Retirement Resources: The Endowment Spending Policy

An endowment spending policy is an important resource in the retirement toolkit, as it’s a strategic approach to determining portfolio withdrawals. To establish a spending policy, investors need to calculate the amount of money needed to supplement the income received from other sources. The annual spending amount should be converted to a percentage of the retirement portfolio to ensure the spending amount is realistic.

Lifestyle Policy Falls Short 

The spending policy you chose determines the way a spending amount is calculated from year to year. People often assume a “lifestyle spending policy,” which increases at the same rate as the Consumer Price Index (CPI), is the best approach because it takes into consideration the effect of inflation. While it’s attractive because it is simple, the lifestyle spending policy is flawed in two key areas:

1. This policy does not tie the spending level to the performance of the underlying investment portfolio. Thus, the lifestyle spending policy never requires the retiree to slow or reduce their spending during an extended bear market.
2.  Spending amounts may increase too rapidly during periods of high inflation, exposing the retirement portfolio to the risk of premature depletion.

The weaknesses in the lifestyle spending policy are illustrated in the chart below, which shows annual spending amounts for a hypothetical retiree who began taking portfolio distributions of 5% from their $1 million retirement portfolio on January 1, 1973, and increased their spending by the rate of inflation every year. Using a lifestyle spending policy, portfolio values suffer dramatically during periods of rising inflation (1973) and declining markets (2000). Failing to make annual spending adjustments that reflect changes in the portfolio value may negatively affect portfolio longevity.

Historically, this was one of the most difficult retirement periods in the last 80 years, due to an extended period of high inflation coupled with a significant bear market. Inflation during the 10 years from 1973–1982 averaged 8.75% annually, which resulted in a doubling of the spending amount during the period.

For this retiree, high inflation was only half the story. Over the same timeframe, the stock market declined significantly. The S&P 500 Index lost approximately 37% during the first two years of this individual’s retirement. The combination of choosing a lifestyle spending policy during a period of high inflation and the losses from the 1973–1974 bear market resulted in the investment portfolio being depleted in just about 21 years (see below). While flawed, the lifestyle spending policy continues to be widely used because of its simplicity. Yet, using this policy in sub-optimal economic and investment markets can lead to a retirement portfolio being prematurely depleted.

Choosing a spending rate is critical. This chart illustrates the effect different spending rates would have on portfolio value. The investor who chose the 4% spending rate would have received income from their investment portfolio for over 30 years and still have a value of $1,927,197.

Endowment Policy Delivers 

A more optimal alternative to the lifestyle spending policy is the endowment spending policy, which is used by some college and university endowments. Unlike the lifestyle approach, the endowment spending policy uses a more conservative approach. It combines a percentage of the prior year’s spending with a percentage of the current market value of the investment portfolio to determine next year’s annual spending amount. Having a percentage of the spending amount tied to the performance of the portfolio will increase or decrease the spending amount in tandem with the value of the investment portfolio. A decrease in the spending amount during an extended bear market is vital for improving the sustainability of any investment portfolio.

While the endowment spending policy is designed to lower the spending amount during a bear market, it does so gradually, thereby allowing the retiree time to adjust spending and stay on plan. Like university endowments that use a similar policy, it provides a balance between funding current operations with preserving assets to cover future operations. To begin using an endowment spending policy, retirees must decide upon two things: the initial spending rate and what formula should be used for the smoothing rule. An endowment spending policy’s variables are as follows:

A spending rate is the percentage of the portfolio value used to calculate the annual spending amount. While there is much debate about what constitutes a sustainable spending rate, industry consensus is that a percentage between 4% and 5% provides a prudent balance between generating reasonable annual income and providing opportunity for portfolio growth. For our hypothetical, we choose 5% as our spending rate, which equates to $50,000 per million of savings in the first year of retirement.

The smoothing rule identifies the speed at which the annual spending amount will be increased or decreased based on the portfolio’s investment performance. For example, a 90/10 smoothing rule assumes that 90% of the spending amount will be based on the prior year’s spending, and 10% will be based on the portfolio’s current valuation.

Endowment Spending Policy Illustrated (1973-1976)

Source: Thornburg Investment Management

The table above illustrates how the endowment spending policy would be calculated during a hypothetical four-year period with high annual inflation. In this example, we assume the retiree, who has a $1 million portfolio, chooses an endowment spending policy with a 5% spending rate and a 90/10 smoothing rule. The illustration shows the portfolio value on January 1 of each year and the annual spending calculation.

Annual calculations reflect changing markets, inflation rates, and may improve portfolio longevity. While spending increases year-over-year using this approach, spending does not increase as quickly as it would have if a lifestyle spending policy had been chosen.

The annual spending rate increases during the first two years of the bear market but does not keep pace with inflation since the underlying portfolio value does not warrant it. This willingness to reduce the spending amount when the investment portfolio is not performing well is key to having a sustainable retirement portfolio. The endowment spending policy also assists in maintaining a reasonable current spending amount during both bear and bull markets.

A Comparison Over a 30-Year Retirement

Let’s return to the January 1, 1973, example and see the difference an endowment spending policy would have made to the sustainability of the retirement portfolio. During the 30 years (as shown below), the portfolios using an endowment spending policy to calculate distributions outperformed the portfolios that chose the lifestyle spending policy, even when the spending rate decreased.

When using an endowment spending policy, spending amounts may not keep pace with inflation unless the performance of the underlying investment portfolio increases enough to support it. This slow “tightening of the belt” during bear markets is one of the keys to a sustainable retirement portfolio.

Key Takeaways

The endowment spending policy is a strategic approach to determining withdrawals. Conceptually, it’s a long-term spending policy that combines a spending rate with an annual smoothing rule, which adjusts a spending amount to gradually reflect changes in portfolio market value. The policy does require belt-tightening during down markets, and it can be more complicated than the lifestyle spending policy, but it remains straightforward to implement.