Category Archives: Present Value

Holistic Financial Health (cont.) – Present Value and Leaving a Legacy

I ended my last post noting that when we consider the future and determine our personal rate of discount we should not limit ourselves to the “rest of our life”. In fact, if you are like most people you care a lot (though maybe not quite as much) about what happens after you leave this world. Except for the very wealthy, very few of us (and even fewer financial planners) really take a hard look at what this implies for how we should manage our financial life both before and after we retire.

As a practical matter, when it comes to financial decisions, what this means is that  not only should you consider those scenarios where you don’t exhaust all your assets, but you should also think about other financial steps that you can take to leave something behind. In addition to your house there are two other mechanisms for leaving a legacy that are worth mentioning now and will be explored more deeply in future posts. The first is Life Insurance which many financial planners will likely suggest should be part of your financial strategy. As powerful and effective as it can be (for protecting your family while working, for generating retirement income, and for leaving a legacy) Life Insurance products are very complex, and purchasing policies as well as managing them well can be a daunting task.

The second and less well known vehicle that can be used to both generate retirement income and leave a legacy is a Charitable Gift Annuity (“CGA”), which even though considered a “Planed Gift” by the philanthropic community, can also be considered as a (not so traditional) retirement planning tool. Steve Vernon as well as many others have explained how effective annuities in general can be in ensuring your financial health. See for example Steve’s post at http://www.cbsnews.com/news/understanding-how-you-can-use-immediate-annuities-to-fund-your-retirement/  .

With respect to Charitable Gift Annuities, this link,  http://www.nolo.com/legal-encyclopedia/charitable-gift-annuities.html   can give you some basic information on how CGA’s actually work, but for now just know that CGA’s operate like any other annuity that you might buy from an insurance company except that instead of allowing a big corporation to make money on your purchase, the “profits” on a CGA go to the Charity that you got it from. You can obtain a CGA from almost any large not-for-profit organization, University or Charity. I purchased one from my old school, but many people get them from large Charities whose mission they believe in.

In order to get a CGA you must first make sure the Charity of your choice has a CGA program. To find out, just call them up and ask for their “Planned Giving “ department. After you transfer funds to the organization you have chosen, they will provide you (based on a legally binding contract) a guaranteed stream of payments starting either now or at some specified date in the future and those payments will continue for the rest of your life. The only difference between this and an annuity purchased from an insurance company is that in addition to the guaranteed lifetime income you get, you also receive an immediate tax deduction for the Present Value of what the Charity expects to recover from the transfer after you die and all of the annuity payments had been made.

In essence, obtaining a CGA allows you to provide yourself guaranteed retirement income, leave a legacy and get an immediate tax deduction for the profits that otherwise would have gone to an insurance company had you bought a more “traditional” annuity. To my mind a CGA is a great way to invest your retirement savings in a vehicle that can play an integral role in your decumulation strategy while at the same time benefiting a cause you believe in.

Of course it is not quite that simple (e.g. CGA’s can be expensive and tricky to obtain), and we will delve into more of the details in a future post. If you can’t wait, you can always read Chapter 12 of “What’s Your Future Worth?” and get the full story of my CGA purchase and take on the world of Planned Giving. In that chapter, as well as throughout the book, the message is the same – ask the experts for help in imagining the future and evaluating what might occur (steps 2 and 3 of the Present Value process), but don’t ever let others set your personal rate of discount (step 4)  by telling you how much (or little) value to place on what you get/give today vs what comes your way tomorrow or even in the distant future when you are gone but the world is still spinning and those you care about are still  around.

That is what holistic financial health is all about.

On Holistic Financial Health and Why Your Financial Planner’s Advice is Usually Wrong

Having successfully infuriated a significant percentage of a key group of potential buyers of my book (e.g. actuaries), I’ve decided to antagonize a few more by sharing some thoughts on why most Financial Planners (including some of the most sophisticated ones out there) generally get it wrong; and not just a little wrong, but fundamentally and seriously wrong.

I am not addressing the obvious problems with Financial Planners who are also marketing particular products (e.g. insurance, stocks, annuities etc) and who therefore provide advice that may be tainted with self-interest. Rather I am talking about the ones you can trust, i.e. the ones who are sincerely trying to give you advice that will help you make better financial decisions

I believe that even the (relatively few) independent fee-based advisors that meet the above criteria are likely to fail you for 3 main reasons. The first is due to their general reluctance to take account of (or even acknowledge) the importance of personal rates of discount. This was the subject of my previous post (the one that got actuaries so upset) and a subject on which I have probably said more than enough (at least for now). The second reason is the (to my mind) unreasonable confidence that Planners (and the experts that they rely on ) have in their ability to predict the future. I will address this aspect of financial planning in much more detail in the future, but before I get to that issue, I want to discuss yet another issue that is even more important than the first two.

Specifically, I want to talk about something you don’t have to be an actuary to appreciate and may actually seem obvious – and that is the failure of almost every Financial Planner I know to approach financial decision making from a holistic perspective, taking into account your entire balance sheet including all of your assets and liabilities as well as your future income and expense streams (much of which is uncertain and related to aspects of your life that Financial Planners may not have access to). Don’t get me wrong, a good Financial Planner will likely ask you for all the information that theoretically could go into the development of that holistic balance sheet, but almost none of them put it all together to help you look at the big picture. I would propose that the failure to do so can render the advice they give almost meaningless.

I say this because, in my experience, even though there are two sides to every balance sheet, it is the asset side that advisors spend almost all of their time on. To my mind the liability side of an individual’s financial world is just as important, and how you manage your liabilities (debt and the Present Value of future expenses) is not only related to your ability to manage your assets (i.e. save and invest) but can actually have a bigger impact on your financial health than the asset allocation strategies that are often the core of what your advisor is concerned with.

But it’s worse than that, not only do advisors typically only focus on assets and income, but they also tend to ignore the single biggest asset that most individuals have, and that is the equity they have in their house. The rest of this post will talk about some of the considerations you should think about regarding your assets and liabilities (including debt and home equity) while you are working and “accumulating” assets (and liabilities), and next time we will talk about how the value of your house as well as your debt can and should be integrated into your overall approach to managing and maintaining your financial health after you stop working and enter the “decumulation” phase of life.

 

Saving for Retirement – Looking at Debt and Real Estate from a New Perspective

Almost all Financial Planners pay some attention to an individual’s credit card debt, and some have even made a career out of telling people to “pay it off and tear it up”. It’s pretty hard to argue with this statement as, in concept, the advice makes sense. After all much of that debt likely arose from “over-consuming” and with interest rates on credit cards generally in the low to mid double digits, a level that is higher than most people’s personal rates of discount, the argument for using current income to pay off that debt and not accumulating more is pretty compelling. But I think just focusing on credit card debt misses the bigger picture.

There are all kinds of debt, and A LOT of it. When Financial Planners (and more than a few retirement consultants) say “get rid of credit card debt and start saving for retirement” what they are really saying is (with the exception of your Visa and Mastercard balances) “ignore your liabilities and increase your assets”. But does that make sense? Well let’s look at some numbers

The reality is that personal debt (i.e. student loans, auto loans, outstanding mortgage debt and credit card balances) is consuming the attention of most people and for good reason. In the aggregate, the amount of debt on individual balance sheets is greater than retirement savings assets and for many people it is much greater. To put it in context, total 401(k) assets in 2013 were about $4.5 trillion. The amount of outstanding student loan debt in that year was over $1 trillion while outstanding mortgage debt was $7.4 trillion and when credit card and auto loans are added in the total amount of debt burdening individuals is close to $10 trillion, an amount that is significantly more than all the retirement savings that individuals have set aside for their retirement years.

But let’s look a little more closely at some of that debt. Other than credit cards, most of that $10 trillion in debt is being used by people to obtain tangible assets (e.g. a house, a car or an education) that will generate some benefit (often but not always monetary) in the future. I would argue that not only were some of those decisions correct from a Present Value perspective (taking due regard of the personal rates of discount of those making the decisions ), but going forward it might actually make sense for many people to take on more debt rather than blindly following the conventional wisdom espoused by the financial planning community and the media in general to “increase your 401(k) contributions and save more for retirement”. This could very likely be the case if the choice is between an increased 401(k) contribution (particularly if there is no Company match involved) and buying a house with its inevitably higher (than rent) mortgage payments, but it could also be true when other types of loans are considered. For example, even the purchase of a new car, with the attendant increase in flexibility and/or reliability of the transportation might expand your ability and options for future income (and pleasure) sufficiently to make the purchase make sense. Investing in your education (where you might have to take out student and other loans ) to pay the tuition and make up for lack of current income is another prime example.

In fact, I believe that taking on debt and foregoing a long term benefit ( e.g. the ability to retire at an early age) for a current asset (e.g. a car) and a future short/medium benefit is the right choice far more often than most financial planners would like to admit, and this is particularly true when the individual honestly and clearly factors in his/her personal rate of discount into the consideration.

Before we talk about incorporating your real estate and debt into your short and long term investment strategy there is another aspect of debt that is well worth considering and that is how high the “quality” of your debt is. It turns out that individual debt is “rated “ just like the corporate and municipal bonds that you can invest your assets in For example, just as (low rated) corporate “junk” bonds yield a high interest rate and may have a place in your investment portfolio, the interest rate that you will pay on a lot of the debt that you take out is based on your credit rating (i.e FICO score). Therefore, one way to minimize the cost of your debt and enhance your financial wellness is to improve your FICO score. The factors and behaviors affecting an individual’s credit rating are complex, but by no means intractable, and just like exercise and good eating habits promote physical well-being, a “fiscal fitness” programs can enhance your financial health as well.

 

Putting It All Together

You may be saying that even if the above is true, once I have improved my FICO score and taken on the amount and kind of debt that makes sense for me, shouldn’t my focus on an ongoing basis still be on saving for retirement and investing those assets wisely? I would suggest that while savings and investing those savings for retirement are certainly worthwhile (I am an actuary after all), I believe that your debt and the value of your house (something that many people don’t think of as a “retirement savings” vehicle) should also play an integral part in the development of your overall asset allocation and the investment strategy that you employ. This is part of what I mean when I say that you should take a holistic approach to financial health.

Before considering overall investment strategy, the first and most important thing is to understand your debt as an “investment”. Even though it is a liability, from an investment perspective, you should think of it as another “asset class”, only in this case it is one that acts like a “negative bond”. Just like regular bonds that reside in your 401(k) account, your debt has a “yield” (the interest rate it costs) and a “duration” (when it needs to be paid off). And just like the very sophisticated “bond management” and asset allocation strategies that your Financial Planner may have discussed with you, I would argue that managing your debt to minimize its cost and the “mismatch” it might have with your assets and future cash flow is a worthwhile exercise that can have a big impact on your financial health.

I would also argue from a theoretical (and practical) perspective that you should consider your debt (as well as your home equity) as part of your total portfolio of “investable funds” when developing a long term asset allocation strategy. Doing so might, for example, cause you to significantly increase your traditional bond holding (to offset the “negative bonds” you already own) and/or stay away from any real estate investments beyond your primary residence (to maintain diversification). Here is where an expert who understands (and can explain) concepts like asset diversification as well as “yield curve”, fixed and variable interest rates, pre-payment penalties, etc can help you truly optimize the long term future outlook of your entire financial world.

In my next post we will shift our attention to how to maintain financial health throughout the “decumulation” phase of life. This is a very challenging problem that many of the best actuarial minds in the country are thinking about. In that post, I will try and give you a sense of the “state of the art” and share a few thoughts on how important a holistic approach is here as well. I will also discuss some of the many new financial tools being developed to aid you in that effort and give my views on some of the more exciting of them, including “longevity insurance”, Charitable Gift Annuities, and reverse mortgages that can be used to convert your home equity into a stream of income that can play a critical role in making sure that your financial health remains intact as least as long as your physical health endures.

 

Memories, Dream Recording and the Present Value of “Stuff”

In my last post, I talked about my son’s consideration of the colleges he might want to go to. That is a decision that he will have to face largely by himself. However, the fact that he will be leaving my wife and me with an “empty nest” has brought us a whole new set of decisions to face, one of which I want to talk about today.

Whatever we decide to do after Adam leaves home, it will almost certainly entail moving to a smaller space. The process of deciding where to live and what to do with the “rest of our life” is obviously another type of Present Value decision and one that I will write about again in future posts, but given that we know that whatever path we choose to take, we will have less space for all of our accumulated possessions, there is really no reason to wait on an important related decision – i.e. what do we do with all our “stuff”?

The “Dream Recorder”

And so, this weekend we started in on our storage shed; the one in the backyard which over the years has become the repository for almost everything that we don’t use, but can’t bear to part with – old toys, photos, school papers, artwork (both Adam’s and ours), comic books, baseball cards, an array of almost useful tools and a vast store of memorabilia filled with magic, associations and significance.

As I started bringing everything out, examining and sorting it into categories (definitely toss, definitely keep and several categories in between) I came across one of Adam’s early creations – the “dream recorder”. He built it when he was 5 years old out of scrap wood, nails and magic markers. Primitive as it is the resemblance to a VCR is unmistakable and, as he had explained to me more than 10 years earlier, that is what it was supposed to be, only instead of plugging it into the TV or a video camera, you plugged it into your head before you went to sleep and after setting the dials appropriately your dreams were recorded and available for playback anytime you wished. This one, despite its bulk, was an unquestionable “keeper”. I didn’t even think about using Present Value; the “Dream Recorder’s” importance and “value” (to me, to Adam, now and in the future) was simply too high to consider the small incremental space savings that we would gain by discarding it. If nothing else, its continued presence in our lives reminds me of just how valuable our dreams and our memories really are.

But what about the rest of the stuff? How would we decide what to keep, sell, give away or discard? And in making those decisions, when should we use Present Value and when should we just go with our first basic instinct? I don’t have space to go into the details of each and every decision, but I do want to talk about one example that may be familiar to those of you who can still remember Ed Sullivan, mini-skirts, and the “British Invasion”.

Albums – The soundtrack to growing up

Unlike baseball cards and old coins, records take up a lot of space. They are also a funny kind of collectible. Of course they bring back all sorts of memories, and many of them have significant investment value, but they also (at least theoretically) can still be played and enjoyed for what they were intended to provide – music to listen to and enjoy. So deciding what to do with our record collection of 500 LP’s as well as the decent turntable that was carefully stored alongside them was a decision that was both complicated and would be of some spatial significance.

Beyond the obvious problem of placing a value on the future pleasure we would get from seeing these albums years from now and recalling the teenage good times associated with them, the really hard part of using Present Value for this decision was steps 2 and 3—imagining possible futures and evaluating their likelihood. As I thought more about it, I realized that to justify the expense, hassle and psychic burden of carrying around a couple hundred pounds of vinyl taking up several cubic feet of space for the rest of our lives we would need a pretty compelling vision of how we would enjoy those records and/or a financial rationale suggesting that a “hold” strategy was better (from a Present Value perspective) than to simply realize the capital gains on some of the unquestionably “savvy” investments I had made in all that “damned noise”(as many of the wise adults around me then called it) all those years ago.

The financial part of the analysis was pretty easy. Beatle records right now are at an all-time high, the market is almost frenzied, and even the records of some of the other more “minor” artists (e.g. The Who, Jimi Hendrix, Rolling Stones etc.) in the collection have been caught up in the market rise and are worth far more than the $3.99 I paid for them (let alone their depreciated value considering the dozens of times each was played). Looking ahead, it seemed to me that if we aren’t yet at a peak, we are probably close – both artists and fans are ageing fast, and those that really want to have and play those records could easily soon be facing the same kind of “space squeeze” we were. Put another way, would I be willing to pay $50 for good quality copy of “Beatles ‘65” today as an investment? And if not, selling surely is the smart move.

But, what about our future “golden years”? We have a farm with an old house up north that we are renovating and it is there, where we hope to spend a great deal of our retirement. Wouldn’t that be the perfect spot to set up the turntable, store the records and spend many a lazy summer evening playing the songs that still make us feel young? How valuable would that be, and wouldn’t the costs of temporary storage and ultimate moving expenses be a modest price to pay for such long term and exquisite pleasure? Even with a relatively high personal rate of discount, that seems, on the face of it like a more than fair trade-off.

Except, that when I really took the time to consider it, I realized that this possible future was just a fantasy and that there was virtually no chance that we would ever find a prominent place in that house (which isn’t all that big anyway) for records, a turntable (with all its accoutrements) and such an antiquated mode of playing music. We have plenty more CD’s that we still actively listen to and with streaming audio services advancing at lightening speed, even if I did get a sudden urge to listen to Iron Butterfly’s “In-a-Gadda–Da-Vida”, Spotify or some other service would be able to deliver it to me with a quick click (or maybe even a voice command). In short, this particular future should be evaluated as having a VERY small probability of being realized.

It was a sad realization, made even sadder by the fact that having the fantasy itself was a source of pleasure, and that as soon as I understood that it wasn’t going to happen, even that modest (and near term) benefit of holding on to the records disappeared. And so this weekend, the best of the lot goes up on E-Bay and those that don’t sell there, could soon be available at your local used record store.

It was an important lesson albeit not a pleasant one to absorb. Specifically, just like (even unrecorded) dreams and memories, fantasies have value too, but more often than we’d like, it makes sense, at least from a Present Value perspective, to face reality and let them go.

More About Time Part 2: Personal Rates of Discount and the Time Value of Time

Now that a few people (including some actuaries) have read “What’s Your Future Worth?” I am starting to get questions on one of the more counterintuitive concepts I propose. Specifically, in the book I have taken the position that there is no “correct” discount rate to use when comparing the future to the present and that to make good decisions about the future, each person should introspect deeply and determine their own “personal rate of discount”. No one seems to doubt that if left to their own devices most people will choose not to delay gratification and opt to receive benefits (monetary or otherwise) sooner than they “should” according to traditional economic theory. Many retirement planners and others in the financial world believe that this is simply a mistake and that their job is to help their clients overcome their “emotional barriers” and think objectively about the future.

I disagree and think that what many financial planners are perceiving as emotional errors are often just manifestations of not only our own individual and completely valid “time preferences” but that the traditional “foregone investment” approach to setting a discount rate is in fact based on a specific (and not necessarily correct) assumption as to the nature of time itself.

How time flows and the Time Value of Time

“I just read with great delight your article on ‘the time value of time’…It was a real eye-opener”
John Haley FSA and CEO of Towers Watson

“I wonder …whether you (in your article) meant to be ‘tongue in cheek’”
David Wesley M.D. and Vice President of Cologne Life Reinsurance Company

My ruminations on the nature of Time and how it flows differently for different people began decades ago and in 1996 I was inspired to put some of those thoughts together in my first, and (thus far) only, attempt to add something new to the field of actuarial science. In essence I started from the observation that for most of us, time feels like it is accelerating as we get older, and that while the months and years seemed to drag on forever when we were young, now they seem to fly by in the blink of an eye. I then defined a concept called “perceived time” based on the (hopefully) reasonable assumption that time is perceived to pass at a rate that is proportional to age. In other words a year will “seem” to last twice as long when you are 20 as it does when you are 40. From there I went on to restate a number of actuarial elements (discount rates, life expectancies, annuity values, etc) using “perceived time” instead of the normal definition of time in developing the formulas. The results were interesting, surprising and in my view explained a lot of the “irrational” choices that people make when faced with economic decisions that require them to choose between getting something now versus later (eg whether to take a lump sum payment or a lifetime annuity from their retirement plan)

At the time I was very satisfied with what I’d come up with. My article was published in the Jan/Feb 1997 issue of “Contingencies” a fairly well respected actuarial publication
( http://www.peterneuwirth.com/?page_id=16 ) . The response was reasonably positive and other than Dr. Wesley’s skepticism, most readers took my paper seriously and found its premise intriguing, if not obviously true. Over time, however, I have come to realize that while there may be a kernel of truth in my “theory”, the nature of our relationship to time, is far more complex than I had imagined.

It turns out that there is a pretty extensive amount of academic study devoted to just this question, though it is framed in a slightly different way. Specifically the term “time preference” is defined by economists as the way people value the present as compared with the future and over the last 40 years quite a few economists have conducted a myriad of often ingenious experiments to determine what the average individual’s personal rate of discount rate is and how it varies by circumstance. The results of these experiments show, first, that personal rates of discount are extremely high (14%-179% according to a 2002 survey of all the studies on the subject), but even more confounding is that the rate will vary by all sorts of factors that are “irrational”. For example:

People show dramatically different discount rates when the choices are presented at different points of time (eg today vs one year from now as opposed to one year from now vs two years from now).

People treat decisions affecting expenses (eg whether to pay $100 now vs pay $110 a year from now) very differently than they treat choices about income (eg whether to receive $100 now vs receive $110 a year from now).

The magnitude of the dollars involved has a big impact on the discount rate used to value future payments ($2000 payable a year from now is worth more today (relatively speaking) than $20 payable a year from now)

When multiple time periods and cash payments are considered (eg payments and/or expenses at 3 or 4 different points in time), choices are inconsistent and do not reflect a stable discount rate.

When risk is combined with choices between the present and the future are given, even when the probabilities of outcomes are specified (eg 50% probability of $1000 one year from now vs $200 for certain today), the answers received vary dramatically and unsystematically both when the probabilities are varied as well as the time periods.

So what exactly is going on? Well, one obvious conclusion is that more work is required to understand the way we, as humans, actually process the passage of time and view the future as compared to the present. On the other hand, as scattered and chaotic as the findings above are, there do seem to be two consistent patterns that suggest my original concept of the “Time Value of Time” plays a part. First, the fact that under almost all circumstances there is a positive discount rate suggests that people prefer to receive something now vs. later. There are some limited circumstances where people’s discount rate is actually negative and individuals prefer to delay gratification, (eg the “Christmas Club” savings account that Banks used to set up where people paid a small fee for the opportunity to not access to their money), but these are the exceptions to the rule. In addition, there seems to be a consistent finding that people’s discount rate is lower the longer into the future one looks. For example Leonard Green and others showed that people would choose to receive $100 today rather than $110 a month from now, but would prefer $110 payable 13 months from now vs $100 payable 12 months from today. The phenomenon becomes even more pronounced when the choice is extended out several years in the future. This is most dramatically illustrated by Richard Thaler who showed that over periods up to one year people manifested personal rates of discount of more than 100%, but over a ten year period average discount rates are under 20%. This finding is called “hyperbolic discounting” and one of the consequences of the concept of “perceived time” as I constructed it is that people’s discount rates will be hyperbolic and tend to decrease as both an individual ages and as an individual looks further into the future (all of these findings can be found in “Time Discounting and Time Preferences: A Critical Review” Journal of Economic Literature 40:pp351-401).

The point here is not to determine exactly how we humans perceive and evaluate the passage of time. That will take many more years of research to figure out. But what we can say, and this is the crux of my argument, is that people do seem to have their own “natural” way of perceiving the flow of time and it seems to have very little to do with how much they could earn on money that is set aside. To see this consider that the studies referenced above took place over a 40 year period during which prevailing interest rates and expected investment returns in general varied widely. As far as I could see there was no meaningful correlation between people’s “personal rate of discount” and the prevailing expectations of investment returns at the time of the study.

The financial planners out there may say that all of the above may be valid but people still should factor in their expected rate of returns when determining a discount rate, because by the time the future arrives they will be happy they did so. Maybe so, and there is no doubt that people should be aware of how much they might earn on money that is set aside, but my belief is that we live in the present and not the future and therefore it is important for us to make decisions in the here and now that are most consistent with who we are as human beings and that if we are true to our own internal values (including our time preferences) we will ultimately be making the right decisions for ourselves and be happier for it.