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Spending guidelines for retirees and endowments

Most Australians become reasonably comfortable matching annual spending to annual income with some provision for saving throughout their working life. On retirement they face a very different and frightening problem; how to determine spending each year from a pool of savings that must last 20-30 years? The same issue faces endowment funds and charities.

Investment income is typically far more volatile than wage income and the market value of investments can fluctuate substantially. For example, in 2009 many retirees through a combination of spending and falling market prices ended the year with around 20% less savings than at the start of the year. Some decided to cut their spending significantly, while others kept spending at a similar rate in the hope that market values would recover.

One solution is to pass this risk onto someone else through the purchase of an annuity. A life annuity, a defined benefit pension and the taxpayer-funded age pension all offer retirees the opportunity to continue spending from a reasonably stable annual income. However, most retirees currently drawdown their super as an allocated pension or withdraw their super as a lump sum to manage their retirement spending privately in conjunction with the age pension. This article discusses a spending rule that might help those retirees who pursue these options.

Annual spending over the long-term

Not-for-profit entities with endowment savings face a similar problem. How should they determine annual spending over a long horizon when investment income and the market value of assets fluctuate substantially from year-to-year. The Yale University Endowment Fund has developed a spending policy that is a useful model for local endowment funds and also may be useful for retirees.

Under the Yale policy, the target long-term spending rate is 5.25% of the Endowment Fund’s market value each year. So if the Fund is worth $20 billion, the annual target spend is just over $1 billion. However, in any given year, Endowment spending is determined by:

  • 80% of the previous year’s spending, plus
  • 20% of the 5.25% long-term spending rate applied to the market value of the Endowment two years prior
  • The calculated amount is then adjusted for inflation over the prior year
  • A constraint is imposed of at least 4.5% and no more than 6.0% of the market value of the Endowment two years prior.

This combines some spending stability with some responsiveness to changing market conditions.

To quote directly from Yale:

"The Endowment spending policy, which allocates Endowment earnings to operations, balances the competing objectives of providing a stable flow of income to the Operating Budget and protecting the real value of the Endowment over time. The spending policy manages the trade-off between these two objectives by using a long-term target spending rate combined with a smoothing rule, which adjusts spending in any given year gradually in response to changes in Endowment market value.” (Yale University Financial Report 2011).

Some comments on the spending policy:

  • The target long-term spending rate of 5.25 per cent reflects Yale’s past 20-year real return from the fund (the return above inflation) and the fact that Yale University has an indefinite horizon. Retirees may want to deplete their capital over their expected lifetime, or they may want to leave capital as a legacy or retain a buffer for risk management reasons. Also, in the current investment climate, they may not have the same confidence that they can earn as high a long-run real return as Yale has done. These factors will change the target spending rate.
  • The adjustment for inflation is designed to maintain the real value of spending and hence, for retirees, implies a similar standard of living in the absence of any adverse changes in the market value of savings.
  • The weights of 80% applied to last year’s spending and 20% applied to the value of the Endowment gives greater weight to spending stability over adjusting more quickly to financial conditions. Yale started with weights of 70% and 30% and a retiree could choose these weights or others to suit their own circumstances.

There is a big difference between the drawdown rate from a pension account and the retiree’s actual spending in retirement. Retiree spending depends upon their total resources both within the superannuation system and those held privately. The drawdown rate from the pension account might be set using the ATO’s minimum annual payments for super income streams. The spending policy might use the Yale model to identify spending guidelines.

Few retirees will spend just because a model indicates that this amount can be spent. In reality, the Yale policy is not so much a methodology for determining annual spending, but rather a warning flag when the unavoidable spending requirements of the day – food, survival, medicine etc. – force one beyond the guidelines into depleting one’s capital faster than planned. It would be a signal to tighten one’s belt.

Lessons for endowments, charities and governments

In Australia, the Benevolent Society Endowment uses a rule similar to Yale’s in determining the annual distributions from their Endowment to support new Benevolent Society initiatives. The target real rate is the forecast long-term real rate that the Endowment expects to achieve, after investment management fees, and the weightings are 70/30. This provides a relatively stable annual cash flow to fund initiatives with the expectation of maintaining the real value of the Endowment for future generations. Real Endowment growth is achieved through attracting new capital donations, which will support real spending growth on initiatives.

The Yale model has useful elements for Australian entities with endowment funds, for Private Ancillary Funds (PAF) that are used by families, individuals or companies to establish grant-making foundations and also for self-funded retirees. A smoothed, constrained spending policy may even have some applications for governments balancing annual spending initiatives against a background of volatile tax revenues due to rapidly changing economic circumstances!


Justin Wood is a founding shareholder in Vinva Investment Management and member of the Benevolent Society Endowment Investment Advisory Committee.


John Picone
August 29, 2014

It would be interesting to see how much Yale spent in the years after the GFC.

Their endowment took a huge hit and they made some big cuts to their budget in ensuing years. I would expect that they would have overspent for a number of years had they spent up to their formula. Had their endowment not recovered so quickly they may have had to make some radical changes.

It would seem they reacted quickly to the new conditions and didn't blindly follow the rules.

Harry Chemay
June 12, 2013

It is interesting to contrast our approach to retirement spending control here relative to the US. There a body of US academic and practitioner research stretching back some 20 years has developed as to the minimum 'safe withdrawal rate'; that percentage of a commencing retirement portfolio that can be drawn each year whilst safely lasting for a defined period, typically 30 years. US Financial Planners spend a great deal of time working out safe withdrawal rates for their retiring clients, and this rate typically sits in the 4% pa to 4.2% pa range.

Here in Australia the dominance of market linked income stream products, such as Account Based Pensions, make this sort of exercise largely redundant, as the only pension decision to be made is whether to draw at the legislated minimum level or at a higher dollar amount if the minimum proves insufficient. Those well superannuated tend to adopt the former course of action, whilst those under-superannuated adopt the latter. And there is a free put option in the form of the government Age Pension, which acts as 'downside protection' to imprudent spending decisions or poor investment returns in retirement.

In short the drivers that have led endowments and US retirees to seek the discipline of a Yale style spending formula simply don't exist here in a retirement planning context. Whether this is a positive or negative situation is more a retirement incomes policy debate than a pure investment one.

David Evans
June 07, 2013

There is a very simple answer to Justin Wood's question. Know how to identify beginnings and ends of trends, and don't give your money to other people to manage, and understand risk management. End of story.

Justin Wood
June 10, 2013

Anyone that can consistently identify the beginning and ends of investment trends will find outcomes less volatile and long-term spending decisions far less scary. The trouble is that most people, including investment professionals, find this hard to do. What investment trends do you see beginning now?

Angus Stephen
June 11, 2013

I think the central message from Justin is how well long term goals are served by having a clearly documented investment policy, the discipline to apply it through an agreed process and the ability to fine tune it based on a certain time frame. Do you employ a similar process to identify the beginning and end of trends?

As to everybody managing their own money - this country's obsession with residential property investment and some sections of the SMSF industry having a single property as the only, heavily geared asset in a fund, suggests that some people could benefit from employing the principle of comparative advantage, and seeking assistance in an area where they are not an expert.

Warren Bird
June 12, 2013

First, I'd like to know how tongue in cheek David was intending to be. As an ironic comment about how 'simple' the solution is, I like it!
But to remark on the substance of the comment, I think it's misleading to talk about managing your money yourself. It's almost impossible to do so, in reality. Apart from owning a property directly and managing the letting, maintenance, etc yourself with every other investment you have to trust someone to do a good job with your money.

Buy shares directly? In which case you are handing over capital to Boards, CEO’s and their staff, trusting that they will make sound business decisions to generate and grow income in order to deliver you a satisfactory return.

Buy bonds or debentures directly? Same thing, really. The issuer of the bond promises to pay you interest and repay your capital, but you still have to trust that they will do that wisely or they may default.

Invest in term deposits? Again, you are trusting the bank to look after the money they take on deposit and not lose it.

Invest in a managed fund? See what I'm getting at - in reality using a funds manager is little different to investing directly. You have to do your homework on the style of the fund, the people who make the decisions and the processes they use, but that's very similar to buying shares. (I have, of course, presumed that the idea of 'managing your own money' is really saying, 'don't use a fund manager'.)

Even if it's merely an index fund, so that the professional organisation can access a highly diversified portfolio on your behalf, investors should research the possibility the same way they research the shares they buy. The idea that 'managing your own money' is a better way to do things is all too flippant a throwaway line.


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