If you have attended a BBH investor day or one of our regular markets and economy webinars, you have heard Chief Investment Officer Scott Clemons say that “volatility is our friend.” During periods of volatility, particularly downside volatility, it often does not feel that way. In turbulent markets, we are patient investors, we work with you to confirm your investment goals, we take advantage of price dislocations in the market, and we go back to fundamentals: discussing what this wealth is for and when, how, and for what reasons the family plans to access it.
While we frequently address the impact of price volatility in our investment portfolios, it also makes sense to consider estate planning and wealth transfer opportunities that present themselves for limited windows when there is volatility in interest rates, public markets, and even private markets. These strategies include:
- Gifts: If you have any lifetime gift tax exemption and/or generation skipping transfer (GST) tax exemption remaining,1 you may want to consider making gifts while asset values are depressed. Simply transferring assets down a generation or more while assets are priced lower than intrinsic value2 is a gift that keeps on giving, assuming the gifted asset eventually appreciates in the hands of the donee. If you have already used all of your lifetime gift tax exemption, or if you wish to make gifts to ancillary family members/friends without using up your exemption, other wealth transfer strategies, such as loans or grantor retained annuity trusts (GRATs), may be attractive alternatives.
- Late Allocation of GST Exemption: If you have existing trusts that are not GST-exempt but that you would like to maintain for the benefit of future generations, and you have remaining GST exemption, you may want to discuss doing a late allocation of GST exemption with your attorney. This is especially true if your remaining GST exemption exceeds your remaining gift/estate tax exemption. A late allocation of GST exemption during a period of depressed market values allows you to maximize the benefit of that allocation while preserving assets for generations to come.
- Loans: Low interest rates present exceptional planning opportunities for wealth transfer. Higher interest rates may also present planning opportunities, and relatively high-interest family loans may be refinanced more easily if and when rates drop than traditional commercial lines of credit or mortgages.
- GRATs: Low “hurdle rates” (the 7520 rate set by the IRS each month) make it more likely that a GRAT will succeed in transferring wealth gift tax-free. Higher hurdle rates (as we are experiencing today) do not mean abandoning GRAT strategies, but instead shifting focus to asset selection and close monitoring of performance – volatility requires vigilance.
Grantor Retained Annuity Trusts
There are a few reasons to think about GRATs today:
- In general, GRATs are a great way to transfer wealth to the next generation (or other beneficiary) without the imposition of gift tax. This strategy is particularly relevant for those who have used up their gift tax exemption.
- Volatility creates opportunity. Funding a GRAT when values are depressed can increase the likelihood for a successful GRAT.
- For those with existing GRATs, consider whether it might be an appropriate time to freeze your GRAT as a result of market volatility and after considering the hurdle rate in place at the time that your GRAT was created in comparison to where it is today.
What Is a GRAT?
In general, GRATs are used to minimize federal estate and gift tax.
To create a GRAT, the grantor makes a gift to a trust. The trust agreement says that the trust will last for a certain term – commonly two years. The trust agreement also directs the trustee to pay an annuity back to the grantor (this is the “grantor retained annuity” part of the trust) over the two-year term. After those two annuity payments are made to the grantor, any assets remaining in the GRAT pass outright or to a trust for the beneficiaries designated by the grantor (often children, but sometimes siblings or other family members/friends).
The grantor makes a gift to the beneficiaries on the day she creates the GRAT, since on that day they are entitled to a future interest (the GRAT “remainder”) after the two-year term of the trust. The value of the gift is the value of what the grantor transferred into the trust less the value of what she is required to take back through the annuities.
Most estate planning attorneys structure GRATs so that the value of the assets transferred into the GRAT is roughly equal to the value of what the grantor is required to take back in annuity payments, plus interest at the hurdle rate. If the assets in the trust appreciate at a rate greater than the hurdle rate, beneficiaries receive the excess amount free of transfer tax. This is sometimes referred to as a “zeroed-out” GRAT because the value of the gift is deemed to be zero.
Why GRAT?
Any growth in assets above the hurdle rate will pass to beneficiaries gift 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 beneficiaries at the end of the GRAT term.
Below is an example of a two-year GRAT funded with $2 million, invested in an S&P index fund (SPY) during the volatile market conditions we experienced in April 2020, when the hurdle rate was 1.2%. This example is for illustrative purposes only, as you would typically fund a GRAT with a single stock, strategy, or sector (rather than an index fund), in order to prevent diversification from canceling out the success of one stock with the failure of another. Here, the market volatility would have allowed for a successful GRAT even if it was funded with an index fund.
| Two-Year GRAT | Opening Balance | SPY Growth | Annuity | Closing Balance |
|---|---|---|---|---|
| Year 1 | $2,000,000.00 | 59% | $925,968.80 | $2,259,492.56 |
| Year 2 | $2,259,492.56 | 13% | $1,111,162.60 | *$1,441,779.74 |
*The red number is the amount passing to the GRAT beneficiary after two years, free of gift tax and without the use of exemption, assuming the grantor survives the term. The GRAT was “zeroed out,” so no gift tax was due. The annuity in year two increases by 20%, which is permitted under the IRS regulations and leaves more assets in the GRAT to grow during the second year, which makes it more likely that the GRAT will succeed in beating the hurdle rate.
Funding a GRAT with assets that have dropped significantly in value as a result of a market downturn can be an effective way to increase the likelihood that the assets held in the GRAT will appreciate at a rate greater than the hurdle rate.3
Today, the hurdle rate over which a GRAT must perform in order to transfer wealth to beneficiaries is 5%. If you are thinking of funding a GRAT, it’s best to use a concentrated asset that experiences large swings in price. It is then important to monitor the asset’s performance to determine whether it makes sense to freeze the GRAT either because it has been so successful or because the asset has depreciated in value such that it is unsalvageable. The strategy of freezing GRATs that have outperformed or underperformed is discussed in more detail here.
Conclusion
Executing on any of the estate planning and wealth transfer opportunities mentioned in this article will require legal advice. These ideas focus on tax savings and, while impactful, must also align with your goals at the intersection of family and wealth. 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 learn more, please contact your BBH relationship team.
