The Spending Rule

A smoothing rule lets an endowment spend steadily without raiding capital in the lean years. (The Yale spending rule.)

Once you accept total-return spending, the next question is how much to draw each year. Spend a flat percentage of the pot's latest value and your income lurches with the market — generous after a good year, painful after a crash, exactly when you can least afford to cut back.

Endowments solve this with a smoothing rule. Yale's, for instance, blends most of last year's spending (raised for the cost of living) with a smaller pull towards a target percentage of the current pot. Spending then drifts gently instead of swinging, and the capital base is protected because you never draw a fixed dollar amount straight into a falling market.

The same idea works for a household. Anchor next year's drawing mostly to this year's — adjusted for inflation — and let it adapt slowly to how the pot has performed.

Illustrative example: steady versus lurching

The chart makes the mechanism visible. The top panel shows a fund whose value rises and falls with markets over ten years. The bottom panel shows two ways of drawing an income from it: one that simply spends a flat 5% of the fund's value each year — which lurches up and down with the market — and one that follows a smoothing rule. The smoothing rule sets each year's spending at 70% of last year's, plus 30% of 5% of the current fund value; that 70% anchor is what keeps the income steady when the fund drops. The figures are illustrative; the point is the far smaller swing.

A spending rule turns an unpredictable pot into a manageable paycheck — and stops a bad market from forcing a bad decision.