The Rate At Which Your Clients Spend Can Have Long-Lasting Wealth Effects
Created: Wednesday, 18 April 2012 12:53
It’s easy to assume that wealthy clients understand how to manage their finances. With so much money in various accounts, the total sum may seem inexhaustible. Even a net worth of $3 million to clients who have not grown up with wealth can make them think the money will always be there.
At a higher level, it can be easy to chalk up the fates of athletes, lottery winners, and other sudden wealth recipients to impulse spending and irresponsible management. Having wealth, especially when you’ve not had it before, can make you feel invincible.
CEOs can become isolated within their own worlds and end up overspending on a large scale. Bad decisions at any level can be rationalized away. John DeLorean and Donald Trump are cases in point. Clients still earning significant income can mask the effect their spending habits have on their wealth. Add a 2008 crisis or two and spend rates have an even more pronounced effect.
Starting the spending conversation with a wealthy client can be tricky. One of the best ways to broach the subject is by explaining simple calculations that can be aligned with the wealth strategy you’ve designed for the client’s portfolio.
For example, you could start by explaining the difference in disposable income and discretionary income. Disposable income is the sum of personal income after personal current taxes are paid. Discretionary income is personal income minus personal taxes minus necessary expenses.
For each $100 of disposable income, the amount spent equals the percentage spend rate. For example, if a client spends $70 of each hundred, the spend rate is 70%. This seems pretty simple until you add the element of behavioral finance. One of the behavioral biases that most affects our financial conditions and investment decisions is mental accounting.
Mental accounting means that we tend to compartmentalize different pools of money for different purposes. The lifestyle compartment may mislead us into thinking that funds will always be available at the same level for the lifestyle we have chosen. Yet, when financial circumstances change, we continue to think the lifestyle is sustainable.
This can be particularly difficult for people facing retirement. Spend rates begin to fall
after age 50. They drop to between 50% and 70% by age 65 and to around 60% by age 80. Most, however, do not accurately anticipate their spending needs during retirement, thinking that they won’t need as much because the statistic has not been applied to their individual situation in a meaningful way.
Longer lifespans can make it more difficult to support even these lower rates of spending. Taxation of social security benefits vary based on the age at which a client begins taking benefits. This can be an unexpected—and significant—burden.
This most affects investors with between $250,000 and $600,000 in assets. If they withdraw needed supplementary funds from social security instead of an IRA or other account, their tax liability on those benefits can rise from 50% to 85%.
Multiple factors can affect a client’s wealth over a lifetime. But a basal element is the client’s spend rate. Regardless of the level of wealth, the rate at which your clients spend their money can have a direct influence on asset location, tax, and allocation issues. Failing to address spend rates in light of developing an investment strategy is every bit as dangerous as thinking the money tree will never stop growing.
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