How to make inheritance an incentive

By Richard Davies

Every successful manager in the business world knows that money can help get things done: end-of-year bonuses can cheer the disgruntled, and targeted cash rewards can help direct effort to where it is most needed. Decisions on what to do about money at the end of a successful career are harder. When writing a will, how do you leave children money in a way that encourages them to work hard?

The number of parents facing this dilemma is growing. Take America. After falling between 1930 and 1980, the concentration of wealth at the top has been steadily rising. By 2012 the richest 1.6m families were worth $14m on average, according to research by Emmanuel Saez of the University of California at Berkeley. John Havens and Paul Schervish of Boston College estimate that by 2061 the baby-boom generation will have passed on $59 trillion – the biggest wealth transfer of all time. With the value of global wealth predicted to rise faster than income for the rest of the century, getting inheritance right is becoming more important.

America’s top tycoons offer a simple rule of thumb: cut your children out altogether. Andrew Carnegie, one of the wealthiest men of all time, argued that the rich should give away their fortunes since “great sums bequeathed oftener work more for the injury than for the good of the recipient”. Warren Buffet is set on giving away 99% of his wealth so that his heirs have “enough to do anything but not enough to do nothing”. The fear is that too much too young leads to idleness.

That worry has its roots in the microeconomics of labour supply. Most people enjoy both buying things and relaxing. But finite funds – the economist’s “budget constraint” – mean that life is a balance: between spending and saving, and between leisure and labour. A massive inheritance blows away the constraint and the need to find that balance, often with predictably grim consequences: the popular press feasts on the stories of the children of billionaires coming to bad ends.

Throughout history, societies’ differing needs have led to a variety of inheritance systems. In 18th-century Massachusetts and Connecticut farming was land-intensive, meaning that workers were spread out. Splitting the farm between all the children – multigeniture – gave every child an incentive to work hard even when toiling far away from parental supervision. In big families, kids become a drain if they stick around too long. This probably explains why ultimogeniture – a bequest to the youngest child – was popular in early farming communities in Europe and Japan. Where elder children are likely to have set up their own households, it makes sense for parents to give younger children an incentive to stay at home and look after them.

Modern economists have been interested in how bequests shape behaviour. In the 1980s economists at Harvard, including Larry Summers, found a rather depressing connection between money and filial attention: looking at data for thousands of families, they found that parents with higher transferable wealth – things like housing, cash, stocks and bonds – got considerably more phone calls and visits from their children. Those that got most attention of all were rich and sick and had two or more kids competing for the inheritance.

Gary Becker, a pioneer of applying economics in legal and social settings, argued that varying the level of inheritance promised to each of your children was a good way to force them to take your wishes seriously. This is increasingly popular: research by Morgan Stanley Wealth Management shows that the use of “incentive trusts” has increased in the past 20 years. Parents tend to include three types of clauses. The first encourages study by tying payouts or bonuses to achieving an undergraduate degree. The second incentivises hard work after graduation by making payouts that match an heir’s salary or reward the creation of a new business. Good-behaviour clauses link cash returns to things like religious adherence or abstinence from alcohol.

The evidence on incentive trusts is mixed. Many say that when carefully designed they work well. But they can generate perverse incentives. An education clause can penalise heirs who drop out of college due to ill health. And income-matching favours high-paying jobs over socially useful ones: parents are implicitly punishing children for choosing teaching over banking. There are ways round this, including trusts that give a bigger income-match for worthy work. But writing a contract that imagines all future eventualities is full of pitfalls. In the end it starts to get so complicated that Carnegie’s simple rule starts to look attractive.

Illustration Donough O’Malley