Policies on paying out from investment portfolios should be regularly reviewed to preserve value and prevent large fluctuations in annual spending, according to a new report.
Produced by London-based private investment office Capital Generation Partners, the study advocated “hybrid” spending policies to balance short-term and long-term interests.
CapGen made the recommendations as it revealed that 40% of private client trusts and foundations polled fail to actively review their spending policy in line with a fund's performance. Similarly, just 29% of pay-out policies are adjusted to account for the wider economy.
CapGen simulations show that one in twenty $100 million funds that spend $4 million annually and have a 5% real return target will run out of money after 16 years if spending is fixed at $4 million annually.
Charlotte Thorne, a CapGen founding partner, said a key message was that there is no need for conflict between beneficiaries who want a portfolio to grow for as long as possible, and those keen to maximise drawdown.
“There's a way to be slightly more creative between these two tensions,” she said.
Strategic Spending: A First Principles Approachadvocates combining “smoothing” and “contingent” spending policies to maximise “system total value”. With smoothing, spending is a proportion of the weighted average of the values of the portfolio over several previous years, rather than a single year. A contingent spending policy may specify that spending can only be made in good years or from real gains in the portfolio.
A hybrid of these two approaches, the report said, facilitates planned spending by creating a more dependable pay-out profile, which is easier for beneficiaries. At the same time, by enhancing the portfolio's resilience and ability to cope with market shocks, there is little risk of the fund running out of money. Thorne said it was not unusual for smoothing policies to be in place, but “almost no one has built in the additional element of flexibility and contingency”.
The report emphasises that spending strategies should be given as much attention as investment strategies and that by considering the two together, funds can target higher investment returns while meeting spending needs.
Bob Berry, Boots Professor of Accounting and Finance at Nottingham University Business School in the United Kingdom, said it was already typical for spending and investment strategies to be considered alongside one other. He indicated that the report's recommendations could nonetheless prove useful.
“They're highlighting the need to understand what clients want and they're highlighting … that you sometimes have to educate your clients about what is possible,” he said.
Thorne said there was no “one-size-fits-all” approach and that spending and investment policies must fit a fund's particular goals. CapGen advocated setting the mount spent at least one percentage point below the real return target. Also, it said simulations should be used to formulate spending and investment policies so the particular goals of investors are met.