Inflation's Distorting Effects on Taxation of Interest

We've been in the era of 2% inflation so long that many of the distortions it causes have faded from memory. While reading up on iBonds, I remembered one of them: taxes are assessed against total returns, not real returns.

High-inflation example: 

• Inflation is 8%
• Your aggregate marginal tax rate is 32%
• You earn 10% interest (2 points above inflation)

So your after-tax yield is 6.8%--somewhat below inflation, so you are not even quite preserving your capital.

Low-inflation example:

• Inflation is 2%
• Same aggregate marginal tax rate of 32%
• You earn 4% (2 points above inflation)

Your after-tax yield 2.76%--somewhat above inflation.

Excellent Retirement Drawdown Calculator, Factors in Social Security and Pension

This calculator is fantastic. It takes care of a really hard part, which is factoring in years between "early" retirement, and time you start receiving Social Security and/or a pension. Also factors in inflation. For what it's worth, my investment rate of return assumptions are:

• Middle/Mildly Optimistic: 7% return, 2% inflation
• Moderately Conservative: 6% return, 2% inflation

Very important note--this assumes 100% equities. If you take a route that involves less market risk and lower volatility, you will likely have substantially lower inflation-adjusted returns. It also assumes that your savings are tax-sheltered; either retirement accounts (fully tax sheltered) or long-term investments (mostly tax-sheltered).

Assumed returns are over the very long term, mind you. Any time horizon under 10 years may well be less predictable (not that there are any guarantees of predictability--this is a build-your-own annuity). Also, as I write this (Feb 2021) the market has been so strong for so long, that I make a near-term adjustment. I assume zero market returns for the next 4 years. That could come either as a near-term correction, and then a return to more normal returns; or it could come as 4 years of stagnation. (DISCLAIMERS: these are just my own uninformed guesses that I bake into my model. Nothing magic about 4 years, either, just my guess/model.)

So to use the calculator, you need to have an idea of how much income you need/want in retirement, and also how much pension and Social Security income you will have (the latter can be looked up online). For instance, here is a model run using some nice round numbers:

This model is for someone who retires today at age 60, and waits until they are 67 to begin drawing Social Security. Here are the results (some intervening years omitted for brevity):

They will run out of money in 20 years, at age 80. 

A crucial aspect of the model is that it factors in inflation. This is absolutely essential. Even with the very low inflation we have been experiencing for many years now, over a decadal timescale inflation  has a huge impact. (Again, the model is only going to be good as your wild guess on inflation, but that is much, much better than ignoring inflation.)

Also crucial to remember: the calculator does not factor in income tax. So that $7000 monthly income could translate to more like $5400 post-federal and state income taxes.

For modeling how much savings you will have at point of retirement, there is another calculator in the family. As for determining your budget, that's an exercise for the reader, but I will offer a few things to consider:

• Don't forget, since you don't pay Social Security taxes from retirement income, your monthly income need is effectively ~7.5% smaller.
• Likewise, in retirement you obviously no longer need to save for retirement, so that is another chunk of your monthly budget to the good.
• If you have significant after-tax savings, the tax rate will be lower. In the case of Roth, tax rate is zero. In the case of regular, non-retirement-account savings, the LTCG is 15%, instead of your 22-24% federal income tax bracket (though I wouldn't be shocked to see that differential eliminated in the future).

Finally, a limitation of the model is that it doesn't factor in cost of health insurance, prior to being Medicare-eligible. And we all know that can be well into double-digits. It also doesn't factor in when you are done paying off a mortgage, which would also be very helpful.

Can't Believe Day Trading Is Back

I observed the foolishness 20 years ago, in the original 90s dot-com bubble. If you don't know better, and want to believe, I suppose it is easy enough to confuse a broadly rising market with being a skilled stock picker. Compounded by the ever-greater convenience, pandemic-driven doldrums, and gambling-like-thrill.

Retirees Should Still Have a Heavy Stock Allocation

I've seen a few articles like this recently: Retiring Into a Shaky Market? Think Long Term Anyway

I am always 100% equities with retirement savings, and always envisioned to continue to be heavily allocated in stocks through retirement.

The one thing that troubles me a little is really bad timing. Market goes down 40% the very year you retire. So this article makes two points that seem like good tweaks.

I like the buffer asset idea. Carve out a relatively small amount of your portfolio in cash. Then as the advisor says:

A really simple rule that I found works quite well and does just as well as more complicated rules, is that you just look at your portfolio balance on the date you retired. Whenever the current balance is less than that number, draw from the buffer asset. Otherwise, you withdraw from your portfolio. This is simple and works well.

I wish they would have given some guidance about how big the buffer should be. I'm going to say, enough to fund 2 leaner-than-ideal years.

I also like this idea:

Some retirement experts have found that an even more conservative mixture at retirement may be ideal. What they suggest next is counterintuitive, but underscores the long game that is the stock market: Instead of maintaining that lower allocation to stocks, they suggest you gradually increase it as you age.

So one thing that could imply is, starting to convert your buffer steadily to equities after, say, 5 years.

Pro Sports Unions Should Aggressively Protect Members Financially

Sad story that superstar running back Adrian Peterson is broke. I think pro sports unions should be as aggressive as possible in protecting their members financially. Which generally means protecting them from themselves. Negotiate for something like 15% salary matching in an approved, low-expense, diversified fund that can only pay an annuity, no touching the principal until age 65.

I don't claim the 15% will be extra money to the athletes. It would effectively come as a reduction in salary. But for newly-wealthy pro athletes, it is money that will never be missed, and will hopefully save them from future penury.

What if Everyone Had the Risk Tolerance to Invest in Equities?

I invest 100% in equities. I have no plans to change this, even in retirement (still years away). Both theory and empirical evidence indicates that, over a reasonably long time horizon, equities provide a much better rate of return than bonds or, heaven forbid, CDs. So my question is, what would happen to the economy if all savers had a risk tolerance for equities? Set aside the transition effects, obviously it would be disruptive if it happened overnight. But assume over the course of a generation, everyone wises up and develops the risk tolerance for equities. What would happen?

1. Would return on equities go down, since more capital is available?
2. Would economies become more productive, since middlemen are being cut out, and risk capital is available?
3. Something else entirely?

Hedge Fund Skepticism

I'm a major skeptic of hedge funds. Actually that is an understatement. I'm highly skeptical they could beat the market before fees. Taking their outsize fees into account, I'm certain they are a losing proposition. Glad Calpers is waking up to this.

Probably Best to Pass on the Lump Sum Pension Offer

I served spent the first 12 years of my career at Otis Elevator, back in the waning days of when defined benefit pensions where still "a thing". So happily I crossed the magic 10-year-mark and am vested, though between the short time of service and low early-career salary basis, it is really a pretty small amount. Material to one's retirement calcs, but only just.

Anyway, I just received advance notice of a forthcoming optional pension lump sum distribution offer from UTC/Otis.  I.e., rather than receive a small monthly payment for the rest of my life starting age 65, I could receive a chunk of cash now, to invest as I see fit (taxable if not rolled into an IRA of course). Without even researching it, my immediate assumption was--almost certainly disadvantageous. It's a classic information asymmetry problem. Other than the minor effect of transaction costs, it is a zero-sum game, so if it were a good deal for me, why would they be making the offer? (One article even likens it to the famous "marshmallow test" of willpower in children.)

I did a little generic research, and it supported my bias and explained the timing:  First, the Internal Revenue Code allows plans to use a higher interest rate in calculating the lump sum than is used by insurance companies in pricing annuities. Second, the Code allows companies to use less conservative mortality tables than those used by insurers.

So I'll probably go to the effort to run a fuller quantiative analysis, but I'm pretty sure I know that the resulting decision will be to pass on the lump sum.

(I realize there are special cases, such as you are age 45 and diagnosed with a terminal illness. Please let's not get into those, they are important for the small number of people to whom they apply, but they utterly distract from the general discussion. :) )

True Value of 15% ESPP Discount

Disclaimer: I am an amateur. I did spend a few hours researching and modeling this. But there is always the possibility I used bad information or, more likely, made a mistake.

My current employer is the first with an Employee Stock Purchase Plan (ESPP). As is typical with such plans, it offers a 15% discount, and up to 10% of one's base salary can be directed to the ESPP. So even if you are generally disinclined to invest in specific stocks, as opposed to broadly diversified mutual funds, this is too good a deal to pass up.

However, what I didn't realize until recently, when I had reason to sell some of the stock, was that it is better than a 15% discount. Considerably better, for several reasons.

First, getting to allocate 10% of your base salary to stock, and buying it at a 15% discount, sounds like a 1.5% bonus. But the benefit is actually the reciprocal of 1.00 - 0.85, or 17.6%. So noticeably better than a straight 15%.

Then there are the tax effects. Two considerations here. First, Qualified ESPPs are not subject to payroll taxes[1]. So no 7.65% FICA. Second, so long as you hold the stock long enough[2], that discount is taxed as long-term capital gains, rather than ordinary income. Your mileage will vary, depending on tax bracket, but a typical scenario would be a 15% rate, rather than 28%. The state's bite, in my state of MN, is unchanged at about 8%. So instead of a total FICA + Fed income tax + State income tax bite of 42%, your rate is only 23%. That means your take home is .77/.58, or 32.7% greater.

So the 17.6% discount, multiplied by a 32.7% benefit from the tax treatment, gives you an effective benefit of 2.34% of your total income, assuming you invest the max 10%. More than a 50% increase in the apparent 1.5% benefit. Most 401k matching is 3%, so one way to view that 2.34% gift is that is almost doubles your 401k match.

But Wait, There's More!

There is more to that 401k parallel. Just as a 401k gives you the opportunity for tax-deferred compounding, so does ESPP compensation--so long as you hold the stock. (That does have a downside, though. Over time, you will accumulate a very large position in a single stock--the non-diversified anti-pattern. Worse yet, it is the stock of your own employer. So my preference is to flip the stock. Hold it long enough to get favorable tax treatment, but then sell it--even as you continue to buy more to get that discount on the new purchase.

One More Thing

Some ESPPs have a "look-back" provision. This establishes the purchase price as the lower of the price at the first day of the period or the last day of the period. This has a couple of benefits versus the last day of the period. In ordinary circumstances, the first day price would be a few percent lower than the last day price. So getting the first day price is more than ample compensation for having your contributions tied up for 6 months, earning no interest. Moreover, if the stock does particularly well, the value of the lookback is greatly increased. On the other hand, in the event of a downturn, you are still protected, receiving the last day price.

Notes 

[1] I'm pretty sure this is true. I found websites that say this, but I had to look really hard, and some seemed to suggest that this might change.

[2] The holding period is tricky. Many people will know there is a 1-year holding period to receive the very favorable long-term capital gains rate. But it turns out there is a 2-year-from-grant-date for the discount to be treated as a capital gain, rather than ordinary income.

Donate Anonymously

A couple of years ago, I gave $50 to an issue-oriented charitable cause. It was a one-off donation, given as a show of support when their issue was front-and-center. I had no intention of becoming a regular supporter.

I should have donated anonymously.

Ever since, I receive 2-4 mailings per month, from this and related organizations, soliciting additional donations. Donations which most definitely will not be forthcoming. If we value the cost per mailing at $0.50, easily half of the value of my donation has been consumed, thus far, in soliciting further support.

It's sickening. Besides the junk-mail nuisance and natural resource waste, the sheer inefficiency of the process is appalling. I'm not singling out this organization, I'm pretty sure this is the dark nature of the organizing/fundraising process. Years ago, I read snarky advice, somewhat but not entirely tongue-in-cheek, that if you wanted to inflict harm on a cause you dislike, the thing to do would be to give them a small amount of money. $15, say. Then sit back and watch as they spend several times that amount in the following years, in the hopeless effort to inveigle further contributions.

I wish I had remembered that bit of wisdom.

Life value of defunct companies like Borland

This post on Dropbox and Evernote got me thinking about something I have always wondered about--what is the value of a lifetime investment in a once-highflying company that eventually founders and becomes defunct, through bankruptcy or acquisition? For whatever reason, Borland is the company I usually think of in this regard, but there are many others of course. Do they pay enough dividends along the way to make it still a decent, if not spectacular, investment, if one holds it from, let's say 1 month after going public, until the bitter end? 

Analysis of Differential Tax Rate Impacts on Timinig of Exercising SARS

Okay, the title is a bit of a joke, I am sure the quality of this analysis is nowhere near the kind of academic rigor that title suggests. (Heck, it's not even peer-reviewed, so there is always the possibility I am just outright wrong.)

Anyway, the proposition I wanted to evaluate: if one has SARS (Stock-Appreciation Rights) that are significantly above water, is there a benefit to exercising them early, for the sole purpose of ensuring all future gains are taxed as long-term capital gains (LTCG), at a rate of 15% + State? In MN, that would equate to about 22% in the typical case. As opposed to holding them as long as possible, in which case all gains will be taxed as ordinary income (OI), at a rate of 28% + State? Again, in MN that would be about 35%.

To cut to the chase, the answer is an emphatic no, do not sell prematurely for tax considerations!!!

This is what I thought going in. A general rule of investing is that tax considerations should take a back-seat to investment strategy (don't let the tax tail was the investment dog). The reason I had to work this out to convince myself, though, is because of the rate differential. I wanted to see if cashing out at some early point, and thereby subjecting all future returns to the much lower LTCG rate, would offset the benefit of deferring taxation as long as possible by holding to maturity.

I am fairly confident that cashing out early is not optimal, under any scenario, given my reasonable, simplifying assumptions. Those are:

• No market timing. Uniform rate of return for all years. Obviously this is not what happens real-world, but over a reasonable long time-horizon, it should be a good approximation.
• Early-exercise proceeds, net of taxes, are immediately reinvested in the same stock (with zero transaction costs).

The model pasted below uses a 6% return on capital, and a 20-year time horizon. For simplicity, it assumes a grant value of $10,000, but any grant value will illustrate the same results. I played with all the parameters, and they affected the relative penalty of early exercise, but never resulted in a scenario where early exercise was optimal.

(A copy of my model is available here.)





So in the scenario above, each row shows the NFV of the investment at 20 years, if it were subject to early exercise at the year denoted in the row. For example, if the initial grant of $10,000 were cashed in at the end of Year 4, and immediately reinvested in the same stock, the value after 20 years would be $3,756. Whereas if held to its 20-year "maturity", the value would be $14,346.

In hindsight, the explanation is blindingly obvious. Before you cash in, you have the entire $10,000 basis working for you. At the point you cash in, you only have whatever you have gained working for you. I think it is a bit analogous to killing the goose that lays the golden eggs, thinking you can invest all those unlaid eggs now, versus taking and investing the eggs as they come.

Concluding thought: The idea of  attempting "market timing"--never a good idea--is wildly inadvisable in the case of SARS (and I think much the same analysis goes for stock options).

Lifetime ROI of Once-Thriving Companies that Go Bust

Just 15 years ago, Borders was growing nationwide. They were wiping out the independent booksellers. Now they are going bankrupt. That reminded me of something I have wondered about, each time I hear the story of a relatively young, successful company that goes bankrupt, or is acquired on the cheap (e.g., Borland).

That questions is--if you invested in the company from "Day 1" of its going public[1], and held your investment through bankruptcy, what would your lifetime ROI be? It seems to me it would most likely not be very good. Most high-growth companies pay little or nothing in the way of dividends. So there wouldn't be much time between no-dividend growth company, and falling star, in which you might get nice dividend payouts.
__________
[1] I want to define Day 1 in a way that factors out any IPO bubble hype. So let's say that is defined as 30 days after IPO.

More Mortgage Problems

I am afraid I agree with this article, that lays out a reason why the mortgage crisis will continue unabated:

It seems that the majority of investors, economists, and governmental leaders are overlooking a very important right hand side of this mortgage rate reset graph. The subprime loan reset period (represented by the green bars) may be nearing the end, but the lightly-shaded yellow bars represent $500 billion worth of option-ARM loans expected to reset from mid 2009 through 2012.

I also think the author is overlooking another factor, which is that 5/1 and 7/1 ARMs for non-subprime borrowers will also be re-setting in the next few years. The results may not be quite as catastrophic, but there will still be a lot of rate jumps, particularly if prevailing rates go up between now and then.

Prepare for a Gruesome Retirement

Scary, scary article on the retirement prospects of those working today. Although my ideological ideal runs toward libertarian and laissez-faire, I think this problem is severe enough that I would, at least in theory, support government-mandated personal retirement savings.

Private Equity Like S&Ls?

I'm sure I'm not the first person to note this, but it seems to me the

The funds typically get 20% of profits in an up year, in addition to a (relatively) small "keep the lights on" management fee. In a down year, they collect the managmenet fee, but if there are no profits, they get no returns. However, I don't think there is typically a "carry forward of the losses". So in the world of private equity management, it is better to go 30, -40, 25 (average return to investors of roughly 5%, but fees of 11%), than to go 10, 10, 10 (average return to investors of 10% but fees of 6%). It's a bit like bookmaking, where the tie goes to the house.

So the motivation is to have some REALLY BIG years, even if that also means having some REALLY BAD years. It reminds me a bit of the pattern for the federally insured S&Ls that crashed 2 decades ago. If your worst-case is to lose nothing (because your government-sponsored insurance will cover any losses), then you almost, almost have a fiduciary responsibility to your investors to take huge risks, if they have a greater expected return than safer alternatives (and it is axiomatic that they should).