Ground Rules & Constraints – Asset Accumulation: Part I

First, delineate the ground rules to stop leaks (asset protection) which ironically is addition by subtraction (via transference of capital & income depletion potential impacts) Next, is accumulation ground rules and constraints (hopefully to avoid premature accumulation which typically requires ‘more’ (personal financial Viagra that disappoints or for the alternative complementary devotees Extends which financially typically less-ends.)

Unfortunately, the nomenclature for most typical asset accumulation ground rules/ constraints is the word ‘risk’ and secondarily a description of what the asset provides. (As to the latter, there is only so much juice in an orange – which will be the metaphor relative to these factors in the discussion of retrofitting.

“Risk Ground Rules”

Per previous entries, I have defined risk as ‘not making the goal – the chance of not making the goal.’ That said the following considerations, which are either “prone” or “offset” in part or in total depending upon your defined parameters – become a basis for ground rules and are typically referred to in terms of risk:

· Inflation or Deflation Risk – fluctuation in purchasing power of assets and or income is a function of inflation or deflation. For example, in general, cash’s purchasing power is eroded in inflation while increases in purchasing power in deflation

· Systemic Risk - occurs when the failure of one party to meet a financial obligation causes others to also not be able to meet obligations. For example, a person who purchase a home for investment purposes may depend on rental income to make the mortgage payments. If the tenant is unable to pay the rent, the home owner in turn may not be able to make the mortgage payment. A more recent example: you pay make your mortgage month in and month out, year in and year out, and you wind up paying your deadbeat neighbor’s mortgage through government bailout due to Barney Frank, Chris Dodds, Andrew Cuomo and Bill Clinton’s Fannie Mae& Fredie Mac policies making renters into owners who could not afford the mortgage and default impacting the value of your house as well!

· Interest Rate Risk – the value of an investment goes up or down with interest rate changes. For example, there is an inverse relationship of bonds to interest rates. When interest rates go down, bonds typically go up and vice versa.

· Liquidity Risk – the potential that one will not be able to sell the investment quickly enough or in sufficient quantities because of selling options are limited often resulting in a dimunition of value of the investment at the time. See forced sale.

· Market Risk – market risk exposes our intangible assets (stocks, bonds, and alternative investments trades as stocks) to the fluctuation of the market and potential capital depletion or appreciation

· Market Timing Risk – attempting to time market movements, investors ‘risk’ being out of the best markets and going into the worst markets

· Reinvestment Risk – that risk that market interest rates/dividend rates have decreased at the time payments/dividends/interest from an investment are received. The investor will be forced to reinvest his or her payment amount at a time when rates are not as favorable as they may have been previously

· Repayment (Credit) Risk – chance that a borrower will not repay an obligation

· Monetary Risk – the value of currency declining

· Political Risk – the possibility of nationalization or other unfavorable governmental actions or Obama being reelected.

· Longevity Risk (A BIGGIE OFTEN IGNORED BY PLANNERS BUT FEARED BY CLIENTS WHETHER THAN KNOW THE NOMENCLATURE OR NOT – the fear of outliving one’s resources.

· Divorce Risk – the up to 50% risk of first marriage dissolution, and 70% of second marriages dissolution causing capital depletion (see previous section on asset protection)

Offsets & Prone

I’d advise you to make three spread sheets consisting per each objective the assets dedicated to the objective running down the column vertically and across two columns for each risk – the amount of the asset ‘prone’ (to that risk), and the adjacent column ‘offseting’ amount (if applicable). For example, the amount of a $200,000 position in intermediate bonds prone to interest rate risk may be $200,000 with no offset. However, the same $200,000 invested in short term bonds (1-2 years) one might say is but $100,000. Relative to deflation risk, the same $200,000 in intermediate bonds (assuming high quality) might be put in as $200,000 offsetting deflation risk whereas if the intermediate bonds were junk quality – maybe the number is $50,000. The net effect, inflation risk – prone versus offset should be divided by the total value of the objective’s portfolio value as a percentage. This analysis should be run three times:
· First baseline relative to each risk if you do nothing per the objective
· Second, what the prone to offset should look like ideally
· Third, after you retrofit your portfolio per objective what each risk would look like (prone to offset) to make tradeoffs between the requirements of the goal and you concern for the risk –prone/offset ratio.

Next: Ground Rules & Constraints – Asset Accumulation: Part II Retrofitting

(The Tease: Most people’s portfolios consist of what they have been sold – not what they have bought)

Ground Rules & Constraints – Part I: Asset Protection

Though my practice was overwhelmingly dealmakers (energy, cable, and real estate), I had one client, an heiress to quite a large position in a publically held oil refiner. Yes, she wanted to be passively financially independent of her large position, without selling a portion of this position – it wasn’t possible.

Thus, not selling any of the stock in this oil refiner became a ‘ground rule / a constraint’ on her personal financial life planning goal of passive financial independence regardless of my mantra ‘an asset is just an asset is just an asset, we manage personal financial life goals not assets’ nor fall in love with the asset.

Another client who bought into Enough – needed his financial Vegas fix. No he didn’t go to Las Vegas but he had a need to speculate. Thus, with a portion over and above Enough as defined, together we recognized what he called ‘his need for speed’ into his Las Vegas fund (which he could afford to lose – and did). Again, another constraint/ground rule that had to be recognized in planning.

Then there is the ‘world is coming to an end, everything should be safe, liquid but I still need to make 15%’ type client. I referred this individual to another planner as there was no way – enough would have been enough as he was a Worry Butt on Steroids.

In Management by Objective terms, there are four Effectiveness Areas (EA) in personal financial life planning:

· Asset Protection · Asset Accumulation · Income Conservation · Asset Conservation
Asset Protection – Addition by Capital Depletion Subtraction!!

Asset protection is typically about capital depletion due to:

· Health/Illness
· Property & Casualty loss
· Liability
· Disability
· Long Term Care Needs
· (Some would include Divorce)

Examples of Ground Rules on Asset Protection (which typically involves shifting risk (large losses – capital depletion) via insurance in return for taking a small loss (premiums & minimum self insurance- deductibles, stop losses, company financial rating, complaint ratio etc.)):

· Health Coverage
1. Deductible
2. Stop loss
3. catastrophic coverage

· Vitamins – “supplemental health insurance!”

· Homeowner Coverage –
1. deductible
2. full replacement value of structure
3. full replacement value of contents
4. replacement value by ordinance (check your policy most don’t have this – and specifics are beyond the scope of this writing
5. underlying liability coverage

· Automobile –
1. deductible
2. collision
3. comprehensive coverage
4. liability coverage

· Liability –
1. underlying coverages on home and auto
2. preferably a blanket excess liability on top of the underlying liability coverage
3. a separate flood insurance policy where applicable
4. where applicable Director’s & Officers insurance as well as Malpractice Insurance .

· Disability Coverage (income replacement due to disability – remember you are the working active asset creating asset accumulation etc until the goals are funded).
1. Loss of income upon partial and or total disability
2. wait period would be chosen before the benefit kicks in
3. inflation rider
4. (Social Security offset is again another subject)
5. coverage to age (65 – lifetime?)

· Long Term Care Coverage
1. Qualification (number of ADL’s activities of daily living out of 6 to qualify,
2. home health care coverage,
3. wait period, coverage years (or lifetime)

· Divorce Insurance – prenuptials, post nuptials – please no Sleepless in Seattle clap trap when 50% of first marriages result in divorce and 70% of second marriages. This is ASS-et protection. You have wills and trusts for contingent events (death) - and I never heard a spouse against those contingencies - why not prenupts, post nuptials. PS you can always change the pre and post nupts later if desired.

The point of the above is illustrative of ground rule/constraint concepts in the asset protection effectiveness area all of which are intended to minimize capital depletion (addition by reducing capital subtraction!) to allow asset accumulation and asset conservation.

THE WORRY BUTTS© aka Getting’ To The Bottom of the ‘But-t’

THE WORRY BUTTS©
aka Getting’ To The Bottom of the ‘But-t’

You’re really a smart person….BUT
There is another …. BUT
I know I should have told you… BUT
You’ll always be special … BUT
Don’t be offended…. BUT
BUT…
BUT…
BUT…
BUT, BUT, BUT
Different Times with Different Lines, by Jim Schwartz, 1971, Denver University Clarion

Confession: the above was written when I was a rationalizing testosterone driven BUTT HEAD of 19 or 20 trying to ‘win the affections’ (euphemism) of Wendy L. (And to answer the question, no, I didn’t ‘bag the babe’ - there was no shtuppee, whoopee and thank God, no chuppie.) (1)

Testostorone driven But-t Headedness is excusable for 19-20 year olds, however, after 20+ years in practice as a fee only personal financial life planner and an additional 16 years of writing etc in the area, I have a BUTinski Schwartzism © relative to BUTs:

“When BUT #1 is fixed BUT #2 is promoted by the Butt Heads”

Oh, yes, as we grow older our “but’s” are more sophisticated with a little song, a little dance, a little seltzer down the pants – with a repertoire of excuses rivaling the yellow pages.
Why is there one but after another but after another in personal financial life planning?

Here’s an interesting personal financial life planning ‘But’ cascade:
· But, I don’t have ‘enough’
· I have ‘enough’ but I need a cushion
· I have enough and a cushion – the means to the end but I need to move the ends apart

Buts escalate even with ‘more and more’ money and resources.
· But Obama could reinflate the currency
· But I could have a bad year (even though I’m the last ice man)
· But What if the water is cut off?

There is no rest for the WORRY BUTT’s but’s – only but promotions. They just escalate exposing the underlying fear which despite the above sarcasm is very real and haunting.
And what is that underlying fear?

The fear of physical extinction (which we identify as ourselves) due to:

· The lack of faith in trust in God (or a higher power)
· The lack of faith in our own proven adaptability and resourcefulness overcoming past difficulties and challenges

No wonder the push for certainty, permanence, continuity stirred and shaken (olives optional) with a chaser of the dreaded secondary fear of being beholden. No wonder the BUTTressing- one BUTT after another BUT-T.

An exercise:

Suggestion: In one column, write down difficult times and challenges and in the other column write how you correspondingly overcame the problem, worry, difficulty, challenge. Then read the sheet in total – reduce it to size and stick it in your wallet for when the next WORRY BUTT wave hits.
(You may even be impressed with your own adaptability and resourcefulness – which earned the necessary current currency and or other resources to overcome the past WORRY BUTTs).

Oh, yes, I know, you’ll say:
· (But) That was then, this is now
· (But) I don’t have the same energy
· (But) I’m older now
· (But) This is different…BUT, BUT, BUT

The point is you have, you did overcome as the track record of the exercise proves, yet still WORRY BUTTs rarely give themselves credit for the evidence of meeting and beating these past challenges.

How come?

Because of the ‘if they only knew(s)’

The ‘if they only knew(s)’ is the deep down belief in being an imposter – derived from the conviction/ironically faith in one’s lacks (lack-tose intolerances) when one scratches underneath the bravado, Gucci and Rolex..
And so it goes, BUTT-er Cups (really only BUTT-er Flavoring).

The fact is we are not self sufficient regardless of personal financial resources. Today’s current currency is tomorrow’s money in a wheel barrow. Unfortunately, especially in an industrial and post industrial society with increased specialization – we need other people.
But if you remember to take out the above reduced piece of paper with the above exercise on it, you might just minimize the anxiety, the buts, and the pain in the butt. You might even remember from those difficult times, you were adaptable and resourceful such that no matter what the current currency – you have adjusted. (This is BUTT management (Preparation BUTT) not BUTT cure ).
Even better yet, I believe, is trust and faith in God to provide strength for one’s latent and or minimized adaptability or resourcefulness to manifest. I am reminded what The Rebbe (2) said relative to health, ‘listen to the doctors instructions, but one’s fate is in Hashem’s hands.’ We have more faith in the dollar or euro (the current currency) than we have in The ‘Everlasting’ Currency.

Of course, you could say all the above is projection. We do teach what we need to learn ourselves, BUTT-er Cups.

As a Rabbi once said, ‘you don’t get rid of Shtick (3), you manage it.’
ENOUGH said. Don't BuTT-er me UP?

1.-Chuppah – The Jewish wedding canopy, that is, the cloth under which the Jewish wedding cere-money is conducted.
2.- The Lubavitcher Rebbe, Rabbi Menachem Mendel Schneerson
3.- Shtick – a contrived gesture or routine done by anyone, often an actor or comedian i.e. my baseball cards for business cards etc.

Rat-e of Return & Me Inflation

It’s not how much you make, but how much you keep after tax, after ‘me inflation’ (or ‘me deflation) (1), risk adjusted (with the least nerve racking fluctuation ‘volatility’) to make each particular personal financial life goal.

The rest, as Rabbi Hillel would say, ‘is commentary. Go study.’

Instead, be it for external comparative validation or just ‘let me cut off my brother’s head so I can be taller,’ joining the Rat-e of Return race is for rats.
Inflation or better termed ‘me inflation’ (of deflation -me deflation) differs with each goal, your income status, and age in life cycle) ll as ‘me deflation.’
Do you really give a rat’es ass to beat the Dow if you meet your goal – and with less volatility? If yes, why- and take a minute to call your shrinks, others talk to yourself and kvell.

After Tax Rate/Rape of Return

As of today, the maximum long term capital gains and dividend tax rate is 15% (assuming you are not into the alternative minimum tax). The maximum marginal income tax rate on wages, short term gains, interest and other ordinary income (not sheltered by depreciation, depletion etc.) is not just 36% but closer to 38%+ given phase out of certain deductions at specified adjusted gross income precipices.
State taxes aside, on the same 10% gross rate of return before taxes, long term capital gains nets 8.5% whereas wages, interest, short term gains at the maximum rate nets 6.4% to 6.6% a 22%-24% net after tax difference in rate of return. (Discussions of the advisability of taxing capital and passive income sources differently than income is an aside. However, remember, long term capital gains and dividend preferred taxation – is not preferential – as there is double taxation involving these sources.)

Inflation adjusted Rate of Return

I gotta be me, I gotta be me, who else can I be than what I am?
Sammy Davis, Jr. “I Gotta Be Me”

Now let’s assume in the above example of 10% gross rate of return, 8.5% after tax return if derived from long term capital gains and dividends, 6.4% if derived from other sources of income, general inflation is 3%. The net rate of return drops respectively to 5.5% and 3.4%.
But WAIT, as the infomercials implore us – inflation is not inflation is not inflation. One’s inflation rate is dependent on:

· income level,
· where you are in the life cycle
· the particular goal in question

Thus, each of us has an overall ‘me inflation’ overall as well as a ‘me inflation’ relative to each goal.
A 60 year old married couple making $150,000 with their kids college education costs out of the way (and the kids finally having self supporting jobs after too long of a boomerang back to their house and food ticket) and no longer with mortgage or those durable good purchases facing them – has an overall ‘me inflation’ rate different than even a 30 year old married couple making $150,000 with two kids, saving for college, with a mortgage, and paying off student loans.
If the consumer price index of inflation is 3% overall, the overall ‘me inflation’ might be 1% (except for health insurance) for the 60 year old couple but 5%+ for 30 year olds!
More importantly, me inflation differs per goal.
Higher education costs (personal financial ebola because it cannibalizes, castrates and or defers the work free retirement due primarily to tenured unaccountable condescending Scholar Barons on the Honor Dole – another discussion) has been running 250% to as high as 400% over the consumer price index of inflation. Long term care costs (nursing homes, assisted home care) has even exceeded the education ‘me inflation’ rate – compounding at one point by over 9% (400% over inflation in some recent years.)
Back to our example of 5.5% and 3.4% after tax:
Given a higher education ‘me inflation’ rate of 6% - there would be a negative after tax after inflation rate of -.5% to -2.6% given the income is derived from ordinary sources (wages, interest, ordinary income, short term gains).
Isn’t that comforting, Bunkie, as you write out those tuition checks and wonder will you be a greeter at Walmart to make ends meet?

For whom does the inflation rate bell toll?
For ‘Thee’s Inflation’ (per goal) – not The Inflation.

Risk Adjusted After Tax After Inflation Rate of Return

That’s okay in practice but how doe it work in theory?
The French

Reality, not theory, is that it is volatility/fluctuation which is equated with risk (be it measurements such as beta, standard deviation etc.).
And fluctuation/volatility is nerve racking on the downside to most.
We have a risk capacity and it is related to:

· fluctuation (volatility) which rightly or wrongly becomes synonymous with ‘risk’
· the proximity to the timing of the goal – the closer to the objective the lower the risk capacity

In theory, risk capacity should be related to probability(P) and magnitude (M) or (PxM) but in reality, those are just words when the fluctuation hits the fans.

Nothing kills rates of return – on the ground, in the trenches – than fluctuation. Proof: Dalbar’s study of investor rates of return versus the S&P showed that the average equity investor earned 1.87%/yr. (overall inflation during the period was 2.89% a year) which the S&P index averaged 8.35%. The average bond investor earned .77% versus 7.43% for the index during the same period.
Furthermore, the rate of return of investors in mutual funds has lagged the rate of return of the mutual funds they are invested in.
The reason: investment returns are far more dependent on investor behavior than the fund/index performance. Thus: risk capacity is a behavioral function.
And people (especially those without a grip on the after tax, after inflation, risk adjusted required rate of return they need to meet the goal) regardless of their chest pounding bravado about their ‘risk tolerance’ hate fluctuation/volatility and equate it with loss. (And remember risk is really the chance/probability of not making the goal!)

So what do – recognizing fluctuation is a risk proxy in reality and remembering ‘the flaw of averages’ and ‘Monte Carlo probability analysis’ from previous sections?
In light of the fluctuation/risk equivalency (rational or not), beta – better yet ‘return on beta’ is a useful tool (1)

Beta, a measure of volatility, is the ratio of a stock or mutual fund’s fluctuation compared to an appropriate benchmark index (i.e. the S&P 500).
Let’s say you require after tax, after inflation, a 4% real rate of return (pretax rate of return 10%, after tax 8% and after inflation 4% yielding a 4% real rate of return). Now Mutual Fund A which you are considering had a rate of return, for argument’s sake, of 12% with a ‘beta’ of 50% when the market was up 12%! The return on beta is 24% (12%/.5%). You would have made 12% (all things being equal) with ‘half the volatility/risk’ of the index (in this case representing the US Stock Market). Goal for the year accomplished after tax, after inflation risk adjusted (12%x.8 tax rate ((inverse of tax rate of 20%))-inflation 4% = 5.6%. The risk adjusted return on beta after tax and inflation is 11.2%!
Fund B, in the same year, did 24% outperforming the index by 12% and made the goal after tax, and after inflation (24%*.8 ((inverse of tax rate)) -4% = 15.2% outperforming fund A. But did it when considering volatility/risk? Given a 300% beta, the rate of return after tax and inflation is 15.2% outperforms the index and fund A. But then when the after tax after inflation rate of return has beta applied the 15.2% becomes 5.06%. Now think, if instead of 24%, the rate of return, the return for Fund B was 16% with a 300% beta – the rate of return on beta becomes 2.93%. Thus, the goal adjusted for ‘risk’ is not made.
Is the heartburn worth it?
More demonstrable is applying rate of return on beta to the gross rates of return. At 12%, Fund A had a return on beta of 24% (24%/.5) whereas Fund B had a return on beta of 8% (24%/3.00).

However, none of this return on beta matters – if the rate of return after tax and inflation isn’t met – given the same present funding levels of the goal per year..
Please remember, return on beta is just a financial tool – and unlike Sears Craftsman tools, it does not come with a lifetime guarantee.

Now could there be an instance where, despite a lower return on beta, one can go for the higher rate of return? Yes (though typically not advised) where the client has a low personal beta.
What the heck is a personal beta?
A gastroenterologist’s income is more stable – varying little with the economy (though moreso with the increasing or decreasing demographic of 50 years old+ individuals who will require colonoscopies every 5 or 10 years. (It is reputed that gastroenterologists believe they are in a ‘sh*tty business’ and ‘love it.’). In contrast, a big ticket commercial real estate developers’ income have a high probability of varying widely with the economy. The gastroenterologists have a low personal betas from which income can more reliably go to fund their goals year in and year out in contrast to the big ticket commercial real estate developers whose income fluctuates (thus having a high personal beta) moreso with the general economy. As a result of the cushion of the low personal beta, the gastroenterologists have the cushion/tushion (though not advisable in most cases) to go for a higher nominal rate of return even if those investments result in a lower return on beta. The scenario for the gastroenterologists taking ‘higher risk’ for ‘greater nominal though lower return on beta’ returns would be that for some reason (divorce etc.) the gastroenteologists cannot maintain the funding level necessary in some year or two and the objective is 10+ years in the future.

Finally, the other risk measure is the probability of funding the goal. Some planners use 80%, others require 90% and still others 95% probability using Monte Carlo analysis previously discussed. Be aware that relative to asset accumulation goals (education, slow down, retirement etc.) the higher the probability required, the ‘more’ assets required (an Assets under Management compensation financial planner’s dream come true annuity). And even at the 95% probability level, there is the possibility of the Black Swan like in 2008.

Next: Constraints, Criteria & Other Ground Rules

(1) For purposes of this commentary, inflation is being assumed rather than the more rare over time deflation – spousal me deflation of one’s character and value is a different question
(2) others may prefer tools like standard deviation which asses the the extent to which a portfolio return differs from the mean. Still others like r2 or downside risk DVR measures.

Temptation, More & Character

When the game is over, the king and the pawn go into the same box.
Italian Proverb

When the game of life is over, the only thing we take with us is our character.
Ironically, necessary for character building is tests (nes) in form of life temptations.

Temptation, however “presented,” manifests as ‘more, better and or now’ (1) as the ‘present situation’ is ‘not enough.’ If what we are and what we have was ‘enough,’ there would be no temptation nor would there be succumbing to temptation.

Ironically, temptation’s aim is not succumbing but rather it is an ally to character building – completing (shelemut) our incompletions.

Otherwise, without temptation how would character flaws, incompletions be limited, restricted or conquered?

Temptation is character’s foil or foil (down fall)

Consequently, temptation, manifested as ‘more,’ is both acculturated and hard wired. As a result, enough, be it ‘enough to live for, enough to live on,’ healing financial anxiety putting money in its place to proceed to significance – why I am, what I am meant to be do and be,’ is an uphill struggle, losing ‘more’ often than the Washington Generals lose to the Harlem Globetrotters, as there is never enough. Enough is futile though not delusional.

“As soon as you win the fight for hotdogs, they want hamburger, and after they get
hamburger, they want steak”
Saul Alinsky (yes, Saul Alinsky, my conservative friends as he has been mischaracterized)

The insatiability for more is originates from the fear of bodily physical extinction (identified as oneself) which germinates the delusional strategy of acquisition (Cain in Hebrew – yes, Cain – means acquisition). Thus Temptations (2) manifest one way or another) as more, better, now (not enough). Though temptation is the parasite we are the hosts.

Character pawn of a king, foil or foiled character – that is man’s work this year and every year relative to the his entry into the Book of Life on Yom Kippur.

(1)- more, better, now typically, in time, becomes ‘less, worse, later.’
(2) – on stage next: The Four Tops – sloth, anger, gluttony & pride

PS The above is why Enough (enough to live on; enough to live for) is a struggle

Correction 9/15/10 Blog

see correction in bold

Personal Financial Life Planning RISK (Part B – Monte Carlo Analysis) – Part III Setting A Personal Financial Life Goal

If the Platte River an average depth of 3’ deep, most people over 3’ tall should be able to walk across without drowning. However, at some points, the Platte River is but 2” and other points 20’, so even Wilt Chamberlain would drown at the 20’ depth.

Personal Financial Life Planning RISK (Part B – Monte Carlo Analysis) – Part III Setting A Personal Financial Life Goal

If the Platte River an average depth of 3’ deep, most people over 3’ tall should be able to walk across without drowning. However, at some points, the Platte River is but 2” and other points 20’, so even Wilt Chamberlain would drown at the 2’ depth.
Thus, the average rate of return - The FLAW of AVERAGES – applied to personal financial life objective(s) is very ‘risky’ business – ironically increasing the risk that you won’t make your personal financial life objective(s).

Yet, average rate of return is still the employed by many financial planners, and cpas. Worse is that average rate of return is the predominant measure employed by actuaries determining the adequacy or inadequacy of public employees’ pension funds understated by multiple billions. (What does this mean to you? Higher taxes but that’s another story with the actuaries and politicians foolishly trying to obfuscate or defend average rate of return with accepted state of the art horse pucky. As one former Colorado Union official stated to me to paraphrase, “PERA (the Public Employee Retirement Association) funding is the nuclear bomb on the State of Colorado Finances.” And that statement was just on the underfunding using an ‘average rate of return.’

It is the sequence of the rate of returns that matter – not the average rate of return!

An example per Dr. Sam Savage’s Flaw of Averages.

“ Suppose you want your $200,000 retirement fund invested in the Standard & Poor's 500 index to last 20 years. How much can you withdraw per year? The return of the S&P has varied over the years but has averaged about 14 percent per year since its inception in 1952. You use an annuity workbook in your spreadsheet that requires an initial amount ($200,000) and a growth rate for the fund. "I need a number," you say to yourself, so you plug in 14 percent. Now you can play with the annual withdrawal amount until your money lasts exactly 20 years. If you do this you will be pleased to find that you can withdraw $32,000 per year.”

At the end of 20 years using the 14% average rate of return, your capital would be exhausted and the investment finished.
Here’s the rub – REALITY IS NOT AVERAGE RATES OF RETURN. Rates of return are volatile – they fluctuate – they are not smooth like Original Skippy Peanut Butter – but are chunky and can wipe out your duration in a JIF.
Given real market rates of return starting in the following years, here is how long the $200,000 would last:.

1973 – out of money in 8 years
1974 - capital intact despite 20 years of payouts at the end of 20 years
1975 - out of money after 13 years
1976 - capital exhausted in 10 years

How come?
The Dow Jones was 1020 at the beginning of 1973 but by the end of 1974 it was 616 or a 40% decline whereas by the end of 1975 having invested in 1974 the Dow Jones when the Dow was 616 was up 38% to 852!

In rate of return and the probability of making the goal, its SEQUENCE, SEQUENCE, SEQUENCE!

It’s the sequence of rate of returns NOT average rate of return!

Beware of averages alone – except in Lake Woebegone – or your personal financial life goal will woe be gone.

Therefore, employing average rates of return, alone, is RISKY and deluding. (Again, Risk is defined as the whether you make the goal or not per PART A. At a gut level: RISK is the danger of not making the goal – the failure to achieve the goal causing negative consequences.)


Okay, what then is an additional standard metric to employ besides ‘average rate of return’ and it’s flaws?

Monte Carlo Modeling.

Simply stated, Monte Carlo Analysis (which goes back to the Manhattan Project) models multiple (often many thousands) alternatives to come up with the probability (as stated as a percentage) of making one’s goal.
Thus: given w amount of resources, deployed in x allocation (% of stocks, bonds, cash etc) for y period of time, at Z payment per year, a existing asset level of assets, beginning in b etc – what is the probability of making the goal?
It should be noted that Monte Carlo Analysis did not save clients and their planners from the financial meltdown ‘black swan’ recently where 15 of 16 asset classes declined. Monte Carlo gives probability not certainty. It also should be noted that Monte Carlo, which typically requires a larger if not much larger funding level to achieve the goal, is an AUM financial planner’s dream of increased fees.

If all you know is a hammer, everything will look like a nail
Dr. Abraham Maslow

What is an AUM financial planner?
The compensation for this financial planner is based to assets under management. Thus, the “more” assets under management the “more”, he or she gets paid.
There is an inherent conflict between this type of compensation and it conflicts with the concept of Enough which is based achieving the financial goal with the less risk possible. The conflict occurs where the goal can be still be reached at a lower rate of return with the trade off being less risk (risk of not making the goal!). Thus, AUM planners inherently are MOREons though their pat answer would be ‘if we aren’t making the goal, we’d be fired – which serves as a check and balance.’ However, offsetting this response is AUM tends to make the goal relative to an external comparison – ‘how did I do versus the Dow Jones, the S&P, etc.’ rather than the internal goal!
There are good reasons and real reasons. Increased compensation – consciously or unconsciously – is the real reason – for the AUM compensation model (the hammer) with too many clients getting ‘nailed.’

(On a continuum of commission/transaction financial planners and flat fee, bracketed or hourly financial planners, I consider the AUM planner’s compensation a faux fee only planning or fee only planning not lite.)

In any event, Monte Carlo most likely will require additional assets under management therefore I prefer the assistance of a fee only planner who charges a flat fee, an hourly, or a bracketed fee (no less than, no more than based to an hourly but capped).
In summation, relative to making the goal, not running a Monte Carlo analysis, regardless of it’s windfall to AUM financial planners, would be close to malpractice – which is exactly what state governments like Colorado are doing which will wind up costing taxpayers and harming your personal financial funding. How? They plans which are underfunded on the ‘flaw of averages’ are way way way understated – in worse shape given monte carlo analysis. To get to the 90% or 95% funding level would require some or all of the following (assuming an actuarial emergency gets the states out of their locked in obligations):
· Increase in taxes or lowering of services
· Increase in bonds from the state – lowering credit rating, paying higher interest from general funds thus lowering services unless there is an increase in taxes
· Additional state and or employee contributions – again increasing or lowering services

Remembering it is not what you make but what you keep, if state taxes go up, your net rate of return goes down. You will then either have to increase your contribution to the goal and or increase the risk (really volatility of rate of return and remember ‘sequence, sequence, sequence’) to get a higher rate of return or lower the amount of the goal and or its start and duration.

Here is the effect of a .5% net increase in state tax rate on the growth of $100,000 for 20 years (7% net versus 8% net – inflation is not taken into account for this example) in reducing your assets:
8% grows to $466, 100
7.5% grows to $424,800

Thank the politicians (who are members of the state pension plans) for costing your goal $42,000…EVEN USING AVERAGE RATE OF RETURN!

State underfunding of employee/politician pensions, the personal financial ebola of higher education costs paying for Scholar Barons on tenure, and long term health care costs converge to cannibalize assets that otherwise would go to funding your goals and requiring less volatility, resulting in the delay or reduction of the goal or worse taking on more volatile ‘risky’ assets even illiquid assets – to meet the goal.