When we think of retirement nowadays, we may not realize that the idea is a relatively modern concept. Conventional “retirement” was a new notion, invented only 126 years ago by German Chancellor Otto von Bismarck. His idea was to retire the older members of the national workforce, in order to free up jobs for Germany’s young people.
An astute politician, Bismarck was less interested in their economic well-being than in avoiding potential social unrest. He knew that when young people have no work prospects, they often inconveniently turn to revolution as an outlet for their energy.
Fast-forward from 1881 to 2007, and the concept of retirement is in flux once again. The conventional standard doesn’t fit into our lives as well as it used to, when people would often work for the same company all their lives. Today we live longer, we have different skill sets, and we perceive the work-life balance differently. In short, we face retirement challenges unknown in Otto’s day.
One such challenge is that many lifelong professionals have no particular desire to stop productive work simply because they reach a certain age. For instance, I have a good friend who runs a successful law practice. He figures he can earn a six-figure consulting income in his “retirement” by sitting on a few professional boards, and offering his accumulated wisdom for hire.
Then there’s people like entrepreneurial coach Dan Sullivan, co-author of the best-selling book Laws of Lifetime Growth: Always Make Your Future Bigger Than Your Past. Dan’s over 60, yet he talks about increasing his business tenfold over the next 25 years.
And we likely all know other creative people who love what they do so much they don’t want to stop. (Even the article you’re reading right now was overhauled by my personal editor, who tells me she’ll never retire from her work – a good thing, as my spelling and grammar need so much attention.)
But there’s one problem with retirement today: people are living so much longer that we now need huge amounts of capital to finance a non-working period that could last for 30 years or more. Because of this, we need to carefully examine our definition of “capital.”
There are two aspects to consider. The first, the one we all know about, sits like a behemoth front and centre of any financial planning: dollar capital, otherwise known as retirement savings. If you combine a 30-year retirement projection with the inflation rate, and throw in a Monte Carlo analysis, you get a required figure that’s in the multi-million-dollar range.
The other aspect is one that most projections tend to ignore: human capital. Simply put, it represents the value of your skills: the amount of income you’re capable of generating through whatever work you choose to still do. (You might also term it “continued earning potential.”)
The people I mentioned above are good examples of human capital. If they choose, they can generate income at any age – depending on how much they decide to work, and on how much the market is willing to pay for their abilities.
In Bismarck’s day, the human capital of most workers was all spent during their short lifespans of back-breaking toil. If you think about it, when average life expectancy was 61, retiring at 65 was no big deal. But it is a big deal today, when you stand a good chance of living until 80 or even a hundred.
So your “human capital” is much more valuable than you might believe. When you work after retirement, every $40,000 you earn is actually worth $1,000,000. Human capital is indexed to inflation since work is worth more when prices go up, and since it takes $1,000,000 to earn $40,000 per year (if we assume a 4% real return), most of us are worth quite a bit of capital.
I’ll leave you with two thoughts. One, be wary of conventional financial-planning models. They often call for impossible savings, and their assumptions are not necessarily rooted in your own personal reality.
And two, make sure that you look after your human capital. As Dan Sullivan reminds us in his book, your future always has the potential to be bigger than your past.
Alan MacDonald is an investment advisor who helps high tech entrepreneurs make smart decisions about money. Contact Alan at Alan.Macdonald@RichardsonGMP.com
Alan MacDonald CFA CFP
Ph: 613-788-8010
Cell: 613-863-5343
Fax: 613-788-8078
343 Preston St. Suite 300
Ottawa, Ontario
K1S 1N4
www.alanmacdonald.ca
www.RicharsonGMP.com
You may have recently read puzzling newspaper headlines like “billions at risk due to subprime mortgage debacle,” or “crisis in the asset-backed commercial paper market.”
What do those terms mean in simple English? Let’s begin with subprime mortgages. You might think this means a mortgage offered at less than prime rate; but in fact it means a loan to an applicant with a less-than-ideal credit status. It’s the borrower that’s subprime, not the interest rate.
In the old days, if someone asked his bank for a mortgage and didn’t have a down payment, the banker would either turn him down flat, or at least subject him to a series of humiliating qualifications. That’s one good thing about today’s financial environment: there are more options now for less-affluent borrowers.
But there’s a downside to this. In the States especially, some clever bankers and investment houses have teamed up to help make mortgage credit really easy to get. They’ve created “securitized” mortgage pools that consolidate risk. So when a borrower goes to the local bank and gets a loan, that loan doesn’t stay with the individual bank. Instead it gets packaged up with a bunch of similar loans, and is sent to Wall Street for the investors there to work their magic.
Wall Street divides up the loans based on their expected defaults. Let’s say the typical default rate is 5%. So the investors create a pool (affectionately known as the “toxic waste” layer), and take that 5% as equity on their own, or on the bank’s, balance sheet. Then, since they’ve already taken care of the expected defaults, the rest of the layers are assigned much higher credit rankings.
That’s where the fun starts. Hedge funds, ever on the lookout for market inefficiencies, notice that the highest grade of these mortgage pools (also known as “asset-backed securities”) pay out even more than government bonds. Since everyone assumes that the defaults have already been taken care of, the hedge fund borrows a few billion dollars of government money and buys into the mortgage pool.
So far it looks like free money. The hedge fund is making a nice profit on the difference between the borrowing rate and the mortgage-pool interest rate. Pension funds and other market players catch on and start buying these securities too, because they pay a bit more than other instruments.
But there’s a downside that no one is paying any attention to. Back at the bank, money is being passed out like Halloween candy. The bankers don’t worry about it, because they know these loans are only going to be on their books for a few days – or even only a few minutes. Then the loans disappear out of their doors, to become part of those giant commercial paper pools.
Unfortunately, recently the music stopped. Those mortgage default rates soared to unanticipated levels, well outside previous experience and models. Another factor was that real-estate prices took a downturn too. So all of a sudden, the figures that had served so well didn’t work any more.
The real fun began when some investors asked a hedge fund for their money back. The fund had to redeem some of its paper to meet the redemption – and discovered that no one wanted to buy it. When it was finally sold, at a whopping discount, the funds were forced to mark their portfolios to market. Losses were huge.
Then all the investors got panicky and wanted their cash. When everyone decides to sell at the same time, and nobody wants to buy, you have the makings of a rout. The market was sent spinning, and central bankers scurried to the backrooms. Things were pretty hairy there for a while, and the fat cats on Wall Street were wailing for a bailing.
Today, capital markets are in the process of re-assessing all these issues, and re-pricing risk. Financial analysts hope the worst is over; but there may be more panic to come, as even more paper comes due – and we wait to see whether there’s actually any cash on the other side of transaction.
So what should the average investor do? Well, unless you personally own a hedge fund, it’s unlikely that you have any of these dodgy investments. A few money-market funds included them, but they were largely covered by the banks involved. Of course, most pension funds are now being rigorous about disclosing their exposure to these particular assets.
What does all this mean to you, the average investor? One widely felt result is that all your non-government instruments (stocks, corporate fixed income, commercial paper) went down. That’s because the market is currently re-pricing risk to more conservative levels.
But like any crisis, this one will soon pass. Those leveraged players on the fringe will disappear, risks will be priced more appropriately, bank loans will be more carefully scrutinized in future – and as always, properly diversified portfolios will do just fine.
Alan MacDonald is an investment advisor who helps high tech entrepreneurs make smart decisions about money. Contact Alan at Alan.Macdonald@RichardsonGMP.com
Alan MacDonald CFA CFP
Ph: 613-788-8010
Cell: 613-863-5343
Fax: 613-788-8078
343 Preston St. Suite 300
Ottawa, Ontario K1S 1N4
www.alanmacdonald.ca
www.RichardsonGMP.com