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Beverly Chandler

Focus on strategic spending says CapGen


Nearly half of private client trusts and foundations, some 40 per cent, do not actively review their spending policy, according to a survey of trustees conducted by private investment office, Capital Generation Partners (CapGen).

CapGen’s research also found that just under a third, at 29 per cent, of those polled revealed that their clients do not adjust their pay-out policy in line with the wider economy.
The firm writes that the results indicate that a significant number of investors are putting their long-term wealth at risk, as the combination of volatility in the investment portfolio and a static spending policy increase the chance that volatility will damage the portfolio permanently.
Khaled Said at CapGen says: “While all investors must accept volatility as they seek to achieve investment returns, it needs to be managed to avoid permanent capital loss.  This is not just for the investment manager to do – the beneficiaries and trustees can also act to soften the effects of volatility by introducing fairly small amounts of flexibility into their spending policies.
“Spending is an under-researched area of wealth management – often seen as the by-product of investment management. We believe this is the wrong approach and that a spending strategy needs to be incorporated into the overall portfolio management strategy. This will allow trustees and advisers to ensure that the pay-out commitments are met while enhancing the portfolio’s long-term resilience. This doesn’t necessarily mean reducing spending. Instead, there are some simple steps that trustees and advisers can take to protect their assets and mitigate the risk.”
CapGen’s paper ‘Strategic spending: A first principles approach’ seeks to minimise the damage volatility can do to a portfolio. The firm looked at a typical USD100 million portfolio with a 4 per cent real return target and a fixed spending rate of USD4 million each year and simulated future possible outcomes. Their survey found that under current conditions 5 per cent of such portfolios would run out of money after 18 years. 
Increasing the return target to 5 per cent with a fixed spending rate of USD4 million a year, to try to build a bigger buffer between returns and payouts, worsens the situation – in this case 5 per cent portfolios will run out of money after 16 years.
Khaled Said says: “Reducing spending or requiring beneficiaries to manage unacceptably large fluctuations in the amount they can spend each year may not be practical. In any case, these options merely take from current beneficiaries in order to prioritise the longevity of the portfolio and future beneficiaries – they are effectively robbing Peter to pay Paul rather than growing the pot so that current and future needs can be met.
“A better approach is to build a modest degree of flexibility into spending policies so that the impact of volatility on portfolios is reduced whilst still giving beneficiaries a degree of certainty over what they can spend.”
CapGen believes applying an integrated approach which combines two different spending policies (smoothing to manage volatility in expenditure, and a contingent spending policy to manage the impact of volatility on portfolio growth) means that the versions of the portfolios outlined above,  4 per cent target return with a 4 per cent payout, would still deliver a consistent level of spending but would never run out of money.
To assist wealth owners and their advisers, CapGen has prepared five basic rules which are: develop an investment strategy in tandem with a spending strategy; to preserve capital set the spending rate at least 1 per cent less than the target real investment return; map out your spending profile to work out how flexible or otherwise your spending is, then use simulations to help choose the unique spending and investment policies to meet your unique goals; use smoothing to provide consistency in spending levels and maximise the future total portfolio value rather than lowering the target investment return; use contingent spending to increase total portfolio value over time if you have spending flexibility and hybrid policies combining smoothing and contingent spending policies may be useful if you need some spending certainty. 
CapGen’s paper – “Strategic spending: A first principles approach” – is available here.

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