This is the third article in a three-part series describing the optimal use of trusts to maximize the after-tax size of your family’s estate. In the first piece, we discussed why 99 out of the 100 richest American families utilize Grantor Retained Annuity Trusts (GRATs) to reduce their estate taxes and pass on more wealth to future generations. In the process, we explained several key concepts in GRAT planning, the 7520 rate and also walked through a few scenarios to illustrate how GRATs work and how to optimize the returns.

Next, we discussed the concept of direct indexing and explained how it can be applied to GRATs to further reduce estate taxes.

In this article, we’ll explain why Valur’s Direct-Indexed GRATs maximize the amount you pass on to future generations free of estate tax.

## Why Does Direct Indexing Increase A GRAT’s Returns 98%?

Direct indexing means lots of moving parts: dozens or even hundreds of stocks, and the same number of GRATs. But, at bottom, there are really only three possibilities for the performance of the GRAT portfolio as a whole:

- Possibility 1: All of the stocks perform better than the 7520 rate. (This is, of course, impossible.) In these circumstances, the Direct Index and Index Fund GRAT approaches would yield the exact same results and leave behind the same remainder value for the next generation estate tax free.
- Possibility 2: All of the assets perform worse than the 7520 rates. This is also unlikely; even in severe bear markets, there are counter-cyclical stocks that go up year over year. But if it did happen, the Direct Index and Index Fund GRAT approaches would have the exact same results and no remainder left over.
- Possibility 3: Some assets perform better than the 7520 rate and some perform worse. (If you own multiple individual stocks, this scenario is your reality.)
**Here, the Direct Index GRAT would significantly outperform the index fund approach.**

To get a relevant view of how few stocks in an index fund drive the returns of most index funds, let’s look at how the individual stocks in the S&P 500 have performed this year, as of September.

In 2023, about half of all stocks in the S&P 500 have gone up, and half have gone down. This is typical, but even this view hides the reality that fewer than 2% of stocks drive most of the index’s returns.

## Direct Indexing vs Traditional Index Fund GRATs: The Numbers

Let’s take a detailed look at a simplified version of Possibility 3 (above) — really the only realistic one — to understand why the Direct Index GRAT strategy is so powerful.

**Assumptions**

- Assets: You own two stocks. Stock A grows from $100 to $200 in the first year and stays at that value until the end of year 2. Stock B decreases from $100 to $50 in the first year and stays at that value until the end of year 2.
- Trusts: In Scenario 1, you set up one GRAT that holds both stocks, or a simplified fund index fund that represents both stocks. In Scenario 2, you set up two GRATs, each holding one stock i.e. the Direct Index strategy.
- Government interest rate (7520 rate): 5.0%

**Results**

- Scenario 1: Traditional GRAT
- One GRAT holds both stocks.
- Collectively, the stocks grow to $250 (from a starting value of $200) during the first year. The GRAT owes a $108 annuity payment at the end of each year.
- As a result of these distributions and growth numbers,
**this trust distributes $216 back to the Grantor and, as a result, has only $34 left for the beneficiaries.**

- Scenario 2: Separate GRATs — Direct Indexing
- Here, one GRAT just holds Stock B, which drops from $100 to $50 during the first year. The GRAT owes a $54 annuity payment at the end of each year. But it runs out of assets in the first year after paying $50 out of the $54 it owes. At that point, the GRAT fails and there is nothing left in the trust for the remaining annuity payment or the remainder beneficiary. The final value of this trust is $0; it pays $50 back to the Grantor and $0 to the beneficiaries, because there is no growth to pass on.
- The other GRAT, meanwhile, holds only Stock A, which grows from $100 to $200 during the first year. That trust can make its full $54 payment each year because it has the assets to do so, for a total of $108. This trust pays $108 back to the Grantor and $92 to the remainder beneficiaries (free of estate taxes), out of $200 total value.
- As a result of these distributions and growth numbers,
**these two trusts, together, distribute $158 back to the Grantor and $92 to the beneficiaries (nearly 3x better than Scenario 1)**

## Why Does It Work This Way?

If in Scenario 2 Stock A had been in the GRAT with Stock B — as in Scenario 1 — Stock A’s growth from $100 to $200 would have been able to cover its own first and second year annuity payments and make up the deficit from Stock B decline in value. But making up Stock B’s annuity payment deficit is just taking money away from the pot that would have gone to the remainder beneficiary. This runs counter to the goal of GRATs: to leave as much as possible for the remainder beneficiaries. The only way to ensure your best performing stocks don’t subsidize the poor performing stocks and minimize the remainder value is to separate your assets into different GRATs.

Another way to think about this is like a preference stack. The annuities have to be paid out first unless the GRAT runs out of money. If a stock performs poorly, it may run out of money to pay the annuities, but if it is in the same GRAT as a well performing asset, the growth from the well performing asset will be subsidizing the annuities for the poor performing assets, instead of going to the remainder beneficiary.

Because the stocks are separated in Scenario 2, the simplified direct-indexed version, this cross-funding doesn’t happen. As a result, Stock A’s GRAT pays out $108 in annuity payments to the Grantor and leaves behind $92 for the remainder beneficiary. Stock B’s GRAT, by contrast, pays out a much smaller annuity and leaves nothing behind. On net, though, Scenario 2 wins. This is the magic of isolating assets and maximizing volatility and variance with direct-indexed GRATs

Even though the Grantor in each approach owns the same underlying assets, growing at the same rate, in the same initial proportions and uses the same structure — a GRAT — the amount that goes to beneficiaries tax free is nearly three times as much in the second scenario, **simply because we are maximizing the volatility of each GRAT by keeping each asset in its own trust.**

How could that be?

GRATs are required to pay out their annuity payments to the grantor unless the trust runs out of money. At the same time, your goal is to leave as much as possible in the trust after paying out the annuity payments, since that is the amount that goes to the remainder beneficiary tax free.

The more the GRAT’s assets grow, the larger the remainder. The simplest solutions would be to just pick assets that are going to grow a lot, right? Easier said than done, unless you are Warren Buffet of course, but remember the heads/tails rule with GRATs: High-growth assets like Stock A are winners, and low- and negative-growth assets like Stock B don’t matter other than by dragging down the performance go high growth stocks. So it’s better to separate your fast-growing assets from your slow (or negative) growth assets, allowing you to reap the benefits of the fast-growth ones while just trying again with ones that don’t grow in a specific GRAT’s time period.

## What Are The Downsides Of Maximizing Volatility In GRATs?

We always hesitate to say this, but there are none, other than the potential setup and administration costs of doing this with upward of 500 assets and 500 trusts. In the old world, those costs could be significant — $5,000 or more upfront per trust, plus the ongoing administration of each of those trusts.

With Valur, though, this is a solved problem. We use software to do all of this work at a fraction of the cost — supplemented by our network of lawyers. As a result, **we can set up and administer 500 GRATs for less than what it would have cost to do two GRATs with traditional service providers** (you can start your GRAT setup here).

How do these features come together to deliver 67% better returns over a 20-year time horizon? We’ve backtested the strategy against historical S&P returns and break it down below, so read on.

## Historical Case Study

Let’s start with the results: Over the 20 years from August 2003 to August 2023, using 500 Direct Indexed equal weighted S&P 500 GRATs would have meant passing on 67% more assets to beneficiaries estate-tax free, as compared to a GRAT that held an S&P Index Fund with the same stocks and same weighting. Strikingly, and importantly, the Direct Indexed GRAT **would have performed better than its counterpart in every single year of this study; in other words, the Direct Indexed GRAT could not have performed worse no matter what period we tested**.

We’ll show you the results in the next section, and then we’ll explain the assumptions and structure of the back test before taking a spin through a few specific years that show the real value of Direct Indexed GRATs.

**Results**

Over the 18 years from 2003 to 2021, out of $18 million invested in the S&P 500 ($1 million per year) via:

**Direct Indexing GRAT: $4.2 million would be passed to beneficiaries estate-tax free****Index Fund GRAT: $2.5 million would be passed to beneficiariesestate-tax free**

That’s 67% more from the Direct Indexed GRAT, and these numbers don’t even account for any additional growth the family would achieve from reinvesting the extra savings.

Strategy | Direct Indexing | Index Fund | Direct Indexing | Index Fund |
---|---|---|---|---|

| Remainder As % Of Initial Contribution | | Total Remainder On $1M Investment Per Year | |

Median / Total | 21.98% | 13.18% | $4,175,947 | $2,503,540 |

| | | | |

2003 | 29.60% | 23.81% | $295,992 | $238,069 |

2004 | 21.36% | 9.96% | $213,600 | $99,556 |

2005 | 13.32% | 0.00% | $133,160 | $0 |

2006 | 10.80% | 0.00% | $108,049 | $0 |

2007 | 0.64% | 0.00% | $6,401 | $0 |

2008 | 4.66% | 0.00% | $46,619 | $0 |

2009 | 31.21% | 25.34% | $312,136 | $253,370 |

2010 | 18.47% | 7.97% | $184,733 | $79,704 |

2011 | 24.57% | 18.37% | $245,672 | $183,699 |

2012 | 58.03% | 49.96% | $580,342 | $499,597 |

2013 | 19.91% | 12.37% | $199,087 | $123,719 |

2014 | 16.53% | 6.41% | $165,306 | $64,128 |

2015 | 18.32% | 9.17% | $183,158 | $91,727 |

2016 | 27.14% | 15.26% | $271,400 | $152,631 |

2017 | 14.98% | 2.69% | $149,789 | $26,878 |

2018 | 13.75% | 0.00% | $137,460 | $0 |

2019 | 28.01% | 21.81% | $280,121 | $218,122 |

2020 | 52.43% | 47.23% | $524,284 | $472,341 |

2021 | 13.86% | 0.00% | $138,637 | $0 |

### Back Testing Deep Dive

For a GRAT set up in August of 2021 with $1 million, the Direct Indexed S&P version would have a remainder value of $138,637 while the Index Fund would have a remainder value of $0. In relative terms, with a Direct Index GRAT we would pass on ~13.86% of the GRATs starting value while nothing would pass on in the Index Fund GRAT. Let’s dive into why this happened to show why pairing Direct Indexing with GRATs is so powerful.

From August 2021 to August 2023, the S&P 500 was relatively flat, starting at 4,468 and ending at 4,369. This means that an S&P 500 index fund GRAT wouldn’t have had enough growth to leave a remainder behind, as the annual growth was negative and, therefore, below the 7520 rate. Direct Indexing GRAT strategy, meanwhile, would have left behind ~13.86% of the initial contribution. You are probably wondering why.

Incidentally, it’s interesting to note that ~40% of those remainder returns were from the energy industry. Why was that industry especially volatile during this window? Geopolitics and economics are complicated, but this one’s pretty simple: Oil prices skyrocketed, in part due to the war in Ukraine and sanctions on Russian oil. Oil prices went from ~$67/barrel to ~$87/barrel and profits in the industry rose faster than the price increase. As a result, energy industry stocks did extremely well, achieving returns well in excess of the 7520 rate.

This is an interesting sidebar, to be sure, but it also captures something deeper: The power of Valur’s Direct Indexed GRAT strategy. Direct Indexed GRATs capture much of the American economy. As a result, in virtually every year there will be some stocks that do well — e.g., energy stocks in 2021 — and some that do not. In this 2021 study, because the excess returns of the GRATs that held energy stocks weren’t weighed down by the poor performance of much of the rest of the S&P 500, those GRATs were able to leave behind a remainder. That wouldn’t have been the case if they would have been combined in a GRAT with poor-performing stocks.

GRATs starting in August 2018, to take another example, reflect similar results: An S&P Index Fund GRAT would have left behind $0 to the remainder beneficiaries, while Valur’s Direct Indexed GRAT strategy would have left behind $137,500, or 13.75% of the initial GRAT value. The reason? A very similar story. The markets didn’t perform especially well that year, but some specific stocks and sectors did. In 2018, ~40% of the Direct Indexed GRAT’s remainder came from the technology and transportation sectors. As you can see, the more the GRAT’s assets grow, the larger the remainder

*** We want you to be able to dig into these tests in as much detail as you’d like. To that end, these are our assumptions:

- We used an equal weighted S&P index starting in August 2003 — in other words, investing an equal amount in each stock in the S&P 500.
- We modeled a total of $1 million invested each year.
- We modeled optimized 2-year zeroed-out rolling GRATs. (Learn more about zeroed out GRATs and rolling GRATs.)

## What Are The Limitations Of Direct Indexed GRATs?

A common question: Is the Direct Indexed GRAT strategy limited to indexing the whole S&P 500? The simple answer is “no.” As we have demonstrated in this series, any set of Direct Indexed GRATs will, by definition, outperform a single GRAT holding an index fund that captures the same stocks. Accordingly, we can offer this strategy for any group of stocks, ranging from sector ETFs to the Russell 2000 to custom indexes that you create.

A good rule of thumb is the more stocks in an index and the greater the interest rates, the greater the value of combining GRATs with direct indexing. For example, below are the additional remainder returns you would have gotten over the last 20 years from direct indexing common indexes across multiple GRATs, as compared to a single GRAT holding the whole index using the historical 7520 rates:

- S&P Industry ETF (11 stocks): ~22% additional return
- S&P 500 (500 stocks): ~67% additional return
- Russell 2000 (2000 stocks): ~101% additional return

On the other hand if 7520 rates were higher, similar to today’s interest rates, the returns would be even higher!

7520 Rate | Index Fund | Direct Index ROI (Over Index Fund) |

2% | S&P Sectors (11 GRATs) | 19% |

S&P 500 (500 GRATs) | 65% | |

Russell 2000 (2000 GRATs) | 97% | |

4% | Sector | 28% |

S&P 500 | 82% | |

Russell 2000 | 115% | |

5.4% (Oct ’23 Rate) | Sector | 38% |

S&P 500 | 98% | |

Russell 2000 | 129% | |

6% | Sector | 44% |

S&P 500 | 105% | |

Russell2000 | 135% |

## Conclusion

Putting all of your GRAT money into a diversified portfolio expected to return 9% per year is nice — the beneficiaries will capture single-digit returns free of estate tax. But if, instead, you bet your GRAT on more volatility — without fundamentally changing the assets you’ve invested in — you could pass on a double digit percentage of your assets every year free of estate and gift tax.

At Valur, we use these principles and our proprietary direct indexing GRAT approach to deliver better GRAT returns than anyone out there — and, specifically, an average of 98% greater returns than if you invested in an index fund with a traditional optimized GRAT while Valur’s technology minimizes the cost, time and effort to set this up.

## Next Steps

You’ve read up on the basics of a GRAT, and now you know more about how Grantor Retained Annuity Trust rules. If you’re interested in going deeper still, then, access our calculator to evaluate the potential return on investment given your situation, or schedule a meeting with us.

## About Valur

We’ve built a platform to give everyone access to the tax and wealth building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $1.1 billion in additional wealth for our customers.

If you would like to learn more, please feel free to explore our Learning Center, check out your potential tax savings with our online calculators, or schedule a time to chat with us!