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The risks of capital depletion

The following represent three examples of a client being exposed to the risk of capital depletion but is unaware of it.

The first is where a portfolio is being managed to meet current financial needs only. Each year the portfolio is rebalanced to meet the income requirement and/or capital is raised to meet a capital expenditure objective.

In this example there is no planning for the effects of future income and capital expenditure on the ability of the portfolio to meet financial needs. The portfolio may be structured to provide the income you want from dividends and interest alone, but the discretionary capital expenditure will be eating away at the portfolio.Text Box:  

This scenario also results in either forced sales of assets or involuntary deferral of expenditure in the event of declining markets. Careful planning of portfolio structure would avoid these risks.

It also takes up much more time on the managers behalf and will increase the costs of portfolio manager as the structure of the portfolio has to be completely reassessed every year. Every time a manager receives a request for capital he or she needs to sell an asset and restructure the portfolio. Planning would structure the portfolio in advance and reduce costs.

The second situation is where the return assumptions used to predict what your portfolio will be worth and how much you can take are not reflecting the risks to returns.

At the end of 1999 and 2000 many in the industry were using average historical returns to determine what the portfolio could provide. Anybody using these assumptions would have been exposed to significant unnecessary financial risk. This is especially the case where the investor continues to draw down capital at the planned rate. In this case the portfolio would be depleted at a much faster rate.Text Box:  

The third example relates to portfolios incorrectly structured to meet financial needs. This problem relates mainly to retail packaged investment solutions.

These portfolios are not actually structured to meet financial needs as and when they arise leading to additional transaction costs and the risk of forced sales of assets.

Many of these vehicles are also exposed to high management charges. Even if the underlying investment performance of the funds is well above average, the investor will be negatively affected by the increased costs and risks of a portfolio that does not match their financial needs.