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Fri, 26 Mar 2010 - 20:20

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Yale Endowment Spending Policy: Part 2

Apologies for yesterday. There was a glitch sending out the DER.

On Wednesday we looked at how the Yale endowment applies a smoothing rule to their target drawdown rate. Today we'll apply this principle to individual investors, with a few tweaks, to improve their financial health in retirement.

Retiring and living off your investments is a common characteristic among investors in the 55 - 70 age group bracket, and while most of the principles in retirement planning are common across the spectrum of retirees, there are always differences between retirees. These differences include your health at retirement, the amount that you have been able to save during the years that you were employed versus how much you wish to live off, and whether you want to leave an inheritance or if you want to use all of your retirement savings while you're alive.

The first step is to calculate your target drawdown rate based on the above factors and any other relevant information. Traditionally this would be the sole determinant of your annual income, but it can result in your income being quite variable. Using the logic of the Yale endowment fund spending policy, we would look at a couple more factors including: - Drawdown ceiling: As this method only has a target drawdown rate it is imperative that there is a ceiling to the drawdown rate to avoid depleting capital prematurely if returns have been consistently poor. - Cap in real income growth: Capping the annual growth of your real income in good times ensures that you don't unnecessarily draw income from your portfolio. This cap still allows for an increased standard of living, but regulates the pace at which it changes. - Ability to stomach varied income: As an investor is able to stomach greater variability in their income they decrease the weight applied to the prior year's drawdown, and vice versa (subject to the above constraints). Yale uses 80% of last year's income as a base.

The below analysis has been done on a hypothetical investor with the following features: - Starting portfolio: R 5 000 000 - Target drawdown: 4.5% - Drawdown ceiling: 7.0% - Real income growth cap: 10% per annum (i.e. growth in income is capped at inflation + 10% per annum) - Weighting to prior year income: 80%

Returns are based on a typical balanced fund until the end of 2009, and then simulated returns are used for the next 18 years. As the first 22 years were characterised by strong real returns we've intentionally simulated poor returns for the next 18 years. As an aside we expect that returns will be more muted going forward than they have over the last 20 years or so.

The resulting inflation adjusted income that is drawn using Yale's smoothing technique is a lot less variable. It is, in fact, 70% less variable than the fixed drawdown method.

The portfolio values also vary as the smoothed portfolio builds up a reserve in the good years (at one stage it is nearly R 7 500 000 larger than the other portfolio) but then eats away at the reserve after a period of poor returns (R 3 800 000 less than the other portfolio after a long period of poor performance).

In this example the drawdown ceiling isn't reached, but the real income growth cap is applied three times.

In only 10% of the years would your nominal income decline using the smoothing technique, with a maximum decline of 1.5%, versus nearly 30% of the years using a fixed rate (maximum decline of 15.8%).

I trust that this has given you some food for thought.

Vincent and I will be in Durban on 7 and 8 April. If you would like to set up a meeting please contact Vincent on vincent@seedinvestments.co.za or the number below.

Take care,

Mike Browne info@seedinvestments.co.za www.seedinvestments.co.za 021 9144 966

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Yale Endowment Spending Policy: Part 2

Apologies for yesterday. There was a glitch sending out the DER.

On Wednesday we looked at how the Yale endowment applies a smoothing rule to their target drawdown rate. Today we'll apply this principle to individual investors, with a few tweaks, to improve their financial health in retirement.

Retiring and living off your investments is a common characteristic among investors in the 55 - 70 age group bracket, and while most of the principles in retirement planning are common across the spectrum of retirees, there are always differences between retirees. These differences include your health at retirement, the amount that you have been able to save during the years that you were employed versus how much you wish to live off, and whether you want to leave an inheritance or if you want to use all of your retirement savings while you're alive.

The first step is to calculate your target drawdown rate based on the above factors and any other relevant information. Traditionally this would be the sole determinant of your annual income, but it can result in your income being quite variable. Using the logic of the Yale endowment fund spending policy, we would look at a couple more factors including:
- Drawdown ceiling: As this method only has a target drawdown rate it is imperative that there is a ceiling to the drawdown rate to avoid depleting capital prematurely if returns have been consistently poor.
- Cap in real income growth: Capping the annual growth of your real income in good times ensures that you don't unnecessarily draw income from your portfolio. This cap still allows for an increased standard of living, but regulates the pace at which it changes.
- Ability to stomach varied income: As an investor is able to stomach greater variability in their income they decrease the weight applied to the prior year's drawdown, and vice versa (subject to the above constraints). Yale uses 80% of last year's income as a base.

The below analysis has been done on a hypothetical investor with the following features:
- Starting portfolio: R 5 000 000
- Target drawdown: 4.5%
- Drawdown ceiling: 7.0%
- Real income growth cap: 10% per annum (i.e. growth in income is capped at inflation + 10% per annum)
- Weighting to prior year income: 80%

Returns are based on a typical balanced fund until the end of 2009, and then simulated returns are used for the next 18 years. As the first 22 years were characterised by strong real returns we've intentionally simulated poor returns for the next 18 years. As an aside we expect that returns will be more muted going forward than they have over the last 20 years or so.

The resulting inflation adjusted income that is drawn using Yale's smoothing technique is a lot less variable. It is, in fact, 70% less variable than the fixed drawdown method.

The portfolio values also vary as the smoothed portfolio builds up a reserve in the good years (at one stage it is nearly R 7 500 000 larger than the other portfolio) but then eats away at the reserve after a period of poor returns (R 3 800 000 less than the other portfolio after a long period of poor performance).

In this example the drawdown ceiling isn't reached, but the real income growth cap is applied three times.

In only 10% of the years would your nominal income decline using the smoothing technique, with a maximum decline of 1.5%, versus nearly 30% of the years using a fixed rate (maximum decline of 15.8%).

I trust that this has given you some food for thought.

Vincent and I will be in Durban on 7 and 8 April. If you would like to set up a meeting please contact Vincent on vincent@seedinvestments.co.za or the number below.

Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

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