These Money Illusions Can Cost Investors Dearly

Money illusions in one’s financial planning can be quite costly. Monte Carlo simulations almost always use unrealistic assumptions, making them dangerous to use. People are also prone to nominal thinking, and they often consider the return of principal as income. Here is how the three common illusions manifest and how investors should reframe their thinking.

Time to Get Real

First, one must use realistic assumptions in planning. As an example, a client recently came to me with a beautiful report from a very popular financial planning software program used by many advisors. I actually think it’s one of the best around. Among several iterations of scenarios, every Monte Carlo simulation gave the client a 99% success rate for the next 30 years without having to reduce real expenditures.

I don’t mean this as a political statement, but I don’t think there is a 99% chance any government will survive the next 30 years. If there is only a 1% chance a government wouldn’t survive a 30-year period, that implies a 50% likelihood of surviving 1,500 years. The Roman empire only lasted 500 years. In other words, the planning program’s output had a very fishy smell.

Buried in the default assumptions were unrealistically high market returns and low volatility. Contrary to Jeremy Siegel’s book “Stocks for the Long Run,” stocks are not a sure thing as shown by Edward F. McQuarrie, professor emeritus at Santa Clara University’s Leavey School of Business. 

Over the years, I’ve reviewed many Monte Carlo simulations and outputs run on those simulators. I’d say that roughly 99% of those are using assumptions that could only exist in a fantasy world. I’ve seen simulations run using a base average return of 10% annually and then adding a couple of percentage points to reflect the planner’s stock picking ability.

Naturally, financial planners want to make clients feel good about placing their financial futures in our hands. This means we have an incentive to pick assumptions showing a bright financial future. To illustrate, during the financial crisis, by 2009 many people were saying Monte Carlo simulations were dead, as stocks falling by half was a one-in-a-million event. By my calculations, it was barely a two-standard-deviation event, meaning it could happen every 20 years. To make matters worse, I typically see no assumptions to account for costs the client is paying on the portfolio.

In addition to portfolio returns and volatility, I often see budgets that list detailed expenditures but exclude lumpy expenses like buying a new car. Most of the time, I don’t see a line item for contingencies. But one thing we can expect is large unexpected expenses. These could include getting a new HVAC system, deductibles for hailstorms, braces for the kid and on and on.

The point is to get realistic on modeling assumptions and then make sure the results are reasonable. As they say, “garbage in, garbage out.” 

Stop Nominal Thinking

Perhaps the second biggest mistake I see in financial planning is nominal thinking. People were happier earning 10% decades ago when inflation was at 12% than today, when Treasury bills are yielding 5% and inflation is at 3.4%. While both scenarios may lose spending power after taxes, the first example loses far more. 

Other mistakes stem from assumptions about living off the income from investments. Some people come to me saying that their portfolio only needs to yield 5% and they can live off the income. As an example, if a client needs $50,000 a year (above Social Security) and they have a $1 million portfolio, they will never need to touch the principal and will leave this $1 million to the kids. But this example ignores inflation, which ran at 3.4% over the past year. At this same inflation rate, one will need more than twice this amount in 21 years just to keep up with inflation. In other words, that $50,000 in the future would buy less than $25,000 of goods and services today.

With such uncertainty about inflation and more than $40 trillion in national debt, it’s critical to think in real terms.

Stop Counting Return of Principal as Income

I’ve had so many people come to me thinking they have bought income for life via various insurance products. The simplest is a single premium immediate annuity (SPIA). For example, as of Sept. 15, a 65-year-old man can buy a SPIA yielding 8.11%. That’s so much better than the current 5% yield of a Treasury. 

How does the insurance company provide so much more income? They frame it using an apples-to-oranges comparison. The Treasury is pure interest (though nominal), while the SPIA is worthless when the annuitants pass away. Of course, one could buy these products with certain guarantees like 10-year period certain or guaranteed return of principal, but these lower the payout rates.

This method of counting return of principal as income is also used by the municipal bond industry. Most munis are issued at a premium and will be called or mature at par, so much of the so-called income is just the amortization of premium, which is the return of the investor’s principal. Only directly owned munis (or through SMAs) are allowed to use this overstatement of income. Mutual funds and ETFs are regulated by the Securities and Exchange Commission and are not allowed to treat this return of principal as income.

Eggs and Baskets. All three of these money illusions make us feel great. We all want a 99% chance of success in our financial lives, live only on our income and get a guaranteed 8.11% return. They give us such a sense of peace and security. Unfortunately, they aren’t real. 

I don’t think many plans have more than a 90% success rate over 30 years. On the plus side, it is getting easier to live off one’s income now that TIPS are yielding over 3% above inflation. This means a $1,000,000 portfolio of TIPS can produce $30,000 real income while the principal keeps up with inflation. And, while not income, it can produce a 30-year real cashflow of nearly $50,000 annually. But even that wouldn’t have a 99% success probability, nor would I recommend someone’s entire nest egg go into any one basket.