Estate Planning Basics for CFA L3
In the CFA Level 3 curriculum estate planning is intertwined with tax issues, retirement issues and longevity risk, and the material around diversifying concentrated positions. It also includes coverage of international taxes and tax jurisdiction which are occassionally tested.
From a testing perspective, estate planning is definitely smaller in terms of weighting than, of course, IPS questions. But it did come up in the 2011, 2013, and 2015 morning section on the CFA Level 3 exam.
So, you can expect or at least shouldn't be surprised if it does show up.
Estate Planning - Process and Definitions
In terms of definitions, an estate is all the property a person owns or controls. This includes things like financial assets, tangible personal assets (like art), property, IP, etc.
Estate planning is the process of determining how and where your wealth should go. That of course is valuable in and of itself, but the other advantage of a formal estate planning process is that you can design it to avoid expensive, often public legal processes called probate.
A will, or a testament, is the document which guides the asset transfer process from a testator to an inheritor. An estate that doesn't have a will is going to go into this process called probate. Probate, which is overseen by the judicial system, is both public and often expensive. .One of the core testable ideas with establishing a trust and specifying where your assets should go centers around the idea of avoiding probate.
Community Property and Forced Heirship Rules
When it comes to what you do with your money it should come as no surprise that the government is bound to get involved.
So, let's talk about the interaction between estate planning and your desires to leave an estate to your descendants with the laws and frameworks that can place restrictions on your ability to decide everything.
There are two main testable concepts here for L3 that relate to forced heirship rules and community property regimes.
Forced heirship rules mandate that children and/or often spouses are entitled to some minimum percentage of an estate irrespective of the wishes of the owner of the estate.
So, let's say the forced heirship rule says that an estate must leave 25% of its assets to each child and there's two children. In this case they are each entitled to 25%, but the will specifies that they're only going to get one million each out of a 10 million portfolio. Obviously, there's a conflict between what the will mandates and what the government rules impose, and when calculating how much the children will get on the exam you will need to go with the higher amount.
The second government rule that can apply is referred to as community property regimes. A community property regime essentially mandates that a spouse is entitled to half of the portion of the estate that (and this is key) was built up during the marriage.
When these calculation questions come up on the CFA Level 3 exam it's often the case that both forced heirship and community property regimes might be in effect.
In this case you have to figure out whether one of the rules applies and then perform the calculation for how much someone will inhert.
So, if I come into a marriage with two million in assets, that $2 million is not subject to community property regimes. But if I then accumulate another eight million, my spouse is going to be entitled to "only" four million, not five million.
One last thing to be aware of here is the possibility of clawback provisions in which the state may require an accounting if any distributions violate some of these statutory provisions.
Do I give a gift or leave a bequest?
Okay. So, shifting gears, we also have in estate planning a core goal of tax minimization.
There are a LOT of strategies for doing this.
Relative to the CFA Level 3 exam, however, the primary scenario you will have to consider is whether it is cheaper to give money to people while you are alive or whether it is cheapter to leave them a bequest in your will. So, can I gift money or should I wait till I die and give it to them in a bequest?
Because bequests often have an array of taxes that are levied against the estate gifts can be quite advantageous. This is doubly true because the person receiving the gift is often less wealthy and thus pays lower income taxes. In fact, because gifts are so powerful many jurisdictions actually cap the annual and/or lifetime amount of gifts.
At some point, gifts may also be taxed, even at the same tax rate as a bequest (gift tax rate = estate tax rate). That doesn't mean gifts are worse. On the contrary they may still be advantegous provided the inheritor has a lower tax rate. The methodology here is simple: even though the gift might be taxed at the same amount when you give it, if the person receives it has a lower tax rate then the money can grow at a lower tax rate over time.
This is a vital concept so one more time: gifts can still be more tax-efficient than bequests even if they are taxed at the same rate depending on if the recipient has a lower tax rate moving forward.
Note that in the curriculum there are 3 relatively in-the-weeds equations for calculating the relative value of a gift vs. bequest. The above concepts should earn you most of the points on the Level 3 exam if this is tested.
Generation Skipping and Valuation Discounts - tax minimization strategies for Estate Planning
There are a couple of other strategies for minimizing estate taxes that are incredibly important for the CFA Level 3 exam.
The first is generation skipping.
The idea here is that if I am very rich and I have kids and my kids are also quite wealthy, then they don't really need my money. So rather than giving the assets to my kids, I can give them straight to my grandchildren. The reason I would do that is that it skips a layer of estate taxes when my kids die and then leave it to their children in turn. Generation skipping is essentially avoiding double taxation provided, of course, that your immediate children don't need the money.
And so the thing that I think would be tested if this came up was that generation skipping increases the value of the estate by a factor of one divided by one minus "t" where "t" is the estate tax rate. So, that's the key to remember here, one over one minus "t".
Another tax strategy is spousal exemptions. If you die and leave your assets to your spouse, many jurisdictions allow those estates to be transferred tax-free or at least greatly reduced tax rates. So this is a straightforward strategy.
The third testable strategy involves valuation discounts. The idea here is that if you own a privately held business that business is generally worth more to you than to an outside third party. We're not talking about endowment bias here but legitimate reasons you value this business more/it is worth more to you as the owner.
The first reason is that because small privately owned businesses are hard to sell they usually have a liquidity discount built in. The second reason is around control. If you sell a piece of your business to an outsider, that outside shareholder wouldn't have much say in the direction of the business, so they will generally require a a non-control discount that's built into the valuation (and a lower valuation lowers the taxable value).
Finally, charitable gifts is another way of reducing the value of your estate. In this case you're not necessarily passing your assets to your inheritors but you are deciding what to do with your money with the added benefit that charitable gifts are tax-free and are not taxed on capital gains.
Core Capital Needs and Longevity Risk
Okay. So, we've covered, I think, community or government laws around estates, then sort of the idea of taxes and tax-efficient strategies. The other thing that we should touch on is this notion of core capital versus excess capital.
The idea is that you should treat your assets as a balance sheet and you really need to make sure that you have enough capital to live your life and you don't run out of money before you die. Core capital is the amount of assets that is needed to meet any of your liabilities that you have for the remainder of your life plus a safety reserve for unexpected needs. Excess capital is anything that's left over which is essentially what we like to call discretionary wealth.
So, you can think of one's financial assets in this sort of portfolio context using the age-old accounting equation. Assets equals liabilities plus equity but you also want to think about how these financial assets tie into your human capital, which you can do by thinking about net employment capital or the present value of any of your future income streams. For now anyway, I think just helpful to know, assets is the sum of any of your financial assets plus your lifetime earnings potential discounted to today. Liabilities is the present value that's important as well, it's all present value of current and future cost that is necessary to sustain a given lifestyle. And then excess capital is your leftover.
If the Level 3 exam asks you to calculate core capital needs you not only consider assets and liabilities, but you also have to bring in this notion of probability of surviving over a given time period. If you're dead your spending needs drop to zero. How do we calculate your odds of survival? This is where mortality tables come into play. And so you have this equation where the probability of joint survival of a husband and wife or a couple is given by this equation. So it's the probability of the husband surviving plus the probability of the wife surviving minus the joint probability.
And so you would be taking the probabilities in this equation from mortality table (and you should really be sure to familiarize yourself with how to read a table like this one), and calculate the probability of either the husband or a wife surviving. Then you can back into the present value of their spending needs or their core capital needs as a function of both how much money they need AND also how likely they are to be around to actually spend it.
So, it's the sum of the probability of one of them surviving in each year times their total spending need for that year, and then you take that and discount it all the way back to the present.
Core Capital Calculations - Nuances for the CFA L3 Exam
If you do see this problem on the exam, it might have sort of a word or table that also shows you safety reserves that you need to take into account. Just add this safety reserve to the core capital to get the final value. And that safety reserve is essentially an additional capital cushion which buffers against any market uncertainty, any model uncertainty, any period of unusually bad returns, living longer than you think you might, and so just mitigating model risk and market risk as well and adding some flexibility. And then you see this spending rate that's often determined using Monte Carlo simulation, so just sort of the helpful tidbit to know.
The last, vital, section of estate planning centers on irrevocable and recovable trusts which we cover in this blog post.