Monday, December 24, 2012

Decamillionaires

We’re in the holiday season and I thought it would be fun to talk about dreams of great wealth. The word “millionaire” is mainly used loosely to mean a person with so much money that he or she can spend far more than the average person with no fear of ever going broke. Increasingly, this loose definition does not match up with the more precise definition of a person with a net worth of at least $1 million.

Consider the hypothetical couple, Sam and Christie, both 56 years old. They met working for the same employer and have 3 children, two of whom are still attending university. Their employer is having tough times and they both got forced into early retirement. Unfortunately for them, their skills are mostly useless now that the entire industry they worked in has collapsed. Fortunately, though, they are collecting a defined-benefit pension of $5500 per month.

Using a rule of thumb that an indexed pension is worth about 15 years’ worth of payments, their pensions have an actuarial value of $990,000. Sam and Christie live in a house worth $450,000, but their mortgage is $300,000, they owe $80,000 on a line of credit, $40,000 in car loans, and $20,000 on their credit cards. This gives a net worth of exactly $1 million. Sam and Christie are millionaires.

Let’s look at Sam and Christie’s cash flow. Their monthly debt payments add up to $4700 per month. This leaves $800 per month to pay income taxes, help with their children’s tuition, heat their home, and buy food. Sam and Christie are in serious financial trouble, but they are still millionaires. Obviously, this is an extreme case. But it illustrates how being a millionaire by the precise definition can be very different from the looser definition.

Some readers might object saying that we shouldn’t count pensions. To these people I offer to buy their pensions for one-tenth of its actuarial value (if this is legal). If pensions don’t count as an asset, then these people should be happy to turn their worthless pensions into cold hard cash.

I think inflation has reached the point where we should be saying “decamillionaire” (a net worth of $10 million or more) to mean a person with enough money to be able to spend without worry. Even if $1 million is tied up in a house and $2 million in a pension, and we draw only a 2% income on the remaining $7 million, this is still $140,000 per year.

Of course, it is possible to burn through just about any amount of money as many professional athletes have demonstrated. But, I think the decamillionaire level gives about the right balance between the loose and precise definitions. Now we just have to figure out how to get the $10 million.

10 comments:

  1. Indeed, pro athletes have proven to be able to squander whatever sum of cash they receive. There are some happy exceptions like Barry Sanders or Matt Bonner but too many get too rich too soon (like a lot of Internet millionaires too).

    Merry Christmas!!!

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  2. @Big Cajun Man: Or as I'm going to try to get into the habit of saying, like a lot of internet decamillionaires.

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  3. I wouldn't call someone a millionaire if they only had a million split between them and their spouse.

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  4. @Miiockm: A fair point. Tragically, Sam died a few months before this financial snapshot was taken. The $5500 per month pension that Christie receives is a combination of her own pension and her surviving spouse benefits from Sam's pension. So, all the money now belongs to Christie.

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  5. shouldn't CPP & OAS expectations be included in net worth as well?

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  6. @Anonymous: Quite correct. I didn't want to add too much detail that would distract from the main point that being a millionaire is not the same as being rich.

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  7. "rule of thumb that an indexed pension is worth about 15 years’ worth of payments"

    I suppose that's just assuming that a person will live 15 years in retirement, say retires @ age 65 and passes @ age 80. But the rule-of-thumb seems to break down pretty significantly, at least in my case. I expect to retire in 2015 at age 56 with a pension of 34.2k until age 65 in 2024 when it reduces to 27.3k. It's indexed, so I believe can consider this all in today's dollars. The 15 year value would be living to age 70 w payments of 9*34.2k + 6*27.3 = $472k.

    But I can realistically expect to live longer:
    if live to to 80, it's worth 9*34.2k + 16*27.3 = $745k
    if live to to 90, it's worth 9*34.2k + 26*27.3 = $1,018k
    if live to to 95, it's worth 9*34.2k + 31*27.3 = $1,154k (my financial planning assumption)

    These valuations are much higher than the rule of thumb, so I guess the rule only applies when a person expects to live 15 years in retirement. (Actually, I'm surprised at the greater value in my case; I would have thought it would be actuarily adjusted to give approximately the same value for any retirement age.)

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  8. @Anonymous: You're right that I chose a fairly low valuation for the pension. I wanted to avoid the criticism that the people in my example didn't have a net worth of at least a million dollars. I did this to avoid distracting from the main point of the article.

    Even if we set aside the problem of not knowing how long we'll live, you have to bring back future pension payments at some interest rate to get a present value. If we assume, say, a 3% return above the inflation indexing, 15 years of payments would have a present value of less than just multiplying the monthly payment by 12x15. We then have to factor in mortality probabilities to get a proper actuarial valuation.

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  9. I think there's no amount of income that allows you to spend without thinking, since there's no limit to the amount of money people are willing to take from you. Your example of the sports star (or lottery winner for that matter) illustrate that.

    Maybe we should switch to "millionators": people who earn a million dollars per year?

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  10. @Patrick: My first thought about someone who had a guaranteed income of a million dollars per year is that there would be no shortage of "helpers" willing to provide a large lump sum now in exhange for the future million-per-year payments. So, even if we focus on income it is possible to spend yourself broke.

    I'm content with the decamillionaire level as an amount of wealth that allows a person to spend extravagantly (in the eyes of the average person) without ever running out of money.

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