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‘Handicapped’ by wealth: The dangers of unprepared heirs

April 02, 2014

By Robert Beaupre | Money Rates Columnist

Varieties of decline

As a generation, baby boomers tend to do things on a massive scale. (Having 77 million living members makes it hard to do otherwise.) Not surprisingly, as more boomers die and surrender their wealth in the coming years, the impact is likely to be anything but small.

Between 2031 and 2045, 10 percent of total wealth in the U.S. will change hands every five years, according to research firm Cerulli Associates. But unfortunately for the boomers who have built or maintained a fortune, not every generation is as adept at managing wealth as the one before it.

John Davis, faculty chair of the Families in Business program at Harvard Business School, studies how family fortunes change over time. He says that declines in assets are common in wealthy families as new generations take control.

“The most common path for family wealth is to increase most in the first generation and then decrease starting around the late second generation or early third generation and become modest by generation three or four,” Davis writes in an email to MoneyRates.com. “This is the shirt-sleeves path.”

The shirt-sleeves path Davis refers to comes from a saying: “Shirt sleeves to shirt sleeves in three generations.” The phrase describes how families that build wealth in a generation tend to lose most of it within three generations. There are a number of factors that can cause this, including children or grandchildren who can’t adapt the family business to changing conditions or overconsume the family’s assets.

Varieties of decline

While Davis hasn’t completed the research necessary to quantify the frequency of these patterns – though he and colleagues are working on it for a future book – he says that the phenomenon is common enough around the world for many cultures to have their own version of the “shirt sleeves to shirt sleeves” saying.

“We are impressed with how much a family grows over time and how much a family's lifestyle expenses typically rise once they become wealthy,” Davis says. “The combination of maturing asset growth and overconsumption is, of course, deadly.”

Even more alarming for successful first generations, Davis says the second most common path for family wealth is what he calls the “steep decline” path, in which the second generation sharply reduces the family’s wealth before the third generation even has a chance.

“These same factors (poor business management and overconsumption) can be influencing families on the steep-decline path, but we generally also see these families making one or two really bad bets on new investments and losing a lot of money,” Davis says.

Bradford Pine, a wealth adviser and president of the Garden City, N.Y.-based Bradford Pine Wealth Group, says that he see families diminish their wealth between generations through a variety of ways – not all of which may have been priorities for previous generations.

“The heirs often have their own ideas for what to do with their inheritance,” writes Pine in an email to MoneyRates.com. “It can range from buying new cars for everyone in their family to paying down debt or financing a young person’s education.”

The art of regeneration

Naturally, not all well-to-do families suffer a decline in wealth in the second or third generations. Davis says that the third most common pattern he sees in wealthy families is the “regeneration path,” in which family wealth continues to increase with the second and third generations and beyond.

What is the difference between these families and the families who witness sharp declines? Davis says that families who continue to increase their wealth over several generations tend to follow a few key principles.

“Regeneration-path families tend to diversify or migrate their investments into business areas that are growing, control family consumption, stay united and develop family talent to keep up with and be able to contribute to their businesses,” says Davis.

Davis says that a large portion of the wealthy families he studies succeed or fail on the fate of their business ventures, thus the business acumen of each generation is a key factor in maintaining family wealth. For families whose children don’t plan to enter the same business as their parents, Pine says there are still some steps first-generation members should take to help preserve their family’s wealth.

“(Diminishing wealth) does not necessarily have to be the case,” Pine says. “If parents make their wishes known early and work with a wealth adviser, an effective estate plan can often be put into place, preserving and managing the family wealth for future generations. Failing to plan is often planning to fail.”

Your money’s legacy

Although his research to date suggests that heirs may sometimes be “softened” by the presence of wealth, dulling the instincts that helped previous generations achieve prosperity, Davis says that focusing on three things can help families enjoy continued financial success.

“First, they need to develop one or more next-generation members to be wealth generators who know how to make good bets with the family’s assets, and develop a critical mass of family members to be good owners, good board members, good family members, etc.,” Davis says. “Second, the family needs to maintain unity in the family and in the next generation. Third, the family needs to have the right governance to make sure it is properly overseeing the unity of its family and the management of its assets.”

More specifically for those who are now preparing their assets for the next generation, Pine says that communicating with heirs about the future can help them prepare more effectively, and that a well-designed estate can help make it easier for them to make wise use of the money they inherit.

“Children may not always agree with their parents’ wishes but often will respect them when proper planning is done,” says Pine. “Be sure parents have an effective will, an estate plan and possibly life insurance plan to handle estate taxes.” 

Davis says that, ultimately, the protection and growth of family wealth is about more than money.

“The object for wealthy families is to build a platform for their heirs to do good things with their lives, using wealth in healthy and productive ways and not being handicapped by the presence of wealth,” Davis says. “This platform is based on a family’s interest in using all of its resources to create things of lasting value. In this culture, a family encourages the heirs to stretch beyond their comfort zone to be who they really are.” 

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