Sustainable Wealth

1. Sustainable Wealth Jeff Speakes California Lutheran University August 2013

2. Wealth • Financial Wealth = Assets –Liabilities • Also known as “Net Worth” • Earnings Wealth = Present Value of Future After-Tax Earnings • Present Value means the value today of income earned in the future • After-tax income • Wealth = Financial Wealth + Earnings Wealth

3. Projecting Future Earnings • Future earnings depends on education, occupation and other factors • On average, people enjoy increasing real income as they progress through their careers • Additional degrees, credentials and experience all tend to increase earnings • Most important, find a profession about which you are passionate

4. Median Income Profiles

5. Earnings Profiles • The median college graduate earns about 50% more than the median high school grad • Income tends to peak around age 50-60, and then stabilize or tail off slightly

6. Earnings Wealth • To obtain an estimate of earnings wealth, we “discount” (take the present value of) earnings for each year in the future and add up the discount values • To do this we need a discount rate. We are going to use 3% for this, and explain why later • One way to think about earnings wealth is that it is amount of money that if invested at 3% would produce the future stream of earnings.

7. Earnings Wealth Profiles

8. Earnings Wealth Profile • Earnings Wealth is quite large for young people • This is because they have a lifetime of future income • Earnings Wealth can be enhanced by more education, credentials and job experience • Eventually, Earnings Wealth will decline toward zero as a person approaches retirement

9. Sustainable Financial Plan • The key to the Sustainable Financial Plan is to increase Financial Wealth to offset the eventual decline in Earnings Wealth • This means that Total Wealth, which is the sum of Earnings Wealth and Financial Wealth, does not decline over time • Financial Wealth increases by spending less than current income, and by earning a return on accumulated wealth

10. Baby Boomers • Most people do not save to prevent Total Wealth from falling • According to the Federal Reserve’s Survey of Current Finances, the median Financial Wealth of households headed by people aged 55-65 in 2010 was slightly over $200,000. • This suggests young people today are, on average, a lot richer than their parents and grandparents.

11. Baby Boomer Wealth

12. Baby Boomer Wealth • The boomers did build up Financial Wealth during their working years, but not by nearly enough to offset the decline in Earnings Wealth • Many boomers will be left with stark choices in retirement: • Reduce spending a lot • Don’t retire

13. Lesson from the Baby Boomers • Save more! • Invest carefully!

14. The Sustainable Spending Rate • Suppose you adopt the following spending rule: • Spend the minimum of 3% of Total Wealth per year or 90% of your disposable income • If your Financial Wealth is growing at 3% a year and you spend 3% of Total Wealth per year, then your financial plan will be sustainable

15. Sustainable Spending Rule

16. Sustainable Spending Rule • If you follow this rule, you will have lots of choices in retirement, like • Ramping up spending • Assisting family members • Financing business ventures • Engaging in charitable activities

17. What about the risk of market downturns? • So far, we have been assuming a steady 3% real rate of return • In fact, investment returns are uncertain and highly volatile • In order to stabilize spending in the face of uncertain returns, we append the spending rule with • The Retrenchment Rule • The Ratchet Rule

18. The Retrenchment Rule • Original use of the term Retrenchment Rule is by financial economist Gordon Pye • The Rule tells you when and by how much to “retrench” your spending when investment returns come in lower than expected • To apply the Rule, calculate the amount of a fixed annuity based on a discount rate of 3%, your current Total Wealth, and the number of years between now and a conservative life expectancy, say 110 years

19. The Retrenchment rule • In EXCEL the relevant command is • PMT(.03, 110-Age, Total Wealth*-1) • You only have to reduce your spending if last year’s consumption was greater than this annuity amount • Generally, you will not have to retrench at all

20. The Ratchet Rule • If investment returns exceed your expectation, Total Wealth will rise thus enabling greater consumption. • The Ratchet Rule tells you when and by how much to increase spending • To implement the Rule you need to specify another discount rate, lower than or equal to the 3% investment return. • I recommend using 1% • Under the 1% Ratchet Rule, spending this year is the maximum of spending last year and Wealth*1%

21. The Ratchet Rule • One rational for the 1% Ratchet Rule is that if you follow this Rule, you have a decent chance of eventually joining the 1% Net Worth Club • Today, the threshold for the 1% Net Worth Club is approximately $5 million. • Another rationale is that this Rule is quite conservative. You can always afford to spend 1% of your Financial Wealth each year.

22. Simulation • Armed with the Retrenchment and Ratchet Rules, we can now simulate randomly chosen paths for investment returns and see how well our plan holds up. • The following chart shows one simulation based on the following assumptions • Expected Equity Return = 6% • Expected Bond Return = 0% • Equity/Bond mix = 50% • 1% Ratchet Rule • Initial Financial Wealth = $0 • Earnings stream = median college graduate • Retirement age = 65

23. Wealth Simulation

24. Wealth Simulation • The prior chart shows a scenario in which investment returns were favorable, and spending adjusted upward according to the 1% Ratchet Rule • The effect is that Financial Wealth trends higher

25. Collecting Results • We can run hundreds or thousands of scenarios and collect results. • Various metrics can be tracked including • The fraction of scenarios in which wealth falls to zero • The fraction of scenarios in which wealth increases above $5 million • Average lifetime spending • Etc • The following chart is a histogram of maximum wealth achieved in each of 1000 scenarios

26. Maximum Wealth

27. Extensions • Social Security • Debts • Student loans • Mortgage loans • Consumer debt • Home ownership • Insurance • Obligations (e.g., college for kids) • Asset allocation

28. Versus Conventional Wisdom • A well-known financial planning rule is the so-called “4% Rule” that says at retirement you can spend 4% of your portfolio (Financial Wealth) and then adjust it with inflation. • The author of the 4% Rule is Bengen who claims that under this rule you are very unlikely to run out of money by age 90. • Some economists argue that the Bengen 4% Rule is too conservative, in that you should be able to spend more than that. • Economist Gordon Pye notes that most retirees cannot live at their accustomed standard if they follow the 4% Rule. That is why he developed his “optimal retrenchment rule.”