Discover more from Economics Matters by Laurence Kotlikoff
Money Magic - Intro to My Latest Book
In case you haven’t had a chance to read Money Magic — An Economist’s Secrets to More Money, Less Risk, and a Better Life (published by Little, Brown Spark) — here’s the introduction as a teaser.
The best things in life are free. But you can keep them for the birds and bees. Now
give me money. That's what I want. That’s what I want, yeah. That’s what I want.
—Money by Berry Gordy and Janie Bradford
We all want money -- some of us dangerously so. King Midas begged Dionysus for the golden touch and got his wish, starving to death as even the food he touched turned to gold. Imelda Marcos, the infamous First Lady of the Philippines, grew up with very little -- not even a pair of shoes. When her husband took power and started plundering the country, shoes topped her list. Twenty-one years and three thousand pairs of footwear later, the people revolted. The couple escaped with their lives, but not with Imelda’s shoes. They are tastefully displayed at the Marikina shoe museum near Manila.
Midas and the Marcos are outliers. They were addicted to wealth. The vast majority of us aren’t money hungry out of sheer greed. We want money for a good reason: we need it. Many American workers haven’t seen a real pay raise in years and most retirees will run out of money before they run out of breath.
Thankfully, there are simple and powerful ways to get more money without gambling your hard-wrought savings. There are also ways to lower your risk. And there are ways to buy more happiness with a given amount of money.
The Magic of Economics-Based Financial Planning
Every profession makes magic. Biologists cure plagues. Engineers build skyscrapers. Physicists split atoms. Geologists date rocks. Astronomers discover planets. Chemists decompose matter.
And economists like myself? You know, the folks who can’t predict the stock market, who missed both the Great Depression and the Great Recession, and who begin most sentences with, “If you assume…”
Despite the challenges of the field, economists make marvelous magic. Adam Smith, our first grand wizard, conjured up the invisible hand that transforms individual greed into collective good. David Ricardo used four mystical numbers to explain why, what, and when countries trade. Alfred Marshall produced the numinous supply and demand curves that rule all markets. And our belated great sorcerer, Paul Samuelson, transposed ancient economic laws into mathematical runes.
Smith, Ricardo, Marshall, and Samuelson are the top economic magicians of all time. But every economist is trained to solve mysteries using the tricks of our trade. This is why economics is so fascinating, surprising, important, and useful, whether applied to understanding global markets, taxing our emissions, or saving our jobs.
Though the common conception of economics is that it’s focused on big, world-spanning issues, economists have, in fact, spent what is now a century studying personal finance. But historically, they’ve worked outside the public’s eye – writing research papers, presenting seminars, and publishing in academic journals. To be sure, across time, economists have periodically emerged from their scholastic cloisters to espouse some general, common-sense principle. “Save for retirement!” “Diversify your assets.” “Buy insurance.” But when asked seemingly simple questions at the neighborhood Christmas party—“Does getting an MA make sense?” “Can I afford to retire?” “Should I prioritize paying off student debt or funding my IRA?”—economists traditionally blush and change the subject.
I used to be one of those blushing, subject-changing economists. Like others cornered at the punch bowl, I knew how to think about people’s money problems. I could list all the relevant factors and formulate a mathematical model to provide the answer. What I didn’t know was how to solve the model. There were simply too many interdependent, hyper-complex, nasty-looking equations at play. And even if you could figure out a software procedure to fit the myriad pieces, using early computers to find the answers would take literally forever.
Times have changed. In recent years, amazing algorithmic and computational advances plus access to cloud computing, with its essentially unlimited computer-processing power, have changed everything. Meet me at a cocktail party today and I’ll go full nerd about iterative dynamic programming, adaptive sparse grids, non-convexities, interpolation bias, certainty equivalence, parallel processing, and so on.
Thanks to these advances, no practical money question remains beyond economists’ ken. Indeed, economics-based financial planning is poised to revolutionize personal finance. Conventional financial “advice”—a collection of crude rules of thumb, which lure households into buying expensive and dangerous financial products—will surely be replaced by economics-based financial planning, which calculates, rather than guesses, what to do. Your reading this book is testimony to that process.
My Bottom Line -- Your Living Standard
All our financial decisions—whether about our education, careers, jobs, lifestyles, marriages, retirement ages, taxes, or investments—involve our living standard, a general term for the spending per household member we can afford over our lifetimes. Yet, most of us make financial decisions with no clear idea about their spending/living standard impact, let alone the economic dangers they entail. Instead, we rely either on the financial industry’s self-interested heuristics or questionable advice from friends and family. In so doing, we forego boatloads of money, are far less happy, and put ourselves at risk.
Here are ten queries, pertaining to people at different stages of life, that illustrate how our financial decisions help to define our living standards.
1. If I borrow $100,000 to get a BA in English will I be able to buy lunch in the near term, let alone pay my rent?
2. Would I have more to spend in a low-paying job in a low-cost city than in a high-paying job in a high-cost city?
3. How much will choosing a higher-paying, but harder job matter to my discretionary spending?
4. We just had another baby. Do I need more life insurance to insure my family’s living standard?
5. How much should we save in our working years to maintain our living standard in retirement?
6. Does a Roth IRA beat a regular IRA in lowering my lifetime taxes, and thus give me more money to spend in the long term?
7. Will pre-paying my mortgage raise my living standard?
8. How would it hurt my sustainable living standard if I retire early?
9. The kids have moved out. How much spending power can we gain by downsizing?
10. What’s the risk to my living standard if I invest primarily in stocks?
These questions and their forthcoming answers may be your questions. Or they may be your relatives’, colleagues’, or friends’ questions. You’re here to get answers for yourself. But helping others, particularly your parents and children, either now or down the road, may be just as rewarding. After all, we are all our brother’s financial keeper. This is why everything that’s coming was either written directly for you or indirectly for yours.
A Living Standard Machine
Imagine a machine that is all-knowing about financial decision -- a machine that could answer your full range of living-standard questions, making you richer, safer, and happier. Such a machine actually exists! As mentioned in the Preface, I spent years building it through my personal financial planning software company. The machine incorporates breakthrough technologies and overcomes heretofore unmanageable technical hurdles. It’s also jam-packed with the fine details of our income, payroll, and state tax systems as well as the provisions of our most complex fiscal system – Social Security.
My living standard machine does four things. First, it figures out what you should spend such that you can keep spending it—in other words, it calculates your sustainable living standard. Economists call this consumption smoothing – maintaining your living standards (spending per household member) on an even keel or as close as possible given your cash-flow constraints. Second, it figures out safe ways to raise your living standard. Third, it calculates the riskiness of your living standard and finds ways to make it safer including suggesting the best ways to invest. Fourth, it helps you buy more happiness with your money by measuring the living-standard costs of personal and life-style decisions before you make them.
While our brains are no match for computers, years of studying economics as well as building and running my software have taught me all manner of financial lessons I’ll convey in the pages below. Each chapter of this book will examine an aspect of your personal finance through the joint lens of economics principles and findings my living standard machine, helping you gradually build a full picture of all of the different ways you can create your own money magic. Along the way, I’m going to focus on three of the same priorities my software does: making you more money, reducing your risk, and enhancing the amount of happiness you derive from the money you spend.
To be clear, this book of financial spells is entirely self contained. There is no need to run software. You’ll learn economics’ recipes for safely raising your living standard and getting more bang for your buck right here within the covers of this book.
My top priority is simple: getting you more money. Here’s an example to whet your appetite. It involves the Smiths -- a Boston couple who share the same birthday and turned 62 last week. The Smiths are a hypothetical household, the first of many in this book. You’ll also meet actual households, but with altered names to protect their privacy.
The Smiths have worked in demanding jobs since they were 25. Like others their age, they burned out. This is why last week’s terrific birthday party was also a terrific retirement party. Today, though, the Smiths are heartbroken. They finally sat down to look at their finances and realized they’ve saved far too little to pay for a retirement that could end up lasting for more years than they worked. Their dreams of annual European vacations, a summer home, a luxury car, and season tickets to the Celtics all evaporated in an hour.
Why didn’t the Smiths examine their finances years ago? They figured that Social Security and maximum contributions to their 401(k)s would be enough. They assumed like most of us that Uncle Sam and our employer, the two parent figures guiding our financial behavior, would get things right and set us on a secure financial path. On top of this wishful thinking, the Smiths were also simply too scared to look.
Fortunately, there are five safe and simple ways the Smiths can rescue their retirement. First, they should wait to take their Social Security benefits at 70, rather than immediately at 62. Second, they should start to withdraw from their 401(k) accounts now, rather than wait till 70. Third, they should take their 401(k) withdrawals in the form of joint survivor annuities. Fourth, they should downsize their four-bedroom house by half. And fifth, they should move to New Hampshire, which has no state income tax.
This retirement makeover makes an amazing difference. In fact, it more than doubles the Smith’s sustainable retirement spending! Under their original plan, the Smiths could afford to spend $5,337 per month in addition to covering their housing costs and taxes. Under the new plan, they can spend $11,819 per month. That’s more than double, and adds up, across of their future life span, to a $1,578,374 increase in lifetime spending measured in present value.
In other words, the new plan amounts to handing the Smiths a bag filled with around $1.5 million in cash. This is money magic, pure and simple.
Reducing Your Risk
My second priority in this book is teaching you how to limit your risk. Risk is defined as how far your living standard can range both above and below its average value. Upside risk – experiencing a higher than average living standard—is great. But downside risk – having your living standard drop, potentially a lot, compared to what you expected—can be an enormous concern.
We all face lots of risks, some of which we can control and some of which we can’t. In this book, I’m going to pay particular attention to five important uncertainties: earnings risk (the risk your career/job won’t pan out), mortality risk (the risk you’ll die young), longevity risk (the risk you’ll die old), inflation risk (the risk higher prices reduce the purchasing power of your income and assets), and investment risk (the risk you suffer major losses in the market). These risks can be intimidating to think about, but there are surprisingly effective ways to mitigate each of them.
Here’s a personal example. When my mom reached age 88, I realized that my siblings and I faced a major financial risk. She could, as we hoped, live for many more years – years during which we’d need to support her at a far higher level than had previously been the case. I suggested we buy her an annuity, which is the opposite of a life insurance policy. Life insurance pays off if you die. Annuities pay off if you live.
My brother and sister thought I was nuts. My mom wasn’t in the best of health, and her life expectancy was only four years. If we bought an annuity and she passed away in four years or less, much of the money invested in the policy would be lost. I agreed, but argued that our far bigger financial risk was that mom would live to, say, 100, requiring our support for much longer than expected.
“There’s no chance she’ll live beyond five years,” they said. “Look at the odds.”
I explained to them that what counted most was the risk she defied the odds. When it comes to risk, we look at worst-case scenarios. Financially speaking, the worst case scenario was that mom lived much longer than expected.
My sibs didn’t appreciate my antiseptic, analytical tone. But ultimately they got the point, relented, and we bought the annuity. It’s a good thing we did. Mom, whom we miss terribly, passed at 98.
Buying the Most Happiness with your Money
My third big goal with this book is to help you spend money in ways that make you happier. To see what’s involved, please come with me on a shopping trip to a strange supermarket. In this supermarket, there are no prices posted. You can’t tell what a gallon of milk costs, what a six-pack of vegan sausages costs, what a bottle of Hellfire Hell Boy Extreme Hot Sauce costs, what a can of fish mouths (yes, this supermarket sells some strange items) costs, or what a loaf of bread costs.
Nonetheless, your task is to walk through the aisles and decide which groceries to put in the cart. As soon as the combined value of what you’ve picked exceeds $200, the cart, which has sensors and a credit card reader, will automatically charge your card for what you’ve chosen and bid you good day.
How would you feel being forced to do such price-blind shopping? Likely you’d be pretty upset. If you don’t know what anything costs, you’ll buy things that cost more than they’re worth to you. You’ll also fail to buy things that cost less than they’re worth to you. Yes, you’ll leave the store with $200 worth of products, but probably not with $200 worth of happiness.
Of course, outside of thought experiments, stores post prices. But there are lots of important and expensive things we buy without knowing their true price. They involve personal and lifestyle decisions. Here are a few examples: retiring early, choosing what college to attend, having another child, switching jobs, renovating a house, moving states, and getting divorced. Each of these decisions has a precise price (possibly even a negative one), measured in terms of your sustainable living standard.
An example will help.
Think about the retiring at age 63 rather than at age 67 from a job with standard benefits. Retiring younger means four fewer years of earnings. It also means four fewer years of employer and employee 401(k) contributions. It means paying for your own health insurance for two years until you go onto Medicare at age 65, among other insurance-related costs. It means potentially reducing your Social Security benefits due to your shorter work history and a possibly lower average level of past covered earnings. It also means dealing with reduced cash flows that may lead you to start retirement account withdrawals, Social Security benefits, or both early. If you start Social Security early, it will mean receiving reduced benefits for the rest of your life. Retiring early also means changing your entire course of spending and saving, and thus the path of future assets, and thus, the path of future taxable asset income, and thus, the paths of future federal and state income taxes.
You get my drift. Figuring what it really means financially to retire four years early is complicated. But have no fear. I’m ready and able to tell you what personal and life-style financial decisions actually cost so you can better decide which ones to purchase. If early retirement is one of the items you’re picking off of your lifestyle grocery shelf, I’m going to help you put a price on it, calculating whether the money you’d earn were you to keep working is worth buying a few more years of leisure. If you expect a 10 percent living-standard hit and you learn that its closer to 20 percent, you may decide to wait a few years to call it quits. On the other hand, if you expect a 20 percent hit and it’s just 10 percent, you may opt to retire when otherwise you’d have slogged along.
In short, I’m going to help you buy the amount of happiness you can afford at a price you understand. Of course, every financial situation is different, but I’ll provide enough examples of people in different situations to give you a pretty clear idea of how much different financial decisions would cost you personally.
Some Bookkeeping: Adding Up Money Across Time
Throughout the book, I’ll assume you’re going to earn a 1.5 percent nominal return on your savings and will experience a 1.5 percent inflation rate. This zero real (after-inflation) return assumption is based on financial conditions as I write. It’s remarkably convenient. It lets me simply add up inflation-adjusted amounts across different future years.
We’re just getting started, but I’ve already produced three financial surprises – an lucrative retirement makeover, a means of insuring yourself against living too long, and a powerful method for getting far more happiness without spending an extra penny. To give you an idea of the breadth and depth of the topics we will cover, I list below some of the myriad financial shockers coming your way. Understanding their source will be fun and, more important, rewarding.
The Game Plan
My goal is to teach you every money-magic trick I know and leave you empowered to make your own money magic. For starters, I’ll focus on your making money the old-fashioned way – by working. But the same amount of work can mean very different incomes and, thus, living standards depending on your choice of career. So, let’s start there.
Sampling Money Magic’s Financial Shockers
Q: Can It Pay to cash out my IRA to pay off my mortgage?
Q: “Can I suspend my Social Security benefits and restart them at a higher value?”
A: Yes, if you’re above full retirement age and under 70.
Q: Can I set a living-standard floor and invest with only upside living-standard risk?
A: Simple as pie.
Q: Do plumbers make as much as GPs over their lifetimes?
Q: Can I significantly raise my living standard by moving states?
A: Almost always.
Q: If I lose Social Security benefits from working, will I get virtually all of them back?
A: Almost always.
Q: Can spending aggressively be as risky as investing aggressively?
A: Should you hold proportionately more stock the richer you become?
Q: No. The rich should invest in bonds and the poor should invest in stocks.
Q: Does timing the market ever make sense?
Q: Do I need more life insurance if we have another child?
A: No, you probably need less!
Q: Should I plan to live to 100 even if the chances are vanishingly small?
Q: In retirement, should I gradually get out of stocks?
A: No, do the exact opposite.
Q: Are Roth conversions worth it?
A: Definitely, when timed correctly.
Q: Are reverse mortgages cost-effective ways to free trapped home equity?
A: Not at all.
Q: Does it pay to get a Masters degree in education?
Q: Can retiring at 67 rather than 62 make a real difference to my retirement?
A: It can make a huge difference.
Q: If I’m young and single, what’s one of my best financial moves?
A: Shack up with mom