Basie has taken risks all of his life, most notably through his business. His intention is to re-create a "paycheck" from his portfolio without invading his principal (in inflation-adjusted terms), which he will leave to his children. However, first he would like to pay off the outstanding mortgage balances on his primary residence, as well as on his vacation home, which total $4 million. Second, he would like to establish a charitable entity (for example, a private foundation or charitable trust), for which he will need advice. He hopes to fund it with $5 million. Finally, he would like to gift his brother and each of his children $500,000.

The Basies’ spending over the past five years has averaged $750,000 per annum. Given the couple’s desire to travel comfortably, they anticipate maintaining a similar cash flow in the future. Admittedly, Basie is not an expert on investments or asset allocation, but he has paid attention to the markets fairly regularly since the 1980s and believes that he would like to hold the bulk of his assets in bonds (roughly 70 percent), with the remaining assets in U.S. equities. He does not know what hedge funds or alternative investments are, and, although his impression of them is that they are very risky, he is still willing to consider them. Basie sees no obvious need for commercial real estate (REITs), considering he owns two residential properties and predicts more trouble in the housing market. Finally, Basie likes the idea of buying and holding a few concentrated stocks in his IRA because the tax will be deferred. Basie notes that after all initial payments and distributions are made, he will be left with a portfolio of $19 million, which should sufficiently support his spending and lifestyle. He considers the annual spending rate of 4.5 percent low, and reasons that any competent investment advisor should be able to deliver such a modest return. —The Editors

RESPONSE:
At Boston Private Bank & Trust, we consider that a solutions-driven approach to solving problems is superior to a product-driven approach in terms of providing lasting client satisfaction. We in the Investment Management & Trust group took this approach with the Basies.

Fellow professionals in the field realize that considerable thought and analysis are necessary in every client situation—including this one—and that many possible solutions exist. On the surface, the Basies have what looks like a set of unlinked objectives. However, the couple’s asset pool would appear adequate to achieve their objectives—if the resolutions could be effectively and efficiently connected while still leaving room for unplanned contingencies.

The Basies face a big challenge in deciding how to ensure inflation-protected cash flow every year for the next 30 to 40 years and still have enough for gifts that will go to charity and to their children. The specific issues the Basies will have to resolve to determine their strategy include the following:

• Debt reduction
• Charitable giving
• Intrafamily gifts
• Portfolio construction

The Basies have a $30 million pool of funds to work with, including a $3 million IRA. They would like to create a $750,000 annual paycheck, pay off their two mortgages, satisfy philanthropic desires and gift monetary sums to family members.

Debt Reduction

Goal: To pay off their two mortgages.
Recommendation: Use $2.9 million of the $30 million pool to reduce mortgage debt from $4 million to $1.1 million in order to capture the maximum mortgage interest deduction. Invest the $1.1 million not used for debt reduction, with the assumption that the Basies are in a high marginal tax bracket and, over time, an investment portfolio would probably generate returns greater than their net interest costs on the outstanding mortgage.

Gifting

Goal: Make lump-sum gifts to family members.
Recommendation: Make maximum annual exclusion gifts to family members—as opposed to large gifts—to keep intact the gift-tax lifetime exemption until they adjust to life without earned income. The other option would be to make some combination of annual exclusion gifts and taxable gifts spread out over time to preserve some of their lifetime exclusion while they adjust to their new lifestyle.

Philanthropic Endeavors

Goal: To establish a charitable entity.
Recommendation: Establish a charitable remainder unitrust (CRUT) with $5 million and a payout of 5 percent for the lives of both Mr. and Mrs. Basie. Fund it with low-tax-basis securities and any concentrated positions, because the trust can sell and redeploy without capital gains. This allows them to diversify investments without capital gains taxes on sales of either the low-basis holdings or any concentrated positions now in their personal portfolio. It also affords them the ability to obtain a larger charitable deduction because they can use the fair-market value of the stock contributed to the charitable vehicle rather than their low-cost basis. This will produce $250,000 of cash flow, which will vary in the future according to how the trust’s portfolio performs.

Investment Strategy

The Basies have made some assumptions about capital markets and risk management that could hinder them over the long run. While they are aware of many of the risks a stock portfolio can face—market, sector and company-specific risks—they have overlooked a major risk that will have a significant impact on their investments over time: inflation.

Inflation could be the biggest risk to the spending power of the Basies’ $750,000 annual paycheck for life. To control that risk, we would advise the Basies to rethink their assumptions on stocks versus bonds, as well as the importance of portfolio diversification.

To meet their goals we recommend that they adopt the following investment strategy:

For the IRA portfolio ($3 million) consider:

• A portfolio of diversified U.S. and foreign stocks targeted for capital appreciation rather than income production, using a tactical approach to take advantage of an IRA’s tax-free status ($3 million to start).
• Do not withdraw from an IRA until age 70½, unless there’s an emergency. This gives the $3 million a 15-year period to accumulate tax free. We recommend our tactical growth style, focusing on high-quality mid-cap and large-cap stocks that can grow earnings faster than the market in sectors of the economy that are expanding.

For the taxable portfolio ($19.1 million) consider:

• 30 percent tax-exempt bonds yielding 3.75 percent.
• 40 percent U.S. equities yielding 2.5 percent.
• 20 percent foreign equities yielding 2.5 percent. We recommend our dividend growth–style for both U.S. and foreign equities focusing on high-quality companies that have strong cash flows and rising dividend payments.
• 5 percent REITs yielding 3.8 percent, provided that the Basies understand REITs are equities and are not proxies for the U.S. housing market.
• 5 percent tax exempt cash reserves yielding 3.2 percent.

Note: Yields are approximate current market yields.

This allocation yields cash flow +/– $570,000.

Eileen B. Buckley, portfolio manager; Arlene S. Franklin, JD, LLM (Taxation), CFP; and Timothy F. Lenicheck, JD, CLU, are with Boston Private Bank & Trust Co., an affiliate of Boston Private Wealth Management Group.

The goal of Scenario Planning is to spark discussion on asset management and portfolio realignment with your financial professionals, not to provide advice. Each month, the editors of Worth choose a case study and respondent. Working with a wealth advisor involves an in-depth process that we cannot replicate in this space. No financial advisor can provide comprehensive counsel without a thorough and ongoing dialogue with you about your goals as your life changes, so let this serve as an exercise to open that discourse. This example is for illustrative purposes only, and no reader should attempt to coordinate his or her situation with the given paradigm.