Zero-Based Budgeting for Heirs

The family matriarch was worried.

She had hired us, Beekman Wealth Advisory (BWA), to manage her portfolio, but her assets were not the issue. The issue was the lifestyle of her youngest son and his wife.1

They were running through her son’s trust at a rate that alarmed the matriarch, and they seemed to have little sense of spending restraint. While her son was solidly employed, his earned income covered only a fraction of the young couple’s spending. The matriarch could foresee a day when her son’s trust would run out, leaving her son, daughter-in-law, and two grandchildren with a sharply reduced standard of living.

Her pleas to her son, as well as the patriarch’s, had fallen on deaf ears. Could we do anything, she wondered?

At BWA, we view our role as taking care of people, not just assets. This view informs our business mode – we sell no products, but instead charge only fixed-dollar retainer fees. It also informs our work ethic – we figure out what needs to be done, and then we do it. So, although this was many years ago, and it was the first time we had been presented with this particular issue, we knew we needed to figure out a way to help this family.

What we came up with was a tool we have continued to use to address spending issues among heirs. We call it ‘zero-based budgeting’. We have found it to be powerful and effective.

In our experience, most people have a pretty good intuitive sense of where their financial issues lie. They already know if they are carrying too much debt, or their portfolio is too concentrated, or their investments are not making much money, or they are spending excessively. We do not usually need to identify the issue. We do need to offer practical help.

This often takes the form of putting a quantitative framework around an issue, clarifying choices and probable outcomes, and helping people make wise and informed choices.

That is what we did here.

Overview

In creating a zero-based budget, we arrange budget numbers into three sections:

  1. sustainable income, by source;
  2. necessary spending, by category;
  3. discretionary spending, by category.

The first step is to do some basic math. Necessary spending is subtracted from sustainable income to yield the amount that is available for discretionary spending. Each individual defines the spending that is ‘necessary’ to living his or her life, and the amount available for discretionary spending can be allocated any way he or she pleases. But once the amount available for spending reaches zero (ie, once all of the sustainable income has been spent, either on necessities or on discretionary items) spending must stop.

We then compare actual spending with the zero-based budget, and track it over time. Cuts and trade-offs are inevitable – if they were not, excess spending would not have been a problem in the first place.

Frequently, users of a zero-based budget come to a new, and more realistic, understanding of what is truly necessary and what – for the sake of a comfortable tomorrow – must be foregone today.

01. Sustainable Income

Section I is usually the shortest and simplest section among the three that comprise zero-based budgeting. Section I typically consists of after-tax earned income, plus sustainable withdrawals from a trust or other asset portfolio, plus any ongoing gifts. Alimony might be another income source.

We typically use monthly numbers, since many bills are paid on a monthly cycle. However, a different time period, such a calendar year, could also be used.

Even Section I, simple as it may seem, has its nuances. These include:

  • The use of after-tax, disposable income. Since we are trying to determine how much income is available for spending, we need first to subtract income taxes. Other ongoing deductions from disposable income, such as contributions to a 401(k) plan or health savings account, must be subtracted as well.
  • The inclusion of ongoing income only. Cash flows in some periods may be augmented by additional sums received – from an inheritance, an insurance policy, or otherwise. These sums (after any taxes due) increase the size of the portfolio from which withdrawals may be made, and so indirectly increase income. But they are not counted directly in Section I.Similarly, gifts, bonuses, and other lump sums should be included only to the extent that they can realistically be counted on as ongoing. An annual exclusion gift received from one’s parents every year on 2 January would be included in Section I. A gift received in recognition of one’s wedding would not.
  • The inclusion of sustainable withdrawals only, with respect to portfolio income. Conceptually, the sustainable spending rate is the rate that can be spent while preserving the real (after-inflation), after-tax value of a portfolio.
  • To put it another way, in order for a portfolio to maintain its purchasing power over time, the total return that it earns after fees and expenses, must do three things:
    1. First, it must cover the ordinary income and capital gains taxes due from the portfolio’s investment income.
    2. Second, a portion of the return must be reinvested in the portfolio to offset inflation.
    3. Finally, whatever is left over can be spent, sustainably.
  • We generally use a sustainable withdrawal rate of 3–3.5% of assets, as this is what is supported by long-term capital markets theory. Market practitioners get to this number in different ways. Here is a simple one, relating to a diversified portfolio comprising 60% equities and 40% bonds:
    Long-term rate of return on stocks @ 9% × 60% allocation 5.4%
    Long-term rate of return on bonds @ 5% × 40% allocation 2.0%
    Equals: Portfolio return 7.4%
    Less: Taxes @ 25% (1.9%)
    Less: Inflation @ 2.5% (2.5%)
    Equals: Sustainable spending rate 3.0%
  • One could of course quibble with any of these numbers,2 but a spending rate somewhere in the vicinity of 3–3.5% is what is likely to be sustainable. To the extent actual returns exceed these levels, the asset size will grow, raising the future dollar amounts of sustainable spending.

Example of Section I

So, let us start to create an example for Jane Q Heir. We will suppose Jane earns employment income of $200,000 per year; has an income tax rate (federal, state and local) of 35%, and therefore keeps 65% of her income after taxes; is the beneficiary of a trust totaling $20 million; and has fond parents who routinely gift the maximum annual exclusion gift to Jane and her husband, John.3 Jane and John spend, rather than save, these annual gifts. John is currently writing a novel, and is not earning income.

Jane’s Section I, calculated on a monthly basis, looks like this:


Section I Table


Example of Section II: Necessary spending

Section II is where the fun – or perhaps the argument – starts. This is where we determine what, and how much, spending is ‘necessary’ for Jane and John’s life.

‘Necessary’ is in quotation marks because this question is clearly subjective. Food, clothing and shelter are necessary, of course, but for most heirs, expenditures for these line items will go beyond the basics. Additional expenditures that most people would deem essential include insurance premiums (health, property, life and other); phone and other utility bills; and transportation in some form.

Other expenditures may be deemed necessary by one person, but discretionary by someone else. These expenditures might include items such as childcare, private school tuition, charitable donations, or memberships of religious or civic organizations.

Much of the ‘necessary’ spending is likely to happen in the form of monthly bill-paying, but we should also accrue for lump-sum necessary expenses that happen predictably but on a less-regular schedule. Houses and other property may swallow large sums of money from time to time, in addition to the regularly scheduled property taxes and ongoing maintenance. This fact needs to be taken into account in creating a budget.

In the case of Jane and John, we will assume that their monthly necessary expenditures are mostly related to care of their small children and their home in an exclusive suburb. They own their home outright, and so have no mortgage payments to make, but they estimate they will need $72,000 per year for lump-sum items, such as a new roof, redecoration and the like. They also like to dress well, and so consider their $5,000 monthly spending on new clothing to be necessary. Jane and John each lease a car, and occasionally use other transportation, such as taxis, when that is more convenient.

Here is where we are after calculating Section II:


Section II Table


So, from monthly sustainable income of nearly $74K, Jane and John spend about $51K for what they consider their basic costs of living, leaving about $23K for monthly discretionary spending. We now turn to the question of how much they actually spend on discretionary items.

Example of Section III: Discretionary spending

Section III is where we account for most of what makes life enjoyable – travel, entertainment, dining out, club memberships, and the like.

In the case of Jane and John, they also put gifts and charity in the discretionary spending category. Others might view these categories as necessary spending. In either case, since charitable giving provides a tax deduction, it should be accounted for net of the tax benefit.

The completed zero-based budget for Jane and John is below, and begins to dimension the problem.


Section III Table


Where do we go from here?

As we can see, based on this budget, Jane and John are actually spending more than $28K per month on discretionary items, which is more than $5K above their available budget. The first item on the to-do list is obvious: Jane and John need to figure out where to cut to make their total spending match sustainable income.

Cuts could come from any of the categories; it is an individual decision. But somewhere, almost $6K per month in budget cuts must be found. In Jane and John’s case, perhaps club memberships, travel, personal grooming, and restaurants should bear the brunt of the budget cuts, since all of these are both large-ticket line items, and mostly discretionary.

One ‘easy’ way out of the budget dilemma should not be taken: cutting the $6K per month reserve for house maintenance might solve the budget issue on paper, but it will not affect actual spending. Roofs still need to be replaced, whether or not one has planned for this in a budget. It’s much better to plan in advance.

The second item on the to-do list is to make sure this budget has accurately captured all spending. If it has, we should expect to see that Jane’s monthly distribution from her trust averages $63,675, which is the sustainable withdrawal ($58,333), plus the excess of spending over sustainable income ($5,432). On an annual basis, this would equal distributions of $764,100.

But suppose we look at actual distributions, and find that they have been at least $1 million per year, each of the last three years. Then, clearly, we are missing something, and will have to delve deeper with Jane and John. Maybe some of their guesstimates are much too low, and we will have to recalculate. Perhaps Jane and John have not budgeted for the art collection they have been building4 – or perhaps there’s an unacknowledged problem with gambling, substance abuse, or something else. Whatever the issue, working through the budgeting exercise will help uncover it.

One final item that is often on our to-do list is to demonstrate to the heir the likely long-term effect of his or her excessive spending. This is appropriate for an heir who cannot or will not cut spending.

In such a situation, we would usually pair our budget analysis with a Monte Carlo simulation analysis of outcomes. Technically, these tools combine deterministic inputs from the budget analysis (asset and spending levels) with many iterations of possible future paths of capital markets returns, from the Monte Carlo simulation, to create a probabilistic distribution of outcomes over time.

Non-technically, we refer to this as our “…And if you don’t stop spending at this rate, you’ll probably run out of money within X years” analysis. It tends to get people’s attention.

Take-aways

As a financial adviser, we cannot force anyone to stop spending unwisely. We can and do, however, quantify the consequences of unwise spending. For anyone who is serious about getting a handle on spending and creating a life that can be sustained over the long term, this is often exactly the help that is needed.

So – what happened with the heir with whom this article started? The story has a happy ending.

Back in 2004 the couple, in conjunction with BWA, created a financial plan for themselves and made a presentation to the matriarch, patriarch, and family office head. The plan had three goals: to earn more, invest better, and spend less.

One year later, in 2005, we presented the results, which included significantly enhanced employment responsibilities and compensation for the heir; a revamped trust portfolio; and – most significantly –spending that had been sharply reduced, to a sustainable level.

That meeting ended memorably: the matriarch started to cry with relief and joy at the steps toward financial responsibility her son and daughter-in-law had taken. Then the patriarch’s tears started, and before we quite knew what was happening, everyone in the room was weeping.

Over the years since then, the young couple’s spending has continued to come up as an issue from time to time. Vigilance and discipline in such situations is often necessary. It is very easy to slip back into old habits, especially when markets are benign.

But for this family, and for others with whom we have worked, zero-based budgeting has been a powerful tool in helping to create a sustainable financial life.

1 Some details of this history have been altered to disguise the family’s identity.

2 For example, inflation is currently lower than 2.5%, but so are yields of high-quality bonds, so these two factors offset each other to a large extent. Also, inflation of the basket of goods consumed by wealthy people may differ from the economy’s overall inflation rate. For example, this writer has heard inflation rates for luxury goods quoted at 12%. No diversified portfolio could produce a rate of return high enough to offset inflation at that rate.

3 Currently, the annual exclusion gift totals $14,000 per donor per recipient, so Jane and John would receive $56,000 per year from Jane’s parents.

4 It is possible to make the argument that using financial assets, such as trust distributions, to build a collection of art, or cars, or jewelery, or other tangibles, is not spending, but rather substituting one form of investment for another. Indeed, this author has heard this argument. This is true only to the extent that the purchasers (1) are buying the tangibles with the intention of selling them at a profit; and (2) have the knowledge and ability to do so. If the tangibles are personal-use assets, such as art to hang on one’s own walls, that consume cash (eg, for storage and insurance) rather than generating it, the financially conservative path is to treat these as assets but not investments, and their purchase prices as spending, not investment.