My BBC NewsHour commentary – On “Virtuous Banking”

BBC newshourI spoke this afternoon on the BBC NewsHour show, along with the author of a think tank publication advocating “Virtuous Banking.” The whitepaper can be downloaded from Res Publica’s site here.

The premise of the paper, which I largely disagree with, is that we can put “virtue” at the center of the finance and banking industry, rather than, presumably, private profit. Not that its a bad sentiment, mind you, only that it seems outside of the realm of possibility.

I don’t mean to imply that people I worked with in finance are not themselves privately virtuous – many of them were, and are. I mean that institutionally, it just doesn’t really work that way. You can make ‘the public good’ or ‘diversity’ or ‘access’ or ‘helping society’ the main goal, but that’s fundamentally changing the game.

The analogy I wanted to use on the program (but didn’t) is that if you replace ‘profit’ with something more virtuous it would be like telling a professional soccer team that the plan is no longer to score the most goals, but rather to ensure the most passes between teammates. Or touches of the ball. Or to get everyone on the bench a few minutes of playing time. Or to encouage audience participation. These are great intentions, and they work well in a scrimmage for my daughter’s soccer league, but it doesn’t necessarily lead to victory in a real match. If your Premier League team decided to concentrate on maximizing touches rather than scoring goals, they’d get relegated to a lower league. Quickly.

Furthermore, individual finance professionals in for-profit banking institutions who replace the profit motive with a kindler, gentler motive probably don’t get promoted. They probably don’t move into management. They probably end up leaving the business. And starting a finance blog, or something.

The  audio streams if you click the little button at the top of this post. My part starts at minute 34:00.

 

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Book Review: The Automatic Millionaire by David Bach

A few weeks back I sent out a proposal to a few prospective agents, expecting at least one would recognize the genius – and their own self-interested business opportunity – in my personal finance book proposal.

One prospective agent asked a reasonable question in reply: “What’s the one thing you would like to get across to readers of your book?”

At the time I got his email I was in the process of sitting down to watch a summer blockbuster movie in the theater[1], so I fired off what came into the top of my head, to which he replied:

“Not good enough. You need to give readers something more concrete and memorable, like ‘Bach’s Latte Effect.”

I puzzled over that one throughout the movie, as I did not recall anything about delicious lactose-based caffeinated beverages in my limited knowledge of the Brandenburg Concertos.

Fortunately, when the movie let out I had recourse to The Google.

I learned that one of the most popular personal finance book of the last decade – The Automatic Millionaire: A Powerful One-Step Plan To Live And Finish Rich, by David Bach – makes use of Bach’s Latte Effect as a central, simple concept for getting rich.

David Bach, not Johannes Sebastian, composed the ‘Latte Effect.’

The next day I ordered the book, fully hoping to hate it, all the better to discard the agent’s comment in an ego-protective way.

I’m sorry to say: This book is quite good.

I mean, mine’s better, obviously, but David Bach has the distinct advantage over me of actually having written and published his book. And, it’s got a couple of extraordinarily simple, memorable, easy steps that could help most people get wealthy by the end of their lifetime.

Bach has two, and only two, major points to make, both of which are absolutely correct.

 

Bach’s first point – The Latte Effect

You do have money to invest.

Nobody thinks they do. Most days I don’t think I do. I mean, the money always runs out first, right? How would I even scrape together an extra $100 a month? It’s just not happening, right? Wrong.

samuel_jackson_motherfucker
Yes, my barista actually made this Samuel Jackson latte and gave it to me. That’s how good a coffee customer I am. Which is scary.

The Latte Effect, coined by Bach, refers to the correct idea that all of us – ALL OF US[2] – are paying for things on a daily and weekly basis that we don’t have to. Each one of us – were we to track every little, literal, expenditure – buys small things that we do not have to buy.

 

Me, as an embarrassing example of the Latte Effect

Personally I have gotten in the habit of feeding my Starbucks addiction to an embarrassing level. Let’s say I spend $2.50 on a Grande per day,[3] for a total of $17.50 per week. And let’s say three times a week I grab a ‘classic sandwich’ for breakfast from that smug little green mermaid because I’m in a rush to drop off the girls at school or camp or whatever for a total of $12 more dollars per week. So I spend $29.50 per week at Starbucks.

So, sue me, what’s the big deal?

The big deal is that this tiny little forgettable expenditure, after 52 weeks, comes to $1,534 per year.

And the next big deal is what I’m not building in long-term wealth by spending that $1,534 annually.

 

How big is the Latte Effect?

Let’s say I saved and invested an additional $1,534 per year in the stock market, and let’s further say I did that for the next thirty years, until I turned 72. How much richer would I be?

Plug this into your compound interest calculators everybody:

At a plausible 6% return from the markets I’d be more than $128 thousand richer by age 72.

At a backward-looking, historically-realized 10% return I’d be more than $277 thousand richer.

What if instead of getting wise at age 42, I had cut out my destructive Starbucks habit and began my caffeine-free living at age 22? Now this gets really interesting.

At the plausible rate of 6% return from the market, I would end up at the age of 72 $472 thousand richer. And if markets returned as much as 10% every year I would be over $1.9 million richer.

So what is my Latte Effect?

Over my working lifetime (age 22 to 72) somewhere between $472 thousand and $1.9 million. Actually I am certain the range of the effect is much higher, as I’ve underestimated both my weekly Starbucks consumption and other unnecessary consumption items, but you get the idea. I should be, and could be, much wealthier.

And so could you. So what’s your Latte Effect?

Your Latte Effect

Now, you may be feeling quite smug because you’re Mormon and you never touch the Starbucks poison. Good for you. You still have a Latte Effect. I guarantee it.

You buy lottery tickets. Or gum. Or tic-tacs. Or Spotify/Pandora. Or Netflix/Hulu/AppleTV. Or internet porn. Or extra leveling-up manna on the Freemium games for the iPhone. I know you have a weakness, you’re just not telling me.

Which is fine. But you should be honest with yourself about your own Latte Effect, if you aren’t coming up with money at the end of the month to invest for your long-term financial security.

automate_your_investments
Automate Investments For The People

Bach’s second point: Automate the Investing

Not only do we not think we have any money at the end of any month, but very few of us – even if we had the money at the end of the month – have the willpower to turn it over to our long-term investment accounts.

The only surefire way to invest – and here I have to give Bach credit for totally nailing it, although also of course I independently urged people to do this last year[4] – is to set up automatic deductions from your checking account (or better yet, directly from your paycheck) into your investment accounts.

[Why does this work? I don’t know. It has something to do with the idea that money that either doesn’t stay in our checking account – or doesn’t even hit it – is money that we will not be tempted to spend. Humans are weird psychological puzzles when it comes to money. Incidentally, here’s a good book I reviewed that explores all the different irrational things we do with money. Ok, back to our regularly scheduled program.]

The following statement – a paraphrase of Bach’s book – deserves the bold, italic, underlined all-caps designation I’m giving it.

THE MOST IMPORTANT STEP YOU CAN TAKE TO BECOMING RICH IN THE LONG RUN IS TO AUTOMATE YOUR MONTHLY INVESTMENT CONTRIBUTIONS

I’ll stop shouting now, and offer a few additional calm thoughts.

  • The first best place to automate investment contributions is to your 401K and IRA, both of which are tax-advantaged, awesome investment vehicles.
  • If you already contribute to your company’s 401K (or 403b for non-profit folks), then check to make sure you are maximizing your annual contributions.
  • Your friendly bank or brokerage company will happily set up a monthly or bimonthly automatic transfer from your checking account into the investment account you open there.
  • If you’re just starting out and don’t think you qualify for the investment to open an account, you can sometimes convince them to waive the minimums, if you set up an automatic investment program.
  • If you’ve never invested before, try dedicating just 1% of your income to your investment accounts through automatic investing. Over time, once you’ve automated contributions, you will see that moving to 5%, and then 10%, of your income is no big deal.

Automatic investing this way is not simply a way to invest, or one way to invest. No. I say with confidence it’s the ONLY way to invest. If you haven’t tried this, but have always wondered how other people actually invest money over time, you may be amazed to learn that the vast majority of people did it, one way or another, based on automatic investing.

So, the TL;DR on David Bach’s book:

You could have money left over at the end of the month if you stop drinking lattes (or whatever), and you could become wealthy if you automatically made contributions to your investment accounts, starting with your tax advantaged retirement accounts.

 

Caveats

I have only two caveats about The Automatic Millionaire, and these caveats apply to every single personal finance book I’ve ever read so far.

Who buys this?

First, the type of person who picks up a personal finance book is already different from your average person who needs help with their finances. A personal finance book buyer has self-selected as someone oriented toward financial self-improvement, and asking for outside ideas. Will buyers and readers of The Automatic Millionaire follow Bach’s advice? I hope so. Will the people who need the book the most actually end up buying it, in order to take their first few simple steps toward financial security? I don’t know.

Compound interest

My second caveat is just my personal pet peeve. Bach makes good use of the concept of compound interest, urging his readers to invest early in their lives to get rich later. Multiple charts and tables in the book show how a few thousand dollars invested, for X years, earning Y% return, will result in Z riches. This is great.

BUT!

Bach, like every other personal finance author who has ever been published, declines to show exactly how the math is done. He decided, the same way every other publisher has previously decided, that book readers cannot be trusted to learn a simple algebraic formula.

With a little attention and a simple spreadsheet, readers should be taught compound interest. Am I the only person who thinks that personal financial advice starts with people understanding compound interest well enough to do the calculations themselves, rather than refer to somebody else’s table in a book?

Apparently, yes.

If I ever spoke with that agent again, I’d like to tell him that the one thing people should understand is the compound interest formula. That is my most firmly held belief.[5]

But I’m afraid it’s not something the publishing world is comfortable with. They don’t trust readers enough to walk them through the junior-high level math. So we get tables and charts instead.

Please see related post All Bankers Anonymous reviews in one place!

Please also see related posts on:

Compound Interest and Wealth

Compound Interest and Debt

The Humble IRA

Become a Money Saving Jedi

 

automatic millionaire

 

[1] 22 Jump Street, if you must know. What? Whaaaat? My wife tells me Channing Tatum is quite a good actor. But I still haven’t convinced her to start calling me “Magic Mike.” I don’t know why she refuses me this simple courtesy.

[2] Ok, obviously not all of us. Because there is real poverty everywhere. And I know there is food insecurity within a few blocks even of my own house, so I should not exaggerate. But many, many, many, more of us – pretty much anybody who is gainfully employed right now and not on complete federal assistance – has their own Latte Effect were they to examine their daily habits scrupulously.

[3] I happen to know my Starbucks habit is much, much worse than this, but I’m not about to confess this to just anyone on the Interwebs. I mean, I have some pride. Also, there are some crazies on the Interwebs, have you noticed? Sheesh.

[4] I’m just bragging here so that any book agents reading this know that I’m totally all over this topic.

[5] That, and also the firmly held belief that Rihanna would totally prefer me over both Drake and Chris Brown, if she was ever given the opportunity. Sorry, RiRi, I am happily married.

 

 

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They’re BAAAAACK: The CIT Takeover of OneWest Bank

john thainWow. I mean. Just, wow.

You gotta love these guys.

Two phrases came to mind when I read the headline today about CIT Group taking over OneWest Bank.

First: “History does not repeat itself, but it certainly does rhyme.”

And

Second: “Madness consists of doing the same thing over and over again and expecting a different result.”

The casual reader of financial headlines will neither recognize nor care about this acquisition by a middle-market business lender (CIT Group) of a California retail branch banking institution (OneWest).

But it’s not the relatively anonymous companies that matter, but rather the people behind the takeover, and the historical provenance of the companies, that matters. This acquisition involves some of the key chess pieces of the 2008 Crisis and the worst excesses of that time. Let me go through some of the key names and highlights.

 

OneWest Bank – This is really IndyMac bank with a new name.

“A rose, by any other name, would smell as sweet.”

You haven’t heard of IndyMac?

IndyMAC was kind of a ground zero mortgage lender in the 2007/2008 time period. Before failing, it was the seventh largest mortgage originator in the United States, and when it was taken over by the FDIC in July 2008 it was the fourth largest bank failure in history.

Of course it was originally founded by the later notorious Countrywide founder Angelo Mozilo, who spun off IndyMac as an independent company in 1997.

IndyMac did the usual thing as everyone else, borrowing with short-term debt, and lending out in the form of illiquid dicey mortgages.

IndyMac in particular was a leader in the intermediate “Alt-A” mortgage lending segment – mortgages too risky to be considered ‘Prime,’ but not entirely as shaky as Sub-prime either.

OneWest Bank became a newly formed bank in March 2009 when it took over the remains of IndyMac, via an FDIC auction of the failed mortgage lender.

Leading up to this transaction, the CEO of OneWest is Steve Mnuchin, a former Goldman Sachs partner and member of the management committee.

Prior to taking over OneWest, Mnuchin led Dune Capital with other Goldman partners who had made their reputations and fortunes investing in the distressed assets of the Resolution Trust Corporation, the government’s response to the Savings and Loan Crisis of the 1980s.

CIT Group – In February 2008, this lending company rang the New York Stock Exchange opening bell to celebrate its 100 years of existence. By April 2008 the company was reeling from losses, ceased its student loan lending, and subsequently its home-loan lending by the summer 2008. With billions in shareholder value destroyed, the company declared bankruptcy in 2009. In January 2010. CIT hired John Thain as Chairman and Chief Executive.

John Thain – Once heir-apparent to the CEO position at Goldman Sachs under Hank Paulson, Thain left Goldman in 2004 to run the New York Stock Exchange when current Goldman CEO Lloyd Blankfein got the clear nod to succeed Paulson. Thain took over the leadership of Merrill Lynch in late 2007, after Stanley O’Neal did his best to drive the old bull straight into a financial ditch through self-inflicted subprime CDO wounds, leading to a $8.4 Billion write-down.

Thain – to his credit – quickly raised $6 billion capital from the Singapore sovereign national fund, only to have to oversee close to another $10 Billion in write-downs in his first half year on the job.

By the Summer of 2008, Thain was forced to market Merrill’s toxic CDOs, offering them to – among others – Steve Mnuchin at Dune Capital, before selling them to Lone Star Capital at a severe discount.

With Merrill reeling by the end of 2008 – and with by then a total of close to $50 Billion in sub-prime mortgage CDO-related write-downs, Thain managed to sell Merrill to the only CEO who actually performed worse than O’Neal throughout the crisis, Ken Lewis from Bank of America.

Criticism of Thain 

Thain subsequently was criticized for:

a) Spending 1.2 million to decorate his executive suite, including his famous $1,000+ gold-plated wastebasket

b) Requesting a $10 million personal bonus from the Merrill Lynch board for saving all of their collective bacon, and

c) Paying out $4 Billion in bonuses to Merrill Lynch executives, just prior to the Bank of America takeover in January 2009, after the firm received $25 Billion in a direct US Treasury infusion of taxpayer money in October 2008.

All of which are fair grounds for accusing him of a touch of, shall we say, hubris. But from Merrill Lynch’s narrow perspective, John Thain was a motherflipping genius.

Thain is a genius, of a sort

Thain’s simultaneous saving of the venerable Merrill Lynch, and fleecing of Lewis and Bank of America’s shareholders in the midst of a financial meltdown is the single greatest sales job ever performed in financial circles.

Seriously. Ever.

But here’s the key point that links this financial history to Thain’s pursuit by CIT of OneWest Bank:

This greatest-sales-job-ever all would have been impossible if Thain’s former boss Treasury Secretary Hank Paulson had not guaranteed a $20 Billion sweetener for Ken Lewis to consummate the deal in January 2009.

Lewis apparently woke up from whatever drunken stupor had led him to acquire first Countrywide, and then Merrill Lynch, and Lewis tried to back out of the deal between December 2008 and January 2009.

Secretary Paulson ponied up $20 Billion in taxpayer first-loss money and jammed the deal through. Paulson could not afford, in the midst of the crisis (as well as Presidential transition) to have Merrill Lynch dropped by Bank of America, and very likely, bankrupted.

 Some other relevant facts

Also, coincidentally, his direct protégé from his Goldman CEO days ran Merrill Lynch at the time. Anyway. Not completely off-point, Thain reportedly earned $83.1 million from Merrill Lynch during his service from December 2007 to January 2009. Anyway.

Thain was a hero for Merrill in December 2008, but crucially could not have pulled off his magic trick had Merrill not been Too Big To Fail. And THAT, my friends, is what this CIT takeover is about.

And Thain has said that as plainly as possible.

CIT, under Thain, wants desperately to be Too Big To Fail

In recent months Thain has talked about whether CIT would pursue a bank acquisition. The additional safe deposits would be nice for CIT, Thain has said, but the key to CIT’s next purchase would be to get well above the threshold of $50 Billion in assets. Why does that matter? Because $50 Billion is currently the cutoff for becoming a “systemically important financial institution, or SIFI.

As the Wall Street Journal reports

On a conference call, Mr. Thain said he believes CIT is ‘well-positioned to satisfy all of the criterion or being a SIFI institution.

And as the Wall Street Journal further reports,

The takeover of IMB Holdco LLC, which is OneWest’s parent company, will bump CIT’s assets up to $67 billion, making the bank large enough to be considered ‘systemically important’ by regulators. CIT, a lender to small and medium-size businesses, had $44.15 billion in assets as of June 30.

 

SIFI, by the way, is what we now call Too Big To Fail institutions.

Ironically, becoming a SIFI should be considered a disadvantage, because it involves additional layers of regulatory scrutiny. In a normal, pro-business, capitalist financial system, we would expect that becoming a “SIFI” would be a “NoNo” for any bank.

Since 2009, regulators from the FDIC, SEC, Federal Reserve, CFTC (and any number of other acronymic bureaucracies) have been struggling with how to deal with Too-Big-To-Fail financial institutions.

Their answer: More regulations, more ‘living will’ requirements, more stress tests, more disclosures, more restrictions on proprietary trading, more capital requirements.

You’d think that any growing financial institution would run for its life, away from this type of bureaucratic morass.

Not CIT. Not Thain.

He knows first-hand how awesomely, personally, profitable it can be to run a massive private financial institution that has socialized any future losses because it’s a SIFI. Thain’s no dummy.

Steve Mnuchin, no slouch himself, will join the company as vice chairman and will join the board as well.

Please see some of the related posts:

 

In Praise of SIGTARP Part II – We blew it on the repayment of TARP

SIGTARP Part V – The AIG Debacle

 

Book Review of Bailout by Neil Barofsky

Book Review of Diary of a Very Bad Year by Anonymous Hedge Fund Manager

Book Review of Too Big To Fail by Andrew Ross Sorkin

 

Life After Debt: Putting the Band Back Together

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Batman strikes – Some Thoughts on Short Sellers

Gotham_City_Hedge_FundIn the bad old days of the 2008 Crisis, a casual reader of the financial news might have been fooled into thinking that “short-sellers,” those financial firms that bet on the price of some financial instrument (like a stock, or bond, or currency, or commodity) going down, rather than up, ranked on the financial attractiveness scale somewhere between Renee Zellwegger and Quasimodo – simpering, disfigured, unpatriotic, and untrustworthy.

For a brief time in the midst of the October 2008 panic, the financial regulators nearly outlawed short-sellers, as if there was some moral difference between short sellers and their counterparts “long buyers.” (We don’t refer to them of course as “long buyers” but rather ”investors,’ but finance folks do use the ‘shorts’ and ‘longs’ monikers when describing market participants.)

Only people who have never participated in financial markets could reasonably argue that ‘short selling’ has any better or worse effect on markets than ‘long buying.’ In fact, brokering most markets absolutely requires short selling, both to offer a product to a client that the broker does not currently have in inventory, as well as to hedge purchases from a client that a broker can not immediately dispose of in the market.

When a client needs to sell a block of a stock, or a pile of bonds, the broker will often sell (sometimes selling short) a similar-characteristic block of stocks or bonds right away, to minimize the market-directional risk of holding the client’s recently dumped position. The ability to sell short, for a hedge, is a key tool in the arsenal of brokers.

Short-selling by hedge funds

The ability to short sell is also the fundamental differentiating tool of 80% of hedge funds vis-a-vis mutual funds: Namely, the former can sell short a stock (or bond, or currency, or commodity) whereas a traditional mutual fund may only deploy money on the ‘long’ side, by buying a financial product. Financial products tend to go both down and up, but your typical mutual fund may only be able to deliver a positive return when the markets go up in aggregate.

A hedge fund by contrast – in theory at least – can deliver positive results regards of the direction of securities or the market as a whole. Or, more frequently, a hedge fund may seek to smooth out investment results through a combination of shorts and longs – achieving an acceptable positive return while delivering a ride with less volatility. In that sense your hedge is acting like a Lexus in city traffic – you won’t necessarily get there any faster but the shock absorbers will deliver a much less bumpy and therefore more pleasant ride along the way. At a much higher cost, of course.

Short-sellers as heroes

All of this explanation I intend as prelude to this week’s story about the Spanish tech company Gowex, in which dedicated short-sellers actually prove themselves not only on a moral plane with the Clinton-formulation abortion (“legal, safe and rare”) but actually clever, necessary, and heroic.

gotham_city_hedge_fund

Enter Gotham City Research LLC, a hedge fund dedicated to short-selling as a primary strategy. As the Wall Street Journal reports, these guys – and similar-strategy firms like them such as Jim Chanos’ Kynikos Associates that took down Enron, and Carson Block’s Muddy Waters Research that took down Sino-Forest Corporation – look to sniff out frauds and bet heavily against them through short-selling.

Gotham City swooped down like the caped avenger and exposed the Gowex fraud in Spain.

As recently as July 1st Gowex was a Spanish high technology of the markets, providing free Wi-Fi to municipalities. They boasted the following credentials:

  • A $2.6 Billion valuation in April 2014
  • In May 2014 Gowex won the top prize from a Spanish marketing association
  • Gowex Founder Jenaro Garcia was the 39th richest Spaniard, with an (on-paper) net worth north of $240 million.

After Gotham City released its report July 1st, claiming 90% of Gowex’ revenues were nonexistent and that Gowex is ‘too good to be true,’ the firm’s stock began to nosedive. After briefly denying the reports and accusing Gotham City of trying to benefit through short-selling, Garcia resigned and asked for forgiveness. Gowex filed for bankruptcy by July 6th.

That is some Batman-style, hard-core, swift justice.

People don’t generally love dedicated short-sellers, because they  profit when other people lose money. The Gotham City vs. Gowex story this week is a great example of why we need these mysterious caped avengers in the cityscape, broodingly seeking out wrongdoers.

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On Longevity Insurance – Do You Feel Lucky?

clint eastwoodFor starters, I hate most insurance products that purport to replace investment products. But I had not heard of longevity insurance until this week, so I decided to check it out.

Here’s the concept: Pay a big lump sum to an insurance company now (before retirement), in order to draw on a hefty fixed income many years in the future – but starting past the age you might not live to see.

The idea – known as longevity insurance or a deferred annuity – is meant to fit a certain type of person concerned with running out of money in the mixed-blessing event that he or she lives long enough to outlive most of his or her savings. By deferring the income for many years, a lump sum can create a significant income-for-life in later years, alleviating the risk that retirement money completely runs out.

This recent Bloomberg article offers the example of a 60 year old man who pays $125,000 to New York Life today in order to draw nearly $45,000 a year, starting at age 80 – twenty years from now. This article says New York Life offers $17,614 guaranteed annual income after age 80 for a $50,000 premium.[1]

dirty harry

The article claims a retiree’s account must grow by an unlikely 11% to match the income available from this type of deferred annuity, without specifying exactly how that percentage was calculated.

You think this is the equivalent of 11% return?

11% return?

“Go ahead. Make my day.”


https://www.youtube.com/watch?v=cg-NNSEPClQ

I’ll use the latter Bloomberg article’s precise numbers later in this post to calculate what I think about all this, from a financial perspective.

To think about the numbers and the math behind longevity insurance, it’s helpful – regrettably – to think about the probabilities of death.

Stats about death probabilities

We know from Social Security’s actuarial tables that the risk of death between 60 and 80 – meaning in this case the risk of paying over a big lump sum and getting exactly nothing back – is significant.

The probability of death at any age each year rises, for a man[2], from about 1.1% for 60 year olds, to about 6% for 80 year olds. Combine the annual risk of death for every year between 60 and 80, and we can see – actually we know this instinctively, but still we can see – that this deferred annuity could end up worth zero.

The sum of all the one-year probabilities of death, for a man, between age 60 through age 79 is 54%, meaning that there’s a greater than 50% chance that the annuity income is never collected.

This all may seem morbid to talk about, but as my friend Clint says in The Unforgiven, “We all have it coming, kid.”

https://www.youtube.com/watch?v=XoAPKt7kbD0

Here are some other interesting and relevant, stats from the SS actuarial tables:

A 60 year old man has an expected life of 21.27 more years. This means the average man has just 1.27 years past age 80, on average, to receive guaranteed income from the longevity insurance annuity. Taken at face value, that seems like very few years, on average, to received guaranteed income after age 80.

Next, should that man make it to age 80, the expected life from that point onward is 8.1 years. That seems more palatable from a financial perspective, and instinctively the guaranteed income for 8 years sounds more reasonable. Below I will do some math, however, to move from ‘instinct’ to ‘calculation.’

Insurance for high-probability events

Now, the low probability of receiving ‘fair value’ for this annuity premium is not – in itself – a reason to avoid longevity insurance. Insurance, after all, can make sense even for low probability events.

I pay for home insurance against complete outlier events like devastating fires or meteor crashes, even though, chances are, these won’t happen in my lifetime. (quickly knocking wood).

But since living and dying are not outlier events, but rather guaranteed events with an uncertain time schedule, I have to consider only a part as insurance against the unknown and part as a straight-up financial investment around a known event, with adjustments for the probabilities of living a certain amount of time, within a limited range – e.g. greater than zero, and something less than 45, for a 60 year old man.

Calculating the returns of longevity insurance

So what does the financial return of longevity insurance look like?

We can use a combination of discounted cash flow and compound interest calculations to answer this question.

In the New York Life quote in the Bloomberg article cited above, a 60 year old man can pay $50,000 and receive an annual income of $17,614, guaranteed for life, starting at age 80.

I’ll cover 4 scenarios for this type of longevity insurance, plus 1 alternate scenario of not buying the insurance.

Clint says it best in A Fistful of Dollars: “Get 3 coffins ready. My mistake, four coffins.”


https://www.youtube.com/watch?v=KZ_7br_3y54

 

Scenario #1 – The 60 year old dies before age 80, receives no income

In this sad case, the insurance company pockets the $50,000 premium and pays out nothing in guaranteed income. Obviously, from a pure financial standpoint, this is a losing trade. Also, this will happen 54% of the time, for the average 60 year old considering this purchase.

The Outlaw Josey Wales says it best: “Dyin’ aint much of a living, boy. You know this isn’t necessary. You can just ride on.”

https://www.youtube.com/watch?v=Bigc7GXHU50

 

Scenario #2 – The average 60 year old man

Let’s say the man lives to the 60 year old’s average of 21.27 additional years, or 1.27 years past age 80.

That 60 year old man today can expect to collect $22,369.78 total in annuity income (that’s 1.27 * $17,614).

But that average future income is quoted in future dollars, so we need to know the present value of those dollars, discounted to the present day.

We use the discounted cash flow formula PV = FV / (1+Y)^N in which

PV = Present Value – That’s what we want to figure out.

FV = Future Value – That’s $22,369.78 in this example.

Y = Some assumed interest rate. Let’s say 5% because that’s close to where NY Life discounts retirement benefits for its employees, according to their 2013 financial statement.

N = Number of years. That’s 20 years in this example.

So plugging those number into the PV = FV/ (1+Y)^N formula, our present value tell us that the future income is worth $8,430.93

Since I’m paying $50,000 today to receive the equivalent value in today’s dollars of $8,430.93, I’m not particularly excited about the value of this product for the average 60 year old man in scenario #2.

The High Plains Drifter is keeping up with this math, so I hope you are.

“How ‘bout it stranger? Think you’re fast enough to keep up with us?”

“A lot faster than you’ll ever live to be.”

https://www.youtube.com/watch?v=vL2la06bUns

 

Scenario #3 – Today’s 60 year-old man lives to age 85.

Again, we will apply the discounted cash flow formula, but now we have 5 years’ worth of receiving a guaranteed annual income of $17,614. More palatable, I think. But let me see what the numbers say.[3]

To figure out the total value of this income – to a hypothetical 60 year-old man living to age 85 – we’ll need to add up the individual values of the annual incomes for each of the years. So, the sum of 5 PVs, using the same PV = FV / (1+Y)^N, just calculated 5 times.

Income Year #1 (through age 81):

FV = $17,614, Y = 5%, N = 20

So, PV = $6,638.53

Income Year #2 (through Age 82):

FV = $17,614, Y = 5%, N = 21

So, PV = $6,322.41

Income Year #3 (through age 83):

FV = $17,614, Y = 5%, N = 22

So, PV = $6,021.34

Income Year #4, (through age 84):

FV = $17,614, Y = 5%, N = 23

So, PV = $5,734.61

Income Year #5, (through age 85):

FV = $17,614, Y = 5%, N = 24

And so, PV = $5,461.54

At the end of all this – admittedly much easier to do and show in a spreadsheet – The total value in today’s dollars is $30,178.43, compared to the $50,000 premium required to receive this value.

Even living to age 85, I still much prefer the insurance company’s side of the deal rather than the hypothetical 60-year-old’s deal.

 

Scenario #4 – The 60 year-old man lives to age 90

I’m going to fast-forward on all the formula stuff, but in this case all that is required for your calculations is to discount the annual $17,614 by ten different discount rates. The total present value at the end of ten years of income is $53,824.03. This, finally, compares favorably to the $50,000 premium. So, from a purely financial standpoint, you start to get the positive side of the deal between years nine and ten after age 80. Enjoy!

Also, by then you’ll be this guy, gruffly shouting at his neighbors to “get off my lawn!”

https://www.youtube.com/watch?v=NelBNtNm8l0

This assumes, of course, that 5% is the right discount rate. In other words, can you achieve an after tax return of 5%, comparable to the discount rate? If you can achieve a better return in the market, then the breakeven is significantly longer than ten years. If you think you can achieve only a 2% return outside of this deferred annuity, then your breakeven point is between four and five years.

 

Alternate scenario

What about that “equivalent to 11% return” quoted in the Bloomberg article? First off, I have no idea how that’s possible, and the author of the article doesn’t say. My guess is that number came straight from New York Life, and the author made no attempt to reproduce those numbers. So, shame on him.

However, we can look at what happens if you invest the $50,000 in market securities at age 60 instead of purchasing a deferred annuity.

For that, we use the compound interest formula, which is just the inverse of the discounted cash flows formula: FV = PV * (1+Y)^N, where:

FV = Future Value – what we’re trying to calculate.

PV = Present Value – That’s $50,000 in our example.

Y = Some assumed interest rate. I’ll stick with 5% for consistency’s sake.

N = Number of years of compounding. N is 20 in our example, to get to age 80. And then we can look at larger Ns, for later years, as the invested amount continues to grow.

Our $50,000, invested in the market and returning a compounded 5% annual growth, becomes $132,665.

Which, if you might die before age 80, you’re significantly better off than if had you paid that $50,000 as a lump sum to New York Life at age 60.

Now, to take income from that $132,665 at age 80 you’ll need to decide at what rate to draw it.

If you decide to withdraw 10% of the total every year – and assuming an after-tax 5% return as well – then at the end of ten years you’ll still have $70,204 left. You’ll also draw a declining income between $13k and $7.5K. That income isn’t great, but you’ll actually have some wealth you can still call your own at age 90, which can be something useful.

If you decide instead to withdraw the fixed $17,614 per year – to match the annuity assumption – again we see that the break-even is between years nine and ten, with one significant difference: There’s money left over for heirs if you die at any time between age 80 and 90 when you invest it yourself, rather than convert it to an annuity. With an annuity, there’s no money left over, ever.

Insurance companies and financial journalists generally don’t want to talk about the poor returns of their investment products.

Which kind of puts me in the mindset of certain elderly gentleman in Detroit, “You ever notice how you come across somebody once in a while you shouldn’t have fucked with? That’s me.”

https://www.youtube.com/watch?v=ny6SJCNUzqY

In sum

I don’t know. Obviously I started out as an insurance-product skeptic, and this exercise did not convince me otherwise. From the math I’m looking at, the vast majority of people would do better by investing their own money for retirement rather than turning over lump sums to an insurance company to receive unlikely income of dubious, low value.

I’ve addressed the pure-finance angle, but some people want total certainty, and they crave a fixed income for life with no risk.

The rest of us, I think, should live with the gamble.

In the end, I must turn again to Dirty Harry to summarize.

Knowing the break-even point is between nine and ten years of guaranteed income for your life past age 80 in the example quoted by New York Life, you have a clear calculation to make.

Now, I know what you’re thinking.

“Will I live 10 more years past 80, or only nine?”

To tell you the truth, in all this excitement, I’ve forgotten myself.

So you have to ask this yourself question:

Do I feel lucky?

Huh punk? Do you?

 

Please also see related posts on:

Calculating Discounted Cash Flows

Insurance I – Risk Transfer Only

Insurance II – The Good, The Optional, and The Bad

Insurance III – Life Insurance As An Investment

Ask an Ex-Banker – Should I buy an Annuity?

Compound Interest – The Most Powerful Force in the Universe

 

[1] The article also mentions a few technical details. The US Treasury has recently made longevity insurance more viable by allowing up to either 25% or a maximum of $125,000 in retirement accounts to invest in deferred annuities like this. Longevity insurance makes up less than 1% of the market right now for insurance, but may grow as insurance marketing kicks in, and the US Treasury rule which began in January 2014 ‘normalizes’ the product.

[2] I’m going to just use the calculations for a man, because it makes it easier for me and the Bloomberg article did not give a price quote for longevity insurance for a woman. We can assume, however, that the income payout will be somewhat lower for a woman, because women live longer on average and the insurance companies will adjust their income payouts accordingly.

[3] I’m going to belabor this point by showing all of the discounted cash-flow math, because the highest wish of my life is that Bankers Anonymous readers will follow along with spreadsheets to see how useful discounting cash-flows can be to understanding finance. So – humor me?

 

 

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The Katsuyama Revolution Continues

Katsuyama & Team at IEX
Katsuyama & Team at IEX

The Wall Street Journal carries an update this morning on the main protagonist of Michael Lewis’ recent book Flash Boys, Brad Katsuyama and his newly launched (October 2013) exchange known as the Investor’s Exchange (IEX).

One of my main questions left after reading the book is the viability of this newly launched exchange. Katsuyama & his team seek nothing less than the irrelevance of both dark pool equity trading and high frequency trading on equity exchanges, a mighty set of targets. Because Lewis published Flash Boys just a few months after the exchange’s launch, we’re left wondering whether Katsuyama’s revolution will happen or not.

As of today’s article, Katsuyama carries on, applying to expand the IEX into a full-fledged stock exchange. Most importantly, he has set the rules of the IEX so that traditional broker-dealers (The Goldmans and Morgans of the world) trade for free – to encourage them to bring their trade flow in high volume to the IEX, while outside firms – most pointedly we assume high frequency trading firm – all pay fixed commissions per trade.

This second part is a key feature of IEX, which is built to counteract the conflicted cost and fee structures of other equity exchanges which pay for order flow in a convoluted – but probably investor-unfriendly – way.

The main thesis of Flash Boys is that the combination of dark pools – in which broker-dealers did not disclose who had access to deal flow and in what manner – and the complicated set of fees paid or received in different equity exchange – seems to have benefited high frequency traders at the expense of slower market participants.

From what we can glean from the article, the Katsuyama revolution rolls on.

Please see related book review for Michael Lewis’ Flash Boys

also see related book review for Rishi Narang’s Inside the Black Box

 

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