The core and excess framework: an executive blueprint for building wealth.

 
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One of the greatest impediments to good wealth planning is that people tend to think of their investment portfolio in one lump sum. Following this instinct, they manage all their wealth based on personal feelings about risk. A risk-averse individual could end up with a portfolio so heavily weighted with low-risk, low-return assets that it cannot reach desired financial goals. It may even fall short of inflation, which is like losing money, because the portfolio's purchasing power has diminished. For a risk taker, it may mean a portfolio of volatile assets with high-return potential but also the likelihood of large losses along the way.

We use a core and excess framework as a simple but powerful way to segregate wealth into two categories for planning purposes. As Display 5 illustrates, core capital is the amount you need to live the lifestyle you want for the rest of your life, calculated to a very high degree of probability. Excess capital is everything beyond that--your financial legacy. It is wealth you intend to leave to heirs or give away to charity, or spend on completely discretionary activities.

Although quantifying how much core capital you need is an inherently subjective exercise, it ends with a fairly precise output. By definition, the number should provide you with an exceptionally high degree of confidence. For entrepreneurial types, this portfolio "for life" may also include a "rainy day fund"--a separate reserve for unanticipated contingencies or opportunities, or perhaps a new business venture. Regardless, the core capital figure is the cornerstone for all the planning that follows. (11)

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If your primary concern is reaching core capital, we generally use the WFS to calculate a core capital figure that provides a 90% degree of confidence that you will never run out of money. But if you want to be even more conservative--when you're planning on transferring excess capital out of your estate, for example--we plan for a 95% degree of confidence. (12) Let's say you are married and you intend to retire at 60 and think $200,000 per year (of constant purchasing power) is how much you and your spouse will need in retirement; we can calculate the amount of core capital you'll need even if inflation is high and the financial markets are dismal, and one or both of you have unusually long life spans. (13)

Display 6 Core Capital Calculations Assume Poor Returns to Assure a Very High Level of Confidence Sustainable After-Tax Spending Rate in Hostile Markets (*) Age 55 60 65 70 75 80 85 Spending 2.4% 2.7% 2.9% 3.3% 3.8% 4.4% 5.3% Rate (Annual) (*) Core Needs Spending $100,000 $4.2 $3.7 $3.4 $3.0 $2.6 $2.3 $1.9 Needs Mil. Mil. Mil. Mil. Mil. Mil. Mil. $200,000 8.3 7.4 6.9 6.1 5.3 4.5 3.8 $300,000 12.5 11.1 10.3 9.1 7.9 6.8 5.7 5400,000 16.7 14.8 13.8 12.1 10.5 9.1 7.5 $500,000 20.8 18.5 17.2 15.2 13.2 11.4 9.4 $750,000 31.3 27.8 25.9 22.7 19.7 17.0 14.2 $1.0 41.7 37.0 34.5 30.3 26.3 22.7 18.9 Million (*) Data do not represent pan performance and are not a promise of actual future results. The above spending rates are tor couples and assume an allocation of 60% globally diversified stocks (see footnote 7. page 10, for global stock assumptions) and 40% diversified intermediate-term municipal bonds in a taxable portfolio. Spending is a percentage of the initial value of the portfolio, grown with inflation; sustainable spending rates assume maintaining spending with a 95% level of confidence. Based on Bernstein's estimates of the range of returns for the applicable capital markets over the periods analyzed for a couple's joint life expectancy. See Notes on Wealth Forecasting System, page 44, for further details. All information on longevity and mortality-adjusted investment analyses in this study are based on mortality tables compiled in 2000. To reflect the fact that the life spans of high-net-worth individuals are longer than average, we subtract three years from each individual's age (e.g., a 55-year- old would be modeled as a 52-year-old). In our mortality-adjusted analyses, the life span of an individual varies in each of our 10.000 trials in accordance with mortality tables. Source: Society of Actuaries RP-2000 mortality tables and Alliance Bernstein Display 6 shows the core capital needs for different ages and spending levels, for a couple with their investments in a diversified portfolio. (It's important to remember that the 95% level of certainty assumes long-running dismal market conditions and poor investment returns in order to provide extremely high confidence in retirement savings: Many individuals may be comfortable accepting a slightly lower degree of certainty, which would reduce their core capital number.) Along the top of the display are age and maximum annual spending rates. On the left are different levels of spending, which we assume...

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