Periodic insights from our Investment and Private Client Teams on a broad range of investment and advice-related topics
Published by the Private Client Team at KJ Harrison Investors
Most people would consider receiving a large sum of money as an unadulteratedly happy occurrence. Yet, as we know from our decades of advising high-net-worth individuals and families, the reality is far more complicated than that, especially when an inheritance is involved.
For younger beneficiaries, in particular, emotions can get complicated. Yes, their newfound wealth is welcome, but on the other hand it is typically the result of a loss in the family. Some end up associating an inheritance with their own grief and even, sometimes, a sense of guilt. Often, those conflicting emotions get even more complicated – by fear. Large inheritances can impact family dynamics, sometimes adversely, and beneficiaries may worry about how their filial relationships will change. Many others who have little investing experience have an added fear: they look at their new capital position and simply have no idea what they should do with it, and they are deeply concerned about making bad decisions.
In our experience, knowledge is the best antidote for fear. If you and/or your family has come into a large inheritance and are asking “Now what?” here are some answers that can ensure you start your new wealth journey on the right foot.
Putting money to work: the basics
Beneficiaries, of course, have lives of their own beyond an inheritance. Many are young professionals who are building their careers; some are entrepreneurs building their businesses. When, however, they inherit a considerable sum of money, they must take on a different role: they become investors. Their financial focus must shift, at least in part, from earning an income to preserving and growing a pool of capital. To do that, they need to put that money to work for them.
The world of investments is large and diverse, but even a rudimentary knowledge of the options is worthwhile. The three most common investment asset classes are stocks, bonds and cash. The last needs no explanation, except to note that while it is appropriate to have some cash in an investment portfolio, it generally generates no return and is subject to depreciation from inflation (a particularly important consideration today).
Stocks are partial shares of a company, which grant “owners” a share of profits (typically through dividends) and often a vote in the governance of the company; bonds are, effectively, loans that investors make to a company or to a government, which promises to pay back the original investment in a specific period of time. Both can generate income for an investor, usually either through dividends (in the case of stocks) or interest (in the case of bonds). As well, both trade on what are known as secondary markets – where investors buy and sell stocks or bonds – which means that they can deliver capital gains (their price goes up) or losses (their price goes down) for investors.
Beyond stocks and bonds, there is a wide array of other investment classes, including real assets (gold, property, etc.), private businesses and alternative investments such as infrastructure, venture capital or even art and antiques.
Understanding risk and reward
It is perhaps a gross oversimplification, but still generally true, that risk and potential reward are positively correlated. That is, the higher the risk, the higher the potential reward; the lower the risk, the lower the potential reward. (Investments that promise high reward and low risk are rare beasts, indeed, and usually too good to be true; ones that come with high risk and low reward are less rare, but generally to be avoided.)
Different asset classes have different risk-and-reward profiles. Stocks, for example, typically carry more risk than bonds, but their potential (and long-term historical) returns are higher. The risk-and-reward dynamic varies within asset classes, too. For example, growth stocks, which may have little or no profits but plenty of room for capital appreciation, are generally riskier than, say, dividend-paying stocks, which might not grow (much) but offer steady income to investors. In the world of fixed income, government bonds are generally less risky than investment-grade corporate bonds, which are less risky than high-yield bonds; as risk rises, so does the yield (a function of the interest to be paid, or bond coupon, as well as the price below or above the bond’s issue price) that investors will demand.
In choosing investments, it is important to understand your own risk tolerance and reward goals. Those may depend on where you are in your life and career. In general, younger investors can tolerate higher risk because they have more time before retirement to withstand periods of market volatility. For that reason, they may choose to carry more risk in their portfolios – say, by holding more stocks than bonds – than an older investor, who has less time to realize long-term gains or to wait out down markets, would. Investors nearing retirement will generally prioritize wealth preservation and ensure they can access it when they need it.
We have found that when people who inherit money don’t have a plan for preserving and growing their wealth; they tend to simply spend it, and overspending is the surest way to squander a nest egg. If you wish to avoid that, then have a firm goal for your financial future. Perhaps you want to have a comfortable retirement or start a business or change careers or finish an education – whatever your goal, putting your money to work effectively requires you to first decide what it is working towards.
There is no right or wrong goal – it has to be appropriate to you and your loved ones. There is room for creativity. For example, we advised one family whose members were very concerned that their substantial inheritance would create divisions among them, and they wanted to create a wealth structure that would allow them to spend quality time together. Their solution: direct part of their inheritance to a joint fund that would support family activities, and then allocate the remainder to individual accounts for each family member.
As an investor, it is important to recognize that different investments are subject to different taxation rules. Not paying attention to this reality can make a very nice-looking return on an investment end up looking not so nice once the taxman is paid.
Tax rules can be complex, but the most important thing to understand when it comes to investing is that capital gains – that is, the return an investor realizes when they sell an asset such as a stock – may be taxed at a lower rate than interest income from an asset such as a bond. Generally, capital gains are taxed at half the investor’s personal income tax rate; interest income is taxed at the full tax rate. This difference can make a significant impact on a portfolio’s after-tax return.
In Canada, investors have two primary vehicles to mitigate taxes on investments. Registered plans, such as the registered retirement savings plan (RRSP), shelter pre-tax income and investment returns from taxation until they are monetized and withdrawn from the plan – essentially deferring taxation, ideally until retirement, when a lower income will mean a lower tax rate. Another useful tool is the Tax Free Savings Account, or TFSA, which allows you to put after-tax dollars into investments whose returns and withdrawals are tax-free. Of course, stringent contribution limits apply for both programs, but younger investors in particular should ensure that they are maximizing their contributions.
If all of this sounds complicated, that’s because it is, and the unfamiliarity of managing a large sum of money can make the inheritance experience even more disorienting than it otherwise would be. Unless you are a financial professional yourself (and probably even if you are), you will need help from a competent, experienced wealth advisor.
Choose carefully to ensure the wealth professional you work with is right for the job. What qualities should you look for? Well, credentials do matter, so check them. A Chartered Financial Analyst (CFA) or Chartered Investment Manager (CIM) designation implies expertise in portfolio management; a Certified Financial Planner (CFP) has expertise in asset allocation and the development of strategic wealth plans to meet a client’s goals.
At least as important, however, are experience and “fit.” If your inheritance is substantial, we would encourage you to seek out a wealth advisor with deep experience supporting high-net-worth or ultra-high-net-worth clients, as your needs typically differ from others’. Make sure they have the connections and the openness to collaborate with other advisors, such as your lawyer and accountant; planning and managing large capital pools often requires a team approach.
And finally, evaluate your prospective wealth advisor for the “soft” qualities that will be vital to managing your money well. A competent wealth advisor should be patient, a good listener, and ready to guide you and your family through your wealth journey. Do you like them? Do you trust them? And – perhaps most importantly – do you trust them to tell you the plain, honest truth at all times, even when you might not want to hear it?
At KJ Harrison, we understand how receiving an inheritance is often accompanied by a panoply of conflicting emotions – excitement, grief, anticipation, fear. The good news, however, is that a little bit of self-education and the assistance of a qualified wealth advisor can help you navigate the inheritance experience with confidence, and put you on a path towards a secure and happy financial future.