“Our family was at a crossroads—businesses maturing, kids growing fast… John and his team have been invaluable, helping us achieve the perfect early retirement.”

Situation & Key Challenges

Despite owning and operating multiple successful businesses, this family’s financial situation is somewhat complex. With two young children, they aimed to retire early to enjoy their kids’ pre-college years. Additionally, with a healthy but aging parent they wanted closer, college savings needs, and underperforming investments with a broker, the couple was tempted to shift to ETFs under their own control in order to gain the flexibility to achieve their personal goals.

Client's Objectives

This client wanted a well-reasoned, financial road map to give them the freedom to enjoy their lives and those of their children. They intended to sell their businesses within five years, parlaying their many years of hard work and achievement into ample returns to funds their kids’ education and help relocate the grandfather.

Benchmark's Solution

1. Retirement Savings at Work – Defined Benefit Plan

A defined benefit pension plan is a pension plan that will provide a retiree with a specific amount of retirement benefits based on the number of years of service that they have provided their company. This is different from a defined contribution plan such as the 401k in which an individual makes specific contributions to the plan and the amount of benefits in the future are unknown.

The main advantage to the husband of a defined benefit plan was the increased amount of retirement savings he could put away for himself while also getting a much larger tax benefit at the corporate level from being able to shelter more taxable income coming from his consistently profitable business.  In his circumstances, he could put away $215,000 per year which compares favorably to the $54,000 per year he was able to put away in his defined contribution plan, a SEP IRA.  This consistently profitability also minimized one of the biggest risks of this type of plan in that the business is forced to contribute to the defined benefit plan through good times and bad.

His wife’s economically sensitive business was not a good candidate for a defined benefit plan, but we did put in place a defined contribution plan with elective deferrals and elective profit sharing provisions which, in a good year, would provide her with $54,000 in retirement savings while not obligating her business to these levels of retirement funding during an economic downturn which would keep diners at home.

2. Passive, Index Tracking Investment 

Passive investment strategies have grown in popularity among investors, but they present a “frightening” risk to the markets, warns a Morgan Stanley strategist.

The flow of investment from active management funds to passive investment funds is significant; it increased to nearly $500 billion in the first half of 2017, according to Bloomberg data. Morningstar data revealed investors have pulled an estimated $26.7 billion from Goldman Sachs Asset Management’s mutual funds so far this year, the Financial Times reported on Sunday.

“I do not like what I see, because you have to consider when you have people getting more involved with passive investment strategies, the market will be less able to react to minor distortions or minor declines on the fundamentals side. You will not see the market direction. You will see just a continued inflow of funds,” he told CNBC’s Squawk Box on Monday.

The appeal of passive funds is they generally charge lower fees than active managed funds, which boosts investors’ returns. But while this helps individual investors, it is problem for the wider market.

“From an aggregate point of view it is frightening. It means that at one point you will not have the active end in the market to stabilize it. You would have just the passive guys getting into herd mentality,” he warned.

Redeker said that investors into passive funds can choose risk strategies allowing them to sell out completely if their investment drops by a certain amount, and this can cause a cascade effect, where small market moves are amplified if passive funds automatically sell off assets.”What is then going to happen if the equity market is going to hit those (sell) levels on the downside? You can have a cascading effect,” he said.

“For the passive investment situation, the passive investor needs to get out, simply because he has hit his 5 percent limit, or 10 percent limit. So this cascading risk needs to be looked at.”Redeker compared this to active managed funds, where the active manager can assess the market and decide if there is a buying opportunity. This can help to stabilize the market when it turns negative.

However, using a passive fund does not rule out using an active fund as well. Laith Khalaf, senior analyst at Hargreaves Lansdown, says clients at his firm use both strategies, showing they are pragmatic and not dogmatic.

“Some passive funds have cut costs significantly, but there are still some more expensive trackers out there so investors still need to do their homework,” he told CNBC via email.Passive and active funds also suit different markets, according to Khalaf. Passive funds work well where it is difficult to outperform the market, such as U.S. large caps, while active funds better serve sectors such as U.K. smaller companies.

3. College Savings Options Beyond the UTMA/UGMA Account

The clients were surprised to find out that their UTMA accounts that were supposed to be in place for their children’s college education may not ever be utilized for that purpose since the UTMA is an asset of the child and controlled by them when they reach the age of majority.  A 529 college savings plan was a much better fit for their objectives with these funds for the following reasons:

Who controls the account: Parents who contribute large sums to college savings accounts will likely expect those funds to be used for college, and with 529 accounts, that is all but guaranteed. If the funds are used for anything other than qualified educational expenses, the earnings withdrawn from the account are hit with a 10 percent penalty, and withdrawals are also subject to federal income tax. If the initial beneficiary no longer needs the funds for college, parents are able to transfer the accounts to another, related beneficiary, such as a sibling.

With UTMAs, controlling the use of the funds is significantly more difficult. A UTMA account is designed to pass a large sum of money, real estate or other inheritance to a minor, and once the child reaches 21 in the state of Illinois, the control of the account is completely – and permanently – transferred.

Parents also cannot dictate how the funds are used once the account is transferred. And unlike 529s, UTMAs have no stipulations on expenditures.

Income tax requirements: The rules governing 529 accounts work to encourage use of the funds for educational purposes because most beneficiaries will want to avoid income taxes. But there’s no special benefit for spending money from a UTMA account on education. Regardless of how the UTMA beneficiary chooses to spend the funds within the account, they will be subject to income taxes. UTMAs are considered assets of the child and the income they produce (including dividends or interest) will be taxed as income to the child. There is a $2,100 ‘kiddie tax’ threshold, above which all excess earnings are taxed at the parents’ highest marginal rate, which is based on parental income. This is extremely disadvantageous for both the child and parents.

Impact on financial aid eligibility: After families fill out the FAFSA, the Free Application for Federal Student Aid, parental income is the first factor considered when determining a student’s expected family contribution. After that, assets of both the parent and the student and the student’s income are examined. With a UTMA, the money is considered a child’s asset, but with a 529 plan, the balance is considered a parental asset. So, the UTMA will be given much higher weight in determining financial aid, making it much more difficult to qualify.

4. Elderly Parent

The husband’s mother passed away several years ago, and by all accounts, his father was adjusting as well as could be expected.  However, his two boys wanted to see “Papa Bear” more often and a recent minor health issue reminded him that his father wasn’t quite the robust “Bear” of days gone by.  Trouble was, his father was resistant to spending any of his fortune built up over years of hard work and savings as a cash crop farmer in Western Illinois.

We suggested working with the father to develop a detailed cash flow budget to analyze his ability to move from fertile fields of Western Illinois to the shores of Lake Michigan.  It turns out that his father was rich beyond belief! Farming was good to his father, and he sold his acreage at top prices during the ethanol boom several years back.  Of course, these facts were well known by the son, but this father wasn’t hearing any of his son’s pleas to move closer.  In his mind, his son was a profligate spender.  Why should he trust the kid’s advice?

After we developed a detailed budget which clearly showed that the father could well afford a nice place close to his son, we established a home purchase budget, put his existing home on the market, and started looking at property near the son’s home.  The father sold his home in Western Illinois before it ever hit the market (a long-time neighbor secretly coveted his home, and when he found out that the home was available he pounced with an above market bid. The neighbor was also a former farmer with fortuitous timing on the sale of his farm).

The farmer now lives a short 15-minute drive away from his son on a heavily wooded street across from a baseball field and park.  He’s teaching his grandson’s how to throw and hit a baseball and the location of every ice cream parlor on the North Shore.  The son is thrilled.

5. Maximizing Personal Finances When Selling a Business

Amid the high-stakes environment of putting a business up for sale, evaluating offers, and trying to close, a business owner may miss a once-in-a-lifetime opportunity to ensure his long-term financial needs are met. Our research highlights the importance of setting financial objectives, prioritizing an investment plan, and optimizing a few key investment vehicles before a sale or merger is closed—increasing the value of the deal to the business owner, as well as the likelihood that the value will be preserved over time. In some instances, these strategies can’t be applied effectively after the transaction occurs.

Employing a quantitative framework to establish a personal financial plan—including asset allocation, spending, and plans for charitable and multi-generational giving—can go a long way toward allaying business owners’ concerns about losing control over their income and the legacy they’ll ultimately leave. What may be the greatest surprise is that such preparation doesn’t have to be onerous. In the client’s case, the plan required the formation of a trust, and it may influence certain terms that the owner seeks in the deal negotiations with respect to what percentage, if any, the Client will be willing to take back in stock from the seller is the merged company.

Our experience has led us to identify three principles that should shape the business owner’s approach:

  • Defining personal financial goals is an essential component of evaluating a deal and managing the proceeds.
  • Addressing spending needs first helps ensure maintenance of lifestyle.
  • Orchestrating trust vehicles can maximize deal value and fulfill financial goals.

Well-planned implementation of family or charitable trusts can help ensure income for spending needs, fund charities, secure children’s futures, and reduce the tax burden. Further, fine-tuning the mix of such vehicles allows a portfolio to reflect precisely the life-defining goals of the business owner.

The couple discussed above were prime candidates for such an approach. After carefully laying out their goals, they opted to maintain their current lifestyle and give annual gifts to charity and their children totaling some three-quarters of a million dollars each year (display below). They wanted to leave $10 million both to the children and to charities, and maintain that amount in personal net worth, possibly for other ventures. Using our analysis as a basis for calculating the long-term effects, the clients’ financial, legal, and tax team will be attempting to negotiate the easing of the lockup period of any seller equity taken in the deal to allow greater diversification sooner; establishing a charitable remainder trust (CRT), which would provide an income stream to fund the core portfolio—a method of efficient diversification, tax breaks, and a final distribution to charity;* and establishing two grantor-retained annuity trusts (GRATs), which would allow for a substantial transfer of wealth while minimizing gift or estate taxes.† Only the first GRAT, which would have a three-year duration, would need to be established before the deal closed.

6. Putting It All Together

To understand the power of pre-transaction planning, we compared the probabilities in meeting this couple’s goals, with and without such planning. Initially, the couple worked planned to use the cash proceeds to buy bonds and to hold onto the seller stock they received. Instead, they will be adjusting the terms of the deal, implementing and coordinating trust vehicles both before and after the sale, and establishing a core portfolio. As a result, their holdings will become better diversified, they will receive income streams and tax protection from their trusts, and they will create a core portfolio that is well funded to meet their spending needs.

What’s the projected result of this approach? After 30 years, we estimate a 90% probability that personal wealth will exceed their financial goal of $10 million. This leaves ample assets to pass additional value to children and charity.

As far as personal legacy goes, there’s a 90% probability that assets left in the trusts, annual gifts from the core portfolio, and the value of the estate at inheritance would equal almost $13 million passed on to the children by year 30, also exceeding the original target of $10 million. Similarly, there’s a 90% probability that the total wealth passed on to charity will be more than $10 million.

All this adds up to far better odds that these clients would meet all their financial goals (display below). Originally, they had only a 75% chance of having the money they wanted for spending, and even worse odds for their personal net worth, the children, and charity. With proper planning, however, they gained no less than a 93% likelihood of meeting their targets for charity, children, and net worth—and a 98% probability for spending. That’s a powerful argument for planning personal finances before the deal is made.

Results & Impact

  • Both clients have optimized the utilization of employer sponsored retirement savings programs at their privately-held businesses.
  • They have a well-diversified portfolio that minimizes volatility and increases the stability of their overall investment portfolio while providing the level of projected growth that they want from their investments.
  • They have the correct investment vehicle in place for accumulating assets in their children’s college savings programs.
  • The husband’s father now lives 15 minutes away from their home and is spoiling his grandchildren to the extent he can get away with doing so.
  • The couple feels well prepared to maximize their financial outcomes when they both sell their respective businesses in a few short years.