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26.02.2015 03:18 Age: 21 days

Time well spent

By Charlotte Thorne is a Partner at Capital Generation Partners.

A priority for the ultra-wealthy is to protect and grow their pool of capital in order to fulfil their philanthropic, personal and family goals for present and future generations. Although it is well understood how an investment strategy can affect wealth and future spending potential, the effect on investment performance of how and when capital is spent is less so.


A spending strategy limits the negative impact spending has on the growth prospects of the portfolio

While many ultra-high-net-worth investors have an investment strategy carefully designed to grow their wealth, most have a very simple approach to spending. A recent survey of trustees showed 33 per cent of private-client charities and foundations do not actively review their pay-out policy and 24 per cent have not adjusted their pay-out in line with the economic downturn. 

However, with some simple analysis, most families could adopt a spending strategy that actively enhances their investment performance, both protecting spending needs and improving investment outlook.


Spending policies

Clearly, spending represents a withdrawal from an investment portfolio and, therefore, potential future growth foregone. It can also damage the robustness of a portfolio – spending drawn down in a bad year crystallises losses in portfolios and makes recovery even more difficult.

Most families apply a constant spending policy, whereby each year they spend a fixed percentage of the portfolio value. But this embeds both of the problems outlined above by taking out cash at the worst time. It also means beneficiaries have little certainty over their spending, as it is dependent on portfolio value in a given year and, therefore, on current market conditions. The net result is a fragile portfolio that may well not endure.

There are two obvious solutions to counteract the negative impact of spending on portfolio growth and longevity – either dial up target returns by making riskier investments to offset the amount of capital taken out of the portfolio, or spend less. But neither of these options is optimal. The first increases the chance of running out of money due to higher volatility, increasing the risk of portfolio collapse, and the second constrains expenditure. This is unlikely to be an appetising prospect for wealth owners, and may not be achievable if spending commitments have already been made.

A spending strategy allows spending to take place in a more modulated fashion, thus limiting the negative impact that spending has on the growth prospects of the portfolio without materially reducing the amount of spending that can take place. This is done by marrying a spending rate (how much can be spent) with a spending structure (under which conditions such money can be spent).


Enhancing standard strategies

One simple enhancement to the standard strategies that many families use is the introduction of a ‘smoothing’ structure. Here a constant spending rate is used, but it is applied to the average value of the portfolio over a number of years – for example, the past three years. This reduces spending volatility, while keeping the benefits of flexibility, allowing the investment portfolio to target higher returns.

A second enhancement to consider is a ‘contingency’ structure, which allows a pay-out only in certain conditions. For example, the portfolio only pays out when there are real investment gains or in individual ‘up years’ and not in ‘down years’. This can significantly increase the total value and longevity of the portfolio. However, it imposes a significant burden on beneficiaries, who have to deal with substantial and potentially unsustainable volatility in their spending power.

Instead, families may consider a ‘hybrid’ structure, which combines the benefits of predictable spending and long portfolio life. For example, a hybrid policy might require that, if the real value of the portfolio is greater than the initial level, then spending is to be set at a constant amount of the original real portfolio value. Conversely, if the real portfolio value is below the initial level, spending is reduced in a smooth fashion. This can be incredibly powerful in terms of overall portfolio value and longevity, but also protects spending needs.

The ultimate aim is to combine an investment strategy and a spending strategy into a powerful system for protecting and growing long-term wealth. This integrated approach represents a real opportunity for wealthy individuals and families to achieve their goals, while maximising total portfolio value over time.