The Myth of "THE FAMILY"

So, what is “the family”, anyway? Just about everyone in private wealth management circles refers to a group of related clients as “the family”. THE FAMILY - a monolith – a group whose members have interests, objectives, concerns, and assets that can be managed in common.

The problem with “THE FAMILY” is that there is no such thing, at least not when it comes to wealth management. The individuals, trusts, foundations, corporations, LLCs and other entities that make up “THE FAMILY” are all unique, and to throw them together and treat them as a homogeneous unit serves no good end (except perhaps to maximize the assets under management).

Families themselves make this same mistake sometimes, particularly when wealth is new, children are young, and the ink has barely dried on the documents creating all the wealth holding structures – trusts, partnerships, foundations. At this point, the patriarch or matriarch may be excused for thinking that the assets belong to THE FAMILY, and making investment decisions based on the notion of a single pot of wealth, but for such a family the process by which the single pot is divided into separate pots, each with its own distinct purpose, constraints and time horizon, has already begun. It is critical for the family’s advisors and for family members themselves to understand each pot, and to consider it as a separate investor.

A specific example may help highlight the risk of investing on behalf of THE FAMILY. Let’s say that the Smith family has multiple accounts with MetroBank, including Dad’s investment account, a trust account for a GST-exempt trust intended to benefit the Smith children and grandchildren, and an account for the family’s foundation. Let’s say, further, that the MetroBank investment advisor recommends that the Smith family invest a portion of their assets in MetroBank’s Alternative Fund, a fund-of-funds designed to give individual private investors access to a broader array of investments and managers. (This suggestion might have raised fewer eyebrows before the market chaos of 2008.) The Smith FAMILY account – all the accounts viewed as a single pool – is large enough to warrant considering the investment, and it fits within the family’s broad investment guidelines and asset allocation. Particularly if family decision-makers are enthusiastic about Alternative Fund, there may be a temptation to make the investment for THE FAMILY and figure out later from which accounts the cash for the investment should be pulled.

But a quick look at the separate accounts raises a host of questions:
• Even if Dad’s account has the cash, does the investment suit his time horizon? If he is retired, what are his cash needs? If the Alternative Fund, like many fund of funds, won’t make distributions, then will Dad’s cash flow be constrained? If Dad should die while holding the investment, it might generate a discount for estate tax purposes, but a lockup provision could create a liquidity problem for his estate. Even if there is no lockup provision, the liquidity constraints experienced by many funds in 2008 and beyond are evidence that liquidity may be unavailable just when it’s needed most. Other questions arise: What are the track records of the individual funds held by Alternative Fund? Does MetroBank conduct any regular due diligence in connection with the fund? What is its long term mandate? Is the fund’s style subject to creep over time?
• The GST-exempt trust is intended for the benefit of Smith children and grandchildren. It potentially has the longest investment time horizon, so it may be a good candidate to make the investment in Alternative Fund. However, its trustees – not the investment advisor, not Dad, not the beneficiaries – are responsible for making the decision whether or not to invest, and they should keep in mind that they have a fiduciary duty to invest to meet the needs of the trust’s beneficiaries. What are the beneficiaries’ projected needs? If the beneficiaries have other sources of income and principal, then perhaps the trust account might benefit from a long-term investment horizon. But if a grandchild is born with a catastrophic medical condition, will the trustees be able to liquidate all or a portion of the investment quickly if necessary to pay for medical treatment not covered by insurance, or ongoing care? Another concern: will the Alternative Fund generate substantial phantom income – say, lots of short term gain – but not throw off cash, thereby creating a tax liability will need to be paid from other assets? And who will bear that tax liability – the trust itself, or is the trust a “grantor” trust, so that the trust’s income, gains, losses will flow to an individual (perhaps Dad) who will be responsible for the taxes? If Dad will bear the taxes, does he have the cash to handle the liability (a question which likewise needs to be answered before Dad’s account invests in Alternative Fund…)
• Considering whether an investment in Alternative Fund makes sense for the foundation account raises the same issues of liquidity, asset allocation, due diligence and long term cash needs as the other two accounts, along with a new question: will the fund throw off UBTI and thereby create a tax liability for the foundation? Even if the fund doesn’t throw off UBTI now, is its investment mandate broad enough that it might in the future? If the investment otherwise makes sense for the foundation, there a separate sister fund for non-taxable investors?

The point of bringing up all these questions is not to put in doubt the validity of this specific investment for the Smith family accounts – this is in no way a cautionary tale about alternative investments. Rather, the point is that any investment needs to be considered investor by investor – viewing each account separately. Taking the easy way out and treating the Smith family accounts as THE FAMILY - failing to recognize the very different investment profile, risk tolerance, cash flow, time horizon, liquidity needs, tax circumstances of each account – can put family wealth at risk.

Thoughts on multi-generational planning - Part 5: Do Inheritances Infantilize?

Warren Buffett’s widely-publicized decision to transfer most of his wealth to charitable foundations rather than to his children and grandchildren has sparked discussion about whether inheriting wealth might be a curse rather than a blessing. Inheriting wealth cripples motivation, saps the will to work, and leads inheritors to live a life of unhappy indolence, or so this story goes. Rather than becoming independent contributors, inheritors regress until, like infants, they become completely dependent upon their inheritance.

But is it true that wealth invariably cripples motivation? Clearly not – just as there are wealthy inheritors who have lost their way, there are inheritors around the globe for whom wealth has been a tool in building a rewarding life and creating value for themselves and others. So, are there steps that families can take to reduce the risk that their kids and grandkids will become trust fund babies?

Perhaps the best way to inoculate the next generation is to set a good example. If parents do meaningful work and manage money wisely, if the family expectation is that all children will study hard, obtain the best possible educations, get good jobs and live well within their means, then kids are more likely to gain confidence and a sense of self-worth from work rather than spending. Kids also need to understand the denominator problem – unless they too commit to sustaining and building the family’s wealth, the inexorable increase in beneficiaries at each generation will quickly dissipate even the biggest fortune.

How wealth is transferred also makes a difference. Trying to protect wealth at all costs – by keeping the next generation in the dark about family wealth, failing to educate them in the basics of stewardship and wealth management, creating trusts with elaborate control provisions – generally backfires. Beneficiaries who sense that they aren’t trusted are much more likely to display the very behavior the grantor feared most. Beneficiaries who understand the uses and purposes of family wealth, who see themselves as responsible stewards with an important role to play in preserving and growing wealth, are more likely to carry on the family’s legacy.

Buffett’s charitable transfers illustrate another important and growing trend in family wealth transfer – the value of philanthropy. Buffett funded substantial gifts to foundations run by each of children, thereby giving them a considerable degree of power, independence and responsibility – a lasting confirmation of his respect for them, their charitable goals and their decision-making ability. Buffett and his first wife undertook major philanthropic efforts individually, jointly, and in partnership with others (including the Gates Foundation) thereby setting a precedent and providing an important education for his children.