Episode 32 – Building a Fortress Balance Sheet

[MUSIC PLAYING]

Welcome to Market Perspectives, a Mercer advisors podcast. Today’s episode is building a fortress balance sheet. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors. And I’m joined today by Don Calcagni, our Chief Investment Officer. Don, thanks so much for being here.

Josh, it’s great to be here. I’m really excited about today’s topic.

So on a recent podcast, we were talking about what to do with some of the current uncertainties out there in financial markets. And Don, you mentioned this idea that you want to secure your finances, not just your portfolio, but your entire financial life, your wealth broadly speaking, into a fortress balance sheet.

And afterwards, we were talking about this, and I think we had the realization of wow, this is a really profound idea, actually, that too often as investors, we get so focused on the nuts and bolts of our portfolios, which stocks, which funds. To be clear, those are still really important considerations.

But we get so focused on the mechanics of our portfolios that we sometimes neglect thinking about our entire balance sheet, our entire wealth. And so, Don, to start this conversation off, let’s start off with your definition of what a fortress balance sheet is and what is it that we’re trying to solve for?

Thank you. Josh, I think our founder, Kendrick Mercer, really said it best when he came up with this concept of economic freedom. And if you really think about what that means, Josh, it means having such a well-managed balance sheet that it achieves and maintains and protects our financial security, our economic freedom.

And it protects us against a wide range of threats to our economic security, to the family’s financial security. And it would protect us against things like over-consumption, quote unquote, “running out of money” that so many families are afraid of.

It protects us against market risk. All of us today have lived through the .com implosion, the Global financial crisis, the COVID crisis. So it would protect us against market risk, these big meltdowns that we see in global financial markets from time to time.

It would protect us against inflation. We’ve all experienced very rapid inflation here over the past several years. It would protect us against a growth shock. A growth shock is, for example, a recession. It’s when the economy stops growing and then ultimately all of the negative repercussions that come out of that.

It would protect us against things like adverse tax law changes. Tax laws are constantly changing. The United States Treasury is broke. There will come a day when we see some very significant tax law changes. How do we protect ourselves? How do we protect our families from these sorts of things?

Other threats, Josh. Things like lawsuits. These are things that we don’t often think about. I have two children who are now young adults who are beginning to drive. And what were to happen, heaven forbid, they were in a horrible car accident and they were at fault?

So lawsuits, natural catastrophes. One of the things I’m dealing with now in my own family, with my parents is, what about cognitive decline? When you have built substantial wealth, who then is going to make all of these decisions that impact the family?

So, Josh, when I talk about building a fortress balance sheet, I mean exactly that. I mean building a fortress of wealth, looking at the balance sheet through many different dimensions in such a way that we not only achieve and can maintain our economic freedom, but how do we protect it against all of these threats?

Some of those that come from inside the family, perhaps cognitive decline, but also all of these external threats that we often think about like inflation, market risk, and tax law changes. That’s what I mean when I say a fortress balance sheet.

Every part of this, obviously, is that what we normally think about when we talk about investing is just one building block of what we’re talking about here. It’s much bigger. It’s much bigger than just what investments you pick.

So when we think about balance sheets, we start with assets and liabilities. That’s the basic definition. So, obviously, my portfolio is an asset. It’s a very important asset. A lot of, times it’s going to be the most important asset by quite a bit. But what else needs to be in that list of assets that we’re thinking about when we’re trying to take this whole of wealth look at our portfolio, at our balance sheet, at our entire financial life?

It’s a great question. And you’re right. I mean, you talk to a stockbroker, they want to talk to you about stocks. You talk to an insurance agent, they want to talk to you about insurance. You talk to a lawyer, they want to talk to you about your will.

What I’m talking about is everything. So the short answer to your question is everything with your name on it that has dollar sign even remotely attached to it should be on your balance sheet. So obviously, stocks and bonds that’s a no brainer. That’s obvious.

But also private investments. Private equity, venture capital, maybe a family-owned business, maybe a farm that you own, maybe timber, maybe a second home, a third home. All of those things–

cash, savings accounts, bank CDs, all of those things, whether you have a pension.

Not just a 401(k) profit sharing plan, which I’ll come back to in a moment, Josh, but maybe you have a pension. Maybe you get a certain amount every month for the rest of your life, annuities, life insurance policies.

I would even argue you could put on that balance sheet. And this is what we need to do. We need to think more expansively. But I could argue that you could even put on that balance sheet, your human capital.

Are you an MD? Do you have an MBA? Are you still working? You have a financial value as an employee or as an entrepreneur that is a function, arguably, of your human capital.

Kind of a question of what your earnings look like for the rest of your career.

Absolutely. We can do some arithmetic. And why is that an important number? Because that’s a number that you would want to ensure through disability insurance, through life insurance, through things like that.

But Josh, it also needs to be more. In financial accounting, we have this concept called–

two concepts called a deferred tax asset and a deferred tax liability. What are those? Why should we even care?

Well, look at your 401(k) profit sharing plan at your employer. If you have a million dollars in that particular plan, I can tell you right now, you don’t have a million in that particular plan. You need to share that with the Internal Revenue Service. They have a legal claim on arguably as much as 40% of that account. And so in reality, you have a deferred tax liability of maybe as much as $400,000.

So what we need to do, Josh, is we need to move towards having a real balance sheet for real families. A balance sheet that is economically accurate. And so accounting for those deferred tax liabilities, that’s just one of them.

Another deferred tax liability could be the estate tax. Think of families that have substantial assets. Well, when you die, the IRS has a very strong opinion on how big of a check your errors are going to need to stroke and send in to the US Treasury.

So again, those are deferred tax liabilities. A deferred tax asset, Josh, would be things like capital losses, tax losses that we’ve harvested somewhere across the balance sheet. They have an economic value. We can use those. Those are assets that we can use to offset future tax liabilities.

So when I talk about building a fortress balance sheet, what I’m also talking about is building an economically accurate, human-centered balance sheet, a real balance sheet for real families that takes into account all of these different moving parts that absolutely affect your economic security and, therefore, the economic security of your family.

That underscores how short you come up if all you’re doing is looking at here’s my 401(k) balance. Here’s my brokerage balance. You’re not just missing part of the picture. You’re really missing almost all the picture.

Josh, it’s almost like you’re standing in the middle of this massive national forest, millions of acres. And you’re standing there looking at one oak tree and saying, wow, what a wonderful oak tree? Let’s spend a lot of time talking about just this one oak tree.

And look, I’m a big environmentalist. I love trees. I love that oak tree. But at the same time, you’re missing the forest for that one tree. I see this all the time when I meet with new clients or with advisors. They all want to talk about NVIDIA or Microsoft or Amazon. And sure, those are great companies.

But what we really should be focused on is the entire balance sheet. How do all of these pieces work together to create a fortress balance sheet that’s going to achieve, maintain, and protect the family’s economic freedom?

Everyone’s balance sheet, when you think of it this broadly, looks really different. A lot of the most important things get missed when the conversation is only about portfolios. And so it follows that the risks are going to be about a lot more than market downturns.

That when you talk about, when you focus too much on portfolios and you think too much about market downturns, you end up missing all the other things that might be risks to your financial life. What do you see as the big risks that get missed here? I mean, we mentioned some of them. But walk through some of these big risks that get missed when we only talk about downturns.

Yeah, I mean, I think one of the biggest that many folks miss is really the risk that inflation presents. So making sure that the balance sheet is appropriately diversified to not just generate income, but to earn inflation beating returns over the long-term. So I think inflation is a big one.

Adverse tax law changes, I think that’s a big one. I think it’s really underappreciated. One, how complex the US Internal Revenue Code is. But number 2, the debt situation that the United States government finds itself in.

And I think it’s just logical that at some point, we are going to see some pretty significant adverse tax law changes. And so those–

Tax increases.

Tax increases. Yeah, absolutely. And I think those things naturally can present a very serious, a very real danger to the economic security of many families. Some of the real big ones that I think are really underappreciated, Josh, would be lawsuits.

God forbid, your kid blows a red light and kills somebody in an automobile accident. Those lawyers are going after the family, our clients, with the deepest pockets.

Cognitive decline.

And we’re seeing this every day. Early onset Alzheimer’s, things like that, that do interfere with our ability to make sound financial decisions.

All of these things, I think, are very serious threats to our economic security that are really underappreciated. So it does nobody any good to build lots of wealth, earn great returns, only to lose it to lawsuits, natural catastrophes. Maybe you weren’t insured properly. Perhaps, some sort of health care crisis that we had not appropriately planned for.

All of these are very real threats. I mean, one of the biggest ones, though, Josh, I’m just going to go back to adverse tax law changes for a moment. The connective tissue across everything on our balance sheet–

our assets, our liabilities, our insurance, all of these things is tax and taxation.

The Internal Revenue service, the departments of revenue of all of the 50 states, they all have strong views and opinions on how each of those assets will be treated, either during your life or after your life. And so making sure that all of these pieces are working together to maximize our wealth over time and at the end of time is critically important.

You can build the perfect portfolio and then mess it up on taxes, mess it up on insurance, mess it up on a liability issue. If you’re not thinking about all these things, there’s that risk of messing it up.

How does each individual start thinking about how to build their own fortress balance sheet? How do we go from recognizing, OK, I’ve got to think about my wealth more broadly than just what’s in my brokerage account to actually setting up my finances this way? What are the kind of steps or what are the components of a fortress balance sheet that I need to be thinking about putting into place?

Well, a fortress balance sheet, Josh, needs to do five things.

Number one is it needs to be positioned to grow. So it has to be allocated to growth assets, not to be confused with growth stocks. That’s an entirely different conversation. But growth assets that over time can outperform inflation.

As I mentioned earlier, inflation is one of the biggest threats to our economic freedom. So number one is we need to have an appropriate allocation to things like private investments, private equity to US and non-US stocks and bonds and so on and so forth.

So number one is it has to provide for real growth. And by real, I mean inflation adjusted growth. Number 2 is it needs to generate in real-time the after-tax income that we need in order to live our lives. And that income can come from any combination of financial or human capital.

So if you’re fully retired, then that income needs to come from your financial assets. If you are still working, it’s fine. It just needs to come from your human capital. Back to that conversation around our human capital being on our balance sheet.

So number 2, it needs to provide for the after-tax income that we need in order to live our lives in here and now. Number 3 is it needs to provide for liquidity.

We all have emergencies that come up in our lives. It could be healthcare-related. It could be a lawsuit. There could be a natural catastrophe.

It could be something a bit more attractive, like an opportunistic investment opportunity. Maybe it’s a co-investment opportunity to invest in a private company. Maybe it’s something like a capital call for a commitment that you’ve made to a private equity fund.

So making sure that the balance sheet has appropriate liquidity. And there’s lots of ways to measure liquidity. This isn’t the place to get into all the different ways to measure it. But if you think about stocks, if you think about bonds, if you think about money markets, all of those are liquid to varying degrees.

So we should think about liquidity, not just in terms of whether something’s liquid or not, but in terms of a spectrum. How quickly can we convert an asset to cash at today’s fair market value. So how quickly can we do that? How cost effectively can we do that? How simple is it to do that? That’s really what I mean by liquidity. So that would be the third thing that a fortress balance sheet absolutely must be able to provide for.

This thing is important there, right? Like if you know you have college tuitions coming up or a wedding that you want to pay for or after you’re moving, you need to buy a new house. This is you have to think about more than just the investment portfolio.

Absolutely. We’re talking about liquidity. We’re talking about planned expenses over the next, say 12 to 24 months, but also unplanned expenses. You’re mentioning planned expenses. If your child is graduating high school and they get into a great college somewhere, unfortunately, all colleges today are unbelievably expensive. So making sure that we have suitable liquidity to cover all of those particular needs.

The fourth thing, and this is often missed in most financial plans, is protection. Protecting the family against a wide range of economic threats. Like I said, those aren’t things just like market declines. But we’re talking about lawsuits, making sure that we are appropriately insured.

Not just life insurance, not just disability insurance. Yes, we need those things. Yes, those things are absolutely critically important, but also things like liability coverage. Having an appropriate liability umbrella.

My wife and I, we own property in three different US states. It is complicated talking to insurance companies to make sure that we are appropriately insured from a liability perspective across all of those different properties, across those three different states.

So making sure that those things are done appropriately, making sure that the titling on your property and casualty and liability insurance policies is accurate. If you own an LLC that owns a property, making sure that the LLC is listed as an additional insured. Making sure that all of these boxes are appropriately checked.

So naturally, lawsuits, litigation, premature death, premature disability, things like that, I think, are important. Cognitive decline, I mentioned already. But things like fraud, identity theft, cybersecurity. Especially if you’re a family of substantial means, you are a target.

And so making sure that we have appropriate protections in place to safeguard our identity and to safeguard our information. So that would be the fourth item, Josh, is that protection. So we have growth, we have income, we have liquidity, and we have protection.

And the last one, which I think is one of the most important, is flexibility. Life changes. I can’t tell you, Josh, how many times I’ve been in meetings over the years where an insurance person or an attorney is pitching some really exciting, esoteric, complicated strategy that is unbelievably rigid.

And the challenge is we’re humans. We change our minds. Life changes. I’m thinking of something as simple as an irrevocable life insurance trust. It’s in the name. It’s irrevocable. But that is a critical estate planning tool.

And it doesn’t mean that you don’t do it, but you should be very careful and make sure that you understand, what does it really mean? What sort of optionality are we giving up when we put a certain strategy in place on our balance sheet?

Think about a commitment to a private equity fund. That is a legally binding commitment.

You can’t just cancel that if you don’t want to do it anymore. Same thing with certain trusts and things like that. So to me, in theory, Josh, the best financial strategies are ones that are totally revocable. But unfortunately, the laws don’t always let us do that.

And so making sure that we maintain flexibility across the balance sheet so that we can adjust for things that change. There could be a new grandchild. There could be some sort of new liability. A member of the family could need some help, maybe a special needs trust or something like that.

So making sure that the balance sheet and the financial strategies that we’ve put in place, making sure that we can still have freedom of movement in the event that we need to reposition balance sheet assets in order to secure our economic freedom. That’s what we mean by flexibility. So those are the key five things, Josh, in my mind. It’s growth, it’s income, it’s liquidity, it’s protection, and then last but not least, it’s flexibility.

As we’re talking through this list, it occurs to me that one of the reasons people probably miss this so often is that when you start off on your financial life, your finances aren’t that complicated, and it is just a matter of building up your savings.

And you wake up at some point in a couple of decades later, and it’s way more complicated than you realize. And you hadn’t thought about all of these things, and you never connected all these dots. It’s a much bigger way to think about our wealth.

Absolutely. And you’re so right. I mean, we go to college, we graduate college, we get that first job, we get that second job. Maybe we start a business. Maybe we become a partner in a firm. Along the way, we invest in mutual funds and ETFs and stocks and bonds.

And we collect a whole bunch of stuff. We buy annuities. We buy insurance. We have this hodgepodge of financial products that have been pitched to us by Wall Street and the financial industrial complex.

But none of it’s working together. None of it really makes any sense.

It might have made sense at the time when we bought the life insurance policy or whatever it is. But along the way, we have children. We have parents who, unfortunately, are in decline that we’re trying to help. All of these things happen to us throughout our journeys.

And this is why I would argue, I mean, having a great advisor, having a great advisory team that works together to remind us of these things and to help us get reorganized and make sure that this assemblage of different assets and liabilities, that they’re working together intelligently to really to maximize our economic security.

It’s hard to get this right if you’re not thinking really holistically.

You need to think holistically. You need someone who can make the orchestra work together to create beautiful music. At the same time, you need domain experts, subject matter experts to play each of the individual instruments. You need a CPA in the room, somebody who is that expert in taxation. Making sure you have an attorney in the room. Making sure you have an investment expert in the room on that team.

So it’s really striking the right balance between the generalist who is there to get the whole orchestra to work together to create beautiful music, but also making sure that we have the experts, the specialists, the non-generalists who were in the orchestra there so that we can all make sure that we’re getting the very best flute, the very best trombone, all of these pieces playing together. That’s really the art of wealth management, is getting everything to work together to create beautiful music.

Don, that’s probably a great place to wrap it up. We all love beautiful music. We want our portfolios to be this sort of soothing thing that is in the background of our lives, that lets us feel comfortable that things are going in the right direction.

If you’re already a Mercer advisors client, you’ve probably had conversations around a lot of this. But if you’ve realized that there’s a piece of your financial life that you want to think more about, great opportunity to reach out to your advisor and have that conversation, make your balance sheet even more of a fortress balance sheet.

If you’re not a Mercer advisors client, but you’re interested in more information, visit our website, merceradvisors.com. It starts with a phone call. Thanks so much for being with us. This has been Market Perspectives.

[MUSIC PLAYING]

PLAYING]