Understanding Private Clients

Overview of Private Clients

Private wealth management refers to investment management and financial planning for individual investors. The private wealth sector has grown considerably as global wealth has increased and as individuals have taken on more of the responsibility for managing their own financial resources.

Private clients include individuals and families seeking to invest their personal wealth. These clients are asset owners but typically retain private wealth managers to undertake investment responsibilities on their behalf.

Private clients have several potential investment objectives. Some common objectives include financial security during the client’s retirement years, the ability to provide financial support to family members, and the funding of philanthropic goals. These objectives, however, may not be clearly defined or quantified.

Private clients have unique constraints, resulting in investment strategies and approaches that are different from those of institutional clients. Such constraints include time horizon, scale, and taxes.

Individual investors have a shorter time horizon than institutional investors, whose horizon is often theoretically infinite. With shorter time horizons, individual investors are typically more constrained than institutions with respect to risk taking and liquidity.

Individual investor portfolios tend to be smaller in size (or scale) than those of institutional investors. Because of this smaller portfolio size, many individual investors face limitations relating to certain asset classes, such as private equity and private real estate, which require a significant investment and would result in an imbalanced portfolio.

Taxes are a significant and complex consideration for many individual investors, and they vary by jurisdiction. The presence of taxes on investment income or on realized capital gains can impact such investment decisions as asset allocation and manager selection.

Investment governance for individual investors tends to be less formal. The individual investor works with a private wealth manager to determine an appropriate investment policy. The investment policy is often described in an investment policy statement and typically grants implementation and reporting responsibilities to the wealth manager.

Unlike institutional clients, private clients do not normally benefit from the “checks and balances” of a formal investment governance framework. As a result, private clients can be more vulnerable to making “emotional” investment decisions.

Information Needed in Advising Private Clients

Relevant personal information that a private wealth manager should determine in discussions with a client include:

  • Family circumstances, including marital status and the number and age of dependents
  • Proof of client identification
  • Employment information, including future career aspirations
  • Retirement plans
  • Sources of wealth
  • Specific return or investment objectives
  • Risk tolerance
  • Investment preferences

Wealth managers can construct a net worth statement of a private client to obtain a comprehensive understanding of the client’s financial profile in terms of assets and liabilities.

A private client’s assets on a net worth statement include:

  • Cash and deposit accounts
  • Brokerage/investment accounts
  • Retirement accounts
  • Other employee benefits
  • Stock/ownership of private companies
  • Life insurance policies with a cash value
  • Real estate
  • Other personal assets

Liabilities on a net worth statement include:

  • Consumer debt and credit card balances.
  • Mortgage loans.
  • Other types of debt.
  • Margin debt in brokerage accounts.

Taxes on individuals vary by jurisdiction and must be considered in the IPS. Some general classifications of taxes are as follows:

  • Income tax. Taxes paid on any form of income
  • Wealth-based taxes. These include taxes paid on the value of certain types of assets and taxes paid on the value of assets transferred to another individual through inheritance, gifts, etc
  • Consumption tax. These include sales taxes and value-added taxes

The effects of taxes must be considered when formulating the investment strategy and portfolio asset allocation for a private client. The following strategies can be used to reduce the adverse impact of taxes:

  • Tax avoidance. This is not to be confused with illegal tax evasion. The private client can minimize taxes by utilizing investment accounts that are legally exempt from taxes on income and capital gains. Some jurisdictions also allow limited gift amounts to be transferred without incurring wealth-based taxes.
  • Tax reduction. The private client can invest in tax-free securities and/or securities that are more tax efficient.
  • Tax deferral. The private client can minimize the compounding effect of taxes on portfolio returns by deferring the recognition of these taxes into the future. Strategies that fall under this category focus on long-term capital gains and low turnover. Tax deferral is also offered by retirement plans such as 403(b) retirement savings accounts.

Additional information that a private wealth manager typically gathers for financial planning purposes includes:

  • Wills and trust documents for estate planning
  • Insurance policies that the private client has taken out
  • Service guidelines
  • Portfolio reporting requirements
  • Periodic liquidity requirements
  • Communications and information to share with other financial services professionals on behalf of the private client

Private wealth managers can assist their clients in formulating their financial goals in the following ways:

  • Quantifying goals
  • Prioritizing goals
  • Changing goals

A private client’s financial goals can be categorized into planned goals and unplanned goals.

Planned goals that can be reasonably estimated within a specified time horizon:

  • Retirement goals
  • Specific purchases
  • Funding the education of dependents
  • Funding significant family events
  • Charitable giving
  • Wealth transfer during a private client’s lifetime or at death

Unplanned goals are related to unexpected financial expenditures.

A private client’s risk orientation can be described in several ways:

  • Risk tolerance. This reflects both the client’s willingness and ability to take risks. The opposite of risk tolerance is risk aversion.
  • Risk capacity. This addresses a private client’s ability to take financial risks, based on the client’s wealth, income, investment horizon, liquidity requirements, importance of goals, and other relevant considerations.
  • Risk perception. This is defined as a subjective measure of investment risk (e.g., whether a private client thinks of investment losses in absolute or percentage terms). Risk perception varies from one private client to the next; a wealth manager can play a part in influencing a client’s risk perception.

Generally, the ability to bear risk is decreased by:

  • A shorter time horizon
  • Large critical goals in relation to the size of the portfolio
  • Goals that are important to the client or those that cannot be deferred
  • High liquidity needs
  • Situations where the portfolio is the sole source of support or there is an inability to losses in value

Private wealth managers can evaluate the risk tolerance of their clients using a combination of questionnaires and conversations.

When private clients have multiple financial goals, the wealth manager should determine the client’s risk tolerance for each goal.

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