My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Fall 2021
The (Surprising) Range of Financial Outcomes in Retirement
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.
Financial Success (Again)
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.
Summer Ruminations
My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2021
Veblen Investors
I thought this paper was excellent. Our language influences what we see and think and having the term “Veblen Entrepreneur” available is very useful. (For example, in cultures without words for certain colors, they can’t easily see that color. We have trouble thinking about concepts without appropriate terminology; this is where jargon is useful to experts.)
I think most people with business/economics backgrounds are familiar with Veblen goods. The term comes from Thorstein Veblen who wrote The Theory of the Leisure Class (1899). Veblen goods are valued for their conspicuous cost rather than for their utility (usefulness). Many luxury cars, watches, handbags, etc. are in this category. They are interesting in that the demand curve, which normally is downward sloping (the cheaper it is the more demand there is), may be upward sloping (the more expensive it is the more demand there is). Veblen coined the term “conspicuous consumption” – it isn’t a new phenomenon!
The authors of the paper are focused on businesses seeking venture capital, but, further down the food chain, I think there are lots of folks who do this on a smaller scale. In my (misspent) youth, I was very active in networking activities through the Chamber of Commerce, BBB, was president of a BNI group, etc. As far as I can tell, these groups are primarily useful to their participants by feeling like work without actually being work. They are frequently people with few (or no) prospective customers talking to each other in the vain hope that one of them will perhaps stumble upon one eventually. Thus, most (not all) of the folks participating were low-end Veblen Entrepreneurs. I think virtually every MLM participant, most real estate agents, and many purchasers of inexpensive franchises are Veblen entrepreneurs, and I love having a good term for it.
I also think that there are many Veblen investors (and I am apparently the first to coin that term!) where the fun, excitement, or social cachet are far more important than the expected returns. Here are some examples of what I believe are Veblen investments:
- Penny stocks
- VC/PE/Hedge Fund investments (for individuals, not institutions)
- Crypto currencies
- SRI/ESG/impact investments
You may have seen articles about Veblen investors joining Robinhood recently… frequently for the LOLs rather than the risk-adjusted returns. (But sometimes, it’s tragic.)
Anyway, back to Veblen Entrepreneurs. I typically give two pieces of advice to people (such as clients) who are thinking of starting a business:
- Read The E-Myth Revisited: Why Most Small Businesses Don’t Work and What to Do About It
- Set a hard stop on how much you will sink into the venture
I want to elaborate on that second item. Many clients have too much money to start a business. I’m sure that sounds odd. What I mean is, to start a business you must be optimistic – you have to believe that even though most new businesses fail you will be the exception. So suppose a client has $1,000,000 portfolio and is unhappy in their job (or loses it). Rather than get another, similar, job, they decide to start a small business – let’s say a restaurant. The problem is that, because of their optimism, they can delude themselves that success is “right around the corner” until they have spent the whole $1,000,000. They need to in advance set a hard stop of some sort. If they only had $200,000 then running out of those funds would force them to close the restaurant and get a job again. With $1,000,000 there is less pressure to get profitable or to abandon the attempt until the whole $1,000,000 is gone. The appropriate metric will depend on the client and business, but it should be 1) specified in advance, 2) in writing, 3) specific, and 4) inviolable.
Recent research has come out that supports my concerns. Here’s the abstract:
We examine how wealth windfalls affect self-employment decisions using data on cash payments from claims on Texas shale drilling to people throughout the United States. Individuals who receive large wealth shocks (greater than $50,000) have 51% higher self-employment rates. The increase in self-employment rates is driven by individuals who lengthen existing self- employment spells, and not by individuals who leave regular employment for self-employment. Moreover, the effect of wealth reverts for individuals whose payments run out. Rather than alleviating a financial constraint, our evidence suggests that unrestricted cash windfalls affect self-employment decisions primarily through self-employment’s non-pecuniary benefits.
Elsewhere in the paper:
[W]e find that, once individuals stop receiving shale royalty payments, they tend to exit self-employment for regular employment, consistent with the idea that shale royalty payments were subsidizing their income in a way that allowed them to be self-employed. This evidence also supports the view that the wealth shocks were not being used to fund self-sustaining or otherwise productive projects…
It is an accepted economics principle that returns will flow to the scarce factor of production. In other words, if you have the coffee shop franchise in Grand Central Station the landlord will extract the excess rents, not the coffee shop. Similarly, capital is abundant but the ability to generate excess returns scarce. Thus, you would expect those capable of producing excess returns to charge fees bringing the net excess returns to zero. These two recent papers (on hedge funds and private equity) support that view – indeed, adjusted for risk and illiquidity, the excess returns (net) are probably negative!
Investing should be done with a clear and unflinching objective of adequate risk-adjusted returns to meet your financial goals – an investment is no place to be stylish!
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