Translating the goals and dreams of a wealthy family into an investment program is a challenging task. Whatever approach the adviser chooses, a crucial first step involves defining and quantifying the family’s financial goals. Only then can a wealth manager develop a strategy to address these goals.

Focusing on specific needs is one area where wealthy individuals or families differ the most visibly and substantially from the merely affluent. Merely affluent individuals often do not have the option to avoid risk or even to consider anything beyond their immediate needs because their assets may be sufficient to provide only some income replacement when they retire. They take risk so their assets to grow and allow them to consider more esoteric goals.  The very wealthy, however, have wealth substantially in excess of their actual needs, if these needs are understood in somewhat “everyday” terms.  Having excess wealth has two implications. First, the very wealthy can afford not to take risk, so their advisers may be misled into thinking that avoiding all risks is all they really want. Second, advisers need to probe more deeply into family governance, management, and dynamics concepts proposed by Jay Hughes or Lisa Gray among others. Because of their wealth, the very wealthy may be able to fulfill their dreams in ways they may  be un able to foresee.  Advisers must try to uncover these dreams to make sure they truly allow their clients to benefit from their financial wealth and integrate it into their broader wealth, which includes human capital, family history, passions, and values, among others. Yet, it goes without saying that uncovering these goals and dreams is only part of the challenge.

Another part of that challenge is to devise ways of quantifying these needs, goals, and dreams and to develop credible and understandable ways of meeting or achieving them. In this short paper, we focus on this task by looking at a few of the questions that individual clients have asked us to address over time. We focus specifically on four approaches that we have used to help answer four distinct types of questions.

Generic Family Needs

Once an adviser starts trying to uncover a family’s dreams and passions, it is not unusual to discover one or several needs that require the family to set aside certain assets so that these goals can be met. At the most basic level, the need might simply involve meeting the current and expected expenses associated with maintaining a given lifestyle. But the need can be considerably more involved and complex; quite a few of these dreams often have some measure of philanthropy in them, although certain dreams may preclude the use of traditional philanthropic structures. Consider:

• A family who wants to create an art endowment in its own name but is not willing to let the art go until some future date
• A family who wants to provide access to the best education or health care to all its direct or even indirect descendants
• A family who wants to provide for some particularly important political or civil cause but for whom the mechanism of a foundation simply is not practical
• A family who wants to provide initial funding to ventures potentially started by descendants over time

Each of these circumstances requires the adviser to work with the family to quantify the financial resources potentially needed and to define the investment parameters that might be appropriate given the goal set by the family.

Although it would be tempting to view these individual circumstances as almost “institutional” in nature (the exercise is about quantifying some liability and defining an asset management program to defease it), it is often not the practical solution. Individuals do not satisfy the requirements underpinning the law of large numbers, which governs probability and actuarial theories. It would be virtually irresponsible to assume that what may be true for a group composed of thousands of members will also be true in a family that might currently have less than 20 members!

Approach 1: A Simple Endowment Portfolio

A common element of the financial needs of the wealthy is providing the funds they require to maintain their lifestyle. Although one might be able to conjure up quite complex solutions to this challenge, the simplest approach is often the best—creating an endowment portfolio that provides income for the needs of the family and grows the corpus sufficiently to protect the family’s real purchasing power. Quantifying this financial need is quite straightforward.

But that approach may not work for everyone. This approach may be appropriate for families whose income needs are small relative to their total wealth. But it may not work for families who require that a significant portion of that portfolio be dedicated to income needs and who also want to be able to transfer assets to future generations. Note, however, that the problem of too high a spending rate does not necessarily conflict with the endowment approach if a family intends to transfer significant assets to philanthropy when the income beneficiaries die.

Approach 2: Declining Balance Portfolio

This approach is best suited to families whose dreams have a definite and limited time frame. Consider a family who wants to build an art collection or participate in a political process but who views that effort as limited to the next 10 years for a variety of reasons. In this case, it is reasonable to use a declining balance funding and investment approach. It assumes that some capital is set aside on Day 1 and invested in some reasonably conservative and liquid portfolio. Every year, the annual contribution (to the art endowment or a political budget) can be made from the portfolio and may require some principal invasion. A simple modeling process can estimate what the initial capital must be to support a given annual outflow (inflated or not as time passes), given some assumed after-tax investment return.

Note that this approach would also be suitable to help a family whose current spending rate appears elevated relative to current assets and who wishes to implement material generational transfers. Here, the time period would be chosen to fit with some notion of life expectancy. Complex gifting tactics might be used to ensure that some additional funding of income needs is possible at a later date if needed.

Approach 3: Discrete Estimation of Liabilities

This approach may be suitable for dealing with dreams that can have an unlimited time frame and some reasonably visible expected outflows. Consider a family who wants to fund university and postgraduate education expenses for all future descendants. Given the age bracket within which post-high-school education is typically undertaken, demographics can be reasonably well estimated for at least one generation. Thus, given the age distribution of all current potential participants, an estimate of the annual cost of education, and some expected rate of inflation, the adviser can create a reasonable budget. The adviser can simultaneously estimate what the per capita budget might need to be at some future point in time, given reasonable assumptions as to birth rates. With that information, the adviser can create an endowment whose goal would be to support expected expenses for this generation with enough real educational purchasing power per capita left at the end of the period to meet the needs of the next generation.

Approach 4: Per Capita Liability Analysis

This last approach is often needed to deal with contingent liabilities that are large on a per capita basis when they arise and highly uncertain. Consider a family who wants to self-insure the health coverage of current and future generations or who wants to serve a “venture capital” function for future family entrepreneurs. These needs are highly unpredictable because the law of large numbers does not apply. One person might require expensive health care while others would never draw on the funds. One member might have a fabulous business idea and need substantial funding while others would simply follow a nonentrepreneurial route.

A sensible solution might involve a three-step process. First, evaluate what the likely lifetime cost of that commitment (health insurance or venture capital requirement) might be for each current member of the family. Second, fund an endowment with the aggregate of these sums, assuming some reasonable investment returns, which can be somewhat more aggressive than those one might assume for a portfolio requiring considerably greater liquidity. Third, keep track of the value of that commitment every year and fund the endowment with that amount any time a new member is born. Some ongoing feedback loop would be required to verify at regular intervals whether the size of the endowment is still reasonable.

This approach can also be used for funding a family educational endowment. Typically, it will require less funds than the discrete estimation analysis discussed earlier. However, the periodic verification that the size of the endowment is still reasonable might require occasional additional funding, which would have to come out of the income replacement portfolio.

Conclusion