Spending Capacity Affected by Uneven Plan Resources

For some plans, you may see an alert noting that:

"The calculation of spending capacity involves smoothing out expected household resources. Because significant resources are delayed in this plan, this spending capacity may not be achievable in the near-term in certain scenarios."

This alert is typically displayed when a large amount of non-portfolio income in the plan is delayed into the future. If the discrepancy between the resources already in the plan and those that will be available later is large enough, it may mean that the plan's Spending Capacity cannot be achieved in certain scenarios unless the client(s) can borrow funds. Here's a somewhat extreme example:

• Plan length: 30 years
• Current Portfolio Balance: $100,000
• Proceeds from anticipated real estate sale in 5 years: $1 million

Income Lab's algorithms, when faced with this extreme example, would see that $1 million is available in 5 years and figure out a way to smooth out the resources in the plan across 30 years. That means it will find a Spending Capacity that "knows" that $1 million is available and even borrows against those resources to fund spending in the interim.

In the example above, the software might calculate a spending capacity of $50,000 per year. Clearly, with only $100,000 in the portfolio, there is a very high risk that the portfolio will be exhausted long before the $1 million is received in year 5. To fund that kind of spending, the household would have to figure out a way to bring some of those anticipated resources forward in the plan, such as by borrowing against that resource.

In some situations, such as when the future resources come from the sale of real estate or other property, it may be possible. In others, such as an anticipated inheritance, it may not be. If borrowing is not possible, this is really a two-phase retirement plan.

• Phase 1:
  • Option 1: Spend as if the future resource were not available to the plan, or were available only in a reduced amount
  • Option 2: Build a spending plan that focuses only on the period before the new resource is available
• Phase 2: Once the resource is actually received, adopt a new spending capacity

The Income Lab algorithm will not automatically adjust the plan to be a 2-phase plan. Instead, it will simply draw attention to the fact that a 2-phase plan may be needed. The reason the software will not automatically make a 2-phase plan is that the particulars of such a plan will depend on the situation and a risk assessment by the advisor and clients.

For example, in the extreme situation above, a plan with only a $100,000 portfolio would have very low spending across 30 years. In this situation, an advisor may build one plan to spend those funds down over 5 years, perhaps with a structure such as a term-certain annuity or bond ladder, and then fund an entirely new plan once the asset sale is complete.

Most examples of plans with lumpy or unbalanced resources will not be as extreme as this example. In some cases, it will be possible that the plan cannot be funded without borrowing, but it may also be possible that, with reasonable returns, the planned spending can be funded. (Say, for example, that the portfolio balance were closer to $250,000 in the example above.) In that case, knowing the risks and monitoring the portfolio balance carefully over time, the advisor and client might decide to proceed with the plan.

In some cases, an advisor might prefer simply to reduce, but not eliminate, the future resource when planning for Phase 1 (using Option 1 above) and then refresh the plan once the clients enter Phase 2. These are judgment calls that are best left with the advisor and clients, not to the automatic adjustments of planning software.