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    Yale Endowment: Spending Policy – Part 1

    Last week we took a look at endowment funds and the Yale Endowment in particular. More specifically we covered the goals of the endowment and how the successful management of the endowment can greatly assist in the running of the institution that the endowment is set up to assist. Click here if you missed that report.

    Key to any endowment is the need to balance income requirements of today with future income requirements. In much the same way one’s retirement assets can be managed like those in an endowment.

    Receiving an income today is vital, but if you draw too much today the future viability of your portfolio will be eroded. An important element of retirement planning is therefore getting your initial drawdown correct, and ensuring that your portfolio is structured to achieve your income needs throughout retirement.

    In addition to your initial drawdown level, another important aspect to consider when setting up your income requirements is the variability of your annual income. Setting a specified drawdown level and sticking to it works in theory, but in practice it is a lot more difficult to change spending habits (especially reducing spending) over the short term. This is where we can take a leaf out of Yale’s spending policy.

    Yale has a target long term spending (drawdown) rate, which is smoothed over time. Managing income requirements using these two methods greatly contributes towards the financial health of the institution (retired person) over time. Yale targets a drawdown rate of 5.25% per annum which is smoothed by taking “80 percent of the previous year’s spending and 20 percent of the targeted long-term spending rate (5.25%) applied to the market value two years prior. The spending amount determined by the formula is adjusted for inflation and constrained so that the calculated rate is at least 4.5%, and not more than 6% of the Endowment’s inflation-adjusted market value one year prior.”

    This method ensures that in good years a buffer is built into the endowment (i.e. not all gains are paid out) so that in the bad years spending doesn’t have to be cut as drastically. The result of the smoothing is that the annual payout has been a quarter as volatile as the endowment value over the past 20 years.

    Below are two charts. The first chart reflects the difference between actual endowment spending and an approximation of what spending would have been had there not been the smoothing rule. The second chart shows the change in spending from the prior year under the two methods.

    Two points to notice from the charts is that one year’s good or bad performance doesn’t overly influence how much income the university receives from the endowment because of the smoothing rule applied. In the same way a retiree won’t want their income level to fluctuate widely based on one year’s performance. Secondly consistent good/poor performance will influence how much the endowment is able to pay out to the university. Likewise, the value of a retiree’s portfolio should still have an impact on how much can be drawn from the portfolio over the longer term.

    Tomorrow we will take a closer look at how we can apply and modify these methods to your income drawdown from your retirement investments.

    Take care,

    Mike Browne
    021 1944 966

    Permalink2010-03-24, 17:35:15, by Mike Email , 1 comment
    Trackback address for this post: http://blog.sharenet.co.za/htsrv/trackback.php/1731

    Comments, Trackbacks:

    Comment from: santohs kumar [Visitor] Email · http://hyderabad
    please send me daily morning equity report i dont complete market pls send sir,
    santosh kuamr
    PermalinkPermalink 2010-04-01 @ 12:50

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