- April 23, 2020
- Posted by: Wade Pfau, Professor of Retirement Income
- Category: Investment, Single Family Offices, White Paper
Author: Wade Pfau, Professor of Retirement Income and Angelo J Robles,
Family Office Association, CEO & Founder
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What is a sustainable distribution rate from an investment portfolio? This is a fundamental question which cuts to the heart of distribution planning for a single family office. It is also the fundamental question of retirement income planning, which is a relatively new field of study within the wider discipline of personal financial planning. Spending policies for family offices share many similarities and some differences with retirement income planning. The field of retirement income planning has blossomed with new research about sustainable spending over the past five years. Within this article, I will explore similarities and differences for the decisions in both areas, in order to provide updated guidance to family offices about sustainable spending rates.
Within the field of retirement income planning, I have described in past works two opposing schools of thought about how to build a retirement income plan and manage risks. What I call the ‘probability-based’ approach shares the most in common with family offices. Probability-based methods rely on spending from a well-diversified but volatile investment portfolio with the hope that the spending strategy can be maintained for the life of the retiree or institution. Spending plans shifted in this direction since the 1970s, as previous ideas about only spending interest from a fixed income portfolio were slowly abandoned for not providing enough income and inflation protection.
These strategies rely on a total-returns investment approach, in which the principal value of the portfolio may be spent as necessary in addition to any interest and dividends generated by the portfolio. Total returns investing focuses on building diversified portfolios with stocks and bonds to seek greater long-term investment growth. By focusing on total returns, the objective is that over the long-run such strategies can produce a greater and steadier amount of income relative to what could be obtained only by focusing on the interest generated by fixed income investments. The view is that a greater allocation to stocks will reliably provide a return premium above fixed income assets to support greater inflation-adjusted spending over time. This is a calculated risk that the additional spending potential created by planning for higher market returns is justified in light of the low chance that those returns will not sufficiently materialize. At the same time, these strategies do create greater portfolio volatility as a part of striving for a greater sustainable spending rate, which in turn does create greater risks for whether the full principal value of assets may be preserved.
Sustainable spending rates for retirees and family offices depend on many factors: asset allocation, market valuations at the present (particularly, current interest rates), the desired spending pattern over time, the degree of budget flexibility to adjust spending in response to market performance, the desires to preserve a portion of the portfolio over long periods of time, and the length of the planning horizon.
A sustainable spending strategy will generally seek to provide a proper balance among three goals:
Many family offices will maintain a great deal of importance on preserving the underlying value of the assets so that they can continue to support distributions for many years to come. At the same time, current budgetary needs call for being able to spend as much as possible at the present. But with a long-term perspective, family offices also seek to continue spending on a sustainable basis without drastic cuts to future budgets.
There are trade-offs between these objectives. Most obviously, spending more today creates risk for future asset preservation and/or future spending goals. As well, a lack of flexibility to adjust spending from a volatile portfolio uniquely amplifies what is known as sequence risk (more on this later). With inflexibility to adjust spending, a more conservative spending rate is the only available risk management technique for a total-returns investment portfolio. Flexibility with spending creates synergies that allow for a higher initial spending rate.