Financial Architects

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Financial Planning vs. Wealth Management

When asked, we refer to ourselves as “wealth managers” and this month I thought I would explain that term and a few related things.

Wikipedia defines Wealth Management as:

[S]ervices to a wide array of clients ranging from affluent to high-net-worth (HNW) and ultra-high-net-worth (UHNW) individuals and families. It is a discipline which incorporates structuring and planning wealth to assist in growing, preserving, and protecting wealth, whilst passing it onto the family in a tax-efficient manner and in accordance with their wishes. Wealth management brings together tax planning, wealth protection, estate planning, succession planning, and family governance.

I want to explain it in a slightly different way. You may remember Maslow’s Hierarchy of Needs (probably from an Introduction to Psychology class in college). In Maslow’s Hierarchy, each need must be satisfied before the next one is relevant (though there is frequently some overlap). In other words, if you are in immediate physical danger you don’t really worry that much about whether you are loved and respected. I believe there is a similar paradigm that I call the “Financial Planning Hierarchy of Needs” which proceeds from a focus on the individual’s immediate personal finances to a focus on needs that are more distant both temporally (i.e. much later) and relationally (i.e. for more distant people):

  1. Desire to be okay financially in the short run. This is the most pressing need. If an individual can’t pay their current bills, the next items aren’t really a concern. (This typically isn’t an issue for our clients, but it is for much of the population.)
  2. Desire to be okay financially in the long run. Once the current bills are paid it is time to be concerned about the future. This is a focus on the individual still, but incorporates a longer time period – including retirement.
  3. Desire to help your descendants. The next goal is usually to help the children (or grandchildren, and possibly even more distant descendants). Frequently this starts with education expenses, but also potentially includes other gifts or bequests.
  4. Desire to help others. This usually takes the form of charitable giving or bequests.

Generally these are funded in order. Item one is generally funded (or is on track to be so) before two, two before three, etc. Financial planning focuses more on the top of the list compared to wealth management.

Over time most people start with a lot of human capital and little financial capital. In other words, in your 20’s you typically don’t have much money but you have a lot of future wages expected. In your 70’s (hopefully) the reverse is true as you have converted wages to financial capital over time by working and saving. Thus, there are two categories of obstacles to achieving the goals mentioned previously that are of varying importance depending on the specific situation:

  1. Human capital impairment
    1. Disability
    2. Premature death
    3. Job loss
  2. Financial capital impairment
    1. Expropriation (primarily through inflation and taxes)
    2. Divorce
    3. Personal liability (e.g. you cause a car accident)
    4. Unexpected health costs (including long-term care)
    5. Low returns
    6. Casualty (e.g. your house burns down)

Generally financial planning can address most of those risks and at least mitigate if not eliminate them by using appropriate insurance, portfolio construction, legal documents, legal entities, etc. As noted earlier, as compared with financial planning, wealth management addresses these issues in a more integrated and comprehensive manner, and typically for people with somewhat higher net worth.

To summarize, as the wealth of the individual or family increases, the focus typically includes more distant descendants (in time) and more distant people (in space). In other words:

  • If you don’t have a particularly high net worth you may just be trying to pay for your children’s college. (financial planning)
  • If you have a significant net worth you may be trying to make sure there are trust funds that will provide for your family for generations, or that your gifts to local charities are made as efficient as possible. (wealth management)
  • If you have enormous net worth you may move to another whole level and try to end malaria in Africa! (large-scale philanthropy)