The 3 Legged Bar Stool
September 10th, 2010 Investments, Observations, Retirement PlanningGood planning at all levels of wealth and in all circumstances should revolve around this principle. It is such a basic rule, it is often dismissed as being too simple. Yet executed correctly, it can prove to be a powerful emotional driver for you and provides a very efficient long term basis upon which to run your affairs, to best meet your objectives as a whole. This is also a process which can effectively be applied to the operation of trusts.
All too often people find themselves slaves to the running of their affairs, when it should be the other way around. This is a problem greatly compounded by those with significant wealth, who are offered a myriad of apparently wonderful choices and services.
It is essential to initially and regularly review and balance the 3 (sometimes conflicting) legs of the finances of an individual or a trust;
- The individual’s goals & concerns, both short term and long term..
- The income and assets both now and in the future they have or expect to have to meet those goals.
- The risk level they can/need to take.
Most people float through life without a clear self determined direction. They may know what they want but do not plan properly to make it happen or assume if they create enough wealth it will happen anyway. Thus, they go where the wind and tide take them, then they wonder what went wrong!
Alternatively there is the Sailors View. Sailors always set sail with a destination in mind AND always plan the route. The wind and tide, (life), may still blow them off course, hence they frequently check their position and make minor adjustments to their course to ensure they reach their chosen destination.
The First Leg
Phase one is the establishment and interrogation of your objectives. This process not only establishes what is important to you but also how important, what conflicts there may be (and invariably are) and establishes a hierachy. It will also look at your pre and post death planning requirements, to facilitate an efficient transition.
Due consideration of tax planning, (Income Tax/ Capital Gains Tax/ Inheritance Tax/ Corporation Tax), though not to the point of letting the tax tail wag the dog, as is all to often the case.
For many, it is important there is detailed analysis of legacy issues, such as protecting legacies against adverse financial circumstances beneficiaries may face, such as bankruptcy, divorce or the profligacy of beneficiaries. Even the risks associated with the subsequent re-marriage of a spouse. Add to these, the family dynamic of trying to ensure children are not de-motivated from achieving in their own right, because they have things too easy or the inter sibling rivalries that may occur when businesses or wealth is handed down.
The concept of Clogs to Clogs is well documented. In short, across all walks of life, wealth generated by the entreprenurial 1st generation is, in 95% of cases, all gone by the end of the third or fourth generation. A powerful reminder of the importance of good planning, for the creation and preservation of wealth has little purpose unless it is focused on helping you achieve those things in life which are important to you.
The Second Leg
How much income and assets do you have to meet your established objective’s. What income and assets can you look forward to in the future, how certain are they and how much do you want to take each of them into account in your planning. (For example, it is quite common for clients to wish to exclude possible inheritances from their planning as they do not wish to rely upon these, to secure the future they wish for themselves and their families). For those running businesses it may or may not be appropriate to include the future sale value of the business.
The Third Leg.
You need to establish both the degree of risk you ‘can’ and ‘need’ to take, for the two are often not the same. All too often, wealth management is seen as getting the best return on your money. Why and at what risk? Should not wealth management be about securing the required return to meet your objectives, in a manner that fits with your attitude to risk, objectives and timelines. Thus if you have sufficient wealth, it may be that you only need to secure a net of costs return of say 4% to achieve what you want. In such a case, why invest more speculatively, for the extra risk does not come with a guarantee of extra return, it may simply lead to a greater loss.
N.B. When investing or saving money, there are 7 types of risk your money may incur.It is not possible to avoid risk even in a deposit account. The greatest reducer of risk is to diversify intelligently.
The Balancing Act.
If all three legs are in balance, the stool will remain upright. If one leg is short , it will fall over. Therefore it is pointless proceeding until this is resolved, otherwise you are simply going to be disappointed with the outcome at a later date. (I suspect that for many of you have previously suffered such disappointment).
To resolve any imbalance choices have to be made. Let us assume the objectives are substantial and your risk profile is quite moderate, it follows the monies will be invested in an environment where you are comfortable with the modest risks being taken. Thus, the returns expected are going to be lower due to the lower risks being taken. This means more wealth is needed at outset, to compensate for the lower expected returns.
If there is not enough wealth, then you have to look at a) moderating your objectives, b) increasing the degree of risk you take, with the aim of trying to secure a better return or, c) find ways of creating extra wealth, (tax breaks/ gearing/ etc), as long as they fall within your agreed risk tolerance.
Cash-Flow Modelling
Piecing all of the above together into a meaningful picture is vital, as is the ability to be able to establish the impact of ‘what if’ scenario’s, (such as, what if I die prematurely, what if I give away more of my wealth, what if I take less risk, what if I bring forward my retirement, what if inflation remains high, etc). To this end, the use of comprehensive cash-flow modelling is very important, as it effectively translates a wealth of information forecasted throughout your life into one easily understood chart. After all, we all know a picture paints a thousand words.
Note
This process can also help entrepreneurs establish how much wealth they need to create through their businesses to achieve their goals, rather than some ‘nominal’ figure that sounds ‘about right’, thus helping to focus an exit strategy with real meaning. For those who are already financially independent and looking at wealth preservation strategies, it can help establish how much wealth you need to keep for your own benefit and how much can be subject to tax and estate planning strategies, which may exclude you from benefiting.
