs of tax proposals becoming law. Then the advisor should work with the Back Up Plan expert to develop a strategy that will meet all the family’s goals and address their concerns. The proposed Financial Back Up Plan should include the steps to be undertaken, the timeline and costs. With all the relevant costs in hand, the client can then properly evaluate the costs and benefits of the proposed Back up Plan …as their “family insurance” policy.
Increasing uncertainty for HNW Americans is a reality. Advisors should therefore use all available tools to help them hedge and insure against the negative impact of these uncertainties. Increasingly this means that the consideration of a practical and livable Back Up Plan will no longer be considered esoteric. A goal without a plan is just a wish.
This article was originally published on wealthmanagement.com in January 2020