How can your family wealth survive through generations?

Seneca, the Roman stoic philosopher, observed:

“For many men, the acquisition of wealth does not end their troubles, it only changes them.”

Over the years, we’ve observed this to be true. For many, stewardship of hard-earned wealth across generations has been challenging. Everything from reckless spending, to ill-thought through investment strategies, to relationship breakdown can dramatically destroy family wealth.

There have been examples, through history, of dynastic families who have been amongst the wealthiest in a nation, who have largely lost everything. The Vanderbilt family built the US railroads and amassed a huge fortune, but through excessive consumption and gambling were far from wealthy, just four generations later. For the Huntington Hartford family, who created America’s first grocery chain – now referred to as “Walmart before Walmart” –  it was a series of failed business transactions. For the Pulitzer family – famous for the Pulitzer Prize –  it was the concentration of their wealth in an 800-acre citrus farm in Florida, that was then ruined by disease.

In this briefing, we explore strategies that can support your family in continuing to prosper over future generations.

Stages of wealth

Aside from the nobility and the aristocracy, the vast majority of family wealth has arisen from entrepreneurial activity. Typically, there has been a period of successful wealth creation, perhaps with the founding and growth of a business.

Generally, some years later, a period of wealth consolidation follows – with, perhaps, the partial divestment of a business (e.g. via a stock market listing,  trade sale or with the investment of a private equity fund). Liquid family wealth outside the business will therefore grow significantly.

Finally, with the eventual disposal of the business and/or the existence of a larger group of family stakeholders, plus the investment of family wealth in liquid investments, a period of wealth distribution commences. By this stage, there will be a host of different family members with differing objectives.

Diagram 1 illustrates and provides further detail on these different stages:

Diagram 1: The stages of wealth – growth, consolidation and distribution

For any family in the latter stages of wealth consolidation or in wealth distribution, there are three main challenges: (1) holding together a disparate range of family members, with different ages and interests, (2) ensuring that wealth is not misused or recklessly spent, and (3) ensuring that wealth is wisely invested for the future. We believe there are important strategies that will maximise the opportunity for success.

Core ingredients of intergenerational wealth transfer

A combination of our professional experience, and theoretical work in this area, demonstrates that there are four core ingredients to successful intergenerational wealth transfer:

• Work-orientated family values with a stewardship orientated mindset

• A clear family governance structure that governs family strategy, behaviour, communication and dispute resolution via a family charter

• A disciplined investment strategy that encourages appropriate risk-taking to deliver above-inflation returns, andAn approach to income and capital withdrawals that is proportionate and not excessive

Diagram 2 provides further information on these ingredients:

Diagram 2: The four core ingredients of successful intergenerational wealth transfer

We will provide ideas on how you can succeed in achieving the right outcomes in each of these four areas.

Family values

Two quotations sum-up the issues faced by wealthy families – the first from the entrepreneurial founder of a diversified business empire in Bahrain, the other from the dynastic Vanderbilt family:

“I think it is very difficult to motivate the third generation because they have lived a better life than we did. We spent a lot of money on them, and they have lots of money coming in. When they ask you for a huge salary it means nothing to them. Unless they can see that they are in power and are getting wealth quickly, they get really despondent and, it has to be said, not all of them want to work. Some, I would say about 50% are not really motivated. This is basically the problem we have, and I don’t know what the solutions are.”

Farouk Yousuf Almoayyed, founder of significant diversified Bahrain business empire

“My life was never destined to be quite happy. It was laid out along lines which I could not foresee, almost from earliest childhood. It has left me with nothing to hope for, with nothing definite to seek or strive for. Inherited wealth is a real hand­icap to happiness. It is as certain death to ambition as cocaine is to morality.”

William Kissam Vanderbilt II, member of the dynastic family that founded the US railroads

Psychiatrists and sociologists have also studied the impact of wealth on families. The leading child psychiatrist, Professor Robert Coles at Harvard University  identified the phenomena of “entitlement” and the sociologist Professor Paul Schervish at Boston College described “hyper-agency”:

At the heart of the two quotations – and these concepts of entitlement and hyper-agency – is the sense that family values are impacted by the freedom that significant financial wealth brings. For example, it becomes possible to make – sometimes reckless – choices without truly bearing the downside risk.

In their paper From Entitlement to Stewardship: How a prosperous family can prepare the next generation, Dennis Jaffe and Fredda Herz Brown advocate teaching a stewardship mindset to younger family members which demonstrates to them the value of wealth, instils the value of work and helps them to understand their good fortune. Their research shows that action is required across three areas: (1) cross-generational engagement from older to younger, (2) financial and life skills development, and (3) instilling of citizenship:

It is with this type of approach that a family will prepare the next generation for the challenges of wealth and reduce the likelihood of misjudgement and recklessness.

Family governance

To put it simply, family governance refers to the structures and processes families use to organise themselves and guide their relationship with their family business or wealth. It has a number of different dimensions, including those in this diagram:

Diagram 3: The role of family governance

Family governance becomes increasingly important as family wealth, size and complexity grows. For example, little governance would be required in a family unit of two adults and two young children where there were no claims on the family wealth outside this small unit. Typically, however, at the point where cousins share an interest in family wealth, family governance becomes critical – as the divergence in age and interests can be very great indeed, and also the room for things to go wrong.

Instituting clear governance increases the opportunity for family harmony and unity, and strong communication. But, each family will need to build a consensus around what is important – overall family goals and values, codes of conduct,  how to resolve disputes and general rules around the management of wealth. These things are often included in an overall governing document for a family, called a family charter.

As you would expect, each family charter is unique to a particular family, but typically, the contents will include the following topics:

Diagram 4: Typical components of a family charter

In arriving at a consensus around the contents in a family charter, it is important that healthy dialogue is facilitated within a family. An external coach or facilitator can play an important role in ensuring that this is a positive journey for a family where appropriate stakeholders get a say and familial bonds are renewed – rather than an occasion where argument and disagreement occurs.

Investment strategy

Let’s start with an illustration. With entrepreneurship booming in the post-war era, several successful families in the US had amassed fortunes of USD75m or more, by 1960. For those that sold their family businesses and elected to live off their wealth, it is interesting to examine where they might be today.

At the heart of our approach is the view that families must invest in risk assets in order to maintain the long-term purchasing power of their wealth. It can be all too tempting to put safety first by retaining significant cash balances or by largely investing in bonds. Unfortunately, with such a strategy, there is little or no hope of long-term prosperity.

In order to demonstrate this, we constructed two sample portfolios of USD75m, examining the period between 1960 and 2020:

• Portfolio 1 was invested in a blend of US equities (50%) and US corporate bonds (50%)

• Portfolio 2 was simply invested in 3-month US Treasury Bills (T-Bills), which could also serve as a proxy for cash

Using actual market returns, and assuming that the family withdrew 5% p.a. to fund its lifestyle, we were able to compare the performance of the two portfolios:

Diagram 5: Long term performance of USD75m between 1960 and 2020 invested in blended portfolio of US equities and corporate bonds versus 3-month T-Bills

We adjusted the original USD75m capital for inflation to create a benchmark for the purchasing power of the original funds. Today, the original USD75m capital would need to be worth USD680m in order to maintain the same purchasing power (see blue line on graph).

Portfolio 1 which invested in the blend of US equities and corporate bonds would be worth over USD800m, with family members enjoying an annual 5% withdrawal of USD40m p.a. (see green line on graph).

Unfortunately, Portfolio 2 which invested in 3-month T-bills would be worth USD70m, with family members enjoying a withdrawal of just USD3.5m p.a. (see grey line on graph).

The difference in outcomes is stark and would be life-changing for the family concerned. This strongly demonstrates the need for a disciplined long-term strategy that includes risk assets, and in particular equities, in order to avoid the ravaging effects of inflation.

Income and capital withdrawals

When a family feels wealthy, it is easy to spend liberally. There are expectations of being able to replicate the same –or even a superior – standard of living for future generations. Those outside the family may have expectations of how the family should be living, as they look-in. At the same time, the level of motivation, acumen and ingenuity that generated the wealth – in the first place –may no longer be present. Each time a grand residence, ski chalet, villa, Ferrari, or private jet is purchased, or with every trip to the casino or auction house, the family wealth is diluted. It is therefore important that withdrawals of income and capital are planned and proportionate to the overall wealth.

In order to illustrate how quite small differences in investment returns and the income requirements of a family can drain family wealth, we imagined a fictional family. Initially, two brothers and their small families – 10 people in total –  had amassed USD200m in 1990 from a business sale (equivalent to USD400m in 2020):

We made some – extremely crude – assumptions around how the family would grow. And deep apologies for the inbuilt sexism and inequality in this model. Each son would get married at a predetermined age and have three children. Each person would die at a particular age. This would continue with future generations. There would not be any of the usual life events that could drain wealth, such as relationship breakdowns, illness or business failure. By 2060, the family would have grown from 10 living members to 102 living members:

We wondered whether capital of USD200m in 1990 could sustain a family, over generations,  if everyone decided simply to live off the family wealth? From the 10 living family members in 1990 to the 102 in 2060.

In addition to the growing size of the family, there were two key dimensions that we decided to examine and vary:

• Firstly, the real returns of the investments, which we set at four potential levels:  inflation plus 0.75% p.a., 1.5% p.a., 3% p.a. and 4.5% p.a.

  
  

• Secondly, the income requirements of each family member, however many there were at any time, starting with 10 living members in 1990 and ending with 102 living members in 2060

  • We set this income as a multiple of the average US salary (USD34,000 p.a. in 2020), with a uniform multiple of salary set for each adult and child family member

  • We allowed for different levels of income in different scenarios: (1) Adult 2 times and Child 1 times [the average US salary], (2) Adult 4 times and Child 2 times, (3) Adult 6 times and Child 3 times

  • To be explicit, in the different income scenarios, for a family of two adults and three children in 2020, the family income would therefore be: (1) USD238,000 p.a., (2) USD476,000 p.a. or (3) USD714,000 p.a. Arguably, the difference between “comfortable” and “well-off”

  • Capital withdrawals were never permitted

We have set out the outcomes grouped by the different levels of investment return, then sub-divided for the different income levels. Depending on the levels of investment return and income withdrawal, there were radically different results:

Key:

# - Income requirement based on multiple of average US salary for each adult or child in family. Actual salaries used to 2020, then assumption that salaries grow by 2% p.a. in real terms from then onwards. There is strong evidence that inflation for high-net worth individuals is consistently above that for the general population

* - Worth around USD400m in today’s money, using purchasing power parity

** - Values in today’s money

Year  - Year that money was exhausted

Year  - Loss of buying power versus original buying power in 1990

From observing the results, it is evident in the worst-case scenario that the family wealth would be extinguished by 2035. In the best case, the family would be far wealthier, as multi-billionaires by 2060. In response to these wide variations, it is possible to make important observations, across all the dimensions that we have been considering in this Briefing:

• Family values: In order to sustain wealth through generations, either a restrained approach to spending is required or the acumen/motivation to generate additional wealth for the family. Offspring should be raised with this in mind, rather than viewing themselves as wealthy and therefore set-up for life

  
  

• Family governance: In order to maintain the necessary discipline for wealth to be sustained through generations, family governance is critical. A clear and transparent code will ensure that wealth is not abused, and will allow for disputes to be resolved. If a family business is retained, it will also ensure that nepotism does not exist, which can have all sorts of negative effects on a business

  
  

• Investment strategy: In order for sufficient growth in family wealth, ahead of inflation, to be achieved, disciplined investment in risk assets is critical. This will likely include investment in equities, real estate and private markets. This will allow the possibility of returns of inflation plus 3% p.a. or 4.5% p.a. An investment strategy focused on cash and bonds will not yield the required returns

  
  

• Income and capital withdrawals: In order to avoid depleting family wealth, income withdrawals need to be at a relatively low level. In the different scenarios, for the family unit of five, this means closer to the lowest scenario of USD238,000 p.a. (“comfortable”), rather than USD714,000 p.a. (“well-off”). Alternatively, there need to be other streams of income from professional activities that supplement the income from the family wealth portfolio

We believe that this illustrates the need for an integrated strategy, for any wealthy family, that takes account of each of these different dimensions. Professional advice across each of these areas will also be absolutely critical – just focusing on one area could have a detrimental impact on the others

Conclusion

Being wealthy brings many challenges – in particular, if you wish to sustain that wealth through future generations. To maximise the opportunity for success, it is critical that disciplined thinking takes place in the following areas: (1) family values, (2) family governance, (3) investment strategy, and (4) income and capital withdrawals.

We can help you consider each of these topics, building a long-term and sustainable plan for the preservation of your family wealth. We take a strategic view, working closely with you to build an integrated approach that is unique to your family.

Return to leadershipinwealth.com

References 

Coles, R. (1967). Children of crisis: A study of courage and fear.

Eckrich, C. J., & McClure, S. L. (2011). Working for a family business: A non-family employee's guide to success. Palgrave Macmillan.

Jaffe, D. T., & Brown, F. H. (2009). From entitlement to stewardship: How a prosperous family can prepare the next generation. The Journal of Wealth Management, 11(4), 11-28.

Schervish, P. G. (2006). The moral biography of wealth: Philosophical reflections on the foundation of philanthropy. Non-profit and Voluntary Sector Quarterly, 35(3), 477-492.

Zellweger, T. (2017). Managing the family business: Theory and practice. Edward Elgar Publishing.