Philanthropy and separate accounts charitably co-exist.
Webster's Dictionary defines the word "philanthropy"
as derived from the Greek word "philanthropos," meaning love of
mankind. The Greek definition carried over to English and, for
centuries, philanthropy referred only to a caring attitude toward one's
fellow man. Now we use the word to describe generosity that promotes
human progress in any field. While the term philanthropist may invoke
visions of benevolent millionaires and billionaires, the vast majority
of charity comes from average American families.
In his new book, Who Really Cares: The Surprising Truth about Compassionate Conservatism, Arthur C. Brooks, an economist at Syracuse University, says that in 2006 Americans gave away a quarter of a trillion dollars. In his study on charitable giving, Brooks states that three out of four U.S. families make charitable donations each year-$1,800 on average. But what does that have to do with advisors today who are turning their time and attention to advising the affluent (and emerging affluent) on philanthropic planning, and specifically, using separately managed accounts (SMAs) as the charitable giving vehicle?
It means that Americans (in general) and investors (specifically) are better educated about giving and do not have to be "sold" a philanthropic bill of goods, and that they are open to having a meaningful dialogue about giving-so it's easier to broach the subject. Keep in mind that the same families and individual clients who ask for financial planning advice, wealth management, tax help and more also have their own ideologies, their own beliefs and, to a greater extent, are willing to share them with you. Increasingly, clients want help in funding something they believe in. We could call it "Ideology Investing." And SMAs are the perfect vehicle for it.
"Simply put, the idea of using an SMA for philanthropy purposes is to invest, buy, sell and donate with specificity for maximum benefit for the client," says Drake Zimmerman, JD, CFP, CAP and principal at Zimmerman & Armstrong in Normal, Ill. "In addition to the flexibility and customization features, they allow planners to integrate portfolio management into charitable planning for the individual with maximum tax benefits. Specifically, you can harvest capital losses while still short term, select the most appreciated assets for donation, and if we still like the investments we donate we can then replace them through repurchase, to step up the cost basis on what we love to own for future tax benefits." Zimmerman manages his own separate accounts instead of using third-party managers, and his clientele size is between $500,000 and $5 million.
Rob Brown, Ph.D., CFA and chief investment officer of Genworth Financial Asset Management Inc. in Encino, Calif., agrees with Zimmerman about the tax benefits. "The SMA's structure, consisting of individual securities, stocks and/or bonds, allows the owner to identify those unique individual securities with the greatest unrealized capital gains and then utilize these to satisfy their charitable objectives," says Brown. "Through this feature, the dual purposes of tax management and charitable giving can be more optimally served." He goes on to suggest that one benefit to the advisor is that the combined charitable giving/SMA structure allows him or her to deliver a more robust value-added to their client base, which includes maximizing the tax benefits through the selection of unique individual positions. "The potential net savings could be far larger than that available if commingled vehicles had been used instead," he says.
The flexibility of SMAs can also help clients who establish charitable remainder trusts. The separate account manager can work directly with the client to manage the taxes paid on distributions from these trusts. According to Scott MacKillop, president and managing principal of Frontier Asset Management based in Sheridan, Wyo., they can do this by managing when they take gains to minimize short-term gain and they may offset the short-term gains generated by the sale of securities in the portfolio by harvesting short-term losses in another part of the client's portfolio. "Mutual funds can also be used effectively in a charitable remainder trust for managing taxes, but separate accounts can add an additional layer of flexibility," he says.
Ideology, Sin Stocks And Better Customization
In addition to the tax benefits, the customization feature is a major reason why clients find the charitable SMAs so attractive (separately managed by a third-party manager as well as those managed by the advisor). Currently, a large variety of socially responsible investments is available. But, oftentimes, SRI for the affluent does not work well with mutual funds for several other reasons. The fund manager, as fiduciary, oversees the objectives of numerous investors, and doesn't necessarily work with any one set of values or ideologies in particular. So the investors in the SRI fund must give up something, and if the affluent client is passionate (or even adamant) about expressing his or her values or ethics, then the customization of the SMA allows them the flexibility to do this.
So, one of the first steps in the dialogue process is to determine what are the clients' ideologies or beliefs, and to what degree are they passionate about them. You can have a meaningful discussion with your clients and/or their family members about their philosophy on traditional American values, for example. With an SMA, you can tailor the portfolio to take into account those values. If the client wants to give to a certain charity, you can tailor the investment portfolio so there is no compromising of the values. "Sin stocks" in the areas of gaming, tobacco, alcohol, defense and/or firearms can be screened out, if desired. For devout Christian clients, for instance, you can tailor the portfolio to include companies that follow religious or biblical principles and screen out any firms that encourage nontraditional lifestyles or behaviors.
Mackillop agrees. "Philanthropic clients can do 'social screening' at a level of detail that they could not do using mutual funds. Although there are many good socially responsible mutual funds available, clients cannot screen their holdings on a security-by-security basis through these funds. Separate accounts can provide this added layer of flexibility."
And what about "restricting" performance? Some believe that using ideology that places restrictions on the portfolio hurts performance. Many philanthropic planners say not so. "You can have excellent performance and continue to maintain your ideology," says Daniel R. Bott of Bott and Associates in Scottsdale, Ariz. " Psychology tends to play a role in the process, and screening stocks becomes a nonissue most of the time." Here's how he explains it:
"After you determine what the client's ideologies and beliefs are and have taken note of the restrictions, you then ascertain the cash flow required to fund their donations. If the client's ideologies are paramount, then making a 6% return instead of 8% or 9% may be acceptable to that client. However, you need to discuss with your client the possible trade-off in the event some of their ideologies may prevent them from fulfilling their commitments to their charitable causes," says Bott. " Which is more important to them, and what is the best avenue to the goal? The ideologies may need to be revisited and the investment policy statement that you developed [see The Process, below] needs to be changed to reflect their compromise because their reasons for wanting to meet the objective become more important."
Also, the level of greed and fear about the assets in a client's SMA earmarked for charity is completely different than when they are investing for themselves, many advisors say. In essence, clients take themselves out of the equation. These types of SMA portfolios tend to be better investing over the long term; more stability is created and the client expectations are lower. The conventional wisdom is that they can maintain ideologies for the long term because most don't have the personal performance objectives to meet: They are not funding their retirement; instead, they are funding something they believe in.
First, you and the client need to determine what is the mission for the money; what are you trying to achieve? When using separate account managers for charitable giving, many wealth managers and consultants create a "business plan" in the form of an investment policy statement (IPS) where the charitable aspects are included (investments are chosen based on this blueprint). Many advisors do this in lieu of using a specific SRI manager. You then need to determine how much money will be needed to achieve the objective, i.e., donor/client wants to fund an animal shelter at $1 million per year for the next ten years. Develop safeguards to put in place to prevent the objectives from not being met, such as a decline in the principal base, needing more capital, etc., and periodically measuring or grading the success of the plan.