Silver Lining Playbook: Wealth Planning Through Volatility

March 17, 2020
Senior Wealth Planner Alison Hutchinson explores time-sensitive and beneficial wealth planning strategies to consider amid the current volatility.

At BBH we are advising clients to be patient investors, reconfirm investment goals and remember what the wealth is for. We are counseling to keep in mind the difference between the current price and the value of the companies we own and to trust BBH and other advisors to help preserve wealth during this time. While we believe it is prudent to stay the course in terms of investment portfolios, it also makes sense to consider implementing some of the following extraordinary, but time-sensitive planning opportunities you can take advantage of today, from home.

  1. GRATs: low hurdle rates make it more likely that a GRAT will succeed in transferring wealth tax-free (described in detail below).
  2. GRATs: volatility requires vigilance. We will discuss in our next update best practices for planning with GRATs that are “underwater” (in other words, GRATs that are not expected to beat the relatively higher hurdles that were likely in place when they were funded in 2018 or 2019).
  3. Loans: Low interest rates present exceptional planning opportunities for wealth transfer.
  4. Gifts: Simply transferring assets down a generation or more while those assets are are priced lower than intrinsic value is the gift that keeps on giving.
  5. Fiduciaries: Review fiduciary appointments and identify succession plans for any high-risk individuals; similarly review the estate plans for any high-risk family and friends.

Executing on any of these ideas will require legal advice. These ideas focus on tax savings and, while impactful, must also be aligned with your goals at the intersection of family, wealth and philanthropy. Transfers should not be made for tax savings alone, but only if they contribute to your broader values-based wealth plan. If you would like to hear more, please contact your BBH Relationship Manager or Wealth Planner, who all remain active, engaged and involved whether at the office or at home.

Grantor Retained Annuity Trusts

There are two reasons to think about GRATs today: (1) low interest rates flow through to GRAT “hurdle” rates (described in detail below) which increases the likelihood of a successful GRAT and (2) volatility in an existing GRAT program requires vigilance in looking for freeze opportunities.

What is a GRAT?

GRAT stands for grantor retained annuity trust. In general, GRATs are used to minimize federal estate and gift tax.
To create a GRAT, someone (the grantor) makes a gift to a trust. The trust agreement says that the trust will last for a certain number of years – by way of example, assume two years. The trust also says that the trustee has to pay an annuity back to the grantor (this is the “grantor retained annuity” part of the trust) over two years. After two annuity payments back to the grantor, anything remaining in the trust passes to a trust for the grantor’s descendants.

The grantor makes a gift to his descendants on the day he creates the GRAT, since the lucky descendants are entitled to get something (the GRAT “remainder”) after the two-year term of the trust. The value of the gift is the value of what the grantor put in the trust less the value of what he is required to take back through the annuities, since that is what the descendants are anticipated to receive. Most modern estate planning attorneys structure GRATs so that the value of what the grantor puts in is roughly equal to the value of what he is required to take back, plus a “hurdle” which the IRS sets each month (similar to the rates for intra-family loans described above). If the assets in the trust appreciate at a rate greater than the hurdle, descendants receive assets transfer tax free. This is sometimes referred to as a “zeroed-out” GRAT because the value of the gift is deemed to be zero.

Why Now?

The hurdle rate mentioned above is remarkably low for GRATs funded this month and is projected to go even lower, potentially as low as 1%, for GRATs funded in April. Appreciation above the hurdle passes to descendants in this example transfer-tax free. If the assets in the GRAT do not beat the hurdle rate, there are no negative tax consequences; the GRAT will just be fully depleted by making payments back to the grantor, and there will be nothing left to pass to the next generation at the end of the GRAT term.

Below is an example of a two-year GRAT funded with $2 million in the low-interest rate environment we experienced in January, 2013, when the hurdle rate was 1%.

The annuity amount in each case is calculated by paying just enough back to the grantor so that the value of the interest the grantor retains plus that low hurdle of 1%, is equal to what was put into the trust. If the value is equal to what was put in, then the “gift” to remainder beneficiaries is nothing, because using accepted IRS growth rates (again, very low at 1%) the anticipated amount to pass to the remainder beneficiaries is zero. These are commonly called “zeroed out GRATs.”

For illustrative purposes, we ran two scenarios, one assuming 3% growth and one with 7% growth.

2-Year GRAT; 3% Growth Opening Balance
3% Growth Annuity Closing Balance
Year 1 $2,000,000.00 $60,000 $923,147.80 $1,136,852.20
Year 2 $1,1136,852.20 $34,105.57 $1,107,777.20 *$63,180.57
2-Year GRAT; 7% Growth Opening Balance
7% Growth Annuity Closing Balance
Year 1 $2,000,000.00 $60,000 $923,147.80 $1,136,852.20
Year 2 $1,216,852.20 $85,179.65 $1,107,777.20 *$194,254.65

*The highlighted number in each example above is the amount passing to the GRAT beneficiary after two years, free of transfer tax or use of exemption, assuming the grantor survives the term. The GRATs were “zeroed out” as explained above, so no gift tax was due. The annuity in year two increases by 20%, which is permitted under the IRS regulations and leaves more in the GRAT in the first year to grow which makes it more likely that the GRAT will succeed in beating the required IRS hurdle.

You may be thinking that the above picture looks much too rosy for the financial turbulence we are currently experiencing. Today, 7%, 3% or even 1% appreciation would feel like a welcome change to the precipitous drops we have seen over the past couple of weeks. Indeed, for those who funded GRATs before the volatility, it is extremely important to consider whether they may be unsalvagably underwater. In that case, the appropriate strategy is not to cross your fingers and hope the GRAT recovers; rather, it is much more prudent to cut your losses and start anew. We will examine when it makes sense to give up on a failing GRAT in the near future.

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