By Alicia Giltinan
Studies show that the average American is one paycheck away from being on the streets, but it's not just the average American who can fail financially; wealthy families can fail too. Overspending, too much portfolio risk and lack of communication are among the main reasons families with a net worth of $30 million or more fail.
For wealthy families, the definition of "failure" varies. For some, failing means they can't maintain on a long-term basis the lifestyle they've grown accustomed to. Others may incur no impact during their lifetime but fail to leave what they consider adequate resources to subsequent generations. For those who went from entrepreneur to investor, the absence of liquidity for opportunistic investing might represent failure. And for most wealthy families, the lack of understanding about financial stewardship in concert with the family's values constitutes failure.
If it's hard to fathom someone with $30 million of financial resources overspending, consider that families with far more resources have done just that. A quick online search will reveal several, some whose net worth was in the billions. Wealth can create a false sense of security that one doesn't really need to create a budget, let alone adhere to it. The family business uses forecasting and budgets, but the family members may not. You'd be surprised how many people cannot readily put a number to the expenses they incur yearly, especially when it comes to professional fees (e.g., accounting, legal, investment management and property management). With the average life expectancy growing, risk-free returns around 2% and market recovery periods lengthening, routine gradual overspending can lead to devastating consequences—similar to the power of compounding, but in reverse.
How could someone with $30 million or more incur too much portfolio risk when seasoned investment advisers are overseeing the family's asset management? To answer that, let's begin by noting that wealthy families have multiple investments. Investments separate from the family operating business will often be held with different custodians, e.g., marketable securities with two separate advisers, a variable annuity purchased years ago, and a property management firm overseeing rental units. The family will receive periodic performance reports from each custodian or adviser regarding the marketable securities portfolios and variable annuity. The standard comparison of how the investment fared against its benchmark will be included with a snapshot of holdings by category. The property management firm's reporting is often in the form of an accounting of rental revenues and related expenses, leaving the actual return on investment calculation to the property owner.
So who takes all the data and prepares a comprehensive performance report factoring in all the investments to determine an accurate representation of asset classes and their returns? Often no one does. Each adviser may be doing his or her best to help the family make investment decisions the adviser believes are suitable. But absent one overriding investment policy statement for the family and a comprehensive portfolio summary from which to work, isolated investment decisions can create unnecessary risk.
The investment policy statement
An investment policy statement serves as a guide for all the family's financial decisions. It should include the following:
• Investment objectives. What is the objective for the family's financial resources as a whole? For example, is the goal to maximize income for annual spending, or is long-term growth and capital preservation the key focus?
• Time horizon. Identify the time frame in which the desired return might reasonably be achieved. If short-term liquidity needs are expected to be minimal or met with cash inflows, then a long-term perspective is possible.
• Risk tolerance. Where does the family fall on the risk-return spectrum? Will there be panic at day-to-day fluctuations in the market, or can some level of risk and variance in the market be tolerated to increase the possibility of achieving the investment objective?
• Performance expectations. This reduces the investment objectives to a minimum rate of return that is desired.
• Duties and responsibilities. Formally state what the investment adviser(s) and custodian(s) are responsible for. The investment adviser(s) should serve as an objective, third-party professional helping to guide the family through a robust, diligent investment process and management. Custodians are responsible for the safekeeping of the investments, settling transactions, collecting income and dividends owed, and detailed reporting.
• Asset class guidelines and strategic allocation. These are determined by factoring in the investment objectives, time horizon, risk tolerance and performance expectations identified earlier. Composition of the portfolio is broken down into a strategic allocation. Acceptable ranges for overweight and underweight are also included.
• Monitoring and review. Benchmarks to assist in monitoring are established for each investment option. Determine if the investment policy statement should be reviewed annually or more frequently.
Most successful business owners understand the importance of turning over the reins gradually. Key executives and family members are taught over time the culture of the company and the corporate values and mission. Budgets and balance sheets are reviewed in board meetings, and strategy is discussed in open and engaging brainstorming sessions.
But when it comes to the family's legacy beyond the family business, the same sense of openness, communication and guidance is often lacking. The second generation may know a family foundation exists, but do they know why? Was it created simply for the income tax savings, or is the first generation passionate about philanthropy—and, if so, what causes do they support? The second generation might understand that a trust was established for their benefit and that of their heirs, but do they know why? Was it simply for the estate tax savings, or does the first generation feel strongly about providing educational resources or seed money to foster the entrepreneurial spirit? If there aren't family meetings where these types of topics and expectations of stewardship are discussed, family members will be left to make their own assumptions. They might unwittingly make decisions that are inconsistent with the family's legacy and values.
Planning a family meeting
At its simplest, a family meeting is a gathering of family members to discuss values, stewardship and deployment of the family resources.
Prepare a basic agenda for the meeting. Begin by discussing the purpose of the meeting. For example, is the group expected to actively engage in a discussion about how they feel the family's resources can be deployed to benefit society, or are they there to understand what the family leader has already identified as the focus? Either way, communication is key.
Set small goals for each meeting rather than trying to cover it all in one sit-down. Work from big-picture goals down to the details. An example might be collectively determining a focus for the family foundation and estimating the dollar amount of grants each family branch can make. Then, at a subsequent family meeting, family members might discuss the recipients they chose, how they arrived at that decision and the expected impact of the donation.
Preventing adverse outcomes
There is no way to completely eliminate the risk of failure, even for wealthy families. But steps can be taken to mitigate the possibility of failure in its various forms:
• Avoid overspending by first creating a comprehensive financial statement that realistically identifies potential income from each source. Next, track down your actual expenses and compare the two. Make adjustments where appropriate. Sound familiar? It should. This is exactly what you've been doing for years with the family's operating business. Now you are expanding to include all the family resources.
• Manage portfolio risk by creating an overriding investment policy statement that clearly outlines investment objectives, time horizon, risk tolerance, performance expectations, strategic allocation, rebalancing and monitoring benchmarks. Consolidate the individual performance reports so you have an accurate picture of the entire portfolio.
• Determine the family's legacy beyond merely continuation of the family business, and communicate it to all the family members, or work collaboratively with them to identify it. Hold family meetings and be open and clear on expectations for financial stewardship and the reasoning behind them.
These strategies can help multiple generations enjoy both the tangible and intangible benefits of the family's financial resources.
Alicia Giltinan, ChFC is CFO and director of family operations for Chasefield Capital, a Colorado-based multifamily office and wealth management firm providing families with consolidated financial affairs (email@example.com).
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