The Family Bank: A Strategy for Preserving Wealth

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

What issue most worries families of means around the world? In our experience, families with significant wealth are focused not only on investment management of their financial assets; they also care deeply about the long-term welfare of their families. Their goal of “capital preservation” is often linked to family objectives and circumstances. The “capital” they care about is human as well as financial, and there is ample evidence that it is wise to have a strategy for preserving and growing both.

"In our experience, families with significant wealth are focused not only on investment management of their financial assets; they also care deeply about the long-term welfare of their families."

Despite all the effort that is put into earning wealth and investing it wisely, many families experience the unfortunate fate described by the famous Chinese proverb, “shirtsleeves to shirtsleeves in three generations.” Whether the wording is “rags to rags,” “clogs to clogs” or “rice paddy to rice paddy,” the meaning is universal. When a family amasses financial wealth, it often disappears within three generations of its accumulation. Studies assert that this regrettable outcome occurs 70% of the time¹.

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

Consider what happens in the cycles of families. The first generation creates a family fortune. These industrious and often frugal people work hard, save wisely, but do not change their way of life and continue their economical habits even after they become wealthy.

The second generation then has the benefit of many advantages the first generation worked hard to provide them. They attain quality educations and other preparation that enables them to launch successful careers and enjoy a level of prominence in their communities. This successful path often leads to an expensive lifestyle commensurate with their greater earnings and civic profile. They, in turn, provide even more benefits to their own children. 

The third generation, having become accustomed to many financial advantages, grows up without necessarily having a realistic understanding of the hard work and sacrifice required by their parents and grandparents to create the family’s wealth. The risk is that the third generation will consume the fortune they inherit because they have the money without experiencing what went into earning it. Unless this generation translates their own unique talents to productive outcomes, they may lack a sense of direction for their lives. The family fortune, no matter how great, will ultimately be consumed. Typically, this is due to not understanding the value of work; that is, a “calling” does not exist that can instill a sense of purpose and motivation as well as financial rewards.

Invest in the Family

Families who aspire to avoid this outcome and to ensure successful long-term preservation—both of their family as well as their wealth—should commit to the growth of their human assets as well as their financial assets, and can designate a portion of their wealth as a tool to achieve both results. This necessitates implementing a sound long-term oriented investment philosophy to preserve and grow the financial capital, using strategies described by my colleagues in this periodic newsletter. It also requires a long-term family strategy focused on the growth and development of family members themselves, who possess the family’s human capital in the form of their varied skills, talents, and abilities. 

"Such a commitment is a high calling because it requires the family to believe that the preservation of the family itself is a worthwhile endeavor, and both time and money should be prudently dedicated to this purpose."

Such a commitment is a high calling because it requires the family to believe that the preservation of the family itself is a worthwhile endeavor, and both time and money should be prudently dedicated to this purpose. This core value should be communicated to family members as intentionally as its other capital preservation principles, such as spending and investing wisely. This approach frames family wealth as a resource that unites the family rather than dividing it.

 "To survive and thrive, a family needs to enhance the growth of its members’ abilities—its human and intellectual capital—to the highest capacity." 

In tangible terms, this means that part of the family’s wealth is used to support in constructive ways the development of each individual family member. To survive and thrive, a family needs to enhance the growth of its members’ abilities—its human and intellectual capital—to the highest capacity. Without this development, family members will not have the human assets to take advantage of new opportunities the future will offer, and to counter the threats that will naturally occur.

Encouraging Empowerment Not Entitlement 

For many families of some affluence, investing in the next generation’s growth and development is a natural process. Children are nurtured, educated and encouraged. Parents and grandparents take pride in contributing significant amounts of their own human and financial capital to launch the next generation through commitments to academic and extra-curricular activities. Tuitions are funded; athletic events are boosted; vacations are enjoyed.

"It becomes more challenging, though, to answer the question of how and how much to support the next generation once they are beyond the teenage years."

It becomes more challenging, though, to answer the question of how and how much to support the next generation once they are beyond the teenage years. Though his resources greatly exceed those of most families, Warren Buffett describes the challenge in this way: “A wealthy person should leave his or her kids enough to do anything but not enough to do nothing.” While the dollars will differ from one family to the next, the goal is one many families share.

One Wealth Preservation Strategy: The Family Bank 

To help with this vexing question of how to support family members’ growth and development without creating a sense of entitlement, some families have used a concept known as the “family bank.” A family bank is not a “bank” in the formal sense. It is an arrangement where parents or grandparents form a trust that designates a portion of the family’s wealth for loans to family members. The purpose of the “family bank” is to foster responsible money behaviors and encourage productive endeavors. Young people may not otherwise be able to qualify for these loans from external sources, so the “family bank” may be uniquely suited to serve this niche.

"The purpose of the “family bank” is to foster responsible money behaviors and encourage productive endeavors."

A family would make such loans because they would seem low-risk in relation to their contribution to the family’s long-term wealth preservation plan. Instead of giving money to children or grandchildren, and face the possibility of the money being lost or not being used productively, the family loans money to children and grandchildren through a formal process to be used in ways that will contribute to their success and independence, lessening the risk of creating dependency on gifts.

What Projects Should Be Funded? 

Two types of loans might be considered. An Investment Loan is one whose purpose is to ultimately increase the family’s wealth by supporting financially remunerative efforts such as starting a new business. Loans for educational purposes that augment professional skills and capabilities might also be considered Investment Loans if the case can be made that they are likely to increase members’ earning power. Examples might be graduate school, professional certifications, or career development programs.

"An Investment Loan is one whose purpose is to ultimately increase the family’s wealth by supporting financially remunerative efforts such as starting a new business."

An Enhancement Loan supports the family’s long-term capital preservation strategy if it increases the family’s human or intellectual capital. These loans have a more indirect impact on the family’s goal of wealth preservation, but can be extremely valuable if they contribute to fostering an independent lifestyle and sense of purpose in the member. For example, some educational or self-improvement programs may not directly increase financial earning power but they may provide a much needed catalyst to finding the path to greater well-being.

"An Enhancement Loan supports the family’s long-term capital preservation strategy if it increases the family’s human or 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 legal and tax advisers, a separate trust should be set up to serve as the family bank. As with any trust, one or more trustees are needed to manage the process and make decisions. Most likely trustees will be family members and/or outside advisers who are knowledgeable and can be helpful in decision-making and administering loans. Rules are needed for such things as whether loans can be forgiven and what happens if a family member defaults 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? 

Given the need for a trust and trustees to administer the loans, a family bank does add complexity. If not administered well, the family bank can create disharmony if decision-making is perceived to be inequitable. If repayment or forgiveness plans are inconsistent, ongoing dependency on a family’s financial resources can reduce family wealth. Repayment or forgiveness plans should be reviewed and monitored with your tax adviser to avoid unintended gift tax consequences. 

"A well-conceived and run family bank provides excellent financial education for family members."

A well-conceived and run family bank provides excellent financial education for family members. It can also protect assets that children and grandchildren might otherwise lose through poor choices. Transparent communication throughout the family about the family bank’s purpose, processes, and decisions encourages dialogue about the family’s wealth and its philosophy regarding the purpose of money.

"Family wealth and family bonds can grow together." 

Perhaps most importantly, individual members learn from each other as different projects are proposed and completed. One member’s idea may be just the catalyst another member needs to launch her own new venture. Family wealth and family bonds can grow together. 

Sources

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

Taylor, Linda Davis. The Business of Family: How to Stay Rich for Generations. Palgrave Macmillan, 2015.

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

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