What is in this article?:
- Risk Management for Wealthy Families
- Why Scenario Planning Fits
Don Kozusko & Paul McKibbin discuss how scenario planning can benefit your high-net-worth clients.
It’s not all about the money. Working together as a family while investing or operating a business can enhance financial outcomes, but that kind of success doesn’t, by itself, ensure that the family will continue to work together and flourish. Wealthy families who have long-term aspirations devote at least some attention to the softer issues as well. Many of these efforts tend to be more reactive than proactive, waiting until the issue is defined by the oncoming course of events. Waiting identifies the need and simplifies the choice of a response. When a succession plan is called for or personal frictions surface, for example, the family engages a suitable expert for that particular issue—and keeps the other advisors close at hand, but focused on their sphere of specialization. This avoids duplication of effort and deploys experts to where they’re most knowledgeable and least likely to trespass on someone else’s turf.
Yet, does emphasizing such efficiency limit effectiveness? The alternative we consider here has the same aims as business planning: to anticipate changes and take actions earlier to manage the risks of certain negative outcomes and promote positive results. As explained in the previous article, “Coordinating Risk Management” (Trusts & Estates, December 2012 at p. 12), the greatest attention would be paid to those areas most neglected by established wealth management techniques—not the dynamics of the investment portfolio or the family business operations, but instead, the risks and rewards that arise on the outside of assets at the intersection of family, ownership, management, regulation and taxes.1 Expanding risk management in this way is challenging because a proactive coordinated effort is necessary to sort through and prepare for events and influences that may, or may not, surface in the future. In this evolving domain of interpersonal relationships, intangible issues and multiple outside influences, is it even possible to steer clear of blind spots and address issues early on in meaningful ways? Would the family become overwhelmed by all the relationships and possibilities or be concerned that they’re wasting resources by attacking problems that never materialize?
Collaboration and Divergent Thinking
Let’s start with something obvious: Such an ambitious process would require a commitment to collaboration among the family and its advisors, possibly augmented by additional experts. Different advisors from different fields brainstorming together could open up the planning process to accommodate more points of view and more than one presumptive future. Collectively, they could better identify and evaluate the relative importance of factors generating risks and opportunities and propose a positive response, as compared to a single expert or family member, or several contributors offering separate observations from discreet silos. Everyone’s judgment is affected by the limits of personal experience.2 We act on our perceptions, not a hidden reality. A collaboration of advisors could move perception closer to reality. If the group could explore different versions of what changes and challenges might arise during the planning time frame, it should enhance the ability to prepare for and adapt to change, and thus, build resilience into the family relationships, so the family works together more smoothly and successfully.
Controlling Divergent Thinking
Is this realistic? Could such a collaborative effort actually bring the family to consider different ways of how the future could unfold, so that the family’s plans anticipate alternatives and adapt if the future, in fact, differs from the single path that everyone naturally expected? If unmanaged, this comprehensive collaboration could instead produce an expensive and open-ended demonstration of another obvious point: The future has no limits. Are we trying to solve a Rubik’s Cube that has no fixed dimensions and randomly changes colors? We’ve previously illustrated in brief examples how multiple factors in wealth management of a family can interact at the intersection of ownership, management, regulation and taxes. (We’ve reproduced those fact patterns in “Case Examples,” p. 37.) In a real world setting, the possible combinations of future events and forces seem beyond measure and control, even in a single family, if the time frame stretches beyond a few years. In a world crowded with ideas, information, finite resources and growing demands, no family can be expected to endure a perpetual competition of divergent ideas and opinions.
Thus, we need a process to open up our thinking, but only within the boundaries of rational judgment. The aim is to understand how a particular family can be affected over time by several forces or events, objective and subjective, internal and external, operating at different times, some more powerful, disruptive, undefined, interrelated or evolutionary than others. The response can’t be embodied in a single contingency plan or a static power point diagram or designed by manipulating spreadsheets. Yet, a disciplined method is essential to bring together collaborators who hold varying, even conflicting, views and to generate, analyze and manage thinking around combinations of events and forces leading to different potential paths and then to empower mere mortals to grasp the implications and make informed decisions.
Fortunately, business and public policy strategists have long since identified the same challenges in their planning environment and, decades ago, began to develop and apply a discipline that became known as “scenario planning.” In its various forms, the method has proven so useful that scenario planning continues to enjoy considerable attention in the academic and consulting literature and is widely employed by planners in business, military and public policy circles. Scenario planning has become a recognized means to deal with multiple factor interactions in uncertain and frequently changing environments, in which qualitative insights about the future prove to be at least as valuable as quantitative forecasts.3 Tackling interrelationships over time looks a lot like planning for risk management for wealthy families, as we’ve described it previously.
As we explained in our article “Coordinating Risk Management,” which appeared in the December 2012 issue of Trusts & Estates, these fact patterns are drawn from a composite of our own clients’ experiences and public records
The trustees of a 100-year trust have broad discretion to sprinkle distributions among the descendants of the grantor. The trustees keep no records, except for tax returns and custodian statements, because no one has ever asked for an accounting; all the living beneficiaries, except one estranged grandchild, have always had substantial other resources and never expected distributions from this trust. That grandchild, Harry, has drifted away, and no one cares to give him information on the trust since the family considers him to be antagonistic, lazy, irresponsible and unlikely to ever deserve a distribution. What’s the unmanaged risk at this point? Fifteen years later, a woman contacts the trustees in her capacity as the mother of Harry’s teenage child, and, on her child’s behalf, she seeks redress against the trustees for neglecting her child as a beneficiary. The trustees believe they exercised reasonable diligence, but have no records to show attention to their duties apart from occasional investment decisions.
A Daughter’s Premature Death
At a father’s death, the family farm continues in trust for his 25-year-old daughter, Katie, until she reaches age 35. What’s the unmanaged risk at this point? Over the next decade, Katie works hard to run the farm to emulate her father’s success, but the operation is under financial stress when Katie dies in a farm accident just a month short of age 35 and outright distribution to her. The ownership continues in trust for her infant child, but the child’s surviving guardian, Katie’s recently divorced husband, seizes the opportunity to sue the two trustees, including his former mother-in-law, for damages due to the poor financial returns attributable to the holding of the family farm. He’s hoping to squeeze out a settlement and force the sale of the farm so he can claim a large guardianship management fee. Katie had released the trustees each year from any such liability, but that doesn’t necessarily bind her infant child as successor beneficiary, and the guardian claims that the losses, including the investment returns that could have been achieved elsewhere, must be calculated for the entire 10-year term of the trust.
Troublesome Charitable Bequest
A widow with no children leaves her entire estate, including a large share of an underdeveloped real estate parcel, to a favorite local charity launched years ago but still primarily funded by the family. What’s the unmanaged risk at this point? While the widow’s estate is being wound up, the real estate parcel spikes in value when it becomes a critical link in a potentially very profitable long-term redevelopment plan. The family wants to control the redevelopment, but must first buy out the charity (with borrowed funds backed by personal guarantees) to meet state regulatory standards and must navigate through the evolving tax rules for charities. Once the charity is cashed out, it appears that the charity can’t have its funds managed as a client of the family office (unless the family office registers as an investment advisor with the Securities and Exchange Commission or restructures the charity’s endowment), because the charity doesn’t qualify as a family client under the single-family office exemption. As a result, the family isn’t only being forced to take on more leverage in its redevelopment plan, but also will lose the ability to add the buy-out proceeds to the assets it manages.
The Founder’s Team
Fifteen years ago, a successful entrepreneur died and left part of her business holdings in trust to provide for her grandchildren and named two long-time business partners as trustees and her lawyer as protector. She wanted to encourage entrepreneurship among the beneficiaries, but their interests and talents vary widely, and only a few have followed that path, including joining in the management of some of the trust’s businesses. What’s the unmanaged risk at this point? One of the trustees has moved his personal residence to a state that might impose an income tax on the trust. The second trustee is slowing down physically and mentally at age 80. The trust protector has the power to replace these trustees, but the family hasn’t been able to agree on a qualified younger individual who’s willing to assume the risk of personal liability as trustee. Moreover, both existing trustees prefer to continue serving and have begun to question the capability of the protector, who seems to be distracted by personal financial stress and health issues. More fundamentally, the trustees have succeeded in active businesses all their lives and can’t imagine selling off the businesses and investing in the volatile public markets, apart from a small bond allocation. Meanwhile, those beneficiaries not involved in the businesses are confused as to what’s the true purpose of the trust and frustrated by their own inability to understand business and by the trustees’ lack of attention to the beneficiaries. The beneficiaries see conflict among their lives and the life cycles of the trust, its holdings and its trustees.
— By Don Kozusko & Paul McKibbin
Plans are worthless, but planning is everything.4
—Dwight D. Eisenhower
Scenario planning isn’t a forecast run by changing quantitative variables in today’s formulas, much less a prediction of what those variables will be in the future. It’s a practice of planning that opens up the participants to an adaptive way of thinking that’s no longer critically dependent on the assumption that reality will, in fact, follow the expected future path that the mind derives from past experience.5 While it shares some of the same creative methods as design thinking and brainstorming,6 it focuses more on interactions that play out over time. In the context of family wealth management, think of it as a process for moving people and things (investments, business holdings, legal structures) through time in a virtual way by creating and examining alternative story lines for the future: the scenarios. We suggest that scenario planning can be used as the enabling discipline for our proposed risk management process, which allows the family to understand and adapt as ownership, management, regulation and taxes interact and change as the family’s financial and human capital changes.7
Although scenario planning has evolved into different versions in use today in business and public policy forums, and specific kinds of projects call for different applications, the basic process is consistent throughout the consulting landscape. Scenario planning moves our thinking across the dimension of time by following a natural progression of imaging and articulating alternative plots of the future and examining the implications of those story lines: (1) study the domain, (2) identify relevant trends, forces and events, (3) create and explore scenarios and their implications, and (4) consider and prioritize adjustments for the future.8 The process is directional, but not linear. It can circle back in iterative fashion through mental feedback loops, such that, for example, thinking about the first set of scenarios and the questions they raise can uncover trends and forces previously overlooked or misunderstood, causing the set of scenarios to be revised or even entirely redesigned and the time frame adjusted.
The creation of thoughtful scenarios is critical to a successful experience. Humans are always scenario planning in an ad hoc way (it’s how we perceive, organize, decide and take action by relating the events of today to past experience, to act or react to what we then surmise is the story of tomorrow). The scenario planning process, however, is much more systematic, deliberative and focused on a specific area of concern or opportunity—a problem domain. While scenarios are intended to be creative enough to challenge existing assumptions, the scenario construction process doesn’t begin and end with raw imagination, nor does it unleash mystical powers of prediction. It’s logical but, nonetheless, subjective.
After participants select the problem domain and planning horizon, they must examine and understand the trends and forces in the environment well enough to reach a judgment as to which of these are more or less pre-determined and which are more uncertain.9 The participants draw these subjective distinctions to frame the boundaries of the scenarios, at least initially. The scenarios then are constructed in story lines that embody those judgments as to what forces are more certain or less certain and more powerful or less powerful, and the scenarios play out how different directions and combinations of cause and effect could affect the problem domain in the future. The purpose isn’t to eliminate uncertainty (that is, to pretend that it doesn’t exist), but instead to recognize and remain conscious of how it could affect the future course of events.10
In its simplest application, four scenarios are created from matching two forces or events of high impact/high uncertainty, putting one on the X-axis of a diagram and the other on the Y.11 The four scenarios in the grid then mix the lesser or greater impact of each of these two drivers as you move along the axes, as shown in “Four Scenarios” (p. 38). This particular diagram reflects the starting point of scenarios that the family office might use to consider the potential impact on its future governance and operations from two factors of highest uncertainty/greatest impact: (1) if the family members disperse and reside in multiple countries, rather than continue to cluster around the original home town, and (2) if the family office sells a core asset holding that anchors the family to the home town, financially and emotionally. The approach in “Four Scenarios” assumes that there’s a constant relationship in which the “dispersal” and “sale” drivers will be the greatest influences on whether the family continues to work together and use the family office as in the past. The four quadrants show different scenarios reflecting the initial judgment that the asset sale and dispersal of residences will cause the family to be less cohesive due to losing frequent informal personal contacts and will attenuate an emotional connection to the home town, where the family history and influence is still prominent. When the anchor asset remains but the family disperses, the scenario is the hardest to imagine, the so-called “dark territory,” because it may represent an unbalanced mix of countervailing forces.
In fleshing out these fact patterns, the participants might conclude that their starting scenarios were too wedded to past experience and underplayed more recent influences (such as family activities involving international philanthropy, “hands-on” direct investments and journeys to fun places) that have begun to replace historical bonds. As a result, the scenarios might be redesigned to consider an alternative view of cause and effect and ways in which the family office can address these new trends. Thus, in the process of creating the scenarios, the future drivers become better understood, and then further reflection and analysis may lead to rethinking and possibly changes in the scenarios. Along the way, some uncertainties are reclassified as unimportant or pre-determined, as the scenarios open up new mental models for viewing future risks and opportunities.