Discover more from Economics Matters by Laurence Kotlikoff
Economics Can Deliver Money Magic
Economists have been studying personal finance planning for a century. Wall Street needs to move from conventional pie-in-the-sky to economics' resource-based planning.
This article originally appeared in Forbes in 2022. Economics-based financial planning is at almost complete odds with conventional financial advice. This fact is surprising, disturbing, and true. The two underlying methodologies, i.e. their underlying mathematical frameworks, have absolutely nothing in common. Economics determines your household’s highest sustainable living standard based on your resources—what you can afford to spend. And it adjusts your spending as your circumstances change.
Conventional planning entails wishful and dangerous thinking. You set a desired retirement-spending target (mine is a billion dollars a year) and are given an investment strategy with the highest chance of hitting that target. What if this potentially super risky strategy fails, leaving you dead broke? "Not our problem. Read the small print. We never guaranteed you a rose garden." Conventional planning was designed by Wall Street to sell product, not to obey commonsense economic principles. This is why not a single top economics or finance department teaches conventional financial planning.
Full disclosure: I sell software — MaxiFi Planner and Maximize My Social Security — for households and financial professionals that strictly adheres to economics’ prescriptions. I’ve also written a book (my 20th), Money Magic — An Economist's Secrets to More Money, Less Risk, and a Better Life, that shows how economics-based financial planning can dramatically raise your or your clients’ living standards, substantially reduce your (their) risk, and improve your (their) lifestyle — at no extra cost.
Here are some of the unconventional ideas explored in my book.
Invest in stocks at no risk whatsoever to your basic living standard.
I call this Upside Investing. The idea is simple. Allocate a certain amount of your resources to stock and don’t spend a penny based on those securities until you’ve converted them to safe assets. I.e. treat your stocks like gambling stakes at the casino that you’re prepared to lose in their entirety. But you’ve disciplined yourself not to spend any winnings until you’re safely back home. What you don’t invest in stocks, invest in long-term Treasuries that are inflation-indexed. They’re called TIPS — Treasury Inflation Protected Securities. Apart from taxes associated with unexpected inflation, TIPS are the safest asset on the planet.
This Upside Investing strategy sets a floor to your living standard. The more (less) you invest in stock, the lower (higher) is your floor. Upside investing is what most of us are after — keeping a hand in the market while protecting our basic lifestyle.
Here’s another favorite:
Cashing out your traditional IRA to pay off high-interest credit-card, student debt, auto loans, and mortgages can you save you tens of thousands of dollars.
If your IRA is invested in the market, this surely sound nuts. Why give up a potentially super high return on stocks to pay off debts? Plus, cashing out your IRA, if it’s not a Roth, means paying taxes now on the withdrawal and a 10 percent penalty if you’re under 59.
My answers: Once you adjust the stock market for risk, its nominal yield is far below the equally safe nominal rates you’re paying on your IOUs. But paying off a, say, 7 percent student loan is economically identical to investing in a perfectly safe 7 percent bond. Hence, paying off the loan rather than investing in stocks, which, as I write, are yielding less than 30 basis points annually on a risk-adjusted basis, is a massive arbitrage opportunity. Yes, you’ll need to pay taxes on the withdrawal. But those taxes must be paid eventually. And with rates so low, the advantage of deferring taxes is small. Plus, given the 2017 tax reform, your future tax bracket may be similar to your current bracket. Finally, you can avoid the penalty by withdrawing on a steady basis.
Now a warning from this here college professor.
Don’t borrow for college.
It’s far too risky. Two in five matriculants don’t graduate yet borrow large sums for the privilege of dropping out. Plus, Uncle Sam — the main student lender — makes Uncle Scrooge look benign. Once you take his money, he’ll hound you for life, garnishing your wages and even your Social Security check if you don’t repay. Plus, he dangles income-related repayment options that sound great, but are borderline scams.
Speaking of scams, Social Security is running three big ones you must avoid. Here’s one.
If you file for widows or divorced widows benefits at the same time as you file for your retirement benefit, you can lose hundreds of thousands in lifetime benefits.
Social Security’s own Inspector General reported the agency let over 13,000 widows make this mistake or made it for them, costing them collectively over $130 million. Rather than fixing the problem and reimbursing those it ripped off, as its IG urged, Social Security is continuing the practice.
Now for a warning about Roth conversions.
Roth conversions make sense if you’re in a low tax bracket compared to where you’ll be down the road.
But if you’re taking Social Security and convert too much, you can trigger taxes on your Social Security benefits. And, if you’re 63 or older, you can trigger far higher Medicare Part B premiums two years from now.
And here’s something for the 4,000 of us getting divorced each day.
Before you lawyer up, force your kids to take sides, and turn the former love of your life into your arch enemy, resolve the big question — the ratio of your living standards going forward. Once you sort this out, everything can be valued and split based on this ratio. The alternative strategy, arguing over each possession one by one, starting with the toaster oven, will lead straight to divorce war.
Next, a way to hedge the inflation bogeyman that may go nuts.
Mortgages are financial and tax losers. But they are a great inflation hedge.
Every point of inflation lets you repay in watered down dollars. As the book describes, you can roll your own inflation-indexed annuity by using a mortgage to buy an annuity. But steer clear of reverse mortgages. They are far too expensive and risky.
Speaking, indirectly, of housing, here’s something that economists, but few others know.
Home ownership comes with a major, hidden tax break that has nothing to do with mortgages.
Imagine living across the street from your precise physical and financial clone who, of course, owns an identical house. Now consider renting from each other. Your housing won’t change except for moving across the street. But both of your taxes will rise since the rent you pay each other will be taxable.
Here’s my last book teaser.
Don’t count on dying on time — at your life expectancy.
If you do, you’ll likely be sorely disappointed and end up running out of money before you run out of breath. Instead, plan for the catastrophic longevity outcome — living to your maximum age of life. But make a spending plan that entails a lower living standard the longer you live. This lets you take a calculated risk that you’ll expire before, say, 100, without leaving you breakfasting on Meow Mix.