After sifting through all the jabber about money, empirical evidence suggests there are only three reasons to save:
1. To provide a measure of security against unforeseen events,
2. To spend/enjoy the accumulation at a later date, or
3. To make it easier for future generations to achieve #1 and #2.
These observations don’t require extended analysis. Rational people know that life has daily costs and a degree of uncertainty about the future. Saving is a logical, prudent response.
So much of the public discussion about money involves saving and accumulation that we sometimes forget the ultimate goal of any accumulation program is to spend it! And not just a little, but as much as possible.
“Spending as much as possible” may come across as wasteful and hedonistic. But what is the purpose of saving, if not to eventually spend it? In a financial emergency, the reason you saved was to have some money to alleviate the crisis. In retirement, a large measure of your satisfaction will come from being able to spend money—for both necessities and pleasures. And even estate bequests are a sort of spending; you are providing the opportunity for loved ones or favored causes to increase their security or enjoyment.
At the most basic level, the money you’ve saved only manifests its worth when you spend it. Your accumulation plans have no impact on your material world until you spend the money—or at least until you know you can spend it if you want to. As long as the money is in a bank account, mutual fund, IRA, whatever, it doesn’t have a tangible impact on your life. Food isn’t more plentiful, the car you drive doesn’t get bigger and your home doesn’t get redecorated.
Yet you might hear or read this advice: “Because of taxes, you’ll want to delay distributions from this account as long as possible.” This is your reward for 20 or 30 years of delayed gratification, to be advised to wait even longer? Sure, saving requires delayed gratification, but it shouldn’t mean canceled gratification.
We have it on good authority that everyone dies. And so far, no one has been able to take the unspent portion with them to the Great Beyond. If those are the facts (and they are), it doesn’t make sense to work and save all your life, and then not enjoy the fruits of your diligence and discipline. An accumulation plan is only half of a financial program. The other part is how to maximize spending.
How then shall we spend?
So once you’ve accumulated, how do you spend? Prompted by the disappearance of pensions, and the surge of Baby Boomer retirees (they impact everything!) the personal financial planning industry is just beginning to evolve beyond rudimentary lifetime spending plans. To understand why new ideas about spending are necessary, it might be helpful to critique the classic spending strategy summarized as Live on Earnings, Conserve Principal.
The Classic Plan: Live on Earnings, Conserve Principal (LOECP)
The idea is simple: Build a large enough accumulation so that you can live on the earnings (interest, dividends and capital gains) generated from the principal. You don’t have to worry about “outliving your money,” because the principal will always be there, generating income. Earnings may fluctuate with returns, but as long as you aren’t touching the principal, your ability to continue spending remains intact. And when you are gone, the principal can be passed on.
Living on earnings also ensures there will be assets to inherit. Depending on the underlying investments, the principal may increase or decrease, but it will never disappear. Executed properly, the live-on-earnings-and-conserve-principal strategy accomplishes the three objectives of saving stated above: There is a sizable reserve for emergencies, an income to be spent and the opportunity to pass the remainder to designated heirs.
The accumulation strategy prior to distribution for an LOECP approach is also pretty simple: Accumulate the largest pile possible. Ideally, a well-funded LOECP provides growth that exceeds income needs. This “extra” can be added to the existing principal, generating ever-larger earnings.
LOECP works…but inefficiently
While LOECP is a workable spending strategy, it may not be the best way to maximize spending. In fact, using LOECP to provide security and inheritance almost guarantees that you will lessen your spending and enjoyment. Here’s why:
1. The untouched principal is one very expensive “insurance policy.” It’s true that living on earnings provides security against outliving your assets, but it does so by assuming you will live forever, and that’s not going to happen. The “insurance” you get from conserving principal comes at a steep price.
Essentially, not touching the principal each year is the premium required to provide “old age security.” With most insurance you pay a small premium, relative to the principal amount, to get a large benefit when, or if, something unexpected occurs. But with LOECP, the principal is the premium and the benefit, and there’s no financial leverage from sharing the risk with others.
Consequently, when you decide to live on the interest, a major beneficiary of your “insurance plan” is the financial institution that holds your assets. Consider:
If you have accumulated $2 million dollars, earning 6 percent annually, living on earnings produces a $120,000 annual income while preserving principal. Depending on how you evaluate your retirement future, $120,000 could sound like a nice number. But that’s not the point.
The bank (or a pension plan, insurance company or investment fund) gives you $120,000 while it uses the $2 million you’ve left in reserve. Year by year, you get $120,000 to spend, and they get $2 million to earn a profit. Who benefits most from your account? One might argue the financial institution has the advantage.
2. If you accept the spending limitations of LOECP because you want to leave an inheritance, there’s another downside. The untouched principal may not transfer directly to beneficiaries. Any significant balances left for the next generation must first be filtered through the government, either by estate taxes or income taxes due on the unspent portions.*
Not only do you forfeit immediate spending and enjoyment, but so do your heirs. And the tax bite is progressive: The larger the principal that remains unspent, the greater the possibility of diminished inheritance.
In light of the previous paragraphs, one could argue that LOECP provides greater benefits for financial institutions and the US Treasury, with you skimming the “extra” while alive, and your heirs getting the after-tax “leftovers” when you die.
3. And there’s another problem with LOECP: When the yields on guaranteed financial instruments are below one percent (like they are right now), spenders must either dramatically reduce spending or take on greater investment risk and volatility to produce the income they require. Not only is the income less certain, but any loss of principal makes it harder to generate income in the future.
In summary, living on interest and conserving principal is a workable spending program, but it requires substantial capital to deliver arguably substandard spending benefits.
Looking for Better Ways to Spend
In the past decade, financial professionals have taken a closer look at maximizing spending using a range of strategies, such as:
• Spend-down calculations to systematically liquidate assets according to longevity projections.
• Sequenced distributions from different asset categories to minimize taxes.*
• Integration of insurance and investment vehicles to achieve real insurance benefits, instead of keeping principal in reserve.
• Blending guaranteed and fluctuating returns to achieve a greater stability in retirement income.
Saving is an essential ingredient for long-term financial satisfaction, but the endgame isn’t accumulation. It’s spending. And spending isn’t just a retirement issue: There can be plenty of reasons to spend before retirement. A fully articulated financial program always has an eye on spending well.
* Tax, legal or accounting advice is not provided by the representative(s). Consult your tax, legal or accounting professional regarding your individual situation.
Elozor Preil, RICP®, CLTC is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at [email protected]. See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.