By Brad Thomason, CPA
One of the things that gets in the way of having easy conversations about retirement planning is that many of the most important variables are important, not for their effect in a given year, but because of the cumulative effects that pile up as the years go by.
Cumulative effect is difficult (to impossible) to track using the kind of mental math tricks we use for calculating how much we should earn in a year from a particular rate of return, or how much money we need to put in the bank to cover the checks we’re about to write. Cumulative implies several, over time, which in turn means lots of calculations. It’s just too easy to get lost – quickly – if you try to track that sort of thing in your head; and instinctively we usually avoid even trying .
This, in turn, leads to an unnerving situation in which the thing that seems to be the obvious choice may be the exact opposite of what you ought to do; and what you ought to do, first pass, makes absolutely no sense.
An investment of $100,000 will earn $7,500 next year if the rate of return is 7.5%. It will earn $500 more if the rate is instead, 8%. Five hundred bucks isn’t a lot of money.
But if you let that difference ride and compound for twenty years in a tax-deferred environment, the cumulative difference is over forty thousand dollars. Which sort of is a lot of money, especially relative to where we started.
We’ve modeled real estate investment deals before where we put in assumptions like “no net income for the first five years” and still had the project be an obvious green-light when viewed from the perspective of a fifteen or twenty year holding period.
How? Such a deal commonly has multiple places where cumulative effect can creep into the equation: the pay down of the mortgage reduces future interest charges; once money is reserved for repairs and maintenance we may get to allocate more to income or debt reduction in future years; the longer the holding period, the more rent checks we get (like selling a product, the more times someone pays to use your property for a month, the more your sales tally goes up). Notice that I didn’t even mention things like rent increases or property appreciation. Or the option of using the earnings from early projects to fund additional projects in the future, increasing the total amount of productive capacity in operation.
All of these things are essentially impossible to see if all you look at is cost to acquire and monthly rent potential (in this particular case). Nor are the effects particularly noteworthy in any given period. But what they accumulate to in the end certainly may be.
When the topic is retirement (an exercise in trying to envision what several decades might look like) small changes in rate of return, inflation assumptions, the timing of medical expenses and a long list of other things can and will affect the results in ways that almost always seem out of proportion to the change itself. It’s just the way it is.
That’s why it’s so important to engage in more than surface level thought. The way things appear on the surface is frequently not indicative of the true effect that they may have over time. What seems like a good idea may be a bad one; and at times you may find yourself wondering why on earth anyone would consider some action which seems to obviously be wrong, and yet, isn’t. You can be fooled either way.
The only way I know to not get fooled is to take the time to be thorough. Which won’t guarantee you a favorable outcome, by the way. But one of the implications of living in a world where big cumulative effects can come from small inputs, is that it can work in your favor, too. You don’t have to avoid walking into too many mistakes before it starts to have a positive effect. So even if you can’t catch them all, nor get guarantees of how random events will unfold, catching even some of the avoidable ones can make a big difference. Which makes it worth the effort.
By Brad Thomason, CPA
When you look at the size and scale of the modern financial industry it would be easy to think that you are witnessing the refined, ultimate expression of the ‘right way’ to do financial services. If you buy into the notion that form follows function, surely a modern financial behemoth is a best-of-class example of the principle.
Well, it might be. But the function that lead to the form may be something different than what you think it is.
This is not a piece about questioning the motives of large corporations or implying that they are secretly out to get you. But I am going to point out a few things which, in the end, though certainly a lot less malevolent, may nonetheless cause you some concern about relying on them too heavily.
1. The form of the modern financial firm is based on providing services to a lot of people that have more or less similar needs. Which is not the same thing as saying that the service offerings are the ones that best meet the needs of the customers. The key to all large, corporate businesses comes down to repetition at scale. They need to be able to do the same things, again and again, with a lot of efficiency. So if efficiency and repeatability are the prime drivers of how they provide services, that sort of automatically knocks any notion of best fit out of the running, doesn’t it? To make money they have to do a pretty good job (not a very good job, and certainly not a great job) of providing services which may confer some benefit – if not optimal benefit – at a high level of efficiency. The service offering that is best for them, may not be the service offering that’s best for you - a principle which is ever on display at any restaurant that has a drive-thru window, by the way. Same basic proposition. McDonald’s can certainly keep you from starving, and adequately satisfy any food-is-fuel needs you may have. But that doesn’t mean there aren’t other levels which could be attained were it not so necessary for them to book such a high quantity of iterations.
2. Providing service at scale takes scale. Which means people. Lots of people. What are the odds that every person that works at a large mutual fund company or bank is an actual financial expert? When you call the service line, how do you really know if you reached such an expert, or whether the person who took your call has more training in being polite than they do in actual matters of finance?
3. Are you representative of the typical client of a large financial firm? Do you fit the same mold as the typical person that they are usually dealing with? Public statistics, going back decades, clearly show that the average person doesn’t have anywhere near enough savings to even make a meaningful start at a prosperous retirement. If you are actually working to properly endow your retirement and set the stage for a success that spans decades, you are materially different than the bulk of the people that they provide service to. That may not mean that they can’t deliver something of benefit, but it does further the idea that what you really need may be something very different than what they are offering. The typical person they talk to day in and day out probably differs from you in substantial and important ways.
4. Do the large firms actually have a track record of success? That is to say, client success stories? What percentage empty their accounts over a few years and go away? Seems like it would have to be a large portion. But even if the ones that didn’t have to spend everything, how many of those occurred simply because the person didn’t live that long? I know that’s an uncomfortable question, but it raises an important consideration; not just for financial firm clients, but in general. How often, when a retirement failure doesn’t occur, is that the result of the person not living long enough for the retirement plan to be truly tested in the first place? The clients of large firms that live a long time and have adequate resources for the whole thing are the ones who had a lot of resources in the first place. It’s not fair to say that the firm played no role whatsoever in the positive outcome. But it is fair to wonder if the outcome was in the cards even without the firm’s input. In the case of large portfolios, it seems plausible that such could be the case.
I don’t assume from the start that the financial industry is evil, per se. I’ve seen some things over the years that convince me that everything is not pristine. But I’ve known some good people who worked hard and truly cared about their clients, too.
So better we skip over the question of good and evil and focus instead on the substance of what’s there. Obviously you would rather work with a firm that is successful than one that is struggling. But don’t automatically assume that their success is a reflection of a set of service offerings which rises to the level of best-available for your needs. They can succeed by doing pretty well for a lot of people that have some of the same needs you do. Between that reality and ‘what’s best for you’ there’s quite a bit of space; and its space that can exist even if you are dealing with folks who aren’t actively out to get you.
If you go to McDonald’s, you aren’t going for prime rib and aged Bourdeaux. The difference is, with McDonald’s you realize that going in. Make sure to realize it when you deal with a large provider of financial services, too.
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