We may not be able to control the direction of the markets or the rate of inflation, but we can control the amount of money we spend.
Once you decide that your client needs to supplement income by taking distributions from an investment portfolio, you need to choose a spending policy. A spending policy is the method for determining how much can be withdrawn from the investment portfolio on an annual basis without depleting the principal too quickly.
There are two kinds of spending policies: the lifestyle spending policy and the endowment spending policy. Two key decisions determine which type of spending policy will be chosen:
- How much will be spent initially?
- How will the spending amount be increased or decreased?
Lifestyle Spending Policy
A lifestyle spending policy is calculated by identifying a percentage of the portfolio that is withdrawn to cover expenses, increased by a cost-of-living adjustment typically measured by the Consumer Price Index (CPI). This spending policy is referred to as a “lifestyle” policy because it is intended to provide the investor with a consistent standard of living that is indexed to inflation.
The lifestyle spending policy, although attractive because of its simplicity, is flawed in two important areas:
- This policy does not tie the spending level of the performance to the value of the underlying investment portfolio. As a result, the lifestyle policy never requires your client to slow or reduce spending during extended bear markets when a portfolio may decline.
- Because the withdrawal rate is driven by the inflation rate, spending amounts may increase too rapidly during periods of high inflation, placing the portfolio at risk of premature depletion.
To understand how a lifestyle spending policy works, it’s helpful to look at a hypothetical client’s situation. Assume you have a client who has a $1-million portfolio and wants to begin taking distributions of 5 percent on January 1, 1973. During the following decade, annual inflation averaged 8.75 percent, and your client’s spending amount doubled from $50,000 to $108,632 (see figure 1).
For this client, high inflation was only half the story. Between 1973 and 1974, stock prices fell dramatically and the S&P 500 declined by approximately 37 percent.
The combination of high inflation and stock market losses caused this client’s investment portfolio to last just 21.5 years (see figure 2).
It may seem unfair to use an example that begins in 1973, during arguably one of the toughest investment periods in the past 80 years. So let’s look at how the lifestyle spending approach worked during a more moderate investment environment that began in 2000. In figure 3, the blue line shows the lifestyle spending rate from 1973 to 1985, a period during which inflation rose from 6.16 percent in 1973 to a high of 13.58 percent in 1980 and then declined to 3.55 percent in 1985.
The gold line shows the spending rate beginning in 2000 when the rate of inflation was 2.19 percent and ending in 2013 when the rate of inflation was 2.07 percent.
Figure 3 shows that, regardless of the rate of inflation, the lifestyle spending approach creates a problem because the amount being spent increases every year, and because there is no relationship between the value of the underlying portfolio and the spending amount.
The client who began taking portfolio distributions in 2000 doesn’t have the same magnitude of the problem as the client who began taking distributions in 1973, because inflation was lower and grew at a much slower rate. Still, at the end of 14 years, withdrawals as a percentage of the portfolio for your 1973 client have increased to 39 percent, and withdrawals as a percentage of the portfolio for the 2000 client have increased to 23 percent. Figure 3 shows that both rates are at odds with the goal of a sustainable portfolio.
So, if the lifestyle spending policy isn’t the way to go, what approach can you take to help clients balance cash-flow needs with inflation, market fluctuation, and the desire to extend the longevity of their investment portfolios?
Consider an endowment spending policy.
Jan Blakeley Holman, CIMA®, CFP®, is director of advisor education at Thornburg Investment Management. She earned a BA in political science from the University of Denver. Contact her at [email protected].