The “Unlucky” Inheritor
November 11, 2015
Receiving a windfall can be wonderful—and provoke enormous anxiety. In this hypothetical case study based on client experience, we look at how Ira, who was 60 years old in 1999 when he inherited $7 million, developed the financial plan that was right for him
Ira was very confused. He wasn’t sure what he could afford to spend, he didn’t know whether he could provide any financial support to his two beloved nieces, and he was uncertain how to invest his newfound wealth. What he did know is that he didn’t want to be whipsawed by the markets.
Ira had already stopped working, and the inheritance constituted the bulk of his funds. Unfortunately, he received his inheritance on January 1, 1999, an unlucky starting date for an investor. He would face two bear markets (the first only a year away) that would make the 2000s a “lost decade” for stocks: The US market retreated by 1% per year over that 10-year period. But neither he nor we knew what lay ahead when we began talking.
Our first task in securing Ira’s long-term financial comfort was determining his core capital: the amount of wealth he’d need to support his spending for the rest of his life, even if he lived to a very advanced age and market returns were very poor. (We define very poor as worse than we’d expect 90% of the time.)
Under these conservative assumptions, we found that Ira could feel confident that $5.9 million of core capital, invested with a moderate 60/40 allocation, would support his desired annual spending of $200,000, adjusted for inflation. Because Ira was confident that his plan would provide for his needs, he decided to give the $1.1 million surplus to his nieces immediately.
The Display below shows what happened to Ira’s wealth through midyear 2015, together with our estimate of his core-capital requirements stretching out for decades.
Turning “Luck” Around
The green line in the display is Ira’s core-capital line. It slopes downward from the beginning, because Ira will require less core capital to support his spending needs as he ages. And while it would be nice to be at or above the core-capital line all the time, it usually doesn’t work out that way. The short-term vagaries of market returns will typically drive a portfolio’s value below the core-capital line from time to time. If a plan is well designed, however, the periods when the portfolio value is below core should be relatively brief and shallow.
Given his unlucky timing, Ira’s portfolio (the blue line in the display) dipped about 14% below core in the bear market of the early 2000s. Luckily, it climbed above core in the good years that followed. It fell back below core during the financial crisis of 2008, but recouped the shortfall relatively soon thereafter.
Of course, Ira felt very anxious during both bear markets. We reminded him that the salient question wasn’t “How much did the market slump?” or even “How much did my portfolio value fall?”
The right question was “What is the effect of the slump on my ability to achieve my long-term plans?” Our answer was that Ira’s portfolio never fell far below his core-capital needs.
Indeed, between the market recovery in early 2009 and midyear 2015, Ira’s wealth rose well above core, so that by age 77, he had an enviable choice to make: Should he bank on his wealth increasing further with his moderate-growth allocation, which would allow him to spend more himself and transfer even more assets to his nieces? Or should he adopt a more conservative portfolio allocation that would significantly reduce the future volatility of his wealth?
There’s no single “right” decision. For Ira, the answer will depend on his risk tolerance at age 77 and his evaluation of the trade-off between growth potential and emotional security. Bernstein’s wealth-forecasting tools give him a way to better assess his options.
The concept of core capital also appealed to Ira because it gave him a way to measure his progress against his specific goals. Ira thinks this is a more important benchmark for him than any market index.
Perhaps most important, our planning analysis allowed Ira to have the confidence to give surplus wealth to his nieces, which he would have otherwise been unlikely to do. And for Ira, seeing the difference his gifts made in their lives was priceless.
See Notes on Bernstein Performance Statistics at the end of “The Right End of the Telescope,” Bernstein, 2015.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.