Why Advisors Can’t Ignore the Balance Sheet

For all the innovation in modern finance, one truth remains strangely overlooked: Most wealth management today is far too narrow to deliver what families actually need. 

We obsess over picking the right stocks, tinkering with asset allocations or attention-grabbing tax maneuvers, yet we routinely ignore the broader economic reality in which real families live. What advisors and their clients need is a different approach and a framework, called the fortress balance sheet. The animating idea behind the strategy is what families are seeking when they turn to our industry and that is to maintain their wealth across the entire financial picture, their entire balance sheet. That helps immunize them against economic threats and reduce their need to worry about money. 

However, it’s a promise that fundamentally cannot be delivered via portfolio construction alone. The full set of risks that face a family’s finances are broad: market risks and inflation, yes, but also over-consumption (running out of money), growth shocks, adverse tax changes, lawsuits, natural catastrophes and more.

Hold Down the Fort

A fortress balance sheet approach begins with taking a comprehensive view of assets, including not just public stocks and bonds, but also private investments, home equity, private real estate, cash, closely held business interests, employee benefit plans, insurance policies, annuities, deferred tax assets (e.g., capital loss carryforwards), and (arguably) even one’s human capital. 

Additionally, it fully and accurately captures the families’ liabilities. While things like mortgages and credit card debt (long-term liabilities) are obvious, a realistic, economically accurate balance sheet would include current liabilities (planned spending over the next 12 months), future expected liabilities (longer-term spending on things such as retirement income, education for kids, healthcare for elderly parents, etc.), and deferred tax liabilities such as those inherent in large estates and 401(k) plans.

With that full understanding in place, building and maintaining a fortress balance sheet requires a specialized team with a shared understanding of the mission. The full complexity of a family’s finances involves matters not only of finance, but also taxation, law, insurance, and more.

Imagine All the Assets

Imagine an investor who picks terrific investments, but neglects their tax strategy, and loses their gains to paying unnecessary taxes. Imagine an investor who gets their tax strategy right, but doesn’t update their estate plan to align with their desires. Imagine an investor who plans their tax and estate meticulously, but finds themselves on the wrong end of a lawsuit, or who doesn’t realize until after a disaster that their home was underinsured. 

It’s only when all the pieces of a family’s finances are organized in concert that their balance sheet can be considered protected. Once it is constructed, the fortress balance sheet has five goals:

• Growth: The strategy provides for real, inflation-adjusted growth for the family to achieve its long-term goals. This should not be where wealth management conversations begin and end. 
• Income: It must also provide the real-time, after-tax income that families need to maintain their lifestyles. Income differs from growth in that income represents the liquid financial returns that we need to earn today, in the here and now, and not the lumpy, unrealized, often illiquid, and typically untaxed, returns characteristic of long-term growth assets.
• Liquidity: Balance sheet liquidity is important to meet liabilities (e.g., unreimbursed hurricane damage to coastal property) or to capitalize on opportunities (e.g., capital calls or opportunistic co-investments). We typically think of liquidity in terms of cash and cash equivalents, but it’s bigger than that. Liquidity is ultimately a measure of how easily, cost-effectively, and quickly we can convert an asset to cash at its fair market value.  The fortress balance sheet aims for liquidity to meet current and future liabilities, whether expected or unexpected, without having to borrow at needlessly high interest rates, incur significant transaction costs, or sell assets at fire sale prices to raise cash.
• Protection: A well-managed fortress balance sheet, through a combination of asset allocation, liability management, insurance and entities, protects families against a wide range of economic threats. Shifting tax laws, litigation, premature death, disability, cognitive decline, fraud and identity theft, to name only a few, pose a clear and present danger.
• Flexibility: Last but not least, the approach provides flexibility to change our minds, reallocate resources as needed or desired, and respond to the inevitable curveballs life throws our way. Protecting your finances is not a task that you undertake once, then place on autopilot. Not only must the sentries (that is, your advisory team) always be on duty, they must be prepared to constantly revisit the plan and adjust if circumstances warrant. 

Flying Fortress. As wealth advisors, our fiduciary responsibility to our clients is both a legal standard and a sacred duty. We can only truly live up to this mandate when we operate under a framework that seeks to protect every aspect of our clients’ finances.

When we focus too narrowly on investments, we not only fail to fully live up to our mandate, we simply aren’t providing clients with the advice they truly want and need.

Don Calcagni is chief investment officer at Mercer Advisors, a CFP professional, and has also earned the Accredited Investment Fiduciary designation.