SPECTRUM. Managing Concentrated Equity Risk. A newsletter for the friends and clients of First Republic Private Wealth Management

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1 SPECTRUM A newsletter for the friends and clients of First Republic Private Wealth Management Volume 41 3rd Quarter 2017 How to Address Four Common Estate Planning Concerns Michael Winn Page 4 Handling an Inheritance Smoothly Margaret A. Zywicz Page 5 Managing a Nonprofit Endowment Dan Rubin, Rebecca DeCesaro Page 6 Managing Concentrated Equity Risk Four Steps to Help Diversify Your Portfolio First Republic Investment Management Most investors understand the value of spreading risk across a variety of different securities, sectors, asset classes and geographical regions. Still, any number of unique circumstances could lead an investor to too much exposure in any of the aforementioned areas. One component of wealth management that affects individuals and their families in particular is concentrated holdings of stock in a single company. A concentrated equity position can potentially represent a substantial portion of an investor s portfolio. (Think of it as the tallest tree in a forest waiting for lightning to strike.) Oftentimes, such positions end up in a portfolio either by a Continued on page 2

2 MANAGING CONCENTRATED EQUITY RISK Continued from page 1 successful investment (that grew from a low cost basis), an inheritance from a grandparent or parent, or represent ownership in a current or former employer or business owners who sell their company and receive proceeds in stock. Creating a strategy to manage concentrated equities often involves navigating complex and cumbersome issues effectively. THINK GOALS, NOT RULES OF THUMB If too much exposure to a single company causes you unnecessary stress, this might indicate you need to take some risk off the table. While many experts define concentrated risk as a percentage of an investor s portfolio, the reality is more nuanced. Consider approaching the question of How much is too much? through the lens of goals-based planning and investing. Specifically, consider how a significant decline in the equity s value would impact your goals. Ask yourself, What is my time horizon? What is my appetite for risk? How much can I afford to lose and still be on track to meet my goals and be financially okay? If too much exposure to a single company causes you unnecessary stress, this might indicate you need to take some risk off the table. The following four steps can help you get started on weighing your options. 1. Liquidate. When concentrated exposure poses a threat to your overall objectives or is simply keeping you up at night your first strategy should be to consider selling off some of your holdings and investing the proceeds in a more diverse mix. Then, there are the usual questions that arise when selling stock, from tax implications no small consideration to current valuations and hypothetical, long-term growth potential. For some, it may make sense to trim holdings incrementally at a set price, whereas others may find selling completely out of the holding in one fell swoop to be the best way forward. 2. Fine-tune the rest of your portfolio. If selling away the holding isn t an option or doesn t sufficiently reduce exposure, you can make adjustments elsewhere in your portfolio to minimize risk so that other holdings in your portfolio zig when the concentrated holding zags. This is called a negative correlation. Keep in mind that diversification isn t just a matter of holding many different securities or diversifying across sectors or geographical regions although 2 Spectrum Vol. 41 3rd Quarter 2017

3 that all undoubtedly can help. Diversifying is ensuring that your holdings do not move in tandem. Remember to seek out securities and funds that have low correlations to your concentrated holdings. An investment professional can help review your overall portfolio and identify asset classes or securities that have low correlations to your concentrated equity positions. 3. Use hedging judiciously. Equity derivatives have become a popular component of hedging risk in a portfolio. This approach can potentially protect against risk by allowing the investor to specify the amount of risk they are willing to take on for a premium. There are a variety of ways to hedge the downside potential of an investor s concentrated holding, while allowing the investor to participate fully in the upside. Keep in mind, however, that the cost of such hedging strategies must be heavily considered as they can be pricey as well as risky. 4. Consider tax-efficient gifting. If you have philanthropic aspirations, there are a number of ways to leave a meaningful family legacy in a tax-efficient way. If you have philanthropic aspirations, there are a number of ways to leave a meaningful family legacy in a tax-efficient way. Charitable Remainder Trusts, for example, allow donors to receive an income tax deduction based on the present value of the charitable contribution. The owner of the trust can then ease out of the concentrated holding and reinvest the proceeds in a more diversified manner typically in line with the investment policy statement of the charity. The donor always has the option to receive ongoing income from the trust for the remainder of their lifetime and can defer capital gains tax until the distributions are paid out. The distributions to the donor may also result in an income and estate tax deduction. When the donor passes away, the remaining assets go to the charity or charities designated in the Charitable Remainder Trust agreement. Such an arrangement may offer a win-win of diversification and charitable giving. SEEING THE FOREST FOR THE TREES Understanding an investor s unique financial needs and the significance a concentrated holding has, either monetarily or emotionally, is crucial to determining which path to follow. The decision to hold, sell or donate your equity should ultimately be driven by your overall financial aspirations, where you are in your financial life cycle and your tolerance for risk. 3

4 Michael Winn, Business and Estate Planning Specialist, First Republic Securities Company How to Address Four Common Estate Planning Concerns Embrace Legacy Planning and Gain Peace of Mind When envisioning their legacy, many wealthy families and business owners desire to plan an effective transfer of assets to future generations and to incorporate their philanthropic goals in a powerful and meaningful way. However, this planning is often easier said than done. When getting to the nuts and bolts of creating an efficient estate plan, many clients encounter questions and concerns that, if not properly addressed, can leave them frustrated and confused, with a plan that does not truly address their long-term goals. Developing a strategic, high-level approach to the process that is unlike the more traditional, academic experience can be invaluable to the ultimate success of an estate plan. Intimate discovery sessions with key advisors, driven by thoughtful questions that seek to understand the unique business and wealth dynamics that drive each family, can help pinpoint precise and detailed objectives. In uncovering these details, it can be possible to create an efficient planning blueprint that guides the advisor team to take action efficiently and with complete clarity. In this way, both the technical and soft issues get addressed, creating a balance between tax savings, flexibility and family harmony. Shorter, more focused working time can also help streamline the process and avoid the long, overly complex meetings that many families Continued on page 8 4 Spectrum Vol. 41 3rd Quarter 2017

5 Margaret A. Zywicz, Senior Trust Officer, First Republic Trust Company Handling an Inheritance Smoothly The Value of a Corporate Trustee When you include a trust in your estate plan, you have to name a trustee a person or entity whose job is to ensure the trust is managed and distributed according to the instructions laid out in the trust. One of the major benefits of naming a corporate trustee is their ability to provide expert guidance to beneficiaries and help them navigate often-complex questions and decisions regarding their inheritance. THE MANY ROLES OF A CORPORATE TRUSTEE A trustee s key role is to effectively manage the trust s assets while following the requirements the grantor laid out in the trust documents. Given the everchanging legal and financial regulatory environment, trustees must stay abreast of proposed and current trust-related laws. They also must comply with any administrative requirements, such as tax filings. But they also serve as a key resource to beneficiaries who often have many questions about how their trust works or concerns about receiving and sustaining their inheritance. The trustee can walk them through the trust s provisions and explain key requirements so they aren t searching for answers during difficult times. Ideally, a beneficiary would know at least the basics of how their trust works by the time the grantor passes away. Here are common questions and misconceptions beneficiaries may bring up with their trustee: I had no idea my parents left me this much money. Continued on page 10 5

6 Managing a Nonprofit Endowment Four Questions to Ask When Considering an External Manager Even the most well-informed board of directors isn t always finely attuned to the endowment trends within an industry or sector. Hard-fought donor dollars are precious assets, which makes your endowment one of the most important areas you can focus on to ensure long-term sustainability. What s more, endowment management is becoming increasingly complex and labor intensive. A strict regulatory environment, fiduciary responsibility requirements and unique organizational investment needs all add up to a wide range of complexities that can leave board members strapped for time, without the consistent bandwidth necessary to focus on actively managing these assets. As an organization grows, many nonprofit leaders start to look for areas where an outside partner can be brought in, so their focus can be placed in the areas that matter most. Is an external endowment manager the right fit for your organization? The following four questions can help you decide. HOW FAMILIAR ARE YOU AND YOUR BOARD WITH CURRENT INVESTMENT POLICY STATEMENT TRENDS? Even the most well-informed board of directors isn t always finely attuned to the endowment trends within an industry or sector. That s where an outside expert can help. The right external endowment consultant will be aware of the strategies being effectively applied by other nonprofits. They can review the investment options available in the market and advise what is appropriate for specific endowments. Endowments come in all sizes and the options should be tailored the endowment size and cash flow needs. That specialized 6 Spectrum Vol. 41 3rd Quarter 2017

7 knowledge can be leveraged to solve the unique investment challenges faced by your organization. An effective external endowment manager or consultant can: Ensure your allocation is appropriate for your investment goals Ensure that the funds or managers selected to build the portfolio have reasonable fees as well as performance history Closely inspect your overall investment options, combing through for unnecessary redundancies that can sometimes hamper return and often crimp risk mitigation strategies Help avoid an unhealthy reliance on proprietary investment options Make tactical adjustments as external events shift and internal motives transform Keep you up-to-date with accounting changes and evolving investment policy issues Compare your endowment coverage ratio with your peer group Dan Rubin, Managing Director, First Republic Bank HOW INVOLVED IS YOUR INVESTMENT COMMITTEE, FINANCE COMMITTEE OR BOARD OF DIRECTORS? An external partner can mitigate the risk of any internal conflicts of interest or turnover, as well as help ensure overall good governance as it relates to the management of your endowment. They also provide a consistent source of vetted, expert advice with dedicated capacity to serve your organization as your board and mission expand. Of course, board committees play an integral role regarding all large-scale organizational objectives. An external expert acts as an extension of your board, a strategy that strengthens their ability to remain well-informed, while also freeing precious hours that can be used to further the mission of your organization. Rebecca DeCesaro, Wealth Manager, First Republic Investment Management HOW IS YOUR ENDOWMENT PERFORMING RELATIVE TO ITS PEERS? The measure of effective investment performance is more than just the reported absolute number. In-depth, individualized performance reporting can help a nonprofit gauge how well (or poorly) its investment vehicles are performing relative to similar funds and sector benchmarks. An external manager will keep the board informed, providing insights into why Continued on bottom of page 9 7

8 HOW TO ADDRESS FOUR COMMON ESTATE PLANNING CONCERNS Continued from page 5 Estate plans must be created with the assumption that unexpected events will happen. experience otherwise. Assembling an efficient team of advisors can bring a human touch to what can be a difficult and sometimes overwhelming experience, helping families stay focused on the end goal. In addition, this process can help tackle four important questions that are typically top-of-mind for high-net-worth families and business owners, including: 1. What if I leave too much? Many wealthy families want to ensure their heirs are motivated to work hard and uphold the family s values and don t want to risk hard-earned assets being squandered by future generations. First Republic s estate planning specialists can guide clients through various planning strategies that can limit access to assets or incentivize beneficiaries to live and spend responsibly. 2. What if I leave too little? Conversely, some clients wonder if they re leaving their heirs enough to sustain them financially over what could be many decades, or if their plan is properly structured to address the tax bill that could be due upon their death. This is of particular concern to families who hold large real estate portfolios or who wish to leave a sizable portion of their estate to charity. That gift of $5 million incorporated into a plan at today s dollars could grow exponentially, resulting in the majority of a client s estate going to charity instead of to their heirs. As with the first item above, an estate planning specialist can help design a plan that provides enough liquidity to pay potential taxes without the need to liquidate property or assets and that maintains the balance of giving intended. 3. What if tax laws change? The prospect of changing estate tax laws may cause uncertainty and inaction for many wealthy families. While no one can predict what estate taxes will be in the future, it is possible to build flexible plans that can be adjusted to account for estate tax changes. For example, a Trust Protector can be named to an Irrevocable Trust and granted the authority to alter trust provisions due to unexpected circumstances, such as tax law changes. 4. What if my legacy doesn t become reality? A premature death or unforeseen life event can derail even the best-laid plans. Estate plans must be created with the assumption that unexpected events will 8 Spectrum Vol. 41 3rd Quarter 2017

9 happen. Working closely with a team of advisors all aligned to address the end goal of a plan will ensure that all the key steps are taken to protect loved ones. All existing documents should be reviewed to confirm that Trusts have been set up and funded properly, assets have been correctly re-titled and that the mechanics of the estate plan have been completed. Estate planning is a critical priority for wealthy families and business owners, but it can also be a complicated and emotional endeavor. Coordinating with a team of advisors dedicated to simplifying the process and seeing the plan through to completion, however, can be a powerful catalyst to getting a truly effective plan design in place. MANAGING A NONPROFIT ENDOWMENT Continued from page 7 particular industries may be increasing or decreasing in value, based on overall market and economic conditions. If it becomes clear that a particular investment is under-performing, an external manager can analyze why, decide when it s time to make a switch, and help find and facilitate the move to an alternate investment option. IS YOUR NONPROFIT POISED FOR GROWTH? An organization s needs can change drastically and quickly particularly just prior to and during expansion. A nonprofit accustomed to an annual four or five percent spending policy, for example, could find it requires additional funds to meet its growth or cash flow objectives during specific periods. An effective policy statement will include the flexibility to increase the draw, if needed. An external partner can help a nonprofit not only build a responsive spending policy, but also identify ways to meet individual investment goals in a way that aligns with the organization s overarching mission. Is stability the goal? Growth of capital? Growth through an endowment campaign? A partner can help identify opportunities to meet these financial goals and work alongside you to bring them to fruition, all while remaining true to the organization s risk tolerance and remaining cognizant of current liquidity needs. In short, an external endowment manager or consultant acts as an organization s external Chief Investment Officer plus a little more. It s a partnership that keeps board members well-informed, while also allowing them the freedom needed to further the organization s mission. An organization s needs can change drastically and quickly particularly just prior to and during expansion. 9

10 HANDLING AN INHERITANCE SMOOTHLY Continued from page 4 I had no idea my parents had this much debt. How am I going to support myself? How do I handle this inheritance? How long will it take for the distributions to come? Why can t I have all the money at once? Why is the trustee preventing me from accessing my own money? Ideally, a beneficiary would know at least the basics of how their trust works by the time the grantor passes away. Realistically though, many beneficiaries have little understanding of their trust s provisions and their corporate trustee thus becomes a valuable advisor. UNDERSTANDING DISCRETIONARY POWERS Many trust documents give the trustee discretion over distributions of income and principal to the beneficiaries. This means the trustee determines the amount the beneficiary receives from the trust. This is often a difficult concept for a beneficiary to understand. Many trust documents give the trustee discretion over distributions of income and principal to the beneficiaries. There can be a range of terms used in trust documents that guide the trustee s discretion over distributions. For example, some trusts grant the trustee full and absolute discretion with no further guidance. When a trust document provides broad discretion to the trustee, a letter of intent drafted by the grantor in their own words and accompanying the trust document can be extremely helpful. A letter of intent offers only guidance, not strict instructions, and may answer, in broad terms, what the grantor hopes the trust will provide to the beneficiary. In the best case scenario, the trustee has an opportunity to discuss the grantor s intent with the grantor, but that rarely happens. Many trusts use the HEMS (health, education, maintenance and support) standard, but rarely does the grantor truly understand how that term is implemented in practice. When distributions are limited to HEMS, it is up to the trustee to determine the beneficiary s financial needs and to balance those needs with the resources available. For example, the trustee must balance many factors, including the term of the trust, the ages of the different beneficiaries, and the current and potential future needs of the different beneficiaries. Again, a letter of intent to guide the trustee when interpreting HEMS can be extremely helpful. 10 Spectrum Vol. 41 3rd Quarter 2017

11 In practice, a trustee often will request a beneficiary to provide a budget when making a request for a distribution, whether under the HEMS standard or a broader standard. Although requesting a budget may be upsetting to a beneficiary at first, the trustee can walk the beneficiary through the process and explain the purpose. The trustee merely wants to carry out the grantor s intent and doesn t want to deplete the trust if that was not the intent. MAXIMIZING THE TRUSTEE RELATIONSHIP Dedicated trust officers also have access to a wide range of expertise, including investment management, insurance and estate planning. The trust grantors and beneficiaries thus have the benefit of this expertise. A trust officer works closely with beneficiaries to help them understand the terms of their trust and maximize their inheritance. For example, if a beneficiary of a net income trust doesn t want or need the net income, the portfolio could be adjusted to grow principal and reduce income. If estate taxes are a concern, distributions may be taken from a non-tax-exempt trust rather than a taxexempt trust. An experienced trust officer can make adjustments to the current situation and abide by the trust terms. Some families may want to appoint a family member as co-trustee who partners with the corporate trustee. This gives the family member a greater role in overseeing the trust once the grantor passes away and allows them to tap the corporate trustee s expertise and services. A family member may not want the responsibility and emotional stress that often comes with being the primary trustee, so being co-trustee allows them to leave major responsibilities to a corporate fiduciary. A trust officer works closely with beneficiaries to help them understand the terms of their trust and maximize their inheritance. An experienced and knowledgeable corporate trustee can take on many roles and work with both grantors and beneficiaries to achieve their long-term financial goals. It s important for families to understand that role and find a corporate trustee that provides them with the best experience possible. If you have any questions, comments or suggestions for Spectrum, please contact us at privatewealthmanagement@firstrepublic.com 11

12 PRESORTED 111 Pine Street San Francisco, CA STANDARD US POSTAGE PAID PERMIT #179 SAN BRUNO, CA spec trum, n. A broad range of related ideas or objects, the individual features of which tend to overlap so as to form a continuous series or sequence. Random House Unabridged Dictionary First Republic Private Wealth Management is comprised of First Republic Trust Company, First Republic Trust Company of Delaware, First Republic Securities Company, LLC (Member FINRA/SIPC) and First Republic Investment Management, an SEC-Registered Investment Advisor. Insurance agency services are provided through First Republic Securities Company, LLC, Member FINRA/SIPC, DBA Grand Eagle Insurance Services, LLC, CA Insurance License # 0I Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. Strategies mentioned in this article will often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. This information is provided to you AS IS, does not constitute legal advice, is governed by our Terms and Conditions of Use, and we are not acting as your attorney. Clients tax and legal affairs are their own responsibility. Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this article First Republic Private Wealth Management Investment, Insurance and Advisory Products and Services are Not FDIC insured, Not Guaranteed and May Lose Value.