From the October 2002 issue of Investment Advisor • Subscribe!

October 1, 2002

All in the Family

Estate planning is no longer just about avoiding t

Taxes have long been a driving motivation in estate planning. Tax avoidance often seems to override all other concerns, making the guiding goal of estate planning to maximize wealth transfers to family members while incurring as little tax as possible. This tax-driven goal subtly suggests that family assets are more important than family itself. Increasingly, estate planning professionals and consumers alike are beginning to recognize that this is a misplaced emphasis that focuses on structure rather than perspective, putting tax savings over family need. When protecting and preserving assets is the primary, if often unstated, goal, the estate planning emphasis is on structures that preserve the assets from taxes or family misuse. When protecting and preserving the family becomes the ultimate goal, estate planning must deal with difficult family issues that might once have been ignored.

It was Ben Franklin who said that "in this world, nothing can be said to be certain, except death and taxes." Inadvertently, this quote also captures the mistake in many estate plans. The focus is too often on the death of the client and the taxes that death may create. Instead, the focus of estate planning should be on the living, with the goal of creating a lasting positive legacy for future generations.

This new perspective inherently involves some limitations on an inheritance, a perspective captured most succinctly by Warren Buffett in a 1986 Fortune article: The perfect inheritance, Buffet said, provides "enough money so that [heirs] feel they could do anything, but not so much that they could do nothing."

Why the Change?

What's driving this shift? The first reason is the explosion of wealth in this country over the past two decades, even with the market correction of the last two years. Boston College researcher Paul Schervish estimates that between now and the year 2050, between $41 trillion and $136 trillion will be passed on by gifts or inheritance. A recent study by U.S. Trust noted that only 10% of today's millionaires inherited their wealth, and that the average millionaire comes from a middle-class or blue-collar background.

Second, estate taxes have declined. A married couple can transfer up to $2 million tax-free to heirs, a sum that could increase to $4 million by 2006. The 2001 tax bill provides for the elimination of the estate tax in 2010, though its continued elimination is highly unlikely. Even without elimination, significant estate tax exemptions will probably remain, reducing the tax confiscation many parents expected and increasing the concerns those parents may have about passing on too much wealth to their heirs.

The third reason for the shift in priorities is that wealthy people are increasing their involvement in philanthropy. Schervish says that a growing number of wealthy Americans are shifting their financial legacies "from heirs to charity." Schervish has the data to back up that assertion: From 1992 to 1997, the value of charitable bequests went up 110%, while bequests to heirs only grew 57%. For estates above $20 million, charitable bequests went up 246% while the value of bequests to heirs went up only 75%.

The fourth reason is that clients are increasingly examining estate-planning approaches that provide for asset protection. States are adopting statutes that make it easier for clients to use trusts to restrict the claims of creditors. With more than 40% of first marriages ending in divorce, more clients are also reviewing how to protect their heirs from the fallout of divorce.

Finally, two demographic imperatives are pressing governmental social programs. The number of Americans aged 65 and older as a percentage of the total population is expanding rapidly, and people are also living longer. The Social Security Administration estimates that by 2037, the Social Security system will be bankrupt; other observers expect a much earlier demise. Medicare may be insolvent by 2008. Estate planning is beginning to reflect growing concerns about the availability of government benefits for family members.

Contrary to general perception, Social Security benefits are not guaranteed. In Flemming v. Nestor (363 U.S. 603 (1960)), the Supreme Court ruled that Congress retains the ability to reduce or even eliminate benefits at any time. For an excellent review of this issue see Andrew G. Biggs' "Social Security: Is It a Crisis That Doesn't Exist?" (Cato Institute, October 5, 2000. SSP No. 21.)

These demographics are changing how clients are addressing the legacy that an estate plan represents. Clients are looking for solutions that involve more than form-driven, cookie-cutter documents. In fact, one of the more uncomfortable aspects of this approach is that standard forms will no longer be as helpful (see sidebar on page 76). Many documents will have to be client-specific. This may result in both higher fees and a cost-based counterbalance to this growing revolution in estate planning.

A Question of Values

In order to understand why these changes are so important, some basic perspectives need to be understood. Clients and planners often avoid delving into the personalities of heirs, or into their spending habits, or into the stability of their marriages, or into their relationships with other family members, or possible health, drug, or alcohol problems. These issues have not usually been perceived to be within the purview of the planner's responsibility. Unpleasant experiences are changing this perspective.

Furthermore, one of the basic laws of science is that for every action there is an equal reaction. This holds true for an inheritance: It will inherently change behavior. The central question that must be addressed is how to encourage positive change. It is simplistic and potentially damaging to ignore the impact of an inheritance.

In addition, inherent in this new perspective is that values count. Including phrases such as "drafting to influence behavior" or even "values-based planning" in estate documents is a recognition that values lie at the core of this new perspective. Unfortunately, this also provides critics with an easy target. While values lie at the heart of this type of estate planning, the goal of the client should not be to preserve his or her values, but to preserve the family; the two goals are not identical. For example, a plan that seeks to demand adherence to today's societal values 100 years from now will be felt as punitive and probably prove destructive to the family.

Influencing the behavior of heirs has always been a part of the estate planning process. For example, placing marital assets in a QTIP trust will by its very nature influence the behavior of both a surviving spouse and the remainder beneficiaries of the trust. Placing assets in a trust for children to delay their ownership of the funds beyond age 21 will influence the life decisions of the children.

Values-based planning is not a single planning device or tool. Instead, it devises a plan designed to protect and preserve the family as the first priority. The tax structure is then built around the family's intentions. The two ideas are not in conflict. Rather, the priority of asset preservation must come second to protecting the family. The planning process should not begin at death. Having someone mentor an heir in financial responsibility should begin in the early years of the heir's development.

Who Are We?

At its core, the estate planning process deals with a major psychological issue: How do we define ourselves as people? This is not a new problem. As King Solomon said thousands of years ago: "Whoever loves money never has money enough; whoever loves wealth is never satisfied with his income. This too is meaningless. As goods increase, so do those who consume them. And what benefit are they to the owner, except to feast his eyes on them?" (Ecclesiastes 5:10-11).

An approach to estate planning that is clearly designed to influence the behavior of heirs should be structured to create opportunities and incentives, not provide an unearned lavish lifestyle to future generations. As with any plan, such an approach will create its own problems. A detailed "risk-reward" evaluation should be made of each proposed opportunity or incentive to determine if the potential new problems outweigh the expected benefits.

An attempt to influence behavior should encourage responsible behavior rather than punish unacceptable behavior. For example, a provision that denies all trust benefits to an alcoholic or drug-addicted heir may be too punitive. Instead, the denial might be predicated upon the heir refusing treatment (at the trust's cost) for his or her addiction.

The behavior that is being influenced necessitates careful drafting. For example, if the desired goal is to encourage people to attend college, drafting a trust that provides "$20,000 a year to my daughter as long as she is in college" may not be sufficient. The $20,000 might be used to pay for a wild lifestyle. Moreover, at age 45 she might be working on her eighth Ph.D.

Drafting to influence behavior must account for the fact that behaviors that are currently acceptable or unacceptable may change over time. For example, some day it may become common to have a computer chip inserted into the brain as a part of the standard educational process. If the plan only provides for college education and does not allow for potential changes in the higher education structure, this technological change might never be funded. Of course, that assumes you would not object to computer chips in the brains of your heirs.

The approach must be drafted with a view toward protecting both the heirs and the decision-makers. The United States Constitution has survived as a living document because of the checks and balances built into it. So, too, any planning that restricts an inheritance must include checks and balances to avoid abuses.

The approach must allow some degree of subjective discretion in the judgment of decision-makers, so that other factors that were not anticipated can be accounted for in the process. It is simply impossible to contemplate and draft for every possibility.

The approach must involve an accurate assessment of the heirs as they are and as they may become in the future.

Furthermore, the document should be only one part of the larger estate plan. For example, providing enough assets to heirs to provide for life opportunities, coupled with assets placed in more restrictive vehicles (e.g., family partnerships) may be the best approach. Placing all assets in restrictive trusts may just create more family conflicts.

The Limitations of Restrictions

One of the most frequent criticisms of restricted inheritances or drafting to influence behavior is that they constitute a blatant attempt to rule from the grave, by mandating that the current generation's value systems govern the behavior of future generations. This critique is fundamentally philosophical and takes many forms. As a starting point remember the earlier Warren Buffett quote. Mr. Buffett's stated goal is not to rule his heirs' lives from the grave, but to aid them in doing what they want to do in their lives. The key is that they do something.

Critics of this approach might argue that "The parents did a bad job, now they want to do from the grave what they couldn't do during life." There is some truth in this statement. Many of today's millionaires wonder whether they spoiled their children and are concerned that their wealth will create an even greater negative legacy. However, the partial truth of the criticism only supports the need for restricted inheritances. Having spoiled their children, do they just throw in the towel, with the expectation that the combination of poor parenting skills and the passage of wealth will only magnify the personality defects in their children? A restricted inheritance may not work with the first generation, but perhaps succeeding generations will benefit.

What about the criticism that "Parents are paying their heirs to do what they think is important"? Paying an heir to do something they do not want to do is courting disaster. Instead, restricted inheritances may be designed to provide incentives that provide enough money to encourage people to make positive decisions. For example, providing $5,000 annually to a college student with a B average is not enough to "pay" him to go to school, but it may provide some encouragement.

A third criticism raises the "specter of a bony hand reaching out of the grave." While this is undoubtedly a great visual image, it is also a distorted one. Restricted inheritances should not be structured as a mechanism for a control freak to micro-manage the lives of his family from the grave. It is, rather, a way for a caring parent to provide opportunities and incentives to a family, while trying to avoid the harmful aspects of wealth.

Another criticism claims it is wrong to try and use the client's values to influence the behavior of future generations. Virtually everything done in the estate planning process influences behavior. It is naive to think that an inheritance has a neutral impact. This criticism carries with it the perspective that one person cannot and should not impose his value systems on another. But the criticism ignores the simple fact that one of the primary parental responsibilities is to mold the character of children. That responsibility does not cease just because someone reaches age 18 or 21. Many restricted inheritances are flexible enough to provide benefits to children whose character is already well developed (children in their 30s) by providing current income to children and incentive-based programs for grandchildren whose character is yet to be defined.

A fifth criticism asks the wealthy to simply trust their children. What critics fail to recognize is that the impact of this perceived lack of trust may be less significant than the impact of an unfettered inheritance. Moreover, in most cases it is not a lack of trust but concerns about the reality of unearned wealth that motivates the parent. The children may resent not being able to spend Mom's wealth, but restricted inheritances may also require them to develop the ambition to make it themselves.

There are some, too, who argue that "it's the kids' money, so they should be able to do what they want with it." But it is not the kids' money; it's the parents' money.

Wealth is a powerful tool, but as with anything powerful, its unrestricted power can be devastating. In many cases, a beneficiary's personality foibles and defects are magnified as an unintended result of an inheritance. If a client knows that a given item stands a good chance of harming the family, is the client more or less responsible by placing limitations on the source of the harm? What is the worst that may happen to their families? They might have to make it on their own, not such a bad thing after all.

Wrapping Up

As a result of the changing landscape, clients are examining their estate plans in an entirely different light. The wealthy client often has four goals for his plan:

First, the client wants to protect his family from ever being destitute.

Second, the client wants to provide opportunities and incentives to his family, hoping that his descendants will take those opportunities and mature into productive citizens because of their own ambition.

Third, the client does not want to provide a non-working lifestyle to his heirs. As the industrialist and philanthropist Andrew Carnegie said: "The parent who leaves his son enormous wealth generally deadens the talents and energies of the son and tempts him to lead a less useful and less worthy life than he otherwise would."

Finally, the client wants to minimize intra-family conflicts. Family is more important than an inheritance and these clients want to build structures that take into account real or potential conflicts.

Estate planners will have to increasingly address all these issues in the coming years. Next month, in part two of our series, we will discuss some of the specific planning techniques to achieve these new goals.

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