Most Australians become reasonably comfortable matching annual spending to annual income with some provision for saving throughout their working life. On retirement they face a very different and frightening problem; how to determine spending each year from a pool of savings that must last 20-30 years? The same issue faces endowment funds and charities.
Investment income is typically far more volatile than wage income and the market value of investments can fluctuate substantially. For example, in 2009 many retirees through a combination of spending and falling market prices ended the year with around 20% less savings than at the start of the year. Some decided to cut their spending significantly, while others kept spending at a similar rate in the hope that market values would recover.
One solution is to pass this risk onto someone else through the purchase of an annuity. A life annuity, a defined benefit pension and the taxpayer-funded age pension all offer retirees the opportunity to continue spending from a reasonably stable annual income. However, most retirees currently drawdown their super as an allocated pension or withdraw their super as a lump sum to manage their retirement spending privately in conjunction with the age pension. This article discusses a spending rule that might help those retirees who pursue these options.
Annual spending over the long-term
Not-for-profit entities with endowment savings face a similar problem. How should they determine annual spending over a long horizon when investment income and the market value of assets fluctuate substantially from year-to-year. The Yale University Endowment Fund has developed a spending policy that is a useful model for local endowment funds and also may be useful for retirees.
Under the Yale policy, the target long-term spending rate is 5.25% of the Endowment Fund’s market value each year. So if the Fund is worth $20 billion, the annual target spend is just over $1 billion. However, in any given year, Endowment spending is determined by:
- 80% of the previous year’s spending, plus
- 20% of the 5.25% long-term spending rate applied to the market value of the Endowment two years prior
- The calculated amount is then adjusted for inflation over the prior year
- A constraint is imposed of at least 4.5% and no more than 6.0% of the market value of the Endowment two years prior.
This combines some spending stability with some responsiveness to changing market conditions.
To quote directly from Yale:
"The Endowment spending policy, which allocates Endowment earnings to operations, balances the competing objectives of providing a stable flow of income to the Operating Budget and protecting the real value of the Endowment over time. The spending policy manages the trade-off between these two objectives by using a long-term target spending rate combined with a smoothing rule, which adjusts spending in any given year gradually in response to changes in Endowment market value.” (Yale University Financial Report 2011).
Some comments on the spending policy:
- The target long-term spending rate of 5.25 per cent reflects Yale’s past 20-year real return from the fund (the return above inflation) and the fact that Yale University has an indefinite horizon. Retirees may want to deplete their capital over their expected lifetime, or they may want to leave capital as a legacy or retain a buffer for risk management reasons. Also, in the current investment climate, they may not have the same confidence that they can earn as high a long-run real return as Yale has done. These factors will change the target spending rate.
- The adjustment for inflation is designed to maintain the real value of spending and hence, for retirees, implies a similar standard of living in the absence of any adverse changes in the market value of savings.
- The weights of 80% applied to last year’s spending and 20% applied to the value of the Endowment gives greater weight to spending stability over adjusting more quickly to financial conditions. Yale started with weights of 70% and 30% and a retiree could choose these weights or others to suit their own circumstances.
There is a big difference between the drawdown rate from a pension account and the retiree’s actual spending in retirement. Retiree spending depends upon their total resources both within the superannuation system and those held privately. The drawdown rate from the pension account might be set using the ATO’s minimum annual payments for super income streams. The spending policy might use the Yale model to identify spending guidelines.
Few retirees will spend just because a model indicates that this amount can be spent. In reality, the Yale policy is not so much a methodology for determining annual spending, but rather a warning flag when the unavoidable spending requirements of the day – food, survival, medicine etc. – force one beyond the guidelines into depleting one’s capital faster than planned. It would be a signal to tighten one’s belt.
Lessons for endowments, charities and governments
In Australia, the Benevolent Society Endowment uses a rule similar to Yale’s in determining the annual distributions from their Endowment to support new Benevolent Society initiatives. The target real rate is the forecast long-term real rate that the Endowment expects to achieve, after investment management fees, and the weightings are 70/30. This provides a relatively stable annual cash flow to fund initiatives with the expectation of maintaining the real value of the Endowment for future generations. Real Endowment growth is achieved through attracting new capital donations, which will support real spending growth on initiatives.
The Yale model has useful elements for Australian entities with endowment funds, for Private Ancillary Funds (PAF) that are used by families, individuals or companies to establish grant-making foundations and also for self-funded retirees. A smoothed, constrained spending policy may even have some applications for governments balancing annual spending initiatives against a background of volatile tax revenues due to rapidly changing economic circumstances!
Justin Wood is a founding shareholder in Vinva Investment Management and member of the Benevolent Society Endowment Investment Advisory Committee.