Wealth Planning Through Volatility

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

At Brown Brothers Harriman, when markets are volatile, we advise our clients to continue to be patient investors, reconfirm investment goals and remember what the wealth is for. We counsel them 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 when the price of the assets you own has declined. 

  • Grantor Retained Annuity Trusts (GRATs): Low hurdle rates and relatively low asset price on funding make it more likely that a GRAT will succeed in transferring wealth tax-free (described in detail below).
  •  GRATs: Volatility requires vigilance. For those clients with active GRATs, here we discuss best practices for planning with GRATs that are “underwater” (in other words, GRATs that are not expected to beat the hurdles that were in place when they were funded).
  • Loans: Low interest rates present exceptional planning opportunities for wealth transfer. In a rising rate environment, locking in lower rates for longer terms may be prudent. Read more here.
  • Gifts: Simply transferring assets down a generation or more while those assets are priced lower than intrinsic value is the gift that keeps on giving.

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.

Grantor Retained Annuity Trusts

There are two reasons to think about GRATs today. First, rising interest rates flow through to GRAT “hurdle” rates (described in detail below). Locking in a lower hurdle increases the likelihood of a successful GRAT. Second, 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” that the IRS sets each month (similar to the rates for intra-family loans). 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 at or near zero.

Why Now?

The hurdle rate mentioned above is relatively low but is rising along with other applicable rates. The hurdle rate is fixed the moment you fund your GRAT, and appreciation above the hurdle passes to descendants 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.

On March 17, 2020, we wrote an article similar to this one describing opportunities for wealth transfer through market volatility, and we suggested it may be a good time to fund a GRAT. Below is an example of a two-year GRAT funded with $2 million on March 18, 2020, when the hurdle rate was 1.8%.

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 1.8% 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 1.8%), the anticipated amount to pass to the remainder beneficiaries is zero. These are commonly called “zeroed-out GRATs.”

As shown in the following table, if you had funded your March 18, 2020, GRAT with an S&P 500 index fund, the closing balance, or the amount passing to your beneficiaries free of transfer tax or use of exemption, would have been nearly $1.5 million. To put this in context, a transfer of the same $1.5 million at death, assuming the transfer was subject to New York and federal estate tax at prevailing rates, would incur over $700,000 in additional tax.

Two-Year GRAT Funded on March 18, 2020

Year Beginning
Start S&P
1 $2,000,000.00 $2,346.50 $3,974.12 63.11% $1,262,154.73 $923,448.42 $2,327,706.30
2 $2,327,706.30 $3,974.12 $4,411.67 11.01% $256,280.11 $1,121,338.12 $1,462,648.29
          GRAT Success $1,462,648.29
This hypothetical example is for illustrative purposes only.

The red number in the table above is the amount passing to the GRAT beneficiary after two years, free of transfer tax, assuming the grantor survives the term. The GRAT was “zeroed out” as explained above, so little or no gift tax exemption was used. 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. But it is precisely the votatility and decreases in price that make now an opportune time to consider GRATs.  Indeed, GRATs created in 2022 before the recent market volatility may be so underwater that they are unable to succeed in their intended wealth transfer. 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 examine when it makes sense to give up on a failing GRAT here.

Up Next
Up Next

Wealth Planning in a Rising Rate Environment: Intra-Family Loans

Senior Wealth Planner Alison Hutchinson delves into the advantages of intra-family loans in this rising interest rate environment.

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