(Dow Jones) In the face of volatile markets and fears that taxes and inflation are set to rise, some advisors are urging their ultra-rich clients to keep spending under 3% of net their worth-especially if they have plans to pass money to the next generation.
It's axiomatic that most family fortunes are gone by the third generation. Though the blame is usually fixed on poor stewardship-human error, in other words-the amount of control most families have over long-term investment performance is slight, and virtually nonexistent when it comes to wealth wasters such as inflation and taxes.
The only area over which a family can reliably exert control is spending.
John Elmes, head of business development for Palm Beach Gardens, Fla.-based GenSpring Family Offices, said some wealthy families are like those in other income brackets: They have no idea how much they spend. He tells of a family worth about $200 million that came to GenSpring thinking its yearly expenditure was $1.5 million. On examination, it turned out to be nearly $5 million.
At 2.5% of the family's net worth, that was probably an acceptable drain, as GenSpring's research suggests.
Take a family investment portfolio that is 50% growth, 45% defensive and 5% cash. Now assume an inflation rate of 3%, an ordinary capital-gains tax rate of 35% and a long-term capital-gains rate of 15%. With an annual pre-tax return of 8.29%, GenSpring gives a family that spends between 1% and 4% of the portfolio principal an excellent chance-between 100% and 85%-of having money left over after 30 years. Increase the spending rate to between 5% and 10%, however, and the chances of such an outcome go from dead even to zero.
These numbers were crunched with a view to having something-even a penny-left after three decades. So how would such a portfolio fare if the aim were to maintain the inflation-adjusted principal over 30 years?
If the family spends 1% of the principal a year, it has a 92% chance of accomplishing that, according to GenSpring. At 2%, the likelihood drops to 77%. Spend 3% of the principal and there is a slightly better than even chance (52%) of preserving the principal.
With annual spending rates of 5% to 7%, the chances range from slim (13%) to nearly none (3%).
That is sobering enough, but most wealth managers are bracing for higher taxes and a resurgence of inflation. So what may now be seen as an acceptable spending rate could soon look like extravagance, especially when timelines are taken into account.