What does "not touching the principal" actually mean?

Question

When talking about "trust fund children" or large savings it's common to hear the phrase "not touching the principal", which means that only the "earnings" from the money are spent, and the cash pile itself does not get smaller.

However I am not sure that this could possibly make sense: interest rates on bank account deposits are essentially zero, so it must mean earnings from the stock markets. There are stocks which pay dividends, but those are rather small, and it would take a stupendously large amount of money to live off dividends.

Another example is rise in stock market price - but that does not make sense either. If one owns 10 shares of company XXX, even if XXX stock price doubles every year, one would still have to sell shares to get anything - in this example any transaction would shrink the principal by 10%.

The only example where it does make sense is if the fund owns a number of properties and collects rent from them - in that case there should be very sizable earnings, but one does not hear about those examples often (I'm also quite curious why, it seems if one has $1 million or more, there's a lot of money to be made by investing in real estate, but with smaller funds, investment seems really hard).

Answer 1

"Not touching the principal" simply means that you leave the principal amount of the trust fund alone and only draw off the interest or dividends it accrues.

So, let's say you inherit $10 million that is invested and earns 7% annually. You can use the $700,000 in interest earnings to live on without dipping into the original $10 million.

If you can "manage" to live on $700k a year or less then the original money (plus any interest you DIDN'T take out) will remain intact going forward.

AND FOR WHAT IT'S WORTH...

If you are a "high net worth" customer of just about any financial institution (meaning you have a LOT of money in their bank), I promise you that you can get a significantly higher rate of return using private banking services than what ordinary people such as myself would ever be offered on a standard savings account.

This means that people who inherit large fortunes COULD afford to live on the returns without choosing to touch the principal, but they may not want to.

Answer 2

There are four problems with your logic.

First, interest rates are low now but they haven't always been. And you get more interest with "locked in" savings like CDs. So what you see offered in your savings account may be low, but that's not the only option.

Second, when you have the kind of money that supports trust fund children, you have a wealth manager. Their job is to make 5-7% after taxes, inflation, and their fees. You can't get those returns, but the wealth manager can. That might be stocks and bonds, it might be real estate, it might be all kinds of things. I am getting about 7% after inflation in a tax-free account through dividends and capital gains on a pretty small portfolio. And this is not my job.

Third, whatever you think is a ridiculous amount of money, there are people who accumulated that. People with hundreds of millions of dollars piled up. If you have 100 million dollars, even 1% of that is a million a year.

Fourth, you seem to feel the fund can't benefit from prices going up because "if you have ten shares of X and sell one, your principal is down 10%". They have way more than ten shares (see third point) but also your wealth manager could sell all your X for a million dollars and then buy some Y that is poised to grow, buying 900K of it and releasing 100k as income.

Answer 3

You are quite wrong in your stock market example. Let's say I have $1 million invested, and since I am not an active investor, the money is in mutual funds. So my principal is $1 million. In an average year, let's say I make 7% return* on that. So I can take out $70K, and still have my $1 million principal intact. It is the market value that matters, not the number of shares held.

But I won't always have average years. Sometimes I'll make a lot more than 7%, sometimes less. Sometimes I might have a really bad year, and the value actually goes down, in which case I can't take anything out until the market recovers. If I'm sensible, I won't have spent everything I earned in the good years, but will save it in my emergency fund, or in personal accounts outside the trust (or 401k/IRA, which more people are likely to have). So it's very unlikely that my principal will decrease below that $1 million and stay there for a long period.

*Dividends & market appreciation, and neglecting inflation for simplicity.

Answer 4

In such a situation, someone’s talking about not reducing the starting total value. If an investment appreciates, then you sell some of it, you may still maintain at least the same base value you started with. It is certainly false that trust funds don’t buy real estate.

Answer 5

Another example is rise in stock market price - but that does not make sense either. If one has 10 shares of company XXX, even if XXX stock price doubles every year one would still have to sell shares to get anything - in this example any transaction would shrink the principal by 10%.

The principle is the monetary value, not the number of shares. The fact that you would sell some stake or a certain number of shares does not mean that you've tapped into the principle.

e.g. you own 100 shares of $AAPL (originally $13,000). $AAPL goes up 10% ($14,300). You sell 9 shares of $AAPL. You spend the $1287 on daily needs. You still have $13,013 in the brokerage account, which is above the principle balance of $13,000. You have not touched your principle.

Answer 6

Note too that we are talking about planning so inflation can be balanced against returns and the "today's dollars" value amount still goes up enough to permit withdrawing the living expenses, whatever they are. The rule-of-thumb "you can retire when you have saved 25 times your expected yearly expenses" is based on exactly that sort of calculation, albeit in much simplified form.

My own retirement planning factors in exactly this goal. Using fairly conservative numbers, I should be able to earn enough passive income to live past my age expectancy in a reasonable amount of comfort and pay for a decade of assisted living/end-of-life care without having to sell the house (keeping that as emergency reserves). In my case, that worked out to wanting about US$1.88M in savings and investments before retiring; your number will probably be different.

(Rephrasing an old song, a million ain't a million any more. I don't like the attempts to redefine "millionaire" as "has income of $1M" -- I think we need a new term to signify that -- but that's a more realistic definition of "rich" these days; being only a millionaire now makes you well-off but not rich.)