Once you decide that your client needs to supplement her income by taking distributions from an investment portfolio, you need to choose a spending policy. A spending policy is the method for determining how much can be withdrawn from the investment portfolio on an annual basis without depleting the principal too quickly.

Spending Policies
There are two kinds of spending policies: the lifestyle spending policy and the endowment spending policy. Two key decisions determine which type of spending policy will be chosen. They are:

• How much will be spent initially, and

• How will the spending amount be increased or decreased?

Lifestyle Spending Policy
A lifestyle spending policy is calculated by identifying a percentage of the portfolio that is withdrawn to cover expenses, increased by a cost of living adjustment typically measured by the Consumer Price Index (CPI). This spending policy is referred to as a “lifestyle” policy because it is intended to provide the investor with a consistent standard of living that is indexed to inflation.

The lifestyle spending policy, although attractive due to its simplicity, is flawed in two important areas.

1. This policy does not tie the spending level of the performance to the value of the underlying investment portfolio. As a result, the lifestyle policy never requires your client to slow or reduce their spending level during extended bear markets when her portfolio may decline.