What should be the response to a low return environment (i.e. high prices on stocks and bonds)? I have touched on this before (here for example), but it seems like it might be time again.

If returns are lower than they were in the past, but risks are the same (i.e. the return per unit of risk is now lower), there are three perfectly rational responses:

1. Keep your portfolio the same but realize you will not get the returns you once did with that portfolio.
2. Decrease the risk in your portfolio.  Since you are not getting paid as much for taking risk you decide to take less of it.
3. Increase the risk in your portfolio.  Since you desire a certain level of return the only way to get it is to increase risk.

Now, the problem is that although the options above are opposed to each other, they all make sense and are rational.  But we have to pick one.

I don’t have a simple answer though.  I think it depends on your resources compared to your needs.  For example, if someone is wealthy (compared to their needs, not in absolute terms) the correct choice is probably different from someone who is not at all wealthy (again, relative to need).  For example, suppose we have three families, each newly retired, and each need $120,000/year. Social Security/pensions/whatever are expected to provide $40,000.  That means $80,000 must be provided by the portfolio.  One client has an $1,600,000 portfolio; one has $2,000,000 portfolio; and one has a $2,400,000 portfolio.

• The family with the $1,600,000 should probably have a slightly more aggressive portfolio than they would have in a higher return environment.
• The family with the $2,000,000 should probably have the same portfolio they would have in a higher return environment.
• The family with the $2,400,000 should probably have a slightly less aggressive portfolio than they would have in a higher return environment.

I think.  This answer is tentative, provisional, and preliminary!

I have been thinking about wealth taxes that have been proposed and it occurred to me that we already have a few of them (property taxes are one, I’ll get to the other below) but we don’t think of them as wealth taxes. That led me to think about some other illogical tax items. This is just about the items related to capital gains; I may or may not go on to other topics in future posts.

I wrote up some reform ideas a few years ago here and here but this is new.

Here are a few oddities just to illustrate some problems. Let’s assume that inflation is 3% (and always was); long-term capital gains rates are 20%; short-term capital gains/ordinary income rates are 40%; and corporate tax rates are 25%. The numbers aren’t really important, but I want to be able to do some simple examples with nice easy round numbers that are close to what exist though not exact (state taxes, Medicare surcharges, brackets, etc. would all change them for various taxpayers anyway).

• Situation 1: Taxpayer Alpha bought Stock X 20 years ago for $100,000 and it has grown at an average compounded rate of 3%. Since inflation has been 3% the real wealth has not increased. Nonetheless, if sold the taxes would be about $16,000 [($100,000 * 1.03^20 – $100,000) * 20%]. This is a wealth tax basically set at the rate of inflation times the tax rate (so in this case 3%*20%), but only collected upon disposition so there are some compounding differences. Our taxpayer, in purchasing power, is $16,000 poorer. We have had low inflation for so long I don’t think people appreciate the damage that income taxes combined with inflation do.
• Situation 2: Taxpayer Alpha dies and leaves Stock X to Taxpayer Bravo. There are no taxes. (Step-up in basis.)
• Situation 3: Company X pays a special dividend (qualified) of $80,000. Taxes would be $16,000.
• Situation 4: Taxpayer Charlie buys Stock Y one year ago for $100,000 and it is now worth $180,000 (roughly the same as the previous example). Since it has not been a year-and-a-day, sales would result in taxes of $32,000.
• Situation 5: Taxpayer Delta buys Stock Y one-year-and-a-day ago for $100,000 and it is now worth $180,000. Sale would result in taxes of $16,000.

You get the idea, the first three situations are economically identical, yet the taxes are different. Worse, there is no actual (real) gain, yet taxes are assessed. This is why using qualified plans/IRAs, Roths, etc. is so vital. That is the only way to avoid paying taxes on phantom (inflation) gains. (Assuming all qualified plans/IRAs are exclusively funded with pre-tax dollars.) The last two situations are nearly identical, but the taxes are wildly different.

So here is my modest proposal. All of these should be adopted simultaneously, not in isolation, as they work very well together, not nearly as well individually. I’m not trying to minimize (or maximize) taxes, I’m trying to make the economic reality of a situation give rise to appropriate taxes. Anyway:

1. All income tax rates for a given taxpayer should be the same marginal rate, no special long-term capital gain or qualified dividend rates. This eliminates the “gaming” that is sometimes done to turn earned income into a capital gain (carried interest for example). This would raise tax liabilities. (But stay with me, it gets better.) A flat tax would be even better, because the sale of large value items (real estate for example) could kick someone into a higher bracket than they would normally be in.

2. Companies should get a corporate tax deduction for dividends paid. This removes the tax incentive to use debt rather than equity. It also means that the rationale for a special dividend rate to compensate for double taxation is removed. (Under current rules/rates above a company makes $20, pays 25% in taxes leaving $15, pays it out in a dividend taxed at 20%, the taxpayer nets $12. With my change, the company makes $20, pays it out in a dividend and it is taxed at 40% leaving the taxpayer the same $12.) This would lower tax liabilities to the company. (It would also incent management to distribute earnings rather than horde them and empire-build.)

3. Step-up in basis on death should be eliminated. Carry over basis eliminates the economic dislocation from holding property that would otherwise be sold, waiting for the owner to die to avoid tax and leave the heirs more. This would raise tax liabilities. It also, given that we have a progressive tax structure, aligns taxes with the economic situation of the heirs. A “starving artist” heir would pay little or no taxes, a neurosurgeon heir would pay much more. That seems fair.

4. Since we have eliminated the step-up in basis, we can eliminate estate taxes now too. This would also free up many very expensive tax attorneys and CPAs to do something socially useful. This would lower tax revenue.

5. Investment assets held longer than a year have the basis indexed for inflation. So there is no more tax on growth that isn’t real. The stock bought for $100,000 that grew to $180,000 over 20 years at 3% inflation would have no tax due. A 20-year bond bought for $100,000 with 3% interest (remember inflation is 3% too, so this is zero real return) would have taxes on the 3% paid each year (at 40% rate). But upon maturity, the bonds would have a capital loss equivalent (roughly, you have compounding issues again) to the interest paid. So the taxpayer, having received no real return, pays (roughly) no tax. This structure means that the effective tax rate on stocks is still a little lower than bonds given that dividends are usually lower than interest so you are ahead on the time value of money, particularly on growth stocks, but then the company didn’t get a deduction if they had earnings. This would reduce tax revenue.

6. Repeal the $3,000 limit on taking losses against ordinary income. Since all the rates are the same there is no point to this. (And it means the bond buyer in the earlier example, can actually use the real loss upon maturity.) This would reduce tax revenue.

7. Section 121 can be repealed (the home sale exclusion of $500,000/$250,000). Since we are indexing to inflation everyone only pays taxes on real appreciation. The current method penalizes people who 1) buy expensive homes (the “free” appreciation is in dollars, not percentages), and/or 2) don’t move. If I buy homes for $1,000,000 and move every five years I will probably never pay taxes on it. If I buy a home for $500,000 and don’t move for 30 years I probably would. That seems … odd. This would probably raise tax revenue, but it could conceivably go the other way. I don’t have data (and behavior would change).

This is just a guess, but I think doing all of that probably wouldn’t materially alter taxes paid (in aggregate) but it would remove a lot of uneconomic behavior that people engage in for tax reasons.

Of course there is zero chance of this being cleaned up logically…

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Fall 2021

If you have a prudent financial plan, with no legacy desires, you very well might accidentally leave your heirs an estate large enough to have an estate-tax problem anyway! I’ll give the conclusion first (less technical) and then the detail of how it was derived (which is almost certainly more than you want to know).

If you use the 4% rule for spending, with a starting portfolio value of $1,000,000, in 30 years you have (in real, i.e. today’s, dollars):

• A 1/20 (5%) chance of running out of money
• A median (50th percentile) value of $2,000,000
• A 1/20 (5%) chance of $7,500,000 or more

Here’s how that was derived and some elaboration:

Using 1926-2020 data on stocks (CRSP 1-10), bonds (5YR TSY), and inflation (CPI) the real arithmetic mean was 8.8% for stocks with a standard deviation of 18.4% and 2.3% for bonds with a standard deviation of 4.7% (all annualized from monthly data by compounding the monthly return and by multiplying the volatility by the square root of 12). The correlation between stocks and bonds was 8.1%.

If we do projections using a Monte Carlo Simulation (MCS) with those figures using $1,000,000 as the starting value and $40,000 for an annual withdrawal (starting immediately) then this is exactly the 4% rule done with a MCS using historical returns to generate many more scenarios than we actually had historically. (Also, if you use rolling historical data, you over-sample the middle years and under-sample the beginning and ending years). I don’t have to inflation-adjust the withdrawals because I used real returns in the first place. Looking at the results at the 30-year horizon (again to match the Bengen research), the success rates range from 91% for all stock up to 97% for 40/60 (stock/bond) and then back down to 79% for all bond. I’ll focus on the typical 60/40 portfolio here. It has a success rate of 95%. I would say that validates the 4% rule pretty well – though expected real returns might be a little lower than historical realized real returns, this has no international diversification, no factor tilts, etc. but also no fees. Close enough probably to assume all of that roughly cancels out.

While this scenario runs out of money 5% of the time, in the median (middle) case there is just under $2,000,000 (and, to reiterate, all of this is stated in real, i.e. today’s, dollars). The 5% case (the 1-in-20 on good side) had an ending value of about $7,500,000, while the 95% case (the 1-in-20 on the other end) is zero.

Doubling everything so a hypothetical single client had a $2,000,000 portfolio to start with and withdrew $80,000/year (adjusted for inflation) to live on in retirement (and had no other assets), in 30 years there is an equal chance of zero and $15,000,000! The estate tax exemption is scheduled to revert to $6,000,000 (ish) and increase with inflation so we can compare our $15,000,000 to that $6,000,000 since both are real. $15,0000,000 minus $6,000,000 is an estate that would owe taxes on $9,000,000. At the current 40% rate, that is a $3,600,000 estate tax bill! To flog the deceased equine further, to have “only” a 5% chance of running out of money, there’s a 5% chance of pretty significant estate tax issues. (Of course in real life you see how it’s unfolding and adjust spending, gifting, etc. to ameliorate both extremes.)

That math is surprising to most people. We don’t generally realize how wide the range of financial outcomes in retirement can be.

This is new, although I’ve written similar things before:

• Financial Success (2016)
• Broke Rich People and Loaded Poor People (2016)
• “Good With Money” (2019)

Aristotle believed that our goal should be eudaimonia which is frequently translated as “happiness” but what he meant was much closer to well-being or human flourishing.  Before Financial Architects existed I briefly thought of naming it Eudemonic Wealth Management (eudemonic means “conducive to” eudaimonia) – fortunately wiser people than I suggested not naming the firm something virtually no one knew or could spell!

Anyway, how did Aristotle believe eudaimonia was to be achieved?  He believed that right actions were usually a golden mean or a middle way; that virtue lay midway between two vices.  (For more, see this for example.)

You are probably wondering what all of this has to do with financial planning.  I believe the virtue of wealth (having enough) is between the two vices of profligacy (over-spending) and miserliness (over-saving).  I also want to note that having “enough” is not entirely income related:  there are lots of high-income broke (i.e. don’t have enough) people as well as low-income not-broke (i.e. have enough) people.  My definition of “enough” is whether someone is likely to have to dramatically curtail their lifestyle (whatever it is) in the future.

Merely by nature of our business, we and our clients have much higher savings rates and wealth levels than the vast majority of society.  Those less-well-off people generally think that they should have more money, but they also would, in most cases, spend the money if they had it.  You can’t both have the money and spend it though!  They want to be millionaires (or more) not to have a million dollars, but so they can spend a million dollars on the things they think millionaires have and do.  But then, ipso facto, they would no longer be millionaires, they would be poor again!

In addition, that desire to be wealthy is usually only a wish, not a real desire.  Let me use an example from another area of life.  Many Americans (myself included), could stand to lose a few pounds.  We want to be thinner, but in sort of an abstract way – we don’t really want to eat less or exercise more (or we would).  In much the same way, many Americans want to be wealthier – but they don’t want to spend less or work harder.

Before I go on, I want to put a little disclaimer here.  From my perspective most people (not most of our clients, most people in the U.S.) are spendthrifts.  From their perspective I am a miser (and you probably are too).  If the goal is to maximize happiness, we could very well all be right.  “They” maximize happiness by living for today and “we” maximize happiness by knowing the future is relatively secure.  The following comments are descriptive not normative.  In other words, I’m stating what is necessary to build wealth; I’m not saying that building wealth is, or should be, the goal for everyone.  There is no way for anyone to make that claim either way for other people.  When I was younger, I would think “those people should…” where now, older and (perhaps) wiser, I more often think, “those people are making choices I wouldn’t make, but it must work for them…”

That said, I’ve given a lot of thought over the years to what causes some folks to build wealth while others don’t.  I think there are two elements: time horizon and locus of control.  I’ll elaborate on those further below.

Time Horizon

Consider a few things that most of us would consider mistakes in most cases (or at least pretty sub-optimal):

• Carrying credit card debt at 18%
• Not contributing to a retirement plan (not even for the match)
• Working a “dead-end” job (and not trying to change the situation)
• Overspending on luxury goods

I would submit that all of those are great financial decisions – if the universe ends on Tuesday. They are only bad decisions if it doesn’t.

Once I saw this, it explained a lot of decisions that people make that seemed obviously foolish to me. They aren’t foolish necessarily; the folks making them just have a very short time horizon. You can equate this to discount rate too. A short-term horizon is the same as a high discount rate. If someone has a 30% discount rate, then 18% credit card debt is a screaming deal. If someone has a 3% discount rate, then paying down on a mortgage at 4% is attractive.

Now, obviously, there are life situations where people are hindered from doing what they “should” do, but ceteris paribus short-term thinkers will do the things on that list and long-term thinkers won’t.

On the flip side a person could have a time horizon/discount rate that is arguably too long – these folks are misers who will never spend any of their money because they “might need it later.”  In the United States today people with this inclination are pretty rare.  The people who aren’t saving enough for the future seem to vastly outnumber those who are saving too much. (Again, from my perspective of what’s “enough” and “too much.”)

Locus of Control

A person with an internal locus of control believes they can affect what happens.  A person with an external locus of control doesn’t think they can.  The “sweet spot” is in the middle with a locus of control that is correctly calibrated.  If you think saving is pointless because even if you save something will happen and you will lose all your money anyway, then you have an external locus of control and you are unlikely to save.  On the other hand, if you think you are planning for retirement, not by saving in a diversified portfolio, but by simply buying a penny stock or lottery tickets because you believe you can (against all evidence) pick winning stocks or lottery numbers, then you have a locus of control that is too high.

Let me try to explain this another way.  A high school student does poorly on a test:

• External locus of control response: “That teacher always hated me.”
• Excessive internal locus of control response: “Despite my failing grades I don’t need to study to succeed. I’ve got this.”
• Appropriate internal locus of control response: “I need to study harder next time.”

Appropriate internal locus of control folks “own it” and do the necessary work while external locus of control folks “blame” their situation on others.  As adults, the three students above grow up and take the following approaches to retirement:

• External locus of control attitude: “The world is rigged against me and I’ll never get ahead so there’s no point in saving.”
• Excessive internal locus of control attitude: “I don’t need to save much (or at all); I’ll just be sure to buy investments that will have at least 100% annual returns.”
• Appropriate internal locus of control attitude: “I’ll save prodigiously and invest in a prudent and diversified portfolio so I can retire comfortably someday.”

Now, I should note that there are people who have an external locus of control and it is appropriate.  If you live in a repressive or authoritarian country or are in the middle of a natural disaster or war, you frequently can’t get ahead by your own work.  In some cultures and families, if you are the one who “does well” you are expected to support others who haven’t done as well (even if it is self-inflicted).  If every time you scrape together a few dollars of savings other people feel entitled to it, then it’s hard to get ahead.  Your success isn’t in your hands if there are excessive demands from your loved ones.

But assuming 1) you live in a country with a relatively free and stable economy, 2) you are capable of working, and 3) you don’t have family and friends who will feel entitled to any wealth you accumulate (or you can say “no”), then financial success is just a matter of having a long time-horizon and internal locus of control.  With those traits, building wealth is almost inevitable; without them, it’s almost impossible.