Approximately 77 percent of retirees now prefer to give money to loved ones throughout their retirement rather than leave inheritances in estates after they pass away according to a recent study.[i]
This post will explore the potential benefits and risks of gifting inheritances early, and help you determine if this could be the right strategy for you.
What are Some Benefits of Gifting Inheritances Early?
- Avoiding inheritance and death taxes. When it comes to estate planning, the tax code can be complicated. Currently, twenty-one states and the District of Columbia have a death tax, inheritance tax, or both.[ii] These taxes can greatly reduce any remaining assets loved ones inherit. The IRS currently allows gifts of up to $14,000 per person each year[iii] that are not taxable for either party. Because of these taxes and the ability to annually distribute monetary gifts, many are looking to distribute their wealth to loved ones early rather than leave inheritances in wills.
- Providing financial assistance when loved ones need it. Gifting to loved ones now allows you to help them when they need the money the most, as opposed to waiting until after a death. This often includes assisting with the purchase a new home, unexpected medical expenses or paying off school loans. The flexibility to assist loved ones financially often makes sense for some when compared to willing assets at a later date.
What are Some Risks of Gifting Inheritances Early?
- Ensuring enough money is left for retirement and unexpected expenses. People are living longer; thus, retirement savings are being stretched further. It is important to determine your retirement lifestyle goals and financial needs first, and then look at remaining resources for loved ones. You don’t want to put yourself in a situation where you are not able to cover your living expenses or unexpected medical costs because you gifted loved ones too much, too soon.
- Not gifting all loved ones equally. Some people may feel pressure regarding how to gift inheritances early rather than leave gifts in their wills, especially if gifted amounts vary. Distributing gifts of varying amounts to family members and loved ones has the potential to create unintended consequences and strain relationships. It will be important to consider your loved ones’ financial needs, and determine when monies will best benefit them.
Next Steps to Consider
Now that we’ve explored some of the benefits and risks to gifting inheritances early, here are some next steps to help in your decision making:
- Consult with an estate planner and tax expert before you determine if the benefits outweigh the risks for you. Relying on experts can help you explore other gifting options that still reap tax benefits, including trusts.
- Work with your RGT wealth advisor to determine how much you can afford to give loved ones now and how much you should allocate into your estate planning.
[i] “Giving in Retirement: America’s Longevity Bonus.” Merrill Lynch and Age Wave. 2016. https://mlaem.fs.ml.com/content/dam/ML/Articles/pdf/ML_AgeWave_Giving_in_Retirement_Report.pdf.
[ii] Drenkard, Scott. “Does Your State Have an Estate or Inheritance Tax?” Tax Foundation. May 2015. https://taxfoundation.org/does-your-state-have-estate-or-inheritance-tax/.
[iii] “Frequently Asked Questions on Gift Taxes.” Internal Revenue Service. https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes.
“The beat goes on, the beat goes on.” The Beat Goes On, Sonny and Cher
In March of this year we marked the 8-year anniversary of the market nadir caused by the financial crisis of 2008. To kick off the beginning of the ninth year of this bull market, stock and bond markets continued their march upward. Global equity markets, as measured by the MSCI ACWI Index, were up 4.25% in the second quarter and are up a robust 11.32% for the year. As was the case in the first quarter, large-cap stocks outperformed small-cap stocks, growth stocks outperformed value stocks, and international stocks outperformed U.S. stocks. The best performing asset class for both the quarter and the year has been emerging markets. The MSCI EM Index rose 6.27% in the second quarter and is up 18.43% for the year. Energy and commodity-related investments struggled in the second quarter. Falling commodity prices drove the Bloomberg Commodity Index down 3.00% in the second quarter and down 5.26% for the year.
U.S. bond markets ended the quarter broadly positive. Intermediate-term municipal bonds were up 1.25% in the quarter and are up 3.17% year-to-date. This is surprisingly strong six-month performance given the current interest rate environment. Much of the strong performance in municipal bonds can be attributed to a continued lack of supply of new municipal bond issuance. Despite this lack of supply, demand for municipal bonds continues to be robust. This dynamic of increasing demand and decreasing supply has provided strong price support to the municipal bond market and has helped to drive returns thus far in 2017.
As noted above, we are entering the ninth year of this bull market. And, as the song says, the beat goes on. Stocks are up, interest rates are low, economic growth is tepid but positive, and inflation remains muted. The beat goes on. This bull market is now 99 months old, not quite as long as the bull market of the 1990’s which lasted 113 months. How this ends is anyone’s guess, but this bull market does seem to be a bit long in the tooth. And like the great bull market of the 1990’s, technology stocks are leading the way. But unlike the many internet and technology companies of the 1990’s that are now long forgotten, these transformative technology companies that have been a primary driver of the most recent phase of this bull market have become so ubiquitous in our everyday lives as to become almost unnoticed. Should one be tempted to Google (up 217% the last 5 years) this month’s quote, they could do so on an Apple (up 66% the last 5 years) iPhone, watch the video on YouTube (owned by Google), and post the video on Facebook (up 383% the last 5 years). You may even be inspired to purchase the music on Amazon (up 180% the last 5 years) or watch the Sonny and Cher Hour on Netflix (up 1,351% the last 5 years). Yes, this bull market will eventually end, but how and when are not known. In the meantime, being thoughtful about asset allocation and prudent about saving and spending, as boring as it may be, remain the surest path to financial independence.
What are factors?
Over the last several years, investors have been inundated with attempts to re-brand factor investing – “smart beta,” “strategic beta,” “engineered equity,” “beta plus,” etc. While the list of marketing-driven buzzwords continues to expand, they are all largely synonymous with factor investing. They each refer to investment strategies focused on systematically gaining exposure to stocks (or bonds, currencies, commodities, etc.) with one or more characteristics that have been empirically shown to drive positive active returns – that is, returns over and above the cap-weighted market index.
The first, and most well-known factor discussed in academic literature is the market factor, which is generally defined as the excess return of the market over the risk-free rate. By increasing exposure to the market factor relative to Treasury bills, (i.e. taking additional, undiversifiable market risk), an investor is compensated with a higher expected return over an extended time horizon. Investors accept the risk of underperforming in the short run for the expectation of outperforming over the long run.
Unfortunately, in practice, exposure to the market factor alone does not fully explain the differences in returns between portfolios. To better understand what characteristics drive performance differentials between portfolios, academics began searching for and finding “pricing anomalies,” otherwise known as factors.
In addition to the market factor, the primary equity factors we focus on are:
- Size – small companies have tended to outperform large companies;
- Value – cheaper companies (in terms of a high book value or earnings relative to market value) have tended to outperform expensive companies;
- Momentum – companies that have recently performed well have tended to outperform companies that have recently performed poorly; and
- Quality – companies with high profit margins and strong balance sheets have tended to outperform companies with lower profits and weaker balance sheets.
Why do these factors add value? If they are widely known, why should we expect them to continue to add value?
The answer to these questions can typically be described as either “risk-based” or “behavioral” in nature. Risk-based explanations assert that factors have rewarded investors with excess returns because stocks that exhibit these characteristics are inherently riskier. Therefore, investors require a risk premium in return for owning them. For example, small companies tend to have smaller capital bases, higher leverage, increased default risk, etc. Value companies, on average, tend to be more exposed to the business cycle, carry more fixed assets, be more highly levered and tend to have a higher risk of distress than growth companies. Given these increased risks, it makes sense that investors would demand, on average, a risk premium (higher expected return) to invest in smaller companies over larger companies or value stocks over growth stocks.
Behavioral explanations assert that factor risk premiums do not exist solely due to increased risk, but rather due to a combination of risk factors and investor biases that hinder the market from correctly pricing these anomalies. For example, the momentum effect is typically supported by behavioral explanations. One version, put forth by Toby Moskowitz, asserts that information travels slowly into prices1. He argues that prices do not immediately adjust to news but tend to drift upwards (or downwards) as the market processes the good (or bad) news – this is underreaction. Somewhat counterintuitively, Moskowitz also finds that overreaction also plays a part as investors chase the newly created trend and can push prices farther from equilibrium, introducing a short to intermediate term momentum effect. Quality is also likely a behavioral anomaly; after all, who would rationally require high quality stocks to generate a risk premium over low quality stocks? Research by Ryan Liu suggests it is related to investor expectations2. Investors are willing to make contrarian bets on low quality companies at the expense of high quality companies. This behavior has the effect of increasing the prices (and therefore driving down expected returns) of low quality firms at the expense of high quality firms, while also increasing expected returns of high quality companies.
All five factors mentioned have risk-based or behavioral explanations that support each factor’s existence, and often more than one of each. What is important to know and remember is that no one can be certain which, if any, hypothesis is correct about why a certain factor works or has worked. We cannot prove why a factor works, but by utilizing a rigorous and analytical framework we may be able to assess whether a factor is real and whether it can be expected to continue to exist in the future.
Researchers and practitioners Larry Swedroe and Andrew Berkin propose such a framework below, requiring that any factor pass the following five-part test3. They stipulate that for an anomaly to be considered a true factor and not just noise, it must be:
- Persistent – it must generate excess returns over long periods of time and across market regimes
- Pervasive – it must be present across different asset classes and geographies
- Robust – it must continue to “work” despite tweaking the definition of the factor
- Investable – the excess returns must be large enough to still add value after frictions such as trading costs are accounted for
- Intuitive – it must have a logical underpinning (risk-based or behavioral) that supports a risk premium being associated with it and that also supports its efficacy in the future
So, is Factor Investing Easy?
Unfortunately, no. Even the factors with the strongest historical returns have the potential to significantly trail the market over long stretches – think Value stocks during the tech boom in the late 1990’s. Even more recently, Value stocks were trounced by the broad market in 2015 and early 2016. Experiencing a massive drawdown or trailing an index by double digits is painful – but potential for such short-term pain is also why factors tend to add value over long time horizons. If something works all the time, there would be no risk premium associated with it. Thus, patience is a prerequisite for harvesting a factor’s excess returns. It is also why diversifying across factors is an important component of a sensible factor strategy. Value and Momentum, for example, have historically displayed a low correlation to each other. When Value tends to be out of favor, Momentum tends to be in favor and can offset losses in the Value portfolio, and vice versa. Similarly, Quality can augment Value and Size, helping to screen out the lowest quality companies most likely to be “value traps.” By diversifying across factors, we can dampen the volatility of the portfolio while reducing the risk of any one factor having an outsized impact on the portfolio.
Factor investing is no free lunch. It requires conviction, patience, discipline, the willingness to be out of step with the broad market, and a long-time horizon. Note that these are many of the same characteristics required to be successful in virtually every other area of investing, as well.
- Factors are characteristics of stocks or stock portfolios that have been shown to drive positive excess returns over time
- Factor investing seeks to harvest excess returns by owning stocks that display these characteristics and by avoiding stocks that display the opposite characteristics
- Factor risk premiums exist due to some combination of increased risk, behavioral biases, or structural inefficiencies in the market
- We can avoid mistaking randomness for a factor that deserves a risk premium by making sure the factors we utilize are persistent, pervasive, robust, investable, and intuitive
- Factor investing is hard; it does not work all the time and individual factors can sometimes trail the broad market significantly. It requires conviction and patience.
- Factor diversification can reduce volatility but not eliminate it.
- Moskowitz, Tobias J., “Explanations for the Momentum Premium,” AQR Capital Management White Paper, 2010
- Liu, Ryan, “Profitability Premium: Risk or Mispricing?” November 2015. https://pdfs.semanticscholar.org/94f3/bb0d05a8fe349d3ca378bbe52e1f9ac72831.pdf
- Berkin, Andrew L. and Larry E. Swedroe. Your Complete Guide to Factor-Based Investing. Saint Louis: BAM Alliance Press, 2016. Print.
Wealth management firm makes list for third year
DALLAS – The Dallas-based financial planning and investment advisory firm, RGT Wealth Advisors (“RGT”), has been named to the Dallas Business Journal’s Best Places to Work list for the third consecutive year.
“Our primary focus is to be champions of our clients’ financial goals and futures, and that all starts internally with our employees and our culture,” said RGT Managing Director Mark Griege. “We work hard to ensure that we are advocates for our employees, and are very pleased to see that they and others in the community recognize that.”
RGT was one of the companies selected from among more than 500 North Texas businesses by a third-party research firm that reviewed applications. Finalists were chosen based on employee survey feedback. RGT was ranked in the medium category for organizations with 50-249 employees.
The firm was recently recognized among the top 10 registered investment advisory firms in the nation by Financial Planning Magazine and has repeatedly been ranked among the top wealth managers in Dallas by D Magazine.
Founded in 1985, RGT is an independent, fee-only firm that provides wealth advisory services, portfolio management and family offices services. Clients partner with RGT to manage their financial life and keep them on track to achieve their goals. To learn more about RGT Wealth Advisors and the firm’s approach, please visit their website at: http://rgtadvisors.com/.