Generating Perpetual Passive Income – Contrasting the American and British Way of Measuring Wealth (Guest Post)

Generating Perpetual Passive Income – Contrasting the American and British Way of Measuring Wealth (Guest Post)

There are two ways of measuring wealth.

wealth-rich-money

This post was originally posted here. The writer, Kyith is a veteran community member and blogger on InvestingNote, with username known as Kyith and 700+ followers.

I didn’t realize this explicitly. I did note this implicitly.

The American Method of Measuring Wealth

The first way is the American method. In United States, when they refer to wealth, you tend to hear someone say, “He has a net worth of $1,500,000.”

What she means is that if this person in question sold her assets, settled all her debts and deposited the remainder of her money into a checking account in a particular bank.

This method of measuring wealth grew in popularity during the rise of Rockefeller and Carnegie.

We can call this net worth or net wealth (because people find the link of wealth to worth to be uncomfortable)

And you can compute this using the personal net worth here.

The British Method of Measuring Wealth

The second way is the concept very prevalent in Great Britain a century ago. In London, the financial capital of the world back then, you tend to hear someone say, “He has a private income of $100,000 per annul.”

This is referring to the household income generated by her portfolio of investments.

This income represents the money the owner could spend without touching her principal. According to the experts, this is not similar to the sustainable maximum withdrawal rate, which is the constant inflation adjusting method of withdrawing money.

Household Income Accentuates the Functional Utility of the Wealth Compared to the American Method of Determining Wealth

One draw back of the American method of measuring wealth is that some of the assets can be rather unproductive.

Here are some examples:

1.Richer people can own a piece of land that is valued at a very high price but cannot be easily sold. They might not be willing to sell it as it is a family heirloom, many family members vested interest determining what they should do with the piece of land

2.A landed property in land scarce Singapore is very valuable so the landed property, if liquidated can fetch a lot of money. However, in terms of how much it could rent for, it might not perform as well, in terms of per square foot net rent, compare to other forms of property. Against other form of investments it might not provide the same level of efficiency as well

3.You could own many different assets such as an expensive motorcycle, and cars. You should be able to liquidate them. However, if you lose your high tier job, a person might be caught in a frame of mind that cannot readily liquidate these assets and turn them into cash flow. They might be unwilling as well

The British method focus on the functional utility of your wealth. It allows you to see how the wealth can change your life.

The first thing is how much of your expenses, that you pay with your work income, can this stream of cash flow replace. This stream of cash flow increases your current overall purchasing power.

It allows you to:

1.wear nicer clothes

2.donate more to charity

3.expand your investment holdings

4.send your grand children to university

5.have better food

The savvy people would know what to do with a lump sum of wealth. Unfortunately, not many are that savvy. But if you have an inexhaustible stream of cash flow, it is easier to think how you could spend this money to help the people around you and yourself.

Most importantly, it limits you from making poor decisions with your money.

Based on sunk cost theory, if you wake up, you could always say “I do not care about what I do with the cash flow in the past, let me plan what I would do with the cash flow going forward”. If you have a lump sum and you erroneously spend it in an inappropriate way, it is not going to come back.

Majority of the People are Incapable of Effectively Managing Large Sums of Money

I do wonder the interest for your local lottery if they say that instead of $10 million, they say they will pay you $20,000 a month for the rest of your life.

That is basically a lottery winning as an annuity that pays you 2.5% a year.

I think the interest will be there, but there will be less allure, as people are more likely to be taken in by how life changing if they won $10 million dollars.

The reality is that if you win a lump sum, it usually would not last long.

Most people did not spend part of their lives learning effective wealth management, how to deploy wealth in a fundamentally sound manner.

Given a large sum without competency it is likely they will:

1.Deploy the money very inefficiently, based on their limited views of money

2.Spend more than they should (judged by their future self)

3.Engage some one they trusted (who usually tends to be less competent than they think)

This is why there are so much research that shows a lot of lottery winners go bankrupt.

Given an annuity of income, they could make a lot of mistakes, but if they wake up, they can re-optimize how they spend the $20,000 a month to improve their lives and move forward.

The British Method is more conducive to becoming Successful and achieved Financial Independence

If you are in the pursuit of financial independence, or financial security, one way to know whether you are ready or not, how much you need to accumulate and your quality of life in financial independence is to know the amount of cash flow per year you could generate.

Compare that to the annual expense that you have.

Thus there are some assets that has low growth but possibly can give you 8% a year in cash flow. There are assets that gives a lower 3-4% a year in cash flow, but they tend to be inflation adjusting and are more consistent over time.

But the overall idea is that in order for you to pursue some schemes of financial independence, you need to know the functional utility of your wealth very well:

1.Asset A generates 8% a year but likely this 8% will fluctuates and over the long run it earns 5% only

2.Asset B generates 3% a year but it is likely conservative and go up over time

A combination of 1 and 2 might allow you to be financial independent for the duration you require. If you are going for a sabbatical, perhaps more of #1 for example and less of #2.

If you are not looking to use the asset but it is meant for financial security, then you should care less about #1 and #2 but focus on the American way of looking at wealth to grow the absolute size of your wealth. However, always be a student of the kind of asset that allows you to generate cash flow like #1 and #2.

If you are in a high income job, and thinking of retiring tomorrow and you don’t wish to work ever again, you probably need to make up your portfolio of #2.

You cannot relate if you use the American method of thinking about wealth. You would have to think how much income could I generate with that lump sum. When you venture into that, you are venturing into the British way.

How do we Generate Maximum Private Income that Last for a Long Time?

What will be on our mind is how do we generate that income that last for a long time. The kind of income that I described?

In a lot of cases,, these income were generated due to guarantees by particular organization:

1.In the case of lottery, it is some agreement to pay you a recurring cash flow as long as they are under contractual obligations to provide

2.In the case of annuities, it is also a contractual obligation to provide the recurring cash flow, according to the permutations that was written into the contract. CPF Life is one example.

How long these perpetual cash flow would last often are determined by the financial standing of the organization. You can have an annuity that has high return, relative to its competitors, but if the insurance company cannot last so long, then what is the use of an attractive high payout if it will be cut one of those days?

In the exact definition, that private income favored by rich people have the following characteristics:

1.provides a recurring cash flow

2.hopefully the cash flow adjust for inflation

3.the capital is protected

4.the whole portfolio of assets are insulated from unsystematic risk (capital impairment from events pertaining to the company, sector events, concentrated geographical events)

I think this is the holy grail and often the solution is a diversified portfolio of different assets that provides returns in different ways.

Usually, the portfolio is made up of particular assets that have capital appreciation and cash flow yield. The range of returns for each will vary from asset to asset. These assets have different volatility and different events affect the volatility of these assets in different way.

When you put assets of long term positive expected total returns with differing volatility together, you have a portfolio that hopefully is smoothed, that is not so volatile.

In retirement we called this the initial withdrawal rate. And the most common is the 4% initial withdrawal rate. However, the 4% is derived for a 25 to 30 year retirement horizon.

If you wish for it to last longer, or to perpetuity, your initial withdrawal rate needs to be lower. So researchers are always trying to find the maximum lowest withdrawal rate that we can spend based on the retirement horizon.

If you want the money to last till perpetuity, the safest I will say is to spend aninitial 1% of your wealth (which is put in a portfolio of different long term positive expected return assets). For example, if you have $1 mil, you will spend an initial $10,000 a year. For subsequent years, you adjust this $10,000 according to inflation.

Your money is going to last. But you might question whether is that all that you can spend after spending all my life building it up?

In retirement planning, you have to prioritise:

1.an income that is able to cover my real annual expenses

2.last a duration of retirement

3.get the maximum income, taking into consideration #1 and #2, and a volatile portfolio

4.you are not going to do lifestyle adjustments, wealth portfolio adjustments under any circumstances

Your priority is to balance between these factors.

When it comes to private income for a long time, your priorities are:

1.last a duration of perpetuity

2.get the maximum income, taking into consideration 1, and a volatile portfolio

3.you are not going to do lifestyle adjustments, wealth portfolio adjustments under any circumstances

Your priorities is not so much to satisfy the expenses, but to ensure that you extract the maximum income and making the wealth last.

Both retirement and private income is a systematic withdrawal plan, that is, whose aim is to ensure the money last for the duration they specify.

If you are very risk adverse, you want your money to last, so you withdraw less. This means you either need more money, or that the cash flow your portfolio generated is going to very low.

This is just math.

For most that are risk adverse, they can never retire because the amount they need is so great due to them not willing to spend down their capital. At the same time they are unwilling to cut their expenses.

There are not much solution to this.

So how do we get the maximum income that last till perpetuity? We cannot be sure, but based on the research there are a few ways to derive how much you can spend till perpetuity.

I will list out the brief research here (some of this may not make sense and I would probably explain more next time)

1. 2%-2.5% of your Initial Wealth Portfolio. One of the blogs I read recently is Rivershedge. He was a management consultant who has been semi retired since 2010 and comes to this discussion from the scientific and math angle. In a recent article, he summarizes some of his work and make a short comment on his thoughts after spending much time doing all sorts of modelling and reading.

He listed 2% as more or less guarantees perpetuity.

In some of my readings and experimenting, I also came to this conclusion.

In my posts on variable withdrawal strategies and making $500,000 last for 60 years, I tried out different ways of spending flexibly. This is what people say what they will do.

The reality is that you could spend flexibly but you lose purchasing power.

The purchasing power you lost is often 50% of the initial withdrawal rate. So if you start at 4% to 5% of your initial wealth, often your real spending for a long duration is HALF the initial rate. That worked out to 2% to 2.5% most often. Flexible spending does work, that is make your money last, but in reality you are essentially you are spending a real amount of around 2% to 2.5% to perpetuity.

2. 3% to 3.25% of your initial Wealth Portfolio if it is 50 to 60 years. Karsten at Early Retirement Now have did extensive data crunching with regards to the robustness of the safe withdrawal rate.

Since he is also early retired, earn a good income, would not want to work again, and want to leave his money to the next generation, his focus is on finding the maximum withdrawal rate that can make his money last for a long time.

One of the best illustration about this is the following:

There are 5 different tables. In each of the tables, Karsten tested that for each initial withdrawal rate of the initial portfolio value (3% to 5%), against 2 different time horizon (30 and 60 years) and different stocks bond allocation (0% stocks to 100% stocks).

The 5 tables differ in terms of the final asset value he wishes to preserve with the last one meaning preserve 100% of the initial wealth portfolio.

Here are some things you might not notice:

1.there are many who talked about increasing the stock allocations relative to bonds so that you can have a higher withdrawal rates. The figures do seem to say, yes higher stock allocations is better, but in terms of success rates, there is not much difference between 80% and 100% stocks. If you have less than 40% stocks, the success of your money lasting is very weak. All things equal, you cannot have too little stocks, but too much makes less of a difference. The sweet spot is usually between 40% and 80% stocks.

2.if you wish to preserve your wealth (the lowest table), you need enough stocks and your withdrawal rate needs to be low enough

3.it is easier for your money to last 30 years. 60 years or more that is another question all together.

The data do show between 3% to 3.25%.

3. Spend between the long term dividend yield and earnings yield. There is a very strong correlation to how much you can safely spend in the initial year with the valuation of the market.

If the market valuation is high, it is likely you cannot safely spend too much. If the valuation is low or normal, you can spend the most. Usually, the measure of valuation is the 10 year cyclical adjusted price earnings or CAPE for short.

I always have a problem resolving this until I read this 2004 article by James Garland called The Fecundity of Endowments and Long Duration Trusts(hat tip Rivers Hedge).

In the article, Garland explains that the role of these endowment funds and long duration trust is to provide spendable cash for their owners and beneficiaries for a long time.

This makes it very suitable for those folks who wish to preserve their money for a long time. I have written about how the flexible spending strategies these endowments used to ensure their money last for a long time, yet provide enough for their university’s spending budget.

Garland explains that the traditional method of spending used by endowments, which is to spend 5% of the current wealth portfolio value is not good because this would mean the spending budget fluctuates a lot.

Garland also explains that thinking in terms of capital preservation is tough as well because we have to think about what we are explaining in terms of. Is it real or nominal? A good example is that you may have $1 mil in 1982 and in 2018, you have preserved $1 mil, the spending power of the $1 mil 36 years ago is very different from now. Even if you preserve the purchasing power of $1 mil, the problem is that the wealth portfolio average earnings yield now can be rather different from in the past.

Garland believes that if you want the money to last for a long time, the figure is between the dividend yield and the earnings yield. The earnings yield can be computed by inverting the price earnings ratio.

So if the current dividend yield of the S&P 500 is 1.91%. The current Shiller PE Ratio is 29.58 times. If we invert this the earnings yield is 3.34%.

So what we can safely withdraw for the money to last lies between 1.91% and 3.34%.

This is because market valuations are high.

Suppose the Shiller PE ratio is closer to the recent mean of 20 times (5% earnings yield) and the dividend yield is 2.5%, you can afford to withdraw more (between 2.5% and 5%)

If you have accumulated a sum of money, and would like to find out if you are ready to press the button to leave your job, viewing it from the earnings yield perspective, I feel, makes the most sense. If you are in a market where valuation is high, you might have to plan with less spending and more wealth.

However, if you are pressing the button when the market is more attractive in value, then your sum and what you can spend can be more optimistic.

We use the market dividend yield and earnings yield because the most passive approach to having a perpetual wealth machine is to have a broad based equity, bond, real estate, cash portfolio. If you tilt your portfolio, concentrate your portfolio, you might improve the dividend yield and earnings yield.

Your equation will be better. But you will also expose your wealth machine to more concentrated sector, concentrated asset class, concentrated geographical region failure.

As a summary, I took notice of the spending ranges that we can afford:

There are 6 methods with F being the popular 4% initial withdrawal rate and D & E being what is written in James Garland’s article with all equity or a 50/50 portfolio.

There are no firm answers. We can only work on a few angles of looking at this problem.

But I think it is safe to say if you want money to last a long time the answer is usually between this 2 to 3% range. It can be higher if you are lucky to reduce your wealth portfolio volatility, and start your spending down during a much more lower valuation period.

Summary

It will be a strange world, if most of us remarked how wealthy others are by the extend of their annuity. So instead of your friend able to afford this condo and that car, we remarked that he does not have any residual cash flow. His cash flow only comes from his work.

In contrast, this this other friend of ours do not have a condo. Yet his wealth allows him to have a residual cash flow of $50,000 a year.

The danger of comparing a stream of cash flow is that, people would chase for yield, and they will be saddled with assets that tends to be overvalued.

The solution to this is to revert to the American method of viewing wealth, by looking at the net wealth. Look at the net wealth during accumulation and when you are in the wealth preservation stage, closer to when you need the money then look upon the British way.

While you are accumulating, always measure your wealth’s yield potential. This will enable you to determine if you are ready to retire.

The savvy folks reading this would observe that there is no better way among the two methods. It is usually the not so savvy ones that needs to distinguish the difference and learn to appreciate the British methods more.

Thanks for reading.

Once again, this article is a guest post and was originally posted on kyiths profile on InvestingNote. 

Become a part of our community and also see what other investors are saying about the current market right now: (click on the view now button)

button_view-now


InvestingNote is the first and largest social network for investors in Singapore. Find out more about us here.

Download our free app here:

apple   android

 

Comments are closed.