I gather from other wealth managers that what their clients are finding hardest to bear is not the fall in asset prices but falling income. A big drop in interest income has already occurred but they are probably starting to see some dividend cuts and they fear more of the same. The recession is making clear to individuals and their agents a well-concealed truth that is right up-front in No Monkey Business thinking: income consumed is inherently no different from capital consumed. From this insight, a very different and much clearer approach to decisions about spending and saving starts to take shape naturally.

Income is whatever amount it is, determined by the market (interest income, dividend income for companies as a whole) or by businesses (individual company dividends). This is how HMRC thinks of income, so the actual level makes a difference for tax. But the level of income tells us nothing about consumption until this is defined and quantified, such as a level of consumption that preserves the real value of capital, or a level that permits a target long-term growth in the value of capital.

This insight becomes obvious when you consider that the majority of the interest income paid (whether on bank deposits or fixed-income bonds) is normally the market’s estimate of the required compensation for future inflation. Spending this component, rather than adding it to capital, is equivalent to ‘eating the seed corn’ once income is defined by reference to a true personal benchmark which is real, or defined in terms of ‘purchasing power’.

One of the objectives and benefits of good financial planning is to frame choices about income and capital consumption versus savings by reference to a set of personal goals. These are then rightly seen as discretionary quantities, in the power of the owner not the market. The relevant source of organic growth, is ‘total return’: capital change plus actual income. This limiting quantity is determined by a combination of the market and the owner’s choices made about investment exposure.

Total return is a ‘stochastic’ process, with highly uncertain paths and outcomes, and so calls for technical skills based on investment and economic knowledge rather than financial planning knowledge. This prompts another No Monkey Business insight: the necessary integration of financial planning and high-level investment skills, comparable to the investment consultancies operating in the institutional market.

IFAs, stockbrokers, private banks or independent portfolio managers do not operate this way and have not seen it as necessary to develop these skills. The impact on private clients is that they are unlikely to receive the contextual information (or education) that they need. The harm includes: spending too much and eroding their capital without realising it (or feeling bad about it), underspending because they do feel bad about eroding capital (but do not need to) and making their spending much more sensitive to market volatility than it safely needs to be.

Apart from all situations where clients spend all or part of their investment income, poor decision making particualrly plagues ‘income drawdown’ from capital in retirement, which is a special case of the desire to maximise current spending without running out of money or eroding future real spending. Level annuities, as a solution to the same problem, are a special case of lack of clarity about both the goal and the risks. The 5% tax-free ‘income’ from insurance company investment bonds is a widespread example of a generic number, only loosely rooted in economic logic, driving bad individual spending choices.

The lack of coherent thinking and clear definition is also a serious source of detriment in family trusts where there is an inherent tension between beneficiaries interested in income and those in capital. Few trustees (and private-client solicitors) even realise this and so their investment managers end up with a wooly mandate which can easily maximise actual conflict.

Clear thinking is not nowadays completely absent in the management of endowment funds (charities, colleges). These are the one category of investor that have typically faced up to the need to have a set of decision rules for determining rates of consumption, or ‘take’, from the fund that are based on explicit definition of their utility.

The right decision framework is a necessary condition for finding a robust solution to the problem of consumption versus saving. But it is not a sufficient condition. It is also necessary to be realistic about the process of investment returns themselves, particularly real returns. I expect to be writing much more about what I think are errors in both directions about investment returns, particularly the nature of equity returns and risk. The industry managing equity investments typically understates risk, usually more from sloppiness than mischief making. But there are many very bright and voluble opponents who we think are overstating the risk and understating the cost, in lost utility, for individuals of trying to avoid equity risk. A search for ‘equity risk’ will bring up some earlier posts.

TAGS: drawdown, Risk, total return