Dynamic spending's market, tax advantages

When creating a dynamic spending plan, advisors often work with clients to find ways to delay—rather than forgo—spending. One crucial component of this approach is to find ways to avoid drawing from a portfolio when markets are down. That was a big priority in the spring of 2020. 

“There could be a situation where you don’t want to touch your portfolio because it’s down 35%, but you can borrow. That way, you don’t need to sell in a down market,” says Terry Charron, Senior Director for BNY Mellon Wealth Management’s Family Wealth Investment Advisor Group.

“For every loss that you have, there’s a higher return required to get back to where you were,” says Robert Pierce, Lead Analyst for Data Management and Quantitative Analysis at BNY Mellon Wealth Management. A 25% loss requires a subsequent 33% gain, while a 33% loss requires a 50% gain.

Dynamic spending can also mean reducing taxes. “One of the best things we did for our clients last year from a spending perspective is reduce their capital gains tax liability,” Charron says. Advisors worked to harvest losses to reduce taxes when markets were down, then reinvested the proceeds back into the market so clients could realize gains when markets recovered.

In a year like 2020, a loss-harvesting strategy could put investors in a position to completely offset realized gains for the year, resulting in $0 capital gains tax liability, while still ending the year with an 18% return.

Small spending changes, huge impact

Advisors helping clients build flexible spending strategies must also help them understand the impact of spending over time. Even small changes in spending add up and can have a significant impact on long-term wealth.

Assuming annual portfolio growth of 5.25%, a family with a $20 million portfolio that spends 3% a year will see their portfolio grow to $31.3 million after 20 years, while a 4% annual spending rate only grows to $24.6 million.

“A comparison like this can be educational, but in real life, families don’t operate in the same way as institutions,” says Al Trezza, Head of the Global Insights Lab at BNY Mellon Wealth Management. “Nonprofits typically have a 5% annual spending target, with some ability to smooth spending over time. Very few individuals will align their spending to an annual percentage of their assets.”

While new retirees may begin with a specific goal, such as 3%, “in future years annual spending will vary based on needs, lifestyle and of course, unforeseen circumstances,” Trezza says. “When you then factor in the impact of market volatility and taxes, including tax loss harvesting and the different taxation for investment accounts, individuals have significantly more decisions to make.”

The benefits of buckets

A more realistic approach is for families to think about spending in buckets: money needed for the next five years, money needed in their lifetime and money they hope to pass down to future generations. Thinking in this way can help take some of the emotion out of investing. 

“If it’s money that you’re planning to leave to future generations, and that’s 25 to 30 years out, you can afford to take more risk and to weather many, many different storms,” says Charron. 

Figuring out how much money should be in each category requires forecasts of projected returns and longevity alongside approximations of future spending. BNY Mellon uses a proprietary tool to help clients meet their lifestyle and wealth transfer goals. 

“It’s nice to be able to have that conversation,” says Trezza, citing an example of how forecasting can ease retirement concerns. “A client was fearful of their spending, knowing that not every dollar was being driven by income or salary. Learning that they had only a 2% chance of outliving assets, they said, ‘I’ll sleep better tonight.’ That’s the kind of impact that bringing these things to life for clients can have.”

Keeping overspending in check

While some affluent investors remain cautious, the current outlook may cause the pendulum to swing to a much more optimistic outlook. With vaccinations and re-openings well underway in the U.S., many are expecting a spending spree, as consumers start to venture out to restaurants, stores and vacation destinations.

“You do have that pent-up demand,” says Pierce. “People were forced to reduce spending last year. They couldn’t go on vacation; a lot of the outlets for spending were simply not there. It seems like we’re set up for people to be spending a lot of money in a short amount of time.”

An outburst of confidence and spending will put new emphasis on the benefits of dynamic spending — to help ensure that spending doesn’t cut into long-term plans.