Hey Fiduciaries: Is It All Financially Unsustainable?

money-all-goneI’ve been thinking recently about financial sustainability.  One version of the financial sustainability question is “How much can you responsibly spend from investments or endowments each year, without running out?”

There’s a lot packed into that single question, and the answers are not as esoteric as they may first appear to the average person.

Retirees living off accumulated savings, and people saving with the hope of one day living off accumulated savings, grapple with this question all the time.  Charitable foundations and institutions dependent on endowments also care deeply about this financial sustainability question, if they plan to exist in perpetuity.

But what about the rest of us, just struggling to put aside enough for whatever future expenses we anticipate – like college education for our kids, or a regular nest-egg for retirement?  Why should we care?

We should care because I suspect that the assumptions that fiduciaries[1] have made about financial sustainability in the previous generation no longer apply in the current market environment.  We have not, however, started adjusting to the new reality.  We’re not doing anything differently despite the new normal.

What does that mean?  It means that your favorite hospital or school or charitable foundation probably spends too much of its endowment every year to be sustainable.  It means your teachers and fireman and policemen – who depend on a pool of money set aside for their pensions – won’t have enough in the pool when it comes time to be paid.[2]

So, thinking about financial sustainability, I don’t think these are just the esoteric musings of a recovering banker with too much time on his hands, and too much sympathy for trust-fund folks and foundations.

The nub of the problem comes down to three facts:

1. Traditional charitable foundation/endowment spending policies[3] call for annual spending of 5% of assets,[4] as a ‘financially sustainable’ rate.

2. Traditional personal financial planning calls for annual spending of 4% of assets as a ‘financially sustainable’ rate.

3. But — riskless investments offer between 0.5 % and 2% returns.[5]

If you want complete safety with your assets, you can earn about a 1% return, which typically lags the inflation rate and puts you on a completely unsustainable path, if you have the policy of a 5% spending rate referenced in fact # 1 above.

Conversely, and axiomatically, the only way to have a fighting chance at ‘financial sustainability ’ with a 5% spending rate is to rely heavily on more risky investments, to boost the riskless 1% return to, at the very least, your 5% spending rate plus the rate of inflation.

So, a prudent fiduciary of her own money, or an institution’s money, can make the choice of taking no risk and guarantee diminishing the pool of money over time, or take a risk on more volatile markets and hope that things work out.  Which is pretty much where every fiduciary struggles right now.

I want to be very careful and point out a few ways in which what I am saying differs from the usual way we discuss this problem.

First, at the risk of breaking a cardinal rule of financial punditry, I am saying “it’s different this time.”  And by “this time” I mean “the investing life of almost everyone alive right now.”

With US Treasury Bond rates at the lowest level of most anyone’s investing life, as seen in the picture of 1953 to 2012 rates, we’re in uncharted territory for riskless returns.

Whereas previous generations of fiduciaries could choose a portfolio anchored with a large plurality of risk-free assets and cover most of their 5% spending rate, plus inflation, no fiduciary can afford risk-free assets any more.  That anchor of 1% risk-free return sinks your ship over time with a 5% spending rate.

Second, I am consciously avoiding making an argument about future return expectations.  I have no idea what future returns on risky assets will be, and I don’t intend to speculate.

It’s traditional for pension managers or endowment managers or even retirees to make assumptions about the future returns on their portfolio, to justify whatever asset allocation they do or do not wish to make.  Again, I’m not able to speculate.[6]

All I do know is that if you have to earn 6 or 7 times the annual return of riskless assets in order to cover your spending rate and inflation, then you need to fill your portfolio with almost entirely risky assets, just to break even with financial sustainability.

The only other solution, of course, is to lower your spending rate to something much closer to expected risk-less returns.  But nobody wants to take less than half the income they’re used to taking.  Or even anything less than the income they’re used to taking, for that matter.

Now it’s fair to say a version of this problem has always existed for people who manage a big pile of money for annual income but who seek financial sustainability.

What’s different now is that when 10 year Treasury bonds offered safe returns above 6% – like they did in the good ol’ days of 2000 for example – the financial sustainability choice was not so stark, or so risky.  You could count on earning most of what you needed to earn in largely risk-free assets.

Fiduciaries for educational institutions for example, face this quandary right now, all the time.  The ‘endowment norms’ from the 1960s give us cover for the idea that a 5% spending rate is prudent.  Fiduciaries know from surveys of similar institutions that they’re right in the middle of the pack, with plenty of comfortable company.  And they absolutely need that income to run the institution.

But if the norms made sense in an earlier generation of lower risk with higher return rates – – they make much less sense in the past decade – particularly in the last year with less than 2% returns for US Treasury 10-year bonds.

I don’t know what everyone should do about it.  I have no solutions.

My soon-to-retire parents hope that the previously-endorsed 4% spending rate for individuals works out.  I hope so too.  Fiduciaries for public and private pension funds hope their spending rates, return rates, and actuarial assumptions turn out to be right.  I hope so too.

My fear, however, is that from the 20/20 hindsight of our future selves, a 5% spending rate and a 1% riskless return rate look like an impossible mathematical equation that we all should have seen as unsolvable.

[1] My wife made me define this.  “fiduciary” = “person with financial responsibility for something”

[2] Which, in turn, means either: 1. Taxpayers make up the difference,   2. Retired public pensioners receive less than they were promised, or  3. Heavy inflation ‘solves’ the problem by lowering the real value of pension payouts.

[3] Based on 1960s theory about financial sustainability for charitable endowments.

[4] Charitable foundations are required to spend 5% of their corpus every year to retain their tax-exempt status.  This requirement to spend 5% of assets is probably related to where the foundation prudent practice of spending 5% came about.  But I’m guessing here.

[5] With 10yr US Treasury notes below the 2% range for the past year, the lowest in anyone’s lifetime.  Incidentally, of course some smart readers will point out that there’s a longer conversation to be had about whether US Treasury 10 year notes are truly ‘riskless,’ because if interest rates rise the bonds may decline in value before they mature, if you need to sell them rather than wait for the return of principal.  Yes, you’re right.  Other smart readers will point out that a downgraded United States no longer represents a ‘riskless’ investment.  Yes, you’re right too, up to a point.  But to the extent the US owes money on its bonds denominated in US currency, bond principal repayment is not at risk, only its purchasing power upon maturity.  All the returns I’m referring to are nominal.

[6] Fine, I’ll speculate a little bit, the following way.  If mega-bank X, which currently has the ability to borrow $ billions of dollars at 2%, had any comfort at all with a safe way to earn, say, 7% in risky assets, then mega-bank X would be doing that trade for a 5% positive carry (the difference between borrowing costs and earned return) all day long.  The fact that 7% in risky assets seems, well, risky, tells you a little something about return expectations from the smartest minds in the business.

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7 Replies to “Hey Fiduciaries: Is It All Financially Unsustainable?”

  1. Excellent post.

    The way I see it, a person has very limited options:
    1) Steal assets from another party
    2) Assume higher risk assets and be as careful as possible (praying never hurts, either)
    3) Continue on a wage-labor exchange until death
    4) Gradually convert saved assets into lower and lower risk categories.
    5) Come up with some kind of valuable and innovative product or service that can be sold at a profit.

    In my case, it comes down to spending as little as possible while preserving as much as possible in myriad assets classes. The more that I think about it, the more that I keep coming back to the notion that any asset whose value is tied to an inflated monetary unit is ultimately a losing proposition. But, you can’t “eat” gold and silver, but you can exchange them. The problem is that there are transaction costs and barriers that make them almost as costly as the next highest asset on the risk spectrum (the dollar). So, it’s a wash, in a way. Thus, I’m resigned myself to working into my seventies, spend less, save more, preserve more, and diversify among many asset classes, adjusting along the way to avoid the traps and pitfalls.

    I’m only 15% long on equities, very long on cash, long on metals, and long on non-traditional assets. I’ve got a few inverse ETFs as a hedge.

  2. Yes, diversifying is best choice if you can afford to lose money short term in hopes of ending up ok in say 10 to 15 years. The old fashioned way is to continue to work hard and earn a salary and assume it will basically track inflation – but that’s no fun!
    Owning property with a low rate mortgage seems like a good way to earn money on your money since you should be able to raise rent along with inflation. Owning some gold is a decent hedge against losing in other parts of your portfolio. Seeking some boring dividend paying stocks seems prudent since there is some cover there for potential inflation. I am trying to do all of the above, but as you point out, I wish I could rely on higher safe bond yields to sustain me. I am in mid forties and need it to last.
    Great article, by the way. A terrific distillation of what’s on every investor’s mind every day.

  3. You’ve referenced “plus inflation” in a variety of places in the discussion of nominal rates & I’m curious what is the real targets you think is realistic?

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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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