Even the rich run out of money and this is how it happens

From shirtsleeves to shirtsleeves in three generations and it’s all because of poor cashflow management.

Holidaying in the world’s most salubrious locations eventually has its downside.

What do you spend each year on travel? Eating out? Home renovations and household help? How about regular recurring expenses?

Answers to such questions don’t come easily to many wealthy families, and when pressed, spending estimates are usually substantially lower than the reality, advisers say.

“High-net-worth individuals generally have a fairly good idea of their sources of income, whether it be salary or distributions, but they typically don’t have a good handle on the expense side,” says Allen Laufer, director of financial planning at Silvercrest Asset Management Group, whose per-client wealth under management averages $US34m.

Unplanned spending may not seem like a significant high-net-worth kind of problem – after all, if you have substantial wealth across public and private investments, real assets, and business interests, not to mention a healthy income, how bad could it be to be top-heavy on discretionary spending?

Pretty bad, when measured over decades, and very bad when measured across a generation, Laufer says, hinting at the familiar adage, “shirtsleeves to shirtsleeves in three generations,” which refers to a common pattern in which wealth gained by one generation is gone by the third.

“We’ve found tracking expenses is eye-opening for clients, and when you run the numbers out for years, it often tells a surprising story,” Laufer says.

Throw in some familiar plot twists — a major stock and bond market downturn and a spike in inflation, for instance — and the prospect for happy endings dims. When you don’t have enough cash to cover expenses, you may have to pull that from your portfolio, potentially creating an unplanned capital-gains tax obligation. Worse, you’ll have less in your portfolio and therefore less income from your portfolio, Laufer says.

“There’s a snowball effect. If you have a net cash outflow year after year that affects your net worth and there may not be as much left at the end of the day as you would have hoped,” he says.

For families to succeed at building and maintaining wealth across generations, it’s critical that they make a clear distinction between overall wealth and the more important factor when it comes to spending: cashflow.

Cashflow management is wealthy families’ form of budgeting, with more flexibility. Budgeting typically involves rigid sources of income that dictate how much you can spend. With cashflow management, the sources of liquidity can be numerous, from earnings and investment income to business interest and rent. Adding to the complexity, assets may be spread across a number of bank, investment, and advisory accounts.

Planning for the right amount of cash to avoid both shortfalls and having too much sitting in low-yielding accounts is a strategic, continuing exercise that should be a collaboration between both

a wealth and tax specialist, and factoring in all accounts even if they are spread between a number of asset managers and investment accounts.

Taxes are an essential part of cashflow analyses. Complex investment and estate plans often trigger low-visibility taxable events that have to be factored into cashflow needs.

“Setting up a trust may be good estate planning, but many don’t realise the senior generation is on the hook for its taxes,” Laufer explains. “They could be looking at a tax bill for millions and not have the cashflow if they haven’t planned.”

Involving a tax specialist in cashflow management also helps ensure cash will be generated in the most tax-efficient manner, says Roger Young at T. Rowe Price “You have to understand the tax consequences of withdrawing from different accounts, and that can change over a retirement at different inflection points.”

Tax strategies can often help create cashflow out of illiquid assets.

One person’s unchecked spending can impact the family legacy. A good plan can set precise spending limits for family members, and serve as a reminder that family wealth can benefit generations.

This is an edited version of a feature which first appeared in Barrons