ESG Considerations for Private Wealth Management – Estate Planning

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide an overview of some of the foundational concepts of estate planning in the context of private wealth management. We then shift our discussion from foundational concepts to implications for ESG-investing. Two basic concepts of domestic estate planning are wills and probate. A will (or testament) is used to transfer the assets of an individual at death. While probate is the legal process to validate and implement a will at death. The probate process can be costly and public. As such, estate planning may seek to transfer assets outside of the probate process. This can be accomplished through joint ownership with rights of survivorship, living trusts, retirement plans, and life insurance.

Estate planners will advise private clients on the two principal forms of wealth transfer: gifts and bequests. Gifts are lifetime gratuitous transfers (or intervivos transfers) and may be subject to gift taxes. Bequests are testamentary gratuitous transfers that are made at death. From the recipient’s perspective, a testamentary gratuitous transfer is called an inheritance. Bequests are subject to estate tax (paid by the grantor) or inheritance tax (paid by the recipient). The legal system may place limits on one’s ability to dispose of assets. Laws may be in place requiring forced heirship (where children are entitled to statutory ownership), community property rights (where the spouse is entitled to half of the estate that is built up during marriage), and separate property rights (where each spouse owns and controls their property). When planning gifts and bequests, estate planners will seek to estimate the amount of funds an individual will need to meet their spending needs plus a safety reserve. These funds are referred to as core capital. Core capital can be estimated with mortality tables or by using Monte Carlo simulation. Excess capital represents assets above and beyond core capital that can be safely transferred to subsequent generations without jeopardizing the first generation’s lifestyle.

Lifetime Gifts and Testamentary Bequests

Having introduced some of the foundational concepts for estate planning we will now discuss how the relative after-tax value of lifetime gifts and testamentary bequests can be evaluated. The ratio of the future value of a gift to the future value of a bequest is the relative value. Relative value can be used for comparison purposes. If the gift is tax free, then the relative value is the ratio of the annual accrual tax function for the gift (reflecting the relevant rate of growth and accrual tax rate) to the annual accrual tax function for the bequest (with a unique rate of growth and accrual tax rate), divided by one minus the estate tax rate. The relative value of a taxable gift is the same, but the function is multiplied by one minus the gift tax rate. If the gift tax is paid by the donor instead of the recipient, the formula used to calculate a relative value of a tax-free gift is multiplied by one minus the gift tax rate plus the product of the gift and estate tax rate. Finally, if we are dealing with a charitable gift, the formula used to calculate the relative value of a taxable gift is multiplied by the ordinary tax rate of the giver and a compound growth rate multiple is added to the numerator.

In addition to relative value calculations, estate planners may also need to quantify the impact of generation skipping on gifts and bequests. Generation skipping is a tax reduction strategy that may be used to increase the value of an estate as it passes from one generation to the next. With no generation skipping strategy, the estate will grow for a period and then will be subject to tax (either gift or bequest tax) when the estate is transferred. This process will repeat when the estate is transferred from generation 2 to 3. By transferring assets directly from the first generation to generation 3, the time allotted for asset appreciation remains unchanged, but the tax payment will only occur once. Employment of this strategy is not for everyone. Obviously, the second generation misses out here, but if their financial circumstances permit, they may be okay with that in order to set up the third generation for greater wealth than they would otherwise have. In addition to generation skipping, other basic estate planning considerations include spousal exemptions and valuation discounts on transferred assets.

Trusts and Life Insurance

Trusts are a legal vehicle that can be used to optimize estate planning. Trusts can be structured as revocable or irrevocable. In a revocable trust, the owner (also known as the settlor) retains the rights to the assets and can use the trust assets to settle claims made against them. Since the settlor still retains control of the assets, the settlor is considered the owner for tax purposes. In contrast, an irrevocable trust involves the owner forfeiting the right to the assets. As such, the settlor cannot use the trust assets to settle claims against them. Trusts can also be structured as fixed or discretionary. A fixed trust involves the trustee following the rules set out in the trust document. This could include rules that specify investment in ESG-related investment products. A discretionary trust gives the trustee discretion to meet the intent of the trust document. Just as an irrevocable trust can protect assets from claims against the settlor, discretionary trusts can protect assets from claims against the beneficiaries. Another category of trust is the spendthrift trust which is created for the benefit of a person (often unable to independently manager his or her spending) that gives an independent trustee full authority to make decisions as to how the trust funds may be spent for the benefit of the beneficiary.

Life insurance is another tool that is essential for estate planning. Life insurance can be used as an alternative when trusts and foundations are not allowed or not recognized by law. Life insurance can provide for a tax-efficient means of wealth transfer. The policyholder will transfer assets (i.e. the premium) to an insurer who has an obligation to pay death benefit proceeds to the beneficiary. The premiums that are paid out are usually not considered part of the grantor’s estate and can be passed to beneficiaries without tax consequences. Life insurance premiums also have the benefit of being transferred outside probate and are typically outside creditor claims. In some cases, the estate planner may establish a trust on behalf of the beneficiary and make the trust the direct beneficiary of the life insurance policy. This allows assets to be transferred outside the probate process.

Tax Jurisdiction

Tax jurisdiction considerations are vital for the estate planner. Taxes are typically levied at the source (for activities that are undertaken within the boarders of a sovereign nation) or by residence (in which taxes are collected on global income of a nation’s residents regardless of where that income was earned). This can create the potential for overlapping tax claims. A residence-residence conflict is when two jurisdictions claim taxes for income earned by the same individual. This form of conflict most often arises when an individual holds dual citizenship or residency. A source-source conflict arises when two jurisdictions claim taxes over the same income. For example, is the source of income for an international mining company the location in which the company is headquartered or is the source of income the location of the mine? A residence-source conflict arises when an individua earns income in foreign country. In residence-source conflicts, usually the source of income is considered primary.

To deal with the residence-source conflict, jurisdictions may cooperate to form tax treaties which specify a method for resolving overlapping claims on income tax. There are three general methods used: the exemption method, the credit method, and the deduction method. The exemption method makes the source jurisdiction the exclusive tax collector and the residence jurisdiction collects no taxes. Alternatively, the credit method makes the source jurisdiction primary and the residence jurisdiction will only collect taxes base on the difference in the tax rates between the residence and source jurisdiction. For example, if the residence tax rate is 50% and the source tax rate is 35%, the residence jurisdiction will collect 15%. The deduction method is like the credit method, but the residence jurisdiction will apply its full tax rate to the residual income after source tax rates are applied. For example, a residence tax rate of 50% and a source tax rate of 35% would leave the individual with on 32.5% of every dollar earned.

Implications for ESG Investing

Having covered some of the foundational concepts of private wealth management and tax considerations, we now turn our attention to ESG and sustainable investment. Investors are increasingly using ESG factors to screen investments as a result of the financial risks attributable to climate change, the potential enhanced reputational benefits associated with sustainable assets, and increased government support for green assets reflected through fiscal spending and regulations. This investment trend is penetrating all aspects of private wealth management including estate planning.

An estate plan can be thought of as a blank slate. There is no formula for determining the best approach and each individual's circumstances, priorities, and preferences are unique. Some individuals that plan to leave behind assets for charity may want to consider ESG-related causes. For example, a bequest to a foundation focused on reducing systemic racism or a non-profit focused on wildlife conservation. Determining an allocation for charitable gifts and bequests requires introspection and questions such as, "Who do I want to take care of? What are my concerns for the future? What do I want to be remembered for? Who or what do I want to honor?” ^[2].

A trust is an important estate planning tool that can be used to advance an individual’s ESG-related priorities. A trust may be structured as fixed or discretionary. A fixed trust involves the trustee following the rules set out in the trust document which could include rules that specify investment in ESG-related assets. In other words, a settlor’s wishes to take into consideration ESG factors, can be included in a letter of wishes and guide the investment mandate of the trust. But what about discretionary trusts? The duties of trustees in English law are set out in the Trustee Act 2000 and trustees generally have wide powers as to how they invest and delegate the investment management function ^[3]. The trustee needs to act fairly and not make decisions that would prejudice some beneficiaries. The trustees have a primary duty to obtain the best financial return and any ESG considerations must come second. However, if ESG-related investments are more sustainable, durable, and resilient, they may produce better returns in the long-run. Where the trustees have considered their obligation, are acting fairly, and have balanced the needs of all beneficiaries, they may choose ethical investments where it is of equal or better financial merit.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://www.forbes.com/sites/forbesfinancecouncil/2020/09/16/estate-planning-establishing-a-sustainable-legacy-in-uncertain-times/?sh=7342ca3e357b
3. https://news.bloombergtax.com/daily-tax-report-international/insight-can-trusts-and-family-investment-companies-be-ethical-investors

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