The Family Bank: A Strategy for Preserving Wealth (2024)

January 4, 2018

“The generations of living things pass in a short time and, like runners, hand on the torch of life.” —Lucretius, Roman philosopher

What issue mostworries families ofmeans around the world? In our experience,families with significant wealthare focused not only on investmentmanagement of their financial assets;they also care deeply about the long-termwelfare of their families. Their goalof “capital preservation” is often linkedto family objectives and circ*mstances.The “capital” they care about is humanas well as financial, and there is ampleevidence that it is wise to have a strategyfor preserving and growing both.

"In our experience,families with significant wealthare focused not only on investmentmanagement of their financial assets;they also care deeply about the long-termwelfare of their families."

Despite all the effort that is putinto earning wealth and investingit wisely, many families experiencethe unfortunate fate described by thefamous Chinese proverb, “shirtsleevesto shirtsleeves in three generations.”Whether the wording is “rags to rags,”“clogs to clogs” or “rice paddy to ricepaddy,” the meaning is universal.When a family amasses financialwealth, it often disappears within threegenerations of its accumulation. Studiesassert that this regrettable outcomeoccurs 70% of the time¹.

Why Is "Shirtsleeves to Shirtsleeves" a Big Challenge for Families?

Consider what happens in the cycles offamilies. The first generation creates afamily fortune. These industrious andoften frugal people work hard, savewisely, but do not change their way oflife and continue their economical habitseven after they become wealthy.

The second generation then has thebenefit of many advantages the first generationworked hard to provide them.They attain quality educations and otherpreparation that enables them to launchsuccessful careers and enjoy a level ofprominence in their communities. Thissuccessful path often leads to an expensivelifestyle commensurate with theirgreater earnings and civic profile. They,in turn, provide even more benefits totheir own children.

The third generation, having becomeaccustomed to many financial advantages,grows up without necessarilyhaving a realistic understanding ofthe hard work and sacrifice requiredby their parents and grandparents tocreate the family’s wealth. The risk isthat the third generation will consumethe fortune they inherit because theyhave the money without experiencingwhat went into earning it. Unless thisgeneration translates their own uniquetalents to productive outcomes, theymay lack a sense of direction for theirlives. The family fortune, no matterhow great, will ultimately be consumed.Typically, this is due to not understandingthe value of work; that is, a“calling” does not exist that can instilla sense of purpose and motivation aswell as financial rewards.

Invest in the Family

Familieswho aspire to avoid this outcomeand to ensure successful long-termpreservation—both of their familyas well as their wealth—should committo the growth of their human assets aswell as their financial assets, and candesignate a portion of their wealth as atool to achieve both results. This necessitatesimplementing a sound long-termoriented investment philosophy topreserve and grow the financial capital,using strategies described by my colleaguesin this periodic newsletter. Italso requires a long-term family strategyfocused on the growth and developmentof family members themselves,who possess the family’s human capitalin the form of their varied skills, talents,and abilities.

"Such a commitment is a high callingbecause it requires the family to believethat thepreservation of the family itselfis a worthwhile endeavor, and bothtime and money should be prudentlydedicated to this purpose."

Such a commitment is a high callingbecause it requires the family to believethat the preservation of the family itselfis a worthwhile endeavor, and bothtime and money should be prudentlydedicated to this purpose. This corevalue should be communicated to familymembers as intentionally as its othercapital preservation principles, suchas spending and investing wisely. Thisapproach frames family wealth as a resourcethat unites the family rather thandividing it.

"To survive and thrive, a familyneeds to enhance the growth of itsmembers’ abilities—its human and intellectualcapital—to the highest capacity."

In tangible terms, this means thatpart of the family’s wealth is used tosupport in constructive ways the developmentof each individual familymember. To survive and thrive, a familyneeds to enhance the growth of itsmembers’ abilities—its human and intellectualcapital—to the highest capacity. Without this development, familymembers will not have the human assetsto take advantage of new opportunitiesthe future will offer, and to counter thethreats that will naturally occur.

Encouraging Empowerment Not Entitlement

For many families of some affluence, investingin the next generation’s growthand development is a natural process.Children are nurtured, educated andencouraged. Parents and grandparentstake pride in contributing significantamounts of their own human and financialcapital to launch the next generationthrough commitments to academic andextra-curricular activities. Tuitions arefunded; athletic events are boosted; vacationsare enjoyed.

"It becomes more challenging,though, to answer the question of howand how much to support the next generationonce they are beyond theteenage years."

It becomes more challenging,though, to answer the question of howand how much to support the next generationonce they are beyond theteenage years. Though his resourcesgreatly exceed those of most families,Warren Buffett describes the challengein this way: “A wealthy personshould leave his or her kids enoughto do anything but not enough to donothing.” While the dollars will differfrom one family to the next, the goal isone many families share.

One Wealth Preservation Strategy: The Family Bank

To helpwith this vexing question of howto support family members’ growth anddevelopment without creating a senseof entitlement, some families have useda concept known as the “family bank.”A family bank is not a “bank” in theformal sense. It is an arrangement whereparents or grandparents form a trustthat designates a portion of the family’swealth for loans to family members.The purpose of the “family bank” isto foster responsible money behaviorsand encourage productive endeavors.Young people may not otherwise be ableto qualify for these loans from externalsources, so the “family bank” may beuniquely suited to serve this niche.

"The purpose of the “family bank” isto foster responsible money behaviorsand encourage productive endeavors."

A family would make such loansbecause they would seem low-risk inrelation to their contribution to the family’slong-term wealth preservation plan.Instead of giving money to children orgrandchildren, and face the possibilityof the money being lost or not beingused productively, the family loansmoney to children and grandchildrenthrough a formal process to be used inways that will contribute to their successand independence, lessening the risk ofcreating dependency on gifts.

What Projects Should Be Funded?

Two types ofloans might be considered.An Investment Loan is one whose purposeis to ultimately increase the family’swealth by supporting financiallyremunerative efforts such as startinga new business. Loans for educationalpurposes that augment professional skillsand capabilities might also be consideredInvestment Loans if the case can be madethat they are likely to increase members’earning power. Examples might be graduateschool, professional certifications, orcareer development programs.

"AnInvestment Loanis one whose purposeis to ultimately increase the family’swealth by supporting financiallyremunerative efforts such as startinga new business."

An Enhancement Loan supports thefamily’s long-term capital preservationstrategy if it increases the family’s humanor intellectual capital. These loanshave a more indirect impact on thefamily’s goal of wealth preservation,but can be extremely valuable if theycontribute to fostering an independentlifestyle and sense of purpose in themember. For example, some educationalor self-improvement programs maynot directly increase financial earningpower but they may provide a muchneeded catalyst to finding the path togreater well-being.

"AnEnhancement Loansupports thefamily’s long-term capital preservationstrategy if it increases the family’s humanor intellectual capital."

Basic Rules for Administering Loans Could Include:

• The borrower provides a written plan and loan application with information similar to what any commercial lender would request.
• The borrower discusses the project’s feasibility and outcome with the family bank trustees.
• If the loan is granted, the borrower provides periodic reports on the investment.
• The borrower ultimately repays the loan, and terms should be well-defined.

Sometimes family bank trustees have difficulty with Enhancement Loans because they seem too much like subsidies. Subsidies are to be avoided because they actually increase dependency, which is counter to the purpose of the family bank. Financial dependency diminishes the family’s financial assets and thwarts the individual’s motivation. To avoid inadvertent subsidies, Enhancement Loans should be made with the same discipline of evaluating their long-term potential for positive outcomes for the individual and the family.

"Financial dependency diminishes the family’s financial assets and thwarts the individual’s motivation."

Possible Evaluation Metrics for Enhancement Loans:

• The borrower states in writing how the loan will increase his or her independence by proposing how the loan will provide the borrower with tools, both practical and psychological, for independent, non-subsidized living.
• The borrower states how the loan will increase his or her intellectual or human capital and therefore benefit the family.
• The family bank trustees should determine whether repayment of the loan may be in the form of demonstrated increased independence of the borrower or must be through financial repayment only.

How Does the Family Bank Work?

In consultation with the family’s legaland tax advisers, a separate trustshould be set up to serve as the familybank. As with any trust, one or moretrustees are needed to manage theprocess and make decisions. Mostlikely trustees will be family membersand/or outside advisers who areknowledgeable and can be helpful indecision-making and administeringloans. Rules are needed for such thingsas whether loans can be forgiven andwhat happens if a family memberdefaults on the loan.

Practices That Families Have Adopted When Setting Up the Family Bank Include:

• State the Purpose:All family members, both lenders (family trustees or decision-makers) and borrowers,should understand the family bank’s fundamental purpose—to provide loans to family members that may be higher risk with lower interest rates to support productive activities.
• Privacy: Family bank processes and activities should remain private within the family and its trusted advisers.
• Governance: Each family has its own culture and therefore should decide how it wishes to manage its family bank. In order to communicate its purpose and philosophy to family members, it should have a written Mission Statement.
• Formal Processes: The family bank should have formal meetings with clear procedures for receiving and processing loan applications.
• Transparency: Loan application materials are generally shared with other family members; certain financial information about the borrower may remain confidential, but the purpose and amount of the loan should be disclosed. This provides a certain accountability on the part of the applicant when considering their request, and communicates a sense of fairness to all family members about how family resources are made available.

What Are the Pros and Cons of the Family Bank?

Giventhe need for a trust and trusteesto administer the loans, a family bankdoes add complexity. If not administeredwell, the family bank can createdisharmony if decision-making is perceivedto be inequitable. If repaymentor forgiveness plans are inconsistent,ongoing dependency on a family’s financialresources can reduce family wealth.Repayment or forgiveness plans shouldbe reviewed and monitored with yourtax adviser to avoid unintended gift taxconsequences.

"A well-conceived and run familybank provides excellent financial educationfor family members."

A well-conceived and run familybank provides excellent financial educationfor family members. It can also protect assets that children and grandchildrenmight otherwise lose through poorchoices. Transparent communicationthroughout the family about the familybank’s purpose, processes, and decisionsencourages dialogue about the family’swealth and its philosophy regarding thepurpose of money.

"Family wealth and family bonds cangrow together."

Perhaps most importantly,individual members learn from eachother as different projects are proposedand completed. One member’s idea maybe just the catalyst another memberneeds to launch her own new venture.Family wealth and family bonds cangrow together.

Sources

Hughes, Jr., James E. Family: TheCompact Among Generations.Bloomberg Press, 2007.

Taylor, Linda Davis. The Businessof Family: How to Stay Rich forGenerations. Palgrave Macmillan, 2015.

1. Williams, Roy and Vic Preisser. Preparing Heirs:Five Steps to a Successful Transition of Family Wealthand Values. Robert Reed Publishers, 2010.

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