In his landmark treatise, An Inquiry into the Nature and Causes of the Wealth of Nations, the Scottish economist Adam Smith observed how difficult it was for families to transition wealth from one generation to the next. He noted, “In commercial countries, therefore, riches, in spite of the most violent regulations of law to prevent their dissipation, very seldom remain long in the same family.” The year was 1776, and in an effort to maintain social order, the British monarchy preferred that wealth remain concentrated in the hands of relatively few aristocratic families, and therefore promulgated a legal structure to encourage that stability of wealth.
Today, of course, the “most violent regulations of law” are designed to achieve the opposite outcome – to ensure that wealth does not remain in the same hands, at least not for long. Unless detailed planning takes place at every step, wealth is taxed upon its creation, distribution and ultimate dispensation.
It is easy to attribute the failure of wealth transfer to today’s ever-changing legal landscape and the complexities that it poses to families with substantial wealth, whether in the form of financial assets, real estate or a family business. But things were seemingly no easier 240 years ago. Then, just as now, very few families succeeded in transitioning wealth beyond a generation or two. It appears that, in addition to mastering the legal and financial complexities of wealth transfers, other elements are at play that influence whether or not a family can preserve its wealth across multiple generations.
A Failure to Communicate
In 2002, Roy Williams of The Williams Group published the results of a 25-year survey of 3,250 instances of generational wealth transfer. He concluded that 70% of those transitions failed, where failure was defined as involuntary loss of control of the assets. That finding underscores and even quantifies the observation that Smith made centuries ago, but Williams took the analysis a step further and explored the reasons for those failures.
The Causes of Failed Wealth Transfer
Williams attributed only 3% of the failed wealth transitions to poor technical advice. There are plenty of moving parts in tax and estate law, and ambiguities abound as to their interpretation and implementation. And so the legal, insurance, accounting and investing professions spend a great deal of time and money on accreditation and continuing education in order to keep up with those changes and stay current on best practices. Although change is certain to remain a constant when it comes to the right trust structures and transition plans, the “how” of wealth transfer is a relatively settled science – and one that advisors rarely get wrong.
Ninety-seven percent of the failures were attributable to the family itself: due to a lack of a family mission (12%), the inadequate preparation of heirs (25%) or a breakdown of family communication and trust (60%). The common thread in each of these causes of failure is a lack of communication. Therefore, better communication is the common cure. Families typically spend more time planning a vacation or researching the purchase of a new appliance than they do discussing the legacy they wish to leave to future generations and how best to realize those wishes. We all need to speak more about the “why” of wealth – not just the “how” of transferring it to our children.
Providing Roots and Wings to Future Generations
Wealth is power, and like any power, is easily abused when easily obtained. A firearm in the hands of someone who doesn’t know how to use it is a terribly dangerous thing, whereas training and respect mitigate that danger dramatically. Similarly, an automobile also represents a great deal of power, which, if taken lightly, can be life-threatening. That’s why we teach teenagers to drive defensively and safely, why we require licensing and why we require relicensing from time to time.
Driving a portfolio is no different. Unless we teach our children why the wealth exists, how to respect and use it wisely and act as good stewards, all the best estate planning advice in the world won’t be enough to escape the old adage that families go from shirtsleeves to shirtsleeves in three generations. The first generation strives to build wealth, the second enjoys the fruits of that labor, and the third has to start all over again with nothing.
Families who transfer wealth successfully from generation to generation understand the family mission. That needn’t be a formal document, but at very least should be an ongoing conversation about why the wealth exists beyond the family’s needs and comfort. This is not an attempt to dictate to future family members how they should think about wealth, what careers they should pursue or what they can and can’t do with the money. Managing from beyond the grave leads to resentment at best – and absolute dysfunction at worst. This is, instead, an attempt to provide future generations with both roots and wings.
Conversations about mission are an opportunity to align values with wealth, and more often than not take the simple form of storytelling. What is the genesis story of the wealth? What risks did mom and dad (or grandma and granddad) take? How did they succeed along the way, and to what do they attribute that success? What would they have done differently?
We had the privilege a few years ago of visiting a new client of Brown Brothers Harriman who was on the verge of selling a company for several hundred million dollars and worried that his family of young adult children would be influenced adversely by the sudden arrival of such wealth. We spent a snowy afternoon with the family members, saying very little, but listening to their stories about working in the family business when they were young, sweeping factory floors on Saturday afternoons, scraping together money to take an annual family vacation in an old VW van, and sharing together in the progress and occasional setbacks of the business. By the end of the afternoon, we were all exhausted from laughing at stories, and my colleagues and I left feeling confident that the family’s second generation was well protected against the negative implications of wealth. Their challenge will be to do the same for their own children one day.
“Conversations about mission are an opportunity to align values with wealth, and more often than not take the simple form of storytelling.”
If that seems soft and subjective, it is – but that doesn’t make it any less important. What about the 25% of failures in Williams’ study that were due to inadequately prepared heirs? We all want our children to be “good with money,” which requires a balanced approach to earning, saving, spending, investing and giving money away, but how is this best accomplished? Families with wealth should ensure that the next generation has a working knowledge of the fundamentals of investing – not necessarily to turn the children into investment professionals, but to make them informed consumers of the guidance they will receive from advisors.
When it comes to educating heirs, all children are home-schooled. The examples that mom and dad set are the best lessons for the next generation, but advisors are a valuable resource in this effort as well. Beyond having the technical knowledge of asset allocation, portfolio construction, investment selection, trust structures, tax planning and so forth, advisors have the vicarious experience of working with multiple families and seeing firsthand how wealth transitions succeed or fail.
Philanthropy plays a powerful role in this exercise. Not only does it provide a tangible expression of a family’s mission and values, it also offers an opportunity for the next generation to learn the technicals of wealth management through interaction with advisors and real-time scenarios. Children who engage in their family’s philanthropic efforts learn about how portfolios work, what form returns can take, how to acknowledge and manage for risk and how to ensure that philanthropies are good stewards of the funds with which they are entrusted. This benefit is obvious when philanthropy takes the form of a family foundation, but even the far simpler exercise of making donations from a donor-advised fund creates an occasion for families to have these sorts of conversations together.
The largest cause of failure in Williams’ study was a breakdown of family communication and trust, and indeed, a lack of trust almost guarantees the failure of wealth transition. This may be the hardest to address of the three broad reasons of failure, as it requires constant attention and nurturing, and there is no finish line. It requires a commitment of the entire family, not just mom and dad, and the dynamic changes as the family changes. Interests and opinions shift over time; new members join the family through marriage – and occasionally roundtrip to an exit through divorce. Just as the Greek philosopher Heraclitus observed that one never steps in the same river twice, so, too, one never has the same conversation with the same family twice. That is both the opportunity and the challenge that families and their advisors face.
Many families rely on a trusted advisor from time to time to facilitate family interaction. That may be the formal role of an attorney or wealth planner, but also may be the informal engagement of a minister, neighbor, teacher or more distant family member. A third party who cares deeply about the family can often provide an independent perspective, provoke conversations that the family should have and simply offer a caring insight into family dynamics. Reliance on such an individual is not a sign of weakness – if anything, it’s a sign of strength and a demonstration of the seriousness with which the family approaches the importance of open, honest communication.
Many families are tempted to ignore these issues. And yet ignorance – at least in this case – is not bliss. The benefits associated with taking the time to define your wealth can not be overstated.
Our ultimate objective as advisors is to help our clients preserve and grow their wealth. If we are to succeed in preserving and growing our clients’ wealth over more than a single generation, we must work with our clients to make sure that future generations are prepared to be good stewards of the family wealth and values. It’s never too early to start, and it’s also never too late.
And it is the best investment a family will ever make.
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