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2017 Tax Act and Qualified Opportunity Zones: Is It Really an Opportunity?

2017 Tax Act and Qualified Opportunity Zones: Is It Really an Opportunity?

 

July 5, 2019

Written by Russell Bucklew, Partner, CFP®, JD and Christopher Bergthold, Senior Client Associate, CFP®

 

The Tax Cuts and Jobs Act of 2017 (TCJA) included a tax break for investors related to realized capital gains. Through this program, an investor may receive tax benefits, including potential deferral and elimination of tax, by investing those gains in a Qualified Opportunity Zone Fund (QOZF).

Qualified Opportunity Zone Funds are investment vehicles targeting properties, businesses, and other assets within outlined opportunity zones in the US. These zones were created alongside the TCJA and are designed to incentivize investment in distressed areas. There are around 8,700 opportunity zones demarcated across the country, and investors can receive significant deferral and in some cases a reduction in capital gains taxes by investing in opportunity zones.

How do opportunity zone tax benefits work?

General Tax Benefits

The first tax benefit is the temporary deferral of federal income tax on realized capital gain until the earlier of the taxpayer’s disposition of the QOZF interest or Dec. 31, 2026. To receive this benefit, the taxpayer must invest the capital gain into a QOZF within 360 days of the capital gain triggering event. At the end of the deferral period, the taxpayer must include in gross income an amount equal to the excess of (a) the amount of deferred capital gain (or the fair market value of the QOZF investment if lower) over (b) the taxpayer’s basis in the QOZF, which is initially treated as zero.

The second tax benefit is up to 15 percent of the unrealized (deferred) gain invested in a QOZF is eliminated if the investment is held for at least seven years prior to Dec. 31, 2026. This happens through a basis increase equal to 10 percent of the deferred gain, if the investment is held for five years, and a further 5% basis increase in year seven. In order to receive the full 15% benefit, the QOZF investment must occur no later than Dec. 31, 2019.

The third benefit is that no federal income tax will be paid on QOZF appreciation if the investment is held for at least ten years. The benefit comes from a taxpayer election to increase its tax basis for the fund to fair market value at the time of the sale or exchange of the investment. This election can only be made for sales transactions that occur no later than Dec. 31, 2047.

In summary,

  • Investors may reinvest capital gains from existing investments and defer, and potentially reduce, capital gains taxes.
  • If held, the original investment’s tax basis increases by 10% after five years and by 15% after seven years.
  • After ten years, investors may permanently defer gain from contributed assets with unrealized appreciation and eliminate capital gains from the appreciation of opportunity zone investments.

Example:

A business owner contributes $11 million asset with $1 million of basis and a long-term cap of $10 million. During the ten-year period, the $11 million asset appreciates $7 million to $18 million.

Year One:  Client owes 23.8% or $2,380,000 in long term capital gain tax. ($10 million x 23.8% = $2,380,000)

Year Five: Client received 10% basis increase to $1,100,000; gain is reduced to $9,900,000, and tax is reduced to $2,356,200.

Year Seven: Client received an additional 5% basis increase to $1,150,000; capital gain is reduced to $9,850,000, and tax is reduced to $2,344,300. Total tax savings on basis increase is $35,700.

Year Ten:  Client pays no tax on the appreciation of QOZF investment with an unrealized gain of $7 million, referred to as “interim gain.” The capital gains tax avoided on the appreciation in the QOZF investment is $1,666,000. Adding the basis adjustment tax savings of $35,700 to capital gain tax avoidance of $1,666,000, bringing the total tax savings to a total savings of $1,701,700.

Disclaimer: This example is for illustration purposes, using the highest capital gains tax rate (20%) and a 3.8% net investment income tax. There may be additional considerations including, but not limited to, state income tax, holding period, basis calculation, alternative minimum tax, and other factors. Please consult with your tax advisor for advice on your specific scenario.

The Hot Financial Topic

There’s enthusiasm for the new tax breaks provided by opportunity zones. However, there are many questions about how the law is applied, and the uncertainty is causing investors to delay putting funds to work. Brett Theodos, a senior researcher at the Urban Institute, said the administration has signaled it is interested in gathering more data. However, for now, he said there are “more questions asked than answers’’. Senators Cory Booker, a New Jersey Democrat who’s seeking his party’s presidential nomination, and Tim Scott, a South Carolina Republican, plan to introduce legislation requiring the IRS to collect data from tax-break recipients to show how their investments are altering economic conditions in their opportunity zones. In other words, is this legislation a tax ‘give-away’ for the rich only, or is it accomplishing its intended purpose of rehabilitating and changing the landscape of economically hard-hit areas?

One of the first funds that hit the ground running is Virtua Partners, a Phoenix-based private equity firm. In July 2018, they launched their first QOZF called Virtua, a $200 million fund that includes three Phoenix-area projects: a 130-room Marriott hotel with furnishings by West Elm, 81 single-family townhomes with a swimming pool and clubhouse, and a 90-unit apartment complex near Arizona State University’s campus in Tempe. According to Virtua representative Derek Uldricks, all three projects would have been completed even without the tax break, but the tax breaks accelerated fundraising by attracting additional investor interest.

Another Phoenix-based real estate firm – Caliber – launched a QOZF to gather $500 million in investor capital targeting $1 billion of hospitality, commercial, and residential real estate investments in the Southwest growth markets of Arizona, Texas, Colorado, Nevada, and Utah. According to Brion Crum, Director of Strategic Relationships, Caliber was able to reposition and take advantage of existing projects in opportunity zones. Interest in opportunity zone investing resulted in additional investor capital, allowing Caliber to expand the purpose and scope of existing projects. Examples include a new hotel for Tucson’s convention center, a revitalization of historic downtown Mesa in a mixed-use project, and energy-efficient townhomes in Tempe.

Some investors are buying in opportunity zones to take advantage of the tax benefits in areas that meet the letter of the law, but not the spirit. In other words, some properties fall within the technical definition and fit in the geographic location but may not be distressed or fit the spirit of what the legislation envisioned. Caliber is seeking to invest in impoverished areas and those intended to benefit from the policy and purpose behind the legislation. Essentially, they are investing in the path of progress, but in distressed areas translating into value pricing and more potential for upside appreciation. One example Brian gave is a large tract of undeveloped land south of Coors Field in Denver, Colorado; while it lies within the geographic parameters and the path of progress with potential for upside appreciation, it is genuinely a distressed area and one that will benefit by redevelopment. This appears to be a very sound strategy.

According to Brian, most of the investment in QOZF stems from business owners transitioning into retirement and sales of professional businesses like doctors exiting their practices. Investors selling concentrated positions of stock may also qualify for the tax break. For example, investors who own low basis, appreciated positions in growth stocks like Apple or Google might defer and reduce significant capital gains, invest in QOZF, and reduce or eliminate the gain on the QOZF investment. Real estate investors may also use QOZF to identify qualified property under the like-kind exchange rules in IRC 1031, allowing an investor to “defer” paying capital gains taxes on the sale of an investment property.

Conclusion

Investing in opportunity zones is brand new, and the final verdict is yet to be determined. Many of the technical rules are still being ironed out, and there are potential traps and unintended consequences. The legislation intends to drive rehabilitation and renovation in poor neighborhoods by providing economic stimulus and social benefits and attracting attention to these areas. Examples include retail, restaurants, apartment buildings, and new manufacturing facilities, to name a few from a long list of possibilities. However, the adage “don’t let the tax tail wag the dog” applies here. In other words, don’t be so focused on tax issues that you lose sight of basic investment principles. See Maneesh Shanbhag article: What is the Opportunity Zone Tax Incentive Really Worth?.

High net worth investors and people transitioning appreciated assets with built-in capital gain are excited about the tax planning opportunities with Qualified Opportunity Zone Funds. This subject is a hot topic at country clubs, cocktail parties with the elite, and professionals including money managers, attorneys, and accountants. No question there are planning opportunities and exciting tax minimization strategies available to taxpayers staring at significant taxable gains. However, we should not allow the “flavor of the day” or the newest idea to steer us away from our discipline and process around investment choices.

To keep us focused and disciplined, here are four rules to help guide our decision making:

  1. The investment has merit on its own, regardless of the opportunity zone tax benefit. If you get tax incentives but don’t make any money, it doesn’t make sense.
  2. The solution will fully qualify for the intended benefits. There are some funds that will mix opportunity zone qualifying deals with non-qualifying deals. Mingling the two may give your accountant stomach acid. Consider single strategy solutions and don’t mix the two.
  3. The operator should have a long track record of success. We don’t want to invest with someone who is starting their first fund to capture opportunity zone money and earn a fee. Invest with experienced real estate developers and managers who can enhance returns with the opportunity zone tax benefit.
  4. Fees need to be reasonable. Access to opportunity zones shouldn’t increase costs.

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Q2 2019 Market Commentary: Winning The Loser’s Game

June 27, 2019 Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer

To view and download a PDF of this commentary, click here.

Anyone who has either played sports or watched children play sports knows that valuable life lessons can come from the experience. Sports can teach teamwork, strategy, the joy of winning, the frustration of losing and, along the way, can lead to the development of lifelong friendships. While the experience and enjoyment of sports can be similar no matter who you are and what sport you play, a distinct difference exists between success at the professional level and success at any other level. Dr. Charles Ellis, founder of the investment advisory firm Greenwich Associates and the former chair of the Yale University Endowment fund, has spoken about this difference many times, and he has related it to our experience as investors in the book “Winning the Loser’s Game”.

Dr. Ellis would suggest that we consider the game of tennis. Regardless of the level, the rules are the same. However, the difference between tennis at the professional level and tennis for everyone else is that professionals win points, and amateurs lose points. Professional tennis players make strong, well aimed shots and seldom make errors. They win by scoring more points than their opponents. Amateurs, on the other hand, rarely beat their opponent, but often beat themselves. They hit the ball into the net or out of bounds, or they try to make plays that are beyond their capabilities. An amateur who wants to win should focus not on making great shots but on avoiding mistakes. By being conservative and keeping the ball in play, an amateur allows his opponent more opportunities to make mistakes than he makes and, ultimately, he ends up winning by not losing.

Dr. Ellis relates the concept to investing in that most investors, to be successful, should focus on making as few mistakes as possible, as opposed to attempting to outsmart markets or other investors. Trying to win in investing is trying to guess when markets will go up or go down, or concentrating portfolios in certain areas or sectors. As humans, we tend to make these decisions far too late anyway. We have a tendency to “buy high” and “sell low” instead of the opposite. A great example is the recent enthusiasm around gold as an investment. The excitement of gold is not because it has hit an all-time low or looks cheap on a relative basis, but because it is at its highest price since 2013. Does this happen in any other area of our lives? Do we buy a new 70-inch tv because it just doubled in price, or a new car because the advertised price is $10,000 more than it was last week? Only in the investment world do people get excited about buying things at higher and higher prices. When we try to win in investing, greed and fear of missing out lead to poor decisions.

“Offense Sells Tickets but Defense Wins Championships.”

This quote has most often been attributed to Bear Bryant, the former head coach of the University of Alabama football team, who finished his career with six national championships. The quote has been used thousands of times by countless others in sports to emphasize that successful teams focus on defense, not on offense.

Dr. Ellis, in an interview with AQR Capital Management, spoke specifically about the Yale Foundation and its phenomenal track record of investing. Yale is far and away the best performer among college endowments, as measured by rate of return. However, Dr. Ellis would tell you that the magic of how Yale invests is that it has always been defensive:

“Really strong defense makes the offense easy. Most of the trouble in investment management is not because you came just a little short of having superb investment results. It’s because you made a mistake.”

(Ilmanen & Sullivan, 2015)

He then goes on to speak about a conversation he had with the Chief Investment Officer of the Yale Endowment, Dr. David Swensen, just prior to the financial crisis. In 2006-2007, the U.S. economy was very strong, there were few reasons for concern, and investing appeared easy. Undoubtedly, Dr. Ellis and others were concerned about Yale not keeping up with other endowments or the market in general. The conversation probably wasn’t a surprise to Dr. Swensen because in the 2006 Yale Endowment annual report he wrote a commentary called “The Futility of Diversification”, which stated:

“Sticking with portfolio diversification can be painful in the midst of a bull market. When mindless momentum strategies produce great returns, market observers wonder about the time and effort expended in creating a well-structured portfolio. During a roaring bull market, diversification seems to punish investors. For the five years ending June 30, 2000, the S&P 500 returned an amazing 23.8 percent per year. Indeed, institutional investors who sought diversification’s free lunch by holding foreign equities saw those diversifying assets lag terribly. During the five years when the S&P produced 20-percent-plus returns, developed foreign markets, as measured by the MSCI EAFE Index, generated an 11.3% annual return, while emerging markets, as measured by the MSCI EM Index, returned 1.0% annually. Alternative asset classes, like absolute return and real assets, fell hopelessly behind the blistering U.S. stock market. By the late 1990s, many investors questioned the wisdom of owning any assets other than U.S. equities, especially high-flying technology stocks, asserting the inherent superiority of American companies and the inevitable dominance of high-tech businesses. Making the mistake of extrapolating future returns from a strong historical base, investors picked the absolute worst time to abandon diversification and increase allocation to U.S. equities, as the stock market’s remarkable run had brought valuations to unprecedented heights.”

(Yale University, 2006)

Returning to Dr. Ellis, he recalled having the following conversation with Dr. Swensen sometime in 2006-2007:

“David, this is going to surprise you, but I’m concerned that you may be too careful, too defensive, too protective. I just wonder; should you be a little bit more assertive and take a little bit more risk?”

Dr. Swensen replied “Honestly, I don’t know. But I do know one thing. Just about the time you think there’s never going to be a horrific negative surprise, one comes barreling along. I may be too careful. I may be too protective. I may be too defensive. Though knowing history, I think it’s probably a good idea.”

Dr. Swensen ended his commentary in the 2006 Yale Endowment report as follows: “In spite of the opportunity costs of diversification in the late 1990s, the University continued to believe in the importance of a properly diversified portfolio with superior risk and return characteristics. Each asset class that had dampened returns in the late 1990s – bonds, foreign equities, absolute return, and real assets – drove the Endowment to a series of positive returns in the face of an equity bear market. In fact, the University’s discipline of sticking with a diversified portfolio contributed to the Endowment’s achievement of the top long-term record of any college or University endowment.”

When people think about the long-term success of the Yale Endowment, they immediately attribute it to the amount of alternative assets or the manager selection, or Yale’s ability to invest in top tier managers given its network and reputation. Yet we believe both Dr. Ellis and Dr. Swensen would attribute the long-term success to a focus on defense over offense.

Maybe This Time is Different?

If one re-reads Dr. Swensen’s recap of the late 1990s above, it is difficult not to conclude that it sounds eerily similar to the world we live in today. Howard Marks, founder of Oaktree Capital, spoke about the commentary they’re hearing about why “this time is different” and why the current environment may last in perpetuity. Among those reasons:

  • There doesn’t have to be a recession.
  • Continuous quantitative easing can lead to permanent prosperity.
  • Federal deficits can grow substantially larger without becoming problematic.
  • National debt isn’t worrisome.
  • We can have economic strength without inflation.
  • Interest rates can remain “lower for longer”.
  • The inverted yield curve needn’t have negative implications.
  • Companies and stocks can thrive even in the absence of profits.
  • Growth investing can continue to outperform value investing in perpetuity.

(Marks, 2019)

Again, these are justifications Marks and his team are hearing from seasoned investment professionals on why there should be no concern about the current environment. Any reader of this list should be confused by at least one of those statements. Several of them sound completely irrational. In recent years, the U.S. has simultaneously experienced economic growth, low inflation, expanding deficits and debt, low interest rates, and rising financial markets. As Marks says, it is important to recognize that these things are essentially incompatible. They generally haven’t co-existed historically, and it’s not prudent to assume they will do so in the future.

It’s Not a Video Game

For investors in diversified portfolios (which is almost everyone who has hired an advisor), returns over the last several years have been lower than expected. International equity markets haven’t contributed, bond returns are low, and many other diversifying asset classes have not contributed much to return. Diversified investors have chosen to play defense with their money in a period of time when markets appear to have video game-like ease (most of us can really only be Serena Williams or Andre Agassi in a video game). Have we all been too careful? Have we all been too protective? Have we all been too defensive? Maybe we have.

At MRA, we are charged first with protecting our client assets, and second with growing those assets. Over-aggressive investing can lead to a fatal mistake, especially for investors who are taking withdrawals from their portfolio. Enduring the full impact of a bad equity market while making withdrawals can compound the effects so dramatically that they may never be recovered. Our approach in managing portfolios has resulted in prioritizing defense over offense. It seems like forever since we’ve experienced a bad market and, in July, it will officially be the longest U.S. recovery on record. However, as Dr. Swensen said, just about the time you think there’s never going to be a horrific negative surprise, one comes barreling along. Our defensive approach is not selling many tickets, but our goal is to win, and winning in investing is all about lasting through good and bad markets.

 

Works Cited

Yale University (2006). 2006 Yale Endowment Annual Report. Retrieved June 25, 2019 from https://static1.squarespace.com/static/55db7b87e4b0dca22fba2438/t/578e42a5e58c629352d75dc1/1468940966928/Yale_Endowment_06.pdf

Ilmanen,A. & Sullivan R. (2015, June). Words From the Wise: Charles Ellis on Challenges Facing Investors. Retrieved June 15, 2019 from https://www.aqr.com/Insights/Research/Interviews/Words-From-the-Wise-Ellis-Executive-Summary

Marks, H. (2019, June). This Time It’s Different. Retrieved June 25, 2019 from https://www.oaktreecapital.com/docs/default-source/memos/this-time-its-different.pdf

Estate Planning in the Aftermath of the 2017 Tax Cuts and Jobs Act

Estate Planning in the Aftermath of the 2017 Tax Cuts and Jobs Act

 

June 13, 2019 Written by Russ Bucklew, Partner, CFP®, JD; Mary Ann Hennelly-Favata, CFP®, Senior Client Advisor; and Ena Dashi, Senior Client Associate

Now that it has been almost 16 months since the passage of the 2017 Tax Cuts and Jobs Act (TCJA), it’s time to come up for air and ask the question: what is the overall impact on estate planners and their clients?  

For estate and gift tax planning, the 2017 TCJA made a significant amendment to the laws. The fundamental change was an increase in the exclusion amount. The amount that an individual may gift to other individuals, during their life or exclude from his or her estate at death (if unused), rose from $5.49 million per person to $11.4 million. Therefore, married couples may now exclude $22.8 million from their estate without any estate tax consequences. Since the generation-skipping transfer (GST) tax exemption is based on the gift and estate tax exemption, the new GST exemption amount has also been increased to $11.4 million.

Now that we have a high exemption, the false assumption is that fewer people will need sophisticated death tax planning. Many estate planning checklists will need to be revised now that fewer people will be subject to the estate tax. According to the Tax Policy Center, less than 0.1% of the 2.7 million people who died in 2018 will pay an estate tax. However, given the potential change in political parties in the executive and congressional branches and the 2017 law sunsetting without congressional action in 2025, the need for planning is more critical than ever.

Question: Why should I worry about my estate plan if I am not impacted or taxed by the law changes and higher exemptions?

Answer: There are many reasons to plan. Here are three considerations:

First, nearly all of the legislation that affects individual taxes, including the estate and gift taxes, is set to expire at the end of 2025. This means that the exemption amounts could decrease to 2017 levels (adjusted for inflation) within six years.

Second, a new Congress could change the law before then and bring the exemptions back down to 2017 levels or, worse, even lower. For example, Senate Bill S. 309, introduced by Bernie Sanders, is affectionately called the “99.8 Percent ACT” for its anti-wealthy sentiment, and it indicates a significant effort in this direction. A key provision includes lowering the estate tax exemption from $11.4 million to $3.5 million, reducing it to the 2009 level, shaving off almost $8 million of the exclusion that could be lost forever. Sanders’ proposed legislation will also reduce the gift tax exemption to $1 million. So, even though some intend to postpone until 2024 or 2025 to make gift tax free transfers under the lifetime exemption, waiting may be costly. Therefore, a family may not need to worry about the estate, gift, or GST tax today, given the sunset provision and the changing political winds; it is future generations—children and grandchildren—who almost assuredly will be impacted. Accelerating the restoration of the pre-TCJA exemption levels would reduce the deficit while affecting just a few thousand large estates. Taking such action now could also curb enthusiasm for making the higher thresholds permanent when they expire at the end of 2025. Our estate planning checklists should prepare for any scenario.

Finally, estate planning is never exclusively about tax minimization. For most individuals, wealth is lost in nontax ways, such as elder financial abuse, divorce, lawsuits, and spendthrift heirs. Modern estate planning prioritizes asset protection (protecting trust assets from potential creditors or spendthrift beneficiaries) alongside tax efficiency and other considerations. Other considerations include minor children, pets, friends, and business partners. Plan for the end of life decisions and incapacity. Address how to provide for a potential beneficiary that is disabled or with special needs.

The higher exclusion amounts are shifting the emphasis from transfer tax to income tax planning for many estate planners’ checklists and their clients. 

One key area is the emphasis on taking advantage of the basis step-up. When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance, determined to be the market value of the asset at the time of inheritance. Many estate planners’ checklists should incorporate analysis and opportunities to avoid income tax through planning on low basis assets. 

One area of renewed interest is the formula General Power of Appointment Clause (GPOA). The power of appointment is given to an older (or ill) beneficiary with a net worth less than his or her remaining exemption amount. The strategy builds in flexibility with a formula that does the following: 1) only applies to assets with a basis less than fair market value (FMV); 2) does not allow exercise in the event of federal or state estate tax; (3) has an ordering provision granting it the priority over highest tax rate assets first; and (4) takes into consideration whether there are assets that likely won’t be sold any time soon. For example, a 90-year-old beneficiary gets a GPOA over stock in XYZ Corp. valued at $2 million with a $1 million tax basis and $1 million built-in capital gain. After TCJA, he will not owe any estate tax because of the increased exemption amount. Thus, the GPOA is exercised, causing the assets to be included in the 90-year-old’s estate, and he gets a step-up in value at death, saving the 20% long-term capital gains tax due on the appreciation. Before TCJA, the asset may have been subject to a 40% estate tax resulting in $800,000 of tax. After TCJA, he is under the exemption amount with no estate tax, freeing the asset up to bring it back into the estate and triggering a basis step-up, saving income tax on the gain of $200,000.

Question: Given that estates now have a high bar for estate taxation, the existence of separate trust legal entities and the income tax consequences of higher brackets must be reviewed and considered in light of the overall changes. Does it make sense to continue to pay higher tax rates inside an irrevocable trust, when the reason for creating the trust – lower estate tax consequences – has been eliminated, even if temporarily? 

Answer: For single individuals, the 37% income tax rate applies for taxable income starting at $510,300 and, in the case of a married couple filing jointly, starting at taxable income above $612,350. However, in the case of estates and trusts, the 37% rate kicks in above $12,500. Also, a 3.8% Medicare surtax on “net investment income” is often assessed against individuals and estates and trusts. A state income tax may also be a factor.

The governing instrument of trusts can confer an infinite number of possibilities for distribution powers on a trustee for income or principal. Given the compressed income tax rates and the current framework of income taxation of individuals and trusts, a trustee could make distributions to current beneficiaries to minimize the overall tax impact. While this may result in increased income taxation to the beneficiaries, it will reduce taxation overall of assets in the trust (taxed at a higher bracket). Ironically, the legislation that increased the trust tax rates was designed to do just that.

In the aftermath of the 2017 TCJA, many of the trusts created for tax planning reasons may no longer be relevant or necessary. Under state law, many estate planning professionals and their legal counsel are taking full advantage of opportunities to change the trust by the use of non-judicial settlement agreements; an irrevocable trust may be modified or terminated with the consent of all interested persons as long as the change doesn’t violate a material purpose of the trust. Another technique for changing the income tax status or other unwanted trust provision is taking advantage of the “decanting” statutes available in most states. These statutes allow the formation of a new trust and termination of the old one.

Just as you decant wine by pouring it from its original bottle into a new one, you can pour trust assets from one trust into a new one, leaving the unwanted terms in the original trust.

Conclusion

Passage of the 2017 TCJA, with increasing exemptions and exclusion of tax for estates up to $11.4 million, may be creating more complacency and a lack of interest in planning. Even before the act, most consumers procrastinated and avoided preparation. The bottom line is, laws come and go. Some stay, some go, and some expire. What is constant is YOU! Your needs, wants, and wishes… You need to put an estate plan in place before something happens to you. IF you wait until you are incapacitated, it will be too late for you to make a plan. Take control of your LEGACY and architect it with the help of an estate attorney, wealth advisor, and CPA. Collaborating with other professionals is wise. Saving time and hassle is money well spent. According to one study of why clients don’t sign their estate plans, 95.9% said the plan did not meet their goals, 93.4% said the attorney made me uneasy, and 90.9% said the plan was incomprehensible. Don’t be a statistic. ACT NOW!

 Supplemental Graphs and Data

(“Key Elements of the U.S. Tax System”, 2018)

Works Cited

Key Elements of the U.S. Tax System (2018). Tax Policy Center’s Briefing Book. Retrieved from https://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax

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Sustainable Draw Rates: Part Three

June 11, 2019 Written by Matthew White, CFA®, Investment Analyst

SUSTAINABLE DRAW RATES STUDY: PART THREE

In part three of the Sustainable Draw Rates Study, we examine results by historical stress testing and reach our conclusion.

Link to Part One

Link to Part Two

Probability of Success Across Multiple Time Horizons

We can conclude that stating portfolios consisting only of stocks are the optimal solution for investors to achieve their goals is incorrect. Rather, adding stocks is useful to improving probabilities of success for investors obtaining distributions from their portfolios – up to a point. This improvement is limited to approximately 70% stock portfolios when investors have access to high-quality, low-correlated non-traditional investments to provide diversity in their portfolios.

However, in absence of access or the ability to evaluate such non-traditional investments, it is likely true that investors seeking to improve their probability of success are best off allocating as much of their portfolio to stocks as they can behaviorally manage. This may explain the existence of all stocks portfolios which we come across from time to time from outside investors.

Historical Stress-Testing

Before concluding our study, we inquired whether our rejection of the hypothesis that an all stocks portfolio is best suited to obtain investor goals is validated by the historical record. Thus, we built a simulation similar to the one we described earlier, but used historical returns and volatility figures for our portfolio allocations. The results add a few caveats to our findings:

  1. History informs us that incrementally adding stocks provides a higher probability of success, though the value-add of stocks ceases somewhere between 40-50% of portfolio value (vs. 70% that estimates from our current environment imply).
  2. The addition of non-traditional assets do not increase the probability of success to the same degree that the current environment dictates. However, they do allow higher probabilities of success at lower stock exposure levels, indicating they would have permitted investors to obtain their goals with lower volatility.
  3. In the historical environment, an all bonds portfolio was able to sustain a 5% real draw rate out to 30 years with a 70% probability of success. This is in stark contrast to a 6% probability of success for an all bonds portfolio over the same time period using current estimates.

Historical Probability of Success

Beyond confirming our current findings on portfolio outcomes, these historical estimates seem to reinforce that the shift in secular interest rates over the past few decades have placed an entire generation of investors in a new paradigm of portfolio construction than the one which preceded them. Indeed, past performance is no indicator of future results.


IMPORTANT NOTE REGARDING RISK:  While we have laid out a mathematical framework that suggests addition of stocks to a portfolio improves potential outcomes, we do not surmise that every investor should increase their allocation to stocks. Humans are not rational creatures, and are subject to emotional reactions, particularly during times of market duress, which can cause us to deviate from our plans; however well thought out they may be. Specifically, investors with higher allocations to stocks are subject to additional volatility in their portfolios and may be more susceptible to behavioral reactions that could sabotage a portfolio’s long-term projected outcomes.

Ultimately, the best allocation for an investor is one that maximizes their probability of obtaining their goal while constraining risk – meaning they are likely to stick with their portfolio through good and bad times.  Defining a palatable level of risk is no small task and is outside the scope of this study. However, a starting point for investors is to have candid conversations with an experienced advisor or counselor who can assist them with establishing an “outside view” of their emotional or organizational tolerance for short term changes in the value of their portfolios. Once a comfort level of tolerable risk is established, our study concludes that investors should seek to maximize their potential return within their tolerance by diversifying into higher returning assets.

Notes

The All Stocks portfolio is assumed to be 38% Large Cap US, 12% Small Cap US, 30% International Developed, 20% Emerging Markets. The 50/50 Stocks Bonds portfolio is assumed to be previously described stock mix and 50% Barclays Aggregate.

Testing is carried out with 2,000 simulations of potential paths beginning with a $1,000,000 portfolio and a 5% draw rate that increases with a 2.2% inflation value each year. In addition to the cash outflow, an annual cost-to-access is assumed to be drawn from the portfolio as a % of recent assets. This is to capture the differing costs that various asset classes incur. Essentially, this implies that managers will exactly earn the market return for their asset class before expenses and will exactly underperform their market on a net basis after fees. The purpose here is to be conservative in estimates of value-add from non-traditional asset classes.

We assume a 7 BP cost-to-access stocks and bonds based on our Beta Portfolios implementation schedule. We do not assign a cost-to-access on Style Premia and Life Settlements as both estimates are round, net-of-fee, future expectations on the strategies. The cost-to-access for other asset classes are based on vehicles used.

Based on our 2018 Capital Markets Assumptions study and the above cost-to-access deductions, we summarize the inputs into the Monte-Carlo analysis.

Our historical stress-testing was based on returns going back to 1926 for asset classes that we could obtain them for, and back to the inception of a proxy index or market access vehicle for remaining asset classes. For more information on our historical data and methodology, please contact us.

What Extra Return Must an Active Manager Provide to Outperform a Lower Cost Passive Equity Solution, Net of Fees and Taxes?

June 3, 2019 Written by Bruce Paulson, CPA, JD, CFP ®, Senior Client Advisor

It is no secret: many active equity managers have a difficult time performing better than average when measured over full market cycles[1]. Higher fees alone pose a performance hurdle for active managers, especially as the cost for passive equity exposure nosedives to near zero.

A lesser known and oft-misunderstood hurdle merits mention: taxes – those caused by active manager trading and striving to do better than some pre-tax benchmark.

  Li’l Abner & Taxes: Buffett Parable

Mr. Buffett’s Li’l Abner parable in his 1993 letter to shareholders comes to mind[2]. Mr. Buffett writes:

“…Tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate…”

An example may be helpful. You invest $1,000,000 in ABC Corporation, trading at 15x earnings. It reinvests 80% of its free cash flow in the business and pays out 20% of free cash flow to shareholders (through dividends and share redemption). It generates 15% return on equity and the price-to-earnings multiple does not change. Your personal tax rate is 33%. In one case, you sit on ABC for 20 years; in the other, you trade ABC stock every year and pay tax. While both may be extreme examples, the charts below show the power of deferring income tax:

Net After-Tax Arithmetic

Another example may help. Imagine four different equity products or choices, with the lowest cost option (SP 500 ETF) costing .05% and returning 8%. Using reasonable assumptions[3], look at the numbers as you move from left (least expensive: lowest tax generating) to right (more expensive: higher tax generating active manager, hedge fund, or hedge fund of fund). The purple bar shows what higher gross return each more expensive choice (using same assumptions) must generate to equal 7.6% net after-tax return from SP 500 ETF.

So, back to the question: What higher net after-tax return must an active manager provide to outperform a lower cost, separate account[4], passive equity solution? Here is a reasonable, if not conservative, estimate:

Parting Observation

There is always a well-known solution to every human problem – neat, plausible, and wrong.

H.L. Mencken, American journalist.

Mencken is right. There is no single active manager-fund hurdle. It depends on facts, comparisons, and choices (one being, how to capture equity index exposure). Whether tax loss harvests are permanent or temporary, tax savings matter as well (and is beyond scope of this discussion). All said, controlling the tax cost of investing often matters far more than investors may realize, especially for families who can defer paying income taxes out over many years (sometimes permanently).

The MRA Associates team welcomes your questions and comments.

Exhibit A

Tax Rates

Note: The numbers assume hedge fund fees are not tax deductible (meaning, they do not quality as so-called “trader expenses” under the Internal Revenue Code). If they do qualify as trader expenses, they would be tax deductible at the partnership level and increase the hedge fund (and fund of hedge fund) net after tax returns.

[1] Your author notes relative outperformance to a fully invested benchmark index is (or is not) the same sole measure of value-add by an investment manager, advisor, or both. Pros and cons exist with any investment decision, which is a conversation beyond the scope of this memo.

[2] http://www.berkshirehathaway.com/letters/1993.html

[3] See Exhibit A.

[4] What tax loss harvesting is worth depends upon several factors, including how you measure it (pre or post liquidation). Please see the following for details: https://www.mraassociates.com/do-tax-harvesting-solutions-deserve-a-place-in-your-passive-or-active-portfolio..  There are many articles and studies on tax loss harvesting, which we are pleased to share with you to support the row c estimate and for your general information.

 

 

Behavioral Biases in Investing

May 6, 2019

Written by Kyle Pitman, Client Associate

A college professor of mine once said, “Rational consumers only exist in economics textbooks.” While I cannot remember which of my professors offered up this wisdom, the quote has stuck with me nonetheless. As humans we are inherently irrational, impassioned, and impulsive at times when making decisions. One recent example of an irrational and impulsive decision I’ve made was to purchase a season pass to a ski resort—having never skied a day in my life—as that was what my friends were doing. My fear of missing out (“FOMO”) clouded my rationality as I certainly was not maximizing my expected utility by committing a reasonable sum of money with no guarantee I would enjoy my time on the mountain. Fortunately for me, I found skiing to be extremely enjoyable. Snowboarding, not so much. Regardless, upon reflection there was a behavioral bias in the form of FOMO that impacted my decision making. Behavioral influences, such as FOMO, are not limited to our consumption decisions as individuals, but extend into how we invest as well. The remainder of this post will focus on a few of the many behavioral biases in investing.

Herding

Herding is one of the simpler behavioral biases to understand and relates closely to the experience of FOMO described above. Humans have a tendency to follow trends, or the herd, in many facets of life, all in an effort to not be left behind. It’s this same concept that allowed for mullets and fanny packs to have their moment. With regard to investing, this results in investors buying as prices are rising and selling as prices are falling, irrespective of other information the investor may have on the investment. While markets tend to be efficient and price movements driven by fundamentals and available information, herding may be an explanation for over- and under-reactions in the markets to new information.

It’s recent enough to remember the buzz and excitement around Bitcoin in 2017, when CNBC had a near around-the-clock graphic tracking its price. However, unless you bought in early, it was unlikely you became a Bitcoin Millionaire, as the market eventually corrected.

Loss Aversion and Prospect Theory

It’s one of the biggest clichés in sports: “I hate losing more than I like winning” or some variation of the phrase. Despite how worn out this saying may be, for many individuals, it remains true. It’s why one might buy insurance to protect against large, yet unlikely, future losses and can explain why an individual may avoid an otherwise profitable activity to avoid paying additional taxes.

Developed by Amos Tversky and Daniel Kahneman in 1979, the concept of loss aversion falls under their larger work on prospect theory. As defined by Aurora Harley in her summary article on the topic, “prospect theory describes how people choose between different options (or prospects) and how they estimate (many times in a biased or incorrect way) the perceived likelihood of these options.”[1] To illustrate prospect theory, consider the following examples:

Example 1: You have the option to either:

  1. A) Receive $500
  2. B) Flip a coin to win either $1000 or $0

Example 2: You have the option to either:

  1. A) Pay $500
  2. B) Flip a coin to pay either $1000 or $0

While the expected value in either example is the same for both choices, it is likely you chose “A” for example 1 and “B” for example 2. Example 1 demonstrates risk aversion and the preference for certainty when it comes to gains rather than taking on additional risk. On the other hand, choosing “B” in example 2 would be risk-seeking behavior and instead illustrates loss aversion.

This concept extends to investing. Investors tend to have a greater emotional response to losses than they do to similar gains. Kahneman estimates the ratio of emotional impact is around 2 to 1.[2] As humans, we seek to minimize losses where possible, which may lead us to sub-optimal portfolios and trade decisions, particularly when markets become volatile.

Overconfidence

The last of the psychological biases in investment behavior is something we all can be guilty of, overconfidence. In a 2015 speech, Dr. Daniel Crosby illustrated overconfidence bias by asking the audience a series of questions to determine if they considered themselves above average in the following areas: looks, sense of humor, intelligence, and investing. He concludes this by stating:

“In general, when these questions are asked of the general populace, you end up getting an answer something about 85% to most of these questions. So about 85% of people think they’re better-looking than average. Every guy in the world thinks he’s two sit-ups away from dating a supermodel. Everyone thinks they’re funnier than average. People tend to think they’re smarter than average. And then this goes over into investment decision-making as well. We tend to think we’re better than average.”[3]

Clearly, it is impossible for 85% of people to be better than average. With regard to investing, this overconfidence extends to individuals believing they can pick the correct stocks or managers to beat the market. While confidence and conviction in investing is important, overconfidence can lead to attempts to time the market and increased trade volume which come with associated trading costs.

Conclusion

Herding, loss aversion, and overconfidence are only a few of many behavioral biases that exist in investing. It should also be noted that these biases are not mutually exclusive. Hypothetically, an overconfident investor may move into a riskier asset that is rising in an effort to avoid portfolio losses. The sum of these parts leads to less than ideal results. The average investor tends to underperform the markets.[4] Behavioral biases tend to play an outsized impact on this underperformance as investors emotionally react to market news. Brad Sherman provides a nice graphic of how this emotional experience may play out for an investor in his article on common biases for Investopedia.

To conclude, it is important to recognize that we as humans are not immune from irrationality. Taking a step back to look in the mirror can be beneficial and help us avoid making impassioned, biased decisions to change our portfolio based on short-term sentiment. While it can be difficult, it is important to do as Oppenheimer Funds suggests in their current advertisement and challenge impulse.

[1] https://www.nngroup.com/articles/prospect-theory/

[2] https://blogs.cfainstitute.org/investor/2018/06/08/daniel-kahneman-four-keys-to-better-decision-making/

[3] https://www.cfainstitute.org/en/research/multimedia/2015/greed-and-fear-of-the-crowd

[4] https://www.marketwatch.com/story/americans-are-still-terrible-at-investing-annual-study-once-again-shows-2017-10-19