Addressing Your Income Requirements

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Here in Berlin, many of the affluent entrepreneurs that I work with face an interesting conundrum: They their made money in asset classes into which they don’t want to invest anymore.

Venture capital no longer feels like the ‘guaranteed return’ as it did prior to interest rate hikes. Real estate is faced with price declines and the burden of higher interest rates. Despite continued growth and profitability, even the outlook for “Mag 7” stocks seem uncertain in the light of a looming recession and a US election. And crypto… well, that’s a whole other story.

To a degree, it is understandable - I know many successful entrepreneurs who actively wanted to stay away from their industry or asset class after making their money there. But it becomes more challenging when all their investing experience comes from only those asset classes. Where do you put your money? Or if you’re just less optimistic on those “high beta” asset classes - what is the right balance? How do you structure your portfolio?

In my search to best tackle such questions, I have become a proponent of the Aspirational Investor Framework. Rather than thinking about asset allocation as something scientific (“what is the right allocation to hedge funds to the second decimal?”), it attempts to help a client define their goals - ranging from short-term safety goals (Safety Bucket), to long-term financial planning to maintain their lifestyle after inflation (Market Bucket), to their entrepreneurial and personal desires (Aspirational Bucket). 

In the last months in discussions with (prospective) clients as well as other financial advisors, I’ve had numerous chances to put it into practice - and in return, face many questions on some of its intricacies. In posts over the next weeks, I’ll address some of the most common questions on the framework that I’ve received.

Today, let’s tackle the #1 question: How to fit today’s income requirements into the Aspirational Investor Framework.

Limits of the Framework

Frequent readers know that I recommend that everyone looking to invest their money should first think about their Investment Objectives: Not the question of a desired annual return or a maximum drawdown, but the specific goals and objectives that you look to achieve through your investments. Potential high-level examples of this would be Capital Appreciation (maximize growth of your invested capital) or Income (generating disposable income from your investment portfolio). 

When talking to individuals that received a significant amount of money (think an exit or inheritance), the most frequent Investment Objective is the wish to never have to work again. In other words, ensuring that no matter whether they receive any sort of ongoing employment-based income, they will always be able to draw sufficient income from their portfolio to maintain their lifestyle, after inflation. Said differently, the aforementioned Investment Objective of Income.

And while the Aspirational Investor Framework can help in many cases, it is (at least in my experience) not entirely clear on how to best implement this goal. The challenges becomes clearer when we look at how this short-term Income goal fits into the three Buckets:

🛡️The Safety Bucket is aimed to provide a buffer for short-term income requirements, such as illness or a loss of employment, but not a long-term cash reserve to draw from. (Investments such as a personal residence without too much debt, however, might help reduce the required income.)

📈The Market Bucket is aimed to generate long-term returns in excess of inflation to allow for long-term income requirements, but investments one would make here, for example your typical ETF portfolio with a 10- to 50-year investment horizon.

🚀 The Aspirational Bucket, fit for binary, high-risk bets like a direct venture investment or aspirational purchases such as a holiday home, is not where you’d search for income, nor does it offer the degree of safety required when it comes to long-term lifestyle planning.

As we can see, none of the three Buckets are perfect. But in my view, it is still the Market Bucket which fits the best: It is long-term-oriented, unlike the Safety Bucket, yet also not as risky and binary as the Aspirational Bucket. I’ve personally found the income goal best defined as a subset of the Market Bucket, which I sometimes like to call Income Bucket: An annuity-like pool of capital which should be structured in a way which allows a client to achieve their income goal with the least amount of risk required. 

Perhaps a practical example might help.

The Income Bucket, in Practice

Let’s consider an entrepreneur who sold their business for 10M€. They are looking to draw 100K€ from their portfolio every year. How much of the portfolio should they put into the Income Bucket? 

There are many ways of tackling this issue, and as with other forms of long-term planning (such as the financial forecasts underlying any attempt at valuing a business), it’s equal part science and art. One idea is to use the FIRE (Financial Independence, Retire Early)’s so-called 4% Rule. According to the 4% rule, an investor would expect to be able to draw 4% of the balance of a well-diversified portfolio every year. Taking the desired 100K€ in income and dividing it by 4%, we’d get to a target size of our Income Bucket of 2.5M€. 

It is important to note that the 4% rule is somewhat simplified. In practice, it doesn’t take into account factors such as fees, taxes, and inflation. It is also vulnerable to what I like to call path dependency: While we all look at the long-term growth rates of asset classes such as equity and fixed income, any investment tends to fluctuate somewhat (or even significantly) around their long-term mean return. Having to draw down 4% in a year when your portfolio is up 10% is no problem - but it is much more painful when you have to draw down 4% on top of a 10% loss. 

As with all things in the world of finance, it’s best to work with a margin of safety. In my calculations for clients, I’ve found ranges of potential drawdowns between 2.5% and 5% fitting, meaning that our Income Bucket might be as “small” as 2M€ (5%) and as “big” as 4M€ (2.5%). I would also advise taking into account the aforementioned combination of fees, taxes, and inflation, all which can considerably drive up your required return. Either build your own model, or talk to an experienced financial advisor. (I’m happy to help, of course.)

Lastly, it’s also worth noting that there might be no need for an Income Bucket. If an individual covers all or most of their expenses from employment or sources of income outside their relevant investment portfolio, an income-oriented portfolio might make less sense, given that income such as interest or dividends are taxed immediately and thus would have a lower expected after-tax return. Equally, if an investor doesn’t have a strict income target today yet likes the idea of being able to tap a source of income at some point in the future, I would not think about an Income Bucket today, but rather see it as a question of sizing the Market Bucket correctly. In the end, the Aspirational Investor Framework is a way to categorize assets into buckets of required size and return - and my Income Bucket is just another hypothetical Bucket.

Playing it safe (but not too safe)

Some readers might be thinking of a question that I’ve heard numerous times before: Why would I need a 4M€ Income Bucket if I have another 6M€ left over to invest? 

On the one hand, I agree with this view. Assuming that the remaining 6M€ aren’t invested into individual, high-risk bets, it’s likely that even in the worst case scenario, many investments would at least generate some return to help fuel that income goal. As a result, that could mean that an investor invested too safely in their Income Bucket, perhaps losing out on incremental return.

But on the other hand, I disagree - because of the benefits of the strict division of Buckets. Many entrepreneurs that I know are able to stomach significant degrees of risk, allowing them to make high-risk, high-reward bets that might pay off handsomely. But they might not always go right, even if just for a time - and leave them searching for liquidity to pay for their lifestyle expenses and mortgage. It’s exactly in such cases where a strictly separated income-oriented part of their portfolio can save the day, especially in cases where such an Income Bucket might just be a small part of their asset allocation. 

There are also benefits to your overall asset allocation. Some entrepreneurs are confused when I suggest that they should take less risk (while still being able to achieve their goals). An Income Bucket, by nature, tends to be more oriented towards stability and lower risk, often including asset classes such as fixed income or commodities that the entrepreneur would likely have discarded otherwise given their lower expected return. Having all of their wealth in lower-risk assets might not be what they have in mind - but even then, they might be able to see the benefits of a slightly higher degree of diversification. Especially when the Income Bucket is just a small part of their overall portfolio, they might always be able to repurpose it, i.e. by selling out of lower-risk and lesser correlated assets such as fixed income or commodities in a market downturn to buy more of the risk assets they prefer.

And lastly, I’ve also experienced the psychological benefits. I’m surprised that even some very wealthy entrepreneurs still are worried that their fortune might one day go away again. Having a lower-risk Income Bucket can not fully take this fear away, but it might help them sleep a little bit more safely by guaranteeing them the same standard of living even if riskier bets don’t pay off. And that, in return, might actually help them with achieving higher returns: Knowing that their lifestyle will be secured, no matter what happens in the markets, might let them actually take the full degree of risk that they are ready to take in the rest of their portfolio - in return, giving them the chance for even higher long-term performance, and perhaps another level of wealth otherwise only reached through “Aspirational” bets.

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