Cover Story: Planning for a multigenerational wealth transfer

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on January 8, 2018 – January 14, 2018.

Issues surrounding inheritance have been at the heart of an increasing number of family feuds in recent years. Industry experts say these incidents, coupled with the increasingly global and complex nature of wealth, have spurred the demand for multigenerational wealth planning and transfer solutions.

Today, ultra-high-net-worth (UHNW) and high-net-worth (HNW) individuals in the region are more open to discussing details of their wealth. This is a vast difference from how the previous generation used to approach this matter, says Carolyn Leng, head of CIMB Private Banking.

“We are seeing a trend in Malaysia where the patriarchs are more willing to sit down and acknowledge the fact that they need to plan. I think that’s a huge step forward compared with maybe six or seven years ago, when they would consider such matters a taboo subject,” she says.

The increase in importance of wealth planning is in tandem with the rise in HNW individuals’ wealth in this part of the world. The largest HNW individual market is in the Asia-Pacific, according to the World Wealth Report 2017 by Capgemini. There are also massive intergenerational wealth transfers occurring in the world as baby boomers prepare to hand over their assets to their heirs.

According to the UBS/PwC Billionaires Report 2017, more than a third of billionaires’ wealth belongs to those above 70 years old, and the greatest wealth transfer in the next two decades will be in Europe and the US. In Asia, 80% of the billionaires are under 70. Various reports have highlighted the emergence of family offices in Asia to meet the demand of the new billionaires.

To ensure that the wealth can be transferred to multiple generations, the planning strategies will have to take into consideration several challenges. For instance, the changing nature of assets will require more expertise to manage them. Otherwise, the next generation may be saddled with taxes and financial burdens instead of wealth.

“You’re not talking about assets only in Malaysia. For example, there may be assets in the US, Japan, China, the EU or other countries with higher taxes or regulatory hurdles. You need a structure that is tax-efficient globally and at the same time, legally compliant and easy to manage,” says Mahesh Kumar, partner of Withersworldwide in Singapore, a law firm that advises the global rich.

In the past, Leng says, UHNW and HNW individuals used to rely on wills as a cheaper option to manage and transfer their wealth. But a will is not able to address everything, especially if it is a company that is being passed on.

“For example, each company has its own debt and that may not be captured properly in the will. So, if you inherit a company, you also inherit the debt. You suddenly enter a situation where you inherit a debt you didn’t incur, but you might not necessarily have the assets for it. A will doesn’t address that issue, so that’s why it’s important to have that conversation [to plan] on what you want to bequeath to your next generation and what is the legacy you want to hand over,” she says.

“Wills can also run into the problem of executors who are not prepared to undertake the role. We often see many choosing their spouses or friends to be their executors of their wills. However, they may not be in a state of mind to deal with the onerous responsibility, demanding duties and complex procedures involved if they are still in grief.”

Another aspect of wealth management that has to be addressed now is in educating the younger generations to preserve and grow the wealth, say industry experts. This is particularly important as different generations may have different preferences in investing and managing wealth. Instead of investing more in real estate assets like their grandparents, they are opting for more risky investments or establishing their own start-ups in new industries.

Derick Tan, CEO of Harveston Financial Advisory Sdn Bhd and Harveston Wealth Management Sdn Bhd, says the baby boomers and generation X mainly focused on accumulating and expanding the wealth, but the millennials may not understand the values and struggles that came with building the wealth. They either seek more instant gratification with the wealth they receive or take more risks in investments.

“Millennials will look for more innovative things. For example, they may be more active in equity markets, position their business for eventual listing or acquire more companies. They are no longer like the previous generations who did a lot of preservation and whose strategy was conservative to not lose money,” he says.

Evelyn Yeo, head of wealth management OCBC Bank (Malaysia) Bhd, says any strategy put together must ensure that the person’s dependents have the ability to manage the wealth. This can be done by imparting knowledge, experience and opportunity.

“There are still gaps in the understanding of wealth transfer plans. Capital growth objectives get mixed with legacy planning objectives, ultimately leading to a failure to achieve either objective successfully. Sometimes, the rich get richer because they become more adept at managing their wealth after learning from their past mistakes. They also start to educate the next generation much earlier and impart a custodian mindset instead of a beneficiary mindset. The failure to address this soft skill often results in the failure to sustain the family wealth,” she says.

“Without this transfer of knowledge, their dependents will run the risk of inheriting a large sum of wealth and end up mismanaging the inheritance. This would destroy the effort to preserve the legacy that was built over the years.”

Setting up the structure for preserving wealth

Some questions individuals will have to ask themselves is if they want to transfer a legacy or purely assets, Leng says. Leaving a legacy involves having the patriarch consider how to ensure the business survives and expands.

“To do this, you will have to start going through the process with your children. Do you see any of them capable of taking over? If none of them are, then what happens? This is where he [the patriarch] needs to start thinking of how he can preserve family harmony and how to prevent infighting [among members],” she says.

“My main advice is, you must know exactly what you want, and as private bankers, we are there to help you choose the path that will help materialise your values and vision for the family wealth. Do you want your company to have a physical presence [in the future]? Do you want the brand to continue or will you be all right with selling it off and distributing the proceeds from the sale? The cash from this can last past the third or fourth generation, so that’s one thing the patriarch needs to decide on.”

One common method of maintaining or sustaining the family legacy is by creating a family constitution. It has a broader scope than a will because it encompasses family values and principles that the individual wants the descendants to practise as well.

“The family constitution contains what the family endorse and what they don’t, who sits on the board and what their roles are. It is about setting expectations. If you have a business, what are your expectations of your children? You need to spell them out. Are you open to spouses? Are you open to sons-in-law coming into the picture? This constitution keeps the focus away from the ‘how much’ and ‘when’. Instead, it redirects the discussion towards what’s important and the ‘how’. Rather than stopping at just the amount and disposition of assets, it gets deeper to the heart of what the family values are and how they hope to perpetuate these values,” Leng says.

The family values could be emphasised in the constitution in different ways, depending on what the individual wants. For instance, Leng says, some patriarchs require all the family members to gather and meet on certain festivals annually to receive dividends. This is a method for the patriarch to make sure the family members — who may be living in many different countries — come together as a family.

“In another example, a client mandates that certain assets cannot be sold at all. This is the family heirloom and he is going to transform it into a museum and make it a home where everybody will come to and everyone will have some sort of story to tell when they do,” Leng says.

Family constitutions are part of a trend by HNW and UNHW families in the region who want more transparency and better standards of governance, Kumar says. This can increase harmony and discourage conflict within the family.

He adds that a family constitution is not legally binding in itself, but it is a strategic framework that ties together other documents that are legally binding such as trust deeds, the will, shareholder agreements and asset management agreements.

“It encapsulates the core values and philosophy of the family as well as the consensus on decision-making and entitlement. When things go sour, a well-drafted family constitution can reduce the chances of disputes because you’ve already anticipated such adverse contingencies. The framework can provide for more efficient options to resolve disputes and the discussions surrounding it can also become evidence before the court,” he says.

Many families use a trust or foundation to manage the distribution of their wealth. Kumar says many families now opt to create more sophisticated trust structures called private trust companies (PTC). The need for the structure arises as more families start planning for diverse assets.

“What if your business is spread globally or is in a regulated industry, like banking, fund management or even mining? Third-party trustees may not understand your business as much as you do, which can create challenges. You want to put this into a trust for succession planning and asset protection, but your family still wants to have sufficient control over the business,” he says.

“Just like the family office is your in-house asset manager, the PTC is your in-house corporate trustee. You create a company that will act as a trustee to your family trust — it provides more flexibility in managing your business assets. An external licensed trustee company is appointed only to provide administrative and anti-money laundering-related services to the PTC.”

The location of the trust deed is equally important, especially after the Panama Paper and Paradise Paper leaks that may shed a negative light on these structures and cast suspicion of tax avoidance. Leng says this is why they have to choose their trustees carefully.

“While many always look at the British Virgin Islands (BVI), one of the jurisdictions we’re starting to like is New Zealand. It’s very well constitutionalised in the way that they structure the trust using limited partnerships. It is one of the strongest jurisdictions there is. BVI has got a poor reputation because of what has gone on in Mossack Fonseca, but New Zealand is actually a great place,” she says. Mossack Fonseca was the law firm at the heart of the Panama Papers scandal.

Another instrument many individuals use as part of the wealth management and legacy plan is insurance. It provides liquidity and can cover for costs arising from inheritance taxes in certain jurisdictions, such as property in the UK.

“There is also variable life insurance where it is a permanent life insurance policy with an investment component. It lasts as long as you pay the premiums and it has a cash value investment component, similar to what whole life insurance offers. A lot of UHNW and HNW individuals are asset-rich but they prefer to designate their own fund manager to manage their assets like stocks or bonds, which could be deployed in exchange for life insurance coverage,” Leng says.

She adds that this is a common strategy elsewhere among UHNW and HNW families. “This has always been popular in Europe because the families have gathered so much wealth they don’t want the insurance companies to decide. So, they will appoint a specific fund manager to run it and they want specific returns.”

Insurance products designed solely for legacy planning can also be used as a form of collateral when the need for liquidity arises during emergency situations, Yeo says.

“Take, 2008, for example. Even the wealthy faced a short-term liquidity crunch. Banks would generally accept such life plans as short-term collateral. Life insurance also functions to ensure a smooth asset distribution to the family,” she says.

Practising discipline and inculcating habits

Malaysians tend to be asset-rich and cash-poor, which means extra caution will have to be paid to emergency situations when liquidity is needed. For instance, liquidity is needed during retirement or for health emergencies. Enough cash should be factored into the wealth plan so that descendants can pay for expenses such as leftover mortgages or inheritance taxes.

“Most Asians are asset-rich and 35% to 45% of their total assets are always in assets like land banks and properties. However, we take mortgages because it is always more efficient from a tax perspective. So, what happens when you die and leave all these [debt from the] mortgages?” Leng says.

“The problem today is when many of these investors buy property, they don’t look at the cash flow and say ‘If anything should happen to me tomorrow, I have sufficient cash to offset this entire debt’. Some would say ‘I have a mortgage reducing term assurance (MRTA), but it’s expensive. Maybe I’ll just take five years’. By right, if you don’t have cash to fall back on, you should purchase an MRTA for the entire loan tenure. But it’s expensive. So, this is where you need a client or investor who takes that diligence and says ‘I should probably balance out my entire cash flow’. If the amount of cash can only support 30% of the property loan amount, then only borrow within that percentage, unless you have an insurance or other forms [of funds].”

While rumours that Malaysia would introduce an inheritance tax were quashed last year, some observers believe that it is only a matter of time before it is implemented as it is a global trend. Tan says this is why sufficient cash flow should be worked into the plan.

“When you transfer your wealth or assets to your beneficiary, which one comes first — the asset or the bill from the bank or law firm? While transferring assets in Malaysia upon death does not carry stamp duty, it involves a transfer fee as you need to engage a lawyer to deal with it,” Tan says.

For the retirement stage, enough liquidity has to be planned for the retiree to maintain his or her lifestyle or health needs. Phang Kar Yew, executive director of Harveston, says at the same time, retirees should not stop growing their assets by investing in income-generating ones in view of rising inflation. Investments in the retirement phase can be more focused on fixed income, balanced funds and high-yield blue-chip stocks that constantly give returns.

“For the first 10 years (of retirement), liquidity is a priority because whatever you have built, you need to cash out. At least, pay off all your loans. You should be debt-free going into your retirement phase. You don’t want to accumulate wealth and have leakages that can come from medical bills,” he says.

It is a common enough concern among individuals that they may not have enough for retirement, but Yeo says even as they continue to invest, they must not lose their legacy planning goals.

“Even individuals with millions of ringgit in their bank accounts continue to wonder if they have enough assets set aside to get them through old age, while also leaving behind a legacy. Such a mindset drives them to continue to seek capital growth, and very often, they fail in their efforts to achieve the objective of legacy planning. Proper planning helps them identify their assets for capital growth and legacy purposes,” she says.

“There is evidence to show that the income generation objective becomes more important as the family wealth is transferred from one generation to the next. The reason is, as the future generations grow and expand, the need for regular income distribution becomes more important to sustain their lifestyles and needs. Hence, the income element promotes a custodian mindset, which is essential in a family wealth structure as it overcomes the need to liquidate assets to fund the living expenses of the beneficiaries.”

However, individuals should also practise discipline when investing. Leng says this is especially important, for instance, when the equity market is doing well.

“Clients want a bit of the action. As most of our clients’ top priority is wealth preservation, we may carve out a small portion, say, 10% of the portfolio, for clients to invest in more volatile asset classes like equity,” she adds.

CIMB also assigns separate pots of money in trusts for different individuals or families, so it is easier to manage the consumption of wealth. Leng says the rate of return is determined by looking at what sort of risks their clients want to take. “[As a private bank,] we look at what sort of rate of return your business is generating. The bottom line is that we don’t take the same risk that you would have on the business side. We would take a lesser risk, but would continuously preserve the capital. If your business is doing 15% or 16%, we would have to aim to generate returns of between 5% and 6%. In that context, we will have to work it out with the individual, but it really takes a lot of discipline.”

Discipline should also be extended to the recipients of the wealth a few generations down.

“A lot of clients have this confusion about whether they should leave them the assets or give them education without the asset, and let them grow it (the wealth) themselves. There are two schools of thought. There is nothing wrong giving money to the children if you have inculcated in them a strong foundation or financial education with family values,” Phang says.

Some families choose to only distribute their wealth at specific ages or under specific requirements. Tan says some parents are getting their children more involved in the planning. “We did a wealth management series almost every two months and observed that many parents brought along their children — some of them had just finished high school, while others were in university. With every asset, they (the parents) will explain what they’re going to use it for, for example, this property will be sold off for their children’s education fund. They begin to educate their children from this perspective and share with them the value of the asset, and for some, get them involved in the planning.

“Most parents don’t give their children [funds] immediately. That is why a lot of people use trusts to help them hold those assets for a period of time before they pass them down. For example, we have a client who engaged us to build an education trust for the whole family, including the grandchildren. To qualify for that trust, you have to be accepted by a university. If that happens, the family fund will pay for the university fee, but not the living expenses. They are using this to tell the next generation that if you want something, you have to work for it.”

The education surrounding wealth planning has to take into consideration the habit of millennials who prefer to hold cash, Leng says.

“Today, interestingly, we notice a slight shift. You’re not seeing millennials save as much because they like to stay in cash. The older generation used to make money in equities, so they continue to fancy equities. This is no cause for concern, but there is a shift in dynamics and mindset. Guiding them through the investment process can help whet their appetite for wealth management. By learning through managing investments, millennials grasp not only the basic financial principles from patriarchs but also the specific family view and culture, that is, what kinds of investments they are involved in, why [they are involved in them] and how should these be maintained,” she says.

“I’ve got parents who say their child just turned 21, so they want to give them RM5 million as spending money. So, I say instead of giving the money, why don’t we put it in a portfolio and let the child manage it? He can enjoy any excess he gets, but he has to try and retain that RM5 million as capital. It teaches him its value.”