Main Street Money: The money cycle
Despite what many people think, income and money are not the same thing. Money is the currency, while income is the source. A nest egg is finite; once it’s gone, the money stops. Income, on the other hand, should be renewable and last a lifetime, even if the nest egg runs out.
Think about it this way. A nest egg is kind of like a leaky open bucket. No matter how much it holds, it only holds that amount. You have spent your lifetime filling the bucket up, while it has been springing leaks that continually hold you back. Leaks such as market losses, fees, poor decisions, unexpected expenses, and of course, inflation, evaporating your supply from the open top.
It is very difficult to accumulate money in such an environment. Growth of an asset is entirely dependent upon the size of the asset. The larger it is, the more incremental growth will help. For example, 3 percent of $1 million is much more than even 10 percent of $100,000. So the bigger it is, the more it grows.
Spending money is even more difficult because spending on top of all the leaks just accelerates the shrinkage. Every time a dollar comes out, less growth will go back in, as growth is always dependent upon the size of the base that’s growing. So, by the very act of spending it down, you are weakening its ability to replenish itself going forward. It’s just a flawed model. Such is the nature of rates of return.
Now, let’s consider your city water supply. It will be fed by some type of perpetual source, perhaps an artesian well or maybe a reservoir. It’s part of a running water system of snowmelt, groundwater and streamflow, freshwater and sea water storage, evaporation, condensation, water storage in the atmosphere, precipitation, and water storage in ice and snow. It’s a dynamic system, constantly replenishing itself by remaining in motion.
Money flow is very similar. Natural resources are mined, companies and their human capital (employees) make things and sell them to customers – often those same employees, generating funds to mine and make more stuff and pay the employees, etc. Again, it’s a self-perpetuating system that is constantly renewing itself, creating more wealth that is distributed and redistributed through the economic cycle.
While both examples are gross simplifications, the concept is sound. So long as the resources, in these cases, water, raw materials, human capital, and money, are kept in circulation, they continue to feed the ever expanding “make more stuff” machine. The key to growing resources is to keep the cycle in motion.
Now, you take it out of the cycle and put it in your nest egg. True, your money is invested, so it’s still in motion. However, it’s being speculated with rather than accumulated. The nature of a risk/return cycle where the greater potential return is driven by greater levels of risk is antithetical to ongoing income. Think about it. You have $350k saved for retirement, and your adviser recommends using only about $10k per year for retirement income (spend-down is more accurate). However, you need more than $10k per year; you need twice that.
So, to generate more income, your adviser counsels you that you need to take more risk, the assumption, not stated but understood, being that a higher risk profile generates a higher yield, thereby generating more income. But does it really? In my opinion, it clearly does not. If it did, there would be no income issues at all. Just increase risk; get more income. But that isn’t the way it works. Increased risk doesn’t increase the level of success; it lowers it. That’s why it’s called risk. The riskier an investment, the greater chance of loss. Yes, you may increase the potential for gain, but the truth is that opportunity for larger returns is offset by the opportunity for larger losses. When engaging in retirement planning, it’s much more important to suppress losses than it is to increase returns.
In this kind of system, the investment always dictates everything else. It’s obvious. Take more risk; lose more money. Lose more money, spend less. Take less risk, lose less money, but have less growth. Increase the spending load, and you will create more stress on the plan, and run out sooner. There is no way around it.
The problem is that performance is tied to the wrong thing. It’s tied to your willingness to lose more money or less money. This is silly. Why should you, getting the income you need from the account you spent a lifetime accumulating, be tied to your willingness to go broke? Unfortunately, however, this is the standard, not because it’s best for the retiree, and not because there is no alternative. It’s because Wall Street is holding around $16 trillion in retirement assets and uses the enormous leverage that provides to keep the status quo.
The key to having enough money to live is tying it to the right thing. The right thing is not your risk tolerance, no matter what Wall Street says. In fact, your risk tolerance is meaningless and should not play a part.
Here’s an idea. Instead of tying your payout to how much money you are prepared to lose, and how much you have in your leaky bucket, why not tie it to your lifespan? Convert that bucket into a garden hose. Have an income stream that will last for as long as you do, even if your account runs out of money. In that system, instead of a longer life putting pressure on you to reduce spending, a longer life keeps paying you money as long as you are alive. That gives you more money. And if we are talking about living longer, shouldn’t we be looking for ways to generate more money?
And one last thing. Doing it this way actually increases your monthly income from the beginning because income generators don’t involve losing money. They involve eliminating losses so you have more money to spend. It’s a double win. More income for a longer period. More now; more later.
Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He authored five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. Steve can be reached at 603-881-8811 or at www.FreeToRetireRadio.com.