Receiving a financial windfall seems like a good problem to have — and it is — but the question of what to do with it can be hard to solve. The easiest answer is to pay down debt or put the money to work in a suitable diversified portfolio and pretend it doesn’t exist. That’s also probably the hardest thing to do for most people.
The impulse to spend it can be hard to resist. The problem with getting an inheritance or settlement (or winning the lottery!) is that it is — by definition — a one-time thing. Lifestyle creep is a real problem, and adjusting lifestyle spending upward is a sure way to get in trouble when the money runs out. It’s very easy to spend more but very difficult to spend less once you’re accustomed to a more elaborate lifestyle. If you do treat yourself, do it in a deliberate, one-time manner rather than getting involved with expensive hobbies or memberships that keep adding up. A windfall shouldn’t change your lifestyle too much going forward unless it is very large.
How large is large and life-changing? There is a rule of thumb based on what is known as the Trinity study that determined how much money would have been needed in various historical periods to retire and never run out of money. The very rough rule of thumb is that you’d need 25 times your current annual spending. In other words, if you are invested in a reasonable portfolio and your existing money plus the windfall is more than 25 times your annual spending, you could withdraw 4 percent of your portfolio the first year, adjust that amount up for inflation each subsequent year, and be unlikely to ever run out of money.
To do this right, you have to work backwards. In other words, don’t look at your income and account balances to determine your lifestyle. Figure out how much you need to spend to be happy, and then consider if your current balances plus the windfall are approaching 25 times your annual spending. If so, then the money truly is life-changing, in the sense that to maintain your current lifestyle, you may not have to supplement your investment returns with income from a job any longer. To be clear, even a windfall much smaller than 25 times your spending can make a big difference in your portfolio’s trajectory; you just can’t quit your job based on it.
For people who keep their lifestyle in check and decide to put the money away for the future, the hardest thing can be to actually invest it. For example, someone with a $50,000 investment portfolio who receives a $10,000 bonus might agonize over putting the money to work in the markets, even though they already have five times that amount invested. As financial advisors, we always say, “it depends,” but it’s unlikely that a windfall like this should be invested at all differently than the money you’ve already put to work. You can always dollar-cost average in over a few months or years, but if history is any guide, it’s probably best to put the money to work as soon as possible, even if you are unlucky and get it invested just before a big drawdown. You should be in it for the long run.
Windfalls can solve a lot of problems, but they can cause a lot of problems as well. The well-documented addictions and bankruptcies among lottery winners and professional athletes is testament to that. Just like everything in investing and financial planning, the numbers matter, but ultimately the question is more behavioral than financial.
If you’re fortunate enough to receive a large windfall, take a deep breath, be patient, and come up with a plan — one that doesn’t involve a broad expansion of your lifestyle. Nobody says, “I sure wish I hadn’t invested all this money 10 years ago,” but there are countless variations of the opposite sentiment.
Gene Gard is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions. Ask him your question at ggard@telarrayadvisors.com or sign up for the next free online seminar on the Events tab at telarrayadvisors.com.
