Being a millionaire isn’t what it used to be. A once-mythic club with few members, about one in 50 Americans is now worth seven figures. In fact, there are so many millionaires in the U.S. that the slightly derogatory term “mass affluent” has been attached to them. Moreover, many of these folks are too ensconced in debt to be good candidates for asset management.
Indeed, the real target for wealth managers is the “ultra-affluent”–those with a liquid net worth north of $5 million. This segment is growing even faster than their mass-affluent counterparts. In fact, the number of households worth $5 million or more is expected to grow at least 8% per year for the next decade, even if the current recession keeps chugging along.
There are currently about 500,000 penta-millionaires in the U.S., and they should be on the radar screen of every enterprising investment advisor. After all, advisors who concentrate on the ultra-affluent have some of the highest profit margins in the industry. Further, the super-wealthy aren’t any more fee-sensitive than less affluent clientele, and they are often willing to give referrals.
The client pictured at left, Mike Rose, embodies many of the time-honored characteristics of the affluent. He has ample assets and a lifestyle that reflects his years of accomplishment. Along with the attributes one would expect from such a super-successful client, he also has a few characteristics that may be a bit of a surprise, including an aversion to traditional asset classes. According to Rose, “Equities are a much riskier investment now than at any time I’ve followed them.” Building a portfolio around an opinion like that is not an easy task.
In fact, when it comes to developing a practice for the super-wealthy, few things are easy. Ultra-affluent investors place investment performance much higher on their list of priorities than other folks, which requires advisors to spend more time on portfolio construction and security selection. The wealthy also demand customized solutions to their financial objectives; off-the-shelf products just don’t scratch their itch. They also expect “cross-platform” advice on such diverse subjects as estate planning, taxation, and trust formation, which requires a level of expertise that demands a lot from advisors. The emphasis on planning is the driving force behind the movement of ultra-wealthy assets from brokerage firms to advisors, according to a recent study performed by the Spectrem Group, a Chicago-based research firm.
It’s no wonder, then, that in the world of ultra-affluent advisory work, many are called yet few are chosen. Although building a stable of penta-millionaire clients is a difficult task, this growing niche offers tremendous opportunity for those willing to invest the time and effort necessary for success.
The difference between the ultra-affluent investors and their mass-affluent counterparts hardly stops at size. Higher-net-worth individuals, for example, tend to be more conservative, and hold more of their portfolios in fixed-income securities and hedge funds than do other investors. The ultra-affluent also tend to have more grounded expectations for asset class returns. As a result, they seem more willing to commit to an expensive, actively managed product with a great investment team than an inexpensive index fund.
The ultra-affluent also tend to be a relatively hands-on group, usually spending more time consulting with their financial advisors, meeting with accountants, and generally managing their wealth than others do. But this is not necessarily because they have more money than most folks. As Thomas Stanley pointed out in his book The Millionaire Next Door, it’s the other way around; the wealthy wind up with more money because they plan more.
According to most ultra-affluent investors, the bottom line in creating wealth is not simply about making more when times are good. It also entails protecting assets when times get tough.
Take our client Mike Rose, for example, who rose in prominence as the chairman and CEO of Holiday Inn Corporation, the best-performing large-cap growth stock in the 1980s. In the late 1980s, the company experienced two significant liquidity events. “According to the financial planners I talked to at the time, the game was all about creating long-term capital gains, which meant long-term investments in equities,” Rose says now. “The difference in taxation between long-term and short-term gains was so significant that the idea seemed to have some merit. But after the late ’90s bear market, it became obvious that I took a lot of risk and gave up a lot of wealth in an effort to structure my holdings in the most tax efficient manner.” The lesson Rose learned–that taxes can’t be the tail that wags the investment dog–”convinced me that going for a more certain but smaller return was the best way to manage my portfolio.”
His solution, like many other ultra-high-net-worth investors, revolved around hedge funds. “I was fortunate in that my first significant investment in alternatives was successful, which encouraged me to continue along that path,” Rose says. “In my mind, hedge funds do a great job of managing risk while allowing for most of the upside of an unhedged equity investment.”
At first glance, the keep-what-one-has mentality of the wealthy may not seem much different than other investors. But the way many of them seek to achieve these goals lies in stark contrast to the traditional asset allocation methodologies that have ruled the investment industry for decades.
If this seems a bit revolutionary, it is. But one must consider that even the most conservative and hidebound investors are now rethinking previous assumptions. Consider, for instance, defined benefit pension plans. While most clients’ investing horizons are decades away, pension plans not only have to invest for the future, but must also be liquid enough to meet the needs of current retirees. How have pension funds changed their investing strategies? According to many industry experts, neither objective can be met with a mix of traditional assets.
Recipe for Disaster?
Defined benefit (DB) plans, which are utilized by the bulk of companies in the S&P 500 index, are a type of plan in which a retired employee receives a specific amount based on salary and years of service, and in which the employer bears the investment risk. The objective of plan administrators is to invest contributions in such a way that the plan’s future liabilities can be met with future assets.
In 1980, Fischer Black, the developer of the Black-Scholes option pricing model, wrote what many consider to be the definitive study on pension fund management. In his view, shifting from equities to bonds in a DB plan makes benefits more secure, even though stocks may be expected to have a higher return. Having the assets in stock will reduce the expected contributions by the firm, but can only make the pension beneficiaries less secure, since it reduces the present value of any defined set of benefits. Just as an increase in the risk of a firm’s assets that doesn’t change the firm’s value will make the bondholders less secure, so an increase in the risk of the pension fund assets that doesn’t change the fund’s value will make the beneficiaries less secure. And since investing pension fund assets in bonds makes the beneficiaries more secure than investing in stocks, it should make the trustees more secure as well.
Fixed-income securities also do a pretty good job of matching the liability stream faced by DB plans. But nearly all plans have to deal with liability “noise,” which mostly comes from such hard-to-predict variables as salary increases. The only way to adjust for those hard-to-predict expenses is to add an equity component to the mix. And as the equity markets continued climbing with hardly a pause in the late 1990s, pension administrators began slowly ratcheting up their stock exposure.
It is easy to see why equities were so tempting during the last bull market. As valuations increased, pensions became overfunded, which resulted in a decrease in required pension contributions from corporations, which in turn helped the company’s stock prices rise. Eventually, the bear market that began in 1999 ended this virtuous cycle. Plagued by years of stock market losses and historically low interest rates, U.S. pension plans are now facing a funding crisis. In just the last three years, the defined benefit plans of the companies in the S&P 500 index went from 30% overfunded to 20% underfunded.