Investment Concepts Every Estate Planner Should Know And Understand

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Checkpoint Contents
Estate Planning Library
Estate Planning Journals
Estate Planning Journal (WG&L)
Estate Planning Journal
2007
Volume 34, Number 11, November 2007
Articles
Investment Concepts Every Estate Planner Should Know and Understand, Estate Planning
Journal, Nov 2007

INVESTMENT CONCEPTS

Investment Concepts Every Estate Planner Should Know and
Understand
Understanding how the investment picture influences an estate planning structure is as
important as grasping the legal and tax ramifications. Ignoring investment implications can
lead to serious issues with the long-term viability of an estate plan.

Author: LAUREN J. WOLVEN, ATTORNEY

LAUREN J. WOLVEN is an attorney and the Regional Trust Head in the Chicago
office of Brown Brothers Harriman Trust Company, N.A., where she manages
fiduciary and wealth management advisory services for the Midwest region. The
author gratefully acknowledges the contributions of her colleagues to this article:
Scott Clemons, Managing Director and Head of the Nassau Wealth Management
Team in the New York office; Fanie Gouws, Head of the Tax Efficient Risk
Management Group based in the Charlotte, North Carolina office; Martin Silfen,
Director of Wealth Planning and Regional Trust Head in the Palm Beach, Florida
office; and Trey Tune, Managing Director and Head of the Chicago office. This
material is intended for information purposes only, and should not be relied upon
as financial, investment, tax, or legal advice. The services of an appropriate
professional should be sought in connection with such matters. BBH makes no
representations or warranty as to the accuracy or completeness of the
information provided. Accordingly, BBH shall not be liable for any inaccurate or
incomplete information.

Having recently transitioned from private law practice advising high net worth private clients to an in-
house trust and wealth advisory role at a privately owned bank and trust company, I have been
fortunate enough to be able to spend time delving deeply into all those investment details that I always
wanted to know more about, but never had the time to give my full attention. As I melded my
experiences from these two different, yet intertwined, roles, I developed the following list of eight
investment concepts that have emerged for me as important keys to providing knowledgeable advice
for estate planning and business succession planning clients.

Whether approached from the legal perspective, the tax perspective or the investment perspective,
estate planning generally has the goals of helping clients preserve, grow and transition their wealth.
When a structure like a grantor retained annuity trust (“GRAT”), for example, is created after carefully
considering the investment factors that influence its success, the technique can become an even more
powerful tool.

1. GRATs generally work better when asset classes are

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segregated
When discussing advanced estate planning techniques with clients, we often place a great deal of
emphasis on selecting the right transfer structure. We worry about whether an installment sale to a
grantor trust is better than a GRAT, whether a GRAT is better than a grantor retained unitrust
(“GRUT”), and whether we should use two-year rolling GRATs or some other combination of GRAT
terms. The minutiae of the legal and tax issues related to GRATs can understandably lead to an all-
consuming focus on the structural aspects of the transaction while the investment considerations are
placed on the back burner.

When asset positioning is taken into account during the planning phase, and the legal and tax structure
is built around and in conjunction with the investment framework, the positive effect on the planning
can be enormous. A primary guiding principle for a GRAT is that it can fulfill its mission only if it earns
more than its hurdle rate, which is the Section 7520 rate applicable to the GRAT. If the GRAT on
average increases at a rate greater than its hurdle rate, the remainder left at the end of the trust term
should be more than the remainder value calculated for gift tax purposes, resulting in a leveraged gift.

The general rule for a GRAT portfolio—unlike most portfolios—is that the less diversified, the better. In
the world of marketable wealth, this essentially equates to a stock portfolio. Including in a GRAT asset
classes such as bonds, which are unlikely to outperform the hurdle rate, puts the effectiveness of the
entire GRAT at risk. A GRAT is not a structure for hedging your bets with a mixed bag of investments;
rather, it is a technique that calls for insulating each asset class from the underperformance of another
asset class.

To demonstrate this theory, we decided to study the performance of stocks based on the total return of
the S&P 500. 1 We measured the performance of a zeroed-out ten-year GRAT funded with $1 million
during 67 different 12-year periods in the stock market starting with the time period 1926-1937 and
ending with the period 1992-2003. 2 To provide a meaningful comparison to our three-year rolling
GRAT study, it was assumed that the amount distributed to the remainder beneficiary at the end of the
GRAT's term was reinvested by the remainder beneficiary in U.S. stocks for an additional two years.
Exhibit 1 summarizes the results of our modeling, with “success” defined as having assets left for the
remainder beneficiaries at the end of the ten-year GRAT term.

If you extend the concept of asset concentration, such as a separate GRAT for each particular stock,
the underperformance of any particular stock is isolated. In this circumstance, some GRATs likely will
fail and others will succeed, but a successful return will not be hindered by a stock that lags or, as a
colleague likes to say, “fails to validate your insight.” Practical cost considerations may prohibit taking
asset segregation to its furthest limits; nevertheless, this investment consideration is one that should
be taken into account at the beginning of the planning phase so it can be determined whether multiple
trust documents or a single document multi-trust structure is most appropriate for the selected asset
isolation.

Complete asset concentration is antithetical to the commonly accepted principle of diversifying your
investment portfolio. Asset isolation within GRATs should be balanced by diversification and proper
asset allocation within the other portions of the annuitant's portfolio. With the isolation, there is a
possibility for some GRATs to fail even to survive the annuity term. Accordingly, the potential for the
loss of annuity income should be considered in the annuitant's broader investment portfolio.

2. Two-year rolling GRATs increase the likelihood of catching the
greatest number of favorable market cycles

You may be thinking to yourself, “This is not news! We have been hearing about this for years.” But did
you ever really understand why the two-year rolling GRAT is most likely better than a three-year rolling
GRAT or some other combination of staggered GRATs?


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Simply put, just as GRATs perform better when you segregate the assets as much as possible, GRATs
also tend to produce a better result when you isolate market periods. With a series of short-term
GRATs, bad performance during one short period is not likely to drag down good performance in the
next short period. Taken to its extreme, this theory would instruct the creation of a new one-day GRAT
every day. Current thinking, though, is that two-year GRATs are the shortest recommended term. 3

Exhibit 2 illustrates the results of testing five consecutive two-year GRATs during the same 67 periods
of 12 years used in testing the ten-year GRATs. As in the ten-year study, we zeroed out the GRATs,
started the transaction with $1 million, and used the total return on the S&P 500 to measure
investment performance. Upon the termination of the first two-year GRAT that had been funded with
$1 million, a subsequent GRAT was funded with the annuity distributions from the prior GRAT, and so
on until five GRATs had terminated. The remainder beneficiary was assumed to have invested the
amounts received upon termination of each GRAT in U.S. stocks. 4 At the end of the fifth GRAT, again
for purposes of comparison to our three-year rolling GRAT study (discussed later), the remainder
beneficiary was assumed to invest the GRAT distributions in U.S. stocks for two more years.

We can see that short-term GRATs are likely to result in a higher degree of successfully transferring
some wealth to the remainder beneficiaries. If the GRATs are then staggered as well, commonly
referred to as “rolling GRATs,” history demonstrates that an even better result is possible.

Exhibit 3 summarizes the historical result for a structure using ten two-year rolling GRATs. This study
assumed that the first GRAT was funded with $666,667. At the start of year two, a second GRAT was
funded with $333,333 plus the first year's annuity distribution from the first GRAT. For the three years
after that, a new GRAT was established at the beginning of the year with that year's annuity
distributions from the prior two GRATs. Each result represents the performance until the termination of
the tenth GRAT in that rolling series of two-year zeroed-out GRATs, with the assumption that the
remainder beneficiary continues to invest in U.S. stocks for an additional year. 5 This last assumption
was made, as in the previous study, to provide a meaningful comparison to our three-year rolling GRAT
study.

Finally, I come to the previously referenced three-year rolling GRAT study to answer the question “Why
two years as the rolling GRAT term instead of something longer?” The assumptions used for the three-
year GRAT study are the same as for the two-year GRAT study with the exception of the straight two-
year investment period by the remainder beneficiary at the end of the last GRAT. Exhibit 4 shows the
results with three-year GRATs.

Although the two-year rolling GRATs and the three-year rolling GRATs were both successful in all 67
time periods, the two-year rolling GRATs outperformed the three-year rolling GRATs in 66 out of the 67
periods tested. These results argue strongly in favor of selecting the shortest possible term for GRATs
when investing in U.S. stocks.

It might be argued that when the hurdle rate is low, it is better to lock it in for a longer period.
However, the benefit of a low hurdle rate for a longer term may be outweighed by the result of
insulating good two-year periods from bad ones. In every one of the 67 periods tested, the two-year
rolling GRAT strategy outperformed a single ten-year GRAT, regardless of the initial hurdle rate. This is
quite telling when you consider that the study includes a time period beginning in 1940, when the
hurdle rate was only 0.6%. The final argument for using the two-year GRAT is the increased chance
that the grantor will survive the term and achieve the desired estate tax result.

3. Kettle if you do, Dumont if you don't

One of the biggest investment traps for the unwary occurs in the fiduciary context. When a trust
instrument provides express investment direction with respect to retention of a concentrated position,
the passive observer might think that the trust instrument has made life easy by providing an
instruction manual for the trustee. Truthfully, a close look at case law indicates that specific direction


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does not necessarily grant a trustee the right to abdicate its duty to engage in reasonable analysis of a
trust's investment situation. Blindly following the investment direction of a trust instrument with regard
to a concentrated position may be a recipe for disaster.

Historically, the directions of the trust's creator provided complete protection for a trustee as long as
the investment policy set forth in the trust instrument was followed. 6 In Hatfield v. First Nat'l Bank, 7
for example, the Illinois Appellate Court held that a trustee was not required to diversify the
investment portfolio when the terms of the trust authorized the trustee to retain the stock originally
owned by the testator. The beneficiaries had never requested that the stock be sold and had, in fact,
expressed their consent to retention of the stock even as the stock plummeted during the depression. 8
In rendering a decision in favor of the trustee, the court noted that a trustee following the investment
instructions set forth by the grantor will not be liable for losses in the absence of negligence, fraud, or
other improper conduct. 9

Recent history, however, demonstrates that times have changed. Two highly publicized cases regarding
single stock positions, In re Estate of Dumont 10 and In re Estate of Kettle, 11 resulted in liability for
both trustees, one of whom retained the concentration and one of whom diversified.

In Dumont, the language in the will creating the trust at issue permitted the corporate fiduciary to
retain the estate's single stock position in Eastman Kodak. 12 The trustee did not diversify the trust's
portfolio from the time it assumed the trusteeship in 1958 until 2002, when it hurriedly sold off the
stock over a nine-month period. The court's own words provide the best summary of the situation:

After the dispositional provisions, the testator added an extensive paragraph quot;LASTLYquot;,
wherein he set forth the powers of the nominated fiduciaries, notably the power to
quot;administer. . . sell, transfer and disposequot; of the stock. Additionally, buried within this
paragraph is an interesting notation that the testator's estate would be primarily comprised
of a single security: the stock of Eastman Kodak Company (quot;Kodakquot;). Further along in this
final paragraph, Charles Dumont included the following language:

It is my desire and hope that said stock will be held by my said Executors and by my said
trustee to be distributed to the ultimate beneficiaries under this Will, and neither my
Executors nor my said trustee shall dispose of such stock for the purpose of diversification
of investment and neither they or it shall be held liable for any diminution in the value of
such stock.

Finally, and most importantly, he concluded his retention language with the following
language (the quot;exception phrasequot;), which remains the crux of this litigation:

The foregoing provisions shall not prevent my said Executors or my said Trustee from
disposing of all or part of the stock of Eastman Kodak Company in case there shall be some
compelling reason other than diversification of investment for doing so. 13

The beneficiaries had objected to the concentration of Kodak stock several times in the few years
preceding the diversification, but the trustee did not officially determine that a “compelling reason” to
diversify existed until December 2001.

The applicable statute regarding diversification had changed during the course of the trust
administration so that diversification was required by law after 1995. The court found the trustee liable
for a breach of duty for its failure to diversify. In addition to its disagreement with the trustee's
interpretation of “compelling reason,” as used in the governing instrument, 14 the court also noted that
the trustee's complete lack of documentation regarding the investment performance of the trust's
assets was a breach of trust in itself. 15


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Finding that the trustee should have diversified before 1/31/74, the court awarded to the beneficiaries
the amount that would have resulted from a sale on such date, reduced by capital gains taxes that
would have been incurred at the time. The court also awarded compounded statutory interest, reduced
by income actually earned by the Kodak stock. In addition, the trustee was ordered to return
commissions paid to the trustee over the course of the accounting period (more than 30 years), with
statutory interest compounded. The total tab was in excess of $20 million, and although this case was
overturned on appeal in 2006, 16 the reasons for its reversal still mandate that the court's analysis of
the diversification issue should not be ignored.

As in Dumont, the testator's will in Kettle provided that the executor and trustee should retain a single
stock position unless there was a compelling reason to dispose of the stock. Specifically, the decedent's
will stated “I note that I am particularly desirous that my TRW, Inc., securities be retained by my
Executrix and by my Trustee unless compelling reasons arise for the disposal thereof.” 17 The trustee
diversified two months after receiving the stock and the testator's widow, claiming breach of trust, filed
suit.

The court ruled that the “trustee acted in breach of its trust when it sold the stock” because the stock
was a good investment when sold and the trustee failed to show a compelling reason for sale
(diversification apparently not qualifying) as required by the express direction of the testator. 18 In
addition to being ordered to repurchase the stock at its own expense, the trustee was required to pay
the widow's attorney's fees and expenses. The issue as to whether the trustee should be required to
reimburse the trusts involved for the capital gain taxes incurred by reason of the sale was remanded.

The moral of the story is this: A trustee with a trust instrument which gives express instruction
regarding trust investments arguably must monitor that investment portfolio even more carefully than
a trustee subject to the default statutory provisions and using a standard investment mix. A trustee
with investment directions in a governing instrument should be careful to ensure the trustee
understands terms like “compelling reason” and documents the monitoring of the concentrated position
as it relates to the market in general.

If the investment strategy set forth in the trust instrument is questionable in light of the facts and
circumstances surrounding the concentrated position, the beneficiary's needs and the trust purposes,
the trustee should take action to make sure it is acting in compliance with its duties, as the
beneficiaries and the courts would expect. First, the trustee should communicate with the beneficiaries
and consider obtaining releases or indemnifications from the beneficiaries. If these options are not
adequate to clarify that the beneficiaries agree the trustee is properly fulfilling its obligations, the
trustee may want to seek the guidance of the courts as to whether it must follow the direction of the
trust instrument or whether it should invest according to a different standard.

4. A concentrated position can be resolved without a lawsuit or
horrible tax consequences
Many families have large concentrations in securities that are highly appreciated and may also have
sentimental value to the family. While such positions often are closely related to the reason the family
is wealthy in the first place, they present real financial risks and also create significant liability for a
trustee if the concentration is held in trust. Individual stocks routinely decline by more than 20% in a
day, so concentrations should not be taken lightly.

Luckily, there are alternatives other than an outright sale of the stock to help alleviate the host of
concerns associated with a concentrated position. Sophisticated investment advisors can help create a
structure designed to both protect and diversify concentrated positions, while spreading the associated
tax burden over an acceptable period of time. These strategies can range from basic options strategies,
such as covered call writing, to sophisticated, over-the-counter hedging structures like a variable
forward or equity collar.


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A covered call is a stock option on your concentrated security that you sell for a premium. For example,
you may sell to the buyer a right to purchase 100 shares of your concentrated position at $45 per
share. For this right, the “covered call,” the buyer pays you $2 per share. When the stock is selling at
$52 19 per share, the buyer has the right to buy it from you at $45 per share because of the call. If the
stock price drops to $40 per share, however, you have partially mitigated your downside because your
$5-per-share loss is offset by the $2-per-share you received for selling the call. 20 The goal of the
covered call is to generate premium income, which can enhance portfolio yield, fund tax payments, and
dampen your downside risk.

Variable forwards and equity collars are referred to as “over-the-counter” because they are negotiated
privately rather than traded openly in a marketplace. There are various firms making markets in these
types of security transactions, and a client must shop around to dealers of this type of transaction and
find the appropriate “over-the-counter” deal.

An equity collar creates a floor and ceiling value for the concentration in order to allow the client both
to retain upside and establish a minimum value if the stock price falls precipitously. An equity collar is a
series of transactions where you are buying puts and writing calls. A put is the purchase of an option to
sell a stock at a fixed price. For example, you may purchase from a seller a right to make him purchase
100 shares of your concentrated position at $45 per share. You pay $2 per share for that right. If the
stock drops to $40 per share, you get to sell the 100 shares to the seller of the put at the $45 strike
price of the put. A collar, therefore, is aptly named. You are fixing a maximum value and a minimum
value on the shares, and trading upside potential for downside protection. If you sell your call for the
same price you pay for your put, the transaction sometimes is referred to as a “costless collar.”

A variable forward works in essentially the same manner as the equity collar, but the put and call are
combined into a single contract. If the client with the concentrated position receives an upfront
payment under the contract, the structure generally is called a “prepaid variable forward contract.” It is
not uncommon for the client to loan stock to the financial institution that usually is on the other side of
the contract. The financial institution can then use the shares to hedge its risk.

If your client is unable to understand the intricacies of such hedging strategies, there are also more
straightforward programmed selling approaches that adjust the pace of diversification for changes in
the stock price, thereby offering the potential to increase the resulting sales proceeds over time. These
strategies are far easier to understand and may achieve a similar result as a hedge, albeit with less
protection during the process.

Two notes of caution should be mentioned, particularly with regard to over-the-counter hedging
transactions: You must carefully consider the underlying economics of the strategy for your client and
you must also evaluate the tax risks. There can be significant embedded compensation for dealers in
these transactions, and it may be advisable to counsel a client against working directly with a single
dealer to construct a hedge. The best analogy is to describe it like shopping around in the market for a
limited edition collector's item. There is no market, and the price is only as good as you can negotiate.
Certain investment advisors will serve as a client's “agent” when constructing these strategies in order
to create an auction between competing dealers. In many cases, the presence of an agent can
significantly alter the terms in the client's favor by introducing competitive bidding between dealers.
Typically, the advisory fees paid to the agent are a fraction of the resulting improvements in pricing for
the client.

As for tax considerations, there are important limitations to how much risk can be hedged away without
triggering a constructive sale of the stock. 21 Certain strategies, like the variable forward, have
attracted close scrutiny of late from tax authorities, particularly in relation to the argument by the IRS
that the loan of the shares is a constructive sale. A client's primary tax advisor should be closely
involved in any hedging process to prevent an adverse tax result.

Inertia can be dangerous in the investment landscape. History has demonstrated the enormous
financial risks of failure to diversify, so it is important for clients to understand that there are methods


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by which much of the tax cost associated with diversification can be recouped in conjunction with the
implementation of a hedge. The bottom line is that it is critical to understand the various strategies
available for dealing with concentrated positions so you can encourage clients to avoid inertia and
consider their risk management alternatives.

5. Open architecture is like an onion
I do not mean that it smells bad and you should stay away from it (though the markets can make you
want to cry at times). Rather, open architecture reminds me of an onion for two reasons: (1) it has
layers (of fees); and (2) just as an onion goes well with a burger but not ice cream, open architecture
meshes with some asset classes, but not with others.

Open architecture is the phrase commonly used to describe a structure where an investment consultant
is hired to choose several money managers who, operating independently from one another, will
choose the individual investments comprising the portfolio. Taken to its most simplified level, the
investment consultant picks the money manager, and the money manager selects the stocks. Both in
private practice and in the in-house fiduciary context, I have been in many meetings where the client
asks of the investment professional “Do you have open architecture?” Unfortunately, many clients stop
with that question and do not ask the crucial follow-up question: “How will it benefit my portfolio?”

The premise of open architecture and its additional layer of fees is that through an organized search,
the investment consultant can routinely identify above-average money managers in each investment
category. As demonstrated in Exhibit 5, the expense of open architecture is more likely to reap rewards
in some asset classes than others. As illustrated in Exhibit 5, the dispersion of active return
demonstrates the difference in performance between the manager in the 75th percentile and the
manager in the 25th percentile.

For example, the private alternatives category in the exhibit demonstrates that the manager who
performs better than 75% of the other private alternatives managers produced an annualized return
8% higher than the manager who performed better than 25% of the other private alternatives
managers. With the private alternatives asset class, the difference in return is more likely to warrant
the use of an investment consultant with expertise and research capabilities to assist in selecting what
are more likely to be the better performing managers.

In the municipal bond area, however, the difference is only 0.7%. Because there is no guarantee the
investment consultant will pick the managers that actually are in the top quartile of managers, you
need to question whether open architecture will provide any benefits in this asset class.

The key to properly applying open architecture is to understand where and why it adds economic
advantage. In efficient asset classes where the performance of a top quartile manager is only
incrementally better than the performance of a bottom quartile manager, it is important to question
whether there is any benefit to paying an overlay fee to identify the top quartile manager.

6. Inflation is the silent killer of foundations and endowments

Most endowments and foundations are designed to be perpetual so that the long-term societal
challenges they address will have support as long as needed. The viability of the perpetual structure
depends largely on crafting a sustainable distribution policy. Setting the spending rate too high dooms
the corpus to gradual depletion. Setting the spending rate too low starves current charitable programs.

So what is a sustainable distribution policy? It would be easy if there were one cookie-cutter answer for
every situation, but unfortunately that is not the case. The starting point for a sustainable plan is
making a thoughtful projection of the annual distribution expectations for the foundation or
endowment. Whether future contributions to the principal base should be considered in the calculation
depends on the facts and circumstances. It may be that future needs of the organization are more


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likely to exceed current needs, so the distributions will increase over time. Or, perhaps the opposite is
true.

There is no doubt that foundations and endowments have a difficult balancing act because merely
setting the spending rate at a level equal to the annual returns provided by the asset base ignores the
wasting effect of inflation and expenses, and likely will result in distributions that over time fail to
support the entity's programs. Inflation has been quite low since the late 1980s, so it is easy to forget
that it is a powerful force on the sustainability of foundations and endowments.

The double-digit inflation of the late 1940s and late 1970s seriously hindered the ability of many
charitable organizations and endowments to support their programs. Although double-digit inflation has
not been seen in some time, even low rates of inflation over a long period can seriously threaten the
purchasing power of an asset base. In the last 25 years, inflation has eroded the value of a dollar by
62%. So how does this equate to real life? A program that required $100,000 of funding in 1980, for
example, would require $250,000 of funding today just based on the Consumer Price Index (“CPI”)
inflation. The low inflation we have enjoyed recently lowers the threat to the sustainability of
foundations and endowments, but the threat remains. Even at 2% inflation, the purchasing power of a
dollar drops by 18% over the course of a decade. The real effect of inflation cannot be ignored.

Entities supporting health care or educational programs face an even tougher challenge. The costs
associated with providing these services tend to rise faster than the general rate of inflation. Each
foundation or endowment needs to look at its purpose and make a best effort to determine how it will
be affected by inflation.

Another challenge all foundations and endowments face is budgeting for expenses. While the expenses
for larger foundations rarely exceed 1%-2% of assets, even a small increase in the anticipated expense
burden can add up over time and negatively affect the purchasing power of the corpus.

All these observations lead to a basic formula. If a foundation or endowment intends to maintain the
purchasing power of its assets, its annual distribution should not exceed its inflation-adjusted
investment returns reduced by expenses.

7. When it comes to capital gain, `Surprise!' is not a word you
want to hear

Most of us are aware that investment advisors have different approaches to arriving at the proper asset
allocation and selecting the “right” securities and alternative products. It may come as a surprise,
however, that investment advisors also have very different methods for migrating a client's investment
portfolio to the advisor's platform. 22 Although advisors tend to reveal their strategy for transitioning to
the model portfolio they propose, clients do not always hear the fine print and grasp its real
implications.

Certain investment advisors immediately liquidate a portfolio when they take on a new client and then
purchase the assets held in their model portfolio. If the client comes to the investment advisor with a
securities portfolio, this strategy can result in substantial capital gain for the client. Other investment
advisors take a more measured approach to the transition of a new client's existing portfolio and
attempt to distribute the gain and loss over time. It is important to ask which way an investment
advisor works and whether there are exceptions to the rule so that tax bills do not come as a surprise.

Differences also appear in the actual day-to-day ongoing management of client portfolios. The majority
of investment advisors have a centralized platform where all client assets are managed in the same
way. So, for example, if Investment Co. decides that Stock B is no longer a proper investment for its
ideal portfolio, Investment Co. orders that all client portfolios should rid themselves of Stock B.
Suppose, however, that Client's portfolio matches the ideal portfolio of Investment Co., but that Client
came to Investment Co. already owning Stock B, which was given to Client by his grandmother 20


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years earlier. If Investment Co. follows the centralized approach, then assuming Stock B has
appreciated dramatically in the last 50 years, Client has just been hit with a large gain.

This scenario may seem surprising; however, certain investment advisors do function in this manner.
Other investment advisors have an ideal portfolio but leave the ultimate buy/sell decisions to the
individual portfolio manager for the client, so legacy stocks and other tax issues can be taken into
account on a more regular basis.

The investment advisory business is a competitive marketplace, and the variety of models available will
suit different people. The speed at which a client wants to be on the platform and the specific tax
concerns of the individual should influence the selection of the investment model. The key is to be
aware of the distinction in the way that investment advisors approach tax management and to be
certain to understand and be comfortable with the tax consequences of the selected investment
advisor's model.

8. Stocks and bonds are only half the story
While there are exceptions to every rule, it probably is fair to say that many people who are not
investment professionals think there are two asset classes: stocks and bonds. Maybe some of them
include real estate and alternatives, and so would consider that there are four asset classes. The truth,
though, is that there are many more.

The class of assets generally known as fixed income typically includes cash equivalents, municipal
bonds, inflation-linked bonds, investment grade bonds, high-yield bonds, and non-U.S. fixed income.
Equity includes long/short equity hedge funds, large-cap U.S. equity, small/mid-cap U.S. equity, large-
cap non-U.S. equity, and private equity. There are also broader groupings like absolute return and real
estate that include within them several other subsets.

While advisory approaches definitely differ, professional investment advisors generally will break down
the asset classes into much more finite classes than “stocks” and “bonds.” The reason for this
distinction is to help achieve diversity across a particular broader class and across the markets in
general. General allocation to fixed income, equity and other asset groupings is the first step, but
delving down into the different types of investment options within that broader class is important as
well.

Thus, for example, the process of structuring a portfolio will start with an analysis related to the
desired return and the acceptable level of volatility. As a general rule, equity typically is more volatile
than fixed income, so portfolios usually become more volatile as their equity investments are
increased.

After the general risk profile is determined, the investment advisor will need to focus on the narrower
allocation within the broader asset class. As in the determination of the risk profile, volatility within a
particular asset class needs to be analyzed. In addition, the tax attributes of each asset subclass are
guiding factors in structuring the portfolio.

Managing the volatility and tax consequences of an investment portfolio can be especially important for
a client with significant outside assets (such as closely held stock) that have their own tax and risk
challenges. Recognizing the levels of analysis involved in formulating a proper asset allocation helps
ensure a proper balance in a client's entire financial picture.

Conclusion

Understanding how the investment picture influences an estate planning structure is as important as
having a clear idea of the legal and tax ramifications. While the list above is not exhaustive, it is a
starting point for analysis. Ignoring investment implications, the third point of the planning triangle,


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can lead to serious issues with the long-term viability of an estate plan. Being able to spot investment
issues when creating a client's estate plan is a skill that every estate planner should take seriously.

PRACTICE NOTES

A trustee with a trust instrument which gives express instruction regarding trust investments arguably
must monitor that investment portfolio even more carefully than a trustee subject to the default
statutory provisions and using a standard investment mix.

Exhibit 1. Ten-Year GRATs

Historical Results for $1 Million Ten-Year GRATs in the Stock Market

12-Year Periods Achieving Success 50 out of 67
Average Wealth Transferred $1,081,691
Median Wealth Transferred $ 849,855
Maximum Wealth Transferred $4,237,385
Minimum Wealth Transferred $ 0
Source: BBH Analysis

Exhibit 2. Five Two-Year GRATs

Historical Results for Five Contiguous $1 Million Two-Year GRATs
in the Stock Market

12-Year Periods Achieving Success * 67 out of 67
Median Wealth Transferred $1,347,023
Minimum Wealth Transferred $ 4,447
Source: BBH Analysis
* “Success” is defined as having assets left for the remainder beneficiaries
at the end of the fifth GRAT term.

Exhibit 3. Ten Two-Year GRATs

Historical Results for Ten $1 Million Rolling Two-Year GRATs
in the Stock Market

12-Year Periods Achieving Success ** 67 out of 67
** “Success” is defined as having assets left for the remainder beneficiaries
at the end of the tenth GRAT term.

Exhibit 4. Ten Three-Year GRATs

Historical Results for Ten $1 Million Rolling Three-Year GRATs
in the Stock Market
12-Year Periods Achieving Success 67 out of 67


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Exhibit 5. Dispersion of Active Return

1

Although the broad market of public equity is not as volatile and concentrated as a single stock, it is
one of the more volatile assets classes and has robust historical data that permits a consistently
applied methodology.

2

To calculate the annual distribution for these historical periods, in lieu of using the Section 7520 rate
(which has existed only since 1989), a proxy was used: 120% of the total return on intermediate-term
U.S. Treasuries for the year of each GRAT's inception, rounded to the nearest two-tenths percent. To
maintain consistency, we used this same proxy for all years, even those post-1989 years when an IRS-
published rate was available. This proxy closely matched the actual published rates since 1989. Other
assumptions used include: (1) in-kind distributions were made annually at the end of each year; (2)
the GRAT's assets, including any undistributed returns, were invested exclusively in U.S. stocks; and
(3) the GRATs incurred no expenses—trading, investment management, legal, accounting, or
otherwise.

3

See Esperti, Peterson, and Keebler, Irrevocable Trusts: Analysis With Forms (WG&L/RIA). The authors
note in footnote 201 that “It may be possible to create a one-year GRAT, although there are no rulings
allowing it. The statute and regulations are not clear on this point. For example, Section 2702(b)(1)
refers to `amounts' rather than amount, indicating that a qualified interest requires more than one


of 13

payment. However, this could just as easily mean that a qualified income interest could be paid in
installments that are more frequent than annually. Moreover, Regulation Section 25.2702-3(b)(1)
defines a qualified annuity interest as a right to receive a fixed amount payable each year of the term.
At this time, it is best to avoid using a one-year term.”

4

The proxy for the Section 7520 rate is the same as that used in the prior study and described in note
2, supra. Other assumptions used include: (1) in-kind distributions were made annually at the end of
each year; (2) the GRAT's assets, including any undistributed returns, were invested exclusively in U.S.
stocks; (3) the GRATs incurred no expenses—trading, investment management, legal, accounting, or
otherwise; and (4) at the end of the fifth GRAT, the remainder beneficiary continued to invest in U.S.
stocks for two years.

5

The proxy for the Section 7520 rate is the same as that used in the prior studies and described in
note 2, supra. Other assumptions used include: (1) in-kind distributions were made annually at the end
of each year; (2) the GRAT's assets, including any undistributed returns, were invested exclusively in
U.S. stocks, with results based on the total return of the S&P 500 for that year; and (3) the GRATs
incurred no expenses—trading, investment management, legal, accounting, or otherwise.

6

See In re Linnard's Estate, 148 A 912 (Pa., 1930).

7

46 NE2d 94 (Ill. App., 1942).

8

See id. at 98.

9

See id. at 99. (“The court is not required to hold honest trustees liable for loss sustained by retaining
an unauthorized security if the trustee acted honestly and prudently. A trustee receiving stock in a
testator's estate under direction to continue the investment, will not, in the absence of negligence,
fraud or other improper conduct, become liable for losses resulting from an honest mistake in judgment
in the retention of stock in a declining market, before making sale thereof. A wisdom developed after
an event and having it and its consequences as its direct source, is a standard no man should be
judged by.”)

10

4 Misc 3d 1003(A), 791 NYS2d 868, 2004 NY Slip Op 50647(U), 2004 WL 1468746 (N.Y. Surr. Ct.,
2004), rev'd sub nom., In re Chase Manhattan Bank, 26 App Div 3d 824, 809 NYS2d 360, 2006 NY Slip
Op 866, 2006 WL 259834 (N.Y. A.D. 4 Dept., 2006). For more on this case, see Cline, “The Impact of
Recent Cases on the Administration of Trusts,” 34 ETPL 15 (Oct. 2007).

11

73 App Div 2d 786, 423 NYS2d 701 (N.Y. A.D., 1979).


of 13

12

See Dumont, 2004 N.Y. Slip Op. 50647U at *2.

13

Id. (Emphasis added.)

14

See id. at *9

15

In reviewing the trustee's performance, the court stated, “It is well settled that a fiduciary's prudence
is a test of conduct, not performance.” See id. at *10.

16

In re Chase Manhattan Bank, 26 App Div 3d 824, 809 NYS2d 360 (N.Y. A.D. 4 Dept., 2006).

17

Kettle, 73 A.D.2d at 786.

18

Id.

19

A call will be exercised whenever it makes economic sense to the buyer to exercise his option.
Typically, the call will be exercised when the call is nearing expiration and the stock is trading higher
than the “strike price,” which is the price at which the buyer has the right to purchase the stock under
the call.

20

Proceeds from covered call writing generally are taxed as ordinary income, so tax treatments must be
factored into the transaction as well.

21

See Section 1259.

22

“Platform” is the common industry term which refers to a particular advisor's ideal portfolio structure.

© 2009 Thomson Reuters/RIA. All rights reserved.


Investment Concepts Every Estate Planner Should Know And Understand

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